Let's consider the effects of the assumption of

shareholder liabilities by the corporation.

Nicholas transferred land with an adjusted basis of $20,000,

and a fair market value of $56,000 to

Sunchaser Shakery Corporation in exchange for all of its stock worth $30,000.

The land was subject to a liability of $26,000,

which Sunchaser assumed with no tax avoidance motives.

What amount, if any, does Nicholas recognize?

So, let's begin where we always begin,

and think about whether Section 351 applies.

We have one or more persons transferring property,

and receiving stock, and having 100 percent control immediately after the exchange.

But the one key exception here,

or one key nuance in this particular problem is that the corporation,

that is Sunchaser, is assuming a liability away

from the individual transferring the property.

So normally, the assumption of liability is not considered boot,

and it does not prevent section 351 applying.

That's sort of the basis of this entire lesson,

but we also learned about two key exceptions that we must always be on the lookout for.

Exception one is that if any liability is

assumed by a corporation for tax avoidance purposes,

then all liabilities are deemed to be boot,

but we have no issue here that we're told to

be concerned with in terms of tax avoidance purposes.

Exception two is that we must recognize gain to the extent that a liability assumed by

a corporation exceeds the aggregate tax basis

of all property transferred by the shareholder.

That is unless it gives rise to a deduction such as trade accounts payable.

So with that in mind, let's start looking at the situation for Nicholas.

So let's start where we often start,

and that is with the amount realized.

So the fair market value of the stock that he's going to receive we're told is $30,000,

but the corporation is also going to take a liability off of his hands of $26,000.

So he's no longer deemed to have to pay that liability,

because he no longer owns the asset that has the liability attached to it.

So the total amount realized by Nicholas is $56,000.

So let's now consider the adjusted basis of the property he gave up,

which we're told the land had an adjusted basis of $20,000.

Which then equates to a realized gain of $36,000.

And so the question then is how much

of this realized gain does the corporation recognize?

Well, section 351 applies,

which suggests that there is no gain or loss recognized.

We don't have any boot received,

so that would not trigger any gain recognition.

However, when a corporation assumes a liability away from the shareholder,

we must consider whether those two exceptions apply.

Here we're told there's no tax avoidance motive,

so we don't have to worry about exception one.

However, we do have to worry about exception two,

because the liability that was taken off the shareholders hands,

of $26,000 exceeds the aggregate tax basis of all property transferred, which is $20,000.

So in other words, $26,000 of liabilities exceeds the $20,000 adjusted basis by $6,000.

So Nicholas must recognize $6,000 of the $36,000 gain.

So we can go a step further here and look at Nicholas' basis in the stock.

The problem didn't ask us for it,

but we know how to calculate this so we may as well use the time to practice.

So we can use the basis formula,

which starts with exchanged or carryover basis.

In this case, the property that he gave up of $20,000,

plus any gain recognized by the shareholder of 6,000,

minus the fair market value of any boot received,

which there was none,

minus any liabilities assumed by the corporation.

And this is the first time where we've been able to

use this element of the basis formula.

And here we have $26,000 of basis.

Liability is being assumed, which affects the basis.

So we do all this,

we see that there is a zero basis for Nicholas and his new shares.

And this makes conceptual sense because if Nicholas turned around and

immediately sold the shares that he just received, what would happen?

So let's just check this conceptually. All right.

So if the fair market value is currently $30,000,

and he's immediately sells his shares that have a zero basis,

he'd have a $30,000 gain on the subsequent sale.

All right. He just recognized $6,000 due to the liability issue,

so that would sum to $36,000.

Which just happens to sum to the total amount of

the realized gain that we calculated a moment ago.

So everything reconciles in another sense.

Okay. Now, let's look at Sunchaser here.

So the problem didn't ask for this,

but we can figure out their basis in the assets that they just received. All right.

So we'd have exchanged or carry over basis of $20,000,

that is the basis that Nicholas had in his hands,

plus any gain recognized by the shareholder.

In this case, $6,000,

so we can also compute the shareholder's basis, which is $26,000.

Nicholas forms Sunchaser Shakery Corporation by transferring

assets in exchange for all of the common stock worth $150,000,

and the corporation's assumption of a $200,000 mortgage on the building.

So specifically, we have accounts receivable with a fair market value of $30,000,

and an adjusted basis of $20,000,

a building with a fair market value of $120,000,

an adjusted basis of $55,000,

and land with a fair market value of $200,000,

an adjusted basis of $75,000.

And we want to know what amount, if any,

does he recognize on the transfer.

Where do we begin? Where we always begin,

section 351. Does it apply?

Well, we have a person or persons transferring property solely in exchange for stock,

and afterwards they have control of the corporation,

so section 351 will apply.

The only real issue of concern here is that we have

the liability assumption by the corporation,

so we must consider that as we work through the problem. All right.

So let's start with amount realized,

and then work our way through the steps as we often do.

So what is Nicholas receiving here?

He's receiving $150,000 of stock fair market value,

and of course they are,

the corporation is taking a liability off of his hands, the mortgage.

So total amount realized is $350,000.

The adjusted basis of the property that he's giving up,

is the adjusted basis of each one,

so the 20,000, for the accounts receivable,

55,000 in the building,

and the $75,000 in the land.

Which sums to $150,000,

so he has a realized gain.

Of 200,000, and how much of this realized gain is recognized.

