Determining when a debt instrument has zero basis

Editor: Christine M. Turgeon, CPA

The Tax Court issued opinions in December 2025 and March 2026 concluding that self–issued or related–party debt had a basis equal to zero. These recent cases are the latest examples of the government’s long–standing position that when taxpayers incur no costs associated with issuing an equity or debt instrument, that instrument has a basis of zero.

Previous cases on this issue concerned shareholders issuing debt instruments to their corporations as part of a Sec. 351 nontaxable exchange and attempted to mitigate the applicability of Sec. 357(c) gain. These new cases, however, apply the Tax Court’s analysis of this dynamic to contexts outside this realm. Taxpayers need to consider all transactions — not just Sec. 351 exchanges — where newly issued debt is involved to determine whether real economic exposure is created and whether the debt will be respected as genuine.

After providing some relevant background, this item discusses earlier case law on this issue and then explores the two recent Tax Court decisions mentioned above.

Determining basis

Asset basis is defined in Sec. 1012(a) as “the cost of such property, except as otherwise provided.” When debt is issued in exchange for property, Regs. Sec. 1.1012–1(g) provides, the “cost of the property that is attributable to the debt instrument is the issue price of the debt instrument as determined under §1.1273–2 or §1.1274–2, whichever is applicable.”

Regs. Sec. 1.1273–2 generally applies to debt issued for money or publicly traded property and publicly traded debt instruments issued for property, while Regs. Sec. 1.1274–2 generally applies to most other debt instruments issued for property (see Sec. 1274(c)). There is little question regarding the basis of both assets and liabilities when taxpayers engage in taxable transactions with third parties; however, the analysis becomes more complicated when executing tax–deferred transactions with related parties.

Debt instrument basis in Sec. 351 exchanges

The basis complexities can be significant in a Sec. 351 exchange where the shareholder executes a promissory note to prevent the application of Sec. 357(c), which generally requires recognizing gain to the extent the liabilities assumed by a transferee corporation exceed the basis of the assets contributed in the transaction.

Alderman, 55 T.C. 662 (1971), involved a transaction in which spouse taxpayers transferred the assets and liabilities of their sole proprietorship to a newly formed corporation. At the time of the incorporation, the liabilities assumed exceeded the taxpayers’ basis in the assets, and the taxpayers executed a personal promissory note payable to the corporation equal to the excess. The Tax Court held that the personal promissory note payable had a basis of zero because the taxpayers had incurred no cost in issuing it and the corporation had carryover (i.e., zero) basis as a result of Sec. 362.

In so holding, the Tax Court agreed with the government’s position, which was similar to the position it took in Rev. Rul. 68–629. In the revenue ruling, an individual taxpayer incorporated his sole proprietorship by transferring all the assets and liabilities to a newly formed corporation in exchange for all the outstanding stock of the corporation. Because the liabilities assumed by the corporation exceeded the basis of the assets contributed, the taxpayer agreed to contribute additional assets equal to the excess in the form of a personal promissory note. Rev. Rul. 68–629 held that this personal promissory note had zero basis because the taxpayer incurred no cost in making it and accordingly recognized gain under Sec. 357(c).

The Tax Court reached a similar result in two later cases that were, however, overturned on appeal. The first case was Lessinger, 872 F.2d 519 (2d Cir. 1989), rev’g 85 T.C. 824 (1985), in which an individual taxpayer transferred assets and liabilities of a sole proprietorship with negative net basis to a corporation he owned, for reasons unrelated to tax planning. Although no promissory note was executed at the time of the transfer, the corporation recorded an asset account titled “Loan Receivable — SL.” The Tax Court held that this receivable should be treated as a sham because it was not represented by a promissory note and no interest was paid. The court further held that even if the promissory note were genuine, it would have had a zero basis in the hands of the corporation because the taxpayer incurred no cost in issuing it.

The Second Circuit determined on appeal that the debt was genuine because the corporation’s creditor relied on the taxpayer’s personal credit, as evidenced by the bank’s requiring the taxpayer to sign a promissory note in 1981. More significantly, the Second Circuit found that the Tax Court had failed to consider the value of the transferor’s (the taxpayer’s) obligation to the transferee (the corporation). The transferee incurred a real economic cost by taking on the proprietorship’s excess liabilities by way of the loan receivable.

