T.C. Memo. 1996-191

UNITED STATES TAX COURT

DONALD J. AND JUDITH E. PERACCHI, Petitioners v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22511-93. Filed April 22, 1996.

Ps contributed three parcels of real property and

their unsecured promissory note to their wholly owned

corporation. The parcels were encumbered by deeds of

trust securing debt obligations in amounts that were in

excess of the combined adjusted basis of the parcels in

the hands of Ps. The face amount of Ps' promissory

note was greater than the excess of the encumbering

liabilities over Ps adjusted basis in the properties. 

Held: Ps failed to carry their burden of proving that

their unsecured promissory note constituted genuine

indebtedness. Under sec. 357(c)(1), I.R.C., Ps are

required to recognize gain measured by the excess of

the debt obligations secured by deeds of trust over Ps'

adjusted basis in the real property.
Craig A. Houghton, for petitioners.

Mary P. Kimmel, for respondent.

MEMORANDUM OPINION

NIMS, Judge: Respondent determined a $172,967 deficiency in

petitioners' 1989 Federal income tax. The deficiency results

from respondent's determination that petitioners realized a

$566,806 gain on the transfer of certain properties to their

wholly owned corporation, and the resulting arithmetically

required reduction in the deductible amount of a conceded

casualty loss.

Since the parties agree that the deductible amount of

petitioners' casualty loss will follow from the resolution of the

property transfer issue, the sole issue for decision is whether

petitioners must recognize gain on the transfer under section

357(c). Petitioners agree that they are entitled to no deduction

for their casualty loss if respondent's determination is

sustained on the section 357(c) issue. Unless otherwise noted,

all section references are to sections of the Internal Revenue

Code in effect for 1989, and all Rule references are to the Tax

Court Rules of Practice and Procedure.

The parties submitted this case fully stipulated, and the

facts as stipulated are so found. 

Petitioners were residents of Fresno, California, at the

time they filed their petition. During the year at issue,

petitioners owned 100 percent of NAC Corporation, a Nevada
- 3 -

Corporation, which had two wholly owned subsidiaries, National

American Life Insurance Company of Pennsylvania, a Pennsylvania

Corporation (NALICO), and Western States Administrators, a

California Corporation (WSA).

During 1989, both NALICO and WSA required infusions of

additional capital. Because of significant 1989 losses in its

accident and health insurance business, NALICO required

additional capital in order to satisfy general industry

guidelines and State law requirements relating to the maintenance

of a premium-to-capital ratio of not more than 10 to 1. WSA

required additional capital in order to maintain, on a

consolidated basis, a minimum net worth of $7 million pursuant to

a bank loan agreement. As of September 30, 1989, NAC

Corporation, WSA, and NALICO had a consolidated net worth of

$5,841,436.

Petitioners undertook to satisfy these capital requirements

by transferring three parcels of improved real property, and

their $1,060,000 unsecured promissory note (the Capital Note), to

NAC Corporation, the parent corporation of the two capitaldeficient, wholly owned subsidiaries. As of December 31, 1989,

petitioners had a net worth far in excess of the consolidated net

worth of NAC Corporation, WSA, and NALICO.

The first of the three parcels, the Clinton Way Property,

had a fair market value of $1,870,000 on December 26, 1989, the
- 4 -

date of transfer, and an adjusted basis of $349,774.06 in the

hands of petitioners on that date. As of that date, the Clinton

Way Property was encumbered by a deed of trust in favor of

Standard Insurance Company securing a note (the Standard

Insurance Note) having an unpaid principal balance of

$1,386,654.50. NAC Corporation did not assume liability under

the Standard Insurance Note, on which petitioners remained

personally liable. 

The second and third of the three parcels of real property

which petitioners transferred to NAC Corporation, collectively

referred to herein as the Fresno/Herndon Property, had a fair

market value of $1,200,000 on December 26, 1989, the date of

transfer, and an adjusted basis of $631,632.42 in the hands of

petitioners on that date. As of that date, the Fresno/Herndon

Property was encumbered by a deed of trust securing a note (the

Bunn & Duran Note) in favor of certain individuals having an

unpaid principal balance of $161,558.28. NAC Corporation did not

assume liability under the Bunn & Duran Note, on which

petitioners remained personally liable. The parties agree,

however, that the Fresno/Herndon Property, when transferred to

NAC Corporation, remained "subject to" the Bunn & Duran Note.

The following table reflects the computation of the excess

of the above-described liabilities over petitioners' combined
- 5 -

adjusted basis in the three parcels of real property transferred

by petitioners to NAC Corporation on December 26, 1989:

Property Liability Adjusted Basis

Clinton Way $1,386,654.50 $349,774.06 

Fresno/Herndon 161,558.28 631,632.42 

 Total 1,548,212.78 981,406.48

The combined excess of liabilities over petitioners' adjusted

basis was thus $566,806.30.

