Peracchi: What is the Right Result?

Louisiana Law Review Volume 59 | Number 3 Spring 1999 Peracchi: What is the Right Result? Susan Kalinka Repository Citation Susan Kalinka, Peracchi: What is the Right Result?, 59 La. L. Rev. (1999) Available at: https://digitalcommons.law.lsu.edu/lalrev/vol59/iss3/7 This Article is brought to you for free and open access by the Law Reviews and Journals at LSU Law Digital Commons. It has been accepted for inclusion in Louisiana Law Review by an authorized editor of LSU Law Digital Commons. For more information, please contact . Peracchi: What is the Right Result?* Susan Kalinka" In Peracchiv. Commissioner,' the Ninth Circuit held that a taxpayer who transferred his own promissory note to his wholly owned corporation avoided gain recognition under section 357(c) on a transfer of encumbered property to that corporation. Under section 357(c), a taxpayer who transfers encumbered property to a corporation in a transaction that otherwise would qualify as a taxfree exchange of property for stock under section 351 must recognize gain if and to the extent that the amount of the liabilities encumbering the transferred property exceeds the adjusted basis of all property transferred to the corporation in the same transaction. The Ninth Circuit held that the taxpayer in Peracchi was not required to recognize gain, even though the amount of the liabilities exceededthe basis of the transferred property, because the taxpayer's basis in the promissory note transferred to the corporation was equal to its face amount. Peracchioffers taxpayers an easy way to avoid gain recognition under section 357(c), as well as an easy way to increase a shareholder's stock basis. Under section 358, the basis of a shareholder's stock received in a section 351 transaction generally is equal to the basis of the property transferred to the corporation, decreasedby the fair market value of property other than stock and the amount of money ("boot") receivedby the shareholder, and increased by the amount of gain recognized by the shareholder on the transaction.2 If a taxpayer has a basis in the taxpayer's own promissory note, the taxpayer can create stock basis simply by issuing a note to a corporation in exchange for stock. While stock basis has significance for shareholders in a C corporation, stock basis is even more important for S corporation shareholders. Under subchapter S of the Internal Revenue Code, a shareholder may deduct a pro rata share of the corporation's net losses only to the extent of the shareholder's stock basis and to the extent of the basis in any indebtedness of the corporation to the shareholder.3 An S corporation shareholder generally may receive tax-free distributions from the corporation only to the extent that the amount distributed does not exceed the adjusted basis of the shareholder's stock. Equity basis has the same significance for partners. A partner may deduct the partner's distributive share of partnership losses only to the extent of the Copyright 1999, by LOUISIANA LAW REVIEW. Reprinted with permission. Copyright 1998 Tax Notes. Harriet S. Daggett-Frances Leggio Landry Professor of Law, Louisiana State University. 1. 143 F.3d 487 (9th Cir. 1998), 98-1 U.S.T.C. para. 50,374, Doc 98-14167 (21pages), 98 TNT 86-11, rev'g 71 T.C.M. (CCII) 2830, Doc 96-12055 (16 pages), 96 TNT 80-13 (1996). * ** 2. Section 358(a). For this purpose, the amount of liabilities assumed by the corporation or taken subject to the transferred property is treated as money. Section 358(dXI). Section references are to the Internal Revenue Code of 1986, as amended, or the regulations thereunder, except as otherwise noted. 3. Section 1366(d). LOUISIANA LAW REVIEW [Vol. 59 adjusted basis of the partner's interest in the partnership4 and may receive taxfree distributions of cash only to the extent of the adjusted basis of the partner's interest in the partnership.5 Concerned that allowing a taxpayera face-amountbasis in a promissory note could cause "mischief' if a taxpayer transferred the promissory note to a partnership or an S corporation, the Ninth Circuit limited its holding to C corporation shareholders.6 The Ninth Circuit, however, cited no authority for so limiting its holding. This article argues that the transfer of a shareholder's own promissory note to a wholly owned corporation should not prevent the shareholder from recognizing section 357(c) gain. On the other hand, if the Ninth Circuit was correct, there is no legal basis for limiting the holding in Peracchito C corporation shareholders. Both President Clinton and the Senate have proposed amendments to section 357(c) that would eliminate the need for a taxpayer to contribute a promissory note to avoid section 357(c) gain in many cases. Under the proposals, a taxpayer would not recognize section 357(c) gain on the transfer of encumbered property to a corporation if the taxpayer remained personally liable for payment of the liabilities. The proposed amendments may not necessarily be appropriate for C corporation shareholders, who may enjoy an economic benefit in transferring encumbered property to a corporation even if they remain personally liable for repayment of the liabilities encumbering the transferred property. The proposals may be more appropriate for S corporation shareholders. If the proposals are adopted, however, there may be a need for furtherguidance before S corporation shareholders may take advantage of them. I. THE PERAccHI CASE Donald Peracchi and his wife owned 100 percent of the stock of NAC Corporation ("NAC"), which had two wholly owned subsidiaries. The subsidiaries needed additional capital to comply with a state law minimum premium-to-asset ratio for insurance companies. To satisfy state law requirements, Peracchi contributed three parcels of improved real estate to NAC, along with his unsecured promissory note with a face amount of $1,060,000. The real estate had a total adjusted basis of $981,400 and was encumbered by liabilities of $1,548,200. The corporation did not assume the liabilities, for which Peracchi remained personally liable. The government argued that Peracchi should recognize $566,800 gain under section 357(c), the amount by which the liabilities exceeded the adjusted basis 4. Section 704(d). 5. Section 731(aXl). 6. Peracchi, 143 F.3d at 494 n.16. The court also limited its holding to cases in which the note is contributed to an operating business that is subject to a non-trivial risk of bankruptcy or receivership, as compared to a shell corporation or a passive investment company and to cases in which the note is in fact worth approximately its face value. Id., at 493, n.14, 494, n.15. 1999] SUSAN KALINKA of the property transferred to NAC, and that Peracchi should not avoid gain recognition because he transferred his promissory note to NAC in the same transaction. In similar cases, both the Tax Court7 and the IRS' have taken the position that since a taxpayer incurs no cost in issuing (...truncated)