Ascertaining the tax impact on the shareholder of a corporate assumption of liabilities in a sec. 351 transfer.

• Author: Ellentuck, Albert B.

Taxpayers have several options for avoiding or reducing gain recognition when transferring debt to a corporation in a Sec. 351 transaction.

Relief of indebtedness is generally a taxable event. However, in most cases, when a transfer of assets qualifies as tax-free under Sec. 351, the transfer of debt (or the transfer of property subject to debt) is not a taxable event (Sec. 357(a)).

The transfer of debt to a corporation will create a taxable event in these three situations:

1. The transfer is made to avoid tax (Sec. 357(b)(1)(A)). In that instance, the full amount of the debt assumed by the corporation is treated as cash (boot) received by the shareholder, and the shareholder recognizes gain equal to the lesser of boot received (relieved debt) or realized gain.

2. If no bona fide business purpose exists for the transfer, the entire debt assumed by the corporation is treated as money received by the shareholder (Sec. 357(b)(1)(B)). In such cases, because money is considered boot under Sec. 351, gain is recognized by the shareholder, but only to the extent of the lesser of gain realized or boot received. For example, assume an individual transfers to a corporation, with no bona fide business purpose, property with an adjusted basis of $60,000 and a fair market value (FMV) of $170,000 along with the underlying mortgage on that property of $80,000. The realized gain will be $110,000 (FMV of $170,000 less adjusted basis of $60,000), and the recognized gain will be $80,000 (the amount of debt). The character of gain (capital or ordinary) to the shareholder usually corresponds to the character of the asset in the shareholder's hands before the transfer.

3. Even if a bona fide business reason exists for the transfer of debt and there is no tax avoidance, gain is recognized by the transferor/shareholder to the extent the aggregate amount of debt transferred to the corporation exceeds the shareholder s basis in the property transferred (Sec. 357(c)). The computation of gain in this situation is applied on a shareholder-by-shareholder basis.

   Example 1. Retaining a liability to avoid shareholder gain recognition in a Sec. 351 transfer: S transferred three properties to T Corp. in a Sec. 351 exchange, as shown in the exhibit. All properties are free of any liabilities except for Property A, which is subject to a $75,000 mortgage. S did not take the legal steps necessary to transfer the mortgage on Property A to T; he remained personally liable for that mortgage and continues to make the monthly payments.

   S recognized no gain as a result of the Sec. 351 transfer. Even though Property A was transferred to 7', the corporation does not assume the liability to which that property was subject. Therefore, the total liabilities transferred ($0) did not exceed the basis of the property transferred ($60,000). T cannot take a basis in Property A greater than the basis in the hands of the transferor ($50,000).

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