Drybrough v. CIR, 16525.

• Decision Date: 30 March 1967
• Docket Number: No. 16525.,16525.
• Citation: 376 F.2d 350
• Parties: F. W. DRYBROUGH et al., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Sixth Circuit

376 F.2d 350 (1967)

F. W. DRYBROUGH et al., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 16525.

United States Court of Appeals Sixth Circuit.

March 30, 1967.

COPYRIGHT MATERIAL OMITTED

Rucker Todd, Louisville, Ky., for petitioners, Brown, Ardery, Todd & Dudley, Louisville, Ky., of counsel.

Robert A. Bernstein, Tax Division, Dept. of Justice, Washington, D. C., for respondent, John B. Jones, Jr., Acting Asst. Atty. Gen., Lee A. Jackson, David O. Walter, Herbert Grossman, Attys., Dept. of Justice, Washington, D. C., on the brief.

Before O'SULLIVAN and CELEBREZZE, Circuit Judges, and McALLISTER, Senior Circuit Judge.

O'SULLIVAN, Circuit Judge.

This matter is before us on the petition of taxpayers, F. W. Drybrough and the executor of the estate of his deceased wife, Citizens Fidelity Bank & Trust Company, to review a decision of the Tax Court of the United States, reported as Drybrough v. Commissioner, 42 T.C. 1029 (1964). Conduct by F. W. Drybrough is primarily involved and we shall refer only to him as the taxpayer or petitioner. The issues before us are (1) the tax effect of the assumption of liabilities in connection with transfers by Drybrough to controlled corporations, and (2) the deductibility of interest paid on certain mortgage indebtedness. The Tax Court opinion sets out in extensive detail the complicated transactions that provide the background of the case before us, and we relate here only such facts as are relevant to the conclusions we reach.

Commencing in the twenties and continuing to the time of the events here involved, Drybrough had been a successful investor in downtown Louisville real estate and, with his wife, also operated a successful mercantile collection agency. To implement acquisition of various holdings, he borrowed heavily from banks and insurance companies. Thus in 1940, 1945 and 1946, years of relevance here, Drybrough borrowed, on the security of his real estate holdings, the sums of $200,000.00, $200,000.00 and $500,000.00, respectively, from the National Life and Accident Insurance Company (National Life). These borrowings were generally used to pay off or consolidate balances of existing mortgages or to acquire additional parcels of real estate.

On April 3, 1953, Drybrough borrowed $700,000.00 from National Life, secured by a mortgage on several parcels of real estate. Of such monies, $357,185.16 was used to pay off his 1946 loan from National Life and some other debts and expenses. The balance, $342,814.84, was deposited in Drybrough's commercial account with the Liberty National Bank & Trust Co. of Louisville. In May, following, Drybrough withdrew from this account $203,602.00 and transferred such sum to an account styled "Public Garage, M. S. Drybrough, owner," allegedly as partial payment of principal and the accrued interest due upon a note of $260,000.00 which he had, on January 1, 1952, given to his wife to evidence an indebtedness to her. Although the Public Garage account into which this sum was deposited was in Marion's name, Drybrough had power to draw checks on it. It may be assumed that it was he who subsequently proceeded to buy, in Marion's name, $200,000 of tax exempt securities, paying for them out of the Public Garage account funds.

In 1957 Drybrough still owed $600,000 on the 1953 loan from National Life. At that time he desired to incorporate certain of his real estate holdings and have the resulting companies take over the payment of the 1953 mortgage balance. In suggesting a way this result could be achieved, Drybrough, on February 27, 1957, wrote to the mortgagee, National Life, saying:

"I would like to have this blanket mortgage (the 1953 $700,000 borrowing) broken into four direct mortgages and suggest $250,000.00, $100,000.00, $75,000.00 and $175,000.00. I would pay anything over and beyond $600,000 owing at the time of executing the new mortgages and cancelling the old.

"As you and Mr. Weaver know and as I explained to you in person several months ago, I have been waiting to incorporate some of my properties and interests for quite a long time."

But this approach was abandoned because new separate mortgages would have called for higher rates of interest and less favorable prepayment terms. Accordingly, Drybrough decided simply to have each of the corporations he planned on creating assume a share of the already existing mortgage. This was done; on June 1, 1957, he transferred to four newly organized corporations, each named by its Louisville street address, four parcels of real estate subject to the 1953 mortgage; each of the corporations agreed to pay an assigned share of that mortgage. Drybrough received all of the issued shares of stock of the respective corporations, and shortly thereafter made a gift of 40% of such shares to his son, F. W. Drybrough, Jr.

