When Does a Promissory Note Create Basis in Controlled Company Stock? – Houston Tax Attorneys

Business owners have choices in how to fund their corporations. Should they contribute cash? Property? Perhaps a promissory note?

There may be some benefit of using a promissory note. You get stock in your company without immediately parting with cash or other assets. The promissory note sits on the company’s books as a receivable, and you control when (or if) it gets paid. Ultimately, when you do this, this leads to questions about your tax basis in the stock.

This question matters when you later sell the stock. Higher basis means less taxable gain (or a deductible loss). So if you contribute a $500,000 promissory note for stock, you get a $500,000 tax basis that reduces your gain on sale of the company.

Not surprisingly, the IRS frequently challenges these transactions. The tax treatment of promissory notes exchanged for stock in controlled corporations has resulted in numerous tax disputes over the years, this is in addition to other similar contribution arrangements involving promissory notes, such as stuffing a corporation with assets before a corporate sale without issuing stock.

The recent case Alioto v. Commissioner, T.C. Memo. 2025-125 gets into this issue. The case invovles a shareholder’s promissory note and the question of what the tax basis is in the stock received from the controlled corporation.

Facts & Procedural History

Alioto incorporated, Probity, an Ohio corporation focused on transportation and logistics consulting. Alioto served as Probity’s sole director and owned all 1,000 shares of stock. By 2014, Probity was receiving program fees and commission income.

In June 2014, Alioto entered into an employment agreement with Probity (signed by his wife as Treasurer) that promised him $550,000 in compensation that was payable in a lump sum on January 31, 2018. Alioto never received this compensation.

The stock ownership then went through several transfers. These transfers are important for this case as Alito takes the position that these transfers establish his tax basis in the stock shares. Alioto transferred 501 shares to his wife for $5.01 (a penny per share) in August 2014. A week later, she transferred 376 shares back to him for the same price. The next day, she transferred the remaining 125 shares to Probity itself.

On February 3, 2015, Alioto signed a promissory note to “purchase” those 125 treasury shares from Probity for $500,000. The note required payment (with 3% annual interest) by February 5, 2018. Alioto himself valued the shares at $4,000 each. His wife signed on behalf of Probity. The note gave Alioto the right to offset the $500,000 obligation against amounts Probity owed him under the employment agreement. Alioto made no payments on the note, asserting it was offset by his unpaid salary.

Between March and November 2015, Alioto sold 298 shares of Probity stock to family members and business associates for $142,720. The sales progressed from $130 per share in March to $260 per share in May and July, and finally to $2,000 per share between August and November.

On his 2014 tax return, Alioto had reported a negative adjusted gross income for 2014 and he never filed a 2015 return to report the 2015 transactions.

The IRS audited his 2014 return and then added the 2015 year. It issued a notice of deficiency determining unreported income for both years. The IRS also examined Probity’s returns as well to ensure that the income and expenses of Alioto are properly reported.

One of the issues on the audit was the income from the transfer of the stock in 2015. During the audit, Alito argued that he held two groups of stock with different tax basis: 875 shares with $0.01 basis per share (“penny stock”) and 125 shares with $4,000 basis per share (the treasury stock acquired via the promissory note). According to Alioto, he sold 36 of the high-basis shares in 2015, which would have produced a capital loss rather than a capital gain. The IRS determined capital gain income of $142,170. Alioto petitioned the U.S. Tax Court.

Section 351 and Nonrecognition Treatment for Corporate Contributions

Section 351(a) of the tax code provides that “no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation” if immediately after the exchange those persons control the corporation. Control means ownership of at least 80% of the total combined voting power and 80% of the total number of shares of all other classes of stock. The policy behind this rule makes sense. When business owners are simply changing the form of their ownership (from direct ownership of property to indirect ownership through corporate stock), Congress decided not to impose an immediate tax.

This nonrecognition treatment extends beyond contributions of tangible property. It applies when shareholders transfer cash, equipment, real estate, patents, and yes, even promissory notes to their corporations in exchange for stock. The question isn’t whether Section 351 applies to such transactions. It almost always does when the control requirement is met. The real question is what happens to the shareholder’s basis in the property contributed.

Section 351 transactions are very common in business. A shareholder contributes property worth $100,000 (with a $60,000 basis) to their wholly-owned corporation in exchange for stock. Under Section 351(a), they recognize no gain on the contribution, even though the stock they receive is worth $100,000. But what’s their basis in that stock?

