Focht v. Commissioner

68 T.C. 223, 1977 U.S. Tax Ct. LEXIS 105

• Court: United States Tax Court
• Decided: May 24, 1977
• Docket: Docket No. 7807-73
• Status: Published

Opinions

Sterrett, Judge:

Respondent determined a deficiency in petitioner’s Federal income tax for the calendar year 1970 in the amount of $22,699.

The issues presented for decision are: (1) Whether gain is recognized under section 357(c), I.R.C. 1954, upon the transfer by petitioner, in 1970, of the assets and liabilities of his sole proprietorship to his controlled corporation; (2) whether petitioner failed to include, for his 1970 taxable year, $2,094 of receipts as rental income; and (3) whether petitioner is entitled to various deductions in excess of the amounts allowed by respondent.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by this reference.

Petitioner Donald D. Focht resided in Bethlehem, Pa., at the time the petition herein was filed. Prior to December 23, 1969, petitioner owned and operated a plumbing and heating service under the name of Don Focht Plumbing & Heating. This business was conducted as a sole proprietorship (the proprietorship) and operated on the cash receipts and disbursements method of accounting. On December 23, 1969, Don Focht Plumbing & Heating, Inc. (the corporation), was incorporated under the laws of the Commonwealth of Pennsylvania. During the taxable year 1970 petitioner transferred to Don Focht Plumbing & Heating, Inc., all of the assets of the sole proprietorship in exchange for all of the stock of the corporation,¹ plus the assumption by the corporation of all of the liabilities of the sole proprietorship. The primary reason for the incorporation of the business was to provide petitioner with limited liability against future business hazards.

The assets transferred to, petitioner’s adjusted basis therein, and the liabilities assumed by the corporation are as follows:

Assets Adjusted basis

Accounts receivable. $42,237.10 0

Cash. 959.00 $959

Inventory. 18,320.00 18,320

Fixed assets:

Cost of assets. $39,741

Less accelerated depreciation as of 12/31/69. 23.553 16,188.00 16.188

77.704.10 ²35,467

Liabilities

Liabilities assumed by the corporation:

Accounts payable. $73,729.00

Salaries and wages paid by the corporation. 1,746.00

Federal income taxes payable on payroll return. 8,168.00

Property subject to liabilities which were transferred to the corporation:

Truck (Clark Sandt). 1,857.00

Auto loan (Merchant’s National Bank). 3.479.00

Total liabilities assumed by the corporation. 88,979,00

Therefore, the sum of the liabilities assumed by the corporation exceeded the total adjusted basis of the proprietorship’s assets transferred to the corporation by $53,512. For his taxable year ended December 31, 1970, petitioner did not report any gain pursuant to the aforementioned exchange. Respondent, in his notice of deficiency dated July 27, 1973, determined that the petitioner recognized an ordinary gain in 1970 of $53,512 under section 357(c), such amount representing the excess of liabilities assumed over the adjusted basis of the assets transferred.

On his 1970 return, petitioner reported gross rental income³ of $16,694.25. Gross receipts for the year, per petitioner’s rental receipt book, total $19,873.25 of which petitioner paid, to himself, $1,200. The receipts indicate petitioner’s payments were for rent on apartment 5, 506 W. 3d Street, petitioner’s address on his 1970 return. The statutory notice increased petitioner’s rental income by $2,094. We find the correct computation of unreported rental income to be $1,979 arrived at as follows:

$19,873.25-$16,694.25-$1,200=⁴$1,979 Petitioner took various deductions on his 1970 return which have been disallowed, in part, by respondent as follows:

Deduction Amount claimed Disallowed⁵

Auto expense. $2,098.01 $497

Legal expense. 589.63 330

Insurance expense. 1,503.00 703

Interest expense. 4,547.67 705

Open house and show expense 910.00 422

Depreciation. 2,150.00 2,150

OPINION

The primary issue for our consideration is whether the transfer of the assets and liabilities of petitioner’s sole proprietorship to his wholly owned corporation constituted a taxable exchange under section 357(c).⁶ We have heretofore held, in a multitude of cases, , that the term "liabilities” as used in section 357 should be given an all-inclusive meaning. These holdings have required an extremely literal interpretation of the statute and . the adoption of a mechanical test. Raich v. Commissioner, 46 T.C. 604 (1966); Thatcher v. Commissioner, 61 T.C. 28 (1973), revd. in part and affd. in part 533 F.2d 1114 (9th Cir. 1976).

