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Avoiding Gain While Transferring Property and Liability to a Controlled Corporation
Summary Internal Revenue Code (IRC) Section 357(a)1 provides that when property is transferred to a controlled corporation in a transaction that qualifies under Section 351 2, and the property transferred has a liability attached to it, the liability assumed by the corporation is not a recognized gain to the transferor – it instead reduces the adjusted basis of the transferred property. If the liability assumed in the transfer exceeds the property adjusted basis – Section 357(c) provides that the excess liability is a recognized gain to the transferor. The prospect that business persons who incorporate their businesses, and in so doing might incur sizable income taxes due to transferred property liabilities exceeding adjusted basis, has no doubt led many to consider ways to increase the adjusted basis of the property transferred to avoid the tax. I suspect that research will uncover IRS Revenue Rulings, court cases, articles, etc., that will detail attempts by property transferors to avoid the gain recognition due because of Section 357(c) in Section 351 transactions. That will be the focus of this paper.

Research Lipton and Bender3 describe situations where taxpayers have attempted to avoid recognition of gain on property transfers due to the application of IRC 357(c). Stuffing transactions are those where taxpayers attempt to take advantage of the fact that the gain recognized by IRC 357(c) is applied to the liability in excess of the aggregate adjusted basis of all the property transferred – not just the basis of the property items that have liabilities. Taxpayers will stuff additional property items into the transfer to raise the aggregate basis up to or in excess of the liabilities transferred.

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They describe that stuffing transactions can be legitimate. As long as the additional property items transferred have valid business uses, the stuffing transaction will be legal and no gain will be recognized. They point out too that some stuffing transactions are deemed abusive by the Internal Revenue Service (IRS), such as when a taxpayer conducts a transaction that creates assets with high tax basis and low fair market value and transfers the assets to the corporation without gain recognition. Step approach transactions are another method that taxpayers use to attempt to avoid IRC 357(c). The common way to do this is the taxpayer borrows cash from a third party and adds the cash to the property basis to meet or exceed the liabilities assumed by the corporation. The corporation then uses the cash to purchase the taxpayer’s note from the third party. The IRS will likely collapse these steps and claim the taxpayer has contributed his own note to the corporation just to avoid a taxable gain. The note will be deemed to have zero basis because it did not cost the taxpayer anything. A third method used to circumvent IRC 357(c) is when taxpayers make a capital contribution to the corporation in the amount of the difference of the property adjusted basis and the assumed liabilities. If the capital contributed is cash or a legitimate third party note, then there is no problem and IRC 357(c) can be avoided. If the taxpayer contributes his own promissory note to the corporation, the IRS will deem the note to have a zero basis and cannot be used to offset the liabilities. Taxpayers have attempted this third method many times and it has led to several interesting and varied rulings and court cases. Revenue Ruling 68-6294 is a concise response from the IRS to a taxpayer who transferred all of his assets in a sole proprietorship to a new corporation in a transfer that qualified under IRC 351(a). The liabilities on the property transferred exceeded the adjusted basis. The

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taxpayer attempted to offset the excess value of the liabilities over the assets value by transferring a promissory note for the difference. The IRS ruled that IRC 10125 provides that the basis of property is its cost. Since the promissory note cost the taxpayer nothing, it did not increase the basis of the assets transferred. In Velma W. Alderman v. Commisioner6, the Tax Court upheld the IRS ruling that the Aldermans owed tax on excess liability in an IRC 351 transfer. The Aldermans owned a sole proprietorship lumber trucking business in Oregon, and in 1963 they incorporated their business. The assets: trucks and trailers, had adjusted basis of $62,782.20. The liabilities assumed by Alderman Corporation were: accounts payable, $24,420.14, and loans on the truck and trailers, $47,591.65. The liabilities exceeded the asset adjusted basis by $9229.59. The Aldermans contributed a promissory note of $10,229.59 to the corporation, creating a capital stock account of $1,000. The Tax Court agreed with the IRS that the promissory note had zero basis and that the taxable income for the Aldermans for 1963 should be increased by $9,229.59. In two more recent court decisions covering cases similar to Alderman, Courts of Appeals overruled the Tax Court. In 1977, Sol and Judith Lessinger7 incorporated their sole proprietorship, Universal Screw and Bolt Co. in a Section 351 transfer. The corporation assumed liabilities of $1.1 million and the liabilities exceeded the asset adjusted basis by $255,000. The Lessingers were oblivious to the tax they owed on the $255,000 of excess liability and carried the debt on their books. In 1981, at the request of one of the Lessinger’s creditors, Mr. Lessinger issued a promissory note to the corporation for $255,000. The IRS ruled that the Lessingers owed tax on the $255,000 of excess liability from the incorporation of their business in 1977. The Tax Court agreed. The Lessingers appealed their case to the U. S. Court of Appeals, Second Circuit which reversed the Tax Court. The Second Circuit agreed with the

