IRC 357, 358, and 362: Assumption of Liabilities in Section 351 Incorporations and Section 368 Reorganizations

Overview: IRC 357 in the Section 351 and 368 Framework

IRC 351 permits a taxpayer to transfer property to a corporation in exchange for stock without recognizing gain or loss, provided that the transferor (or the transferor group) controls the corporation immediately after the exchange. That nonrecognition benefit is a cornerstone of tax-free incorporation planning. But when the property contributed carries liabilities that the corporation assumes as part of the transfer, a threshold question arises: does the assumption count as the receipt of consideration (boot) by the transferor, triggering gain recognition? IRC 357 answers that question.

The three subsections of IRC 357 govern three distinct situations. IRC 357(a) states the baseline rule: an assumed liability is not treated as money received, and the exchange remains tax-free at the shareholder level. IRC 357(b) carves out an exception when the assumption is motivated by tax avoidance or lacks a bona fide business purpose, in which case the full assumed-liability amount becomes taxable boot. IRC 357(c) imposes gain recognition when the aggregate liabilities assumed exceed the aggregate adjusted basis of all property transferred, treating the excess as realized gain without regard to intent.

The basis consequences under IRC 358 (shareholder's outside basis in the stock received) and IRC 362 (corporation's inside basis in the property received) flow directly from the IRC 357 outcome. A transaction that avoids gain under IRC 357(a) produces a carryover basis under both IRC 358 and 362. A transaction in which gain is recognized under IRC 357(b) or (c) adjusts both bases upward by the gain recognized. Understanding these three sections together is essential for any practitioner structuring a leveraged incorporation or advising on a reorganization where the target carries significant debt.

IRC 357 also applies, with modifications, in IRC 368 reorganizations. Type C reorganizations treat assumed liabilities as money paid by the acquiring corporation, which affects the 20% boot ceiling in that structure. Type A mergers operate differently: liabilities pass by operation of law and do not threaten the reorganization's qualification. The coordination rules and their planning consequences are addressed in Section 8 of this guide.

IRC 357(a): The General Nonrecognition Rule

The text of IRC 357(a) is direct: except as provided in subsections (b) and (c), if, as part of a section 361 or section 351 exchange, a liability of the transferor is assumed by the other party to the exchange, the assumption shall not be treated as money received by the transferor. The practical effect is that the transferring shareholder does not recognize gain solely because the corporation took over a debt that the shareholder owed.

This rule reflects the economic reality of leveraged incorporations. When a sole proprietor contributes a business with $400,000 of assets and $150,000 of trade liabilities to a newly formed corporation, the corporation's assumption of those liabilities does not put cash in the proprietor's pocket. The proprietor still owns 100% of the corporation (which now carries the debt), and the net economic position is unchanged. Treating the assumed liability as a cash distribution would generate a phantom tax event with no corresponding liquidity, frustrating the nonrecognition policy underlying section 351.

The assumed liability does, however, reduce the transferor's outside basis in the stock received under IRC 358(d), treated as money received for basis purposes (though not for gain recognition purposes). This basis reduction prevents the shareholder from stacking up an inflated cost basis in the stock by contributing heavily encumbered property, deferring tax on the embedded appreciation indefinitely. The basis mechanics under IRC 358 are addressed in detail in Section 6 of this guide.

A critical threshold requirement for IRC 357(a) to apply is that the transaction must qualify as a valid IRC 351 exchange to begin with. If the "control immediately after" requirement of IRC 351(a) is not satisfied, the exchange is fully taxable regardless of how the liabilities are treated under IRC 357. Practitioners working through the liability analysis must first confirm that IRC 351 applies to the base transaction before layering in the IRC 357 analysis.

IRC 357(b): The Tax Avoidance Exception

IRC 357(b) overrides the general rule of IRC 357(a) in two circumstances: (1) where the principal purpose of assuming the liability was to avoid federal income tax, or (2) where the assumption was not undertaken for a bona fide business purpose. When either prong is satisfied, the entire amount of all liabilities assumed in the exchange is treated as money received by the transferor (boot), triggering gain recognition to the extent of the transferor's realized gain on the exchange.

