Unsecured note makes gain disappear.

Individuals can incorporate an ongoing business tax-free, according to IRC section 351. For example, if a sole proprietor whose assets have a fair market value of $600,000 and a basis of $200,000 wants to incorporate his business, the $400,000 gain would not be recognized. However, according to IRC section 357(c), gain must be recognized immediately if liabilities assumed by the corporation exceed the basis of the transferred assets. The taxpayer in the above example would owe taxes on the $150,000 gain if the assets were subject to a $350,000 mortgage.

In order to avoid this gain, CPAs generally advise clients to contribute additional cash of $150,000 or to pay off $150,000 of the debt prior to incorporation. Now, according to Peracchi v. Commissioner (CA-9, 4/29/98), there is an easier way to avoid recognizing gain.

In 1989, Donald Peracchi transferred two parcels of real estate with a basis of $981,400 to NAC, his wholly owned corporation. The assets were encumbered by $1.5 million in liabilities. To avoid recognition of gain on the excess of debt over basis, Peracchi issued an unsecured promissory note, agreeing to pay NAC $1,060,000 over a term often years at 11% interest.

The IRS determined that Peracchi realized a gain on the transfer, asserting that the note was not genuine indebtedness under IRC section 357(c)(1) because Peracchi incurred no cost in issuing the note to NAC. According to the IRS, the basis in the note was zero. However, Judge Alex Kozinski said it was more important to determine whether Peracchi had any basis in the note. If so, then he had contributed property with a basis exceeding liabilities and no gain would be recognized.

The court concluded that the note was genuine because

* Peracchi was creditworthy and had the funds to pay the note.

* The promissory note carried a market rate of interest for a reasonable and fixed term.

* The note was transferable and enforceable by third parties and NAC could borrow against it.

Peracchi also put himself at economic risk by transferring the note to NAC. If NAC filed for bankruptcy, its creditors could enforce the note as an unliquidated asset of NAC. The court ruled that if the risk of bankruptcy was significant and the taxpayer was financially capable of making future payments on the note then the shareholders should get a basis in the note. The court found that NAC's risk of bankruptcy was significant and ruled in favor of Peracchi. Thus, he was not required to recognize any gain on the transfer.

Observation. If a taxpayer recognizes a gain under IRC section 357(c), the taxpayer's stock basis generally is reduced to zero. This creates a major problem for subchapter S shareholders. Under IRC section 1366(d)(1), an S shareholder can deduct corporate losses only to the extent of his or her stock or debt basis. The Peracchi decision now allows certain creditworthy S corporation shareholders to get additional basis in their S stock simply by issuing an unsecured promissory note to the corporation.

--Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.