 Hello and welcome to this session in which we'll discuss section 351. Specifically, we're going to be involving boot and liability assumed. Let's go back and review what is section 351. Well, we have a bunch of shareholders that they wanted to form a corporation. What they do is they contribute money and property to this corporation to form the corporation and in return, the company would give them stocks ownership. The only difference in this example that we're going to be illustrating is the property contributed by the shareholders, for example, building, land, whatever property they are contributing, attached to it is some sort of a liability. And when you transfer the property to the corporation, you are also going to transfer the debt to the corporation because the debt is simply attached to the property. Now, we are also going to introduce the concept that in addition to the company's stocks, the corporation is going to give the shareholders a boot. Now, where is a boot? Simply put, they might give them cash or some other property. That's a boot. And we're going to see that sometime the debt itself, assuming the debt by the corporation is a form of a boot, we're going to see the details for that as well. So simply put, if section 351 applies, no recognized gain or loss on property transferred, unless boot is involved. Boot and I have in parentheses debt, because we're going to see sometime the debt might be considered a boot. Now, the other thing you want to know before we proceed any further is boot is one way. The corporation don't receive a boot. There's no such a boot, given boot to the corporation. The corporation will give the boot. But this is what we need to learn in this session, because we're going to have to compute the gain. And we have to look at the character of the gain, how much of it is recognized, so on and so forth. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Character of the gain and how to compute the gain. So when you have a gain, you have to understand how to compute the gain. Well, you want to make sure you know this formula. Well, how much of the gain am I going to recognize? In other words, how much of the gain is taxable? Well, the gain will be the lesser of the realized gain. What is the realized gain? So first you have to compute the realized gain. When you transfer something, you have to compute the realized gain. We're going to put the fair market value of that item minus the adjusted basis, minus the AB. This is the realized gain. So the recognized gain, the gain that's taxable, it's going to be the realized gain, or the fair market value of boot received, whichever is lower, the lesser of realized gain or fair market value received. Now you have to remember too that the total recognized gain includes the fair market value of services transferred. So when you compute the recognized gain, you have to include any service transferred because that's taxable as well. And that's important for the basis. We will see it in the formula later on. So again, the services is added to the recognized gain. It increases the basis because you already pay taxes on that. What is the recognized loss? Zero. You don't compute the recognized loss. It's the reverse of gap because in gap we are conservative here. We, you know, we don't want to recognize any loss because losses are good. Now this is the general rule. So section 351 don't trigger any loss recognition. We're going to see later in another session, next session. You can, if you want to, the shareholder can take the loss, but we'll look at that later. How about the character of the gain? Because our concern is the gain. Well, it all depends on the asset that we are transferring. If you are transferring ordinary assets such as inventory, the gain is ordinary gain. If we are transferring section 1231 asset, the gain is section 1231 gain. If you are transferring capital asset, we're going to have a capital gain. Now also you need to know that section 351 is mandatory because this could be just a simple example on the exam or whether it's optional or not. Section 351 is mandatory. Let's start by looking at the assumption of liabilities under section 357, specifically subsection A because we're going to have subsection A, subsection B, and subsection C. So what is the big idea? Well, when we have a liability, why do we have to care about this? Well, let me give you a simple example. Let's assume I gave you my vehicle. My vehicle is worth $15,000. So I just, I said, here's my vehicle. I'm going to give you my vehicle. It's worth 15,000. But here's what I wanted to tell you. With that vehicle, there's a loan against that vehicle of $10,000. So I gave you a vehicle worth 15,000. Great. I'm happy to take your vehicle. But the vehicle has a loan of 15,000. So how much did I really give you in value? Well, I gave you in value only 5,000. Why? Because you have this vehicle, but you are also responsible for 10,000. So the net, your net, your net benefit is only 5,000. So just keep that in mind because I gave you an asset, but I gave you a