61 T.C. 28">*28 In these consolidated cases, the respondent determined the following deficiencies in 1973 U.S. Tax Ct. LEXIS 42">*45 the petitioners' Federal income taxes:

Concessions having been made by the parties, the issues remaining for decision are: (1) Whether the liabilities transferred to a corporation as a part of an exchange under section 351 of the Internal 61 T.C. 28">*29 Revenue Code of 1954² exceeded the basis of the assets acquired by such corporation in such exchange so that section 357(c) is applicable; (2) what is the basis of the stock acquired by the transferor in such exchange; and (3) whether the respondent properly disallowed deductions to the corporation for salary payments made to Karl D. Teeples.

FINDINGS OF FACT ³

1973 U.S. Tax Ct. LEXIS 42">*46 Wilford E. and Estella M. Thatcher are husband and wife who, at the time of filing the petition herein, resided in Portland, Oreg. They filed joint United States individual income tax returns for the taxable years 1963 and 1964, on the cash receipts and disbursements method of accounting, with the district director of internal revenue, Portland, Oreg.

Karl D. and Iva A. Teeples are husband and wife who, at the time of filing the petition herein, resided in Portland, Oreg. They filed a joint United States individual income tax return for the taxable year 1963, on the cash receipts and disbursements method of accounting, with the district director of internal revenue at Portland, Oreg.

Teeples & Thatcher Contractors, Inc., is an Oregon corporation having its principal place of business at the time of filing its petition herein at 8850 S.E. Otty Road, Portland, Oreg. Its United States corporation income tax returns for the period February 1, 1963, to December 31, 1963, and the taxable year 1964, prepared on the cash receipts and disbursements method of accounting, were filed with the district director of internal revenue at Portland, Oreg.

On March 31, 1956, Wilford E. Thatcher and1973 U.S. Tax Ct. LEXIS 42">*47 Karl D. Teeples (hereinafter sometimes referred to as Thatcher and Teeples, respectively), formed a general partnership to engage in business as general contractors under the name of Teeples & Thatcher Co. (hereinafter sometimes referred to as the partnership). On August 1, 1960, the partnership purchased farm and cattle ranching properties.

From August 1, 1960, until February 1, 1963, the partnership owned and operated the contracting business and the farm and cattle ranching business. From February 1, 1963, until June 30, 1963, the partnership operated the farm and cattle ranching enterprise as its sole business activity. The partnership maintained its books and filed its partnership returns on the cash receipts and disbursements method of accounting.

In January 1963, Teeples & Thatcher Contractors, Inc. (hereinafter referred to as the corporation), was organized. On February 1, 1963, 61 T.C. 28">*30 the partnership transferred to the corporation all of the assets and liabilities of the general contracting business in exchange for all 500 shares of the authorized stock of the corporation and the assumption by the corporation of the liabilities of the partnership.

The assets transferred1973 U.S. Tax Ct. LEXIS 42">*48 to the corporation as of February 1, 1963, included the following:

The amounts of the liabilities assumed by the corporation as of February 1, 1963, included the following:

1973 U.S. Tax Ct. LEXIS 42">*49 61 T.C. 28">*31 In addition, as part of the same transaction, the partnership transferred to the corporation unrealized receivables amounting to $ 317,146.96, consisting of partially completed construction contracts, and the corporation assumed accounts payable amounting to $ 164,065.54, consisting of costs incurred on account of said contracts. The unrealized receivables and accounts payable taken over by the corporation had not, prior to the date of transfer, been reflected in the computation of income and expenditures by the partnership for purposes of taxation.

After February 1, 1963, the corporation continued in business as general contractor and, in the course thereof, during 1963 paid all of the accounts payable assumed by it, and deducted said expenditures as business expenses on its United States corporation income tax return for the taxable period February 1, 1963, to December 31, 1963. Additionally, the corporation, in computing its taxable income for this period, reported as gross income all cash receipts thereafter collected by it, including all amounts collected in respect to the partnership unrealized receivables transferred to the corporation by the partnership.

