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:
- 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.
- 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.
- 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 below. 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 T, 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).
Had T assumed the $75,000 mortgage, S would recognize a $15,000 gain ($75,000 liabilities less $60,000 total basis of properties transferred). If S had merely furnished a personal guaranty on the notes, with the corporation primarily liable, and made the monthly mortgage payments, he would have also recognized gain on the transaction. A personal guaranty by the shareholder does not shift the liability from the corporation back to the shareholder (Seggerman Farms, Inc., 308 F.3d 803 (7th Cir. 2002)).
Only liabilities actually assumed by the transferee corporation are included in computing any gain. A recourse liability is treated as assumed if, based on all the facts and circumstances, the transferee corporation agrees, and is expected to satisfy, the liability regardless of whether the transferor has been relieved of the liability (Sec. 357(d)(1)(A)). A nonrecourse liability will be treated as assumed by the transferee of any assets subject to that liability. However, the amount of the liability treated as assumed will be reduced by the lesser of (1) the amount of the liability the owners of other assets also subject to that liability, but not contributed to the corporation, agree to and are expected to satisfy or (2) the FMV of the other assets subject to the liability (Sec. 357(d)(1)(B)).
Example 2. Assuming nonrecourse debt in a Sec. 351 transfer:Assume the same facts as in Example 1, except that Property A and other land owned by S are subject to nonrecourse debt of $150,000. The land's FMV is $50,000. S makes an agreement with T Corp. that he will personally satisfy $75,000 of the nonrecourse note.
T is treated as having assumed the nonrecourse debt reduced by the lesser of (1) the portion S agreed to personally satisfy ($75,000) or (2) the FMV of the other property subject to the nonrecourse debt ($50,000). Thus, T assumed $100,000 of the nonrecourse debt ($150,000 total debt less the $50,000 FMV of the other property subject to the debt). S received boot in the amount that the assumed debt ($100,000) exceeds his adjusted basis in the property transferred ($60,000), or $40,000, resulting in a taxable gain of that amount.
The IRS has issued a proposed change to Regs. Sec. 1.351-1. If the proposed regulation is finalized, a potential tax-free transaction under Sec. 351 could become taxable if the transferor does not surrender net value and the transferee does not receive net value (Prop. Regs. Sec. 1.351-1(a)(1)(iii)). An exchange of net value would require that a transferor both surrender net value to a transferee corporation and receive net value from that corporation. To surrender net value to a transferee corporation, a transferor would need to transfer property with a value greater than the amount of liabilities assumed (or deemed assumed) by the corporation plus the amount of any boot received by the transferor. In the absence of an exchange of net value, the transactions would represent sales of property rather than issuance of stock for property (see preamble to Prop. Regs. Sec. 1.351-1).
Example 3. Transferring no net value: C, an individual, transfers equipment with an FMV of $90,000 to XYZ Corp. in exchange for 100% of the stock. The equipment is encumbered by a liability of $100,000. Under the proposed regulation, the stock received by C from XYZ will not be treated as being issued for property because no net value was transferred. To prevent the exchange from being disqualified under Sec. 351, C should contribute additional property with an FMV of at least $10,000.
Avoiding or Reducing Gain Recognition
Transferring additional property to the corporation: A shareholder can reduce or eliminate the gain arising from the transferee corporation's assuming liabilities in excess of the basis of assets by transferring additional unencumbered property to the corporation. All assets transferred by the shareholder are aggregated for determining total debt, total basis, and total gain (i.e., the determination of excess liabilities is based on total debt assumed less basis of all assets transferred) (Sec. 357(c)(1); Regs. Sec. 1.357-2; Rev. Rul. 66-142).
The aggregation-of-assets principle includes partnership interests contributed to a corporation. If a taxpayer contributes interests in more than one partnership in exchange for an ownership interest in the corporation, any gain would be computed by comparing his or her bases in all of the contributed partnership interests to his or her combined share of total partnership liabilities. This gives a partner the potential to reduce gain by offsetting a partnership interest in which liabilities exceed basis with another partnership interest in which the basis exceeds liabilities (Rev. Ruls. 66-142 and 80-323; IRS Letter Ruling 8715003).
Paying down debt: Another planning option is to pay down the debt prior to transfer.
