Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Determining the Character of Section 357(c) Gain
Fred B. Brown*
Under section 351, a person transferring property to a controlled corporation generally recognizes no gain or loss on the transaction; thus, such transfers are generally free of federal income tax. An exception to tax-free treatment is contained in section 357(c), which generally provides that a transferor in a section 351 transaction recognizes gain to the extent that any liabilities assumed by the corporation on the transfer exceed the transferor’s aggregate adjusted basis in the assets transferred. Over the last few decades, tax scholars have devoted a significant, and possibly inordinate, amount of attention to the issue of whether a shareholder can avoid section 357(c) gain by contributing her own promissory note to a corporation. While this issue no doubt has (or had) practical importance, perhaps a major attraction for tax scholars is that the issue involves fundamental questions relating to basis and liabilities.
Another issue under section 357(c) is the character of gain that is recognized under the provision, that is, whether it should be capital gain or ordinary income. Unlike the “promissory note” issue under this provision, the “character issue” has not received much in the way of extensive scholarly analysis. Yet, the issue seems ripe for a more detailed examination. The statute suggests that the character of section 357(c) gain should be based on the character of the transferred assets, but this does not provide a clear answer when two or more assets of differing character are transferred to the corporation. The Treasury regulations prescribe a method for determining the character of section 357(c) gain in this situation that allocates the gain according to the relative fair market value of the transferred assets. However, a few U.S. Tax Court decisions have not followed this method, and several commentators have stated that the regulatory method is simply wrong; instead, these cases and commentators espouse an alternative method that determines the character of section 357(c) gain based on the relative amount of realized gain on the transferred assets. Similar to the promissory note issue, the character issue involves some interesting fundamental issues, such as the manner in which basis is recovered in section 351 dispositions that involve the assumption of liabilities, as well as the way these dispositions should be conceptualized for tax purposes.
This Article analyzes the section 357(c) character issue and determines which of the competing methods and underlying constructs is more appropriate in light of the relevant tax rules and principles, and in particular those relating to nonrecognition. Part II of the Article begins the analysis by providing a brief primer on section 351, section 357, and related provisions applying to transfers of property to controlled corporations, along with the policies and principles underlying these rules. Part III describes two competing methods for determining the character of section 357(c) gain: the relative fair market value allocation method that is provided under the Treasury regulations, and the relative realized gain allocation method that has been applied in a few U.S. Tax Court decisions and advocated by several commentators. Part IV offers different ways of conceptualizing transfers to corporations in connection with the assumption of liabilities, each of which supports one of the competing methods for determining the character of section 357(c) gain. The relative fair market value allocation method is supported by an aggregate asset construct that combines the tax attributes of the transferred assets; the relative realized gain allocation method is supported by a modified separate assets construct that generally treats the transaction as transfers of separate assets.
Part V evaluates the constructs and resulting methods by examining section 351 and related provisions, including their underlying principles as well as general principles, and determines that the modified separate assets construct and resulting relative realized gain allocation method is the more appropriate manner for determining the character of section 357(c) gain. Part VI considers whether the modified separate assets construct should be modified for assets with secured liabilities, and decides against doing this for conceptual and administrative reasons. Based on this analysis, Part VII recommends the adoption of the relative realized gain allocation method for characterizing
section 357(c) gain, along with a method for coordinating this approach with that used for recognizing gain under section 351(b) where a transferor receives boot in addition to having liabilities assumed. This part also evaluates whether the Treasury has the power to adopt the relative realized gain allocation
method by amending the section 357 regulations without the need for congressional authorization. Part VIII provides the conclusion.
*Associate Professor of Law and Director of the Graduate Tax Program, University of Baltimore School of Law; Rutgers University, B.S. with high honors, 1982; Georgetown University, J.D. summa cum laude, 1985; New York University, LL.M., 1986