Comment by Louis S. Nunes
Sections 351, 357, 358, and 362 of the Internal Revenue Code comprise a delicate gain deferral system that is activated when a taxpayer transfers property to a corporation in exchange for a controlling interest in the corporation. The underlying theory is that the gain should not currently be recognized because such a transfer is merely a continuation of the taxpayer's investment in a modified form, rather than a liquidation of that investment. The recognition is deferred until liquidation actually takes place.
Section 357(a) generally provides that a corporation's assumption of a taxpayer's liabilities in a transfer that falls under section 351 will not result in a recognized gain to the taxpayer. This gain, although not presently taxed, is deferred through the special basis provisions of sections 358 and 362. Section 358 generally provides that the basis of the stock received by the taxpayer is equal to the adjusted basis of the assets transferred. The corporation, under section 362, has a basis in the acquired assets equal to the basis of the assets in the hands of the taxpayer.
A problem arises when the liabilities assumed by the corporation exceed the adjusted basis of the assets transferred to it. Section 357(c) provides that a gain must be recognized in an amount equal to that excess. Taxpayers historically have tried to avoid recognition of gain under section 357(c) by executing a promissory note in favor of the corporation for the amount by which the liabilities assumed by the corporation exceed the adjusted basis of the assets transferred. Until 1989, these attempts proved largely unsuccessful, especially in the Tax Court, which consistently ruled that this procedure could not be used to avoid present recognition of gain under section 357(c). In 1989, however, the Second Circuit overruled such a decision. In Lessinger v. Commissioner, the Second Circuit faced a complicated set of facts that seemed to result in harsh treatment to the taxpayer under the existing system. Perceiving problems in the gain deferral system, and ignoring all precedent, the court looked to other sections of the Code and held that a taxpayer could avoid recognizing a gain under section 357(c) by executing a promissory note in favor of the corporation for the liabilities assumed by the corporation in excess of the adjusted basis of the assets transferred. Although it represented a victory for the taxpayer, this decision destroyed the delicate interdependence of sections 357(c), 358, and 362(a), and created uncertainties in the system where none previously existed.
About the Author
Louis S. Nunes.
Citation
65 Tul. L. Rev. 663 (1991)