Easson v. CIR

• Court: U.S. Court of Appeals — Ninth Circuit
• Writing for the Court: ORR, BARNES and MERRILL, Circuit
• Citation: Easson v. CIR, 294 F.2d 653 (9th Cir. 1961)
• Decision Date: 08 September 1961
• Docket Number: No. 17170.,17170.
• Parties: Jack L. EASSON, June B. Easson, and Envoy Apartments, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Jack L. EASSON, June B. Easson, and Envoy Apartments, Respondents.

294 F.2d 653 (1961)

Jack L. EASSON, June B. Easson, and Envoy Apartments, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Jack L. EASSON, June B. Easson, and Envoy Apartments, Respondents.

No. 17170.

United States Court of Appeals Ninth Circuit.

September 8, 1961.

Nathan L. Cohen, Ralph R. Bailey and Maguire, Shields, Morrison, Bailey & Kester, Portland, Or., for petitioner.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Melva M. Graney, Kenneth E. Levin, Dept. of Justice, Washington, D. C., for respondent.

Before ORR, BARNES and MERRILL, Circuit Judges.

BARNES, Circuit Judge.

The Tax Court had jurisdiction to hear taxpayer's¹ petition to redetermine a deficiency asserted by the Commissioner (§ 272(a) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 272(a)). This court has jurisdiction on appeal (§ 7482, Internal Revenue Code of 1954, 26 U.S.C.A. § 7482).

In 1952 taxpayer owned and operated an apartment house in Portland, Oregon. On June 19, 1952, taxpayer encumbered the apartment house with a $250,000 mortgage, taxpayer himself signing and assuming personal liability on the notes underlying the mortgage. In October of 1952, taxpayer formed the Envoy Apartments, an Oregon corporation, and transferred the property, subject to the mortgage, to the corporation in exchange for all of its capital stock. Taxpayer, however, remained personally liable on the notes. The Tax Court found that taxpayer had a legitimate business purpose in consummating this transaction and that his principal purpose was not tax avoidance.

At the time of the transfer, the basis of appellant's property was $87,214.86, and its fair market value was $320,000. The principal balance of the mortgage was $247,064.01. Taxpayer and his wife, on their 1952 returns, reported no gain in connection with the transfer of the apartment to the corporation. They claimed that the transfer was tax free under § 112(b) (5), Internal Revenue Code of 1939, 26 U.S.C.A. § 112(b) (5). The Commissioner, however, determined that taxpayer realized a gain on the transaction and determined further that such gain was taxable at ordinary income tax rates rather than at capital gains rates.

I. The Tax Court's Decision

The Tax Court agreed fully with neither the Commissioner nor the taxpayer. It held that only a portion of the gain should be recognized and taxed in 1952. The taxable portion, the court held, was the difference between taxpayer's basis ($87,214.86) and the principal balance on the mortgage ($247,064.01), viz. $159,849.15. Of this amount part was taxable at ordinary income rates and part at capital gains rates. The portion of the gain allocated to depreciable assets (the building) was taxable at ordinary income rates, while the portion of gain attributable to the land was taxed at capital gains rates. This result derives from the court's interpretation and interrelation of §§ 112(b), 112(c), 112(k), 113(a) and 117(o) of the Internal Revenue Code of 1939, 26 U.S.C.A. §§ 112(b, c, k), 113(a), 117(o).

Section 112(b) (5) provides that no gain or loss is to be recognized when property is transferred to a corporation solely in exchange for stock of the corporation, if immediately after the transfer, the transferor is in control of the corporation. Thus, at first blush, it would appear that taxpayer should prevail; he exchanged the apartment for stock of the corporation and immediately after the exchange he was in control of the corporation. He has met the requirements of § 112(b) (5). But there was more to the transaction than just an exchange of an apartment house for stock. The apartment was transferred subject to a mortgage and this circumstance can, in some circumstances, alter the tax consequences of the transaction. Subsection (c) (of § 112) provides that gain will be recognized in a § 112(b) (5) transaction to the extent that "boot," i. e., money or property other than stock, is received by the taxpayer. Can the transfer of encumbered property be considered as the receipt of "boot"? Section 112(k) provides a clear answer to this question.² It provides that the transfer of property subject to a liability does not constitute the receipt of money or other property within the meaning of § 112(c), and the existence of the encumbrance does not disqualify the exchange for tax-free treatment under § 112(b) (5) — unless the purpose of the taxpayer, in this regard, was tax avoidance or was not a bona fide business purpose. The burden to establish his exemption is on the taxpayer. Here, however, the Tax Court specifically found that taxpayer was not principally motivated by considerations of tax avoidance and that he had a bona fide business purpose. Thus, taxpayer met the test of the specific provisions of § 112(k); the provisions of § 112(c) are, therefore, inapplicable to this transaction. It would seem, then, that the entire transaction comes within § 112(b) (5), and that no gain should yet be recognized. Nevertheless, the Tax Court did not so hold.

