TO: J Corporation

FROM: Yizhen Gong

RE: §357(c) gain IRS examination

DATE: October 13, 2014

Facts
Joe owns 100% of the stock of J Corporation. Joe plans on contributing a parcel of land to J co. having a fair market value of $1.5 million and a basis of $350,000. Further, the land is subject to a mortgage of $1.2 million. To avoid the gain that would result on this transaction, due to §357(c), Joe plans on contributing a promissory note to J Corporation of with a face value of $850,000. He claims that this note will have a basis equal to its face value thus eliminating the gain caused by §357(c).

Issues
Whether Joe’s transfer of a promissory note to its wholly owned corporation, in an amount equal to the excess of liabilities over the basis of assets contributed in a §351 transfer, avoids §357(c) gain recognition? Can he increase the basis of the assets by transferring his own promissory note to the corporation?

Conclusion
1. Joe received stock valued at $300,000 and thus realized a gain of $1,150,000 ($300,000+$1,200,000-$350,000). §357(c) requires Joe recognize a gain of $850,000 ($1,200,000-$$350,000).
2. It depends on whether Joe’s note has a basis in Joe’s hands for purpose of section §357(c).

Analysis
1. Under §357(c), no gain or loss is 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. Joe transferred land to a corporation he controlled. An exception to tax-free treatment is contained in §357(c), which generally provides that a transferor in a §351 transaction recognizes gain to the extent that any liabilities assumed by the corporation on the transfer exceed the transferor’s aggregate adjusted basis in the assets transferred. Joe plan to contribute a parcel of land to J co. having a fair market value of $1.5 million and a basis of $350,000. Further, the land is subject to a mortgage of $1.2 million. The liability assumed by the corporate transferee ($1.2 million) would exceed the adjusted basis of the transferor's property ($350,000) by the amount of $850,000, which amount, under §357(c), must be recognized as gain to petitioners. In order to avoid this result in the present case, Joe executed a personal promissory note ($850,000) to their wholly owned corporation in an amount equal to the excess of liabilities transferred over the adjusted basis of the transferred assets. Joe claims this note will have a basis equal to its face value thus eliminating the gain caused by §357(c).

2. The major controversy in this case is the determination of the note’s basis. § 1012 provides that the basis of property is its cost except as otherwise provided in the Code. In the case of Peracchi v. Comm'r (98-1 U.S. Tax Court No. 50374), The Ninth Circuit held that Peracchi incurred cost in issuing his note because the note was enforceable by company’s creditors. However, 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. Revenue Ruling 68-629 outlines that Gain is recognized under section 357(c) of the Code where a promissory note is issued for the excess of liabilities over the adjusted basis of assets transferred by a sole proprietorship to a controlled corporation.

3. In this case, Joe plans on contributing a promissory note to J Corporation with a face value of $850,000. If Joe indeed incurred cost in contributing the promissory note, and the note have genuine indebtedness, the basis of promissory note transferred should equal to its fair market value therefore it can help Joe avoid the gain from §357(c). Nevertheless, if Joe does not incur cost in contribution the promissory note, the basis in note should be 0 both for Joe and J Corporation. In this situation, Joe does not increase the basis of assets transferred in a section 351transaction and still recognize a gain of 850,000.

Authorities
Revenue Ruling 68-629, 1968-2 C.B. 154.
Internal re venue code §351, §357, §1012
Case Peracchi v. Comm'r (98-1 U.S. Tax Court No. 50374)