liability with it. Therefore, what I really gave you, that in quote, the net asset is only 5,000. And this is what we called Section A, when the liability is transferred to a corporation, the transferor must reduce his or her adjusted basis in the stock received. So if I told you, what is your basis in this car now? Well, your basis is 5,000. Yes, you did receive a vehicle of 15,000. But unfortunately, I attached a loan to it. Therefore, you reduce the debt. The debt reduces your value. Now, what is the basis of the stock that you received? Well, the formula that I gave you, it might be a different formula than your textbook, a different formula than your CPA review course, but it gets you to the same answer. So what's the basis of the property if liabilities are involved? Well, first, you're going to start with the adjusted basis of the property transferred, whatever the adjusted basis are. Then you're going to add any recognized gain. Now, the question is, why do you add recognized gain? Why do you add the gain to the adjusted basis? Once you have a recognized gain, the implication is recognized means taxable. And if you already paid taxes on that asset, on that property, because you already paid taxes, you should increase your basis because you already paid the taxes. So when you sell this asset later, your gain is lower. That's why you increase your basis by any gain because you already paid the taxes. You also increased your basis by ordinary income from services. And the answer is why? Because services are taxable. Same concept. Once you pay taxes on something, you increase your basis because it's going to lower your taxes down the road. Then you subtract any fair market value of boot received. Why? If you receive the boot, if you receive something of a value, well, you are reducing your basis. Why? Because that value, you receive something of a value. Therefore in the future, you have to recapture the value of that in the gain. Then you also reduce your basis by any liability transferred, not considered as boot. What do we mean not considered as boot? We're going to see later, some liabilities will be considered a boot. Some liabilities will not be considered a boot. Well, think of it here. So if I gave you once again the vehicle for 15,000, but I gave you a liability of 10, well, my basis is 5,000. My basis is not 15 because I have to reduce my fair market value, my adjusted basis, whatever I received, let's assume that's the adjusted basis of 15,000, I have to reduce it by the liability. And this is going to be your adjusted basis of stock received. Now if you're not copy this formula down, that's a good idea. So we can apply it. Let's start with this example. We have an individual A, transfer the property of 100,000, the adjusted basis is 40, and with that asset comes a liability. Now this liability, we're going to be assuming it's under section A, and with section A, it has a business purpose. Simply put, we took out the liability for a business purpose. For a business purpose means we use the funds to grow the business by inventory. It has a business purpose. Well, we have a liability that's transferred. Then we have to figure out now, what's the realized gain? Well, fair market value of property transferred, adjusted basis is 40,000. We have a realized gain of 60. So 100 minus 40 equal to realized gain of 60. Now we have to know what's the recognized gain? What's the formula? The recognized gain is the lesser of realized gain or fair market value of boot received. Well, what's the fair market value of boot received? Zero. Zero. Why? Well, if that's why, because this liability has a business transfer. If it has a business transfer, it's not considered a boot. So the recognized gain is zero. No boot received in this example. Why? Because the liability, what we're saying is it's under section A, and it's under section A, it has a business purpose, liability for business purpose. That's why it's not considered a boot. Therefore we have no boot. So what is the basis for the shareholder? Well, we're going to start with the adjusted basis, which how much it is? 40,000 adjusted basis of property transferred. Add any recognized gain or ordinary income, none. Taxes on ordinary income, none. We don't have this. Less fair market value of boot received, none. Less liability transferred, that's not a boot. Well, we did transfer a liability of 25,000. Therefore, the adjusted basis minus the liability transferred, all in all, the basis is 15,000. So simply put the liability reduced my basis because I'm responsible for this. You gave the corporation 40,000 of adjusted basis, but you also gave the corporation 25,000 of liability. Therefore, the adjusted basis of stock transferred is only 15,000. That's the basis for the shareholder. Now this is a section 357, section A liability is not a boot. Let's look at assumption of liabilities under section 357, subsection B. So this is B. What is the big idea here? Well, we have two rules under subsection B. We have rule one. If there's no business transaction for the liability, then