Joel’s Alternative Plan, Case Study Example

The owner of the company, Joel, has operated his business as a sole proprietorship for many years; however, he has decided to incorporate the business in order to limit his exposure to personal liability.  His plan resulted in a problem with the liabilities of his proprietorship.  The liabilities exceeded the basis of the assets to be transferred to the corporation by $70,000 ($200,000 liabilities-$130,000 basis), requiring Joel to recognize a gain of $70,000. He is not pleased with this result and as an alternative he would like to draw up a $70,000 note that he would transfer a future payment to the corporation of $70,000.  This paper evaluates and researches additional cases in order to determine if Joel’s alternative solution can avoid gain recognition for tax purposes following the applicable IRC section 357 (c).


Internal Revenue Code §357(c) states, if the sum of the amount of the liabilities assumed 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.

Internal Revenue Code §357(c)(3)(A) states, FTCWG&L Treatises In general. If a taxpayer transfers, in an exchange to which section 351 applies, a liability the payment of which either (i) FTCWG&L Treatises would give rise to a deduction, or (ii) FTC would be described in section 736 (a), then for purposes of paragraph (1), the amount of such liability shall be excluded in determining the amount of liabilities assumed.

Internal Revenue Code §357(c)(3)(B) states, Subparagraph (A) shall not apply to any liability to the extent that the incurrence of the liability resulted in the creation of, or an increase in, the basis of any property.

Internal Revenue Code §357(a) states, section 357(a) provides a 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.

One example in rulings in regard to Code 357 is William H. Christopher, Jr. TC Memo 1984-394.  In this case, the majority shareholder of the corporation had to recognize gain on incorporation of sole proprietorship.  The petitioner received a loan of $46,000 from a Bank in Tulsa. By the end of 1975, the proprietorship had an outstanding liability to the Bank of $127,000, which included the $46,000 note.  The petitioner did not transfer the $46,000 from his personal account to the corporation in 1976 and reported no interest income from the corporation on his 1976 return, nor did he claim any deduction or interest paid on the $46,000.  The petitioner claimed that he informed the agents that the new corporation had not assumed the $46,000 note from the Bank and that he was personally liable on that note.  The result was excess corporate liability at time of incorporation was ordinary income to shareholder; corporations indebtness used to calculate N.O.L. didn’t include loan from shareholder to corp.

The case of Velma W. Alderman, 55 TC 662, offers similar outcome.  The petitioner had a taxable gain a taxable gain due to her deceased husband’s liabilities that were assumed by the newly formed corporation A, which exceeded the adjusted basis of assets transferred in an exchange. The liabilities that were assumed exceeded the adjusted basis of the assets transferred to it by $9,229.59. The Alderman’s agreed to make this difference up through executing a personal promissory note payable to the corporation in the amount of $10,229.50, which created a capital stock account of $1000.  The promissory note had a basis of zero at the time of transfer and therefore was recognized as gain to the Alderman’s.  It was therefore ruled that the excess of liabilities over basis was allocable to depreciable property and the gain was taxable.

The case of Donald J. Peracchi, et ux. V. Commissioner, TC Memo 1996-191, Code Sec(s) 357, also offers a similar outcome.  In this case the taxpayers had to recognize the gain on transfer of property that was encumbered by deeds of trust and a promissory note to their owned corporation, due to the exceeded basis. It was ruled that the board of directors minutes should that the note’s purpose was to offset the difference between property’s allocated liability and basis.  Therefore, the ruling in this case held that the petitioners were required to recognize gain under section 357(c)(1).

While the above three cases offered examples in which liabilities were taxable, the case, Peracchi v. Comm., Cite as 81 AFTR 2d 98-1754 (143 F. ed 487), 4/29/1998, Code Sec (s) 357, exhibits a ruling in which the Tax Court held that the taxpayers didn’t have to recognize Code Sec. 357(c) gain on transfer of real property by the promissory note to their owned corporation.  This case is in regard to case Donald J. Peracchi, et ux. V. Commissioner, TC Memo 1996-191, Code Sec(s) 357.  The court initially ruled that the petitioners were required to recognize gain; however, the court ruled that the note did have basis of its face value, not zero as the IRS claimed previously.   In addition, the IRS didn’t consider the possibility that the corporation could go bankrupt and creditors could obtain the taxpayers assets.  Therefore, the Tax Court ruled that the note was indeed genuine indebtedness.  Furthermore, the IRS’s arguments in the case that the note was to avoid tax or was a gift were rejected.

When comparing Joel’s case to the ones above, they are very similar.  Joel is the sole proprietor of the corporation and it was in his capacity to determine if he should incorporate the business in order to decreases his personal liability.  In doing so, he created a gain of $70,000 in liabilities.  He decided to write a promissory note for future payment to the corporation to avoid showing a gain of $70,000. As in the case, Velma W. Alderman, 55 TC 662, the shareholders created a promissory note; however, it was still ruled that they were liable for the gain. Same as in the case, William H. Christopher, Jr. TC Memo 1984-394.  The petitioner was responsible for the gain.  Only in case, Peracchi v. Comm., Cite as 81 AFTR 2d 98-1754 (143 F. ed 487), 4/29/1998, Code Sec (s) 357, do we see where the Tax Court ruled in the favor of the petitioner where the note had basis.  It seemed that the only difference in this case was due to the possibility of the corporation going bankrupt.


The facts in Joel’s case are very similar to the facts of the cases presented above.  As Joel wrote a note to avoid tax on the gain after transferring, Joel will be responsible for the gain.  Only if there is a possibility of the corporation going bankrupt will there be a chance for Joel to avoid begin taxed on the gain.


Works Referenced


Donald and Judith Peracchi, TC Memo 1996-191; 71 TCM 2830 (Trial court case)

Peracchi v. Comm. 81 AFTR 2d 98-1754; 143 F 3d 487 (CA-9, 1998) (Appelate court case)

Velvia Alderman, 55 TC 662 (1971)

William Christopher, Jr., TC Memo 1984-394; 48 TCM 663.