Accounting Case Brief

CASE CITATION: 143 F.3d 487

FACTS: Peracchi is an individual taxpayer who held a controlling interest in a closely-held corporation, NAC. During the year in question, Peracchi contributed additional capital to NAC in order to avoid violating some state laws related to the business. In particular, Peracchi contributed two pieces of real estate that had significant value, but relatively low basis. In addition, both parcels were subject to substantial liabilities that exceeded the bases of the parcels. In addition to contributing the parcels, Peracchi also contributed a personal note for more than $1 million. If the note had not been transferred, Peracchi would have had to recognize gain on the transfer to the corporation, even though the transfer would appear to meet the requirement of being non-taxable, because the amount of the liabilities exceeded the basis of the assets transferred. Comment by Rupert, Timothy: Generally, you should try to provide the motivation for the taxpayer and the IRS for the tax treatment. Why do they want it treated the way they are suggesting?

The taxpayer is appealing an earlier Tax Court decision to the Ninth Circuit Court of Appeals. In the Tax Court case, the IRS argued that the personal note was not a legitimate debt. The Tax Court ruled in favor of the IRS and concluded that the taxpayer should have to recognize gain on the transfer.

ISSUE: Does a personal note transferred in a nontaxable (sec. 351) transaction to a corporation have a basis of zero or a basis equal to the amount obligated to be paid? Comment by Rupert, Timothy: The Issue should be a concise question (or questions if there is more than one issue).

HOLDING: A personal note transferred by a shareholder in a Sec. 351 transaction has a basis equal to the amount of the note. Comment by Rupert, Timothy: The Holding should generally be one sentence for each issue and should correspond to the issues (for example, if there are two issues, there should be two sentences—one that answers each issue).

ANALYSIS: In arriving at its decision, the court noted that Sec. 351 provides that a transfer to a corporation controlled by a taxpayer is generally treated as a non-taxable transaction unless the shareholder receives boot. The court also noted that, under Sec. 357, when the corporation agrees to assume liabilities that are associated with property that is transferred, the shareholder is considered to receive boot for the amount of the liability assumed by the corporation. However, Sec 357(c) provides that the shareholder must only recognize gain on the liabilities as boot if the liabilities exceed basis. In the present case, the liabilities do exceed the basis in the real estate transferred. However, if the fair market value (amount) of the personal note transferred by the shareholder is considered to be part of the basis of the property transferred, the shareholder would not have to recognize gain because the basis now exceeds the liabilities associated with the real estate. The court decided that the amount of the personal note should be considered the basis of the note because the shareholder had extended his economic risk by providing the note. If the corporation declared bankruptcy, the shareholder would have been required to pay off the loan, so this seemed inconsistent with the IRS’ argument that the personal note was nothing more than a signed piece of paper that wasn’t necessarily enforceable. The fact that the taxpayer was creditworthy meant that he did indeed bear responsibility for paying off the note.