Corporate Taxation Cases to Draw

¶ … corporate taxation cases to draw similarities and differences and analyze the resulting rules of law. First, Seggerman Farms will be closely examined for its impact, and then, reversing the process of time, an earlier case that it relied on - Lessinger - will be examined next. This paper will then demonstrate which case is more supportable and will endure into the future of taxation.

The Rulings in Seggerman Farms and Lessinger

This case deals with the recognition of gain upon incorporation when transferred liabilities exceed asset basis.

The facts were as follows: The taxpayers incorporated their family farming business, which they had previously operated as a joint venture. As part and parcel of the incorporation, the taxpayers transferred various farm assets to the newly minted corporation. The corporation then assumed the farm liabilities, and some of the property was transferred subject to liability. The adjusted basis of the assets was less than the liabilities assumed plus the amount of liabilities to which property was subject. However, the taxpayers were personally liable for all the debt before and after the incorporation, in the court's finding.

Specifically, Ronald and Sally Seggerman, Craig and Linda Seggerman, and Michael Seggerman (collectively, "the Seggermans") worked as grain and cattle farmers in Illinois. See id. At the request of particular creditors, the Seggermans incorporated their farm into an Illinois corporation in 1993, known as Seggerman Farms, Inc. which will now be referred to as Seggerman Farms.

In exchange for stock, Ronald, Michael, and Craig Seggerman transferred assets to the corporation subject to liabilities. Seggerman Farms also took on myriad farm-based liabilities of Ronald, Michael, and Craig. In each of these instances, "the dollar amount of liabilities transferred to the Corporation exceeded the transferor's adjusted basis in transferred assets," according to the court.

Seggerman Farms later "refinanced a portion of the transferred debt, incurring debts totaling $300,000" and Seggerman Farms, "with the Seggermans as co-makers, borrowed an additional $407,000," according to the court. The Seggermans remained secondarily liable on all of the above-noted transferred debt, even though no particular Seggerman or farm owner or operator ever directly received any of the loan proceed disbursements. More specifically, "Ronald executed a commercial guaranty and Sally, Craig, Linda, and Michael executed unlimited, continuing personal guaranties of the Corporation's debt," according to the court.

In July, 1999, the Seggermans and Seggerman Farms received notices of deficiency of federal income tax for the 1993 and 1994 tax years. See id. The Commissioner claimed that the deficiencies resulted, in part, from the Seggermans' "failure to report as income on their federal tax returns the amount by which liabilities transferred to the Corporation exceeded the adjusted basis in the transferred assets," as noted in the opinion on Seggerman Farms.

That is why in October, 1999, the Seggermans filed petitions in the United States Tax Court seeking a reevaluation of their alleged tax deficiencies. They argued that as guarantors of the Seggerman Farms' debt, they were not relieved personally from any debt that... [Seggerman Farms] assumed or to which the transferred property was subject or that was refinanced pursuant to restructuring of corporate debt, and therefore they should not have to recognize any gain on the amount of the liabilities that exceeds the adjusted basis of the transferred assets," according to the court in Seggerman Farms.

The issue in the case was whether taxpayers must recognize a gain on the transfer of assets to the corporation under I.R.C. 357 to the extent that the amount of liabilities that were assumed plus the amount of liabilities to which the property was subject exceeds the total of the adjusted basis of the property that was transferred by those same taxpayers to the corporation.

The court's thinking was that in general, I.R.C. 357-(1)(a) dictates that in the case of an exchange to which I.R.C. 351 applies, if the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the grand total of the adjusted basis of the property transferred pursuant to such exchange, then such excess needs to be considered as a gain from the sale or exchange of a capital asset or indeed of actual property which is not a capital asset, as the case may be.

The court cited many precedents. In Rosen v. Commissioner, 62 T.C. (CCH) 11 (1974), which was affirmed sans a published opinion, 515 F.2d 507 (3rd Cir. 1975), the court addressed a similar issue in similar circumstances. The taxpayer in Rosen transferred all of the assets and liabilities of a sole proprietorship to a corporation in which he owned the full gamut - 100% -- of the outstanding stock.

In fact, for the taxpayer, the liabilities exceeded the adjusted basis of the assets that were transferred, and that is why the taxpayer remained personally liable for the liabilities that were transferred. The court ruled in Rosen that the even though the taxpayer remained personally liable for the payment of the liabilities, there is no requirement in I.R.C. 357-(1) that the transferor be relieved of liability and held that the taxpayer had to recognize a gain under I.R.C. 357-.

The taxpayers in Seggerman Farms relied not only on Rosen but on two Court of Appeals decisions in which the Courts of Appeals granted taxpayers relief from recognizing a gain under I.R.C. 357-. For starters, in Lessinger v. Commissioner, 872 F.2d 519 (2nd Cir. 1989), rev'g 85 T.C. (CCH) 824 (1985), the distinction between the adjusted basis of the assets and the liabilities that were transferred was recorded as a loan receivable from the taxpayer to the corporation.

