Business Entities · Forming a corporation

Transfer of property subject to indebtedness

Verification 2026 Verified
tax year · reviewed 2026-08-21 · Draft for I. Ohu review

Liabilities are the reason an incorporation that should have been tax-free produces tax. Three provisions apply in sequence and each does something different: IRC § 357(a) says an assumed liability is not boot, IRC § 357(b) takes that away where the assumption was motivated by tax avoidance, and IRC § 357(c) taxes the excess of liabilities over basis regardless of motive. The third is the one that catches ordinary commercial transactions, because it operates on arithmetic rather than on intention.

The rule

Not boot. the assumption of a liability is not treated as money or other property for the purposes of IRC § 351(b), so it does not by itself cause gain to be recognised and does not prevent the exchange qualifying — the rule that matters is the separate one for liabilities exceeding basis (IRC § 357(a))^TY2026

Unless the purpose was wrong. where, considering the nature of the liability and the circumstances of the arrangement, the taxpayer's principal purpose in the assumption was to avoid federal income tax on the exchange or was not a bona fide business purpose, the whole of the liabilities assumed is treated as money received on the exchange (IRC § 357(b))^TY2026

And in any case, the excess over basis. where in an IRC § 351 exchange the sum of the liabilities assumed exceeds the total adjusted basis of the property transferred, the excess is treated 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 (IRC § 357(c)(1))^TY2026

With deductible liabilities left out. a liability whose payment would give rise to a deduction, or would be described in IRC § 736(a), is excluded in determining the amount of liabilities assumed for the purposes of the excess-over-basis rule — so a cash-basis transferor's accounts payable do not create gain (IRC § 357(c)(3))^TY2026

What it does to basis. where another party to the exchange assumes a liability of the taxpayer as part of the consideration, the assumption is treated as money received by the taxpayer for the purpose of computing the basis of the stock received — except to the extent the liability is excluded under IRC § 357(c)(3) (IRC § 358(d))^TY2026

And to the corporation’s basis. where property is acquired by a corporation in a transaction to which IRC § 351 applies, or as paid-in surplus or a contribution to capital, its basis is the same as it would be in the hands of the transferor, increased by the gain recognised to the transferor on the transfer (IRC § 362(a))^TY2026

Current figures

Item	Rule	Authority
Assumption not boot	the assumption of a liability is not treated as money or other property for the purposes of IRC § 351(b), so it does not by itself cause gain to be recognised and does not prevent the exchange qualifying — the rule that matters is the separate one for liabilities exceeding basis (IRC § 357(a))^TY2026	IRC § 357(a)
Tax avoidance purpose	where, considering the nature of the liability and the circumstances of the arrangement, the taxpayer's principal purpose in the assumption was to avoid federal income tax on the exchange or was not a bona fide business purpose, the whole of the liabilities assumed is treated as money received on the exchange (IRC § 357(b))^TY2026	IRC § 357(b)
Liabilities over basis	where in an IRC § 351 exchange the sum of the liabilities assumed exceeds the total adjusted basis of the property transferred, the excess is treated 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 (IRC § 357(c)(1))^TY2026	IRC § 357(c)(1)
Excluded liabilities	a liability whose payment would give rise to a deduction, or would be described in IRC § 736(a), is excluded in determining the amount of liabilities assumed for the purposes of the excess-over-basis rule — so a cash-basis transferor's accounts payable do not create gain (IRC § 357(c)(3))^TY2026	IRC § 357(c)(3)
Effect on stock basis	where another party to the exchange assumes a liability of the taxpayer as part of the consideration, the assumption is treated as money received by the taxpayer for the purpose of computing the basis of the stock received — except to the extent the liability is excluded under IRC § 357(c)(3) (IRC § 358(d))^TY2026	IRC § 358(d)

How it works in practice

Take the three provisions in order, because they are not alternatives — the second and third are exceptions to the first, and the third can apply where the second does not.

IRC § 357(a) is the general rule and it is generous. A liability assumed by the corporation, or to which the transferred property is subject, is not treated as money or other property (IRC § 357(a)). So contributing a mortgaged building does not produce boot and does not disqualify the exchange, even though the transferor has been relieved of a real economic burden. That is a deliberate concession: without it, almost no business could be incorporated without tax.

IRC § 357(b) is the anti-abuse provision and it is brutal when it applies. Where, considering the nature of the liability and the circumstances of the arrangement, the taxpayer’s principal purpose with respect to the assumption was to avoid federal income tax on the exchange, or was not a bona fide business purpose, then the total amount of the liabilities assumed is treated as money received. Not the excess — the whole amount. A transferor who borrows against property shortly before contributing it, and has the corporation take the debt, is squarely in the provision’s aim.

IRC § 357(c) is the arithmetic rule and it is the one that catches honest people. Where the sum of the liabilities assumed exceeds the total adjusted basis of the property transferred, the excess is gain. No purpose test, no defence. This happens routinely: a building held for twenty years has been depreciated down while the mortgage has been refinanced up, and the two cross. The transferor recognises gain on an incorporation from which they received nothing but stock.

