Opinion ID: 255027
Heading Depth: 1
Heading Rank: 3

Heading: Appeal By Commissioner

Text: 21 This brings us to the appeal by the Commissioner. The Commissioner contends that the Tax Court erred in not holding all of taxpayer's gain from the exchange to be presently recognizable and taxable. This is the Commissioner's primary position and his defense of the Tax Court's decision in the appeal brought by taxpayer is only an alternative position, if his position here is rejected. 22 The Commissioner contends that the transaction is governed by § 112(c). This section, it will be recalled, provides that gain will be recognized in a § 112(b) (5) transaction to the extent that boot (money or property other than stock) is received by taxpayer. The corporation's acquisition of the property subject to the mortgage, the Commissioner contends, constitutes the receipt by taxpayer of boot. Since the boot so received, $247,064.01, exceeds taxpayer's gain of $232,785.14 (fair market value of the property, $320,000, less taxpayer's basis, $87,214.86), all of the gain must be recognized and taxed. Section 112(k), we have seen, precludes the result contended for by the Commissioner, but § 112(k) contains an exception and it is this exception which the Commissioner relies upon now. Section 112(k) provides that 23 [if] it appears that the principal purpose of the taxpayer with respect to the assumption or acquisition was a purpose to avoid Federal income tax on the exchange, or if not such purpose, was not a bona fide business purpose, such assumption or acquisition (in the amount of the liability) shall, for the purposes of this section, be considered as money received by the taxpayer upon the exchange. 24 The Tax Court found, however, that taxpayer's principal purpose in exchanging the property subject to the mortgage for all the capital stock of the new corporation was not to avoid Federal income tax on the exchange, and that he had a bona fide business purpose in so transferring the property. (Record, p. 51.) In so finding, the Commissioner contends, the Tax Court erred. 25 The Tax Court substantiated its ultimate findings by finding further that taxpayer desired to place himself in an extremely liquid position to take advantage of a business downturn which, he believed, would soon occur. In order to achieve this liquid position, taxpayer mortgaged his property, since he was unable to sell it despite efforts to do so. Having decided to retain the apartment for himself, taxpayer also decided to operate the property in corporate form, as he had done for twenty years. For tax reasons, taxpayer had taken the apartment out of the corporation when he had contemplated selling it. After deciding not to sell it, he desired to return it to corporate form in order to secure limited liability and convenience of management should he desire to move elsewhere and to turn the property over to a local real estate organization. 26 The Commissioner contends (and this is the crux of his appeal) that the Tax Court missed the point of § 112(k). The true question, missed by the Tax Court, the Commissioner contends, is whether the corporation's taking subject to the liability had some bona fide business purpose in connection with the corporation's business. Thus, the Commissioner contends, the question was not whether the transfer of the property subject to the liability benefited taxpayer's business interests as an investor; the issue is whether the taking-subject-to-the-liability had any purpose with respect to the business of operating the apartments as rental property. The Tax Court found no such business purpose, and, therefore, the Commissioner claims, it erred in holding that taxpayer met the test of § 112(k). 27 We cannot go along with the Commissioner's interpretation of the statute. We believe it is erroneous. It finds little, if any, support in the case authority cited. The test suggested by the Commissioner looks to the origin of the encumbrance and to the use of the proceeds derived from it. Section 112(k), however, says nothing about the origin of the encumbrance. It says only that if a corporation acquires from the taxpayer property subject to a liability such    acquisition shall not be considered as boot, unless the taxpayer's principal purpose regarding the acquisition is tax avoidance or not a bona fide business purpose. Nor is there anything in the section which deals with the reasons for the encumbrance, or the manner in which the mortgage proceeds are used. If there is a good business purpose for transferring the property without first removing the encumbrance, the requirements of § 112 (k) are satisfied. Certainly, an investor's desire to remain liquid in order to capitalize on an expected business recession is a good business reason for not discharging the mortgage. Mertens, Law of Federal Income Taxation, supports the proposition that personal motives may properly induce the original hypothecation: 28 Obviously many if not most incorporations involve encumbered property or the personal indebtedness of the incorporators. The indebtedness is therefore assumed or else the property is taken over by the corporation subject to encumbrances or liabilities against it. To impose tax based on either the assumption of liabilities by the corporation or the taking of the property subject to such liabilities would in many, if not most, cases render ineffectual the provisions for nonrecognition of gain in cases of transfers to a controlled corporation. The present law removes the recognition of gain in such instances by providing that such assumption of liabilities or taking subject thereto shall not be considered `other property.' 3 Mertens, Law of Federal Income Taxation, Chapter 20, p. 104. 29 The Commissioner seeks support for his position in Bryan v. Commissioner, 4 Cir., 1960, 281 F.2d 238, certiorari denied 364 U.S. 931, 81 S.Ct. 378, 5 L.Ed.2d 364. The facts of that case, with some simplification, may be readily stated. Taxpayer obtained construction loans of $1,643,500 to build houses. This exceeded his actual cost by $157,798.04. After building the houses taxpayer transferred them to four corporations which in exchange gave him stock and assumed the construction loan. The Tax Court and the Court of Appeals held that taxpayer, under these circumstances, received money or other property and therefore did not meet the requirements of § 112(b) (5). 