Example 4. Avoiding gain on transferred debt in a Sec. 351 transfer:J operates her business as a sole proprietorship. Five years ago, she borrowed $60,000 to update her factory and pledged the factory building as security. The security agreement provides that the building cannot be held by anyone other than the debtor. The loan was set up with no principal payments due until the sixth year. Thus, J still owes the entire $60,000.
The building's FMV is $125,000; J's adjusted basis in the plant (net of depreciation) is $40,000.
J wants to incorporate the business and contribute the building in exchange for stock. However, she does not have the cash to pay off the loan on the factory. Thus, she must also transfer the debt. Since J has a valid business reason for transferring the debt, along with the factory, to the corporation, her motive for the transfer is not tax avoidance.
To comply with the collateral agreement, she must transfer the debt to the corporation with the factory or repay the loan. However, the amount of debt assumed by the new corporation ($60,000) exceeds J's basis in the factory ($40,000). Thus, she will be deemed to have received boot of $20,000 on the transfer of the factory and the underlying debt to the corporation. Because the amount of boot is less than the realized gain ($85,000), J must recognize a $20,000 gain on the transfer of the factory and debt to the corporation
To avoid recognizing the $20,000 gain, J has the following options:
- She could pay down the debt prior to the Sec. 351 transfer so that the note balance is equal to or less than her basis in the factory (i.e., pay down the debt by at least $20,000).
- She could contribute additional property with a basis of at least $20,000. This will preclude recognition of gain because the determination of excess liabilities is based on total debt assumed less basis of all assets transferred.
Transferring the shareholder's personal note to the corporation: In Lessinger, 872 F.2d 519 (2d Cir. 1989), the taxpayer transferred an accrual-basis sole proprietorship to a corporation in a transaction qualifying as a Sec. 351 transfer. However, the liabilities transferred exceeded his adjusted basis in the transferred assets by approximately $250,000. To make up this deficit and avoid recognizing gain, he also transferred his personal note, in the amount of the deficit, to the corporation.
Both the IRS and the Tax Court ruled that he recognized the gain because he had a zero basis in the personal note. However, the Second Circuit found that even though the taxpayer had no basis in the personal note (it was his liability), the corporation had basis in the personal note. The corporation had basis because it incurred a cost in the transfer equal to the excess of the liabilities over the other assets transferred. The corporation would recognize income as the shareholder made note payments if the corporation had no basis in the note. The court further reasoned, in measuring the excess of liabilities over adjusted basis, that it was the corporation's basis, not the taxpayer's, that mattered. The court also concluded that Sec. 362(a), which gives the corporation a carryover basis in a Sec. 351 transaction, did not apply to the taxpayer's debt. The Ninth Circuit majority in Peracchi, 143 F.3d 487 (9th Cir. 1998), did not follow Lessinger (which focused on corporate basis in the note) but found the note to be real and entitled to basis equal to its face value (at least for Sec. 357(c) gain purposes).
In the Seventh Circuit's Seggerman Farms case, the taxpayers alleged that their guaranties on debt that was transferred in a Sec. 351 exchange were the same as transferring personal notes as was done in Peracchi. The taxpayers transferred their farming assets and debt (that exceeded the basis of the assets) to a new corporation. The court ruled that the taxpayers recognized gain on the transfer. The court noted that a guaranty is not the same as transferring personal notes because a guaranty is a promise to pay only if certain events occur.
The Lessinger and Peracchi decisions conflict with a previous Tax Court decision as well as the stated position of the IRS (Alderman, 55 T.C. 662 (1971); Rev. Rul. 68-629).
Example 5: Using a shareholder's personal note to avoid gain on a Sec. 351 transfer: H wants to avoid recognizing $20,000 of taxable gain on incorporation; however, he does not have the cash to pay down the debt or any additional property to contribute to the corporation. He is considering contributing a $20,000 personal note to the corporation to avoid taxable gain.
The IRS might challenge this approach during an audit, assuming H lived outside the Second and Ninth Circuits. Within any circuit, the note should be properly structured (e.g., have a market rate of interest, include a reasonable repayment schedule, and be collateralized, if possible) to withstand scrutiny.
Observation: Since promissory notes from purchasers are commonly treated as cash when determining the basis of the property in the buyer's hands, it seems logical to treat a note like cash when determining the basis of the property transferred in a Sec. 351 exchange.
This case study has been adapted from PPC's Tax Planning Guide—Closely Held Corporations, 29th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.