The consequence of IRC 357(b) is severe in comparison to IRC 357(c). Under IRC 357(c), only the excess of liabilities over basis is recognized as gain. Under IRC 357(b), the entire assumed-liability amount becomes boot, which can produce a far larger gain recognition even when the liabilities do not exceed the property's adjusted basis. A transferor who loads up a corporation with debt shortly before an incorporation, without a genuine business reason for having the corporation bear that debt, faces recognition of the full liability amount as a deemed cash distribution.

The Two-Year Presumption

Treasury Regulation section 1.357-1(c) and the legislative history underlying IRC 357(b) give the IRS a factual presumption when a liability was incurred or increased within two years prior to the transfer and in anticipation of it. While not a statutory bright-line rule, this presumption shifts the practical burden to the taxpayer to establish bona fide business purpose. Practitioners advising clients who incorporated after recently incurring significant debt should document the business rationale at the time the liability was incurred, not merely at the time of the section 351 transfer. Verify current IRS guidance on this presumption at IRS.gov.

What Constitutes a Bona Fide Business Purpose

The regulations under Reg. 1.357-1 address the bona fide business purpose requirement. A liability is assumed for a bona fide business purpose when it is part of the ordinary capital structure or operating liabilities of the business being incorporated. Examples that generally satisfy the standard include: trade payables incurred in the ordinary course of the transferred business, bank financing used to acquire the business's operating assets, and mortgage debt on real property contributed to the corporation where the mortgage was incurred to fund the acquisition or improvement of that property.

Examples that raise IRC 357(b) risk include: personal consumer debt loaded onto the corporation without a business connection, a line of credit drawn down immediately before the transfer to generate cash that the shareholder retains, and inter-company loans substituted for pre-existing business debt at elevated amounts near the transfer date. In each of these, the question is whether a rational non-tax business reason explains why the corporation, rather than the shareholder, should carry the liability.

IRC 357(c): The Excess-Liabilities Gain Trap

IRC 357(c) is intent-neutral. It does not ask why the liabilities were assumed. It applies automatically whenever, in a section 351 exchange, the sum of all liabilities assumed by the corporation exceeds the sum of the adjusted bases of all property transferred by the transferor. The excess is recognized as gain by the transferor, with the character (capital or ordinary) determined by reference to the type of property transferred that would have generated such gain on a deemed sale.

The mechanics require aggregating all property transferred and all liabilities assumed across the entire integrated section 351 transaction, not property-by-property. If a shareholder contributes three parcels of real estate with aggregate adjusted bases of $900,000 and the corporation assumes mortgages totaling $1,100,000, the shareholder recognizes $200,000 of gain. The gain is not computed separately for each property; the totals are compared. This aggregation rule, established in Reg. 1.357-2(a), prevents the taxpayer from isolating low-basis property with high-basis property on a claim-by-claim basis.

Character of Recognized Gain

The character of the gain recognized under IRC 357(c) is determined as if the properties transferred had been sold for consideration equal to the gain recognized. Treas. Reg. 1.357-2(b) provides that the gain is allocated among the properties transferred in proportion to the gain inherent in each (fair market value over adjusted basis). Gain allocated to capital assets held for more than one year is long-term capital gain. Gain allocated to section 1245 property (depreciable personal property) or section 1250 property may be characterized as ordinary income under the recapture rules. Gain allocated to IRC 1231 assets flows through the IRC 1231 hotchpot analysis. The character analysis can produce a mix of ordinary and capital gain components even when the numerical computation is straightforward.

Illustrative Example (Hypothetical, For Illustration Only)

IRC 357(c) Gain and the IRC 358 Basis Result

When IRC 357(c) gain is recognized, the transferor's IRC 358 outside basis in the stock received is adjusted upward by the recognized gain. Without this adjustment, the transferor's stock basis would be negative (liabilities exceed basis, and basis is reduced by liabilities assumed under IRC 358(d)). The addition of recognized gain under the IRC 358 formula prevents a negative basis result and preserves the correlation between the tax paid on the IRC 357(c) gain and the stock basis available for future disposition purposes.

IRC 357(c)(3): Exclusion for Deductible Liabilities

IRC 357(c)(3) narrows the scope of liabilities counted in the IRC 357(c) excess computation. It provides that for purposes of IRC 357(c), the term "liabilities" does not include any liability the payment of which would give rise to a deduction (or, in the case of a liability arising under a revenue law, the amount of which would not be included in income). The most common and commercially significant application is accounts payable of a sole proprietor or other cash-method taxpayer.

