Incorporation of an existing business almost invariably raises the question of whether the corporation should assume the business's liabilities and whether such an assumption creates income tax problems under section 357 of the Internal Revenue Code. Cash basis taxpayers in particular have encountered special problems when incorporating a partnership or sole proprietorship and often have received an unexpected tax liability in the year of incorporation. Generally, gain or loss is not recognized when assets and liabilities are transferred to a controlled corporation solely in exchange for the stock or securities of that corporation. Section 357(c) of the Internal Revenue Code, however, requires that gain be recognized to the extent that the liabilities assumed (plus liabilities to which the property transferred is subject) exceed the aggregate adjusted basis of property transferred to the new corporation. The cash basis taxpayer's unexpected tax liability results from a very literal interpretation of section 357(c). Under this interpretation, for the cash basis taxpayer, the adjusted basis of accounts receivable is zero while the accounts payable are liabilities which are valued at their face amount. Therefore, unless other property with a substantial aggregate adjusted basis is transferred, instant income is recognized under the section 357(c) formula. Recently, the Court of Appeals for the Second Circuit, in Bongiovanni v. Commissioner, disagreed with the prevailing literal interpretation and held that the liabilities referred to in section 357(c) were tax liabilities and not accounting liabilities. Accordingly, the court held that, for tax purposes, a cash basis taxpayer's accounts payable should not be valued at face amount but at zero. The court justified this distinction on the grounds that, since the cash basis taxpayer had not been allowed a deduction for the accounts payable, a contrary determination would promote inequality between accrual and cash basis taxpayers. This comment examines the history and purpose behind section 357(c), including an analysis of the defects in pre-1954 law which section 357(c) was designed to remedy, to determine the proper application of the section when accounts receivable and accounts payable are involved. In addition, the implications and inconsistencies of both the Bongiovanni decision and the "majority" view of section 357(c) are explored to determine whether equality between cash basis and accrual taxpayers exists under either interpretation.
Stephen C. Johnson,
Section 357(c): The Quest for Equality between Accrual and Cash Basis Taxpayers,
52 Neb. L. Rev. 527
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