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

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 corporation. On the facts of the example, recognition of $40 of gain will leave the taxpayer with a basis in his stock in the corporation of $0, thereby eliminating the negative basis.

This was the dilemma confronting Peracchi. The adjusted basis of the property to be transferred to NAC was $981,406, but the liabilities encumbering the property totaled $1,548,213. Unless Peracchi did something, he would recognize gain of $566,807 -- the amount by which the liabilities exceeded the adjusted basis of the transferred property. In an attempt to mitigate the gain recognition, Peracchi transferred to NAC, in addition to the encumbered properties, a personal note with a face amount of $1,060,000. If the personal note had a basis equal to its face value, then the adjusted basis of the transferred property exceeded the amount of the liabilities and Peracchi would achieve his objective.

What is the basis of a note to its issuer? Section 1012 provides generally that the basis of property is equal to its cost. The IRS argued that it "cost" Peracchi nothing to issue his own note and hence under Alderman v. Commissioner, 55 T.C. 662, 665 (1971),(5) and Rev. Rul. 68-629, 1968-2 C.B. 154,(6) the note's basis in his hands is zero. The IRS framed its analysis of the issues in a pragmatic fashion, arguing that the note would not be paid unless Peracchi caused his controlled corporation to seek payment.

The Ninth Circuit agreed that it "cost" Peracchi nothing to make a note to NAC so long as he remained in control of the corporation. What happens, the court asked, if NAC goes bankrupt, or if Peracchi otherwise loses control of the corporation? In that event, the taxpayer would have put "a million dollar nut within the corporate shell, exposing Peracchi to the cruel nutcracker of corporate creditors in the event NAC goes bankrupt. And it does so to the tune of $1,060,000, the full face amount of the note."

That Peracchi would face personal liability in the event of NAC's bankruptcy was critical in the Ninth Circuit's analysis. Without the note, no matter how deeply the corporation was in debt, it could not reach Peracchi's assets. With the note on NAC's books, however, creditors could reach into Peracchi's pockets by enforcing the note.

But is the risk of bankruptcy a sufficient reason to treat the note as having a basis equal to its base value? The Ninth Circuit viewed this as the crux of the matter, concluding (without citing any authority) that if the risk of bankruptcy is sufficient, Peracchi should obtain basis in his own note. If the risk of bankruptcy is remote, however, the note should be ignored. Posing the question in this fashion, the court thought the answer clear. Peracchi's obligation on the note was not conditioned on NAC remaining solvent. Rather, the note represented a new and substantial investment in NAC. Reasoning by analogy to the at-risk rules of section 465, the court concluded that Peracchi was entitled to a step-up in basis to the extent of his risk of economic loss if the investment were to become unrecoverable.(7)

The Ninth Circuit also determined that the economics of the transaction supported the taxpayer's position. Most important, the transaction did not differ from others that would have given basis to Peracchi. For example, the court noted, Peracchi could have borrowed $1 million from a bank and then contributed the cash to NAC. NAC could, in turn, use the cash to purchase the note from the bank. Unless the IRS successfully asserted the step-transaction doctrine against the hypothetical alternative, section 357(c) would not apply. The court dismissed the possibility of the step-transaction doctrine applying to the hypothetical alternative on the grounds that it should not matter how a taxpayer structures a transaction so long as it has real economic effect.(8) The only economic difference between the actual and the hypothetical transaction, the court noted, is that the taxpayer would pay fees to the bank.

Judge Kozinski found further support in Bittker & Eustice for his conclusion that a note transferred to a corporation should be treated the same as cash borrowed from a bank:

Section 357(c) can be avoided by a transfer of

enough cash to eliminate any excess of liabilities

over basis; and since a note given by a solvent

obligor in purchasing property is routinely treated

as the equivalent of cash in determining the

basis of the property, it seems reasonable to give

it the same treatment in a section 351 exchange.(9)

Furthermore, one may ask, what is the alternative? If the note has a zero basis, NAC will recognize gain on a subsequent sale of the note. The possibility that -- (1) Peracchi could recognize gain when the note was contributed (because of the zero basis to the transferor-issuer) and (2) the corporation would, even without subsequent appreciation on the note, recognize gain when it sold the note -- persuaded the court that zero basis was not right answer. In the opinion, the court rejected the analysis and conclusion in Lessinger that a corporation takes a basis in a contributed note equal to face value even though the note has a zero basis in the hands of the shareholder-transferor.(10)

