A Definition of Liabilities in Code Sections 357 and 358(d)

Internal Revenue Code section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation solely in exchange for its stock or securities and the transferors control the corporation immediately after the exchange. If, in addition to receiving stock or securities in an exchange that would otherwise qualify for section 351 treatment, a transferor receives other property or money -- boot -- any realized gain is recognized up to the amount of the money and the fair market value of the other property received. The transferee corporation\u27s assumption of the transferor\u27s liabilities or its acquisition from the transferor of property subject to a liability is not treated as boot unless the principal purpose of the assumption or acquisition was to avoid federal income tax or was not a bona fide business purpose. Regardless of the transferor\u27s purpose, however, he will recognize gain under section 357(c) to the extent that the sum of the liabilities transferred exceeds the aggregate adjusted basis of the assets transferred. Section 357(c) has caused significant problems for cash method taxpayers seeking to transfer the assets and liabilities of a going business in a section 351 exchange. In Peter Raich, a cash method taxpayer transferred all of the assets and liabilities of his sole proprietorship to a controlled corporation. The proprietorship\u27s chief asset consisted of more than $77,000 in trade accounts receivable; its liabilities exceeded $45,000 and included more than $37,000 in trade accounts payable. While the Commissioner of Internal Revenue stipulated that the transaction qualified as a section 351 exchange, he successfully claimed in the Tax Court that the trade accounts payable were liabilities within the terms of section 357(c), and that the trade accounts receivable had a zero basis. Accordingly, although the book value of the transferred assets was almost twice the face amount of the transferor\u27s liabilities, Raich recognized a taxable gain of $34,741.08, the amount by which the liabilities assumed by the corporation exceeded his basis in the transferred assets. Two subsequent Tax Court cases, Wilford E. Thatcher and David Rosen, have followed Raich; the Second Circuit, in Bongiovanni v. Commissioner, has rejected it