Peracchi v. C.I.R., 96-70606

• Citation: 143 F.3d 487
• Decision Date: 29 April 1998
• Docket Number: No. 96-70606,96-70606
• Parties: -1754, 98-1 USTC P 50,374, 98 Cal. Daily Op. Serv. 3181, 98 Daily Journal D.A.R. 4405 Donald J. PERACCHI; Judith E. Peracchi, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

Page 487

143 F.3d 487

81 A.F.T.R.2d 98-1754, 98-1 USTC P 50,374,

98 Cal. Daily Op. Serv. 3181,

98 Daily Journal D.A.R. 4405

Donald J. PERACCHI; Judith E. Peracchi, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 96-70606.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Sept. 17, 1997.

Decided April 29, 1998.

Craig A. Houghton, Baker, Manock & Jensen, Fresno, California, for the petitioners-appellants.

Bruce Ellisen, Tax Division, United States Department of Justice, Washington, DC, for the respondent-appellee.

Appeal from a Decision of the United States Tax Court; Arthur L. Nims, III, Judge, Presiding. Tax Ct. No. 22511-93.

Before: MAYER, ^* Chief Judge, KOZINSKI and FERNANDEZ, Circuit Judges.

Opinion by Judge KOZINSKI; Dissent by Judge FERNANDEZ.

KOZINSKI, Circuit Judge:

We must unscramble a Rubik's Cube of corporate tax law to determine the basis of a note contributed by a taxpayer to his wholly-owned corporation.

The Transaction

The taxpayer, Donald Peracchi, ¹ needed to contribute additional capital to his closely-held corporation (NAC) to comply with Nevada's minimum premium-to-asset ratio for insurance companies. Peracchi contributed two parcels of real estate. The parcels were encumbered with liabilities which together exceeded Peracchi's total basis in the properties by more than half a million dollars. As we discuss in detail below, under section 357(c), contributing property with liabilities in excess of basis can trigger immediate recognition of gain in the amount of the excess. In an effort to avoid this, Peracchi also executed a promissory note, promising to pay NAC $1,060,000 over a term of ten years at 11% interest. Peracchi maintains that the note has a basis equal to its face amount, thereby making his total basis in the property contributed greater than the total liabilities. If this is so, he will have extracted himself from the quicksand of section 357(c) and owe no immediate tax on the transfer of property to NAC. The IRS, though, maintains that (1) the note is not genuine indebtedness and should be treated as an unenforceable gift; and (2) even if the note is genuine, it does not increase Peracchi's basis in the property contributed.

The parties are not splitting hairs: Peracchi claims the basis of the note is $1,060,000, its face value, while the IRS argues that the note has a basis of zero. If Peracchi is right, he pays no immediate tax on the half a million dollars by which the debts on the land he contributed exceed his basis in the land; if the IRS is right, the note becomes irrelevant for tax purposes and Peracchi must recognize an immediate gain on the half million. The fact that the IRS and Peracchi are so far apart suggests they are looking at the transaction through different colored lenses. To figure out whether Peracchi's lens is rose-tinted or clear, it is useful to take a guided tour of sections 351 and 357 and the tax law principles undergirding them.

Into the Lobster Pot: Section 351

²

The Code tries to make organizing a corporation pain-free from a tax point of view. A capital contribution is, in tax lingo, a "nonrecognition" event: A shareholder can generally contribute capital without recognizing gain on the exchange. ³ It's merely a change in the form of ownership, like moving a billfold from one pocket to another. See I.R.C. § 351. ⁴ So long as the shareholders contributing the property remain in control ⁵ of the corporation after the exchange, section 351 applies: It doesn't matter if the capital contribution occurs at the creation of the corporation or if--as here--the company is already up and running. The baseline is that Peracchi may contribute property to NAC without recognizing gain on the exchange.

Gain Deferral: Section 358(a)

Peracchi contributed capital to NAC in the form of real property and a promissory note. Corporations may be funded with any kind of asset, such as equipment, real estate, intellectual property, contracts, leaseholds, securities or letters of credit. The tax consequences can get a little complicated because a shareholder's basis in the property contributed often differs from its fair market value. The general rule is that an asset's basis is equal to its "cost." See I.R.C. § 1012. But when a shareholder like Peracchi contributes property to a corporation in a nonrecognition transaction, a cost basis does not preserve the unrecognized gain. Rather than take a basis equal to the fair market value of the property exchanged, the shareholder must substitute the basis of that property for what would otherwise be the cost basis of the stock. ⁶ This preserves the gain for recognition at a later day: The gain is built into the shareholder's new basis in the stock, and he will recognize income when he disposes of the stock.

