Avoiding gain when a shareholder receives corporate debt.

• Author: Ellentuck, Albert B.

A shareholder's receipt of debt issued by a corporation in exchange for contributed property will ruin an intended tax-flee Sec. 351 exchange, because the debt will be treated as taxable boot to the extent of its fair market value (FMV).

Generally, this is not a problem when the FMV of the property contributed to the corporation equals its basis in the transferor's hands. For instance, if only cash and depreciated personal property with a FMV equal to or less than basis is contributed in a Sec. 351 exchange, the shareholder would recognize no gain, even if the transaction failed to qualify under Sec. 351. However, if property with (1) no basis in the shareholder's hands (such as cash-basis receivables) or (2) a FMV in excess of its basis is transferred, the shareholder will recognize gain to the extent of the lesser of any boot received or the FMV in excess of basis.

Example 1

Bill forms a corporation, Billco, to operate a new business that will be acquired by direct purchase from a third party. Bill transfers $300,000 cash and appreciated real property (with a $200,000 basis and $800,000 FMV) to Billco in exchange for all of its stock. At the same time, he loans Billco $700,000 that he borrowed from a bank. Billco will make the loan payments to Bill, as he is required to repay the bank. Billco uses most of the cash contributed and loaned by Bill to purchase new business assets.

Because Bill has contributed real property with a FMV in excess of basis, he recognizes gain on the transfer to the corporation if the transaction does not qualify as a Sec. 351 exchange. Bill failed the solely-for-stock requirement, because he has also received a debt instrument from Billco in the same transaction; thus, he recognizes $600,000 gain ($800,000 FMV--$200,000 basis in the appreciated real estate). However, with careful tax planning, Bill should be able to avoid this situation.

Example 2

The facts are the same as in Example 1, except that Bill guarantees a loan made directly from the bank to Billco, rather than borrowing $700,000 from...