On March 15, 1957, Drybrough borrowed the sum of $150,000 from the Liberty Bank of Louisville, mortgaging a property known as 620 South Fifth Street. This property was once a part of the security for the 1953 loan, but had been released therefrom in 1956. Relevant to this property, Drybrough had, in 1956, included in a letter to National Life the observation that, "620 South Fifth and the Mexican Village property are both clear and I am eager to mortgage them to the limit before combining these two properties in a corporation." The proceeds of this $150,000 loan were deposited in Drybrough's commercial account at the Liberty Bank. Drybrough testified that he had an original intention to use this money to acquire some additional property, but the specific proceeds were not so employed; they were disbursed by Drybrough primarily to purchase tax exempt securities. He did, however, use other of his funds to purchase two parcels of property costing over $150,000. After putting the $150,000 mortgage on the 620 South Fifth Street property, he conveyed, by gift, an undivided 40% interest in the fee thereof to his son. Thereafter on June 28, 1957, the father and son transferred this property to a new corporation, 620 South Fifth Street, Inc., in exchange for 60% and 40%, respectively, of that company's issued shares. The corporation took title to the property subject to the $150,000 mortgage and assumed and agreed to pay its then balance of $149,000.

A total of five corporations were thus created in 1957, four of them assuming the balance unpaid on the 1953 mortgage, and the fifth assuming the 1957 mortgage. We have set out in the margin their names, their dates of incorporation, the fair market values of the transferred properties, Drybrough's total basis in these properties and the amount of liability assumed by each corporation.¹

On their joint tax return for 1957, Drybrough and Marion reported $223,806.12 as long term capital gain arising from the transfers of the properties to, and the assumption of liability by, the newly created controlled corporations. That sum represented the total amount by which the mortgage debt assumed by the transferee corporations exceeded Drybrough's basis in the respective assets transferred; such amount would be taxable under Int.Rev.Code, 1954, Section 357(c) (1), and the taxpayer's return assumed that the gain on the transfers was not otherwise taxable by virtue of the provisions of § 357(a) of the Code. We set out §§ 357(a) and 357(c) (1) below.² The Commissioner, however, assessed a deficiency, claiming that Section 357(b) IRC 1954,³ controlled, on his assertion that Drybrough had failed to prove that his principal purpose in arranging these transactions was not that of tax avoidance and was not for a bona fide business purpose and, therefore, the assumption of the liabilities should be treated as money received on the exchange. A deficiency of $170,306.89 was assessed for the year 1957.

The Commissioner also disallowed Drybrough's deduction of the interest paid on $200,000.00 of the $700,000.00 borrowed in 1953, on the claim that this sum was used to purchase tax exempt securities. Section 265(2) IRC 1954 forbids such deduction.⁴ A deficiency arising from the disallowance of these interest deductions was accordingly assessed.

The Tax Court sustained the Commissioner's determinations in the above respects. We reverse the Tax Court's holding that the assumption of a total of $600,000.00 of the 1953 borrowing by the four corporations organized on June 1, 1957, was taxable in full. We affirm its holding as to the assumption of the $149,000 mortgage by 620 South Fifth Street, Inc. (the 1957 borrowing); and we affirm the disallowance of the interest paid on $200,000 of the 1957 mortgage of $700,000.

1) 1957 corporate assumptions of 1953 mortgage debt.

Until the Supreme Court's 1938 decision in United States v. Hendler, 303 U.S. 564, 58 S.Ct. 655, 82 L.Ed. 1018 (1938), taxpayers and the Treasury Department had assumed that no taxable event occurred when a taxpayer transferred encumbered assets to a controlled corporation which assumed the obligations of the encumbrance. Such an assumption was not considered as "other property or money" as those terms were used in Code sections precedent to §§ 351 IRC 1954 and 112(b) (5) IRC 1939, the sections which provided for the familiar "tax free exchanges" identified under the term "Transfer to Corporation Controlled by Transferor." The simplest form of such a tax free exchange was the changing of a business enterprise from a proprietorship to the corporate form. Even though the assets transferred had acquired a market value in excess of their cost, or base, and consequently the stock shares received by the transferor were worth the enhanced value of the transferred assets, still no taxable gain was then realized. Such gain, however, did not escape taxation because upon subsequent sale or other transfer, the stock shares carried the same basis as the original assets that had been transferred. The Hendler decision, however, held that the amount of such an assumed obligation was equivalent...