I. Introduction
Under section 351(a), no gain or loss is recognized if property is transferred by one or more persons to a corporation in exchange for stock where such person or persons are in control of the corporation immediately after the exchange. Under section 351(b), the shareholder is required to recognize gain to the extent of the lesser of the shareholder’s realized gain or the boot received. Thus, one of the most basic of issues in a section 351 exchange is the treatment of boot and the determination of the amount of recognized gain and the character of the recognized gain in an exchange where section 351 applies. Section 351 has existed in some form since 1921, so it is true to say that the amount of gain recognized by reason of boot in a section 351 exchange is a century old question. Thus, it is perhaps surprising that, even to this day, the Internal Revenue Service (the Service) utilizes a flawed methodology for allocating boot and for determining the amount of gain recognized when multiple assets are transferred in a section 351 exchange. The government’s flawed methodology in Revenue Ruling 68-55 allocates boot based on the relative fair market value of the shareholder’s contributed assets regardless of whether or not a particular contributed asset has any actual built-in gain. The boot allocation methodology in Revenue Ruling 68-55 has become required reading in the leading law school casebooks that address corporate taxation.
But, as pointed out by one of the leading corporate tax casebooks, the allocation of boot based on relative fair market value can, in certain section 351 fact patterns, result in inappropriate negative stock basis outcomes that, in turn, fail to accomplish the relevant design parameters of sections 351, 357, and 358. As this article will seek to demonstrate, boot should be allocated first only to assets that have a realized gain to the extent of the total realized gain in the transaction, and then only the excess boot above the amount of realized gain should be afforded a basis recovery. This alternative methodology ensures that the application of sections 351, 357, and 358 trigger sufficient gain recognition in a transaction where boot is present so as to avoid negative stock basis outcomes. This article’s methodology also prevents premature basis recovery on the receipt of boot where realized gain exists in the section 351 exchange and otherwise would not be recognized under the methodology set forth in Revenue Ruling 68-55.
Unfortunately, the boot allocation mistake at the core of Revenue Ruling 68-55 is not isolated to the determination of the amount of gain recognized in a section 351 exchange. It also is utilized to determine the character of the recognized gain. In this regard, in Regulation section 1.357-2(b), the government has indicated that the character of gain recognized by reason of section 357(c) is to be determined based on the same flawed methodology that Revenue Ruling 68-55 utilizes to allocate boot for purposes of determining the amount of recognized gain. Yet, as pointed out in one of the leading corporate tax casebooks, the manner in which the character of gain is determined under Regulation section 1.357-2(b) is deeply flawed, because it can cause the recognized gain in a section 351 exchange to be characterized inconsistently with how the realized gain is characterized in the exchange. It makes no sense to determine the character of recognized gain by reference to the character of assets that have no realized gain, but that is what the existing regulations literally require in certain fact patterns.
Yes, the determination of the amount of recognized gain, and the determination of the character of that recognized gain, are ancient issues. And yes, Revenue Ruling 68-55 and Regulation section 1.357-2(b) are longstanding pronouncements. However, the fact that administrative authorities are old does not make them sacrosanct. Flawed rules should be reformed even if they represent old mistakes. The Service and Treasury have considered elevating the flawed boot allocation methodology set forth in Revenue Ruling 68-55 into a regulatory rule under section 351, but the Treasury withdrew its proposal, albeit there is no indication that its withdrawal had anything to do with the mistaken boot allocation aspects of that prior regulatory project. In any event, the Service and Treasury were right to not elevate its flawed section 351 boot allocation methodology into a further regulatory pronouncement, but even so the problem is that Revenue Ruling 68-55 remains the controlling governmental authority on this topic pending further administrative guidance. To make matters worse, in 2021 the Tax Court in a memorandum decision indicated that it would defer to Revenue Ruling 68-55 as the controlling authority for boot allocation in a section 351 exchange notwithstanding that the Tax Court recognized that this revenue ruling was inconsistent with the Tax Court’s earlier case law precedent. This deference to Revenue Ruling 68-55 was an unforced error on the part of the Tax Court as the Tax Court’s findings of fact in that memorandum decision did not require the Tax Court to independently rely upon Revenue Ruling 68-55 as part of its holding, so the Tax Court’s supportive dicta in favor of Revenue Ruling 68-55 represents another missed opportunity to correct its longstanding mistaken methodology.