In Raich v. Commissioner, supra, we held that the sum of the liabilities assumed, including the accounts payable, by the corporation exceeded the basis of the assets transferred because of our conclusion that trade account receivables of the cash basis petitioners/transferors had a basis of zero.⁷ This reasoning is now generally accepted. See Thatcher v. Commissioner, 61 T.C. at 36.

We have always recognized that our all-inclusive definition of the term "liabilities” and the mechanical application of section 357(c), while defensible literally, produce a harsh result that does not appear to be in conformity with the overall purposes of sections 351 and 357(a).⁸ However, in the past, we have been unable to find a satisfactory rationale for giving the term "liabilities” a more limited meaning. Thatcher v. Commissioner, 61 T.C. at 37; Rosen v. Commissioner, 62 T.C. 11, 19 (1974), affd. without opinion 515 F.2d 507 (3d Cir. 1975). Now two Circuit Courts of Appeals have indicated their dissatisfaction with our strict construction. Prior to the trial of this case, the Second Circuit reversed a Memorandum Opinion of this Court in Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir. 1972); and subsequent to trial, the Court of Appeals for the Ninth Circuit reversed our decision in Thatcher v. Commissioner, supra.⁹

The Second Circuit believed that the legislative history¹⁰ of section 357(c) amply justified the giving of a more restrictive definition to the word "liability.” Thus, it said:

It was not meant to be synonymous with the strictly accounting liabilities involved in the case at bar. Section 357(c) was meant to apply to what might be called "tax” liabilities, i.e., liens in excess of tax costs, particularly mortgages encumbering property transferred in a Section 351 transaction. Any other construction results in an absurdity in the case of a cash basis taxpayer whose trade accounts payable are not recognized as a deduction (because he is on the cash basis) but whose "liabilities” (although unpaid) are recognized for purposes of Section 357(c). The payables of a cash basis taxpayer are "liabilities” for accounting purposes but should not be considered "liabilities” for tax purposes under Section 357(c) until they are paid. [Bongiovanni v. Commissioner, supra at 924. Citations omitted.]

The Ninth Circuit’s decision in Thatcher v. Commissioner, supra, commended the Bongiovanni result but was uncomfortable with the method utilized in reaching such result.

There the court defined liabilities in an ad hoc manner that may have worked equity in that case, but the definition is likely to produce unforeseen results in other cases. * * *

In attempting to retain the ordinary meaning of liability "while giving vitality to the purposes of both section 351 (tax-free exchange) and section 357 (closing the escape of taxes by borrowing against assets before transferring them to the new corporation, and blocking the creation of a 'negative’ basis),” the appellate court adopted Judge Hall’s dissenting theory in Thatcher v. Commissioner, supra, to wit: a setoff of deductible trade accounts payable against trade accounts receivable, up to the lesser of the trade accounts payable or the gain recognized under section 357(c).

The statutory purpose is far better served if payables paid by the transferee in the taxable year of transfer are treated as deductible to the transferor to the extent the offsetting receivables are treated as received by him. Since payment of a deductible liability by a cash method taxpayer gives rise to a deduction, the same deduction should be allowed on payment when section 357(c) treats the liability as assumed in exchange for receivables. [61 T.C. at 42-43, Hall, J., dissenting.]

Our steadfast position has divided this Court¹¹ and produced reams of commentary from the tax bar.¹² As previously stated two appellate circuit courts disagreed with our harsh result and in differing manners have prevented taxation of something that was not in fact economic gain to a cash basis taxpayer. It is time for us to reconsider. We now hold that it is inappropriate to treat an assumed liability¹³ of a cash method taxpayer as income to him and simultaneously to deny him a tax benefit, if the obligation would have been deductible upon his payment, for the satisfaction of that debt. Congressional intent, under sections 357 and 358(d), was to affect only those liabilities that, if assumed by a transferee corporation in a tax-free exchange, would cause gain recognition. An obligation should not be treated as a liability, under sections 357 and 358, to the extent that its payment would have been deductible if made by the transferor. To the extent that this position is inconsistent with our prior case law (Raich v. Commissioner, supra, et al.), we will no longer follow those decisions.