In May 1973 U.S. Tax Ct. LEXIS 42">*50 1963, the partnership distributed 300 shares of stock of the corporation to Teeples and distributed 200 shares of this stock to Thatcher. In August 1963, the corporation redeemed the 300 shares of the corporation stock owned by Teeples for $ 42,500. In June 1964, Thatcher sold 90 shares of stock of the corporation to Harry Pajutee for $ 22,500 and 20 shares of its stock to Lester Thatcher for $ 5,000.

The respondent has determined that Teeples and Thatcher, as partners, realized a taxable gain under section 351(a) and (b) and section 357 to the extent that the total liabilities assumed by the corporation exceeded the adjusted basis of the partnership in the assets or property transferred to the corporation. Consistent therewith, the respondent further determined that the stock of the corporation had a zero basis in the hands of the partners for the purpose of computing the gain realized by Teeples and Thatcher, respectively, on the subsequent redemption or sale of such stock.

Teeples was also manager of the partnership farm and cattle ranching business and devoted a substantial part of his time to this activity from the time the partnership acquired these properties until he sold1973 U.S. Tax Ct. LEXIS 42">*51 his partnership interest to the Thatchers in June 1963. The farm and ranching business of the partnership was located approximately 350 miles from Portland, Oreg., and encompassed aproximately 1,400 acres.

In March 1963, the corporation and Teeples entered into an agreement which provided that Teeples was to be employed by the corporation from March 1, 1963, until October 31, 1969, a period of 6 years and 61 T.C. 28">*32 8 months for a total salary of $ 100,000 payable in monthly installments of $ 1,250. Teeples was to serve in an executive capacity with the corporation in matters relating to the management and administration of the corporation's overall construction activities, particularly with respect to matters involving the bidding, planning, negotiating, and supervision of contracts relating to construction jobs.

During the period March 1, 1963, to August 1, 1963, Teeples rendered services for the corporation, such as visiting prospective clients, negotiating jobs, and setting up contracts.

In June 1963, Teeples received a mission call from his church, the Church of Jesus Christ of Latter Day Saints, which he duly accepted, to serve as an adviser to the church in Formosa for construction1973 U.S. Tax Ct. LEXIS 42">*52 activities it carried on there. Sometime in August 1963, Teeples left the United States to travel to Formosa to serve his mission and did not return to this country for approximately 3 years.

On July 22, 1963, a special joint meeting of the stockholders and directors of the corporation was held because of the mission call Teeples had received. At this meeting, it was decided that the corporation would continue to make payments to Teeples pursuant to the employment agreement of March 1963. During the period Teeples was in Formosa, the corporation continued to make the monthly payments to him specified in the agreement of March 1963. No services were actually rendered by Teeples to the corporation during the period he was in Formosa.

During the taxable period February 1, 1963, to December 31, 1963, and the year 1964, the corporation made total payments of $ 14,700 and $ 15,000, respectively, to Teeples and claimed deductions for these amounts in computing its taxable income. The respondent has disallowed $ 5,950 of the amount claimed for the period from February 1 to December 31, 1963, and $ 12,000 of the amount claimed for the year 1964.

OPINION

First, we must decide the principal1973 U.S. Tax Ct. LEXIS 42">*53 issue of whether the liabilities transferred to, and assumed by, the corporation in a section 351 exchange exceeded the adjusted basis of the assets transferred to the corporation.

Section 351(a) provides that where property is transferred to a corporation solely in exchange for stock or securities of such corporation, and immediately after the exchange the transferor is in control of the corporation, no gain or loss shall be recognized on the exchange. However, section 357(c)(1) provides that in a section 351 exchange --

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 61 T.C. 28">*33 of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.

The parties agree that the liabilities assumed by the corporation, excluding accounts payable, amounted to $ 264,194.52, and that the total adjusted basis of the assets transferred, other than accounts receivable, was $ 325,892.33. They disagree on the treatment to be accorded the accounts1973 U.S. Tax Ct. LEXIS 42">*54 receivable and accounts payable. The respondent contends that the adjusted basis of the accounts receivable was zero, that the accounts payable of $ 164,065.54 were liabilities, and that, therefore, the amount of the liabilities assumed, $ 428,260.06, exceeded the total adjusted basis of the assets transferred, $ 325,892.33, by $ 102,367.73. On the other hand, the petitioners contend that the adjusted basis of the accounts receivable is equal to the amount of the accounts payable, $ 164,065.54, and that, therefore, the amount of the liabilities assumed, $ 428,260.06, did not exceed the total adjusted basis of the assets transferred, $ 489,957.78. Alternatively, they contend that accounts payable of a cash basis taxpayer are not liabilities within the meaning of section 357(c), and that, therefore, even if the accounts receivable had a zero basis, the amount of liabilities assumed within the meaning of section 357(c), $ 264,194.52, did not exceed the total adjusted basis of the assets transferred, $ 325,892.33.