On December 26, 1989, petitioners also transferred their

Capital Note in the face amount of $1,060,000 to NAC Corporation. 

The Capital Note was unsecured. It purported to be petitioners'

unconditional promise to pay NAC Corporation interest at the rate

of 11 percent per annum in monthly installments commencing

February 1, 1990, and continuing in each consecutive month to and

including January 1, 1995. Beginning February 1, 1995, monthly

installments of $23,046.97 were payable until all principal and

any accrued but unpaid interest were paid in full, with any

remaining balance due January 1, 2000. 

The Capital Note provided for acceleration in the event of

default at the option of the holder. The payment terms of the

Capital Note did not parallel those of the Standard Insurance

Note, which provided for equal monthly payments of principal and

interest at 11 percent per annum (with provision for a certain

rate adjustment after five years) until the earlier of January 1,

1998, or the date on which the note has been paid in full. 
- 6 -

On December 21, 1989, in advance of the above actions, the

NAC Corporation board of directors (consisting of petitioner

Donald J. Peracchi as the sole director) "acknowledged and

accepted" as capital contributions the above-mentioned parcels of

real property, and the Capital Note "to offset the difference

between the allocated liability and the basis in the buildings

located at 5118 E. Clinton Way [the Clinton Way Property]." 

The following table reflects the computation of the net

amount of petitioners' contribution to capital if the Capital

Note is taken into account at face value: 

Item Contributed Fair Market Value

 to Capital or Face Value Encumbrance Net Amount

Clinton Way Property $1,870,000 $1,386,654.50 $483,345.50

Fresno/Herndon Property 1,200,000 161,558.28 1,038,441.80

Capital Note 1,060,000 1,060,000.00

 Total 4,130,000 1,548,212.78 2,581,787.30

Petitioners made no payments on the Capital Note during

1989, or at any time thereafter until March 15, 1992, when they

made an interest payment of $233,200. The IRS audit of

petitioners' 1989 income tax return had been under way for almost

a year, having commenced during April, 1991. 

In February, 1990, management of NALICO was advised by Ernst

& Young, NALICO's independent certified public accountants, that

under Chapter 9 of the National Association of Insurance

Commissioner's Accounting Practices and Procedures Manual for

Life and Accident and Health Insurance Companies (NAIC Manual),
- 7 -

the Capital Note would be classified as a "nonadmitted asset

because it was unsecured;" thus, it would not be treated as an

asset of NALICO for purposes of computing its capital-to-premium

ratio as of December 31, 1989. 

The parties agree that the transactions under scrutiny

qualify under the nonrecognition provision of section 351, except

as that section may be limited by section 357(a) and (c)(1). 

They also agree that section 357(b) is not applicable, but

disagree as to the application of sections 357(a) and 357(c)(1).

SEC. 357(a) provides: 

(a) General Rule.--Except as provided in

subsections (b) and (c), if--

(1) the taxpayer receives property

which would be permitted to be received under

section 351, 361, 371, or 374, without the

recognition of gain if it were the sole

consideration, and 

(2) as part of the consideration,

another party to the exchange assumes a

liability of the taxpayer, or acquires from

the taxpayer property subject to a liability, 

then such assumption or acquisition shall not be

treated as money or other property, and shall not

prevent the exchange from being within the provisions

of section 351, 361, 371, or 374, as the case may be.

Section 357(c)(1) provides:

(1) In General.--In the case of an exchange--

(A) to which section 351

applies, or
- 8 -

(B) to which section 361

applies by reason of a plan of

reorganization within the meaning

of section 368(a)(1)(D),

if the sum of the amount of the liabilities assumed,

plus the amount of the liabilities to which the

property is subject, exceeds the total of the adjusted

basis of the property transferred pursuant to such

exchange, then such excess shall be considered as a

gain from the sale or exchange of a capital asset or of

property which is not a capital asset, as the case may

be. 

Thus, for present purposes, section 357(a) provides the

general rule that, in a section 351 nonrecognition exchange, the

effect of section 351 is not nullified even though as part of the

consideration the transferee assumes a liability of the

transferor, or acquires property in the exchange which is subject

to a liability. Then, section 357(c)(1) provides an exception to

the general rule; namely, that if the sum of the liabilities

assumed plus the amount of the liabilities to which the

transferred property is subject exceeds the adjusted basis of the

property, then the excess is treated as a gain from the sale or

exchange of property.

