FEDERAL TAXATION

Reduction Of Boot With A Promissory Note

By Zev Landau, CPA, DDK & Co. LLP

Is there something that a taxpayer who has borrowed $566,000 more than his basis in property can do to avoid taxation under IRC section 357(c) when transferring property to a controlled corporation? Can he increase the basis of the assets by transferring his own promissory note to the corporation? One judge from the Ninth Circuit in the case of Peracchi v. Comm'r (98-1 U.S. Tax Court No. 50374) declared that "with all magical solutions he cannot just transfer the property to the corporation and promise to pay off the encumbrance." But his was a dissenting opinion. The majority of the judges ruled in favor of the taxpayer and held that the basis of the note was equal to its face value, and the entire gain was deferred.

The taxpayer was required under state laws to contribute additional capital to his closely held corporation. Three encumbered parcels of real estate were contributed. The taxpayer also contributed a promissory note, promising to pay to the corporation $1,060,000 over a term of 10 years at 11% interest, apparently to eliminate the excess liabilities to which the real estate was subject over its adjusted basis ($566,000).

Analysis and Discussion

No gain or loss is recognized if property is transferred to a corporation solely in exchange for stock of that corporation if, immediately upon the transfer, the transferors are in control of the corporation. Peracchi transferred property to a corporation he controlled. He did not receive additional stock of his own corporation since issuance of new stock to a sole shareholder in exchange for assets would be meaningless.

Gain is recognized to any transferor, however, up to the amount of "boot" received. Boot is money or property other than stock in the corporation received by the shareholder in exchange for the property contributed. Peracchi did not receive cash or any other property. Or did he?

The court explained, "When a shareholder contributes property encumbered by debt, the corporation usually assumes the debt and the Code normally treats discharging of liabilities as receiving money." Taxability of assumption of liabilities in all circumstances diminishes the benefits of IRC section 351. The Code therefore states that an assumption of liabilities is not considered boot even if the corporation assumes the obligation. It was agreed that the transfers made by Peracchi were based on business reasons (i.e., the compliance with state laws). If Peracchi failed to show a business motive he would have to include all the liabilities assumed as boot under IRC section 357(b).

Thereafter, it is necessary to consider IRC section 357(c), which forces a shareholder to recognize gain to the extent liabilities exceed basis and provides that gain shall be recognized if the sum of the liabilities assumed plus the sum of the amount to which the property is subject exceeds the total of the adjusted basis of the property transferred pursuant to such exchange.

The issue then becomes, does a personal note have a basis in the hands of the note's maker? The original basis for property is usually its cost. The court said that the term "cost" is not defined in the IRC. (It is defined in Regulations section 1.1012-1(a) as the amount paid in cash plus the fair market value of other property plus liabilities incurred.) The court therefore chose to forgo the historical definition approach, since no amount was paid for Peracchi's own note, and adopt a prospective approach: The taxpayer incurred a risk when he transferred the note to the corporation, because if the corporation became bankrupt in the future, the creditors could try to enforce the payment against the shareholder.

Bona fide Indebtedness or Sham?

The IRS reasoned that it was unlikely the corporation would try to collect the note from its controlling shareholder. When he missed two payments nothing was done to accelerate the debt. Additionally, payments were only made well after an IRS audit was under way. The court of appeals, however, observed that the taxpayer had a good credit history and would likely have the funds to pay his debt. The interest rate was comparable with the market interest rate and the note had a fixed term. The note was also transferable and enforceable by third parties, including hostile creditors.

The IRS also argued that the note was a gift because Peracchi did not get any consideration from the corporation. The court's answer was that the contribution of the note was no more a gift than a contribution in cash to the corporation would have been. "A corporation never gives up anything explicitly when it accepts a capital contribution."

The major controversy in this case was the determination of the note's basis. The taxpayer claimed that the basis of his note was equal to its face value. The IRS claimed that the basis of the note was zero. The taxpayer prevailed and therefore was able to avoid tax on the transaction, since the liabilities did not exceed his basis in the sum of the assets and his note. If the IRS had won, the difference between liabilities and basis would be subject to tax. (See the Exhibit.)

While Peracchi was decided in the Ninth Circuit, which includes the states of California and Nevada, it was consistent with decisions made by the Second Circuit (i.e., New York) in Lessinger v. Comm'r [(CA-2) 89-1 U.S.T.C#9854]. In Lessinger, the court emphasized that the term "basis" refers to assets. Liabilities by definition have no basis. Basis prevents double taxation on income that has already been taxed. It is possible that the transferor had no basis in his own note. Nevertheless, the corporation incurred cost in the transaction by assuming liabilities of the transferor that exceeded the basis of assets and therefore obtained basis in the note. If the corporation had no basis in the shareholder's note, it would have to recognize gain when the shareholder paid the debt. The court looked at the basis of the note in the hands of the corporation and concluded that the face value was the true basis. The basis carryover provisions, according to the court in Lessinger, did not apply to the definition of adjusted basis in the context of the definition of boot. The application is relevant in corporate tax-free transfers to avoid step up in basis.

Peracchi and Lessinger are the only cases sanctioning this technique in the corporate area. In addition, the Peracchi court limited its holding to cases in which the shareholder is creditworthy and the corporation is an operating business subject to a "nontrivial" risk of bankruptcy. Practitioners should use caution when contemplating similar strategies.

The principle that basis is determined generally by cost also applies to other transactions. Numerous cases have held that if a partner or a shareholder or a purchaser makes his own promissory note without incurring any costs, he does not have a basis in the note. Some commentators believe that one set of rules in the matter of promissory notes applies to transfers of assets to controlled C corporations and another set of rules may apply to transfers to pass-through entities. In C corporation scenarios they agree with the notion that, based on facts and circumstances, the basis of a promissory note may be equal to its face value. In S corporation scenarios they believe the basis of the note is zero. Therefore, the Peracchi victory will not work, because apparently a transfer to a C corporation is a transaction between two taxable entities, whereas a transfer to an S corporation is more similar to self-dealing by one person who is both a creditor and a debtor.

Interestingly enough, the U.S. House of Representatives recently passed a bill limiting the amount of recourse liability assumed for purposes of IRC section 357(e) to liabilities the transferee both has agreed to pay and is actually expected to pay. This bill awaits Senate approval. *

CORRECTION

As a result of editing, the following paragraph was inadvertently omitted from the article "Charitable Contributions by Individuals" appearing in this column in the May issue:

The fair market value, rather than basis, of appreciated publicly traded stock contributed to private nonoperating foundations is deductible as a charitable contribution. The provision, which previously was scheduled to expire on June 30, 1998, was made permanent as part of the Tax and Trade Relief Extension Act of 1998, effective for contributions made on or after July 1, 1998.

Our apologies to author Richard Greenfield, CPA, and to our readers for any inconvenience the omission may have caused.

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Kevin Leifer, CPA,
Ernst & Young LLP

Richard M. Barth, CPA

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.