The fact that gain is deferred rather than extinguished doesn't diminish the importance of questions relating to basis and the timing of recognition. In tax, as in comedy, timing matters. Most taxpayers would much prefer to pay tax on contributed property years later--when they sell their stock--rather than when they contribute the property. ⁷ Thus what Peracchi is seeking here is gain deferral: He wants the gain to be recognized only when he disposes of some or all of his stock.

Continuity of Investment: Boot and section 351(b)

Continuity of investment is the cornerstone of nonrecognition under section 351. Nonrecognition assumes that a capital contribution amounts to nothing more than a nominal change in the form of ownership; in substance the shareholder's investment in the property continues. But a capital contribution can sometimes allow a shareholder to partially terminate his investment in an asset or group of assets. For example, when a shareholder receives cash or other property in addition to stock, receipt of that property reflects a partial termination of investment in the business. The shareholder may invest that money in a wholly unrelated business, or spend it just like any other form of personal income. To the extent a section 351 transaction resembles an ordinary sale, the nonrecognition rationale falls apart.

Thus the central exception to nonrecognition for section 351 transactions comes into play when the taxpayer receives "boot"--money or property other than stock in the corporation--in exchange for the property contributed. See I.R.C. § 351(b). Boot is recognized as taxable income because it represents a partial cashing out. It's as if the taxpayer contributed part of the property to the corporation in exchange for stock, and sold part of the property for cash. Only the part exchanged for stock represents a continuation of investment; the part sold for cash is properly recognized as yielding income, just as if the taxpayer had sold the property to a third party.

Peracchi did not receive boot in return for the property he contributed. But that doesn't end the inquiry: We must consider whether Peracchi has cashed out in some other way which would warrant treating part of the transaction as taxable boot.

Assumption of Liabilities: Section 357(a)

The property Peracchi contributed to NAC was encumbered by liabilities. Contribution of leveraged property makes things trickier from a tax perspective. When a shareholder contributes property encumbered by debt, the corporation usually assumes the debt. And the Code normally treats discharging a liability the same as receiving money: The taxpayer improves his economic position by the same amount either way. See I.R.C. § 61(a)(12). NAC's assumption of the liabilities attached to Peracchi's property therefore could theoretically be viewed as the receipt of money, which would be taxable boot. See United States v. Hendler, 303 U.S. 564, 58 S.Ct. 655, 82 L.Ed. 1018 (1938).

The Code takes a different tack. Requiring shareholders like Peracchi to recognize gain any time a corporation assumes a liability in connection with a capital contribution would greatly diminish the nonrecognition benefit section 351 is meant to confer. Section 357(a) thus takes a lenient view of the assumption of liability: A shareholder engaging in a section 351 transaction does not have to treat the assumption of liability as boot, even if the corporation assumes his obligation to pay. See I.R.C. § 357(a).

This nonrecognition does not mean that the potential gain disappears. Once again, the basis provisions kick in to reflect the transfer of gain from the shareholder to the corporation: The shareholder's substitute basis in the stock received is decreased by the amount of the liability assumed by the corporation. See I.R.C. § 358(d), (a). The adjustment preserves the gain for recognition when the shareholder sells his stock in the company, since his taxable gain will be the difference between the (new lower) basis and the sale price of the stock.

Sasquatch and The Negative Basis Problem: Section 357(c)

Highly leveraged property presents a peculiar problem in the section 351 context. Suppose a shareholder organizes a corporation and contributes as its only asset a building with a basis of $50, a fair market value of $100, and mortgage debt of $90. Section 351 says that the shareholder does not recognize any gain on the transaction. Under section 358, the shareholder takes a substitute basis of $50 in the stock, then adjusts it downward under section 357 by $90 to reflect the assumption of liability. This leaves him with a basis of minus $40. A negative basis properly preserves the gain built into the property: If the shareholder turns around and sells the stock the next day for $10 (the difference between the fair market value and the debt), he would face $50 in gain, the same amount as if he sold the property without first encasing it in a corporate shell. ⁸

But skeptics say that negative basis, like Bigfoot, doesn't exist. Compare Easson v. Commissioner, 33 T.C. 963, 970, 1960 WL 1347 (1960) (there's no such...