Respondent argues that, by virtue of section 357(c)(1),

petitioners must recognize gain resulting from the transfer to

their wholly owned corporation of property subject to liabilities

in excess of petitioners' basis in the property.
- 9 -

Petitioners take the position that they did not realize (nor

were they required to recognize) a gain when they transferred

property, including their $1,060,000 Capital Note, to their

wholly owned corporation, and that, for purposes of section

357(c), the adjusted basis of their Capital Note was its face

amount and not zero. Petitioners reach these conclusions by a

complicated route. They make the following arguments:

1. Since NAC Corporation acquired the 5118 Clinton Way

buildings and improvements subject only to $326,654.50 of the

unpaid principal balance of the Standard Insurance Note, an

amount not in excess of the adjusted basis of the 5118 Clinton

Way buildings and improvements, no gain should be recognized by

petitioners under section 357(c).

In so doing, petitioners attempt to apply the rationale of

the wraparound mortgage-installment sale line of cases, of which

the progenitor is Stonecrest Corp. v. Commissioner, 24 T.C. 659

(1955); petitioners argue that NAC Corporation acquired the

Clinton Way Property "subject to only $326,654.50 of the unpaid

principal balance of the Standard Insurance Note (the

$1,386,654.50 unpaid principal balance of the Standard Insurance

Note, minus the $1,060,000 face amount of the Capital Note)," and

that the sum of the Clinton Way and Fresno/Herndon liabilities,

$488,212.78 ($326,654.50 plus $161,558.28), was thus less than

the sum of the adjusted bases of the three properties,
- 10 -

$981,406.48. Thus, petitioners say, no gain is to be recognized

under section 357(c)(1).

2. Since petitioners undertook genuine personal liability

for the excess of the unpaid principal balance of the Standard

Insurance Note over the adjusted basis in the 5118 Clinton Way

buildings and improvements, no gain should be recognized by

petitioners under section 357(c) of the Internal Revenue Code.

3. Under section 1012 of the Code, petitioners' basis in

the Capital Note was $1,060,000, its face amount.

4. Alternatively, under section 1012 of the Internal

Revenue Code, NAC Corporation's basis in the Capital Note was

$1,060,000, its face amount.

All of petitioners' arguments presuppose that the Capital

Note represents genuine indebtedness. Since we do not agree that

it does, we need not address the various convoluted approaches

petitioners ask us to take to arrive at the conclusion that they

are not required to recognize gain under section 357(c). Nor

need we address such nettlesome questions as whether a taxpayer's

unsecured promissory note can ever constitute "property" for

purposes of section 357(c)(1) and related Code sections, and

whether such an instrument has a basis for purposes of section

1012, and, if so, the amount thereof. See Lessinger v.

Commissioner, 872 F.2d 519 (2d Cir. 1989), revg. 85 T.C. 824

(1985), Alderman v. Commissioner, 55 T.C. 662 (1971). 
- 11 -

Petitioners' own course of conduct belies their efforts to

lead us to believe that on December 26, 1989, they placed a debt

instrument in the hands of their 100-percent owned corporation

that they actually intended to honor under all circumstances. 

Notwithstanding the fact that this case was submitted fully

stipulated, petitioners nevertheless bear the burden of proving

that they intended to and did create genuine indebtedness. Rule

142(a); see Rule 122(b); Service Bolt & Nut Co. Trust v.

Commissioner, 78 T.C. 812, 819 (1982), affd. 724 F.2d 519 (6th

Cir. 1983). This they have failed to do. 

The parties stipulated that as of December 31, 1989,

petitioners had a net worth far in excess of the $5,841,436

consolidated net worth of NAC Corporation, WSA, and NALICO. It

may therefore be presumed that, had they chosen to do so,

petitioners could have funded the disputed excess of liabilities

over basis by means other than an unsecured promissory note,

which, as events transpired, cost them nothing in terms of cash

layouts for over two years after their December 26, 1989,

contribution of the Capital Note to NAC Corporation.

As previously stated, the Capital Note contained

petitioners' unconditional promise to pay NAC Corporation

interest at the rate of 11 percent per annum in monthly

installments (presumably $9,716.67 monthly) commencing February

1, 1990, and continuing until January 1, 1995. Despite the
- 12 -

"unconditional" nature of petitioners' obligation, however, they

chose to make no payments whatsoever until March 15, 1992, when

they made a lump sum interest payment of $232,200. At the time

of the payment, the IRS audit of petitioner's 1989 return had

been underway for almost a year. (The parties stipulated that

petitioners' obligation had been made current by December 4,

1994, the day before the case was submitted. We note, however,

that since the Capital Note provides that no principal payments

would be required until February 1, 1995, none were required to

make the obligation current as of December 4, 1994.) 

