Memorandum Case

Memorandum

To:

From: Student

Date: 3/4/20XX

Re:

Facts: Joel is an owner of a sole proprietorship that has decided to incorporate his business to limit his liabilities. The liabilities that he will be transferring to the corporation exceed the basis in the assets transferred by $70,000. This creates a problem for Joel in that he must now recognize $70,000 in gain for the transaction.

Issue: What is one option that would possibly allow Joel to defer the gain that is created through this transaction, which does not require Joel to pay cash into the business as an additional investment?

Conclusion: One possible way that Joel could avoid this gain is to sign a legitimate promissory note for $70,000 to the corporation, agreeing to pay a certain some of money in the future. This would increase the basis of the assets that Joel is transferring to the corporation to the same amount as the liabilities, thereby avoiding the problem of negative basis.

Discussion: To start the analysis of this case it is important to determine where the gain comes from, and how exactly it is generated. Normally under §351, when someone transfers property to a corporation in exchange for stock, no gain or loss must be recognized on the transaction (Code §351). Although this is the case, under §357(c) there is an exception to the rule that states that if the total amount of liabilities assumed exceeds the basis of the property transferred, then the excess that is assumed becomes a taxable gain (Code §357(c)). The purpose of this exception is to make sure that the taxpayer does not create a negative basis in the property, and by making the taxpayer recognize the gain, this problem is avoided. The facts that are presented in this case fall under these rules, and therefore to be able to avoid the gain, the transferor must somehow either create additional basis or reduce the amount of liabilities assumed by the corporation. This would allow him to be able to avoid the problems associated with section 357(c).

There have been several cases where taxpayers have successfully avoided section 357(c) by creating additional basis through the contribution of a promissory note to the corporation, promising to pay the corporation some amount of money in the future. An important case demonstrating this concept is Peracchi v. Commissioner of Internal Revenue (98-1 USTC ¶50,374). In this case Peracchi contributed two parcels of real estate that were encumbered by liabilities. These liabilities made it so that the transaction was applicable to §357(c), but Peracchi also contributed a promissory note that made up the difference between the basis and the liabilities (98-1 USTC ¶50,374). The main question became what exactly the basis of the note

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