Liabilities Assumed by a Corporation in an Exchange
There are three issues involved when a corporation assumes your liabilities in an exchange of property for stock.
- Gain recognition
- Your basis in the stock you receive
- The corporation's basis in the property it receives
Gain Recognition (IRC Section 357-Assumption of Liability):
Liabilities assumed by the corporation (or other party to the exchange), are generally NOT treated as money or other property received by you. Therefore, such liabilities are generally ignored for gain recognition purposes.
However, there are two exceptions where gain would be recognized:
If the assumed liability exceeds your adjusted basis in the property transferred, the excess amount over the property's adjusted basis is recognized gain.
For example, if you transfer property with an adjusted basis of $20,000 and it is subject to a mortgage of $26,000, you would recognize a gain of $6,000.
However, if a liability that is assumed is of the type that would give rise to a deduction, then, no gain is recognized. This generally applies to a cash basis taxpayer for a liability, that, had the taxpayer paid the liability before the exchange, the taxpayer would have gotten a deduction.
For example, assume a cash basis taxpayer bought $100 worth of office supplies on credit prior to the exchange. A cash basis taxpayer only recognizes an expense when it is actually paid. Therefore, if the taxpayer did not pay the $100 liability prior to the exchange, but could have recoginzed a $100 expense (office expense) had the taxpayer paid the $100 prior to the exchange, no gain is recognized if the corporation assumes this type of liability.
You must recognize gain up to the amount of liabilities assumed if there is no good business reason for the corporation to assume your liabilities, or if your main purpose is to avoid federal income tax.
Your Basis in the Stock Your Receive:
Under Section 358(d)(1)-Assumption of Liability, for purposes of adjusting your stock basis in an exchange of property for stock, liabilities assumed by the corporation are treated as if you (the shareholder) received money. Therefore, you must reduce your stock basis by the amount of such liabilities assumed.
However, do not reduce your stock basis for a liability that is of the type that may give rise to a deduction. For example, trade accounts payable.
The corporation's Basis in the Property it Receives:
The rule is:
The corporation's basis in property it receives in an exchange is the same as the shareholder's adjusted basis at the time of the transfer, increased by any gain recognized by the shareholder.
- Return to the Tax Basics for Startups Table of Contents to find related links.