Basis Determination Under Section 358

Section 358(a)(1) answers the basis question. It provides that “the basis of the property permitted to be received under section 351 without the recognition of gain or loss shall be the same as that of the property exchanged.” This is called “substituted basis” or “exchanged basis.” The shareholder’s basis in the stock received equals their basis in the property they contributed.

This rule preserves the built-in gain (or loss) for later recognition. Using the example above, the shareholder contributed property with a $60,000 basis and $100,000 value. Under Section 358(a)(1), their stock basis is $60,000. If they later sell the stock for $100,000, they’ll recognize the $40,000 gain that was deferred when they made the contribution. The tax hasn’t been forgiven, just postponed.

The substituted basis rule applies regardless of what type of property the shareholder contributed. Real estate, equipment, inventory, intellectual property—the shareholder’s basis in the stock equals their basis in whatever they put in. This leads to a logical question: What’s a shareholder’s basis in a promissory note they create and contribute to their controlled corporation?

When Does a Promissory Note Create Basis?

The Tax Court in Alioto relied on Alderman v. Commissioner, 55 T.C. 662 (1971), for the proposition that “a taxpayer incurs no cost in making such a note and that the basis to the taxpayer is zero.” This makes intuitive sense. You’re writing an IOU to yourself (or rather, to your company that you control). You haven’t parted with anything of value. You haven’t incurred any economic cost. Therefore, you have zero basis in your own promise to pay.

Under Sections 351 and 358, this zero basis carries over to the stock received. The shareholder exchanges property (the promissory note) with zero basis for stock. Under Section 358(a)(1), the stock basis “shall be the same as that of the property exchanged”—which is zero.

This result frustrates business owners who want to create basis through paper transactions. But it reflects sound tax policy. Allowing shareholders to create basis by giving IOUs to their own controlled corporations would let them manufacture tax losses at will. They could contribute a $1 million promissory note for stock, claim $1 million of basis, immediately sell the stock, and generate a tax loss without any real economic investment or loss.

The problem gets worse in closely held corporations where the shareholder controls both sides of the transaction. There’s no arm’s-length negotiation. No real expectation of payment. No genuine economic substance. Just paper shuffling designed to create tax benefits.

The Peracchi Exception: Notes Backed by Business Risk

But what if the promissory note isn’t just paper? What if there’s genuine risk that the shareholder will have to pay? That’s the question the Ninth Circuit addressed in Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998) and that the court in this case distinguished in a footnote in the case.

In Peracchi, a shareholder contributed both cash and a promissory note to his corporation in exchange for stock. The Ninth Circuit held that the note could create basis equal to its face value because it was “contributed to an operating business which is subject to a non-trivial risk of bankruptcy or receivership.” The court reasoned that if the business failed, creditors could enforce the note against the shareholder personally. This created real economic risk and real economic cost.

The Peracchi exception makes economic sense. If a shareholder gives their corporation a $500,000 promissory note, and the corporation later goes bankrupt with creditors who can enforce that note, the shareholder faces genuine liability. They might actually have to pay $500,000 to satisfy creditors. That’s a real economic burden, not just paper shuffling.

The Ninth Circuit emphasized that the exception applied because the note was contributed to “an operating business” with real bankruptcy risk. This wasn’t a shell corporation or passive investment vehicle. It was an active business with operations, creditors, and the possibility of financial failure. That business risk made the promissory note meaningful.

Peracchi created a circuit split. The Ninth Circuit allows basis in promissory notes when there’s genuine business risk of enforcement. Other circuits have not adopted this exception. The Tax Court noted in Alioto that Peracchi represents the minority view. Most courts follow Alderman and hold that a shareholder’s promissory note to their controlled corporation creates zero basis, period.

For taxpayers in the Ninth Circuit (which includes California, Oregon, Washington, Alaska, Hawaii, Arizona, Nevada, Idaho, and Montana), Peracchi remains good law. Business owners in those states can potentially claim basis in promissory notes contributed to their corporations if they can show genuine business risk. But the exception is narrow and one has to document the transfers, which many taxpayers fail to do.