Prior to setting forth the rationale for our holding, we must clear a procedural hurdle — our Golsen rule. Golsen v. Commissioner, 54 T.C. 742 (1970), affd. on the substantive issue 445 F.2d 985 (10th Cir. 1971). Appeal in the instant case lies to the Third Circuit, which affirmed without opinion our decision in Rosen v. Commissioner, 515 F.2d 507 (3d Cir. 1975), affg. 62 T.C. 11 (1974). In Rosen v. Commissioner, supra, the taxpayer transferred all the assets and liabilities of his sole proprietorship, which accounted for its income and expenses on the accrual method, to his wholly owned corporation. At the time of the transfer there were no accounts receivable, and liabilities exceeded assets, the corporation being insolvent. Rosen remained personally liable for the payment of his proprietorship’s liabilities assumed by the corporation. We held, in essence, that the Raich doctrine was applicable therein.

However, the facts of the instant case are materially different from those in Rosen. Although petitioner’s proprietorship was, and his wholly owned corporation is probably, insolvent, as was the case in Rosen, petitioner utilizes the cash method of accounting as contrasted with the accrual method of accounting as contrasted with the accrual method involved in Rosen. While not required by the rationale of the theory that we propound, nevertheless the bottom line result to a cash basis taxpayer might well be different from the result to an accrual basis taxpayer. This difference in result makes Golsen inapplicable¹⁴ to the instant case.

Returning to our rationale we note at the outset that the predecessor of section 357 was section 112(k), I.R.C. 1939, which was enacted in response to the Supreme Court’s decision in United States v. Hendler, 303 U.S. 564 (1938). In Hendler, Hendler Creamery Co., Inc., transferred all its assets to the Borden Co. in exchange for 106,306 shares of Borden’s stock, some cash, and Borden’s assumption of all Hendler’s liabilities as existed as of the date of closing of the exchange. Such liabilities included first mortgage bonds redeemable at 7 Vz -percent premium, current bank loans, and merchandise accounts. Borden paid all these liabilities within a month after closing of title. Hendler, on the transfer, realized a gain of over $6 million but asserted in its tax return that the transaction constituted a tax-free exchange, a reorganization under section 112(i) of the Revenue Act of 1928, and that the cash was distributed in accordance with then section 112(d)(1). It also claimed as a deduction the 7%-percent premium payable in redemption of its bonds by Borden and the unamortized discount on such bonds. The Government asserted that Borden’s assumption of the mortgage bonds was money constructively received by Hendler, which was not distributed to its shareholders, and thereby resulted in recognition of gain under section 112(d)(2). However, the Government did not extend its contention to the bank loans and merchandise accounts assumed and paid by Borden. Also it played safe by claiming that the deduction for discount and premium should be disallowed.¹⁵

The District Court¹⁶ held that Borden’s assumption of Hendler’s liability did not constitute the receipt of "money or other property” within the meaning of section 112(d) and was not taxable boot. "As to form, the money used to pay the bonded debt was never actually received or distributed, or retained by the corporation; and as to substance, all that Hendler received in the transaction (other than a comparatively small amount of cash distributed to preferred shareholders) was common stock of Borden, representing the equity in its property in exchange for the equity in Hendler property.”¹⁷ Additionally, Hendler’s deductions for bond discount and premiums were disallowed, because Borden and not Hendler had paid the redemption premium and that when the obligation on the principal of the bonds itself was removed from Hendler’s liabilities, it could lay no claim to the unamortized discount.

The Government appealed on the main issue to the Fourth Circuit Court of Appeals and Hendler did not press for the deduction. The Fourth Circuit affirmed the District Court¹⁸ and the United States Supreme Court granted certiorari.¹⁹ In reversing²⁰ the lower court’s decisions Justice Black writing for the Supreme Court stated at page 566:

We are unable to agree with the conclusion reached by the courts below that the gain to the Hendler Company, realized by the Borden Company’s payment, was exempt from taxation under section 112.

It was contended below and it is urged here that since the Hendler Company did not actually receive the money with which the Borden Company discharged the former’s indebtedness, the Hendler Company’s gain of $534,297.40 is not taxable. The transaction, however, under which the Borden Company assumed and paid the debt and obligation of the Hendler Company is to be regarded in substance as though the $534,297.40 had been paid directly to the Hendler Company. The Hendler Company was the beneficiary of the discharge of its indebtedness. Its gain was as real and substantial as if the money had been paid it and then paid over by it to its creditors. The discharge of liability by the payment of the Hendler Company’s indebtedness constituted income to the Hendler Company and is to be treated as such.