This article ruminates on the mistaken negative stock basis outcomes that can (and do) arise under Rev. Rul. 68-55 with the hope that doing so can clarify why a better boot allocation and gain characterization methodology is needed. To that end, in Part II, this article sets forth the statutory design parameters that the boot allocation and gain recognition rules should effectuate in the section 351 context as those design parameters are the lens through which the soundness of the boot allocation and gain characterization methodology should be evaluated. Second, in Part III.A., this article then sets forth how the methodology employed in Rev. Rul. 68-55 and Regulation section 1.357-2(b) fail to harmonize with the design parameters of sections 351, 357, and 358. By highlighting the absurd results that arise under the flawed methodologies set forth in Revenue Ruling 68-55 and Regulation section 1.357-2(b), the reforms needed to recalibrate Revenue Ruling 68-55 and Regulation section 1.357-2(b) are brought into clear focus. In Part III.B., this article sets forth how this article’s alternative methodology avoids inappropriate negative stock basis outcomes and avoids inappropriate gain characterization outcomes so that the design parameters for sections 351, 357, and 358 are faithfully implemented.
II. Statutory Framework
To properly understand the policy issues at stake, one needs to agree on the guiding principles for allocating boot in a section 351 transaction. The starting point for that analysis is the statutory framework. Under section 351(a), no gain or loss is recognized if property is transferred by one or more persons to a corporation in exchange for stock where such person or persons are in control of the corporation immediately after the exchange. Importantly, in a section 351 exchange, the shareholder is not allowed to recognize any realized losses, but the shareholder is required to recognize gain to the extent of the lesser of the shareholder’s realized gain or the boot received. In terms of determining the amount of boot received by the shareholder in the section 351 exchange, the general rule set forth in section 357(a) is that liabilities assumed by the transferee corporation should not be treated as boot for gain recognition purposes. This creates a symmetry problem, however, because receipt of loan proceeds is not treated as income at the time of receipt and yet the nonboot treatment generally afforded under section 357(a) is not intended to provide tax forgiveness even though the shareholder’s repayment obligation is assigned away from the shareholder. The means by which immediate gain recognition is generally avoided, and yet the ultimate shareholder level gain is preserved, is accomplished by means of a downward basis adjustment to the shareholder’s stock basis by the amount of the shareholder liabilities assumed by the transferee corporation in the section 351 exchange. In this regard, under section 358(a)(1), the starting point for determining the shareholder’s basis in the stock received in the section 351 exchange is a substitute basis (i.e., the shareholder’s basis in the property transferred). However, that substitute stock basis is then further adjusted. First, the shareholder’s substitute stock basis is decreased by any boot received by the shareholder per section 358(a)(1)(A), and for this purpose any shareholder liability assumed by the transferee corporation is treated as boot for this purpose whether or not gain is immediately recognized with respect to the corporation’s assumption of those shareholder liabilities. Thus, even though section 357(a) states that the corporation’s assumption of a shareholder liability generally is not treated as boot for gain recognition purposes under section 351(b), section 358(d) in contrast does treat the amount of any shareholder liability assumed by the transferee corporation as boot received by the shareholder for purposes of determining the shareholder’s resulting stock basis in the section 351 exchange. The effect of decreasing the shareholder’s substitute stock basis by the amount of the shareholder’s liabilities assumed by the transferee corporation works to ensure that the shareholder’s ultimate potential gain or loss reflected in the shareholder’s stock basis preserves both the shareholder’s original built-in gain or loss in the property transferred and then is further adjusted downward to preserve the economic benefit of the shareholder’s assignment of her liabilities away from the shareholder. In combination, these shareholder stock basis adjustments preserve the potential to tax the shareholder on both the original built-in gain or loss and the economic benefit of the shareholder liabilities assumed by the transferee corporation. However, section 358(a) allows the shareholder’s stock basis to be increased by the amount of any gain immediately recognized by the shareholder in the section 351 exchange. It is here where the boot allocation rules must trigger a sufficient amount of immediate shareholder gain recognition to ensure that the ultimate shareholder stock basis determined under section 358 does not lead to an absurd negative stock basis result.