the liability is treated as a boot. If the liability is attached to the property, then there's a business purpose for the liability. Well, if attached means one, it means it's a mortgage liability attached to the property transfer, then it's a business transfer. So whether it's attached or not attached, whether it's a business purpose or not a business purpose. And we'll work some examples, illustrate this. And we have rule number two, non-business purpose liability, taints or liability transfer. And we're going to see rule number two is sometime what's going to happen is we're going to have a liability with a business purpose, a liability with no business purpose and we'll work an example for rule two. So under subsection B, we have two rules. We're going to look at rule number one first. We have an asset, we have an individual contributed a property of 100,000, adjusted basis of 40,000. And we have a liability of 25,000. And this liability has no business purpose. So let's take a look at the realized gain, 100,000 minus 40 equal to 60,000. That's the realized gain. The recognized gain is the lesser of the realized gain or boot received. Now since this is not a business purpose, the liability is considered a boot. So what's the smaller of 60 or 25, 25, the recognized gain is 25,000. Now why is this $25,000 a boot in contrast to the prior example? Because the liability had no business purpose. It has no business purpose. It's for no business purpose. Simply put, we took this money and they want on a vacation. They purchase a vehicle for personal use, whatever the reason might be. So what's the basis for the shareholder? Well, the adjusted basis, it's still 40,000. Then we have to add recognized gain, recognized gain, which is how much it is 25,000. That's taxable. Then we have to deduct less boot received because we did receive a boot. We did receive a boot of 25,000. Well, there's no liability transferred here because liability is considered a boot. Therefore, the basis is 40,000. Simply put, we did receive a boot of 25,000. That boot is taxable. So once we pay taxes on that boot, it's going to increase our basis. So we receive the boot at lower our basis. Then we pay taxes on it. It increased our basis. Therefore, what they do is they cancel each other out. So I did receive the property, which is good. If I receive the property, I received something, it's going to reduce my basis, but I pay taxes on it, it's going to increase my basis. So overall, they cancel each other out. That's what we are looking at here. So this is section 357 liability is a boot. Let's take a look at section 357, section B. But here we're going to be looking at non-business purpose liability, the taints or corrupt or liability transfer. So here we're going to have section 357. Some of the liability is for business. Some of the liability is not for business. We're going to look at a property of 100,000 adjusted basis of 40,000. We had a business loan on that liability for 25,000. That's great. Then we took a personal $10,000 loan and we went to Vegas. So this is, we're still section B here. So let's take a look at what we have now. Fair market value of property transferred 100,000 minus the adjusted basis. We have a realized gain of 60. Here's what's going to happen. The recognized gain is the lesser of realized gain or fair market value of boot received. What are we going to do now? Because we took some money out for personal use and tainted all liabilities. Tainted all liabilities means all the liability now is considered a boot and all the liabilities are 35,000. So the recognized gain is 35,000. Boot received. Why? Because personal liabilities taint all liabilities. So everything is considered a boot. Now what's the basis for the shareholder? It's going to be the adjusted basis of the property received. You're going to add to it recognized gain 35,000 because we're going to recognize this much gain. Then we're going to reduce our basis by the fair market value of property of boot received because we're receiving a value. It's going to reduce our basis, but since we're paying taxes on it, it's going to increase the basis. Therefore, the effect is zero. There is no liability transferred here. Therefore, the adjusted basis of the stock is 40,000. Again, as I said, this is, we're still section B. This is section B rule two. Now let's take a look at, let's look at section C. What is section C? Section 357B assumption of liabilities. If the business purpose liability transfer exceeds the adjusted basis, here what's going to happen is this. We have a loan. The loan is for business purpose. However, the loan value is greater. So the debt that we are transferring is greater than the adjusted basis. Well, what does that mean? It means the adjusted base, the excess debt is considered a boot. Now you might be saying, how can we have more debt than the adjusted basis? Well, simply put, let's assume you purchase a piece of land for $100,000, 10 years ago. You went to the bank today and said, I would like to take out a loan. Now the fair market