Facts:
• An accrual basis taxpayer Charles Cho engages in a Section 351 transaction with the newly-formed Patten Corporation.
• In the transaction, Cho transferred his gas station to Patten, in exchange for the stock of Patten and assumption of the contingent environmental liabilities.
• The land underneath the gas station has potential environmental problems but Cho did not take any remediation to fix environmental problems before the exchange.
• A year later, Patten pays a third party $100,000 for environmental clean-up costs to remediate the site.
• The transaction does not have tax avoidance purpose.
Issues
The main issue encountered in this case is whether the contingent environmental liabilities assumed by Patten is a liability that would give rise to a deduction within the meaning of Internal Revenue Code (IRC) section 357 (c)(3) and whether Cho’s basis in the stock is determined by reference to Section358 (d)(1) or Section 358 (d)(2). The issue for Patten is how to determine the tax consequence based on the transaction.
Applicable Laws
The most pertinent Sections are directly cited form Code and listed as below:

IRC Section 351(a):
“No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c) of the corporation.”

IRC Section 357(a):
“Except as provided in subsections (b) and (c) , if—
(1) the taxpayer receives property which would be permitted to be received under section 351 or 361 without the recognition of gain if it were the sole consideration, and
(2) as part of the consideration, another party to the exchange assumes a liability of the taxpayer,”

IRC Section 357(c)(3):
(A) “In general. If a taxpayer transfers, in an exchange to which section 351 applies, a liability the payment of which either—
(i) would give rise to a deduction, or
(ii) would be described in section 736(a) , then, for purposes of paragraph (1) , the amount of such liability shall be excluded in determining the amount of liabilities assumed.
(B) Exception. Subparagraph (A) shall not apply to any liability to the extent that the incurrence of the liability resulted in the creation of, or an increase in, the basis of any property.”
IRC Section 358(a)(1):
“(a) General rule. In the case of an exchange to which section 351, 354 , 355 , 356 , or 361 applies—
(1) Nonrecognition property. The basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged—
(A) decreased by—
(i) the fair market value of any other property (except money) received by the taxpayer,
(ii) the amount of any money received by the taxpayer, and
(iii) the amount of loss to the taxpayer which was recognized on such exchange, and
(B) increased by—
(i) the amount which was treated as a dividend, and
(ii) the amount of gain to the taxpayer which was recognized on such exchange (not including any portion of such gain which was treated as a dividend).”
IRC Section 358(d)(1) and 358(d)(2):
“ (1) In general. Where, as part of the consideration to the taxpayer, another party to the exchange assumed a liability of the taxpayer, such assumption shall, for purposes of this section , be treated as money received by the taxpayer on the exchange.
(2) Exception. Paragraph (1) shall not apply to the amount of any liability excluded under section 357(c)(3).”

IRC Section 162(a)
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business …”

In additional to the IRC, I also researched tax cases similar to this case. In court case The Black & Decker Corp. v. U.S., 97 AFTR 2d 2006-841(436 F.3d 431), the corporation paid $561 million to a subsidiary it controlled in exchange for 10,000 shares of the subsidiary's stock and the subsidiary's assumption of a $560 million contingent liability of the corporation The court ruled that the taxpayer wasn't required to reduce its basis in stock of the newly-formed healthcare management corporation by the amount of contingent liabilities transferred because the contingent liability fell within Code Sec. 357(c)(3) 's exclusion and Code Sec. 358(d)(2)’s exception. As a result, under Section 358(d)(2)'s exception to the general rule of Section 358(d)(1), the liability should not be treated as “money received” by the taxpayer for basis reduction purposes.

There are several more similar cases involving contingent liabilities transferred under Section 351 such as Coltec Industries,Inc. v. U.S., 98 AFTR 2d 2006-5249 (454 F.3d 1340) and Brown v. Helvering, 291 U.S. 193 [13 AFTR 851] (1934). Both cases did not consider contingent liabilities as liabilities for tax purposes. Coltec Industires, Inc. v. U.S., cited from Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders (7th ed. 2002),: “At the time of a § 351 exchange, it is not ordinarily necessary to determine whether a liability that is assumed by the transferee corporation or to which the transferred property is subject is too contingent to be taken into account or is instead fixed so as to qualify for the exemption of § 357(a); either way, it does require the recognition of gain.”

