The petitioners finally contend that the issue of whether income was recognized on the transfer of assets to the corporation is not before us, because such issue was conceded by the respondent in his answer. We do not interpret the answer as having conceded such issue. Moreover, in his opening statement, counsel for the petitioners referred to such issue as the "essential" issue of the trial, and at trial, the petitioners presented evidence on such issue. In their briefs, the parties have extensively argued the issue. Under such circumstance, it is clear that the issue is properly before us. See, e.g., Ross Glove Co., 60 T.C. 569 (1973); Nat Harrison Associates, Inc., 42 T.C. 601, 617-618 (1964). In view of our holding as to the applicability of section 357 (c), the partnership's adjusted basis in the stock which it received from the corporation in exchange for the transfer of assets was zero. Pursuant to section 358, the basis of the stock so acquired is computed by increasing the partnership's adjusted basis in the transferred assets ($325,892.33) by the gain recognized on the transfer ($102,367.73) and by reducing such total by the amount of the liabilities assumed by the corporation and those to which the transferred property was subject ($428,260.06).

4

It remains for decision whether respondent erroneously determined that not more than $250 of a total of $1,250 per month paid by the corporation to Teeples during his absence in Formosa was allowable as an ordinary and necessary expense under section 162(a)(1)."

Briefly, the facts are that Teeples and the corporation entered into a contract whereby in consideration of specified services, the corporation would pay Teeples $1,250 per month. Thereafter, in accordance with the custom of his church (Church of Jesus Christ of Latter Day Saints), 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 Teeples were not an allowable deduction under section 162 (a) (1).

The petitioner has the burden of proof that the amount in question constituted reasonable compensation within the meaning of section 162 (a) (1). Petitioner failed to do so. Teeples performed no services

Since the decision in this issue turns on the evaluation of the evidence in the case, we have adopted Judge Quealy's opinion with respect to it.

SEC. 162. TRADE OR BUSINESS EXPENSES.

(a) IN GENERAL.-There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including

(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;

for the corporation while in Formosa. With respect to what services he may have performed prior to leaving, the testimony was vague and general, if not contradictory. The corporation was under no obligation to Teeples and the fact that the corporation elected to continue his salary, although commendable, did not give rise to an allowable deduction.

In accordance with the foregoing,

Reviewed by the Court.

Decisions will be entered under Rule 50.

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 (1963), affd. 327 F.2d 788 (C.A. 7, 1964), and Peter Raich, 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 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; Peter Raich, supra.1

As was aptly pointed out by the appellate court in Bongiovanni v. Commissioner, supra, 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 account

A similar harsh result may follow where a cash basis taxpayer becomes bankrupt. Henry O. Mueller, 60 T.C. 36 (1973).

ing, 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:

Section 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 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).1

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 the 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 obliga

For example, where the transferor has purchased machinery and equipment with borrowed funds, irrespective of the method of accounting, the transferor's basis for depreclation reflected the full cost of the machinery and equipment.

tion 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 contract 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. 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 stock

532-904-74

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.

GOFFE, J., agrees with this opinion.

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's 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 (1962); Royal Oak Apartments, Inc., 43 T.C. 243 (1964); Andrew Jergens, 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 receivables 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. Since payment of a deductible liability by a cash method taxpayer gives rise to a deduction,