The design principle for how the boot allocation rules should operate can also be gleaned from the policy goals that underlie the statutorily prescribed exceptions to the general nonboot treatment afforded by section 357(a). The first exception to this nonboot treatment afforded to the shareholder when the transferee corporation assumes shareholder liabilities is found in section 357(b), which in turn has existed ever since the original enactment of section 357’s predecessor. Under section 357(b), the shareholder is required to treat the assigned shareholder’s liabilities as boot for purposes of triggering immediate gain recognition if an assumed shareholder liability is created with a tax avoidance purpose or if transferring the shareholder liability served no business purpose. If any assigned shareholder liability is found to have been created or assigned with such a prohibited purpose, then all of the shareholder’s assumed liabilities (and not just the problematic shareholder liability) are treated as boot for immediate gain recognition purposes to the shareholder. Because the ultimate application of section 357(b) depends on a facts-and-circumstances determination of “business purpose” and “tax avoidance purpose,” the precise contours of section 357(b)’s application is not always clear.
The second situation where the shareholder has immediate gain recognition due to the transferee corporation’s assumption of the shareholder’s liabilities is set forth in section 357(c), which in turn provides that the transferee corporation’s assumption of the shareholder’s liabilities triggers immediate gain recognition to the shareholder when the amount of the shareholder’s liabilities exceeds the aggregate adjusted basis of the property transferred in the section 351 exchange. In that situation, the shareholder is required to immediately recognize gain in an amount equal to the excess of the assumed shareholder liabilities over the adjusted basis of the properties transferred. When section 357(c) is implicated, the recognized gain is treated as gain arising from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.
The underlying rationale for section 357(c)’s triggering immediate gain recognition may seem obvious to some, but even so a correct framing for why section 357(c) requires immediate gain recognition is an important foundation from which to then consider how the boot allocation methodology and the stock basis adjustment rules should operate. In this regard, when the amount of the shareholder’s assumed liabilities exceed the adjusted basis of the transferred property in the section 351 exchange, the Service’s administrative practice prior to the enactment of section 357(c) appears to have been that the shareholder’s stock basis could never be less than zero (could not be a negative stock basis) even though section 357(a) by its literal terms allowed the shareholder to avoid immediate gain recognition and even though the plain textual reading of section 358(a)(1)(B)(ii) seems to require a negative stock basis outcome when the adjusted basis of the properties is less than the full amount of the shareholder’s liabilities.
This “non-negative stock basis” limit to any downward stock basis adjustment is clearly endorsed by the Tax Court in Easson v. Commissioner, but that case is an unusual case. To begin with, the Tax Court decided Easson after the enactment of section 357(c), but the case involved a tax year that predated the applicability of section 357(c). Thus, Easson sets forth an opinion that construes the interaction of sections 351, 357, and 358 but does so for a relevant time period that predated the enactment of section 357(c), but even so the Tax Court’s decision in Easson was informed by Congress’ later enactment of section 357(c). In addition, Easson is also unusual because the government in that case did not advance the theory upon which the Tax Court ultimately utilized to rule in the government’s favor. To begin with, the government’s litigating position in Easson was that the shareholder’s liabilities should have triggered the application of section 357(b) because the shareholder’s liabilities were created (according to the government) with a prohibited tax avoidance purpose shortly before their assignment to the transferee corporation. The Tax Court rejected the government’s reliance on section 357(b) as the Tax Court found that there was a business purpose for the creation of the shareholder’s liabilities prior to their assumption by the transferee corporation.
Instead of ruling in favor of the government based on the rationale advanced by the government, the Tax Court instead utilized a theory that appears to not have been advanced by any of the parties in the litigation. In this regard, the Tax Court referred to the Supreme Court’s decision in Crane as supportive of the principle that a negative stock basis outcome should be avoided. The Tax Court in Easson then applied a broader interpretive framework that drew heavily from the Supreme Court’s treatment of excess liabilities assumed by the transferee as creating income to the transferor in the taxable exchange context as authority for ensuring that the shareholder’s assignment of her excess liabilities to the transferee corporation in a section 351 exchange had a similar immediate gain recognition outcome to avoid an otherwise absurd negative stock basis result in the nontaxable exchange context. Said differently, the Tax Court interpreted the Supreme Court’s policy driven interpretation in Crane that included the transfer of excess nonrecourse liabilities in amount realized as authority for triggering immediate gain recognition upon the transfer of excess liabilities in the nontaxable exchange context. In order to avoid an absurd negative stock basis result, the Tax Court held that the shareholder in the section 351 exchange must recognize gain to the extent the shareholder’s liabilities exceeded the aggregate transferred property’s basis notwithstanding the literal language of section 357(a) because to do otherwise leads to an absurd result that could not have been intended by Congress. The Tax Court then stated that it viewed the legislative enactment of section 357(c) as merely “clarifying existing law” and thus viewed the later Congressional enactment of section 357(c) as a tacit legislative endorsement of the Tax Court’s purposeful interpretation of section 351 and section 357(a) so as to avoid both an inappropriate tax forgiveness outcome and to avoid an absurd negative stock basis outcome. Finally, the Tax Court then allocated the resulting recognized gain based on the relative gain in the transferred assets. The Tax Court’s decision represented a thoughtful opinion that reached an appropriate result, but unfortunately the Tax Court’s decision was reversed on appeal by the Ninth Circuit, which saw no reason to deny nonrecognition treatment for the transfer of liabilities in excess of basis, and also saw no reason to resist a negative stock basis outcome under section 358.
