Under section 351, a person transferring property to a controlled corporation generally recognizes no gain or loss on the transaction. An exception to tax-free treatment is contained in section 357(c), which generally provides that a transferor in a section 351 transaction recognizes gain to the extent that any liabilities assumed by the corporation on the transfer exceed the transferor's aggregate adjusted basis in the assets transferred. An issue under section 357(c) is whether the recognized gain should be capital gain or ordinary income. The statute suggests that the character of section 357(c) gain should be based on the character of the transferred assets, but this does not provide a clear answer when two or more assets of differing character are transferred to the corporation. The Treasury regulations prescribe a method for determining the character of section 357(c) gain that allocates the gain according to the relative fair market value of the transferred assets. However, a few U.S. Tax Court decisions have not followed this method, and several commentators have stated that the regulatory method is simply wrong; instead, these cases and commentators espouse an alternative method that determines the character of section 357(c) gain based on the relative amount of realized gain on the transferred assets.
This article analyzes the section 357(c) character issue and determines which of the competing methods and underlying constructs is more appropriate in light of the relevant tax rules and principles, and in particular those relating to nonrecognition. The article offers different ways of conceptualizing transfers to corporations in connection with the assumption of liabilities, each of which supports one of the competing methods for determining the character of section 357(c) gain. The relative fair market value allocation method is supported by an aggregate asset construct that combines the tax attributes of the transferred assets; the relative realized gain allocation method is supported by a modified separate assets construct that generally treats the transaction as transfers of separate assets. The article then evaluates the constructs and resulting methods, and determines that the modified separate assets construct and resulting relative realized gain allocation method is the more appropriate manner for determining the character of section 357(c) gain.