Lessinger, Peracchi, and the Emperor’s New Clothes: Covering a Section 357(c) Deficit with Invisible (or Nonexistent) Property

In general, no gain or loss is recognized by a shareholder who contributes property to a controlled corporation solely in exchange for stock of that corporation. If the contributed property is encumbered by liabilities, tax-free treatment is again generally permitted. When, however, the shareholder is relieved of liabilities in excess of such shareholder’s basis in the contributed property, section 357(c) requires the shareholder to recognize any realized gain up to the amount of such excess (“section 357(c) gain”). For years, it had appeared settled that there were only two ways to prevent the result mandated by section 357(c). The shareholder could contribute to the corporation either additional cash or property having sufficient tax basis in order to avoid the recognition of section 357(c) gain. Alternatively, the shareholder could reduce the amount of liabilities transferred to the corporation so that the section 357(c) deficit (the difference between the amount of liabilities and the adjusted basis of the assets transferred to the corporation) was eliminated.Prior to the Second Circuit’s decision in Lessinger v. Commissioner and the Ninth Circuit’s decision in Peracchi v. Commissioner, however, it appeared to be settled law that a contribution by a shareholder of his or her own promissory note was not considered a contribution of property with a tax basis that would prevent such shareholder from recognizing section 357(c) gain. The opinions issued by the circuit courts in Lessinger and Peracchi appear to have changed this result. Whether one agrees with the result that these two courts achieved, one cannot justify the analyses taken by these courts in reaching those results.Although Lessinger was decided in 1989 and Peracchi was decided in 1998, the law in this area remains extremely unclear. While these cases come to the same conclusion – that the contribution by a shareholder of its own note to a controlled corporation can provide that shareholder with sufficient basis to prevent the application of section 357(c) – the courts’ reasonings are so different that, depending on the facts of a particular case, a taxpayer in the Second Circuit could wind up with a different result than one whose case is tried in the Ninth Circuit. Moreover, an analysis of these cases provides little guidance as to the appropriate outcome outside of the jurisdiction of these circuit courts. Finally, this Article argues that these cases were incorrectly decided and that legislative intervention is currently needed to resolve a problem created by the Second and Ninth Circuits.Part II of this Article examines the statutory framework dealing with the contribution of property to a corporation, including section 357(c). Part III explores prior decisions dealing with the issue of whether a shareholder could retain personal liability with respect to obligations that were secured by assets transferred to a corporation to prevent the application of section 357(c). Part III also discusses legislative amendments made to section 357, which provide additional clarification for determining when liabilities are to be considered assumed by a corporation as part of a section 351 transaction. Part IV considers the use of a shareholder’s own promissory note to avoid section 357(c) gain, and analyzes the Tax Court’s decision in Alderman v. Commissioner, as well as the Service’s holding in Revenue Ruling 68-629. Both of these authorities hold that a shareholder’s promissory note does not provide the shareholder with any basis and, as a result, neither increases the shareholder’s basis in the property transferred nor eliminates any section 357(c) deficit. Part IV also examines the decisions of the Tax Court and the Second Circuit in Lessinger, as well as the decisions of the Tax Court and the Ninth Circuit in Peracchi, concluding that the circuit courts were wrong in both their analyses and in the conclusions that allowed the taxpayers in those cases to avoid the application of section 357(c). Finally, Part V provides specific guidance for correcting the mistakes that have been created by the Second Circuit in Lessinger and the Ninth Circuit in Peracchi. Both courts, by allowing the taxpayers to utilize to their own advantage the basis generated by self-created property, have turned these taxpayers into weavers of mythical cloth. But, unlike the emperor whose subjects were able to see him exposed in the flesh, these taxpayers have created a fabric through which the Second and Ninth Circuits could not see. The Lessinger and Peracchi cases are modern-day, real-life versions of The Emperor’s New Clothes – an example of how the refusal to speak up for fear of seeming foolish can lead to an even more foolish result.