In 1954, Congress recognized that a negative basis outcome represented an undesirable outcome, and the legislative history clearly indicates that the enactment of section 357(c) “closes this loophole” whenever “the liability assumed exceeds the basis of the property . . . transferred to a controlled corporation.” The mistaken negative basis outcome might arise where the taxpayer avoided being taxed on the receipt of loan proceeds and then avoids any gain recognition by reason of its assignment of the liability and when a sufficient stock basis reduction is constrained by the non-negative stock basis limitation so that the full amount of the economic benefit of the shareholder’s liability shift is not preserved through a downward stock basis adjustment. To remedy this mistaken outcome, Congress enacted section 357(c) which now explicitly requires the shareholder to recognize gain when the transferee corporation assumes shareholder liabilities in excess of the adjusted basis of the property transferred to the corporation. When the assumed liabilities do in fact exceed the adjusted basis of the transferred property, section 357(c) provides that “such excess shall be considered as gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.” By requiring immediate gain recognition to the extent that the assumed liabilities exceed the basis in the property transferred, the negative stock basis problem is avoided as the additional immediate gain recognition triggered by reason of section 357(c) affords the shareholder with a positive stock basis adjustment under section 358(a)(1)(B)(ii).
The statutory enactment of section 357(c) has been widely recognized as a Congressional effort to eliminate the negative stock basis problem and at the same time to avoid an inappropriate tax forgiveness outcome, and the rules that implement the boot allocation rules should be construed in light of those policy goals. Thus, regardless of how one might have viewed the contortions taken by the Tax Court in Easson to avoid an absurd negative stock basis outcome and an inappropriate tax forgiveness outcome under prior law, the subsequent enactment of section 357(c) should be understood as a Congressional attempt to clarify that a negative stock basis outcome is not appropriate, nor is the morphing of section 351 into a tax forgiveness provision appropriate either. The Ninth Circuit, which had reversed the Tax Court in Easson and at one time had been favorably inclined towards the possibility of a negative stock basis outcome under section 358 prior to section 357(c)’s enactment, stated in Peracchi that the negative basis outcome was now “extinct” because Congress enacted section 357(c) with the goal of eliminating the negative stock basis possibility. The Ninth Circuit was certainly correct in its understanding of Congress’ intent to avoid such outcomes, but the Ninth Circuit failed in Peracchi to realize that the Service’s administrative guidance in Rev. Rul. 68-55 does not faithfully implement that design parameter.
III. Administrative Guidance
In order to apply these statutory provisions in a rational manner, boot must be allocated so that the amount of the shareholder’s immediate gain recognition can be determined. After Congress’ enactment of section 357(c), a clear policy parameter should be that the boot allocation methodology must trigger immediate gain recognition in an amount sufficient to prevent an absurd negative stock basis outcome. A basis allocation methodology that fails to accomplish that goal fails to accord with the Ninth Circuit’s statement that negative stock basis, like Bigfoot, should not exist.
Yet, failures abound. The existing Service and Treasury administrative rules for allocating boot and determining the amount of immediate gain recognition can create negative stock basis outcomes under the existing administrative guidance notwithstanding the design parameters that undergird the statutory nonrecognition provisions. These situations will be explored in this Part III.A., infra. The Service and Treasury have authority to adopt a boot allocation methodology that does not create inappropriate negative stock basis outcomes, and this article sets forth a proposed methodology that would achieve that objective in Part III.B., infra. It is this author’s belief that the Service and Treasury Department should modify its existing administrative guidance so that its guidance no longer creates inappropriate negative stock basis outcomes, as both Congress and the courts have expressed hostility towards such outcomes.
