| ||Section 357(c) and the Elusive Basis of the Issuer’s Note |
*Associate, Locke Liddell & Sapp, Dallas, Texas; Rutgers University, B.A. 1992; University of Texas, M.A. 1994, J.D. 2002. The author would like to thank Professor Calvin H. Johnson for his inspiration and assistance.
Section 357(c) provides that a shareholder must recognize gain on a section 351 exchange to the extent that the liabilities assumed by the corporation exceed the total adjusted basis of the property transferred. Attempts by shareholders to increase their basis, thereby avoiding gain recognition, by transferring their own notes to the corporations are controversial. Until the Second Circuit's decision in Lessinger v. Commissioner reopened the question, the common wisdom was that Alderman v. Commissioner made futile such an attempt by the taxpayer to increase his basis in the property transferred. But when the facts aroused sympathy for the taxpayer, appellate courts in both the Second and Ninth Circuits (but so far no published Tax Court opinions) found ways to make the taxpayer's note generate sufficient basis to avoid section 357(c) gains. These decisions performed a valuable service by reexamining the troublesome zero-basis theory adopted in Alderman, but neither one has replaced it with an entirely satisfactory rationale. This paper argues that a transfer of a note should eliminate section 357(c) gain not because it generates immediate basis, but because the note reduces the liabilities assumed. But such relief should be limited to cases in which the shareholder has actually retained the obligation apparently assumed by the corporation.
Part I of this paper introduces the section 357(c) problem by reviewing the statutory framework, the Service's zero-basis theory as adopted by Alderman, and the inappropriate results of this approach. Part II examines the rationales used by the circuit courts in Lessinger and Peracchi to avoid such results. Part III discusses the possibility of deferring basis instead of immediately granting either a face value or zero basis. Part IV offers a more satisfactory solution that does not wreak havoc with the basis rules: to the extent that a transferor's note offsets liabilities transferred, those liabilities should be treated as not assumed. Part V explores how the solution offered here works with the purpose of section 357(c). This paper concludes that there is no satisfactory theory by which taxpayers can generate immediate basis in their own notes, but the transfer of a note may nevertheless be sufficient to eliminate any section 357(c) gain.