The Ninth Circuit also said that Peracchi's facts would not create problems similar to those addressed in Commissioner v. Tufts, 461 U.S. 300 (1983), in which nonrecourse debt permits a taxpayer to have a basis in excess of his economic investment. If a taxpayer is willing to increase his exposure to personal liability through the contribution of a valid, unconditional promissory note with full recourse, there is no basis in excess of economic investment. Furthermore, since Peracchi involves a C corporation, the court was unconcerned about the pass-through of artificial losses resulting from the step-up in basis.(11)

After concluding that the shareholder has a basis in his note equal to its face amount, the Ninth Circuit turned to the Tax Court's decision that the note was not a genuine indebtedness. The Tax Court concluded that the note was illusory because (1) NAC was controlled by Peracchi, and (2) when two years' payments on the note were not made, NAC did nothing. As a factual conclusion, the Tax Court's determination must be sustained on appeal unless clearly erroneous.(12)

The Ninth Circuit opinion by Judge Kozinski blew past these two facts, saying that Peracchi paid imperfect attention to his obligation, as frequently happens when the debtor and creditor are under common control. The proper approach to analyze whether the indebtedness is genuine, the court said, is to look at the face of the note and consider whether the legal obligation is illusory. According to the court, the note's bona fides were adequate. Specifically, (1) the debtor (Peracchi) was creditworthy and able to pay, (2) the note bore a market rate of interest, (3) the note had a fixed term, (4) the IRS did not argue that the note's value was less than its face amount, and (5) the note was fully transferable and enforceable by third parties, such as hostile creditors. On these facts, the court, citing Sacks v. Commissioner, 69 F.3d 982, 989 (9th Cir. 1995), concluded that the note was an ordinary, negotiable, recourse obligation that must be respected as genuine debt.

The court's analysis of the bona fides of the note, however, ignored a substantial body of law within the Ninth Circuit concerning the validity of indebtedness. Specifically, in Bauer v. Commissioner, 748 F.2d 1365, 1368 (9th Cir. 1984), eleven factors were identified for distinguishing capital contributions from loans. In Bauer, the court developed the following list of factors to consider: (1) the name given to the certificate evidencing the indebtedness, (2) the presence or absence of a maturity date, (3) the source of payments, (4) the right to enforce the payment of principal and interest, (5) the participation in management, (6) a status equal to or inferior to that of regular corporate creditors, (7) the intent of the parties, (8) "thin" or adequate capitalization, (9) the identity of interest between the creditor and stockholder, (10) payment of interest only out of "dividend" money, and (11) the ability of the corporation to obtain loans from outside lending institutions. Applying these factors to Peracchi's note, it is unclear whether the note should be considered genuine debt.

On the other hand, the IRS arguments were not entirely persuasive. The IRS argued first that the note should be viewed as a sham because it was executed simply to avoid tax. Although a legitimate concern, the court said that the tax avoidance issue must be addressed under the anti-avoidance rules in section 357(b) rather than section 357(C).(13) Since the IRS did not raise the section 357(b) sword to attack the transaction, the court was unwilling to do so.

The IRS next contended that the note should be treated as a gift to NAC because Peracchi received no consideration on the exchange. Conceding that tax deferral was a benefit to Peracchi, the IRS nonetheless argued that this is insufficient to make the bargain enforceable. The Ninth Circuit said the IRS argument proved too much: all contributions to capital would be deemed gifts. The contribution of the note was no more a gift than a contribution of $1 million in cash.

Based on its analysis, the court concluded that Peracchi was entitled to a basis step-up equal to the face value of the note. As a result, section 357(c) did not apply.

The Dissent 

In a colorful dissent full of allusions to magic and alchemy, Judge Fernandez skewered the majority opinion. The judge asked rhetorically whether a taxpayer who has borrowed hundreds of thousands of dollars more than his basis in his property can avoid taxation on a transfer of that property. He can under the majority view, the dissent noted, provided he issues a note. As a result, Judge Fernandez observed, a taxpayer can extract a large part of the value of the property, pocket the funds, use them, divest himself of the property, and pay the tax another day, if at all.

The technique, however, requires the proper magical incantations. The taxpayer cannot simply promise to make a contribution to the corporation, because that would not provide basis. Rather, the taxpayer must prepare an unsecured promissory note and transfer that note to the corporation. Even though this "promise to pay" neither reduces the taxpayer's assets nor constitutes an actual payment, the majority opinion would treat the note as increasing the basis of the property transferred. A promise to pay not evidenced by a note would also not pass muster. Judge Fernandez saw no support in the law for distinguishing between contributing a note and executing a note payable to the corporation.(14)

The taxpayer argued that the note bore all the hallmarks of economic reality, but the dissent was unpersuaded. Instead, Judge Fernandez dismissed the transaction as a bit of sortilege that would have made Merlin envious, because something (basis) was created out of nothing (a promise to pay).