Well, normally, Section 351 will tell us that we don't have to recognize any of it.

However, we know we have to be careful about these exceptions.

And the one that applies here is from Section 357(c).

Which basically says that assuming no taxable in its motive,

the taxpayer must recognize gain to the extent that any liability assumed,

in this case $200,000,

exceeds the aggregate basis of all property transfered.

In other words the sum of the three basis is for each asset, or 150,000.

So in other words, we have a $200,000 liability being assumed by the corporation,

and that exceeds the aggregate basis of all property transferred, which is 150,000.

So, he's going to recognize up to $50,000 of his $200,000 gain.

So, that's basically the answer to the question.

But we can go a step further,

because we now have all the tools to answer other questions,

such as, what is Nicholas's basis in the shares that he receives?

Where we would use our basis formula,

which is exchanged for carry over basis,

in this case the sum, $150,000.

Plus any gain that he recognized,

which we just determined was 50,000.

Minus the fair market value of any boot he receives,

in this case 0, and minus the assumption of

any liability by the corporation, which is 200,000.

And so we see that there's a 0 basis in the new shares,

and we can do a quick check to make sure that that makes conceptual sense.

So, if he had a subsequent sale of the stock,

so let's say that he immediately sells the stock for fair market value,

which would be $150,000 for 0 basis.

He'd have a $150,000 gain.

We just determined that he will recognize right now with

the 351 transaction 50,000 of gain.

So, that would ultimately sum to 200,000,

which equates to our total realized gain from before of 200,000.

We know we've accounted for everything properly, it all reconciles.

Let's take a look at Sunchaser's basis,

and the property that they receive in the transaction.

So they're getting three items of property,

where we have the accounts receivable,

the building, and then the land.

So, we would start with exchange basis in each scenario.

So 20,000, the carry over basis from Nicholas and the accounts receivable,

the 55,000 in the building,

and the 75,000 in the land,

and the rest of the corporation's basis formulas to

include any gain recognized by the shareholder.

And we know that the shareholder recognize a

$50,000 gain as we just computed a moment ago.

But the question is, which asset would we put this to?

Do we allocate it across all three or do we just pick one?

And the short answer is that, we can easily assign the

$50,000 gain to the asset that created the situation.

So, which asset created the situation?

It's the asset which has the mortgage assigned to it,

in this case the building.

So, we don't have to make any adjustments for the accounts receivable or the land,

but we're add the $50,000,

the gain recognized by the shareholder,

to the asset that caused sort of the problem here.

So we can sum all these up and get our final basis numbers for

the corporation in each of the assets.

So, 20,000, 105,000, and 75,000.

And then in sum, we can just make sure that it all makes

sense by checking everything one last time.

So, if we add all these up we would get $200,000,

which just so happens to match the exchange basis in sum,

plus the gain recognized by the shareholder.

So, again, everything balances.

Nicholas transferred property within just the basis of $40,000 to

Sunchaser Shakery Corporation in exchange for all of its stock worth $60,000.

The property was subject to a $35,000 mortgage,

which Sunchaser assumed for legitimate business purposes.

What is the basis in the property received for each party?

So, where will we begin?

Where do you think? To Section 351 apply.

We have one or more persons transferring property solely in exchange for stock.

And then afterwards, we have all of the stock present, so we have control.

So, Section 351 does indeed apply.

The only real issue here again is that we have an assumption of the liability,

which typically does not constitute boot unless one of the two exceptions exist.

The taxable evasion motive,

or the liability amount exceeds the aggregate basis of all the property transferred.

So, we don't have any mention of any tax avoidance issues,

so we don't need to make that assumption.

The question is whether the liability issue arises. So, let's take a look.

Let's start with the amount realized,

which is $60,000 the fair market value of the stock received.

Then consider the $35,000 liability assumed by the corporation,

such that the total amount realized is 95,000.

The adjusted basis of the property transferring is 40,000

such that there's a realized gain of $55,000.

So, how much of this realized gain is then recognized on the tax return?

Well, typically under Section 351,

nothing would be recognized.

We don't have any boot that would trigger gain recognition.

We don't have a tax avoidance motive with the assumption of the liability.

However, we have to check to ensure,

that the liability did not exceed the aggregate basis of all the property transfered.

So, liability is of $35,000.

The aggregate basis of all the property transferred is $40,000.

So, this is, unlike the last problem,

this one it does not exceed it.

So, we do not have to recognize any gain to the extent of this particular liability.

So, there is no gain recognition here.

And 351 just in general,

will prevent that situation from happening.

So, now we can look at the basis in the stock that

Nicholas receives. And how do we do that?

We use our basis formula that we've used many times now.

So we start with exchange or carry over basis of the property contributed.

So 40,000, plus any gain recognized,

which in this case is 0.

Minus the fair market value of any boot received, which is 0.

Minus any assumption of liability by the corporation,

which in this case is 35,000.

So we see that the basis in the shares is now $5,000.

And we can also look at Sunchaser's basis in the property.

And we use the corporation's basis formula

which starts with exchanged, or carry over basis.

In other words what was the basis in the hands of the transfer, which is 40,000.

Plus any gain recognized by the shareholder,

which we concluded was 0.

And so the Sunchaser's basis in the property is $40,000 as well.

Lesson 4.1.2 Assumption of Liabilities: Applications

Taxation of Business Entities I: Corporations

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