30 This case, however, provides only weak support for the Commissioner's position here. The Tax Court found in Bryan, as it did not find in the instant case, that taxpayer's principal purpose with respect to the assumption of the liabilities by the four corporations was a purpose to avoid tax, and hence that it was immaterial    whether such purpose might otherwise be considered not a bona fide business purpose. (W. H. Weaver, 32 T.C. 414, 434.) The court of appeals agreed that his only purpose was to appropriate to himself a major portion of the excess funds    and to do it in a form which gave him hope of avoiding federal taxes on the funds with which he enriched himself. Bryan v. Commissioner, supra, 281 F.2d at page 242. There was, therefore, no problem in determining that § 112(k) did not apply. 31 The Bryan case does offer some support for the Commissioner's position in stating that the corporation's assumption of the mortgage in excess of taxpayer's basis constituted an indirect payment of cash to taxpayer. As a cash payment, the nonrecognition sections would have no application. Ibid. These statements must, however, be considered as dicta in view of the court's holding that taxpayer did not meet the requirements of § 112(k) and that therefore the assumption of the mortgage constituted the payment of money or other property. If, on the other hand, the court had held § 112(k) applicable, the statements would have been inappropriate. Section 112(k) provides, clearly, that an assumption of liability is not the payment of other property or money, and to hold that such assumption constitutes a cash payment is a clear contradiction of the words of the statute. 32 The Tax Court's findings regarding taxpayer's business purpose have not, in our opinion, been shown to be clearly erroneous. And the Commissioner's assertion that taxpayer is a highly tax conscious person (Commissioner's brief, as petitioner, p. 28), as are many citizens these days, is certainly not sufficient to overthrow the Tax Court's further finding that taxpayer's principal motive in this transaction was not tax avoidance. The Tax Court fully examined the evidence regarding the exchange before concluding that taxpayer entered this transaction for bona fide business reasons and not to avoid federal taxes. 33 In concluding his main argument, the Commissioner says, There is nothing theoretical about Easson's gain. The unencumbered cash is in his hand, and ought to be immediately subjected to the payment of income tax. This statement, we believe, lays bare the Commissioner's basic error. The Commissioner believes that taxpayer is in a genuinely different position now than he was before the exchange. This, we believe, is not so. Before the exchange taxpayer owned an apartment house subject to a liability. After the exchange, taxpayer was the sole owner of a corporation which owned the same apartment house subject to the same liability. Where was any income? His stock in the corporation was worth no more than the physical asset which he owned directly before incorporation. Section 112(b) (5) was enacted to deal with this very situation — to permit business reorganizations which, realistically viewed, do not alter the taxpayer's basic position. To use the Commissioner's phraseology, the unencumbered cash was in taxpayer's hand as soon as taxpayer had mortgaged the apartment, but the Commissioner does not claim that the hypothecation of the building constituted a taxable event (see brief for Commissioner as respondent, p. 13). Taxpayer's transfer of his encumbered apartment house to his wholly owned corporation did not make the cash obtained from the mortgaged transaction any more real or any less encumbered than it was before the transfer. It is our belief that the purpose of the tax laws will best be served by not assessing a tax against taxpayer until he realizes his gain in a transaction in which, realistically speaking, he actually changes his position. 34 The Commissioner's next contention applies only if the court rejects his positions both as appellee and appellant. In such event, Commissioner contends, taxpayer received dividend income (§ 115 (a), 1954 Code, 26 U.S.C.A. § 115(a)) in 1953 by virtue of the corporation's payments on the mortgage. This contention is based upon the theory that the corporation's payments discharged a legal obligation of taxpayer. While the corporation may incidentally have benefited taxpayer by reducing the mortgage, it is clear that the corporation did not thereby distribute any assets. The corporation owned the apartment subject to the mortgage and as the mortgage decreased its equity in the apartment house increased. Thus when it took money out of cash and applied that amount to the mortgage, its net worth remained constant. Its total assets were unchanged because the credit to the cash account was offset by a corresponding debit to the fixed assets account. The payments of interest on the mortgage cannot, obviously, be analyzed in this way; these payments, it would seem, did constitute income to the taxpayer who would then be entitled to take the deduction for interest paid (1 Mertens, Law of Federal Income Taxation, § 9.08, p. 19, n. 74). The net effect would be to deny the deduction to the corporation. This interpretation is, however, at variance with the Commissioner's own regulations and should, therefore, be rejected. 26 C.F.R. 1.163(1) (b) provides: 35 Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage may be deducted as interest on his indebtedness. 36 And see Mertens, supra, § 26.03. 37 We believe the Commissioner erred in asserting a deficiency against taxpayer based on the 1952 transaction, whereby taxpayer exchanged the apartment house for stock of Envoy Apartments. Furthermore, the Commissioner is in error in his contention that taxpayer received dividend income in 1953 by reason of mortgage and interest payments made by the corporation. We reverse the judgment of the Tax Court, and direct that judgment be entered in favor of taxpayer.