In a variety of contexts the "assumption" of a liability can trigger recognition of gain from a disposition of property that is otherwise tax-deferred. For example, in an installment sale, the excess of the liabilities assumed over the tax basis of the transferred property is treated as a "payment" received by the taxpayer in the year of sale and is reportable as gain. Temp. Reg. § 15A.453-1(b)(3)(i). Similarly, a taxpayer engaging in a section 1031 exchange is treated as receiving "boot" (and is required to recognize any realized gain) to the extent that the liabilities assumed by the exchange counterparty exceed the liabilities assumed (plus the cash paid) by the taxpayer in the exchange. Reg. § 1.1031(b)-1(a) and (c).
Liability assumptions can also produce gain recognition or other tax consequences when property is transferred to or from a corporation or partnership. For example, when a taxpayer transfers property to a controlled corporation in exchange for stock, the taxpayer is required to recognize gain under section 357(c) if the corporation "assumes" liabilities of the taxpayer in excess of the tax basis of the transferred property. Likewise, a liability "assumed" by a partnership in connection with a property contribution by a partner can, in certain circumstances, be included in the sale price of property deemed sold to the partnership (See Reg. § 1.707-5), or, in other contexts, treated as a deemed distribution to, or contribution by, the partner that affects the partner's tax basis in its partnership interest or, in some circumstances, produces gain (See section 752(a) and (b)).
In these situations and others, the question often arises as to whether the taxpayer can avoid the adverse tax consequences of a debt assumption by an agreement to remain liable for the debt. A recent decision sheds considerable light on how the Seventh Circuit Court of Appeals views this issue. Seggerman Farms, Inc. v. Commissioner, 90 AFTR 2d 2002-6981 (7th Cir. 2002).
Background
In Seggerman Farms members of the Seggerman family had operated a farm as a joint venture until 1993, when they incorporated the farm at the request of their creditors. In exchange for stock and the corporation's assumption of certain secured and unsecured debts, the Seggermans arranged for the transfer of the farm assets to the corporation. The Seggermans remained secondarily liable as guarantors on all of the transferred debt.
In their tax returns the Seggermans reported no gain from the exchange, taking the position that the transaction qualified in its entirety as a tax-free transfer of assets under section 351. The IRS proposed deficiencies, based on the contention that the liabilities transferred to the corporation exceeded the adjusted basis of the transferred assets and, to that extent, the taxpayers received taxable "boot" in the exchange under section 357(c), as in effect before the 1999 amendments to section 357, which are discussed below. The Seggermans argued that section 357(c) did not apply and, therefore, they were not required to report gain from the transaction, because they remained personally liable on all of the debt assumed by the corporation by virtue of their guaranties.
In a Memorandum decision, the Tax Court (Judge Cohen) rejected the Seggermans' argument. The court applied a literal reading of section 357(c), holding that the statute applied to any debt assumption, without regard to whether the transferor remained liable on the assumed debt.
The Seventh Circuit
The Seventh Circuit affirmed. In his opinion, Judge Bauer rejected the Seggermans' contention that the guaranties prevented debt assumptions from occurring, even though the guaranties ensured the transferors' continuing exposure to liability for the debts. The court followed an earlier Seventh Circuit precedent (Testor v. Commissioner, 327 F.2d 788, 790 (7th Cir. 1964)), which had established that it is the transferee's assumption of liability, not the transferor's relief from liability, that determines whether a liability has been assumed for purposes of section 357(c).
The court distinguished several earlier decisions that had permitted taxpayers to avoid gain under section 357(c) by issuing promissory notes to the transferee corporations. Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), and Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989). In these cases the IRS had argued (see Rev. Rul. 68-629, 1968-2 C.B. 154) that the transferor's promissory note should be regarded as an asset with a zero basis and, therefore, no effect on the computation of gain under section 357(c). Peracchi and Lessinger rejected the IRS argument, concluding that the adjusted basis of the transferor's note should be regarded as equal to its face amount, which had the effect of rendering section 357(c) inapplicable to the transaction.
In Seggerman Farms, the Seventh Circuit held that Peracchi and Lessinger were distinguishable, because the Seggerman's guaranties were mere conditional promises to pay and did not represent "economic outlays" of the kind involved in Peracchi and Lessinger.
Observations
In 1999 Congress amended section 357 (for years not involved in Seggerman Farms) to add new subsection (d) for the purpose of clarifying when a debt is assumed for section 357 and other purposes. Miscellaneous Trade and Technical Corrections Act of 1999 (the "1999 Act"), Pub. L. 106-36, § 3001(e). Section 357(d) treats a recourse liability as assumed if "the transferee has agreed to, and is expected to, satisfy such liability . . . , whether or not the transferor has been relieved of such liability." It also treats a nonrecourse debt as "assumed" by any transferee of an asset that secures the liability (unless, and to the extent that, the liability is secured by the assets of another person and such other person has agreed to (and is expected to) satisfy the liability).
This change was not limited to section 357(c). In fact the 1999 Act extended these concepts of debt assumption to various other reorganization provisions (sections 368(a)(1)(C) and 368(a)(2)(B) (relating to "C" reorganizations), 584(h)(3) (relating to transfers to certain investment companies), and 1031(d) (relating to like kind exchanges) and authorized the IRS to promulgate regulations specifying other areas of the tax laws to which the section 357(d) debt assumption rule should apply. Pursuant to this authority the IRS extended the section 357(d) definition of debt assumption to distributions under section 301. Reg. § 1.301-1(g).
The 1999 Act effectively disposes of the specific issue raised in Seggerman Farms for future transactions. Under section 357(d), a mere guaranty will usually be insufficient to prevent a debt assumption from occurring, where the facts establish that the transferee agrees to assume the liability and is expected to be the primary source of payment.
However, Seggerman Farms continues to have implications outside of areas covered by section 357(c) and the 1999 Act (e.g., partnership transfers). It confirms that in the Seventh Circuit, the retention of liability for a debt by a transferor of property is not by itself enough to prevent an assumption of the debt from occurring for tax purposes, unless the transferor retains primary, rather than secondary, liability for repayment of the debt.
In addition, the Seventh Circuit's analysis of Peracchi and Lessinger suggests that in the Seventh Circuit, a taxpayer can avoid a debt assumption by issuing an offsetting promissory note, which was not addressed in section 357(d).