Opposition Brief — Owen v. Commissioner

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WILLIAM F. OWEN AND GRETCHEN K. OWEN,

PETITIONERS

Vv.

-

| COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

KENNETH W. STARR

- Solicitor General

SHIRLEY D. PETERSON

Assistant Attorney General

RICHARD FARBER

Attorney

Department of Justice

Washington, D.C. 20530

(202) 633-2217

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QUESTION PRESENTED

Whether a taxpayer who transfers property to a

controlled corporation realizes taxable gain on the

transfer under Section 357(c) of the Internal Reve-

nue Code to the extent the transferred property is

subject to liabilities that exceed his adjusted basis in

the property, even though the taxpayer remains per-

sonally liable for those liabilities following the

transfer.

(1)

TABLE OF CONTENTS

Page

Opinions below ......................-- so 8 EE SEL PORE RO ATO 1

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TABLE OF AUTHORITIES

Cases:

Commissioner V. Asphalt Products Co., 482 U.S.

+ eet I ea a 9

Commissioner V. Tufts, 461 U.S. 300 (1983) ........ 7

Griffin v. Oceanic Contractors, Inc., 458 U.S. 564

i cen ananasositiinmnibiabppsicee 6

Lessinger V. Commissioner, 872 F.2d 519 (2d Cir.

ORE 2 an 9

McEachron v. Commissioner, 873 F.2d 176 (8th

ree Ae SE a 4

Rosen Vv. Commissioner, 62 T.C. 11 (1974), aff’d,

Be ee CUE Gs BOUT ercccicccccincecenstceccneccsene 7,8

Smith yv. Commissioner, 84 T.C. 889 (1985),

aff’d, 805 F.2d 1073 (D.C. Cir. 1986) ................. 6-7

United States v. Ron Pair Enterprises, Inc., 109

a cnachimienmensiodeses 6

Statutes:

Internal Revenue Code of 1954 (26 U.S.C.) :

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(III)

Iu the Supreme Court of the United States

OCTOBER TERM, 1989

No. 89-715

WILLIAM F. OWEN AND GRETCHEN K. OWEN,

PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FORA WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. Al-

A8) is reported at 881 F.2d 832. The memoranduin

opinion of the Tax Court (Pet. App. A9-A25) is re-

ported at 53 T.C.M. (CCH) 1480.

JURISDICTION

The judgment of the court of appeals was entered

on August 9, 1989. The petition for a writ of cer-

tiorari was filed on November 2, 1989. The jurisdic-

tion of this Court is invoked under 28 U.S.C. 1254

(1).

(1)

2

STATEMENT

1. In 1977, petitioner William F. Owen and Step-

hen McEachron formed a general partnership called

McO Investment (McO), in which they were equal

partners.’ In 1980, petitioner and McEachron en-

tered the seismic drilling business. They borrowed

money to buy drilling equipment, personally guar-

anteeing the loan and giving the lender a security

interest in the equipment, and they placed title to the

equipment in the partnership. The partners then

leased most of the equipment to Western Exploration,

Inc., a corporation in which petitioner and McEach-

ron each owned 50% of the shares, and Western

proceeded to conduct the seismic drilling operations.

Pet. App. A2, A10-A12.’?

The seismic drilling venture was unsuccessful.

Petitioner and McEachron decided in 1981 to aban-

don their efforts and to sell the entire venture. They

believed that the sale of their business could be more

readily accomplished if it were first combined into a

single entity. Accordingly, petitioner and McKachron

decided to transfer ownership of the drilling equip-

1 Petitioner Gretchen K. Owen is a party to this suit solely

by virtue of having filed a joint return with her husband

William; accordingly, references to “petitioner” are to Wil-

liam F. Owen.

2 Petitioner and McEachron chose to have McO own the

equipment and Western conduct the drilling operations be-

cause the partnership’s ownership of the equipment would

allow them to claim the investment tax credit and deprecia-

tion deductions associated with the equipment on their in-

dividual tax returns, while the use of a corporation to conduct

the drilling operations would provide them with protection

against personal liability in case of a catastrophe. Pet. App.

All.

3

ment from McO to Western and then sell their stock

in Western. The equipment transfer was effected on

December 31, 1981. As of that date, the transferred

equipment was subject to liabilities of $988,008,

which exceeded McO’s adjusted basis in the equip-

ment by approximately $200,000. Pet. App. A8, A12-

A138.

2. On audit, the Commissioner determined that,

pursuant to Section 357(c) of the Internal Revenue

Code,* McO realized taxable gain on the transfer of

its drilling equipment to Western to the extent the

liabilities to which the equipment was subject ex-

ceeded McO’s adjusted basis in the equipment.* The

Commissicner’s resulting adjustments to McO’s in-

come produced corresponding deficiencies in the in-

come tax of its two partners, petitioner and McEach-

ron. Each partner petitioned the Tax Court for re-

determination of the asserted deficiencies, and their

cases were consolidated for trial and opinion. Pet.

App. A10.

The Tax Court ruled in favor of the Commissioner

(Pet. App. A9-A24). Petitioners’ principal conten-

tion in the Tax Court with respect to the Section

357(c) issue was that, pursuant to an oral agree-

3 Unless otherwise noted, all statutory references are to

the Internal Revenue Code of 1954 (26 U.S.C.), as amended

(the Code or I.R.C.).

* Section 357(c) (1) of the Code provides that, in the case

of a transfer of property by a taxpayer to a controlled cor-

poration, “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 * * *, then such excess shall be considered as a

gain from the sale or exchange of a capital asset or of prop-

erty which is not a capital asset, as the case may be.”

4

ment with the Wayzata Bank that was in effect by

December 31, 1981, the bank had released its security

interest in the transferred equipment to the extent

that interest exceeded McO’s adjusted basis in the

equipment. Therefore, petitioners argued, the liabil-

ities to which the transferred property was subject

did not exceed the adjusted basis of the property, and

Section 357(c) did not require the recognition of any

gain on the transfer. See Pet. App. Al9. The Tax

Court found as a factual matter, however, that the

bank did not agree to the reduction of its security

interest until September 1982. It also concluded that

this agreement should not be treated as retroactive to

December 1981. The court thus concluded that at the

time of the equipment transfer the liabilities to which

the property was subject did exceed McO’s adjusted

basis, resulting in taxable gain under Section 357(c).

Pet. App. A21-A23.°

3. On petitioners’ appeal, the Ninth Circuit af-

firmed (Pet. App. Al-A8).° The court declined to

5 The Tax Court did agree with petitioners’ contention that

a $100,000 certificate of deposit pledged by the partners as

additional security for the debt owed to the Wayzata Bank

should be treated as a reduction in the amount of indebted-

ness to which the equipment was subject on the date it was

transferred to Western. Pet. App. A23-A24. This treatment

produced a corresponding $100,000 reduction in the amount

of gain that McO was deemed to have realized on the transfer

under Section 357(c) (1). The Commissioner did not appeal

the Tax Court’s ruling on this issue.

® McEachron, a resident of Minnesota at the time he filed

his Tax Court petition, appealed to the Eighth Circuit advanc-

ing the same arguments as petitioners. The Eighth Circuit

also affirmed the decision of the Tax Court, McEachron Vv.

Commissioner, 873 F.2d 176 (1988), and McEachron did not

seek certiorari.

5

disturb the Tax Court’s conclusion that, despite the

1982 agreement of the bank to reduce the liabilities

encumbering the property, the liabilities did exceed

the partnership’s adjusted basis in the property at the

time of the transfer (id. at A8).’ The court also re-

jected petitioners’ alternative argument that, even if

the liabilities did exceed the adjusted basis in the

equipment at the time of the transfer, Section 357

should not require the recognition of taxable gain be-

cause petitioner remained personally liable for the

indebtedness to which the property was subject and

therefore he received no economic benefit as a result

of the transfer. The court held that, under the statu-

tory scheme enacted by Congress, petitioner’s contin-

uing personal liability for the loans secured by the

transferred equipment is irrelevant. Pet. App. A5-

A8.

ARGUMENT

The court of appeals correctly rejected petitioners’

contention that the plain terms of Section 357 (c) (1)

should be disregarded and instead a limitation read

into the statute to the effect that liabilities to which

transferred property is subject may be ignored in

computing the transferor’s gain under Section 357, to

the extent the transferor remains personally liable

for the indebtedness secured by the transferred prop-

erty. The court of appeals’ decision accords with the

decisions of the other courts of appeals that have con-

sidered this issue, and it does not confiict with any

decision of this Court. Accordingly, there is no rea-

son for review by this Court.

7 Petitioners do not seek review of this aspect of the Ninth

Circuit’s decision.

6

1. The general rule of Section 351(a) of the Code

is that no gain or loss is recognized by a taxpayer on

the transfer of property to a corporation controlled

by him. Section 857(c)(1) expressly establishes an

exception to that rule. If, in the case of a Section 351

transfer, the sum of the liabilities assumed by the

transferee plus the amount of the liabilities to which

the property is subiect exceeds the adjusted basis of

the transferred property, then that excess “shall” be

considered as taxable gain to the transferor. Peti-

tioners do not challenge in this Court the factual de-

terminations that the partnership transferred prop-

erty to acontrolled corporation and that the liabilities

to which the property was subject exceeded the part-

nership’s adjusted basis in that preperty. Thus, the

plain terms of Section 357(c) (1) dictate the result

reached by the courts below.

Petitioners contend, however, that the partnership

should not be treated as having realized any taxable

gain on the transfer because the partners remained

personally liable for the loans secured by the trans-

ferred property. But petitioners do not suggest how

the text of Section 357(c) (1) can be read to support

this rule. Nor do they provide any arguable basis for

disregarding the apparent meaning of the statutory

language since they suggest no reason for believing

that the result, reached below is at odds with the in-

tent of Congress. See, e.g., United States v. Ron Pair

Enterprises, inc., 109 S. Ct. 1026, 1031 (1989) ;

Griffin v. Oceanic Contractors, Inc., 458 U.S. 564, 571

(1982). Thus, the partners’ personal liability for the

indebtedness provides no basis for departing from

the taxable gain consequences required by the plain

statutory text, and the courts consistently have so

held. See Smith v. Commissioner, 84 T.C. 889, 909

7

(1985), aff'd, 805 F.2d 1078 (D.C. Cir. 1986)

(Table); Rosen v. Commissioner, 62 T.C. 11, 19

(1974), aff’d, 515 F.2d 507 (8d Cir. 1975) (Table) ;

McEachron v. Commissioner, 873 F.2d 176 (8th Cir.

1988).

Moreover, contrary to the main thrust of the peti-

tion, there is nothing unreasonable or unfair about

the application of Section 357(c) (1) in the circum-

stances of this case. Petitioners’ assertion (Pet. 19-

24) that the partners realized no economic benefit as

a result of the transfer of the equipment from McO

to Western ignores the fact that they obtained sub-

stantial tax benefits through the accelerated deprecia-

tion deductions claimed by McO with respect to that

equipment. As the Tax Court has explained, Section

357(c)(1) “is analogous to other recapture provi-

sions in the Code”; its purpose is to recapture tax

deductions attributable to property acquired with bor-

rowed funds, where the property is transferred to a

controlled corporation and the liabilities to which the

property is subject (or that are assumed by the

transferee) exceed the transferor’s adjusted basis in

the property. See Rosen v. Commissioner, 62 T.C. at

19 n.3.

Upon its purchase of the drilling equipment in

question, McO acquired a depreciable basis in the

equipment equal to its cost. I.R.C. § 1012. This cost

basis included the amount of the liabilities to which

the equipment was subject by virtue of the financing

arrangement between McO and the Wayzata Bank.

See Commissioner v. Tufts, 461 U.S. 300 (1983).

