Settling a Debt Guarantee

TAX CASE

If a taxpayer transfers appreciated property to repay a liability, the law treats the amount of the liability as proceeds from the sale of the property and the taxpayer must recognize a gain. Recently, the Tax Court considered the taxation of a transfer of appreciated property to settle the guarantee of a debt.

Joel Friedman was a minority shareholder and member of the board of directors of United Bankshares, Inc. (UBI). His son Mark approached United National Bank (UNB), a wholly owned subsidiary of UBI, about a loan for his business, Centrium Hillsboro Corp. Although the father did not take part in the decision to loan Centrium money, he assured UNB’s officers they would not lose any money if they made the loan. The bank lent Centrium approximately $2.6 million. When the company couldn’t repay the loan, UNB’s officers reminded Joel of his promise. He transferred appreciated UBI stock to UNB to settle his son’s loan. The IRS treated the transfer as a sale of the stock, and increased Joel’s income by the amount of the built-in gain. The taxpayer objected to treating the transfer as a sale.

Result. For the taxpayer. IRC section 1001 requires all taxpayers to report gains on the excess of the amount received for transferred property over the property’s basis. Under Treasury regulations section 1.1001-2(a)(1), the release of a liability is treated as additional sale proceeds. The Tax Court concluded the rule did not apply to this case because the released liability was not the taxpayer’s personally; it was an obligation of his son’s corporation.

The court cited two precedents. In Landreth, 50 TC 803, the taxpayer did not have income from the release of a guarantee when the primary debtor paid off the debt. The court also cited INI, Inc. (TC Memo 1995-112, aff’d 107 F3d 27(CA-11)). In that case the taxpayer did not have to include debt release in the amount realized when a creditor kept an excess payment as settlement of a separate loan to the taxpayer’s corporation. However, neither of these cases really addressed the issues at hand.

The Tax Court also did not deal with any of the collateral issues. For example, a guarantor usually steps into the creditor’s shoes when he or she pays off a debt. Therefore, did the corporation have cancellation-of-debt income when the guarantor chose not to pursue collection? Did the transfer of the appreciated stock to the creditor result in a gift to the son since the father was not legally obligated to pay the debt?

The decision in this case appears to raise more questions than it answers. It does, however, provide an argument that the use of appreciated property to settle a guarantee need not create a taxable gain.

Joel Friedman v. Commissioner, TC Memo 2001-236.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.