What is “boot” and what is its relation to IRC Section 351?
Because Congress wishes to promote the growth of new businesses, it accepts the philosophy that the incorporation of a business should generally be tax-free both to the shareholders and to the corporation. This philosophy was codified in Section 351 of the Internal Revenue Code, which provides that no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock in such corporation. This holds true only if the transferors are in control of the corporation immediately after the exchange.
Thus, your gain or loss won’t be recognized at present if you comply with the requirements of Section 351. However, what if you fail to comply with one element of Section 351 and you receive cash or property other than stock in the corporation–will your entire transaction be taxable? Not necessarily. Although Section 351 requires that you transfer property to the corporation in return for stock only, this does not mean that the entire exchange will be taxable if you do receive cash or other property (“boot”) in addition to the stock. Rather, the boot may trigger partial gain recognition.
“Boot” may be defined as any property a corporation gives you in addition to its own stock.
If you receive boot in addition to stock, to what extent will you recognize gain?
If you transfer property to a corporation in exchange for stock in the corporation plus some cash and other property, you will recognize gain to the extent of the cash and the fair market value of the other property received. Your basis in the stock (and the corporation’s basis in the property received) increases to reflect any gain recognized.
Example: Assume Abner transfers land with a fair market value of $50,000 and a basis of $10,000 to his newly formed corporation. In return, the corporation gives Abner stock worth $30,000, $10,000 in cash, and $10,000 worth of other property. Although Abner realized a $40,000 gain ($50,000 aggregate value in cash and property received minus $10,000 basis in transferred property), he will only recognize a $20,000 gain (fair market value of boot received, consisting of $10,000 cash plus $10,000 of other property). The stock, worth $30,000, receives the nonrecognition treatment under Section 351.
If you receive boot in addition to stock, how will your basis in the stock be affected?
Your basis in the stock received (the “nonrecognition property”) is determined by reference to your basis in the property you contributed to the corporation. Your basis in the stock is calculated as follows: A – B + C = Stock Basis, where:
- A = Basis of property you transferred to the corporation
- B = Fair market value of boot and cash you received in return
- C = Amount of gain recognized by you on the transfer
If you receive boot in addition to the corporation’s stock, you will often end up with a stock basis equal to your original basis in the property that you gave to the corporation. In the preceding example with Abner and his corporation, Abner’s stock basis will amount to $10,000. This is calculated as (A) Abner’s basis in land transferred ($10,000), minus (B) fair market value of cash and other property received by him ($20,000), plus (C) gain recognized ($20,000). The calculation becomes more complicated if you transfer several different assets each with different fair market values to a corporation and receive boot and stock in exchange. In such a case, it is necessary for you to perform an allocation calculation to determine the amount of gain recognized. If you want more information on this topic, you should contact your attorney or accountant.
If you receive boot, to what extent will you recognize a loss and how will your basis be affected?
If you contribute depreciated property to a corporation in exchange for corporate stock and boot, you are not allowed to recognize the loss in a Section 351 transaction. Rather, any unrecognized loss will be preserved in your adjusted stock basis and in the corporation’s basis in the property you transferred to it.
Example: Jen transferred a building with a fair market value of $50,000 and a basis of $60,000 to XYZ Corporation, in return for $30,000 worth of stock and $20,000 worth of other property. Although Jen realized a $10,000 loss ($50,000 aggregate basis in property received, minus $60,000 basis in transferred property), she cannot recognize any of this loss. Her stock basis would amount to $40,000 ($60,000 basis of property transferred, minus $20,000 boot received, plus zero gain).
When you transfer property to the corporation, what basis will the corporation take in the property?
The corporation takes a substituted basis in the assets received in a Section 351 transaction. More specifically, the corporation’s basis in the property will consist of the transferor’s basis in the property, plus any gain recognized to the transferor.
Example: George owns property with a fair market value of $50,000; George’s tax basis in the property is $20,000. George transfers the property to Gracie Industries, Inc. for $40,000 worth of stock and $10,000 cash. The property basis received by Gracie Industries, Inc. will amount to $30,000 (George’s $20,000 basis plus $10,000 gain recognized by George).
When you transfer property to the corporation, what happens if the corporation assumes your liabilities (debt)?
If you transfer property that is subject to liability to a corporation, relief of that debt is not considered boot; that is, you can still obtain the nonrecognition treatment offered by Section 351. However, your basis in the stock received will be adjusted downward to reflect the relief of your liabilities.
Example: Assume Arthur owns a piece of property currently worth $100,000. The property originally cost him $50,000 and has an outstanding mortgage in the amount of $20,000. Arthur transfers the property to Clara Corporation, which assumes the mortgage. In return for the property, Clara Corporation gives Arthur $80,000 worth of stock (the net value of the property). Arthur has realized a $50,000 gain on this transaction (the value of the stock, plus relief of the $20,000 mortgage, less Arthur’s $50,000 basis in the property). However, Arthur will recognize no gain, since the relief of liabilities is not treated as boot. Arthur’s basis in the stock received will be $30,000 (his original $50,000 basis in the property transferred, less $20,000 mortgage relieved). As for Clara Corporation, it will receive a $50,000 basis in the property that was Arthur’s basis; assumption of the mortgage won’t affect this basis since Arthur recognized no gain.
Are there any exceptions to the general rule regarding relief of liabilities?
There are certain exceptions to the general rule regarding relief of liabilities.
Tax-avoidance transactions: If your principal purpose in allowing a corporation to relieve your debt is tax avoidance (or if you do not have a bona fide business purpose in transferring the encumbered property to the corporation), then the entire amount of debt assumed by the corporation can be treated as taxable boot. This provision might be invoked, for example, if you borrow money against an asset shortly before transferring the asset to a corporation, and then use the proceeds to buy a car.
Liabilities relieved in excess of basis: Any liabilities assumed in excess of your basis in the contributed property are treated as gain from the sale or exchange of the transferred property. This provision prevents your stock basis from being reduced below zero. It’s important to note that this provision will apply even if you remain personally liable (as a guarantor) on a liability assumed by the corporation.
Example: Jack owns a building worth $40,000 subject to a $20,000 liability. His basis in the building is $15,000. He transfers the building (and liability) to Acme Corporation for $10,000 worth of stock and $10,000 in cash. Jack must recognize a $15,000 gain.
Business transactions involving the assumption of liabilities can be very complex.
For additional information about exceptions to the general rule, contact the Experts at Henssler Financial: