When you transfer property to a corporation, the corporation often assumes any liabilities attached to that property. Normally, assumption of liabilities is treated as a taxable “boot” – as if you received cash. United States v. Hendler, 303 U.S. 564 (1938). But that would make it very hard to incorporate a leveraged business without immediate tax.
Congress solved this with § 357. Under § 357(a), assumption of liabilities is not treated as boot for purposes of § 351(b). But there’s a catch: § 357(c) provides that if the amount of liabilities assumed exceeds your adjusted basis in the property transferred, you have to recognize gain – even if you receive no other boot. The gain is the amount of the excess.
Drybrough v. Commissioner, 376 F.2d 350 (6th Cir. 1967), shows how this plays out. Drybrough transferred properties subject to mortgages to four newly formed corporations. The liabilities exceeded his basis, so under § 357(c) he had to report gain. But the IRS argued that § 357(b) applied instead – that the principal purpose of the transfers was tax avoidance, so all liabilities should be treated as boot. The Sixth Circuit disagreed, at least for the older mortgages. The court said the “tax avoidance” purpose must relate to the assumption of liabilities itself, not the original borrowing. For one mortgage that Drybrough took out just before the transfer and used to buy tax‑exempt bonds, however, the court agreed that § 357(b) applied.
The lesson: If you’re planning to contribute encumbered property to a corporation, make sure the liabilities don’t exceed your basis. If they do, you’ll have immediate gain. And don’t incur new liabilities just before the transfer solely to avoid tax – that can trigger § 357(b) and make the whole liability taxable as boot.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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