Taxing the transfer of debts between debtors and creditors.

• Author: Schnee, Edward J.

The frequent transfer of cash between closely held businesses and their owners is very common. If the owner works in the business, the transfer is likely to be either a salary to a shareholder/ employee or a Sec. 707(c) guaranteed payment to a partner. Alternatively, the transfer may be a loan. As long as the true substance of the transaction is a loan, it will be respected for tax purposes. (1)

The cash flow is not exclusively from the businesses to the owner. Many owners prefer to capitalize their closely held business with a combination of equity and debt. Once again, these loans will be respected and not reclassified as equity if they are bona fide loans.

In the normal course of business, these loans are repaid. The receipt of the repayment will be tax free except to the extent it is interest. However, in difficult economic conditions, many of these loans are not repaid. To the extent that the creditor cancels the obligation, the debtor has cancellation of debt (COD) income under Sec. 61(a)(12). This income is taxable unless the taxpayer qualifies for an exclusion under Sec. 108. In other cases, the debt is transferred between the parties either as an independent transaction or part of a larger one. This article reviews these transactions.

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Two basic types of transfers have created significant tax issues. In the first, the debtor transfers the debt to the creditor. If the debtor is the owner of a business and the business is a creditor, the transfer appears to be a contribution. If the business is the debtor and the owner is the creditor, the transfer can be a distribution, liquidation, or reorganization. The other type of transfer is from the creditor to the debtor. Again, the transaction can take the form of a contribution if the creditor is the owner, or it can take the form of a distribution, liquidation, or reorganization if the creditor is the business.

Debtor-to-Creditor Transfers Corporations

The two seminal cases that established the framework for analyzing the transfer of a debt obligation from a debtor to a creditor are Kneen' and Edwards Motor Transit Co.3 Arthur Kniffen ran a sole proprietorship and owned a corporation. The sole proprietorship borrowed money from the corporation. For valid business reasons, Kniffen transferred the assets and liabilities of the proprietorship to the corporation in exchange for stock of the corporation, thereby transferring a debt from the debtor to the creditor. The transaction met the requirements of Sec. 351.

The government argued that the transfer of the debt to the creditor was in fact a discharge or cancellation of the debt (a single step), which should have been treated as the receipt of boot under Sec. 351(b) and taxed currently. The taxpayer argued that the transfer was an assumption of the debt and, based on Sec. 357(a), should not be treated as boot.

The Tax Court acknowledged that the debt was canceled by operation of law. However, it did not accept the government's argument as to the structure of the transaction. Instead, it determined that two separate steps occurred. First, the corporation assumed the debt. This assumption was covered by Sec. 357(a). After the assumption, the interests of the debtor and creditor merged and the debt was extinguished. Since the transfer was not for tax avoidance purposes, Sec. 357(b) did not apply. The result was a tax-free Sec. 351 transaction, except to the extent that the assumed debt exceeded the bases of the assets transferred, resulting in gain under Sec. 357(c). This decision established the separation of the debt transfer from its extinguishment.

Edwards Motor Transit Co. cites, and is considered to have adopted, the approach in Kniffen. For valid business reasons, the owners of Edwards created The Susquehanna Co., a holding company, and transferred Edwards' stock to it under Sec. 351. Susquehanna borrowed money from Edwards to meet certain financial obligations. To eliminate problems that arose from having a holding company owning the stock of an operating company, the owners merged Susquehanna into Edwards under Sec. 368(a) (1)(A). The government acknowledged that the basic transaction was a nontaxable merger. However, the government wanted the company to recognize income as a result of the cancellation or forgiveness of the debt. The Tax Court ruled for the taxpayer, on the grounds that the debt transfer (from debtor to creditor) was not a cancellation of the debt. The ruling cited Kniffen as authority for this conclusion.

On its surface, Edwards Motor Transit affirmed the decision and reasoning in Kniffen. The Tax Court stated, "The transfer by the parent corporation of its assets to Edwards [its subsidiary] ... constituted payment of the outstanding liabilities ... just as surely as if Susque-hanna had made payment in cash." This statement relied on both Kniffen and Estate of Gilmore: In Gilmore, a liquidating corporation transferred a receivable to its shareholder who happened to be the debtor. In that case, the court ruled the transaction was an asset transfer and not a forgiveness of debt. The court based its conclusion in large part on the fact that no actual cancellation of the debt occurred.

The statement in Edwards Motor Transit quoted above, however, is inapposite to the conclusion in Kniffen. A payment is not a transfer and assumption of a liability. Since Susquehanna was deemed to have used assets to repay the debt, the Tax Court should have required Susque-hanna to recognize gain to the extent that the value of the assets used to repay the debt exceeded their bases. The conclusions in Kniffen and Edwards are consis-tent only in their holdings that these debt transfers were not cancellations of debts that would result in COD income. In Kniffen, the court ruled that the debt was assumed and then extinguished. In Ed-wards, the court ruled that the extinguishment of the debt constituted repayment.

It is possible that the Tax Court reached the correct outcome in Edwards Motor Transit but for the wrong reason. In Rev. Rul 72-464,5 a debtor corporation merged into the creditor corporation in a tax-free A reorganization under Sec. 368(a)(1)(A). The ruling concluded that the debtor corporation did not recognize any gain or loss on the extinguishment of the debt within the acquiring corporation. General Counsel Memorandum (GCM) 349026 provided the detailed analysis behind the conclusion.

The GCM cited both Kniffen and Edwards' and adopted their underlying rationale. Specifically, it concluded that the basic transaction (the reorganization) results in a transfer of the debt to the acquiring corporation. It is after the transfer that the debt is extinguished by the statutory merger of interests. The transfer is an assumption of debt, which is nontaxable under Sec. 357(a). Therefore, the transferor (debtor corporation) recognizes no gain or loss.

This is exactly what happened in Edwards. The debt was assumed, not repaid. Therefore, the Tax Court should have reached the conclusion that the transaction was nontaxable under Sec. 357(a) and not have relied on the questionable authority of Estate of Gilmore' or concluded that the debt was repaid.

Liquidations

The transactions discussed up to this point have been either tax-free corporate formations (Sec. 351) or tax-free reorganizations (Sec. 361). In a different transaction that is likely to occur, the creditor/shareholder liquidates the debtor corporation.

If the transaction is not between a parent and its subsidiary, taxability is determined by Secs. 331 and 336. Prior to 1986, the outcome might have been determined by Kniffen and Edwards. With the repeal that year of the General Utilities' doctrine (tax-free corporate property distributions) and the enactment of current Sec. 336, the outcome is straightforward. Under Sec. 336, the debtor corporation that is liquidated recognizes its gains and losses. Whether the liquidated corporation is treated as using assets to satisfy a debt requiring the recognition of gain or is treated as distributing assets in a taxable transaction under Sec. 336, all the gains and losses are recognized.

The taxation of the shareholder is a little more complex. First, the shareholder must determine how much it received in exchange for the stock. The most reasonable answer is that the shareholder received the value of the assets minus any debt assumed and minus the face amount of the debt owed to it by the liquidated corporation. This amount is used to determine the gain or loss that results from the hypothetical sale of stock under Sec. 331. Second, the shareholder must determine what was received for the debt, whether assets or the debt itself. The amount received in payment...