F. W. Drybrough v. Commissioner of Internal Revenue
1967 U.S. App. LEXIS 6929, 376 F.2d 350, 19 A.F.T.R.2d (RIA) 1076 (1967)
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Rule of Law:
Under Section 357(b) of the Internal Revenue Code, the taxpayer's principal purpose for a liability assumption is tested 'on the exchange' itself; a tax-avoidance motive for incurring the original debt years prior to and unrelated to the corporate formation does not trigger taxation, whereas a debt incurred immediately before and in anticipation of the exchange does.
Facts:
- F. W. Drybrough was a successful real estate investor who frequently used mortgages to acquire and consolidate his holdings.
- In 1953, Drybrough borrowed $700,000, secured by several real estate parcels. A portion of the proceeds, approximately $200,000, was used to purchase tax-exempt securities.
- In early 1957, Drybrough decided to incorporate his real estate holdings.
- On March 15, 1957, Drybrough borrowed an additional $150,000, securing the loan with a property at 620 South Fifth Street. He had previously expressed in a letter his desire to 'mortgage them to the limit before combining these two properties in a corporation.'
- The proceeds of this new $150,000 loan were primarily used to purchase more tax-exempt securities.
- On June 1, 1957, Drybrough transferred four properties to four newly created corporations, and each corporation assumed a portion of the remaining balance on the 1953 loan, totaling $600,000.
- On June 28, 1957, Drybrough transferred the 620 South Fifth Street property to a fifth new corporation, which assumed the outstanding balance of the March 1957 mortgage, totaling $149,000.
Procedural Posture:
- Taxpayers F. W. Drybrough and his wife filed a joint tax return for the 1957 tax year.
- The Commissioner of Internal Revenue assessed a deficiency against the taxpayers.
- The taxpayers (petitioners) petitioned the Tax Court of the United States for a redetermination of the deficiency.
- The Tax Court sustained the Commissioner's determinations, ruling against the taxpayers on all issues.
- The taxpayers (petitioners) appealed the Tax Court's decision to the United States Court of Appeals for the Sixth Circuit.
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Issue:
Under Section 357(b) of the Internal Revenue Code, does a taxpayer have a principal purpose to avoid federal income tax 'on the exchange' when newly formed controlled corporations assume liabilities of the taxpayer, where one liability was incurred years before the exchange for unrelated reasons and the other was incurred immediately preceding and in anticipation of the exchange?
Opinions:
Majority - O'Sullivan, Circuit Judge
No, as to the assumption of the 1953 loan; Yes, as to the assumption of the 1957 loan. The court held that a taxpayer's principal purpose must be evaluated with respect to the liability assumption on the exchange itself, not the original motivation for incurring a pre-existing debt. For the 1953 loan, the court found it was too remote in time from the 1957 corporate formation to have been incurred for the purpose of avoiding tax 'on the exchange,' even if its proceeds were used for tax-avoidance purposes. The incorporation served bona fide business purposes, such as estate planning and liquidity. However, the 1957 loan of $150,000 was incurred 'immediately prior to the transfer and solely in anticipation thereof.' Drybrough’s own letter demonstrated a clear intent to encumber the property to extract its value in cash tax-free immediately before transferring it to the new corporation. This direct connection established a principal purpose to avoid tax 'on the exchange' for that specific transaction. The court also affirmed the disallowance of the interest deduction on the portion of the 1953 loan used to buy tax-exempt bonds, finding the taxpayer's claim of a debt to his wife to be a 'sham' and thus the interest was non-deductible under Section 265(2).
Analysis:
This decision provides a crucial interpretation of the 'tax avoidance purpose' test under Section 357(b). It establishes a de facto 'old and cold' rule for liabilities, clarifying that debts existing long before an incorporation are generally safe from challenge, even if the original use of the funds was questionable. Conversely, it solidifies the principle that liabilities incurred in close temporal proximity to, and in anticipation of, a corporate formation are highly vulnerable to being classified as having a tax avoidance purpose. This distinction provides a clearer, though not absolute, line for taxpayers and practitioners structuring corporate formations involving the assumption of debt.
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