McO’s basis in the equipment was adjusted down-

ward.as it claimed depreciation deductions with re-

spect to the equipment. I.R.C. §§ 167, 1016. It is

because of this downward adjustment ir McO’s basis

in the equipment (reflecting its recovery of its in-

iii

8

vestment through depreciation), without a corre-

sponding reduction in the indebtedness encumbering

the property, that the liabilities to which the equip-

ment was subject exceeded McO’s adjusted basis on

——the date of the equipment transfer. In enacting Sec-

tion 357(c)(1), Congress considered it likely that,

in order to avoid foreclosure, the new owner of trans-

ferred property that is subject to Habilities will sat-

isfy those liabilities regardless of whether it has any

personal obligation to do so. Absent the recapture

nrovisions of Section 357(c) (1), the satisfaction of

those liabilities by the transferee would result in un-

warranted tax benefits for the transferor because the

transferor has already received the benefit of depre-

ciation deductions-computed on the assumption that

he would satisfy the liabilities to which the property

is subject. See Rosen v. Commissioner, 62 T.C. at

19 n.3.

Thus, petitioner’s continuing liability for the in-

debtedness secured by the equipment transferred to

Western is irrelevant; the statutory scheme is based

on the expectation that the new owner of the property

(i.e., Western) will satisfy that indebtedness. If this

assumption proves unfounded, it will result in no un-

fairness to the partners, as petitioners candidly rec-

ognize (see Pet. 16). In that event, the partners’

basis in their Western stock would be increased to

reflect the reduction of indebtedness, which would

serve to increase their loss or reduce their gain on

their disposition of that stock.

In essere, petitioners’ complaint is that the statu-

tory scheme is founded on-the wrong assumption,

which, they assert, can affect the “timing and char-

acter” of the tax (Pet. 16). In petitioners’ view,

where the transferor of property remains personally

9

liable for indebtedness to which the transferred prop-

erty is subject, it should be presumed that the trans-

feror, not the transferee, will satisfy those liabilities.

If so, the transferor should not be treated as realiz-

ing gain at the time of the transfer, but rather

should realize gain only in the event that it is the

transferee who satisfies the indebtedness. The sim-

ple answer to petitioners’ argument is that, while

Congress could have chosen to adopt such a statutory

scheme based on the assumption that the transferor

will satisfy the liability, it clearly did not do so. The

courts below correctly applied the statute that Con-

gress cnose to enact. See Commissioner v. Asphait

Products Co., 482 U.S. 117, 121 (1987).

2. Contrary to petitioners’ contention (Pet. 12-14,

17-19), the decision below does not conflict witn that

of the Second Circuit in Lessinger v. Commissioner,

872 F.2d 519 (1989). In that case, the transferor, at

the time of a transfer that on its face appeared to

come within Section 357(c) (1), obiigated himself to

pay the transferee an amount equal to the excess of

the liabilities assumed by the transferee over the ad-

justed basis of the property subject to those liabili-

ties. This obligation was entered on the transferee’s

books as a receivable due from the transferor, and

the transferor subsequently gave the transferee a

note evidencing his obligation to pay the amount of

the receivable. Although the Tax Court was of the

view that the receivable had no effect on the ap-

plicability of Section 357(c)(1), the Second Circuit

reversed. It held that the receivable constituted addi-

tional property transferred to the transferee and that

the property had a basis in the transferee’s hands

equal to the face value of the transferor’s obligation.

872 F.2d at 525-526. Under this analysis, the liabil-

ities to which the transferred property was subject

10

did not exceed the adjusted basis of the transferred

property, and, consequently, the court of appeals held

that the transferor recognized no gain on the trans-

fer under Section 357(c) (1).

While the correctness of the Second Circuit’s deci-

sion is, in our view, open to question, its holding does

not conflict with the decision below. The court in

Lessinger held that no gain was realized on the trans-

fer because, after taking into account the receivable

due from the transferor, the liabilities to which the

transferred property was subject did not exceed the

adjusted basis of that property. In other words, the

Second Circuit held that no gain was realized be-

cause, in its view, there had not been a transfer that

came within the terms of Section 357(c)(1). That

holding is fully consistent with the decision below

that when a transfer does come within the statute,

gain must be recognized in accordance with its terms,

notwithstanding the fact that the transferor remains

personally liable to a bank for the indebtedness to

which the transferred property is subject.

CONCLUSION

The petition for a writ of certiorari should be

denied.

Respectfully submitted.

KENNETH W. STARR

Solicitor General

SHIRLEY D. PETERSON

Assistant Attorney General

RICHARD FARBER

Attorney

JANUARY 1990

WY U. S. GOVERNMENT PRINTING OFFICE; 1990 262203 726