Personal Guaranty Does Not Preclude Gain Recognition on Transferred Liabilities

Sec. 357(c) is an exception to the general nonrecognition rules for incorporations under Sec. 351(a); it provides that gain is recognized to the extent that liabilities assumed exceed the total adjusted basis of the property transferred.

In Peracchi, 143 F3d 487 (9th Cir. 1998), a somewhat curious pro-taxpayer decision, the court held that a creditworthy shareholders basis in his own note contributed to his wholly owned corporation equaled its face amount. The Ninth Circuit concluded that the promissory note represented valid debt; Sec. 357(d) did not apply, because the transferred assets aggregate basis exceeded transferred liabilities. A like result was reached in Lessinger, 872 F2d 519 (2d Cir. 1989), in which credence had been given to a shareholder-generated loan receivable held equal to the excess of liabilities assumed over assets transferred.

In Seggerman Farms Inc., 308 F3d 803 (7th Cir. 2002), the taxpayers had apparently overlooked the Sec. 357(c) gain recognition rule. As a result of creditor pressure, the Seggermans incorporated their farming business. The liabilities that the new corporation assumed were significantly in excess of the adjusted basis of the assets transferred. Crucial to their defense was the fact that they had remained secondarily liable as guarantors on all the transferred debt.

The Seggermans argued in Tax Court that there was no enrichment as part of the transfer; they remained liable on all debts. They maintained that Sec. 357(c) should be disregarded after the Tax Court rejected their other arguments. In essence, their arguments were shrouded under the cover of equitable relief.

The Seventh Circuit ruled that the Tax Court had not erred in (1) relying on precedents that sanctioned the automatic trigger of Sec. 357(c) and (2) concluding that there is no requirement that the transferor be relieved of liability. The Tax Court had previously held that the fact that application of Sec. 357(c) could result in gain realization for tax purposes when none really exists is irrelevant. The Seventh Circuit dismissed the taxpayers argument that such precedents were outdated; in fact, it appeared somewhat offended by the proposition that passage of time alone renders precedent less binding.

The Seggermans then referred to Peracchi and Lessinger as the embodiment of a theory based on an emerging equitable interpretation of section 357(c). They claimed that the personal guaranties were analogous to the promissory note and loans receivable of those cases. However, the Seventh Circuit saw no need to either embrace or disavow such theory; it simply found that these cases were entirely distinguishable. Well-established tax principles hold that without economic outlay, personal guarantees of corporate debt should not be afforded treatment as bona fide debt. Sec. 357(c)s plain language mandating gain recognition must control in a guaranty situation.

The Seggermans final suggestion was that the court should exercise its general equitable power to formulate a case-specific exception to the Sec. 357(c) provisions. Although it recognized the resulting harsh tax consequences to the taxpayers, the court declined to disregard the Codes plain language. When a statute is unambiguous on its face, any safeguard against a taxpayers undue hardship is the domain of Congress, not the courts.

Although the Seventh Circuit reached the correct decision based on a literal reading of the statute, the fact pattern in Peracchi, in which debt was created solely to compensate for any imbalance between liabilities and assets transferred, seems to have survived.

From Paul Dailey, CPA, New York, NY