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The Tax Lawyer

The Tax Lawyer: Winter 2025

Ruminations on Negative Basis, Rev. Rul. 68-55, and Bigfoot Fallacies

Bret Wells

Ruminations on Negative Basis, Rev. Rul. 68-55, and Bigfoot Fallacies
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Abstract

Revenue Ruling 68-55 addresses the manner in which boot is allocated in a section 351 exchange. In that ruling, boot is allocated based on the relative fair market value of the shareholder’s contributed assets regardless of whether or not a particular transferred asset has any actual built-in gain. Although Revenue Ruling 68-55 is a longstanding ruling, this article argues that the methodology employed in Revenue Ruling 68-55 is flawed and can in certain fact patterns result in inappropriate negative stock basis outcomes. The article argues that the government should replace its flawed boot allocation methodology espoused in Revenue Ruling 68-55 with a boot allocation methodology that first allocates boot to property transferred in a section 351 exchange that has realized gain, before any excess boot is allocated to other property. The article demonstrates that this alternative approach better achieves Congressional intent and the statutory directives set forth under Subchapter C.

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.

Example 1
  Equipment Land
Fair market value $700 $300
Percent of fair market value 70% 30%
Amount realized    
     Fair market value of stock received in exchange ($300) $ 210 $   90
     Promissory note ($200) $ 140 $   60
     Debt assumption ($500) $350 $ 150
  $700 $300
Basis $250 $300
  $450 $     0
Gain recognized per §351(b) $ 140 $     0

The shareholder’s basis in the stock of X Corporation, as determined under section 358, is negative $10, computed as follows:

Basis of transferred property
Equipment $250  
Land $300  
    $550
Minus boot & debt
Note $200  
Debt assumed $500  
    ($700)
Plus gain recognized   $ 140
Basis of stock   ($  10)

The mechanical application of the Service administrative guidance to this fact pattern results in a negative stock basis outcome, and there is no way around it under the flawed methodology utilized in Rev. Rul. 68-55. Notwithstanding what Judge Kozinski said in Peracchi about negative basis and Bigfoot being extinct, the flawed methodology employed by Rev. Rul. 68-55 leads inexorably to this absurd negative stock basis result.

The outcome becomes more convoluted when it comes to characterizing the recognized gain. In situations where gain is triggered by reason of section 357(c), the Service administrative guidance has consistently indicated that the character of the recognized gain triggered by reason of section 357(c) should be determined by the character of the asset to which that gain was attributable and should not be based on the relative fair market value of the contributed assets. However, these lower-authority administrative pronouncements for how gain is characterized when triggered by reason of sec. 357(c) diverge from how Regulation section 1.357-2(b) would determine the character of the recognized gain recognized in a section 357(c) context.

The transferee corporation is generally afforded a carryover basis in the transferred assets plus any gain recognized with respect to the assets. The Service appears to accept that the boot allocated to property that triggers the recognized gain is the appropriate asset to which the basis increase should be made. However, when the basis of the transferred property exceeds it fair market value, section 362(e)(2) limits the aggregate bases of all property transferred to the corporation by any particular transferor to the aggregate fair market value of the transferred property. That restriction is not implicated by the posited facts in the above hypothetical, but it could have been implicated if the posited facts for this Example 1 had assumed that the land had a built-in loss greater than the built-in gain attributable to the equipment.

The government’s flawed boot allocation approach can also create negative basis outcomes in situations where gain is triggered by reason of section 357(c) notwithstanding the fact that the legislative history to section 357(c) clearly indicates that this provision was enacted to prevent such outcomes. To illustrate this flawed outcome, suppose the facts are the same as in Example 1 except that (1) the shareholder liabilities are in total $100 more than in Example 1 (i.e., the mortgage debt on the equipment is $420 (not $350) and the lien debt on the land is $180 (not $150) and (2) the promissory note provided to the shareholder is $100 less (i.e., it is $100 in amount not $200). In this revised Example 2, it is assumed that the $450 of realized gain on the equipment would be characterized as ordinary income by reason of section 1245 recapture. In a section 351 exchange, the shareholder receives all of the common stock of X Corporation (fair market value $300), a promissory note for $100, and X Corporation assumes the $600 of debt encumbering the two transferred assets. Because the $600 of the assumed shareholder debt now does, in fact, exceed the aggregate basis of the equipment and the land ($550), gain of $50 is recognized under section 357(c). In addition, after applying the principles of Rev. Rul. 68-55, the shareholder is required to recognize gain of $70 by reason of section 351(b) as a result of the shareholder’s receipt of the promissory note as indicated in the below table:

Example 2
  Equipment Land
Fair market value $700 $300
Percent of fair market value 70% 30%
Amount realized    
     Fair market value of stock received in exchange ($300) $ 210 $   90
     Promissory note ($100) $   70 $   30
     Debt assumption ($600) $420 $ 180
  $700 $300
Basis $250 $300
Gain (loss) realized $450 $     0
Gain recognized per §357(c) $   35 $    15
Gain recognized per §351(b) $  70 $     0