Also, in Revenue Ruling 95-74, a parent corporation (P), forms a subsidiary (S) in a Section 351 incorporation for business purposes and then transfers to S all of the assets of a manufacturing business in exchange for all of S's stock. In this situation, the land on which the manufacturing business is located was bought by P in “pristine condition” and was later contaminated by P's plant operations. Before the transfer took place, P hadn't done anything to remediate the contamination. S then assumed all of the environmental liabilities of the manufacturing business, including its contingent liability for soil and groundwater remediation. S later incurred environmental remediation costs for cleaning up the land. According to Revenue Ruling 95-74, these costs would have been deductible in part and may be capitalized in part by P if it had not transferred the property to S. Therefore, the Revenue Ruling concludes that the environmental cleanup costs resulting from the environmental liabilities assumed from P are deductible as business expenses or are capitalized by S, if appropriate. The IRS ruled that contingent environmental liabilities that have not been deducted or capitalized, and that are assumed by a newly-formed subsidiary in a Section 351 exchange, will not be treated as “liabilities” for purpose of Section 357(c)(1) and 358(d)(1).
Analysis
According to the court cases cited above, they are similar with this case in nature. Although in our case the transfer does not fit within the exact terms of Section 351(a), Cho and Patten would still eligible for the tax-free treatment of § 351(a) if the taxpayer could successfully satisfy Section 357(a). In our case, Cho had not yet considered contingent environmental liabilities assumed by Patten before the exchange and hadn't deducted or capitalized any environmental clean-up costs. Consequently, contingent liabilities had neither given rise to deductions for Cho nor lead to the change to basis in Cho’s property. As a result, contingent environmental liabilities are excluded from determining whether the transfer meets 357(c)(1). Thus, based on IRC Sections 357 and 358, Cho does not need to reduce the basis in the transferee’s stock by the amount of the liabilities transferred. Therefore, the basis in the stock is the fair market value and holding period for the stock includes holding period of property contributed. Meanwhile, Patten’s basis in its property received is the adjusted basis of the property received. The holding period for property received includes holding period, deprecation, recapture, deprecation method, etc of property contributed.

Additionally, the Revenue Ruling 95-74 specifically addressed the issue of how to treat the $100,000 remediation costs. Although revenue rulings represent IRS’s application of the Code and Regulations to specific factual situation and they do not carry the same force of authority as Code and court cases. However, Revenue Ruling 95-74 provides valid precedent to our case since our case is substantially the same as the description in the ruling. According to the ruling, the liabilities assumed by Patten in the Section 351 exchange are “deductible by it as business expenses under Section 162, or alternatively will be treated as capital expenditure under Section 263, as appropriate, under the subsidiary method of accounting.“ Prior to the transfer, there were potential environmental problems that existed. The remediation costs incurred by Patten to do not prolong the useful life of the land or change the use of the land. Thus, clean-up costs to treat environmental problems associated with Cho’s prior operation of business are deductible by the Patten as business expenses under § 162. Costs properly allocable to other constructing treatment facilities, however, are capital expenditures under § 263. Also, this Ruling reinforces the courts’ ruling in treating contingent liabilities not as liabilities since they are deductible.

Cho will realize gain or loss as: Amount realized by Cho- Adjusted Basis of the property transferred since the transaction qualifies as 351 exchange, all realized gain or loss will be deferred for Cho. Therefore, Cho recognizes no gain or loss. Meanwhile, Patten recognizes no gain or loss too.

Conclusion
The central issue in the case is how contingent liabilities should be treated for tax purposes in a Section 351 exchange and how the payment of environmental remediation costs should be handled. According the IRS Code Sections, Court cases and Revenue Rulings cited above which were used as the basis for analysis of the issues presented in this case, the conclusion is that the liabilities assumed by Patten is deductible as a business expense up to a certain amount based on Section 162. For Cho, the exchange itself does not trigger a gain or loss for tax purposes.