In Peter Raich, 46 T.C. 604">46 T.C. 604 (1966), the assets of a sole proprietorship, including accounts receivable, were transferred to a corporation in1973 U.S. Tax Ct. LEXIS 42">*55 a section 351 transaction, and the corporation assumed the liabilities, including the accounts payable, of the sole proprietorship. The issue was the same as in this case, and this Court concluded that the basis of a cash method taxpayer in accounts receivable was zero, treated the accounts payable as liabilities, and found that the liabilities assumed by the corporation exceeded the basis of the assets transferred.

The petitioners take the position that the Raich case is distinguishable because that case involved a transfer of assets by a sole proprietor, whereas the present case involves a transfer of assets by a partnership. They argued at great length that section 751 and the regulations thereunder provide a different basis for the accounts receivable of a partnership. Section 751(c) provides that for the purposes of subchapter K, the term "unrealized receivables" includes accounts receivable "to the extent not previously includible in income under the method of accounting used by the partnership." Section 1.751-1(c)(2) of the Income Tax Regulations provides:

(2) The basis for such unrealized receivables shall include all costs or expenses attributable thereto paid or accrued1973 U.S. Tax Ct. LEXIS 42">*56 but not previously taken into account under the partnership method of accounting.

61 T.C. 28">*34 The petitioners interpret such regulation to mean that, for all purposes throughout the Code, the accounts receivable of a partnership reporting its income on the cash receipts and disbursements method of accounting have a basis equal to the accounts payable attributable to such accounts receivable. They, therefore, conclude that their accounts receivable had a basis of $ 164,065.54.

The petitioners' argument overlooks the fact that section 751 has an altogether different purpose. That section has been referred to as the "collapsible" partnership provision. See, e.g., S. Rept. No. 1616, 86th Cong., 2d Sess., p. 77 (1960); S. Rept. No. 1622, 83d Cong., 2d Sess., p. 98 (1954); Willis, Partnership Taxation, sec. 20.08 (1971). It was enacted in response to cases such as Swiren v. Commissioner, 183 F.2d 656 (C.A. 7, 1950), reversing a Memorandum Opinion of this Court, certiorari denied 340 U.S. 912">340 U.S. 912 (1951). In Swiren, the taxpayer sold his partnership interest in a law firm, whose assets consisted largely of uncollected or unbilled1973 U.S. Tax Ct. LEXIS 42">*57 legal fees, and the Court held that the entire gain from such sale was capital gain, even though the receipt of the legal fees by the partnership would have given rise to ordinary income. Section 751(a) seeks to prevent such a "conversion of potential ordinary income into capital gain" (S. Rept. No. 1622, supra at p. 98), and it provides that:

(a) Sale or Exchange of Interest in Partnership. -- The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to --

(1) unrealized receivables of the partnership, or

(2) inventory items of the partnership which have appreciated substantially in value,

Quealy, J., dissenting and concurring: I must disagree with the opinion of the majority with respect to the application of section 357(c) to the facts in this case.

With respect to this issue, the opinion of the majority follows the line of prior decisions of this Court in N. F. Testor, 40 T.C. 273">40 T.C. 273 (1963), affd. 327 F.2d 788">327 F.2d 788 (C.A. 7, 1964), and Peter Raich, 46 T.C. 604">46 T.C. 604 (1966). That view was rejected by the U.S. Court of Appeals for the Second Circuit in Bongiovanni v. Commissioner, 470 F.2d 921 (C.A. 2, 1972), reversing T.C. Memo. 1971-262. While it was my decision that was reversed, I am in full accord with the decision of the appellate court in the Bongiovanni case.

