Sean, a sole proprietor, is engaged in a service business and uses the cash basis of accounting. In the current year, Sean incorporates his business by forming Aqua Corporation. In exchange for all of its stock, Aqua receives: assets (basis of $400,000 and fair market value of $2 million), trade accounts payable of $110,000, and loan due to a bank of $390,000 . The proceeds from the bank loan

were used by Sean to provide operating funds for the business. Aqua Corporation assumes all of the liabilities transferred to it.
a. Does Sean recognize any gain on the incorporation? Explain.

b. What basis does Sean have in the Aqua stock?

c. What basis does Aqua Corporation have in the assets it receives?

a. Initially it seems as if the liabilities of $500,000 [$110,000 (trade accounts payable) + $390,000 (bank loan)] exceed the basis of the assets so as to make § 357(c) apply. However, for this purpose the trade accounts payable are not counted since they originate from a cash basis taxpayer and would give rise to a deduction. Thus, Sean has no recognized gain.

b. $10,000 [$400,000 (basis in the assets) – $390,000 (bank loan assumed by Aqua Corporation)].

c. $400,000 (Sean's basis in the assets).