Donald J. Peracchi Judith E. Peracchi v. Commissioner of Internal Revenue
143 F.3d 487 (1998)
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Rule of Law:
A taxpayer has a basis in their own recourse promissory note equal to its face value when contributed to their wholly-owned corporation because the note represents a genuine economic outlay and risk of loss, thereby increasing the taxpayer's total basis in the contributed property for purposes of I.R.C. § 357(c).
Facts:
- Donald Peracchi was the sole shareholder of a closely-held corporation, NAC.
- NAC, an insurance company, needed to increase its capital to comply with Nevada's minimum premium-to-asset ratio.
- To meet this requirement, Peracchi contributed two parcels of real estate to NAC.
- The liabilities encumbering the two properties totaled $1,548,213, which exceeded Peracchi's combined basis in them ($981,406) by $566,807.
- To avoid recognizing immediate taxable gain on this excess liability under § 357(c), Peracchi also contributed his personal unsecured promissory note to NAC.
- The note promised to pay NAC $1,060,000 over ten years at an 11% interest rate.
Procedural Posture:
- The Internal Revenue Service (IRS) determined a deficiency in Donald Peracchi's federal income tax.
- Peracchi petitioned the U.S. Tax Court for a redetermination of the deficiency.
- The Tax Court, as the court of first instance, ruled in favor of the Commissioner (the IRS), holding that the promissory note was not genuine indebtedness and therefore had a zero basis.
- Peracchi, as the appellant, appealed the Tax Court's decision to the United States Court of Appeals for the Ninth Circuit.
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Issue:
Does a creditworthy shareholder's personal, unsecured promissory note contributed to their wholly-owned corporation have a basis equal to its face value for the purposes of calculating gain under I.R.C. § 357(c)?
Opinions:
Majority - Judge Kozinski
Yes, a shareholder's personal promissory note has a basis equal to its face value for purposes of § 357(c). The court reasoned that basis is derived from cost, and Peracchi's cost was the genuine economic risk he undertook. By contributing the note, Peracchi exposed his personal assets to corporate creditors in the event of NAC's bankruptcy, an exposure that did not previously exist. This increased economic investment and risk of loss is a substantial enough contingency to confer economic effect and justify basis. The court also noted that treating the note as having zero basis would lead to an absurd result if the corporation sold the note, as it would recognize phantom gain on the full face value. The transaction was economically equivalent to Peracchi borrowing from a bank and contributing cash, which would undisputedly provide basis.
Dissenting - Judge Fernandez
No, a shareholder's personal promissory note should not be given basis. The dissent argued that the taxpayer incurred no cost, as defined by I.R.C. § 1012, in simply writing a promise to pay his own corporation. This allows the taxpayer to create basis out of nothing, a 'magical' solution to avoid taxes that lacks economic substance. The dissent viewed the maneuver as 'a bit of sortilege' that allows a taxpayer to improperly extract value from property while deferring taxation without any real economic outlay.
Analysis:
This decision created a significant and controversial tool for tax planning in corporate formations, establishing that a shareholder's own note can be used to avoid § 357(c) gain. It adopts an 'economic exposure' theory of basis, moving away from a strict 'out-of-pocket cost' interpretation. By focusing on the real-world risk to the shareholder from corporate creditors, the Ninth Circuit provided a rationale that other courts, like the Second Circuit in Lessinger, had struggled to articulate, even while reaching the same result. The case remains a key authority for taxpayers seeking to contribute highly leveraged property to a corporation without triggering immediate gain recognition.