Why Alioto’s Note Failed the Peracchi Test

The Alioto court distinguished Peracchi on several grounds. First, and most fundamentally, Alioto retained the ability to “unilaterally extinguish his debt by offset” with the employment agreement. The promissory note required Alioto to pay Probity $500,000 (plus interest) by February 5, 2018. But his employment agreement provided that Probity owed him $550,000 on January 31, 2018—just five days earlier. The note explicitly gave Alioto the right to offset one obligation against the other.

This offset provision destroyed any claim of genuine debt. Alioto controlled both obligations. He decided whether Probity would pay him under the employment agreement. He decided whether to exercise his right to offset the note. The entire arrangement was “wholly in Mr. Alioto’s control and exceedingly unlikely” to result in any actual payment by anyone. This wasn’t a note backed by business risk. It was a circular arrangement designed to cancel itself out.

The court also found several other deficiencies that showed the note lacked economic substance. There was no payment schedule for principal or interest. Probity had “no clear source of income that might assure” it could pay the employment compensation that Alioto would then use to pay the note. The whole structure suggested that “the parties did not contemplate that the obligation would be met.”

Most tellingly, Alioto’s own testimony “suggests that the two agreements were meant to cancel each other out, with no indication that Probity planned to pay Mr. Alioto anything under the employment agreement or that Mr. Alioto planned to pay under the promissory note.” When the taxpayer himself admits the arrangements were designed to offset each other, it’s hard to argue there’s genuine debt with genuine risk.

The court applied “special scrutiny” to the transaction, as required for dealings between closely held corporations and their shareholders. The Court cited Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971), for this principle. When a shareholder controls all aspects of a transaction with their corporation—deciding what the corporation pays them, what they pay the corporation, and whether to offset one against the other—courts examine such arrangements skeptically.

Even if Alioto had been in the Ninth Circuit (he wasn’t—he was in Ohio, which falls under the Sixth Circuit), he couldn’t satisfy the Peracchi exception. Peracchi requires “non-trivial risk of bankruptcy or receivership” that would force the shareholder to pay creditors on the note. Alioto had no such risk. He could unilaterally eliminate his obligation through the offset provision. No creditors could force him to pay. No bankruptcy would make him write a check. The note created no real economic burden.

The Takeaway

This case highlights the stock basis questions that come up when promissory notes are given by shareholders to their controlled corporations. This can result in zero basis in stock received, even when structured as formal transactions with interest and maturity dates. As in this case, when shareholders retain the ability to unilaterally extinguish their debt through offset provisions or other control mechanisms, courts will find the notes lack economic substance and create no basis. The Peracchi exception remains available in the Ninth Circuit for notes contributed to operating businesses with genuine bankruptcy risk, but that exception is narrow and one has to document the transaction to prove it. Business owners capitalizing their corporations must ensure that debt instruments reflect real economic obligations with realistic prospects of payment, not just paper transactions that cancel themselves out through related party agreements.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Tax Planning for Net Operating Loss Carryback Elections – Houston Tax Attorneys

Congress has used Section 172 for net operating losses to stimulate the U.S. economy. It has done this by allowing certain losses to be carried back, thereby generating cash refunds to the taxpayer. This puts cash into the hands of taxpayers who are suffering losses. One only has to look at the history of changes to Section 172 to see this history.

One such allowance was for specified liability losses. These are losses that were specifically listed in Section 172 and allowed to be carried back to prior tax years. Environmental remediation costs were an example. When an oil and gas company has a drilling platform that needs dismantling or contaminated land requires cleanup, the tax loss can generate cash to help pay for these often extraordinary expenses.

The question hasn’t been clear in the various machinations of Section 172 is what happens when there are different loss carryback rules at play for a taxpayer in the same tax year. Can the taxpayer have two net operating loss carrybacks from the same tax year, to different prior years? The specified liability loss rules provide an example, as they had a 10 year carryback, whereas general losses had a two year carryback. So if a taxpayer incurred both in the same year, could they carry back 10 years and two years?

This brings us to Apache Corporation v

This brings us to Apache Corporation v. Commissioner, 2025 T.C. 11, which addresses this very issue. The tax court case provides important guidance on whether taxpayers can selectively waive certain carryback periods while preserving others–effectively being able to use NOL elections as part of their business and tax planning.

