How debt can become Draconian boot in a sec. 351 exchange.

• Author: Clark, Robert E.

Sec. 351 allows property to be transferred to a controlled corporation by one or more persons without gain or loss recognition.

Example 1: Taxpayer A contributes a building (with a $1 million basis and $3 million fair market value (FMV)) to a new corporation solely in return for stock. Under Sec. 351,A recognizes no gain or loss.

Small changes in facts can alter the results.

Example 2: The facts are the same as in Example 1, except that A received stock and $100,000 in exchange for his contribution. The contribution of the building still qualifies under Sec. 351(a), but A's $2 million realized gain ($3 million FMV--$1 million basis) is subject to Federal income tax, to the extent of the $100,000 boot received; see Sec. 351(b)(1)(A). Further, under Sec. 351(b)(1)(B), had A received property instead of cash, his realized gain would have been taxable to the extent of the property's FMV.

Transfer of Property Subject to Liabilities

Property contributed to a corporation in a Sec. 351 exchange can be (and often is) subject to liabilities; these liabilities are frequently assumed by the transferee corporation. Normally, the liability assumption is in accordance with Sec. 357(a) and will not cause the contributing taxpayer to recognize gain or loss. To be in accordance with Sec. 357(a), the assumed liability cannot be in excess of the contributed property's tax basis, under Sec. 357(c), and must have been generated for a bona fide business purpose, under Sec. 357(b).

Example 3: The facts are the same as in Example 2, except the transferee corporation also assumes a $500,000 purchase money mortgage note on the building. The contribution of the building still qualifies under Sec. 351(a), and A is still subject to Federal income tax, but only to the extent of the $100,000 boot received.

Because the note was incurred for a bona fide business purpose (i.e., the purchase of the property) and the amount of the liability does not exceed A's basis in the building, the assumption of the note does not subject A to tax.

Again, small changes in facts can alter the results.

Example 4: Taxpayer B obtains a $100,000 personal loan by pledging a building as collateral. B keeps the funds and contributes the building (with a $1 million basis and $3 million FMV) to newly formed F Corp. solely in exchange for F's stock. F assumes both a $500,000 purchase money mortgage note on the building and the personal loan.

In Example 4, it would certainly appear that there is no...