Transfer of encumbered property to corporation can have negative tax consequences.

• Author: Hudson, Boyd D.

When a person transfers property to a corporation in return for the corporation's stock in a transaction qualifying under Sec. 351, he normally takes a basis in the stock equal to the basis in the property transferred, plus or minus certain adjustments. Sec. 358(a)(1) provides that the stock basis will be (A) decreased by (i) the fair market value of any property received by the taxpayer, (ii) the amount of any money received and (iii) the amount of loss recognized on the exchange, and (B) increased by (i) amounts treated as a dividend and (ii) any gain recognized by the taxpayer. (In a typical incorporation transaction, there can be no dividend.) If, as part of the transaction, the corporation assumes a liability of the transferor or takes the transferred property subject to a liability, the liability assumed or acquired will be treated as money received by the transferor, thereby reducing basis (Sec. 358(d)(1)). There is a certain logic to this rule, because a taxpayer should not receive a comparable basis in substituted property (the stock) if he is no longer liable for a debt associated with the property transferred. Finally, a transferor recognizes gain on a Sec. 351 exchange if the sum of the liabilities assumed exceeds the transferred property's adjusted basis (Sec. 357(c)).

In a literal interpretation of these rules in Letter Ruling (TAM) 9640001, the Service recently denied substituted basis treatment even though the taxpayer remained subject to the liability on transferred property.

X owned a building that he leased to his 98%-owned corporation, S. The building was subject to three loans made by Bank: one to S, one to X and a line of credit to S. Under the loan agreements, X was personally liable for all three loans...