There are inherent problems in applying section 357(c) in the case of a taxpayer whose books and records are kept on the cash basis of accounting where there has been a transfer of the business in "midstream." Since neither all of 1973 U.S. Tax Ct. LEXIS 42">*70 the income actually earned nor all of the expenses actually incurred may be reflected on the books of such taxpayer, the transferor will not have fully accounted for its income and deductions. Where the transfer qualifies for nonrecognition under section 351, the transferee is required to pick up any unreported income and receives the benefit of any deductions attributable thereto which have not been paid by the transferor. Under the opinion of the majority, however, the allowance of the deduction to the transferee is offset by the inclusion of a corresponding amount in the gain taxable to the transferor under section 357(c). This has troubled the courts. Bongiovanni v. Commissioner, supra;46 T.C. 604">Peter Raich, supra.¹

As was aptly pointed out by the appellate court in Bongiovanni v. Commissioner, supra,1973 U.S. Tax Ct. LEXIS 42">*71 section 351 was originally enacted to provide for the simple incorporation of a sole proprietorship or partnership for purposes of continuing the business in that form without the realization of any taxable gain or loss. Where the liabilities assumed in that type of transaction are reflected in the transferor's method of accounting, 61 T.C. 28">*40 it is only logical to take such liabilities into account in determining the consideration received. ²

On the other hand, where neither the liabilities in question nor the corresponding receivables have been taken into account under the taxpayer's method of accounting, the treatment of such liabilities as "other property" received by the transferor produces an absurd result. Accordingly, in the Bongiovanni case, the appellate court said:

Section1973 U.S. Tax Ct. LEXIS 42">*72 357(c) -- if read literally -- requires that "liabilities" assumed by the transferee corporation which exceed the aggregate adjusted basis of the properties transferred are to be considered as gain from the sale or exchange of that property. However, we believe that the word "liability" is used in Section 357(c) in the same sense as the word "liability" referred to in the legislative history of Section 357(c). It was not meant to be synonymous with the strictly accounting liabilities involved in the case at bar. Section 357(c) was meant to apply to what might be called "tax" liabilities, i. e., liens in excess of tax costs, particularly mortgages encumbering property transferred in a Section 351 transaction. See 3 U.S. Code Cong. & Admin. News pp. 4064, 4266-67, 4908 (1954). Any other construction results in an absurdity in the case of a cash basis taxpayer whose trade accounts payable are not recognized as a deduction (because he is on the cash basis) but whose "liabilities" (although unpaid) are recognized for purposes of Section 357(c). The payables of a cash basis taxpayer are "liabilities" for accounting purposes but should not be considered "liabilities" for 1973 U.S. Tax Ct. LEXIS 42">*73 tax purposes under Section 357(c) until they are paid. See Note, Section 357(c), And The Cash Basis Taxpayer, 115 U. Pa. L. Rev. 1154 (1967). [470 F.2d 921, 923-924 (C.A. 2, 1972).]

In resolving this issue, wherever possible it is our duty to arrive at a decision which will be compatible with the statute as a whole. As Judge Rives said in Davant v. Commissioner, 366 F.2d 874, 879 (C.A. 5, 1966), "rules prescribed by Congress in the Code are often wholly reasonable and appropriate when taken in isolation, but that fact alone should not and must not prevent a court from harmonizing these apparently divergent elements of specific policy so that they may continue to cohabit the same body of general law which Congress has directed shall be viewed as a single plan."

The decision of the appellate court in the Bongiovanni case achieves that result. In fact, it more nearly carries out the intent of the Congress in that a distinction is made not on the basis of "secured liabilities," but on the basis whether the liability in question was reflected in determining the income and expense of the1973 U.S. Tax Ct. LEXIS 42">*74 taxpayer on a cash basis. Where a taxpayer buys a depreciable asset with borrowed funds, the deduction for depreciation enters into the computation of the taxpayer's income on a cash basis of accounting regardless whether the borrowings constitute a lien on the asset or represent a general obligation 61 T.C. 28">*41 of the taxpayer. The indebtedness is reflected in the taxpayer's accounting. On the other hand, where the liability represents an inventoriable or deductible expense, it cannot be reflected in the computation of income on a cash basis until paid. The distinction makes sense, and I would adopt it.

