The Liability-Offset Theory of Peracchi
Bradley T. Borden and Douglas L. Longhofer*
Transfers of property subject to liabilities are the focus of significant commentary and multiple court decisions. Such transactions conducted between unrelated parties raise complicated issues and may trigger taxable gain or cancellation of indebtedness income. The issues become more complicated if the transfer is to a controlled corporation.
Transfers to controlled corporations differ fundamentally from transfers to unrelated parties. For instance, transfers to controlled corporations often represent mere changes in the form of legal ownership of property. Tax law recognizes that difference and generally taxes transfers to unrelated parties—but often allows tax-free contributions to corporations. Whereas liability relief is part of the amount realized or cancellation of indebtedness income if it is part of a transfer to an unrelated party, it generally does not trigger gain or cancellation of indebtedness income if it is part of a contribution to a controlled corporation.
If, as part of a section 351 transaction, a corporation assumes liabilities that exceed the adjusted basis of the transferred properties, section 357(c) generally requires a taxpayer to recognize gain on the transaction. Taxpayers may structure transactions to avoid section 357(c) gain. For example, a taxpayer may contribute a self-created note to the corporation, hoping it will increase the basis of contributed property, or reduce assumed liability. In Peracchi v. Commissioner, the Court of Appeals for the Ninth Circuit held that a shareholder has a basis in a self-created note contributed to a corporation as part of a section 351 transaction. That holding allowed the taxpayer to avoid section 357(c) gain.
The Ninth Circuit’s holding in Peracchi sparked substantial debate because it contradicted what many felt to be well-settled law: that section 357(c) operated mechanically and that methods to avoid section 357(c) gain were limited. Commentators suggest that by allowing the contributor to take a basis in a self-created note, the court granted shareholders the power to eliminate section 357(c) gain and essentially “pull the teeth” out of that section.
Commentators have advanced two general theories for the proper tax treatment of contributed self-created notes since Peracchi, but neither of them has satisfactorily addressed these transactions from both an economic and tax perspective. This Article argues that a satisfactory theory of the proper tax treatment of contributed self-created notes under section 357(c) should satisfy four criteria (referred to hereafter as the “Four Criteria”): (1) recognize the economic substance of the transaction; (2) appropriately tax both the corporation and the shareholder on contribution; (3) properly account for payments made by the shareholder on the note; and (4) properly treat the corporation’s subsequent disposition of the note or repayment of the liability. Theories presented prior to this Article fail to adequately address these Four Criteria.
Because the Four Criteria are essential to the analysis that follows, they deserve brief consideration. First, a theory properly recognizes the economic substance of a transaction if it considers whether a contribution alters a shareholder’s economic situation. For example, the theory must ask what interest a shareholder takes in a corporation and how the contributed note affects that interest. The theory must also properly account for the shareholder’s economic situation before and after the contribution. If the shareholder’s economic situation does not change as part of the contribution, neither the shareholder nor the corporation should recognize gain or loss on the contribution.
Second, the theory must appropriately tax both the contributing shareholder and the corporation. That generally requires that the shareholder and corporation recognize no gain or loss on the contribution. It also requires that the shareholder and corporation take the appropriate bases in the stock and contributed property.
Third, the theory must properly account for the shareholder’s payment on the contributed note. The treatment of the shareholder’s payment must be consistent with the treatment of the contribution and generally should not result in taxable gain or loss to the shareholder or corporation.
Fourth, the theory must properly treat the disposition of the note by the corporation. This treatment should relate to the tax treatment applied to the contribution of the note. The theory must also properly account for any payments the corporation makes on the assumed liability. That treatment should be consistent with tax treatment afforded the contribution of the note.
The discussion below reveals that the Peracchi decision fails to properly account for the basis in the note, so it fails the second criterion. That failure causes difficulties with the third and fourth criteria. Therefore, its rationale is unacceptable. As a result of Peracchi, the existing theories and criticisms often focus on whether the note constitutes property for purposes of a section 351 exchange, and whether the note has a basis in the shareholder’s or the corporation’s hands. One such theory, which this Article refers to as the separate-transaction theory, argues that the law should not treat stock issued in exchange for self-created notes as stock issued for property. This theory suggests that the law should treat the contribution of property and self-created notes as two separate transactions—the transfer of property in exchange for stock and the transfer of the note in exchange for stock. The separate-transaction theory fails, however, to appropriately tax the contribution. Under this theory, the shareholder will often recognize gain on the contribution. Thus, the separate-transaction theory fails the second criterion.
Other commentators have proposed an open-transaction theory. This theory leaves the transaction open, requiring the shareholder to accrue basis in stock as payments are made on the note. This theory fails the fourth criterion by not properly addressing the corporate disposition of the note. The discussion below illustrates that this failure creates unnecessary confusion by potentially giving the contributor of the self-created note a negative basis in the stock received.
This Article suggests that a fully developed liability-offset theory, which views the contribution of a self-created promissory note as a reduction of the
liabilities assumed by the corporation, satisfies the Four Criteria. Instead of analyzing whether the note increases basis in the transferred assets, the liability-offset theory suggests that the self-created note should reduce, or offset, the amount of liabilities assumed by the transferee corporation. If the note represents valid indebtedness, the liability-offset theory reflects the intent of lawmakers, recognizes the economic substance of the transaction, and avoids problematic issues that arise from giving the note basis in the hands of the corporation or the shareholder. Furthermore, the liability-offset theory allows for the appropriate tax treatment when the shareholder makes payments on the note and when the corporation subsequently factors the note. The liability-offset theory helps explain why the tax-free treatment in Peracchi is correct, even though the court’s reasoning is flawed.
Part II of the Article briefly reviews the tax rules governing corporate formation. It explains the rationale for section 351 nonrecognition and the section 357(c) exception to the nonrecognition rule. It also reviews the case law and rulings that have considered the proper tax treatment of a contributed self-created note. Finally, it recounts legislative developments that help inform the analysis of the liability-offset theory. Part III presents and critiques the separate-transaction and open-transaction theories of Peracchi, and illustrates how they fail to satisfy the Four Criteria. Part IV presents the liability-offset theory and illustrates how it satisfies the Four Criteria and presents a better way to consider contributed self-created notes. Part V concludes.
* Bradley T. Borden is a Professor of Law at Brooklyn Law School in Brooklyn, New York. Douglas L. Longhofer is an Associate at Martin, Pringle, Oliver, Wallace & Bauer in Wichita, Kansas. Professor Borden and Mr. Longhofer thank Danielle Schulte for her research assistance with this Article.