The character of that gain follows the property: capital or ordinary “as the case may be”, and where several assets are transferred it is apportioned across them. And note that IRC § 357(c) applies even where the transferor has an overall economic loss — the test is liabilities against basis, not value against basis. A property worth less than its debt but with a very low basis produces gain on contribution.

IRC § 357(c)(3) is the release valve and it matters most for cash-basis businesses. A liability whose payment would give rise to a deduction is excluded from the count. So a cash-basis sole proprietor incorporating a business with accounts payable does not count those payables, because paying them would have produced a deduction. Without this, every cash-basis service business would generate gain on incorporation, since its receivables have no basis and its payables are real.

Basis. IRC § 358(d)(1) treats the assumed liability as money received for the purpose of computing the stock basis — so the stock basis is reduced by the liability, which is what keeps the deferred gain in place. IRC § 358(d)(2) excludes the same liabilities that IRC § 357(c)(3) excludes, so a cash-basis transferor’s payables do not reduce stock basis either. The two exclusions are deliberately matched.

The combined effect where liabilities exceed basis is worth stating: stock basis reduced to zero (it cannot go below), gain recognised for the excess, and the corporation’s basis in the property increased by that gain under IRC § 362(a). The corporation ends up with basis equal to the liability it assumed, which is the economically sensible answer.

Scenarios

The depreciated building and the refinanced mortgage

Thaddeus has held an apartment building for twenty-two years. Its adjusted basis is now $310,000 after depreciation, its fair market value is $1,900,000, and it carries a $740,000 mortgage taken out in stages to fund other property. He contributes it to a corporation he will wholly own, which takes the building subject to the mortgage. He receives only stock.

He recognises $430,000 of gain. IRC § 357(a) means the mortgage is not boot, and IRC § 357(b) does not apply because the borrowings were for genuine business reasons over many years. But IRC § 357(c)(1) taxes the excess of the $740,000 of liabilities assumed over the $310,000 aggregate adjusted basis of the property transferred, and there is no purpose test to argue about. His stock basis is $310,000, reduced by the $740,000 treated as money received under IRC § 358(d)(1) — floored at zero — and increased by the $430,000 of gain, so zero. The corporation's basis is $310,000 plus $430,000, so $740,000.

The loan taken out the month before

Ottilie owns land worth $1,200,000 with a basis of $900,000, unencumbered. In March she borrows $500,000 against it and spends the proceeds on a house. In April she contributes the land to a new corporation, which assumes the loan, and she receives all its stock.

The whole $500,000 is treated as money received. IRC § 357(b)(1) applies where, taking into account the nature of the liability and the circumstances in which the arrangement for the assumption was made, the taxpayer's principal purpose was to avoid federal income tax on the exchange or was not a bona fide business purpose. A personal borrowing a month before an incorporation, with the debt pushed onto the corporation, meets that description. Note what the provision does: the whole $500,000 is boot, not just the excess over basis, so she recognises $300,000 — her full realised gain, capped by the boot. Under IRC § 357(c) alone she would have recognised nothing, because $500,000 does not exceed her $900,000 basis.

The cash-basis practice with payables

Genevieve incorporates her cash-basis consultancy. She transfers $38,000 of receivables with a zero basis, office equipment with a basis of $14,000, and the corporation assumes $52,000 of accounts payable for supplies and subcontractors.

She recognises nothing. Without IRC § 357(c)(3) she would have $52,000 of liabilities against $14,000 of aggregate basis and would recognise $38,000 of gain on incorporating a business that is nowhere near as profitable as that sounds. But the payables are liabilities the payment of which would give rise to a deduction, so IRC § 357(c)(3)(A)(i) excludes them from the liabilities counted. Her stock basis is similarly protected: IRC § 358(d)(2) disapplies the money-received treatment for the same excluded liabilities, so her basis is $14,000 rather than negative. The two exclusions are matched by design.

The property worth less than its debt

Marek contributes a warehouse to a corporation. Its fair market value is $600,000, its adjusted basis is $180,000, and it carries a $650,000 non-recourse mortgage. He is economically underwater by $50,000.

He recognises $470,000 of gain. IRC § 357(c)(1) compares the liabilities assumed with the aggregate adjusted basis of the property transferred — not with its value — so the fact that he has an overall economic loss is irrelevant to the computation. $650,000 less $180,000 is $470,000, treated as gain from the sale or exchange of the property, capital or ordinary as the case may be. This is the least intuitive result in the section and it is a consequence of the section being written against basis rather than against value.