With respect to the second issue, the facts are that for some 7 years Mr. Thatcher and Mr. Teeples had been partners in the contracting business in Portland, Oreg., and in the operation of a farm some 350 miles distant. They divided their duties, Mr. Thatcher being in charge of the contracting business and Mr. Teeples being in charge of the farm. As of January 1, 1963, a corporation was organized to take over the contracting business. Mr. Teeples owned or controlled 300 shares of a total of 500 shares of stock outstanding. In March 1963, the corporation entered into a contract1973 U.S. Tax Ct. LEXIS 42">*75 to pay Mr. Teeples a total of $ 100,000 in monthly installments of $ 1,250 for such services as he might perform for the corporation. It was understood at that time that Mr. Teeples would continue to reside at the farm but would be available from time to time as needed.

In May of 1963, the corporation redeemed or repurchased the 300 shares of stock owned by Mr. Teeples for the sum of $ 42,500. Thereafter, in accordance with the custom of his church (Church of Jesus Christ of Latter Day Saints), Mr. Teeples was called upon to undertake a mission for the church in Formosa. He accepted the call. Thereupon the board of directors of the corporation voted to continue his salary during his absence. The respondent has determined that at least to the extent of $ 1,000 per month, the amounts paid to Mr. Teeples were not an allowable deduction under section 162(a)(1).

It is clear from the record that Mr. Teeples was withdrawing from the contracting business, whether in anticipation of the call from his church or otherwise. He so testified. Furthermore, in determining the price at which his stock, representing three-fifths of the outstanding stock of the corporation, was redeemed, Mr. 1973 U.S. Tax Ct. LEXIS 42">*76 Teeples said:

I did not have access to the books, but I have an accountant that was handling the books all of the time. And when this split came we, of course, figured what we had, less the liabilities and the obligations that I had, to complete the jobs that we would have to complete, and that was the amount of money that was left over.

Such testimony is only compatible with the facts if it is assumed that the contractual liability to pay Mr. Teeples $ 1,250 per month until October 30, 1969, was also taken into account. In other words, either the employment contract was a part of the consideration for the sale by Mr. Teeples of his stock or the financial condition of the corporation was grossly understated to him. Since he was the controlling stockholder 61 T.C. 28">*42 holder at that time, I am not inclined to accept the latter. We must assume, therefore, that the additional amounts which Mr. Teeples was to receive, whether he worked or not, were in part consideration to be paid for his stock.

Hall, J. I respectfully dissent. If a cash method taxpayer transfers $ 1,000 of trade receivables to an outside party in exchange for the assumption and payment of $ 1,000 of the taxpayer's1973 U.S. Tax Ct. LEXIS 42">*77 trade payables, he has no taxable income. He realizes $ 1,000 of gross income on the receivables, for they have been sold for payment of the payables, but he realizes an offsetting deduction of $ 1,000 on the payables, for they have been paid for by the recipient of the receivables. See James M. Pierce Corp. v. Commissioner, 326 F.2d 67 (C.A. 8, 1964), reversing 38 T.C. 643">38 T.C. 643 (1962); Royal Oak Apartments, Inc., 43 T.C. 243">43 T.C. 243 (1964); Andrew Jergens, 17 T.C. 806">17 T.C. 806 (1951). Under the majority's reasoning, the same taxpayer making the same exchange with his wholly owned corporation will have $ 1,000 of taxable income. Section 351, intended as a shield against recognition of gain on incorporation, thereby perversely becomes a sword to impose a tax where none would be due in an ordinary recognizing transaction.