value of this land could be worth $750,000. They might say, no problem. We're going to give you a loan for $400,000. So notice here that debt is $400,000. The basis is $100,000. Well, the liability is an excess. The liability is an excess of the land. You might be saying, why would the bank do that? Well, the bank does not care. They don't care about your adjusted basis. They said, well, if you don't pay off the loan, we can sell this land. It's worth $750,000 and get our money back. So that's why the bank is okay with giving you such a loan because the fair market value of the property is way greater than the debt. If section 357B and 357C both apply, B will dominate section C. Let's take a look at an example. We have an individual transferred $100,000 of property adjusted basis as $40,000. A liability is worth $50,000 and the liability is for business purpose, section B. Notice here we have section B and section C in a sense that it's for business purpose, but the liability exceeds the liability. The $50,000 is greater than the $40,000 adjusted basis. Let's take a look at the fair market value of the property minus the adjusted basis equal to $60,000 and we have an access boot here. Access boot. We have an access boot of $10,000. So the realized gain is $60,000. The recognized gain is the lesser of the realized gain of $60,000 or the boot. How much is the boot? Because remember, if section B and C exist, we're going to assume the $40,000 is a business. What's remaining is the $10,000, the access boot. Therefore, the access boot, the fair market value of access boot is $10,000. Therefore, the recognized gain is the lesser of $60,000 and $10,000, which is $10,000. So did we receive a boot? Yes. How much is the boot? $10,000. $10,000. So of the $50,000 debt, we're going to say $40,000 is for section B, business purpose, and the remaining is $10,000. That's section C, which is access liability, which is the boot. Let's take a look at the basis of the shareholder. Well, the adjusted basis of the stock starting with the adjusted basis of property transfer, $40,000. We add the recognized gain of $10,000. Then we subtract the fair market value of boot received. Then we have to deduct the liability transferred. The liability transferred is $40,000. Why? Because, well, we still transferred the liability with the business purpose. It's not a boot. It's a liability transferred. All in all, the adjusted, the stock basis is zero. The stock basis is zero. So if you sell your stock for any amount, that amount is taxable. That amount is taxable. So this is where the liability exceeds the adjusted basis. Remember, the basis cannot be below zero. Now let's take a look at the corporate basis and property received. Now we're going to look at the other side. The other side means the corporation. What basis do they take in that property? Well, basis and property received if section 351 applies. Well, it's the adjusted basis of property transferred. That's the whole idea. Then if you have any recognized gain, when you would have any recognized gain, when would the shareholder have any recognized gain if the corporation paid any boot? Now remember, any recognized gain by the shareholder, you don't include the ordinary income from service because the shareholder also would recognize gain, which is taxable from the ordinary income from service. That's not included. So simply put, adjusted basis of property transferred plus recognized gain, that's the result of the boot. The boot paid by the shareholder, not the ordinary income because when the corporation pays that ordinary income, it's deductible for the corporation. It has nothing to do with the basis. So remember, it's adjusted basis of property plus recognized gain as a result of the boot by the shareholder. This is the carry over concept, property basis carried over to the corporation. That's, remember, basis from the shareholder goes to the basis to the corporation because there should be no taxable event. Now any liability transferred to the corporation is simply recognized as a liability on the corporate books. So if you transferred asset and with that asset comes a liability, as far as the corporation is concerned, they don't treat it anything else other than a liability. So they will treat it, they would record it as a liability. Therefore, notice in the formula, there's no place where it says a liability add or subtract the liability because the liability is treated separately. Now what happened if you transfer property and Section 351 does not apply all together? Simply put, there's no Section 351. Easy, not easy, but if there's no Section 351, you transfer the property at fair market value, at fair market value. What should you do now? You should go to Farhat Lectures, look at MCQs, True, False, Additional Exercises that can help you understand this important concept. Section 351 would liabilities are assumed and boots are involved. Whether you are a CPA candidate, enrolled agent, or an accounting student, invest in yourself. Good luck, study hard, and of course, stay safe.