Congress immediately responded to nullify the Hendler result by enacting section 112(k), I.R.C. 1939,²¹ and the Ways and Means Committee Report, H. Rept. No. 855, 76th Cong., 1st Sess. (1939), 1939-2 C.B. 518-519, clearly showed its intent.

It has long been the policy in our income tax law to give due consideration to the exigencies of business in connection with corporate reorganizations by postponing, in certain specifically described instances, the recognition of gain realized in such transactions. In general, if gain is realized in such a transaction, nonrecognition of the entire gain is allowed only where, under the specifically defined circumstances, the taxpayer transfers property and receives in exchange therefor stock or securities in a corporation which is a party to the reorganization. If, in addition to such stock or securities, other property or money is received, gain is recognized to the extent of such other property or money.

The recent Supreme Court case of United States v. Hendler (303 U.S. 564 (1938)), has been broadly interpreted to require that, if a taxpayer’s liabilities are assumed by another party in what is otherwise a tax-free reorganization, gain is recognized to the extent of the assumption. In typical transactions changing the form or entity of a business it is not customary to liquidate the liabilities of the business and such liabilities are almost invariably assumed by the corporation which continues the business. Your committee therefore believes that such a broad interpretation, as is indicated above will largely nullify the provisions of existing law which postpone the recognition of gain in such cases. To enable bona fide transactions of this type to be carried on without the recognition of gain, the committee has recommended section 213 of the bill.

Congress chose to postpone the recognition of gain in such cases by amending section 113(a)(6) to reduce the transferor’s stock basis by the amount of the liabilities assumed or taken subject to by the transferee.²² Therefore, it is reasonable to conclude from the above that sections 112(k) and 113(a)(6) were intended to affect only liabilities, similar to those under Hendler, that, if assumed (or taken subject to) by the transferee in a tax-free exchange, would cause gain recognition.

Nine years after its decision in Hendler v. United States, supra, the United States Supreme Court delivered its landmark opinion in Crane v. Commissioner, 331 U.S. 1 (1947). Crane involved the transfer of real property subject to a mortgage on which interest was due and unpaid. The Court found that the amount realized by the transferor on the sale included the mortgage, although the transferee did not assume the debt but only took the real property subject to the liability. Citing its decision in Hendler,²³ the Court noted the taxpayer conceded that, if she had been personally liable on the mortgage and the transferee had either paid or assumed it, "the amount so paid or assumed would be considered a part of the 'amount realized.’ ” However the Supreme Court did not consider, as an amount realized by the transferor, the interest due on the mortgage and unpaid at the time of transfer. The Commissioner on brief to the Supreme Court at page 25, footnote 12, conceded that the amount of outstanding interest, taxes, etc., should be disregarded from the computation of the amount realized, "because they were deductible from gross income or from the proceeds of sale.” The Court in measuring the amount realized noted, in its opinion, this concession and stated at page 4, footnote 6:

The Commissioner explains that only the principal amount, rather than the total present debt secured by the mortgage, was deemed to be a measure of the amount realized, because the difference was attributable to interest due, a deductible item.

In light of the Supreme Court’s rationale in Hendler²⁴ it seems highly probable that had Hendler pressed its claim for the deductions, and if such items were properly deductible if paid by Hendler, the Supreme Court would have sustained this part of the claim. Implicit in this conclusion is the view that Hendler foreshadowed Crane’s exclusionary treatment of assumed deductible liabilities, an exclusion we now find incorporated into sections 357 and 358.²⁵

Furthermore, the same above analysis applies to section 357(c). Although the purpose for its adoption is unclear from the aforenoted House and Senate committee reports, illustrating the transfer of real property with a mortgage in excess of its basis, one can speculate that Congress was dissatisfied with the operation of what is now section 357(b) (the tax-avoidance safeguard to 357(a)) because it was too subjective and dependent upon a determination of a taxpayer’s motive. Through transferor’s manipulations of credit and depreciation substantial economic gain was going untaxed. Therefore, in 1954, a new test was added to apply in an automatic and mechanical fashion in situations where the transferor realized economic benefit which, if not recognized, would otherwise go untaxed.²⁶

It is apparent that in construing section 357, section 357(c) is applicable only as an exception to section 357(a). Where section 357(a) does not apply, section 357(c) should not apply. Hence, the term "liability” in both of these sections should be limited to those obligations that, if transferred, cause gain recognition. An obligation to the extent that its payment would have been deductible if made by the transferor should not be such a liability.