The difficulty with the majority's reasoning does not lie in the application of section 357(c), for the statutory mandate there is clear. In our illustration, the incorporating taxpayer has caused his corporation to assume $ 1,000 of liabilities, and the receivables1973 U.S. Tax Ct. LEXIS 42">*78 transferred had a zero basis. Accordingly, $ 1,000 "shall be considered as a gain from the sale or exchange of * * * property [the receivables] which is not a capital asset." Sec. 357(c)(1). In other words, the taxpayer has made a taxable sale of his receivables. But what for? Clearly, assumption and payment of the payables. It is the assumption, under the statute, which generates the gain. But, as we have noted, when a cash method taxpayer sells his receivables for assumption and payment of his payables, he is just as much entitled to a deduction for payment of the payables as he is accountable for income on the sale of the receivables. Section 357(c) takes so much of the transaction out of section 351 and treats it as an ordinary recognizing exchange. It should be so treated as to both payables and receivables. Nothing in section 351 or 357 requires treatment of only one side of the receivable-payable "sale" as a recognizing transaction. The statutory purpose is far better served if payables paid by the transferee in the taxable year of transfer are treated as deductible to the transferor to the extent the offsetting receivables are treated as received by him. Since1973 U.S. Tax Ct. LEXIS 42">*79 payment of a deductible liability by a cash method taxpayer gives rise to a deduction, 61 T.C. 28">*43 the same deduction should be allowed on payment when section 357(c) treats the liability as assumed in exchange for receivables.

Admittedly no such deduction is available where assets are transferred in a section 351 transaction to the extent not treated as a sale under section 357. Arthur L. Kniffen, 39 T.C. 553">39 T.C. 553, 39 T.C. 553">566-567 (1962); ¹Doggett v. Commissioner, 275 F.2d 823 (C.A. 4, 1960), affirming a Memorandum Opinion of this Court, certiorari denied 364 U.S. 824">364 U.S. 824 (1960); Citizens Nat. Trust & Savings Bank v. Welch, 119 F.2d 717 (C.A. 9, 1941). Likewise, a bankrupt gets no deduction on the mere transfer of assets to a trustee, where a new entity is created and there is no direct correspondence between transfer of assets and subsequent payment of the bankrupt's liabilities. Henry C. Mueller, 60 T.C. 36">60 T.C. 36, 60 T.C. 36">43-44 (1973); B & L Farms Co. v. United States, 238 F. Supp. 407">238 F. Supp. 407, 238 F. Supp. 407">409-410 (S.D. Fla. 1964), affirmed1973 U.S. Tax Ct. LEXIS 42">*80 per curiam 368 F.2d 571 (C.A. 5, 1966), certiorari denied 389 U.S. 835">389 U.S. 835 (1967). Neither of these situations is comparable to the present facts, where (in order to avoid a negative basis) section 357 treats a portion of what would otherwise be a section 351 transaction as a taxable sale.

1973 U.S. Tax Ct. LEXIS 42">*81 Our analysis is fully in accord with the purpose of section 357(c). Under it, there is no need to strain, as does Bongiovanni v. Commissioner, 470 F.2d 921 (C.A. 2, 1972), to read the word "liabilities" in a difficult-to-define, artificial "tax" sense. Section 357(c) is given full, literal effect. As a matter of appropriate allocation, in the case of incorporation of a cash basis business, the trade accounts payable should, for this purpose, be netted against the trade accounts receivable, up to the lesser of the trade accounts payable or the amount of liabilities treated as paid under section 357(c). Such an allocation is simple, straightforward and best follows the statutory intent.

Applying these principles to the present case, the liabilities assumed exceeded the adjusted basis of assets transferred by $ 102,367.73. Accordingly, there is $ 102,367.73 of section 357(c) gain. There were $ 164,065.54 of unrealized accounts payable, and $ 317,146.96 of unrealized receivables. The corporation paid all the payables in petitioner's 61 T.C. 28">*44 same taxable year. Accordingly, all $ 102,367.73 of the section 357(c) gain would properly be allocated1973 U.S. Tax Ct. LEXIS 42">*82 to sale of the receivables in exchange for assumption and payment of the payables, and the partnership should be treated as having paid $ 102,367.73 of the payables. Since the payables appear to have represented ordinary and necessary business expenses (they were all deducted by the corporation), the partnership was entitled to deduct that amount, which exactly offsets the section 357(c) ordinary gain on the receivables. There should be no net addition to taxable income on the transaction. It is not necessary for present purposes to consider the effect, if any, of application of the above analysis to the subsequent corporate payment of the payables assumed and receipt of the receivables purchased thereby.