Accounts Payable and the Cash-Method Mismatch

A cash-method sole proprietor operating a service business typically carries accounts payable to vendors that have not yet been paid. These payables represent amounts for which no deduction has yet been taken (because no payment has been made). The adjusted basis of the proprietor's assets does not include those payables (they create no basis). If the payables were included in the IRC 357(c) liability total, the proprietor could be forced to recognize gain on the incorporation, and then take a deduction later when the corporation pays the bills. Congress rejected this mismatch in IRC 357(c)(3): the deductible-upon-payment payables are excluded from the liability count, so the IRC 357(c) test compares only non-deductible liabilities against the aggregate adjusted basis.

The exclusion does not apply to liabilities that generate basis rather than deductions. A bank loan used to purchase an asset results in cost basis to the borrower equal to the loan amount; payment of the loan is not deductible. Such a loan is fully included in the IRC 357(c) computation. The line separating deductible liabilities from capital liabilities is therefore critical: practitioners advising cash-method businesses should catalog each category of assumed liability and apply IRC 357(c)(3) only to those whose payment would produce a deduction, not a basis recovery.

Contingent Liabilities

IRC 357(c)(3) has also been applied to contingent liabilities that, when paid, will generate deductions. Unfunded deferred compensation obligations, litigation reserves, and environmental remediation obligations are examples where practitioners have argued for exclusion under IRC 357(c)(3) on the ground that eventual payment will be deductible. The better analytical path, however, is first to determine whether a contingent liability is fixed and determinable as of the transfer date. Under Rev. Rul. 2007-8 (addressed in Section 9), liabilities that are not fixed and determinable at the time of transfer are generally not included in the IRC 357(c) computation at all. The IRC 357(c)(3) exclusion then addresses only liabilities that are fixed and determinable but would give rise to a deduction when paid. Practitioners should apply the two analyses in sequence rather than relying solely on IRC 357(c)(3) to remove contingent amounts. Verify current guidance at IRS.gov.

IRC 358: Transferor Shareholder Outside Basis

IRC 358 governs the basis of the stock (or other property) that the transferor receives in a section 351 exchange. The general formula under IRC 358(a)(1) is:

Outside Basis = Adjusted Basis of Property Transferred
minus: money received + fair market value of non-stock boot received + liabilities assumed by the corporation (IRC 358(d))
plus: gain recognized by the transferor on the exchange

In a clean section 351 exchange with no boot and no assumed liabilities, outside basis equals the transferor's adjusted basis in the contributed property. The gain built into the property is preserved as a latent liability that will be recognized when the stock is eventually sold, a deferral, not a forgiveness, of the tax on the embedded appreciation.

Impact of Assumed Liabilities on IRC 358 Basis

When a liability is assumed, IRC 358(d) requires that the assumed-liability amount be subtracted from the transferor's stock basis, as if the assumed amount were cash received. This is true even when the assumed liability is not treated as boot for gain recognition purposes under IRC 357(a). The asymmetry is intentional: the assumed liability is not "money received" for gain recognition purposes (IRC 357(a)), but it is treated as money received for basis reduction purposes (IRC 358(d)). The effect is to reduce the transferor's deferred tax asset in the stock.

Preventing Negative Basis: The IRC 357(c) Correction

In an IRC 357(c) scenario where liabilities exceed basis, the bare application of the IRC 358 formula would produce a negative stock basis (liability reduction exceeds the basis being reduced). Negative basis is not permitted under the Code. The mechanism that prevents it is the "plus gain recognized" component of the IRC 358 formula. When IRC 357(c) gain is recognized, that gain amount is added back under IRC 358(a)(1)(B)(ii), bringing the net basis to zero (or slightly above in cases where the gain recognized does not fully offset the negative before the correction). The result: a transferor who recognizes IRC 357(c) gain ends up with a zero (or near-zero) stock basis, reflecting the fact that all inherent gain in the contributed property has been recognized currently rather than deferred.

