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

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. Immediately prior to the transfer, the building was subject to liabilities exceeding X's basis in the building. X transferred the building to S in return for additional S stock in a transaction qualifying under Sec. 351. After the transfer, the obligations to Bank did not change and X continued to make payments on his personal loan. X's position was that, because his obligations did not change as a result of the transfer (i.e., he was still liable to Bank on all three loans), he should take a basis in his S stock equal to his basis in the building prior to the transfer.

The Service found that Sec. 358 applies to all liabilities to which the transferred property is subject, regardless of whether X retained personal liability after the exchange or S assumed any liability in the exchange. In addition, X must recognize gain on the exchange, because the liabilities to which the building was subject exceeded his basis in the building under Sec. 357(c). Therefore, X's basis in the stock was equal to his basis in the building decreased by the liabilities assumed by S and increased by the gain he recognized on the exchange.

Comment: Shareholders should be cautious when transferring property subject to liabilities to a corporation in return for stock. Such a transfer may not only result in gain recognition, but also a reduced basis in the corporate stock received. As can be seen from this ruling, these negative consequences result even though the shareholder's personal liability was unchanged.