Traps

An assumed liability is not boot. IRC § 357(a) — so it does not by itself produce gain and does not disqualify the exchange.
IRC § 357(b) taxes the whole liability, not the excess. Where it applies, the total amount assumed is treated as money received.
IRC § 357(c) has no purpose test. Liabilities exceeding aggregate basis are gain however commercial the borrowing was.
It is basis, not value. A transferor economically underwater can still recognise substantial gain.
Deductible liabilities are excluded. IRC § 357(c)(3)(A)(i), which is what makes cash-basis incorporations workable.
The basis exclusion is matched. IRC § 358(d)(2) leaves the same liabilities out of the stock basis computation.
Stock basis floors at zero. The excess becomes gain rather than negative basis.

How this has changed

IRC § 357 has been stable in structure since 1954, and the excess-over-basis rule in subsection (c) has been in place throughout. The exclusion for deductible liabilities in IRC § 357(c)(3) is the significant addition, and it resolved a long-running problem for cash-basis taxpayers whose incorporation would otherwise have produced gain purely because their payables exceeded the basis of their assets. Material predating it treats a cash-basis incorporation as a routine IRC § 357(c) exposure, which it no longer is.

What has moved around the section is the treatment of who “assumes” a liability. The Code now distinguishes between a recourse liability, treated as assumed where the transferee has agreed to and is expected to satisfy it, and a non-recourse liability, treated as assumed to the extent the property transferred is subject to it — with an adjustment where other assets also secure the same debt. Those rules were codified after a period of case law disagreement, and material that speaks simply of a liability being “assumed” without distinguishing the two is describing the position before that codification.

The interaction with IRC § 362(e)(2) matters here too. Where property carries both a built-in loss and liabilities exceeding basis, the corporation’s basis is increased by the IRC § 357(c) gain under IRC § 362(a) and then tested against the § 362(e)(2) cap. Sequencing the two is not addressed in either subsection and is the kind of point on which a practitioner should look for current guidance rather than reason from the text.

Exam focus

Almost every question is IRC § 357(c) arithmetic: total the liabilities assumed, total the adjusted bases of the property transferred, and the excess is gain. The distractors substitute fair market value for basis, or compare the liability with the value of the property.

Where a question describes a borrowing shortly before the incorporation, or a liability with no business connection, it is testing IRC § 357(b) — and the answer is that the whole liability is treated as money received, not the excess.

Where the transferor is on the cash basis and the liabilities are trade payables, check IRC § 357(c)(3) before computing anything: those liabilities are excluded and the answer is usually that no gain arises.

Check yourself

1. A transferor contributes property with an adjusted basis of $240,000 and a fair market value of $900,000, subject to a $310,000 mortgage the corporation assumes. What gain is recognised?

Answer: $70,000. IRC § 357(c)(1) treats as gain the excess of the liabilities assumed over the total adjusted basis of the property transferred — $310,000 less $240,000. The fair market value is irrelevant, and there is no purpose test to satisfy.

2. On the same facts, what is the transferor’s basis in the stock received?

Answer: nil. Under IRC § 358(a)(1) the basis starts at the $240,000 adjusted basis, is decreased by the $310,000 treated as money received under IRC § 358(d)(1) — floored at zero — and increased by the $70,000 of gain recognised. The corporation’s basis in the property is $240,000 plus $70,000, so $310,000, equal to the liability it took on.

3. A transferor borrows $200,000 against unencumbered property for personal reasons two weeks before contributing it to a controlled corporation that assumes the loan. The property has a basis of $600,000. What is the consequence?

Answer: the whole $200,000 is treated as money received. IRC § 357(b)(1) applies where the principal purpose of the assumption was to avoid federal income tax on the exchange or was not a bona fide business purpose, and it treats the total amount of the liabilities assumed as money received — not merely the excess over basis. Under IRC § 357(c) alone nothing would have been recognised, since $200,000 is well under the $600,000 basis.

4. A cash-basis proprietor incorporates, transferring assets with an aggregate basis of $9,000 and having the corporation assume $46,000 of trade accounts payable. What gain arises under IRC § 357(c)?

Answer: none. IRC § 357(c)(3)(A)(i) excludes from the liabilities assumed any liability the payment of which would give rise to a deduction, and trade payables of a cash-basis business are exactly that. With the payables excluded there are no liabilities left to compare against the $9,000 of basis.

5. A transferor contributes property with a basis of $150,000 and a fair market value of $400,000, subject to $480,000 of debt. He is economically underwater. Does he recognise gain?

Answer: yes, $330,000. IRC § 357(c)(1) measures the excess of liabilities assumed over the aggregate adjusted basis of the property transferred, and does not look at fair market value at all. That the transferor has an overall economic loss on the property does not affect the computation.

Change log

2026-08-21Initial draft. Sets out the IRC § 357(a) rule that an assumed liability is not money or other property, the § 357(b) recharacterisation of the whole of the liabilities where the principal purpose was tax avoidance or was not a bona fide business purpose, the § 357(c)(1) treatment of liabilities exceeding the aggregate adjusted basis of the property transferred as gain, the § 357(c)(3) exclusion of liabilities whose payment would give rise to a deduction, and the § 358(d) treatment of an assumed liability as money received for basis purposes with its matching exception.