The Tax Court noted that a statute must be construed in accordance with its purposes and must not be so interpreted as to lead to "absurd results." The purpose of § 112(b) (5) is not to exempt gain from taxation but to postpone the taxable event to a later time. This postponement is effectuated by adjusting the basis of the stock which the taxpayer receives in the tax free exchange. Under § 113(a) (6), the basis of the stock is the basis of the property transferred, decreased, however, by the amount of money received, including for purposes of this section the amount of the mortgage, and increased by any gain recognized. Thus, unrecognized gain is retained as a potential liability by reducing the basis of taxpayer's stock.

As an example, if a taxpayer in a § 112 (b) (5) transaction transfers property worth $10,000 which cost him $1,000, he has an unrecognized gain of $9,000. Since his stock takes the same basis as the property transferred (viz. $1,000), he will recognize the gain when he sells the stock at a later date (presumably at $10,000). If the property transferred were subject to a $500 mortgage, taxpayer would have an additional gain of $500, the gain being currently unrecognized, however, by virtue of § 112(k). This additional gain would be postponed by reducing the basis of the stock received by the taxpayer as follows:

Basis of stock received by taxpayer equals the basis of the property transferred, $1,000, less money or property received (including the amount of the mortgage), $500, plus the amount of gain currently recognized (-0-), viz. $500.

When taxpayer sells the stock, presumably, for $10,000, he would realize and pay tax upon a gain of $9,500.

As applied to the facts of this case, the computation prescribed by § 113(a) (6), would result in a negative basis with respect to the stock acquired by taxpayer. Taxpayer's basis on the transferred property was $87,214.86; deducting from this figure the amount of the mortgage ($247,064.01) yields a basis of minus $159,849.15. Holding that property cannot have a negative basis, the court held, further, that the adjusted basis of the stock is zero. This determination, however, would permit the gain of $159,849.15 to escape taxation, unless the nonrecognition provisions of § 112(b) (5) are ignored. If petitioner sold his zero basis stock for an amount that equaled the equity in the property transferred, $72,935.99 ($320,000, fair market value, less $247,064.01, mortgage), he would be taxed on that amount and nothing more. Taxpayer would, in effect, have converted the property into cash, realizing a gain of $232,785.14, but never paying a tax on $159,849.15 of it. Since the purpose of § 112(b) (5) is not a permit tax avoidance but only to permit postponement, it cannot, consistently with its purpose, be applied without limitation to this transaction. That portion of the gain, which if not presently recognized, will never be recognized, must be taxed now. The Tax Court thus held that $159,849.15 should be currently recognized and taxed. Further, applying § 117(o) relating to the sale or exchange of depreciable property between related persons, the court determined that the portion of taxable gain attributable to the building should be taxed as ordinary income. The gain attributable to the land, a nondepreciable asset, was taxed at capital gains rates. Both the taxpayer and the Commissioner have appealed from the Tax Court's decision.

II. Appeal of Jack Easson, Taxpayer

Taxpayer contends that the Tax Court's holding does violence to the clear and unambiguous language of the code sections involved. Section 112(b) (5) states unequivocally that no gain is to be recognized when property is transferred to a corporation in exchange for stock and immediately after the exchange the transferor controls the corporation. Section 112(k) is also clear in providing that the existence of an encumbrance on property exchanged in a § 112(b) (5) transaction does not deny the transferor the benefits conferred by § 112(b) (5). When a statute is unambiguous, the courts may not look elsewhere for the legislative intent. See e. g., 62 Cases, etc., of Jam v. United States, 340 U.S. 593, 596, 71 S.Ct. 515, 95 L.Ed. 566, and 1 Mertens, Law of Federal Income Taxation, § 3.03. We believe that the Tax Court did err in failing to adhere to the unambiguous language contained in the statutes in question here. Assuredly, there is authority for departing from the literal meaning of statutory language when literal application would produce absurd results (1 Mertens, Law of Federal Income Taxation, § 3.04), but here the Tax Court's interpretation is directly contrary to the language of the statute. Section 112(b) (5) says no gain shall be recognized if certain conditions are fulfilled, yet the Tax Court says gain shall be recognized even though all the conditions enumerated are fulfilled. This is judicial l...