Summary of a Recent
Judicial Development in
Estate Planning and Taxation

Farmers' Basis in Transferred
Assets Are Taxable Gain

Randal Busby
National AgLaw Center Research Assistant

Several taxpayers have brought an action before the United States Court of Appeals for the Seventh Circuit challenging a determination made by the Commissioner of Internal Revenue to recognize as taxable gains certain transfers of property that the taxpayers made to a farming corporation in exchange for stock. Seggerman Farms, Inc. v. Comm'r of Internal Revenue, 308 F.3d 803, 804 (7th Cir. 2002). The Seventh Circuit has affirmed the Commissioner's determination, ruling that the taxable gain resulted in the amount that the liabilities exceeded the taxpayers' adjusted basis in the transferred property. See id. at 807-08.

Ronald and Sally Seggerman, Craig and Linda Seggerman, and Michael Seggerman (collectively, "the Seggermans") were grain and cattle farmers in Illinois. See id. At the request of certain creditors, the Seggermans incorporated their farm into an Illinois corporation in 1993, Seggerman Farms, Inc. ("Seggerman Farms"). See id. In exchange for stock, Ronald, Michael, and Craig Seggerman transferred assets to the corporation subject to liabilities. See id. Seggerman Farms also assumed various farm-related liabilities of Ronald, Michael, and Craig. See id. In each of these instances, "the dollar amount of liabilities transferred to the Corporation exceeded the transferor's adjusted basis in transferred assets." Id. at 804-05.

Seggerman Farms subsequently "refinanced a portion of the transferred debt, incurring debts totaling $300,000" and Seggerman Farms, "with the Seggermans as comakers, borrowed an additional $407,000." Id. The Seggermans remained secondarily liable on all of the transferred debt, even though no particular family member ever directly received any of the loan proceed disbursements. See id. More specifically, "Ronald executed a commercial guaranty and Sally, Craig, Linda, and Michael executed unlimited, continuing personal guaranties of the Corporation's debt." Id.

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." Id.

In October, 1999, the Seggermans filed petitions in the United States Tax Court requesting a redetermination of the deficiencies. See id. 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.

Id.

The Tax Court rejected this argument and affirmed the Commissioner's determinations of deficiency. See id. It concluded that pursuant to I.R.C. § 357(c), the Seggermans were required to recognize a gain on the transfer of assets to Seggerman Farms. See id. (citing Seggerman Farms, Inc. v. Comm'r, T.C. Memo 2001-99 (2001)). The Seggermans appealed the Tax Court's determination to the Seventh Circuit. See id.

The Seventh Circuit explained that the Tax Court's ruling that "I.R.C. § 357(c) requires the Seggermans to recognize a gain on the transfer of property to the Corporation involves a question of law, subject to a de novo review." Id. (citation omitted). It also explained that as a general rule, I.R.C. § 351(a) provides that "'[n]o gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in [I.R.C.] § 368(c)) of the corporation.'" Id. at 805-06 (quoting I.R.C. § 351(a)). It further explained, however, that § 357(c)(1) provides the following exception to the non-recognition provision contained in § 351(a):

[I]f the sum of the amount of the liabilities assumed exceeds the total of the adjusted basis of the property transferred pursuant to [a § 351] 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 base may be.

Id. at 806 (quoting I.R.C. § 357(c)(1)).

The Seggermans argued that "[b]ecause they remained liable as guarantors on the debts assumed by the [c]orporation or debts to which property transferred to the [c]orporation was subject, the amount by which the transferred liabilities exceeded transferred assets should not be recognized as taxable gain." Id. Although they recognized that the amount in question was a gain according to § 357(c), they contended that the controlling precedent was "outdated" and that the court should fashion "a judicial exception to the plain statute language of § 357(c)." Id. The Seventh Circuit rejected these arguments. See id.

The Seggermans asserted that the Tax Court's reliance on the "'strict'" interpretations in Rosen v. Comm'r, 62 T.C. 11 (1974) and Testor v. Comm'r, 327 F.2d 788 (7th Cir. 1964), was improper because Rosen and Testor were "'outdated'" precedents. See id. In Rosen, the Tax Court ruled that "'there is no requirement in section 357(c)(1) that the transferor be relieved of liability' for a gain to be recognized in a transfer of liabilities in excess of assets" and noted that "the provision 'may produce a harsh result [and] . . . may even result in the realization of a gain for tax purposes where none in fact exists." Id. (quoting Rosen, 62 T.C. at 18, 19). In Testor, the Seventh Circuit ruled "'that both the language and the legislative history indicate that § 357(c) is meant to apply wherever liabilities are assumed or property is transferred subject to liability.'" (quoting Testor, 327 F.2d at 790).

"That the interpretations adopted in Rosen and Testor," the court stated, "were either restrictive or mechanical takes nothing away from their precedential value." Id. It added that

[a]fter all, statutory interpretation is precisely the business of the judiciary. It is well within the ambit of this (or any other) Court to interpret statutory language as restrictively or mechanically as it deems appropriate, so long as it respects the bounds of controlling precedent and the Constitution. Nor does the age of the Rosen and Testor holdings diminish their precedential weight, contrary to the Seggermans' assertion that the Tax Court relied on "outdated Court of Appeals decisions, including a 1964 case from this Seventh Circuit Court of Appeals." There is simply no merit to the proposition that precedent somehow becomes less binding solely with the passage of time. In short, the Seggermans provide[d] no controlling case law that overrules Rosen and Testor, and the Tax Court properly relied on that precedent in reaching its decision.

Id. at 806-07.

Relying on Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989) and Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), the Seggermans argued in the alternative that the court should "depart from the law of this jurisdiction in favor of what they term 'the emerging equitable interpretation of section 357(c).'" Id. The Seggermans asserted that because the taxpayers in Lessinger and Peracchi "were permitted to avoid § 357(c)(1) gain recognition despite liabilities transferred in excess of assets" they were "illustrative of . . . [the] emerging equitable interpretation" of § 357(c). Id.

In Lessinger, "a loan receivable owed by the taxpayer equal in amount to the excess of liabilities transferred over assets was recorded on the corporate books of the transferee corporation." Id. (citation omitted). In Lessinger, the Second Circuit determined that the "the loan receivable represented a genuine debt, and thus the taxpayer realized no gain on the transfer under § 357 because liabilities transferred equaled assets transferred." Id. (citation omitted).

In Peracchi, "a taxpayer transferred encumbered real property to his wholly-owned corporation, and liabilities transferred exceeded his adjusted bases in the transferred property by $566,807." Id. (citation omitted). In addition, the taxpayer contributed to the corporation a $1,060,000.00 note. See id. (citation omitted). In that case the Ninth Circuit ruled that "the taxpayer had a basis of $1,060,000 in the note, that the note represented genuine indebtedness, and that, therefore, the aggregated basis of transferred property exceeded transferred liabilities" and that there was no taxable gain recognized on the taxpayer's transfer. Id. (citation omitted).

The court stated that Lessinger and Peracchi were distinguishable from the present case because "'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. [Their] guaranties do not constitute economic outlays.'" Id. (citations omitted). It added that

[t]hus, to the extent that any such "emerging equitable interpretation" can be gleaned from the cases upon which the Seggermans rely, those cases are entirely distinguishable from this one. Accordingly, we hold that where a taxpayer retains liability as a guarantor on debts transferred pursuant to I.R.C. § 351, the plain language of § 357(c) nonetheless requires that the amount by which transferred liabilities exceed the taxpayer's basis in the transferred assets be recognized as taxable gain.

Id. at 808.

The case was decided on Oct. 24, 2002; this summary was posted Dec. 23, 2003.