Magazine article The CPA Journal

Reduction of Boot with a Promissory Note

Magazine article The CPA Journal

Reduction of Boot with a Promissory Note

Article excerpt

Is there something that a taxpayer who has borrowed $566,000 more than his basis in property can do to avoid taxation under IRC section 357(c) when trans ferring property to a controlled corporation? Can he increase the basis of the assets by transferring his own promissory note to the corporation? One judge from the Ninth Circuit in the case of Peracchi v. Comm'r (98-1 U.S. Tax Court No. 50374) declared that "with all magical solutions he cannot just transfer the property to the corporation and promise to pay off the encumbrance." But his was a dissenting opinion. The majority of the judges ruled in favor of the taxpayer and held that the basis of the note was equal to its face value, and the entire gain was deferred.

The taxpayer was required under state laws to contribute additional capital to his closely held corporation. Three encumbered parcels of real estate were contributed. The taxpayer also contributed a promissory note, promising to pay to the corporation $1,060,000 over a term of 10 years at 11% interest, apparently to eliminate the excess liabilities to which the real estate was subject over its adjusted basis ($566,000).

Analysis and Discussion

No gain or loss is recognized 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. Peracchi transferred property to a corporation he controlled. He did not receive additional stock of his own corporation since issuance of new stock to a sole shareholder in exchange for assets would be meaningless.

Gain is recognized to any transferor, however, up to the amount of "boot" received. Boot is money or property other than stock in the corporation received by the shareholder in exchange for the property contributed. Peracchi did not receive cash or any other property. Or did he?

The court explained, "When a shareholder contributes property encumbered by debt, the corporation usually assumes the debt and the Code normally treats discharging of liabilities as receiving money." Taxability of assumption of liabilities in all circumstances diminishes the benefits of IRC section 351. The Code therefore states that an assumption of liabilities is not considered boot even if the corporation assumes the obligation. It was agreed that the transfers made by Peracchi were based on business reasons (i.e., the compliance with state laws). If Peracchi failed to show a business motive he would have to include all the liabilities assumed as boot under IRC section 357(b).

Thereafter, it is necessary to consider IRC section 357(c), which forces a shareholder to recognize gain to the extent liabilities exceed basis and provides that gain shall be recognized if the sum of the liabilities assumed plus the sum of the amount to which the property is subject exceeds the total of the adjusted basis of the property transferred pursuant to such exchange. …

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