Tax planning under section 357(c): Peracchi and creating something out of nothing.

• Author: Lipton, Richard M.
• Position: IRC s. 357(c

Section 357(c) of the Internal Revenue Code has long bedeviled corporations transferring assets to subsidiaries. Where the liabilities to which transferred property is subject exceed the basis to the transferor, gain is recognized. Although this gain might be deferred by an affiliated group filing a consolidated return, the gain would nonetheless be lurking as a deterred intercompany gain.

Every problem, however, presents opportunities. Tax practitioners know that if the transfer of property subject to a liability results in gain recognition, there is also a step-up in the basis of the transferred property. Moreover, if the transferor is not taxable (say, a foreign or tax-exempt person), a basis increase may be engineered without paying a tax liability. Furthermore, since section 357(c) does not require the apportionment of the liabilities that are assumed or taken subject to, multiple properties subject to a single liability can be transferred, resulting in a replication of the basis of the transferred property.

Two new developments will interest students of section 357(c). In Peracchi v. Commissioner, No. 96-70606 (April 29, 1998), a divided panel of the Ninth Circuit permitted a taxpayer to engage in alchemy by ascribing basis to the taxpayer's note contributed to a corporation in order to avoid the effect of section 357(c). If Peracchi and its predecessor, Lessinger v. Commissioner, 872 F.2d 519 (2d. Cir. 1989), correctly reflect the law, then section 357(c) may be a mere a trap for the unwary. A taxpayer that transfers property in a transaction subject to section 357(c), however, relies upon Peracchi at its peril.

On the other hand, if Peracchi makes the application of section 357(c) elective, Congress may renew its recent unsuccessful attempt to pare the potential benefits of tax planning involving section 357(c). Specifically, the Senate version of the IRS Restructuring and Reform Act included a provision that would have modified section 357(c) by requiring the transferor, in the case of a transfer of any property subject to a non-recourse liability, to apportion the liability on the basis of the relative fair market values of all assets subject to the liability. Hence, this provision would have restricted so-called "basis multiplication" transactions. This provision, however, was eliminated in conference, so it remains possible to create "something from nothing."

Peracchi

In order to comply with Nevada's minimum premium-to-asset ratio for insurance companies, the individual tax payer in Peracchi was faced with contributing additional capital to his closely-held corporation, NAC. Peracchi contributed two parcels of real estate that were encumbered by liabilities that exceeded his adjusted basis in the properties by $566,807. Peracchi also contributed his own note of $1,060,000, which had a term of ten years and bore interest at the rate of 11 percent per annum. Peracchi was solvent at the time of making the note, so it constituted a "good" liability, but no payments were made on the note, including interest, until the IRS audit began.

The issue was straightforward. Peracchi claimed that his note had a basis equal to its face amount, thereby making the total basis in the property he contributed greater than the total liabilities. The IRS, on the other hand, contended that either (1) the note was not a genuine indebtedness and should be treated as an unenforceable gift, or (2) even if the note were genuine, it should not increase Peracchi's basis in the contributed property. If the taxpayer was correct, he owed nothing; if the IRS prevailed, Peracchi would have gain of $566,807.

The Tax Court

The Tax Court had no difficulty analyzing or disposing of the issue. In his decision in Peracchi, T.C. Memo. 1996-191, Judge Nims noted that no payments were made on the note until after the IRS commenced its audit. Hence, he concluded that the taxpayer did not intend to pay the note according to its terms. As a result, the note should not be considered to be genuine indebtedness. Disregarding the note, the basis of the contributed assets was less than the amount of the liability encumbering them. Furthermore, even though Peracchi remained personally liable for the indebtedness, under Owen v. Commissioner, 881 F.2d 832 (9th Cir. 1989), section 357(c) required the recognition of gain by the taxpayer.

The Ninth Circuit Opinion

The straightforward analysis of the problem by the Tax Court can be contrasted with the Ninth Circuit's majority position. The court, in an opinion by Judge Kozinski, reviewed numerous rules of corporate taxation and concluded that the shareholder's note should be respected and have a basis equal to its face amount,(1)(*) The opinion begins with an overview of the rules concerning tax-free incorporation, which, the court said, should be "pain-free from a tax point of view."(2) The general rule is that a capital contribution should be a nonrecognition event because it is merely a change in the form of ownership -- like moving a billfold from one pocket to another. The ability to transfer property to a corporation without the recognition of gain is the "baseline" for understanding the Ninth Circuit's analysis.

The court noted that a shareholder's basis in property may differ from its fair market value. Although section 1012 generally provides that an asset's basis is its cost, in the case of a transfer that qualifies for nonrecognition under section 351, the shareholder must substitute the basis of that property for what would otherwise be the cost basis of the stock. Substitution of basis preserves gain for recognition at a later date, and deferral, of course, was Peracchi's goal.

The principal exception to nonrecognition of gain under section 351 arises where a taxpayer receives "boot" -- money or property other than stock in the corporation -- in exchange for the property contributed. In that case, gain is recognized to the extent of the boot received pursuant to section 351(b). Peracchi, however, received no boot in connection with the transfer.

The second exception to nonrecognition of gain on the transfer of property to a controlled corporation involves the assumption of liabilities by the transferee corporation. If the liabilities assumed by the transferee are less than the transferor's basis in the transferred property, the shareholder-transferor's substitute basis in the stock received is decreased by the amount of the liabilities assumed by the corporation.(3) In effect, the taxpayer's deferred gain is preserved in the reduced basis for the stock.

Where the adjusted basis of transferred property is less than the amount of the liabilities assumed or taken subject to by the corporation, however, preserving the gain is difficult because of the "negative basis" problem. For example, assume that a shareholder organizes a corporation and contributes as its only asset a building with a basis of $50 and a fair market value of $100; the property is subject to a mortgage debt of $90. If all of the gain inherent in the transaction is to be preserved, the shareholder's substituted basis of $50 must be reduced by $90 (under section 358(d)), leaving the shareholder with a negative basis of ($40).

There is, however, no concept of negative basis in the Code.(4) Instead, section 357(c) provides that the transferor must recognize gain if and to the extent that the sum of the amount of the liabilities assumed by the corporation, plus the amount of the liabilities to which the property is subject, exceeds the adjusted basis of the property transferred to the...