We believe our holding implements the aforenoted congressional intent by preventing the recognition of gain or loss where there has been a mere change in form of ownership in a tax-free reorganization. The transferor has not sustained an economic benefit but only a theoretical gain. The following illustrates this principle. P, a cash basis sole proprietor, has the following assets and liabilities:

Adjusted Assets Value Basis

Marketable securities $10 $10

Tangible assets. 25 25

Accounts receivable... 20 _0

Total. 55 35

Liabilities Salary unpaid to employees. 40

P wishes to incorporate his business by transferring the assets and liabilities to his wholly owned shell corporation, "X.” Applying our holding that the term "liability,” as used in sections 357 and 358(d), does not include an obligation to the extent that its payment would have been deductible if made by the transferor results in the following: P has no section 357(c) gain; his X stock basis is $35; and X’s basis in its assets is also $35. Upon sale of his stock P receives $15, the net worth of X, and recognizes a loss of $20. This leaves P in the same position, with respect to his stock, as he was with respect to his proprietorship’s assets and liabilities prior to the transfer. X’s assumption of P’s liabilities is as if X had paid the money to P and then P had paid his creditors. United States v. Hendler, supra at 566; Crane v. Commissioner, supra at 13; James M. Pierce Corp. v. Commissioner, 326 F.2d 67, 71-72 (8th Cir. 1964).

Moreover we note that prior to P’s transfer of assets and liabilities to X, P could have withheld $40 of assets to pay his $40 of liabilities. If he had withheld $15 of accounts receivable, the $10 of marketable securities, and $15 of tangible assets to pay his liabilities, he would have recognized $15 of gain on his accounts receivable and would have been entitled to a deduction of $40 on payment of the payables— netting to a $25 loss. P then would have transferred the remaining $5 of accounts receivable and the $10 of tangible assets to X corporation pursuant to section 351. His basis in the X stock would be $10 with a value of $15. Hence on sale of his X stock he would recognize a gain of $5 or, again, an aggregate loss on both transactions of $20.²⁷

We have previously noted that Congress was aware that in the typical situation a sole proprietor would not liquidate the liabilities of a business prior to the transfer of his business in a tax-free reorganization and that customarily the transferee corporation would assume such obligations. To avoid perverting the realities of the transaction with unnatural tax consequences the gain at both the shareholder and corporate levels should not be premised on an application of the term "liability” in a pervasive, unrealistic manner. The result under Raich taxes the transferor on an amount which never was, and never will be, received by him as an economic gain. It is no answer that the transferee corporation receives a stepped-up basis under section 362 when the transferor had no gain on the exchange.

Unlike the theory adopted by the Ninth Circuit in Thatcher v. Commissioner, supra, our result alleviates the problems raised when a cash method taxpayer transfers insufficient receivables to cover the proposed gain under section 357(c). If P transfers to X $35 in cash and deductible accounts payable of $40, the account receivable/accounts payable setoff theory is inapplicable.²⁸ P would recognize $5 of section 357(c) gain. Under our theory since the accounts payable are deductible if paid by P, their assumption would not fall within sections 357 and 358. In sum, the rule we propound is as follows: the assumption of a deductible obligation of a cash method taxpayer is a nonrealizable event because it is improper to treat the assumed liability as income to the transferor and deny him the tax benefit for its satisfaction.²⁹ However, a cash basis taxpayer transferring a nondeductible liability realizes gain irrespective of whether he enjoyed a prior tax benefit, as actual payment would generate no additional tax deduction.³⁰

We need not decide here the tax consequences to the transferee when it pays the assumed liabilities.³¹ For present purposes, we hold that to the extent petitioner’s obligations, assumed by the corporation, would have been deductible by him upon his payment, such obligations are not to be treated as liabilities for purposes of sections 357 and 358.

Having previously found that respondent erred in his determination of the precise amount of additional unreported rental income, we turn next to respondent’s disallowance of petitioner’s various deductions. Petitioner has not offered any evidence to rebut the presumption of correctness of such adjustments and is, therefore, not entitled to deductions in excess of the amounts allowed by respondent. Welch v. Helvering, 290 U.S. 111 (1933); Rule 142(a), Tax Court Rules of Practice and Procedure.

Decision will be entered under Rule 155.

Reviewed by the Court.

Raum, J., concurs in the result.