The shareholder’s basis in the stock of X Corporation, as determined under section 358, is now a negative $30, computed as follows:

Basis of transferred property
Equipment $250  
Land $300  
    $550
Minus boot & debt
Note $100  
Debt assumed $600  
    ($700)
Plus gain recognized   $ 120
Basis of stock   ($ 30)

The mechanical application of the Service administrative guidance to this fact pattern results in an even larger negative stock basis outcome even though the direct policy rationale for the enactment of section 357(c) was to eliminate such absurdities. Moreover, even though all of the realized gain in this transaction is attributable to equipment that “should” generate ordinary income by reason of recapture, the literal application of Regulation section 1.357-2(b) would cause $15 of the recognized section 357(c) gain to be treated as a capital gain because 30% of the relative fair market value of the transferred properties was a capital asset, and this is the outcome notwithstanding the fact that the capital asset in this Example 2 had no realized gain at all. Why should an asset that has no realized gain determine the character of the portion of the recognized gain that was economically attributable to a realized gain entirely attributable to an ordinary asset? There is no good answer to this rhetorical question because the mischaracterization of the recognized gain in a manner that is divorced from the character of the realized gain is simply an absurd result. A strong chorus of commentators have argued that section 357(c) gain should be allocated among assets based on their relative amounts of realized gain in the gain assets. Even though Regulation section 1.357–2(b) determines the character of the recognized section 357(c) gain with the same methodology that Rev. Rul. 68-55 utilizes to determine the amount of the recognized gain, it is widely understood that Regulation section 1.357-2(b) is deeply flawed.

When a mechanical application of Regulation section 1.357-2(b) causes the character of the recognized gain to become unmoored with the character of the realized gain, the case law has refused to apply the methodology set forth in Regulation section 1.357-2(b). In Easson, the Tax Court determined that boot should be allocated according to the ratio of total potential gain which would avoid gain being allocated to property that did not have a realized gain. After Congress enacted section 357(c)(1), the Tax Court in Raich characterized the gain created by an excess of liabilities over adjusted bases by excluding cash and prepaid rent from its analysis because those assets had no realized gain. After doing so, the Tax Court characterized the resulting gain as ordinary income because the assets that had a realized gain were zero basis accounts receivable and depreciable property subject to recapture. In Rosen, the taxpayer owned a corporation that sold picture juke boxes called “cineboxes,” a machine that showed preselected movies. In making a section 351 transfer, the taxpayer transferred liabilities that exceeded the adjusted bases of the assets by $147,315. Although the cineboxes were hardly used, the taxpayer had taken almost $190,000 of depreciation on them. According to the regulation, the resulting gain should be apportioned to all of the assets based on relative fair market value, but the Tax Court instead looked only to the assets that had a realized gain and thus avoided any allocation to cash, the prepaid charges, or film rights because their book value could not exceed their fair market value. The court decided that it was only logical to allocate the entire gain to the assets that had in fact experienced a realized gain. In each of the cases previously discussed, the Tax Court allocated section 357(c)(1) gain not using the method prescribed in Regulation section 1.357-2, but in a ‘logical’ manner so as to avoid characterizing the recognized gain in a manner that diverged from the realized gain.

But the absurdities still don’t end here. In this regard, the Service administrative position appears to be that the basis increase afforded to the transferred property should be made based on the same flawed methodology that was utilized to determine the characterization of gain under Regulation section 1.357–2(b). The methodology set forth in Regulation section 1.357-2(b) certainly is consistent with Rev. Rul. 68-55, but allocating a basis increase in the same manner as Regulation section 1.357–2(b) determined the character of the recognized gain is flawed because it can cause the basis increase to be allocated to a transferred asset that has not appreciated in value. This is problematic because section 362(d)(1) provides that the basis of a transferred property in the hands of the transferee corporation cannot be increased to an amount above the transferred property’s fair market value by reason of any gain recognized to the transferor as a result of the assumption of a liability. Thus, if $15 of the $50 of total basis increase is allocated to the land, the land’s basis would then be increased above its fair market value, which section 362(d) prohibits. Thus, the $15 portion of the basis increase due to section 357(c) gain is simply lost because the basis in the land in no event can exceed the fair market value of the property (determined without regard to section 7701(g)). The normatively correct result would be to assign the basis increase in the transferred property arising from the section 357(c) recognized gain to the property that had the realized gain in the exchange. That allocation allows the basis increase from the section 357(c) gain to avoid the inappropriate disallowance under section 362(d). The absurdities just continue to mount as one works through the application of Rev. Rul. 68-55 and Regulation section 1.357-2(b) and then overlay those flawed methodologies with the application of section 362(d).