Allocation of Basis to Multiple Classes of Stock

When the corporation issues more than one class of stock in the same section 351 exchange, Treas. Reg. 1.358-2 allocates the aggregate outside basis determined under IRC 358(a) among the different classes in proportion to the relative fair market values of each class received. Practitioners structuring incorporations that issue both common and preferred stock must apply this allocation rule before computing each class's holding period and gain characteristics.

IRC 362: Corporate Inside Basis

IRC 362(a) governs the basis that the corporation takes in property received in a section 351 exchange. The rule is a carryover basis: the corporation's inside basis equals the transferor's adjusted basis in the property at the time of transfer, increased by any gain recognized by the transferor on the exchange. This rule applies whether or not the corporation assumed any liabilities, and whether or not the liabilities caused IRC 357(b) or 357(c) gain.

The Gain Recognition Step-Up

When the transferor recognizes gain under IRC 357(b) or IRC 357(c), IRC 362(a) increases the corporation's inside basis by the gain recognized. This step-up is the quid pro quo for the tax the transferor paid: the corporation inherits a higher basis, reducing its future taxable gain on a disposition of the same property. The step-up is sized exactly to the gain recognized, maintaining the sum of the shareholder's outside basis plus the corporation's unrealized gain at a constant value. The government has collected the tax on the gain, so the corresponding amount of gain is removed from the property's embedded appreciation at the corporate level.

No Basis Reduction for Assumed Liabilities at the Corporate Level

A frequently misunderstood point: the corporation's assumption of a liability does not reduce its inside basis in the received property under IRC 362. The corporation's inside basis is determined solely by IRC 362(a) (carryover from the transferor, plus gain recognized). The assumed liability is a balance-sheet obligation of the corporation; it affects the corporation's financial accounting and its future deductions when the liability is paid, but it does not further reduce the IRC 362 inside basis below the IRC 362(a) carryover amount. This is in contrast to IRC 358, where assumed liabilities do reduce the transferor's stock basis. The asymmetry between IRC 358 and IRC 362 on this point is a recurring source of confusion in post-incorporation basis tracings.

Inside Basis Limitation Under the TCJA (IRC 362(e))

Congress added IRC 362(e) in 2004 (and modified it under subsequent legislation) to address "loss importation" transactions: section 351 exchanges in which the fair market value of contributed property is less than the transferor's adjusted basis. Without limitation, the corporation would inherit a high basis in depreciated property, available as future loss deductions, while the transferor recognized no loss on the tax-free transfer. IRC 362(e)(2) limits the corporation's inside basis in each transferred property to the property's fair market value at the time of transfer when the property is a "loss property" (FMV less than adjusted basis) and when the overall exchange results in a net loss position. Practitioners structuring contributions of property that may have declined in value below its adjusted basis must account for the IRC 362(e)(2) limitation and consider the election under IRC 362(e)(2)(C) to instead reduce the transferor's stock basis (which, unlike the inside basis limitation, permits the loss to eventually be recognized by the shareholder). Verify the current scope of IRC 362(e) at IRS.gov.

Application in IRC 368 Reorganizations

IRC 357 applies not only in section 351 exchanges but also in certain tax-free reorganizations under IRC 368 where property is transferred to a corporation. The specific interaction depends on the reorganization type.

Type C Reorganizations: Liabilities as Money Paid

In a Type C reorganization under IRC 368(a)(1)(C), the acquiring corporation transfers solely its voting stock for substantially all of the target corporation's properties. The defining structural constraint of a Type C is the 20% boot limitation under IRC 368(a)(2)(B): the acquiring corporation may pay up to 20% of the total consideration in non-stock property (including cash), but any amount above that ceiling destroys the Type C's qualification.

IRC 368(a)(2)(B) provides that any money paid by the acquiring corporation and the fair market value of any non-stock property transferred are counted against the 20% ceiling, and it further specifies that the assumption of a liability of the acquired corporation (and the taking of property subject to a liability) is treated as money paid by the acquiring corporation for this purpose. The result is that assumed liabilities consume the Type C boot capacity at the rate of dollar-for-dollar.

In a target with $5,000,000 of gross assets and $900,000 of assumed debt, the 20% cap permits at most $1,000,000 of non-stock consideration (20% of $5,000,000). The $900,000 of assumed debt consumes most of that capacity, leaving only $100,000 for cash or other boot. A target with total debt exceeding 20% of its gross asset value cannot qualify for a Type C reorganization at all, regardless of how clean the consideration otherwise is. Verify current IRS guidance on the Type C 20% boot ceiling at IRS.gov.