Analysis

The ink was barely dry on Judge Kozinski's majority opinion when the criticism erupted? Although it is easy to sympathize with the taxpayer in Peracchi, the court's opinion treads on very thin precedential ice, particularly from a factual perspective. On the other hand, Peracchi may be viewed as a long-overdue recognition of the fallacy of the zero-basis problem, both generally and specifically in the case assumptions of debt in transactions subject to section 357(c).

A threshold question is whether the court's opinion is correct under the standard of review that applies to factual matters. The Tax Court's factual determination should be reversed only upon a finding of "clear error" in that determination. Under Bauer, the classification of an instrument as debt for federal income tax purposes requires a factual determination. In light of Peracchi's failure to make payments on the note until the IRS audit commenced, it is difficult to argue that the Tax Court was "clearly erroneous."

Moreover, the Ninth Circuit opinion completely ignored well-established principles for determining whether a debt instrument should be respected for tax purposes. Instead, the court substituted a new five-part test based on formalities rather than economic substance. Although Judge Kozinski might have reached the same result in Peracchi under the 11-factor test, there is no way to know for certain.

Hence, for taxpayers, the legacy of Peracchi may be the new five-part test for determining a genuine indebtedness. As long as a note is facially adequate, bears a market rate of interest, is issued by a creditworthy borrower, and may be collected by third parties, Peracchi says that the note will be treated as debt for tax purposes. This is so even where the obligation is held by a related party and interest payments are missed. Hence, Peracchi may ultimately be applied broadly to characterize debt instruments as such or to support interest deductions among related parties.

The more problematic issue is the question of the taxpayer's basis in his own note. The Tax Court in Alderman concluded that, since it costs a taxpayer nothing to write his own note, there is no basis for purposes of section 357.(16) On the other hand, because of the duplication of gain when a corporate transferee subsequently sells or collects the note, courts have been reluctant to accept the notion of zero basis for the note in the hands of the transferee.(17)

The real problem with the zero-basis conundrum is that it is a trap for the unwary. As Bittker & Eustice point out, taxpayers can avoid the problem merely by borrowing money from a bank, transferring the money to the corporation as part of the section 351 transaction, and then having the corporation acquire the note from the bank. Because the borrowed money has a basis equal to its face amount, there would be no tax consequences to the shareholder. The same result occurs where (1) the transferor uses his note to acquire readily-tradeable assets (such as stocks or bonds), (2) the transferor transfers the liquid assets to the corporation to increase the basis of the transferred property, and (3) following a subsequent sale of the assets by the corporation, the corporation uses the proceeds to acquire the shareholder's note. In this series of transactions, the section 357(c) problem is avoided and gain recognition is postponed in the same fashion as in Peracchi.(18)

Peracchi may also present a planning opportunity for persons transferring low-basis, encumbered property to a corporation in exchange for stock. In this case, Peracchi will give such transferors the ability to argue that their notes have a basis equal to face amount, particularly if all of the formalities of the obligation are observed. The IRS's argument that taxpayers always have a zero basis in their own obligation has visceral appeal, but courts are seemingly loathe to apply it where double recognition of gain can arise.

The alternative is the approach adopted in the consolidated return rules. There, a transfer between members of the affiliated group can produce negative basis through the creation of an excess loss account in the parent corporation's basis in the stock of a subsidiary. The excess loss account is picked up in income only when the subsidiary is sold or certain other triggering events occur. In this regime, the shareholder's note can be ignored because the negative basis cures the problems created by section 357(c).

What about the IRS's argument that the transfer of the taxpayer's note should be disregarded as a tax-motivated transaction? The Ninth Circuit's response to this argument was likely correct: A taxpayer can transfer additional property to a corporation in order to avoid a section 357(c) problem, as long as such property is truly transferred to the corporation. Moreover, in the case of related corporations, the transfer of a note can be structured to produce state tax savings (particularly in non-unitary jurisdictions) by shifting income from one corporation to another.

Notwithstanding that two circuit courts facing the issue squarely have refused to apply section 357(c) in a literal fashion, there is considerable uncertainty whether the taxpayer's transfer of its own note avoids the application of section 357(c). The Tax Court's conclusion in Alderman that it costs a taxpayer nothing to make its own note has a ring of truth. Certainty will only come only if more courts adopt the Ninth Circuit's view or if Congress addresses the issue head on.