B. Better Rule to Achieve Congress’ Goals in this Iterative Rubric

In Easson, the Tax Court correctly came to a rational boot allocation methodology: the Tax Court allocated boot to only the transferred properties that had appreciated in value. Yet, in a recent Tax Court decision, the Tax Court appears to have abandoned its Easson boot allocation methodology and afforded deference to the government’s boot allocation methodology set forth in Rev. Rul. 68-55. The Tax Court was too quick to reject its earlier case law because the approach taken by the Tax Court in Easson leads to a coherent outcome whereas (as demonstrated in the proceeding Part III.A) the approach set forth in Rev. Rul. 68-55 does not. In the below Example 3, the facts are identical to those set forth in Example 1 except that the boot is allocated only to the asset that has a realized gain in accord with the Tax Court’s methodology employed in Easson, and in that event the results are set forth below.

Example 3
  Equipment Land
Fair market value $700 $300
Basis $250 $300
Gain (loss) realized $450 $     0
Boot $200 $     0
Gain recognized per §351(b) $200 $     0

The shareholder’s basis in the stock of X Corporation, as determined under section 358, is now $50, computed as follows:

Basis of transferred property
Equipment $250  
Land $300  
    $550
Minus boot & debt
Note $200  
Debt assumed $500  
    ($700)
Plus gain recognized   $200
Basis of stock   ($ 50)

The allocation of boot in a section 351 exchange entirely to the gain property that is part of that exchange ensures that the boot is not afforded with a premature basis recovery except when the amount of the boot exceeds the gain realized in a section 351 exchange. The above result makes conceptual sense because the taxpayer has $200 of boot and recognizes the lesser of the boot received or the realized gain in the transaction, whichever is less. Using that approach avoids the negative basis outcome and also ensures that the nonrecognition provisions do not allow receipt of nontaxable boot when there is a realized gain in the transaction.

The above methodology also achieves an appropriate outcome in the context where gain is triggered by reason of section 357(c). To illustrate this coherent result in that context, suppose the same facts as in Example 2 except that now the methodology utilized in Easson were utilized in lieu of the methodology in Rev. Rul. 68-55. In that event, the shareholder is required to recognize gain of $100 by reason of section 351(b) with respect to allocable portion of the promissory note attributable to the equipment and must recognize another $50 by reason of section 357(c). The results are set forth in the following table:

Example 4
  Equipment Land
Fair market value $700 $300
Promissory note ($100)    
Debt assumption ($600)    
Basis $250 $300
Gain (loss) realized $450 $     0
Gain recognized per §357(c) $  50 $     0
Gain recognized per §351(b) $100 $     0

The shareholder’s basis in the stock of X Corporation, as determined under section 358, is now zero as one should expect in a transaction to which section 357(c) applies, as the below computation so indicates:

Basis of transferred property
Equipment $250  
Land $300  
    $550
Minus boot & debt
Note $100  
Debt assumed $600  
    ($700)
Plus gain recognized   $ 150
Basis of stock   ($   0)

IV. Conclusion

In 2021, the Tax Court in Complex Media, Inc. v. Commissioner had the opportunity to say that Rev. Rul. 68-55 and Regulation section 1.357-2(b) can lead to absurd negative stock basis results and should not be followed when those absurdities are presented. The Tax Court in the Complex Media case did recognize that its approach in Easson was not followed by the government in its administrative guidance, but the Tax Court then drew the wrong conclusion, noting that the government’s failure to adopt the Tax Court’s approach in Easson meant that Easson was no longer a controlling precedent. That was a terrible mistake because the reality is that the Tax Court’s approach in Easson does faithfully implement the design parameters of section 351, section 357, and section 358 whereas the government’s flawed methodology set forth in Rev. Rul. 68-55 and Regulation section 1.357-2(b) does not. The Tax Court should have said that its decisions in Easson, Raisch, and Rosen stand for the proposition that negative basis outcomes and the mishandling of the gain characterization must be avoided and that the government’s guidance that fails to avoid those pitfalls is ill-conceived. The Tax Court gave too much deference to the Service administrative guidance on boot allocation in its Complex Media decision, and so that opinion represents a missed opportunity to correct that guidance.

For its own part, the Treasury Department should have withdrawn Rev. Rul. 68-55 and should have modified Regulation section 1.357-2(b) long ago. The Treasury Department should have adopted the Tax Court’s methodology set forth in Easson so that its administrative guidance implemented an appropriate boot allocation and gain characterization methodology that faithfully implements the design parameters of section 351, section 357, and section 358. But instead of doing so, the Treasury Department has left its mistake-ridden published guidance in place. This is a continuing mistake.

It is now time for the Tax Court to make clear to the government that it will not apply its flawed administrative guidance when that guidance creates absurd outcomes, and it is now time for the Treasury Department to take it upon itself to reform its mistake-ridden administrative guidance. Now is the time to correct those mistakes so that the boot allocation and gain characterization methodologies lead to results that more faithfully implement the design parameters of section 351, section 357, and section 358. The continuing failure to make corrective reforms frustrates the policy goals for these nonrecognition provisions and perpetuates absurd Bigfoot-type sightings that should instead be treated as figments of an overly active imagination.