A. Rev. Rul. 68-55 Methodology
In order to determine the amount of gain recognized, it is necessary to determine the amount of boot attributable to each transferred asset. In Rev. Rul. 60–302, the Service posited a situation where a shareholder transferred a single property with a fair market value of $500 and a basis of $200 to a corporation in a transaction subject to section 351. In addition to issuing stock, the corporation assumed a $210 liability secured by the property and gave the shareholder transferor a note for $80. The ruling held that the shareholder recognized a $10 gain under section 357(c) and also recognized $80 of gain under section 351(b) for a total recognized gain of $90. Interestingly, the Service cited the Tax Court’s decision in Easson as authority for the approach taken in that administrative ruling. The reasoning and outcome in Rev. Rul. 60-302 is noncontroversial and well-reasoned, and it is instructive that the Service favorably cited the Tax Court’s decision in Easson as consistent with current law. This deference to Easson’s holding and approach would not continue in future guidance, however.
The government addressed the nuances of how to allocate boot when multiple assets are transferred in a section 351 exchange in Rev. Rul. 68-55, and it is in that ruling where the Service’s administrative guidance becomes flawed and can lead to absurd negative stock basis outcomes. It has been the longstanding position of the Service that the determination of the amount of gain recognized in a section 351 exchange must be separately determined for each property transferred to the corporation in that section 351 exchange. On this score, the Service’s approach is well grounded as it is appropriate to determine gain on a property-by-property basis. The Service justified its reasoning in Rev. Rul. 68-55 on the grounds that each asset must be separately considered because “any treatment other than an asset-by-asset approach would have the effect of allowing losses that are specifically disallowed by Section 351(b)(2).” However, Rev. Rul. 68-55 then mistakenly allocates the boot in the section 351 exchange to each of the transferred assets based on the relative fair market value of each transferred asset. Although no general counsel memorandum explicitly cross-references Rev. Rul. 68-55, G.C.M. 33,909 appears to set forth the government’s (mis)handling of the relevant boot allocation issues in Rev. Rul. 68-55. The government starts out well in G.C.M. 33,909 as it correctly notes that a fundamental purpose of the nonrecognition provisions was to avoid a permanent tax forgiveness outcome and that Congress and the courts have endeavoured to avoid a negative stock basis outcome. In its discussion, G.C.M. 33,909 favorably cites the Tax Court decision in Easson. However, instead of relying on the allocation methodology actually utilized in Easson, the general counsel memorandum ultimately determines to allocate boot based on relative fair market value of the contributed assets. In Rev. Rul. 68-55, the government added a citation to Regulation section 1.1245-4(c)(1) as additional support for its methodology. That regulation provides that, for purposes of determining the amount of section 1245 gain, the consideration should be allocated between section 1245 property and non-Code section 1245 property in certain nonrecognition transactions (including section 351 exchanges) based on relative fair market values. Even so, as has been pointed out by others, the authorities that support the Rev. Rul. 68-55 allocation methodology in the section 351(b) context appear to be scarce.
It is notable, however, that the Service abandoned the Easson methodology for allocating boot in Rev. Rul. 68-55 and did so without any explanation for its rejection of the prior case law approach. In Part III.B., this article will address in greater detail why the Tax Court’s original boot allocation methodology in Easson was correct, but what is important for the reader to understand at this point is that Rev. Rul. 68-55 struck out on its own to utilize a different and flawed boot allocation methodology that is inconsistent with the prior case law even though the contemporaneous general counsel memorandum had favourably cited that very same prior case law. Rev. Rul. 85-164 is consistent with Rev. Rul. 68-55, but it clarifies that the government’s relative fair market value allocation methodology cannot be altered by contractual agreement between the parties. This represents a divergence from the taxable exchange context where the parties are able to separately identify and allocate the components of consideration in a multi-asset acquisition, but G.C.M. 39,418 explains this restriction in part by stating that it would be impractical to allow such an identification given the non-arm’s length nature of a section 351 exchange. Thus, whatever similarities may exist between Rev. Rul. 68-55 and the manner in which consideration is allocated in the taxable exchange context, the government has conceded that different factors are at work in the non-taxable exchange context.