Basis Duplication

The zero-basis problem under section 357(c) may be a trap for unwary taxpayers, but it also poses potential problems for the rise as well. Congress recently considered, but did not approve, legislation that would limit the planning opportunities for basis duplication caused by section 357(c).

Whenever property subject to a liability is transferred to a corporation, the transferor recognizes gain if the amount of the liability exceeds the adjusted basis of the property transferred. Section 357(c) does not, however, adequately address situations where a single liability encumbers more than one property or where more than one corporation receives property encumbered by the same debt. The literal statutory language indicates that the gain would be duplicated.

For example, assume that a U.S. taxpayer engaged in the real estate business owns two properties, Blackacre and Whiteacre, each of which has a fair market value of $1 million and an adjusted basis of $100,000. The two properties are collateral for a single note in the amount of $2 million. If the taxpayer transfers the two properties to a single corporation subject to the liability, the taxpayer recognizes gain of $1.8 million, and the corporate transferee takes a basis in the property of $2 million.

What is the result if more than one corporate transferee is involved? For example, assume the taxpayer transfers Blackacre to X corporation and Whiteacre to Y corporation. Logically, the result should be the same, i.e., the taxpayer should recognize gain of $1.8 million. Under the literal language of section 357(c), however, the threshold issue is the amount of liability to which each transferred property is subject. In this case, each property is subject to $2 million in liabilities. Hence, the transfer of Blackacre to X corporation produces a $1.9 million gain to the taxpayer, and the transfer of Whiteacre to Y corporation produces another $1.9 million gain, or a total of $3.8 million. In other words, the taxpayer recognizes $2 million more gain than if the property is transferred to a single corporation.

The flip side of gain recognition to the transferor is that each corporation has a basis in the transferred property that includes gain recognized by the transferor. As a result, where Blackacre and Whiteacre are transferred to separate corporations, as in the previous example, each corporation has a basis of $2 million in its respective property. If each property is subsequently sold for its fair market value of $1 million, each corporation incurs a loss of $1 million.

The planning opportunity, of course, is that if the transferor is exempt from taxation (either under section 501 or as a foreign person), the gain is not taxed but the transferee will obtain a basis increase. For example, assume the same facts as the last example except that a tax-exempt organization (Exempt) owns Blackacre and Whiteacre. Exempt decides to "cash out" by borrowing $2 million against the properties. Exempt then transfers Blackacre to X Corporation and Whiteacre to Y Corporation in section 351 transactions. The properties have a fair value of $1 million each. Contemporaneously with Exempt's transfers, Bigco, the unrelated common parent of a consolidated group of corporations, transfers sufficient cash or other property to X and Y corporations in exchange for 80 percent of the stock of each. The transfer of the properties to the corporations is subject to section 351. Also, since the liabilities that encumber the transferred properties exceed their basis, a taxable gain of $3.8 million is engendered under section 357(c), but the gain is entirely exempt. The corporate transferees become members of the Bigco consolidated group, and each obtains a step up in the basis of their respective property to $2 million. If X and Y subsequently sell the respective properties for the $1 million fair value, the Bigco consolidated group will realize and recognize a $2 million loss. The IRS's only recourse would be to argue that section 269 prevents recognition of the loss. The issue would then become whether the principal purpose of the acquisition was the evasion or avoidance of federal income tax, a factual question that could lead to a significant dispute.

The Senate version of the IRS Restructuring and Reform Act of 1998 included proposed new section 357(c)(4), which would provide that in the case of the transfer of property subject to a nonrecourse liability, the transferee is treated as assuming with respect to each property only a "ratable portion" of the liability. The liability would be apportioned on the basis of the relative fair market value of all assets subject to the liability? On the facts of the example, this provision would prevent the basis duplication by allocating half of the liability to Blackacre and half to Whiteacre. The provision, however, was eliminated by the Conference Committee.

The proposed legislation would have applied only to transfers of property subject to nonrecourse liabilities. This would leave some planning opportunities involving recourse debt. For example, if in the preceding example the liability that encumbered Blackacre and Whiteacre were a recourse liability of Exempt, which liability was jointly and severally assumed by the corporate transferees (and Exempt released), proposed section 357(c)(4) seemingly would not have applied. In any event, since the proposed legislation was not enacted, the planning opportunities remain.

Conclusion

Section 357(c) has always been an important consideration for tax planners. Although this provision was recently turned against the government, in most situations it is taxpayers who feel the sting of section 357(c). While the full implications of Peracchi remain uncertain, the decision may prove a useful planning device for transferors who wish to avoid the recognition of gain by using their notes to increase the basis of the transferred property.

Notes

(1) Judge Kozinski's opinion is as colorful as it is likely to be controversial, with allusions and commentary concerning the complexity of corporate taxation.