Type A Reorganizations: Operation of Law

Type A reorganizations, including forward and reverse triangular mergers under IRC 368(a)(2)(D) and (E), operate under state merger law. All assets and liabilities of the target pass to the surviving entity by operation of law, not by contract or voluntary assumption. Because there is no discrete "assumption" transaction, the IRC 368(a)(2)(B) counting rule does not apply to Type A mergers. Liabilities that transfer in a Type A do not count against any boot ceiling and do not threaten the reorganization's qualification. This feature makes the Type A (and its triangular variants) substantially more favorable than the Type C for leveraged target acquisitions. A highly indebted target that would fail a Type C because of its debt load can be acquired in a Type A or forward triangular merger without those liabilities disqualifying the transaction.

Basis Rules in Reorganizations: IRC 358 and 362 Coordination

In a qualifying reorganization, the target corporation's shareholders exchange their target stock for acquiring corporation stock. Their basis in the acquiring corporation stock is governed by IRC 358, applying the same formula as in a section 351 exchange: carryover basis of the surrendered target stock, reduced by boot received, increased by gain recognized. The acquiring corporation's basis in the target's assets is governed by IRC 362(b) in a reorganization context: the assets take a carryover basis from the target corporation (not the individual shareholders), with an upward adjustment for any gain recognized at the target corporate level. The overlap of IRC 357, 358, and 362 with IRC 381 (carryover of tax attributes) and IRC 382 (NOL limitation) creates a basis tracing exercise that can span multiple corporate layers in complex reorganizations. Verify the applicable basis rules at IRS.gov before finalizing basis schedules in a post-reorganization integration.

Rev. Rul. 2007-8 and Regulatory Guidance

Treas. Reg. 1.357-1: General Rule and Definitions

Treas. Reg. 1.357-1 implements IRC 357(a) by confirming that a liability assumed in a qualifying section 361 or section 351 exchange is not treated as money received by the transferor for purposes of computing gain recognition. The regulation defines "assumption of a liability" broadly to include not only a direct contractual assumption of the transferor's debt but also any arrangement under which the transferee takes property subject to a liability without a formal contractual assumption. Practitioners should confirm which definition applies in their transaction, as the characterization can affect both the gain analysis and the basis adjustments under IRC 358 and 362. Verify current definitional guidance at IRS.gov.

Treas. Reg. 1.357-2: The Excess-Liabilities Computation

Treas. Reg. 1.357-2(a) provides the mechanics for computing IRC 357(c) gain. It confirms the aggregation rule: all properties transferred and all liabilities assumed in the same integrated transaction are pooled for the excess test. It provides that if the sum of liabilities exceeds the sum of adjusted bases, the excess is gain, recognized as of the date of the exchange. Treas. Reg. 1.357-2(b) addresses the character of the recognized gain, applying a proportionate-allocation approach that ties the character to the asset classes and the built-in appreciation of each transferred property. The regulation also addresses the interaction with IRC 358 (basis reduction) to prevent double-counting. Verify that these regulations have not been superseded or amended at IRS.gov before applying them in a specific transaction.

Rev. Rul. 2007-8: Contingent Liabilities

Rev. Rul. 2007-8 addressed a section 351 exchange in which the corporation assumed contingent liabilities of the transferor that were not fixed and determinable as of the transfer date. The IRS held that a contingent liability that is not fixed and determinable is not "assumed" within the meaning of IRC 357 at the time of the transfer and therefore does not enter the IRC 357(c) computation at the transfer date. The liability is accounted for in basis computations (IRC 358 and 362) only when it becomes fixed and is paid or accrued. This ruling has significant practical value for practitioners structuring incorporations involving pending litigation, environmental contingencies, or deferred compensation arrangements: those liabilities should not be added to the IRC 357(c) liability total if they are not fixed and determinable. Practitioners should confirm that Rev. Rul. 2007-8 remains current authority and that no subsequent guidance has modified its holding at IRS.gov.

