|Section 358 and Crane — A Reply to My Critics |
John A. Bogdanski*
*Professor of Law, Lewis & Clark Law School; Saint Peter's College, A.B., 1975; Stanford University, J.D., 1978. The author is grateful to Stuart Lazar for a thoughtful dialogue about the issue discussed herein.
In the Fall 2003 issue of The Tax Lawyer, Steven Quiring attacked my affirmation of the results in Lessinger v. Commissioner and Peracchi v. Commissioner, on the ground that I engaged in circular reasoning. This criticism is not new, but it is mistaken. I may not often think outside the box, but my view of these cases is clearly outside the circle. Mindful that readers may have little interest in an ongoing debate over a picky point (and an overwritten topic, to boot), I have nonetheless run out of cheeks to turn, and so I reluctantly rise in my own defense.
I. BASIC ISSUE AND MY ANALYSIS
The issue in Lessinger and Peracchi can be boiled down to a simple hypothetical: An individual forms a corporation, transferring to it assets with an adjusted basis of $750,000, in exchange for all of the corporation's stock. As part of the transaction, the corporation assumes the shareholder's personal liability of $1,000,000. To avoid recognizing gain under section 357(c), the shareholder also contributes to the corporation, as part of the same exchange, his or her own promissory note in the amount of $250,000, representing true indebtedness. Does the shareholder recognize $250,000 gain under section 357(c), or not?
The Ninth Circuit in Lessinger and the Second Circuit in Peracchi have held that the shareholder does not recognize gain—that the contribution of the note insulates the shareholder from gain recognition under section 357(c). In my view, this is the correct result, because the sole function of section 357(c) is to prevent the shareholder from having a negative basis in the stock under section 358(d). Since the note generates $250,000 in basis in the stock to supplement the $750,000 stock basis carried over from the contributed assets under section 358(a), I believe the courts are correct in holding that on the facts of the hypothetical, the shareholder recognizes no gain, and the basis of his or her stock is zero. (If the shareholder subsequently fails to make good on his or her promise to pay, however, the usual tax consequences of discharge of indebtedness should follow.)
Although the Peracchi court got this mostly right, the Second Circuit in Lessinger reached the correct result for the wrong reason. It asserted that section 357(c) referred to the corporation's basis in the contributed indebtedness. That, I noted, was a misreading of the statute and resulted in circular reasoning. My critics have accused me of making the same type of error, but most assuredly I did not.
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