(2) Judge Kozinski echoed the comment in Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, [paragraph] 2.01 (6th ed. 1997) (hereinafter "Bittker & Eustice"), that a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.

(3) I.R.C. [sections] 358(d).

(4) Notwithstanding the statement in the text, the "excess loss account" applicable to affiliated corporations filing consolidated returns may be viewed as a form of "negative basis."

(5) In Alderman, the Tax Court held that taxpayers had no basis in a promissory note they issued because they incurred no cost in making such a note. 55 T.C. 662, 665 (1971).

(6) The court noted that the conclusion might have been different if the IRS issued regulations addressing a taxpayer's basis in its own note. According to the court, the IRS's litigating position in a revenue ruling is entitled to some deference, but not as much as a regulation. That Rev. Rul. 68-629 offered no rationale, let alone a reasonable one, for its conclusion may have diminished its persuasiveness.

(7) The court attempted to limit its decision to cases where the note is contributed to an operating business subject to a non-trivial risk of bankruptcy; the result might well be different in the Ninth Circuit if the corporation were a shell or simply held passive investments.

(8) Alternatively, Peracchi could have swapped promissory notes with a third party, contributing the note received in the swap, and then closing the loop with another exchange of notes. The presence of a third party (either the note swapper or a bank) serves to value the note, but it does not change the underlying economics of the transaction for a creditworthy taxpayer that could otherwise contribute its own note to the corporation.

(9) Bittker & Eustice, [paragraph] 3.0614][b].

(10) The Ninth Circuit agreed with the IRS that the Lessinger approach is untenable, because a corporation's basis in contributed property must be determined by the basis of the property in the hands of the contributing shareholder. The court's approach, however, will produce the same result as Lessinger on the subsequent sale of the note.

(11) Notwithstanding the court's express attempt to limit the decision to C corporations, it is difficult to say why Peracchi would not apply to a transfer of a shareholder's note to an S corporation. The relevant provisions of subchapter C are the same and section 1371 applies the provisions of subchapter C to S corporations.

(12) Commissioner v. Duberstein, 363 U.S. 278, 291 (1960). Judge Kozinski did not mention the standard of review in his opinion.

(13) Section 357(b) provides that if, taking into account the nature of the liability and the circumstances in which the arrangement for the assumption or acquisition was made, it appears that the taxpayer's principal purpose with respect to the assumption or acquisition was a purpose to avoid federal income tax on the exchange or, if not with such a purpose, was not undertaken for a bona fide business purpose, then such assumption of acquisition shall, for purposes of section 351, be considered as money received by the taxpayer on the exchange. The court's analysis of section 357(b) was flawed, however, because that section addresses the treatment of a liability being assumed and not the additional assets being conveyed to the corporation to increase the basis of all the transferred assets. On the other hand, the court was certainly correct in concluding that a tax motivation for transferring additional assets in order to avoid section 357(c) did not taint a transaction as a "sham." Section 357(c) is a mechanical provision that can be avoided by transferring additional assets to the corporation.

(14) Judge Fernandez also questioned the majority's determination that the Tax Court clearly erred in deciding the note was not genuine indebtedness.

(15) Sheppard, "Negative Basis, Economic Exposure and Runaway Metaphors," Tax Notes, May 11, 1998, at 676; Cummings, "Ninth Circuit Avoids Lessinger Misstep, But Makes Another," Tax Notes, May 11, 1998, at 781; Raby & Raby, "'Sorcery' Creates Tax Basis from `Piece of Paper'," Tax Notes, May 18, 1998, at 873.

(16) 55 T.C. 662 (1971). See also Rev. Rul. 68-629, 1968-2 C.B. 154.

(17) Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989), holding (seemingly without authority) that the corporate transferee had a stepped-up basis in the note.

(18) The presence of a third party (the lender or the seller of the assets) willing to accept the taxpayer's note may validate the valuation of the obligation, but it does not change the underlying legal issue.

(19) Section 357(c)(4)(B). Also, proposed section 357(c)(4)(A) would have clarified that a liability is treated as having been assumed to the extent, as determined on the basis of the facts and circumstances, that the transferor is relieved of such liability or any portion thereof (including through an indemnity agreement or other similar arrangement).

(*) Notes appear on page 260.

RICHARD M. LIPTON is a partner in the Chicago law firm of Sonneschein, Nath & Rosenthal. He is a frequent lecturer on corporate tax issues, and has published articles in numerous publications. His article on the effects of the Alumax decision appeared in the March-April 1998 issue of The Tax Executive.