The Peracchi Problem and Its Aftermath

The Ninth Circuit's decision in Peracchi v. Commissioner (143 F.3d 487, 9th Cir. 1998) addressed a creative but contested planning strategy: a taxpayer contributed a promissory note to a corporation alongside property in a section 351 exchange, arguing that the note increased the adjusted basis of property transferred for purposes of the IRC 357(c) test (eliminating the excess). The Ninth Circuit agreed that a valid, bona fide promissory note creates basis under IRC 358, but this position has not been universally adopted and the IRS has continued to scrutinize note-contribution strategies. Practitioners considering note-contribution solutions to IRC 357(c) problems should be aware that the IRS's formal position and the circuit-court landscape outside the Ninth Circuit may differ. Verify current IRS guidance on note contributions in section 351 exchanges at IRS.gov before deploying this approach.

Planning: Avoiding IRC 357(b) and the IRC 357(c) Trap

Documenting Business Purpose Against IRC 357(b)

The most reliable defense against IRC 357(b) is contemporaneous documentation establishing that each assumed liability serves a genuine business function of the transferred enterprise. This means tracing each liability to its origin in the business's ordinary operations or capital structure, preparing board and shareholder resolutions that specifically authorize the corporate assumption and state the business reason, and retaining that record permanently as part of the tax files for the incorporation. Because IRC 357(b) is a facts-and-circumstances test with no statute of limitations shorter than the general assessment period, documentation created at the time of the transfer is worth far more than reconstruction after an IRS inquiry begins. Verify the current standard for documenting business purpose at IRS.gov before the closing date.

Managing the IRC 357(c) Arithmetic Before Closing

The IRC 357(c) trap is mechanical and preventable if the arithmetic is checked before the exchange closes. The pre-closing diagnostic requires four steps: (1) list every asset to be transferred and confirm its current adjusted basis; (2) list every liability to be assumed; (3) apply IRC 357(c)(3) to exclude deductible liabilities; and (4) compare the adjusted total of non-deductible liabilities against the total adjusted bases. If the comparison shows an excess, the practitioner has several options before closing:

• Retain some assets: The transferor can keep high-basis assets out of the section 351 exchange, improving the ratio of bases to liabilities in the exchange assets. Retained assets remain in a taxable transaction if eventually transferred.
• Pay down liabilities before transfer: If the transferor can liquidate some debt before the closing date, the section 357(c) excess may disappear. This approach requires available liquidity and lender consent for prepayment.
• Contribute additional cash or property: Adding high-basis or cash assets to the transfer increases the aggregate adjusted basis, potentially eliminating the excess. The contributed amounts increase both the IRC 358 stock basis and the IRC 362 inside basis.
• Contribute a promissory note (Peracchi approach, Ninth Circuit only): As noted in Section 9, this strategy is unsettled outside the Ninth Circuit and carries litigation risk. Verify current IRS guidance at IRS.gov before using this approach.

Installment Notes and Contingent Liabilities

When a transferor's business carries obligations that are payable over time under an installment arrangement, the practitioner must determine whether those obligations are fixed and determinable as of the transfer date. Under Rev. Rul. 2007-8, obligations that are not fixed and determinable are not counted in the IRC 357(c) test at the transfer date. Practitioners should distinguish between a fixed installment note (fully counted under IRC 357(c) because the total obligation is fixed) and a contingent obligation whose eventual payment depends on a future event (not counted until the liability is fixed). Structuring earnout obligations and contingent indemnification payments as genuinely contingent, rather than as fixed deferred payments, can materially reduce the IRC 357(c) exposure in complex transactions.

Leveraged Contributions to Existing Corporations

The IRC 357 rules apply not only to newly formed corporations but to any section 351 exchange, including contributions of leveraged property to an existing corporation in which the transferor already holds stock. In the existing-corporation context, the IRC 357(c) arithmetic must include only the property and liabilities in the new contribution, not the transferor's existing basis in previously held shares. Practitioners who advise clients making follow-on contributions of leveraged property to an existing subsidiary or operating company should run the IRC 357(c) diagnostic on the incremental contribution, not on the taxpayer's overall position in the corporation. Verify the applicable rules at IRS.gov before closing any leveraged contribution to an existing entity.

Comparison Table: IRC 357(a), 357(b), 357(c), 358, and 362