Loan guaranties and tax-free transfers to controlled corporations.

IRC section 351 allows a taxpayer to make a tax-free transfer of property to a controlled corporation in exchange for stock. Section 357(c), however, requires the taxpayer to recognize a gain when the liabilities the corporation assumes, plus the liabilities on the transferred property, are greater than the property's adjusted basis. The gain equals the amount by which the liabilities exceed the adjusted basis.

Ronald Seggerman and his two sons operated a farm as a joint venture. In 1993, at the request of their secured creditors, the three incorporated the operation to restructure their debt. The newly formed corporation, Seggerman Farms, received numerous farming assets from the three taxpayers, some encumbered by debt. In addition the corporation assumed various of their liabilities. The total amount of the liabilities the three transferred to the corporation exceeded the adjusted basis of the property by $510,690. They remained personally liable because they had executed personal loan guaranties with the creditors. Neither Seggerman nor his sons reported any gain on their individual income tax returns related to the transfer. The IRS assessed a deficiency against all three taxpayers. In 2001 they petitioned the Tax Court for relief; the court consolidated the cases prior to trial.

The Seggermans argued they should recognize no gain since they had received no debt relief based on their personal guaranties. The Tax Court disagreed, citing Rosen v. Commissioner, 62 TC 11. In Rosen the court held that relief from the transferred debt was not a necessary condition to trigger gain recognition under section 357(c). The Seggermans also cited two appeals court decisions where, in somewhat similar situations, the transferors did not have to recognize gain: Lessinger v. Commissioner, 89-1 USTC and Peracchi v. Commissioner, 98-1 USTC.

The Tax Court distinguished the two appeals court cases from the Seggermans' situation since in those cases the taxpayers had also contributed personal notes to the corporation. The notes had a face value equal to the amount by which the assumed liabilities exceeded the adjusted basis of the transferred property. When the basis of the notes was added to the basis of the other contributed property, the amount of the transferred liabilities did not exceed the adjusted basis. As a result, in neither case did the taxpayer recognize any gain.

The Seggermans also argued their guaranties were no different from the contributed notes since they still were liable for the corporate debt after the transfer. The Tax Court contrasted their loan guaranties with the contributed notes since the obligation under the loan guaranty had depended on uncertain future events and did not require any economic outlay. The court went on to say that the taxpayers had been free to choose how to arrange the transaction and now had to live with the tax result. In 2002 the taxpayers appealed the decision to the Seventh Circuit Court of Appeals.

Result. For the IRS. The taxpayers asked the higher court for relief because the Tax Court's reasoning in Rosen was outdated in light of Lessinger and Peracchi. They further argued the two cases represented "an emerging equitable interpretation" of section 357(c) that the Seventh Circuit also should adopt. That court, however, upheld the Tax Court decision that a shareholder's personal guaranty of corporate debt clearly was different from a shareholder's being indebted to the corporation. The Seventh Circuit conceded the result was harsh, but to rule otherwise would ignore the plain language of section 357(c).

For CPAs this case 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 provided 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(c). Thus, 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 doesn't assume the liability.

* Seggerman Farms Inc. v. Commissioner, 2002-2 USTC.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting and interim chair of the department of business and economics, University of Wisconsin, Superior.