Even so, it is perhaps instructive to at least consider the allocation methodology employed in the taxable exchange context where multiple properties are involved even though the policy issues at stake in that context are different. In the taxable exchange context, the case law has long held that realized gain or loss from the sale of a going business is determined on an item-by-item basis. Further, in the context of a taxable sale of a trade or business, a lumpsum purchase price must be allocated to the purchased assets using a residual allocated methodology based on asset classes. However, if the parties agree to an allocation and the allocation follows the asset class prioritization set forth in the regulations, the administrative practice has allowed the parties to determine the allocation of the components of compensation to specific assets in the multi-asset acquisition. If the parties do not agree on an allocation of the components of consideration to various purchased assets, then the consideration is allocated pro ratably among the acquired assets based on their relative fair market value. Importantly, the taxable exchange context involves situations where gain or loss is realized and recognized in full, so the allocation of the components of consideration in that context does not run afoul of any prescription against the recognition of losses as exists in section 351(b)(2).
Specifically, in a transfer subject to section 351, losses are not allowed to be recognized by reason of section 351(b)(2), so the allocation of boot that inappropriately allows an offset of realized losses against the amount of recognized gain implicates different policy concerns from those that govern the taxable exchange context. In this regard, Rev. Rul. 68-55 allows boot to be allocated to property that might not have any built-in gain, and in fact Rev. Rul. 68-55 explicitly contemplates that outcome in its stipulated fact pattern. Thus, even though the statute is clear that realized losses are not to be utilized to reduce the amount of gains recognized in the section 351 exchange, the allocation of boot to built-in loss property (as was done in Rev. Rul. 68-55) has the effect of allowing unrealized losses and premature basis recover so as to reduce the amount of gain recognized in the section 351 exchange. This is a mistake.
In Easson, the Tax Court posited that the allocation of boot should be done based on the proportion of the amount of realized gain in each gain property has to the total realized gain in the exchange. It is interesting that the Service, which had favourably cited Easson in Rev. Rul. 60-302 and G.C.M. 33,909, did not utilize the allocation methodology adopted by the Tax Court in Easson even though the Service consistently stated that Easson remained a correct interpretation of existing law. The Tax Court has recognized the government’s divergent approach, but so far the Tax Court has given deference to the government’s adopted allocation methodology, stating as follows:
After our decision in Easson, the Department of the Treasury issued regulations under section 357(c) that require gain recognized under that section to be apportioned among transferred assets in proportion to their relative values, as Rev. Rul. 68-55, supra, requires for the apportionment of gain attributable to taxable boot. See sec. 1.357-2(b), Income Tax Regs. Thus, even leaving aside the reversal of our decision in Easson by the Court of Appeals for the Ninth Circuit, our Opinion in that case has little or no precedential value concerning the determination of gain attributable to specific transferred assets as a result of a shareholder’s receipt of boot in a section 351 exchange.
The Tax Court’s above post-mortem assessment in Complex Media of its prior Easson holding was an unforced error. The taxpayer in the Complex Media case did not disagree with the allocation methodology and so it was not a contested issue in the litigation, and the validity of the allocation methodology was not in controversy. What is more, Judge Halpern made findings of fact that ensured that Rev. Rul. 68-55’s application leads to the same outcome that the Easson methodology would have afforded on those facts, so there was no need for Judge Halpern to even discuss Rev. Rul. 68-55 and its divergent methodology. Consequently, the Tax Court’s endorsement of Rev. Rul. 68-55, even in a memorandum opinion, is unfortunate because the Tax Court had it right in Easson and should not have added fodder to the potential fissure between the Easson and Rev. Rul. 68-55 methodologies.
The flaws in the Rev. Rul. 68-55 methodology are best seen through an illustrative example. To that end, suppose that a shareholder transfers two assets to X Corporation: (1) Equipment, with a fair market value of $700 and an adjusted basis of $250 that is subject to a mortgage debt of $350, and (2) land with a fair market value of $300 and a basis of $300 that is also subject to a lien debt of $150. In this Example 1, it is assumed that the $450 of realized gain relates entirely to the equipment and would be characterized as ordinary income by reason of section 1245 recapture. In the section 351 exchange, the shareholder receives all of the common stock of X Corporation (fair market value $300), a promissory note for $200, and X Corporation assumes the $500 of shareholder debt encumbering the two transferred assets. Because the $500 of the assumed shareholder debt does not exceed the aggregate basis of the equipment and the land ($550), no gain is recognized by reason of section 357(c). However, after applying the principles of Rev. Rul. 68-55, the shareholder is required to recognize gain of $140 by reason of section 351(b) with respect to the portion of the promissory note allocable to the equipment, but the shareholder does not recognize any further gain or loss as indicated in the following table.