Facts & Procedural History

The taxpayer in this case is an oil and gas exploration and production company. For 2016 and 2017, the company filed consolidated corporate income tax returns showing net operating losses of approximately $1.9 billion and $3.1 billion respectively.

Buried within those massive losses were much smaller amounts that qualified as “specified liability losses” under Section 172(f)(1). In 2016, the taxpayer reported a specified liability loss of $40.7 million. In 2017, it reported $30.8 million. These amounts represented environmental remediation costs, decommissioning expenses, or similar cleanup obligations that qualify for special tax treatment.

The taxpayer made elections on both returns to waive the carryback period under Section 172(b)(3) for its consolidated net operating losses. But the taxpayer explicitly stated it was not electing to relinquish the carryback period for the specified liability losses. The company wanted to carry those environmental losses back the full ten years while carrying the regular losses only forward.

The taxpayer then filed Form 1139 applications seeking tentative refunds. It carried the $40.7 million specified liability loss from 2016 back to 2006, claiming a refund of $13.8 million. It carried the $30.8 million loss from 2017 back to 2007, claiming $10.1 million. The IRS issued both refunds.

Later, during an IRS audit, the government changed its position. The IRS issued a notice of deficiency for 2006 and 2007, disallowing the carrybacks entirely. The IRS’s position was that when the taxpayer elected to waive the carryback period, it waived everything. No cherry-picking allowed.

The taxpayer petitioned the U

The taxpayer petitioned the U.S. Tax Court for redetermination. Both parties filed cross-motions for partial summary judgment on the carryback issue. The case was reviewed by the full court.

Net Operating Losses Under Section 172

Section 172 allows taxpayers to smooth income over time. When deductions exceed gross income in a year, the resulting net operating loss can be carried to other years. This prevents businesses from being overtaxed simply because their profitable and unprofitable years don’t align with the calendar.

The basic mechanism works like this. A net operating loss can be carried back to prior years to offset income that has already been taxed. This generates tax refunds–so cash paid to the taxpayer. Any loss remaining after the carryback can be carried forward to offset future income. The carryback provides immediate cash flow. The carryforward preserves the loss for future use.

Under the default rule in Section 172(b)(1)(A) that applied prior to 2022, net operating losses can be carried back two years and forward twenty years. The taxpayer starts by carrying the entire loss to the earliest possible year. If that year’s income doesn’t absorb the full loss, the excess carries to the next year, and so on until the loss is consumed or exhausted.

This default rule doesn’t work for everyone. Consider a company with significant research tax credits that are about to expire. If it carries losses back to years when it had those credits, the loss will eliminate the income. The credits then sit unused and eventually expire worthless. The company loses twice—once from the operating loss and again from the wasted credits.

Section 172(b)(3) addresses this problem

Section 172(b)(3) addresses this problem. It allows taxpayers to elect to waive the entire carryback period and carry losses only forward. This preserves credits and other favorable attributes in the earlier years while banking the loss for future use. This is similar to rules that allow taxpayers to opt out of bonus depreciation, foregoe immediate expensing, etc.

The Ten-Year Carryback for Specified Liability Losses

Congress recognized that certain losses are particularly large and sporadic. Environmental cleanups don’t occur on predictable schedules. When they do occur, the costs can dwarf regular operating expenses. Limiting these losses to a two-year carryback often means the company can’t fully use them because income in just those two prior years won’t absorb the entire loss.

For the years in this case, Section 172(f)(1) defined specified liability losses to include two categories. First are product liability losses under subsection (A). Second are amounts under subsection (B) that satisfy liabilities under federal or state law for land reclamation, nuclear plant decommissioning, drilling platform dismantlement, environmental remediation, or workers compensation payments.

Under the rules applicable to these years, these losses must meet specific timing and accounting requirements. The deduction must arise from a liability that existed for a substantial period before the deduction year. The liability must be identified in financial statements or tax returns from earlier years. These requirements prevent taxpayers from manufacturing specified liability losses out of ordinary business expenses.

Section 172(b)(1)(C) grants specified liability losses a ten-year carryback period instead of the usual two years. This extended window gives companies a realistic chance to absorb the loss against income from more years. For businesses with cyclical earnings, reaching back ten years instead of two can mean the difference between using the loss fully or losing part of it forever.