1 One thousand shares of common stock, par value $10 per share.

2 The record does not indicate the fair market value of the assets, although the Court specifically raised the point.

3 The rental properties were individually owned by petitioner.

4 Note, respondent does not argue that petitioner be taxed when transferring money from his one hand to the other.

5 Respondent’s explanation of these adjustments in his notice of deficiency was as follows: (1) The auto expense was a personal expenditure; (2) the legal expense, a capital expenditure; (3) the insurance, interest, and open house expenses were all disallowed for lack of substantiation; and (4) the proprietorship’s depreciation expense was disallowed because its assets had been transferred to the corporation in January 1970.

6 SEC. 357(c). Liabilities in Excess of Basis.—

(1) In general. — In the case of an exchange—

(A) to which section 351 applies, or

(B) to which section 361 applies by reason of a plan of reorganization within the meaning of section 368(a)(1)(D),

if the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.

7 The adjusted basis ' * the property transferred, excluding trade accounts receivable, was $11,251.73; liabilities transferred were trade accounts payable of $37,719.78 and notes payable of $8,273.03. Therefore, petitioner was held to have a recognized gain of $34,741.08.

8 SEC. 357(a). General Rule. — Except as provided in subsections (b) and (c), if—

(1) the taxpayer receives property which would be permitted to be received under section 351, 361, 371, or 374 without the recognition of gain if it were the sole consideration, and

(2) as part of the consideration, a; -. party to the exchange assumes a liability of the taxpayer, or acquires from the taxpayer property subject to a liability,

then such assumption or acquisition shall not be treated as money or other property, and shall not prevent the exchange from being within the provisions of section 351, 361, 371, or 374, as the case may be.

9 Petitioner testified that a significant reason for litigating his case was the Second Circuit’s reversal in Bongiovanni. Nonetheless petitioner, pro se before this Court, has not favored us with a written brief.

10 Both the House and Senate committee reports illustrate an example of the application of sec. 357(c) wherein a mortgage incumbering land in an amount exceeding the land’s basis is transferred pursuant to sec. 351. S. Rept. No. 1622, to accompany H. R. 8300 (Pub. L. No. 591), 83d Cong., 2d Sess. 270 (1954); H. Rept. No. 1337, to accompany H.R. 8300 (Pub. L. No. 591), 83d Cong., 2d Sess. A129 (1954). Moreover, sec. 1.357-2(a), Income Tax Regs., contains a similar example.

11 There were five dissenters in Thatcher v. Commissioner, supra.

12 In view of our holding infra, see particularly: Kahn & Oesterle, "A Definition of 'Liabilities’ in Internal Revenue Code Sections 357 and 358(d),” 73 Mich. L. Rev. 461 (1975).

See also: Burke & Chisolm, "Sec. 357: A Hidden Trap in Tax-Free Incorporations,” 25 Tax L. Rev. 211 (1970); Del Cotto, "Sec. 357(c): Some Observations of Tax Effects to the Cash Basis Transferor,” 24 Buffalo L. Rev. 1 (1974); Phelan, "Conflicting Definitions of 'Liabilities’ Threatens Some Tax-Free Reorganizations,” 40 J. Taxation 356 (1974); Roha, "Application of Section 357(c) of the Internal Revenue Code to a Section 351 Transfer of Accounts Receivable and Payable,” 24 Cath. U. L. Rev. 243 (1975); Wellen, "New Solutions to the Section 357(c) Problem,” 52 Taxes 361 (1974).

13 For purposes of this opinion the assumption of a liability shall be equated with the taking of property subject to a liability.

14 Furthermore, petitioner’s contention in Rosen was that the transferee corporation never assumed or took subject to the liabilities at issue within the meaning of sec. 357(c)(1). The assumption was merely formal, since the corporation lacked assets needed for payment. We held, at p. 19, that although petitioner "remained personally liable for the payment of such liabilities, and the creditors never looked to Filmotheque [the transferee corporation] for payment, there is no requirement in section 357(c)(1) that the transferor be relieved of liability.”

15 See Surrey, "Assumption of Indebtedness in Tax-Free Exchanges,” 50 Yale L. J. 1 (1940).

16 Hendler v. United States, 17 F.Supp. 558 (D. Md. 1936). Hendler’s principal stockholder, Mr. Hendler, elected to pay the deficiency and sue for a refund.

