8.2 Boot, Section 357 Liabilities in Excess of Basis & Section 1244 Stock

Boot, Section 357 Liabilities in Excess of Basis & Section 1244 Stock

While corporate formation under IRC §351 is designed as a nonrecognition regime, real-world incorporations frequently involve non-stock consideration (boot) or encumbered property. When a shareholder receives cash, short-term promissory notes, or other property alongside corporate stock, the transaction becomes partially taxable. Similarly, when a corporation assumes shareholder debt, specific anti-abuse and mechanical statutory safeguards under IRC §357 dictate whether the assumption triggers immediate taxable gain.

Finally, because new corporate ventures entail substantial financial risk, Congress enacted IRC §1244 to incentivize investment in small business corporations. Section 1244 provides tax relief by recharacterizing capital losses as ordinary loss deductions if the business falters.

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Receipt of Boot under IRC §351(b)

If an exchange satisfies the property and 80% control requirements of Section 351, but the transferor receives property other than corporate stock, the non-qualifying consideration is classified as boot.

What Constitutes Boot?

• Cash and cash equivalents
• Corporate debt instruments (promissory notes, debentures, bonds)
• Real or personal property other than the transferee corporation's stock
• Nonqualified preferred stock under IRC §351(g)
• Securities and stock warrants

Gain Recognition Rule: IRC §351(b)(1)

When boot is received, the transferor shareholder must recognize gain equal to the lesser of:

1. The realized gain on the exchange (FMV of all stock and boot received minus adjusted basis of property transferred); OR
2. The fair market value of boot received (including cash).

$\text{Recognized Gain} = \min(\text{Realized Gain}, \text{FMV of Boot Received})$

Absolute Disallowance of Loss: IRC §351(b)(2)

Under IRC §351(b)(2), no loss is recognized in a Section 351 exchange, even if the shareholder receives boot. Realized losses are completely deferred and absorbed into the substituted stock basis.

Character and Allocation of Recognized Gain (Rev. Rul. 68-55)

When a shareholder transfers multiple assets in exchange for stock and boot, the IRS requires an asset-by-asset allocation under Rev. Rul. 68-55:

• The total consideration (stock and boot) is allocated among the contributed assets in proportion to their relative fair market values.
• Realized gain or loss is computed separately for each asset.
• Boot is allocated to each asset based on relative FMV. Recognized gain for each asset equals the lesser of that asset's realized gain or allocated boot.
• The character of recognized gain (ordinary income, Section 1231 gain, or capital gain) is determined by the character of the specific asset, including depreciation recapture under IRC §1245 or §1250.

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Corporate Assumption of Liabilities: IRC §357

When an ongoing business is incorporated, the corporation almost invariably assumes existing liabilities, such as mortgages, equipment loans, and operational accounts payable. The tax treatment of these assumed liabilities is governed by IRC §357.

1. General Rule: IRC §357(a)

Under IRC §357(a), the corporation's assumption of a liability is not treated as money or boot received by the shareholder for purposes of recognizing gain under §351. The exchange remains tax-free.

However, under IRC §358(d), the assumed liability is treated as cash received by the shareholder solely for the purpose of computing stock basis. Consequently, liabilities assumed reduce the shareholder's stock basis dollar-for-dollar.

$\text{Stock Basis} = \text{Adjusted Basis of Property} - \text{Liabilities Assumed}$

2. Tax Avoidance Exception: IRC §357(b)

Congress enacted IRC §357(b) to prevent abusive pre-incorporation borrowing. If, taking into consideration the nature of the liability and the circumstances under which it was arranged, the shareholder's principal purpose regarding the assumption was:

• To avoid federal income tax on the exchange; OR
• Was not a bona fide business purpose;

then ALL liabilities assumed from that shareholder in the exchange are treated as taxable cash boot.

3. Liabilities in Excess of Basis: IRC §357(c)

Under IRC §357(c)(1), if the sum of liabilities assumed by the corporation exceeds the total adjusted basis of all properties transferred by that shareholder, the excess must be recognized as taxable gain.

$\text{Taxable Gain under Section 357(c)} = \text{Total Liabilities Assumed} - \text{Total Adjusted Basis of Contributed Property}$

• Aggregation Rule: Section 357(c) applies on a shareholder-by-shareholder basis. A shareholder aggregates the adjusted tax bases of all assets they contribute to compare against the total liabilities assumed from them.
• Basis Result: When §357(c) gain is recognized, the shareholder's stock basis becomes $0 (Basis = Original Basis + Gain Recognized - Debt Relief = Basis + (Debt - Basis) - Debt = $0).