Notwithstanding the provision of the Capital Note providing

for acceleration in the event of default at the option of the

holder, there is no evidence suggesting that NAC Corporation

chose to exercise this option. Since petitioners did not intend

to make timely payments on the Capital Note, it is not surprising

that they did not see fit to cause NAC Corporation to exercise

its option. Petitioners, 100 percent stockholders, were totally

in control of NAC Corporation. Donald Peracchi was the sole

director. In cases involving closely held corporations, such as

this case, where the parties do not deal at arm's length, it is

highly unrealistic to expect them to enforce obligations against

themselves, as petitioners' casual approach to their payment

obligations bears out. See Alterman Foods, Inc. v. United

States, 505 F.2d 873, 877 (5th Cir. 1974).
- 13 -

We have held on more than one occasion that in the closely

held corporation context, loan repayments that commenced only

after a taxpayer had notice of an IRS audit go far to weaken the

payments as persuasive evidence of a preexisting intention of

paying on schedule, or at all. See, for example, Tollefsen v.

Commissioner, 52 T.C. 671, 680 (1969), affd. 431 F.2d 511 (2d

Cir. 1970); Piekos v. Commissioner T.C. Memo. 1982-602; Granzotto

v. Commissioner, T.C. Memo. 1971-106; see also Williams v.

Commissioner, 627 F.2d 1032, 1034 (10th Cir. 1980) (repayment of

taxpayer notes in stockholder control situation not made until

after taxpayers were aware that their returns were to be audited,

thus constituting a mere formalism of no great significance),

affg. T.C. Memo. 1978-306. 

Petitioners apparently wished to keep their commitments to

their financially troubled consolidated group of corporations as

ephemeral as possible. Although Ernst & Young advised

petitioners in February, 1990, that the Capital Note would be

treated as a nonadmitted asset for purposes of computing NALICO's

capital-to-premium ratio under State insurance company

regulations, the record reflects no effort by petitioners to

rectify the situation, although their very substantial net worth

exclusive of their NAC Corporation holdings would make it seem

probable that they could have done so. From this, and from

petitioners' and NAC Corporation's general indifference to
- 14 -

compliance with the terms of the Capital Note, it is reasonable

to conclude that the Capital Note's only significance was to

serve as a makeweight against the potential of recognition of

gain under section 357(c).

We accordingly find that petitioners did not intend to pay

the Capital Note according to its terms, and that therefore no

genuine indebtedness was created.

It is noteworthy in this connection that the December 21,

1989, NAC Corporation board of directors' minutes makes no

reference to any corporate acceptance of the Capital Note as

assistance in the rectification of the twin problems of net worth

and capital-to-premium ratio deficiencies. Rather, insofar as

any corporate purpose is reflected by the minutes, the sole

function of the Capital Note was to offset the difference between

the "allocated liability and the basis" of the Clinton Way

Property; i.e., to aid NAC Corporation's sole shareholder--

petitioners--in the avoidance of the recognition of gain under

section 357(c)(1).

Petitioners suggest on brief (although they do not press the

point very vigorously) that even if their liability under the

Capital Note is not taken into consideration, their continuing

liability under both the Standard Insurance and Bunn & Duran

obligations avoids the requirement that they recognize gain under

section 357(c)(1). This position, however, is inconsistent with
- 15 -

the decision of the U.S. Court of Appeals for the Ninth Circuit

(the court to which this case would normally be appealed) in Owen

v. Commissioner, 881 F.2d 832 (9th Cir. 1989), affg. T.C. Memo.

1987-375.

In Owen, taxpayer was an equal partner with McEachron in

McO, a general partnership engaged in the seismic drilling

business. In 1980, the partners borrowed money to buy drilling

equipment, secured the loan by the equipment, gave their personal

guaranties to the lender, and placed title to the equipment in

McO. In 1981 the partnership transferred the equipment to the

partners' wholly owned corporation, at which time the

indebtedness secured by the assets exceeded the assets' adjusted

basis. The Ninth Circuit affirmed our holding that section

357(c)(1) applied. The court held that "'So long as the

transferred property remains liable on the debt, then, such debt

can be a section 357(c) liability even if the * * * [taxpayer]

retained personal, unrelieved liability on it.'" 881 F.2d at

835, quoting Smith v. Commissioner, 84 T.C. 889, 909 (1985), and

citing additional decisions to the same effect.

In the case before us, the Standard Insurance Note was

secured by the deed of trust encumbering the Clinton Way

Property, and in the event of a default by NAC Corporation,

Standard Insurance would unquestionably have looked in the first

instance to the Clinton Way Property, the security under the
- 16 -

Standard Insurance Note, for satisfaction of the debt. The same

is true for the Bunn & Duran obligation. The fact that

petitioners remained liable on the Standard Insurance and Bunn &

Duran debts does not alter their section 357(c) liability under

the rationale of Owen. For the above reasons, we hold that

petitioners are required to recognize gain under section

357(c)(1), measured by the excess of the debt obligations secured

by the three parcels of real property at the time of the transfer

to NAC Corporation over petitioners' total adjusted basis in the

property. 

To reflect this holding,

Decision will be entered

for respondent.