Jonathan has owned and operated an accrual basis golf driving range for a number of years. The sole proprietorship has been successful and has grown to the point where it now offers golf lessons and sponsors tournaments and other activities. Jonathan has been advised that incorporating his proprietorship would give him an opportunity to restructure the business debt and to acquire additional working capital at more favorable rates.

Based on this advice, Jonathan transfers the business assets (fair market value $1 million, adjusted basis $200,000) along with the associated debt ($325,000) to the newly formed corporation. As far as he is concerned, nothing has really changed in his relationship with the creditor bank: he still feels personally obligated to pay off the debt. In fact, before the debt is assigned to the newly formed corporation, the bank insists that Jonathan remain secondarily responsible for its payment. Even though the proprietorship's liabilities transferred exceed the basis of the assets transferred, Jonathan regards the transaction as tax-free because:

Nothing has changed with his business other than its form of operation.

A business justification exists for changing its form to that of a corporation.

He has enjoyed no personal gain from the transaction.

Determine whether Jonathan is justified in his position. If you believe the transaction as currently planned would be taxable, identify strategies that could be used to eliminate or reduce gain recognition.

Partial list of research aids:

§ 357(c).