The tax code treated specified liability losses as separa…

The tax code treated specified liability losses as separate from the rest of a net operating loss. Section 172(f)(5) provides that for purposes of applying the sequencing rules in Section 172(b)(2), specified liability losses are treated as separate net operating losses to be taken into account after the regular portion. The taxpayer first carries back its regular loss two years, then separately carries back the specified liability loss ten years.

The law has changed since the years at issue here

The law has changed since the years at issue here. The special treatment for specified liability losses described in this case no longer exists. The Tax Cuts and Jobs Act (“TCJA”) eliminated most net operating loss carrybacks effective for losses arising after December 31, 2017. Under current law, specified liability losses receive no special carryback period. They follow the general rule—no carryback at all, only carryforward.

Losses can be carried forward indefinitely but are subject to an 80% limitation on the amount of taxable income they can offset in any given year. Congress provided temporary relief for losses arising in 2018, 2019, and 2020, allowing those losses a five-year carryback. But this temporary provision applied to all net operating losses during those years, not specifically to specified liability losses. The entire framework of extended carrybacks for environmental remediation costs, decommissioning expenses, and similar liabilities has been removed from the tax code.

Setting aside the policy argument for allowing specified liability loss carrybacks, this case is still relevant as to the broader statutory interpretation principles it establishes. The tax court’s analysis applies whenever Section 172(b)(1) provides multiple carryback periods for different types of losses in the same year. For example, farming losses currently receive a two-year carryback under Section 172(b)(1)(B). If Congress enacts future legislation creating additional special carryback periods for particular industries or types of losses, which it has done repeatedly over the years, the court’s reasoning would govern whether taxpayers can waive some carryback periods while retaining others.

The Election to Waive Carryback Periods

With that background, we can get into the election. Section 172(b)(3) states that any taxpayer entitled to a carryback may elect to relinquish the entire carryback period with respect to a net operating loss for any taxable year. The election has to be made by the due date of the return for the loss year. Once made, the election is irrevocable.

The statute uses specific language—”a carryback period” and “the entire carryback period.” Whether these terms refer to one unified period or potentially multiple periods becomes the central interpretive question. If Section 172(b)(1) establishes only one carryback period per loss, then the election necessarily applies to the whole loss. If it establishes multiple periods, then potentially the election could apply to each period separately.

Farmers and certain other taxpayers face similar questions. Section 172(b)(1)(E) allows eligible losses (including casualty losses and disaster-area losses) to be carried back three years. Section 172(b)(1)(F) allows farming losses a five-year carryback. Each of these provisions includes its own election mechanism allowing taxpayers to waive the extended carryback for that particular type of loss.

The question is whether Section 172(b)(3) works the same way. Can a taxpayer with multiple types of losses subject to different carryback periods waive some but not others? Or does the statute require an all-or-nothing choice?

The tax court held that taxpayers entitled to multiple carryback periods under Section 172(b)(1) may waive them individually. The court based this conclusion on statutory text, structure, judicial precedent, and the government’s own prior interpretation.

The tax court agreed with the taxpayer that reading Secti…

The tax court agreed with the taxpayer that reading Section 172(b)(3) as all-or-nothing makes little sense given the number of different carryback periods in Section 172(b)(1). Why would Congress grant taxpayers the flexibility to waive carrybacks entirely but then remove all flexibility to make nuanced choices when multiple carryback periods apply? Section 172(f)(6) provides another example of congressional flexibility.

This provision allows taxpayers with specified liability losses to elect out of the special ten-year carryback and instead use the regular two-year carryback. A taxpayer might make this election if it had sufficient income in the two most recent years to absorb the loss and wanted to preserve attributes in earlier years. The existence of this additional election shows Congress wanted to give taxpayers choices about how to use these losses.

The Takeaway

This case confirms that the NOL rules can create multiple carryback years. Taxpayers can make elections to use their loss carrybacks strategically, which is what Congress likely intended. When a business has both regular operating losses and specified liability losses, for example, it can waive the short carryback period for regular losses while preserving the extended carryback for environmental and decommissioning costs.

This flexibility allows companies to avoid wasting valuable tax attributes in recent years while still obtaining immediate refunds from the special losses. The same principles apply to other losses today. For example, a farm business with both farming losses (which get a two-year carryback) and other business losses could use the Apache framework to selectively waive carrybacks and preserve expiring credits or other tax benefits. This is another tool in the taxpayer’s tax planning toolbox.