Consequently, as a direct byproduct of including the face value of the loan receivable in the assets, the Second U.S. Circuit Court of Appeals ruled there was no I.R.C. 357 gain. In Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), rev'g, 71 T.C.M. (CCH) 2830, in a similar situation, the distinction in liabilities and asset basis was recorded as a personal note from the taxpayer to the corporation. The Ninth Circuit, in Peracchi, ruled that the taxpayer had a basis in the personal note equal to the face value of the note and that there was no gain to recognize under I.R.C. 357-.

That is why the IRS argued that the structure of the taxpayers' I.R.C. 351 transaction in Seggerman Farms simply was not identical the structure of the taxpayers' transactions in Lessinger and Peracchi. Concurring with the IRS' position, the court concluded that personal guaranties of corporate debt are not the same as incurring indebtedness to the corporation because a guaranty is merely a promise to pay in the future if certain events should occur and taxpayers' guaranties do not constitute economic outlays.

That is why the court in Seggerman Farms held that under I.R.C. 357, taxpayers must recognize a gain on the transfer of assets to the corporation.

The impact of this case is undoubtedly immense for the IRS, taxpayers and most importantly for CPAs who will be doing taxes for taxpayers. The taxpayers requested the higher court for relief because the Tax Court's reasoning in Rosen was outdated in light of Lessinger and Peracchi, as mentioned above. The taxpayers also argued the two cases represented "an emerging equitable interpretation" of section 357- that the Seventh Circuit also should adopt. That court, however, upheld the Tax Court decision that a shareholder's personal guaranty of corporate debt obviously was distinct from a shareholder's being indebted to that same corporate entity. The Seventh Circuit admitted that the result was harsh, but to rule otherwise would skip over the plain language of section 357-.

For CPAs in particular, Seggerman Farms illustrates the importance of carefully examining the form of a transaction when a client is contributing assets to a controlled corporation. Taxpayers need to consider the strategy adopted in Lessinger and Peracchi in which the taxpayers avoided recognizing gain by contributing their own notes to the corporation in addition to other assets.

Congress also legislated relief in the Miscellaneous Trade and Technical Corrections Act of 1999 by eliminating the phrase "the amount of liabilities to which the property is subject" from section 357-. As a result, a taxpayer can avoid gain recognition when he or she transfers property encumbered by liabilities in excess of basis to a controlled corporation. This favorable result will occur even though the taxpayer remains personally liable for the debt as long as the corporation does not assume the liability.

Which case is more supportable?

Seggerman Farms is, by far, more supportable than Lessinger. That is primarily because Seggerman Farms takes the ruling in Lessinger and aptly adapts it to modern times.

In a variety of venues the "assumption" of a liability can trigger recognition of gain from a disposition of real property or assets that assets otherwise tax-deferred. For instance, in an installment sale, the excess of the liabilities assumed over the tax basis of the transferred property is considered a "payment" received by the taxpayer in the year of sale and is reportable as gain. Temp. Reg. 15A.453-1(b)(3)(i). Similarly, a taxpayer engaging in a section 1031 exchange is treated as receiving "boot" (and is required to recognize any realized gain) to the extent that the liabilities assumed by the exchange counterparty exceed the liabilities assumed (plus the cash paid) by the taxpayer in the exchange. Reg. 1.1031(b)-1(a) and -.

Liability assumptions can also result in gain recognition or other tax consequences when property is transferred to or from a corporate entity or partnership. For instance, when a taxpayer transfers property to a controlled corporation in exchange for stock, the taxpayer is required to recognize gain under section 357- if the corporation "assumes" liabilities of the taxpayer in excess of the tax basis of the transferred property.

Similarly, a liability "assumed" by a partnership in connection with a property contribution by a partner can, in certain circumstances, be included in the sale price of property deemed sold to the partnership (See Reg. 1.707-5), or, in other contexts, treated as a deemed distribution to, or contribution by, the partner that affects the partner's tax basis in its partnership interest or, in some circumstances, produces gain (See section 752(a) and (b)).

In these fact patterns and in others, the issue often arises as to whether the taxpayer can avoid the adverse tax consequences of a debt assumption by an agreement to remain liable for the debt. That is where Seggerman Farms waxes superior to Lessinger. In Seggerman Farms, the recent appellate court decision sheds a lot of light on how the Seventh Circuit Court of Appeals views the issue of corporate liability for corporations that are essentially the same entities as their owners. Seggerman Farms, Inc. v. Commissioner, 90 AFTR 2d 2002-6981 (7th Cir. 2002).

The 1999 Act to a large degree dismisses the specific issue raised in Seggerman Farms for future transactions as mentioned above. Under section 357(d), a simple guarantee will often just not be enough to prevent a debt assumption from occurring, especially where the facts establish that the transferee agrees to assume the liability and is expected to be the primary source of payment.

However, Seggerman Farms continues to have implications outside of areas covered by section 357- and the 1999 Act (e.g., partnership transfers). It confirms that in the Seventh Circuit, the retention of liability for a debt by a transferor of property is not by itself enough to prevent an assumption of the debt from occurring for tax purposes, unless the transferor retains primary, rather than secondary, liability for repayment of the debt - in other words, the exact opposite, to a certain degree, of the result in Lessinger.