4. Deductible Liabilities Exclusion: IRC §357(c)(3)

Under IRC §357(c)(3), liabilities that would give rise to a tax deduction when paid are excluded from the §357(c) excess-liability calculation. Common examples include:

• Accounts payable of a cash-method taxpayer
• Accrued trade expenses (unpaid wages, interest, rent of a cash-basis business)

These liabilities do not trigger gain under §357(c) and do not reduce stock basis under §358(d). This exclusion ensures cash-basis sole proprietors with zero-basis receivables and substantial payables can incorporate without catastrophic phantom income.

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Section 1244 Small Business Stock

Stock in a corporation is ordinarily a capital asset under IRC §1221. Under general tax principles, a loss on the sale, exchange, or worthlessness of corporate stock is a capital loss, subject to the stringent $3,000 annual deduction limit against ordinary income under IRC §1211(b).

To encourage investment in small operating companies, IRC §1244 allows eligible shareholders to treat losses on qualifying stock as ordinary loss deductions.

Annual Statutory Loss Caps

• Single / Head of Household / MFS: Up to $50,000 of ordinary loss per year.
• Married Filing Jointly: Up to $100,000 of ordinary loss per year (even if only one spouse owned the stock).
• Excess Losses: Any loss in excess of the annual $50,000 / $100,000 ceiling is treated as a capital loss, subject to standard capital loss rules ($3,000 annual ordinary income offset with indefinite carryforward).

Qualification Requirements for Section 1244 Stock

To qualify for Section 1244 treatment, the stock must meet all of the following requirements:

1. Eligible Taxpayers (Original Issuee Rule): Only individuals and partnerships who were the original issuees of the stock can claim Section 1244 ordinary loss treatment. If stock is acquired by purchase from another shareholder, gift, inheritance, or distribution from a partnership, Section 1244 status is permanently lost.
2. Small Business Corporation ($1,000,000 Capital Ceiling): At the time the stock was issued, the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus cannot exceed $1,000,000.
3. Active Business Test: For the 5 most recent tax years ending before the date the loss is sustained (or for the period of the corporation's existence if shorter), the corporation must have derived more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales/exchanges of stock or securities (passive investment test).
4. Common or Preferred Stock: The stock may be voting or nonvoting, common or preferred (prior to 1984, only common qualified; current law allows preferred stock).

Special Basis Limitation for Contributed Property (IRC §1244(d)(1))

If a shareholder contributes property with a tax basis in excess of fair market value (built-in loss property) to a corporation in a §351 exchange for §1244 stock:

• For computing the Section 1244 ordinary loss, the stock's basis is reduced to the fair market value of the property at the time of contribution.
• Any loss attributable to the pre-contribution built-in loss remains a capital loss.

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Comprehensive Worked Numerical Examples

Example 1: Section 351(b) Boot Calculation

Facts: Marcus transfers a commercial building (adjusted tax basis $60,000, FMV $150,000) to Vertex Corp. for 80% of Vertex stock (FMV $120,000) plus $30,000 cash boot.

1. Realized Gain: Total consideration ($120,000 stock + $30,000 cash = $150,000) minus Basis ($60,000) = $90,000.
2. Recognized Gain (§351(b)): Lesser of Realized Gain ($90,000) or Boot Received ($30,000) = $30,000.
3. Marcus's Stock Basis (§358): Basis: $60,000 (basis) + $30,000 (gain recognized) - $30,000 (boot received) = $60,000
4. Vertex Corp.'s Inside Basis in Building (§362(a)): Basis: $60,000 (carryover basis) + $30,000 (gain recognized) = $90,000

Example 2: Section 357(c) Liabilities in Excess of Basis

Facts: Samantha incorporates her sole proprietorship, transferring business assets with an aggregate adjusted basis of $70,000 (FMV $140,000) and liabilities of $100,000 (equipment loans) which the corporation assumes. Samantha receives 100% of the corporate stock.

1. Section 357(c) Gain: Liabilities assumed ($100,000) minus Total Basis ($70,000) = $30,000 Taxable Gain.
2. Samantha's Stock Basis (§358): Basis: $70,000 (basis) + $30,000 (gain) - $100,000 (debt relief) = $0