17 Hendler v. United States, 17 F.Supp. 558, 568 (D. Md. 1936).

18 United States v. Hendler, 91 F.2d 680 (4th Cir. 1937).

19 United States v. Hendler, 302 U.S. 680 (1937).

20 United States v. Hendler, 303 U.S. 564 (1938).

21 SEC. 112. RECOGNITION OF GAIN OR LOSS.

(k) Assumption op Liability not Recognized. — Where upon an exchange the taxpayer receives as part of the consideration property which would be permitted by subsection (b)(4) or (5) of this section to be received without the recognition of gain if it were the sole consideration, and as part of the consideration another party to the exchange assumes a liability of the taxpayer or acquires from the taxpayer property subject to a liability, such assumption or acquisition shall not be considered as 'other property or money’ received by the taxpayer within the meaning of subsection (c), (d), or (e) of this section and shall not prevent the exchange from being within the provisions of subsection (b)(4) or (5); except that if, taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption or acquisition was made, 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.

22 "Section 213(d) of the bill amends section 113(a)6 of the Internal Revenue Code to provide that in the determination of the basis under that section any liabilities of the taxpayer assumed by the transferee or to which the transferred property is subject shall be considered as money received by the taxpayer upon the exchange and hence is applicable in reduction of the basis of the property received by the taxpayer on the exchange. This provision applies whether or not the assumption of the liability or the taking subject to the liability is considered money under section 112(k). No amendment is made to section 113(a) (7) or (8), because the payment by the transferee of the liabilities assumed, or to which the property was subject, does not give rise to any increase or adjustment of the basis of the property transferred. [Ways and Means Committee Report, H. Rept. No. 855, 76th Cong., 1st Sess. (1939), 1939-2 C.B. 519.]”

Apparently, secs. 112(k) and 113(a)(6) were broadly and cautiously drafted to protect against an application of the Hendler doctrine, not only to assumptions of liabilities but to property acquired subject to the liabilities.

23 See Crane v. Commissioner, 331 U.S. 1, 13 n. 34.

24 "Its [Hendler’s] gain was as real and substantial as if the money had been paid to it and then paid over by it to its creditors.” United States v. Hendler, 303 U.S. 564, 566 (1938).

25 A transferee’s assumption, absent a creditor’s relief of the transferor, does not literally satisfy the debt to the creditor. Although there is no statutory justification for granting a transferor a tax deduction until the debt is actually paid, and recognizing there is a paucity of cases in this area, the Crane exclusionary approach does offer substantial administrative conveniences. See James M. Pierce Corp. v. Commissioner, 326 F.2d 67 (8th Cir. 1964); Dean v. Commissioner, 35 T.C. 1083, 1090 (1961); cf. Royal Oak Apartments, Inc. v. Commissioner, 43 T.C. 243 (1964).

26 See Rosen v. Commissioner, 62 T.C. 11, 19 n. 3 (1974), Thatcher v. Commissioner, 533 F.2d 1114, 1116 (9th Cir. 1976). However many tax commentators suggest that the purpose of the sec. 357(c) enactment was to avoid problems of a negative basis. See Cooper, "Negative Basis,” 75 Harv. L. Rev. 1352 (1962); Easson v. Commissioner, 33 T.C. 963 (1960), revd. 294 F.2d 653 (9th Cir. 1961).

27 Alternatively, P, prior to transferring his assets and liabilities, could have secured a loan of $40 and used the proceeds to pay his deductible liabilities. Absent the prohibited purpose test of 357(b) (P had a bona fide business purpose in paying his creditors) P would recognize a sec. 162 deduction of $40 and a sec. 357(c) gain, on the transfer, of $5. Sale of his X stock would result in a $15 gain, or again, an aggregate loss of $20.

28 Sec. 1.357-2, Income Tax Regs., raises another problem. Under these regulations it appears that a particular sec. 357(c) gain is to be allocated among the transferred assets according to their respective fair market values and therefore such gain would not necessarily be fully allocable to accounts receivable. Accordingly, part of any such gain could be allocated to transferred capital assets, characterized as long-term capital gain, and the ordinary deduction to which the Ninth Circuit postulated the transferor of accounts payable to be entitled would not constitute a "wash” with the sec. 357(c) gain.

29 This exclusionary approach, under Crane, establishes that the transfer of deductible obligations does not cause gain realization and thus cannot cause gain recognition within the statutory framework of secs. 357 and 358.

30 Similarly the assumption of a liability of an accrual basis taxpayer constitutes gain realization if payment by the transferor, at date of assumption, would not entitle him to an additional tax benefit.

31 See Magruder v. Supplee, 316 U.S. 394 (1942).