The second case was Peracchi, 143 F.3d 487 (9th Cir. 1998), rev’g T.C. Memo. 1996–191, where an individual taxpayer contributed to his closely held corporation two parcels of land that were encumbered with debt that exceeded his basis in the land, to comply with state regulatory requirements related to the minimum premium–to–asset ratio for insurance companies. To avoid the application of Sec. 357(c) as a result of the corporation’s assuming liabilities in excess of the assets’ tax basis, the taxpayer executed a long–term promissory note to the corporation. The Tax Court held that the promissory note was a sham because the taxpayer held an unenforceable promise to pay himself, and even if it were genuine, it had a basis equal to zero because he incurred no cost in issuing the instrument.

On appeal, the Ninth Circuit found that the obligation was genuine because it represented a new and substantial increase in the taxpayer’s investment by which he would be personally liable if the corporation became distressed. Additionally, the Ninth Circuit found that this transaction did “not differ substantively from others that would certainly give [the taxpayer] a boost in basis” (i.e., by borrowing money from a bank and contributing the cash, followed by the corporation’s purchasing the note from the bank).

In both Lessinger and Peracchi, the appeals courts determined the basis of the taxpayers’ debt instruments by reference to either the cost the corporation incurred in assuming excess liabilities or to the taxpayers’ exposure to liability in a potential bankruptcy. Taxpayers in the Second and Ninth Circuits, therefore, have some support for the position that newly issued promissory notes in similar related–party transactions do not have zero basis.

But as discussed next, newer opinions by the Tax Court raise questions about the Lessinger and Peracchi analysis that taxpayers have been familiar with.

Latest Tax Court cases raise new questions

In Alioto, T.C. Memo. 2025–125, an individual entered into two agreements with his wholly owned corporation within a seven–month period. The first was an employment agreement under which the taxpayer was to be paid a lump sum four years later, while the second was a promissory note the taxpayer issued to purchase the corporation’s treasury stock. The taxpayer made no payments with respect to the promissory note, as he asserted the promissory note was offset by the employment agreement.

Citing Alderman, the Tax Court held that the promissory note had a basis equal to zero because the taxpayer incurred no cost in issuing it. Moreover, the court then determined the promissory note was a sham. The parties did not have “an actual, good–faith intent to establish a debtor–creditor relationship” because there was no intent by either party to repay the obligation. It is unclear whether debt that is treated as a sham would necessarily be viewed as having zero basis. The court did not attribute a value to the taxpayer’s potential exposure to the corporation’s liability as the Ninth Circuit did in Peracchi, because the taxpayer in Alioto had an opportunity to unilaterally extinguish the debt by offset, thereby eliminating any potential exposure.

The Tax Court also recently distinguished the facts in Continental Grand Limited Partnership, 166 T.C. No. 3 (2026), from those in Lessinger and Peracchi. In Continental Grand Limited Partnership, a German holding company wholly owned multiple German subsidiaries. On March 26, 2001, the German holding company issued a promissory note to one of its German subsidiaries that subsequently was contributed by the German subsidiary to a newly formed U.S. limited partnership in exchange for a partnership interest. On April 12, 2002, the German subsidiary elected to be disregarded as an entity separate from the German holding company effective to a time before the promissory note was issued and contributed to the partnership. This retroactive election resulted in the initial issuance of the promissory note by the German holding company being disregarded, and, instead, the German holding company was treated as having issued its own note to the partnership upon formation.

The court declined to extend Lessinger’s interpretation of Sec. 357(c) to the partnership basis rules under Sec. 722, noting that the partnership assumed no liabilities from the holding company, which recognized no gain. And the Ninth Circuit in Peracchi had specifically stated that its holding with respect to the corporation in that case did not extend to partnerships.

A new focus?

Tax practitioners and taxpayers should pay close attention to any further developments in Alioto and Continental Grand Limited Partnership, as any future appellate review could further shape the tax consequences associated with shareholder–issued debt instruments. In the meantime, taxpayers considering issuing related–party loans should evaluate the potential implications if the debt instrument is found to have a basis equal to zero.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.