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Tax Court that the Lessingers had no basis in the note. But it found that the corporation should have a basis in the note. The court recognized that its ruling ran counter to IRC 362 8 which provides a carryover basis to transferred property. The court supported its decision by finding that the purpose of IRC 362 is to prevent an increased basis of property transferred to a corporation without gain recognition. The court found this lower basis of property allows for more depreciation deductions. But depreciation does not apply to a promissory note contribution. So the Second Circuit allowed the Lessingers to avoid paying tax on the excess liability of $255,000. In a case similar to Lessinger, Daniel and Judith Peracchi9 incorporated their life insurance businesses into NAC Corporation in 1989. The Peracchis contributed over $3 million of property with basis of $981,406 and liabilities of $1,548,212. The liabilities exceeded the property basis by $566,806. To add additional capital to NAC, the Peracchis also contributed an unsecured promissory note in the amount of $1.06 million. The IRS ruled that the Peracchis had a recognized gain of $566,806. The Tax Court upheld the IRS ruling. The Tax Court stated it was unlikely that the Peracchi’s would ever pay off the note, that its only purpose was to avoid taxation. The Peracchis appealed their case to the U. S. Court of Appeals, Ninth Circuit which reversed the Tax Court. The Ninth Circuit agreed that the Peracchi’s note had no basis and there was no guarantee that the note ever would be collected, and therefore may never cost the Peracchis anything. But the court evaluated other circumstances in which the note might be collected without the Peracchi’s consent. The court found three situations where the Peracchi’s could be caused to repay the note. NAC Corporation could enforce the note. This was not likely given that the Peracchi’s controlled NAC. Second, NAC could sell the note to a third party and the third party could enforce the note repayment.
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Third, bankruptcy could force the Peracchis to have to pay the note. The court found that because bankruptcy was a real possibility for NAC, and the note would still be present if NAC went bankrupt, the note had actual economic value and should have a basis equal to its face value to both the Peracchi’s and NAC Corporation. Conclusions The examples of Alderman and Peracchi where the Tax Court ruled against the taxpayers because notes transferred had no basis that were subsequently overturned by the Courts of Appeals appear to be aberrations. One comment 10 stated that the Ninth Circuit, which ruled in Peracchi, pointed out that IRS Revenue Rulings, such as Rev. Rul. 68-629, are not entitled to as much deference as are regulations. The Ninth Circuit felt that Rev. Rul. 68-629 offered little in support of its position that promissory notes had no basis. But it is certainly not clear how much basis a promissory note would have if Peracchi was not in financial trouble and the note was not transferable. No relevant IRS regulations governing IRC 357(c) have been published subsequent to the Ninth Circuit’s ruling in Peracchi. I believe it would be wise for taxpayers who incorporate their businesses to find ways to avoid the tax because of IRC 357(c) that are currently accepted by the IRS, and not count on Courts of Appeals to find novel ways to rule in their favor and overturn the IRS and the Tax Court.

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References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Internal Revenue Code Section 357 – Assumption of Liability Internal Revenue Code Section 351 – Transfer to Corporation Controlled by Transferor Lipton, R. M., and J. E. Bender. 1999. Peracchi and Making Something Out of Nothing, or Does Debt Have a Zero Basis to its Maker… Taxes – The Tax Magazine March: 1-19. Revenue Ruling 68-629, 1968-2 CB 154 January 1, 1968 – Section 357. - Assumption of Liability Internal Revenue Code Section 1012 – Basis of Property-Cost V. W. Alderman, 55 T.C. 662, Dec. 30, 611 (1971) S. Lessinger, CA-2 89-1 USTC paragraph 9254, 872 F2d 519 Internal Revenue Code Section 362 – Basis to Corporations D. J. Peracchi, CA-9, 98-1 USTC paragraph 50,374, 143 F3d 487 CCH Tax Research Consultant, CCORP: 3,106.10, Assumed Liabilities in Excess of Basis

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