## Facts

- F. W. Drybrough was an experienced Louisville real-estate investor who borrowed heavily, using mortgages secured by his properties.
- In 1940, 1945, and 1946, he borrowed $200,000, $200,000, and $500,000 from an insurance company, generally to refinance existing debt or acquire additional real estate.
- On April 3, 1953, he borrowed $700,000 secured by mortgages on several parcels; a portion retired prior debt and expenses, and the remaining proceeds were deposited into his bank account.
- Drybrough withdrew part of the 1953 loan proceeds and transferred it to an account associated with a note he had issued to his wife; he testified he initially planned to use borrowed funds to acquire property but instead disbursed proceeds primarily to purchase tax-exempt securities.
- In 1957, Drybrough transferred multiple mortgaged parcels to separate corporations he controlled, receiving all their stock.
- The transferee corporations assumed portions of the outstanding mortgage liabilities, including a large remaining balance on the 1953 loan and an additional mortgage incurred in 1957 whose proceeds were also used to buy tax-exempt securities.
- Drybrough reported limited gain on the transfers under I.R.C. § 357(c) (liabilities exceeding basis), treating the incorporations as largely nonrecognition transactions.
- The Commissioner determined deficiencies, asserting that the liability assumptions were undertaken with a principal purpose of tax avoidance under I.R.C. § 357(b) and that claimed interest deductions on the mortgage debt should be disallowed or limited.
- The Tax Court sustained the Commissioner; Drybrough petitioned for review.

## Issues

1. Whether, in transfers of encumbered property to controlled corporations, the corporations’ assumption of liabilities was governed by I.R.C. § 357(b) (tax-avoidance purpose) rather than I.R.C. § 357(c) (liabilities exceeding basis), causing assumed liabilities to be treated as money received.
2. Whether interest on the relevant mortgage indebtedness was deductible under I.R.C. § 163 when the borrowing and use of proceeds were found to be structured primarily to generate deductions while investing in tax-exempt securities.

## Decision

- The Sixth Circuit affirmed the Tax Court’s decision sustaining the Commissioner’s deficiency determinations.
- The court upheld the finding that a principal purpose of the liability assumptions was tax avoidance, triggering § 357(b) treatment and increasing recognized gain.
- The court upheld the denial or limitation of claimed interest deductions where the borrowing arrangements lacked a bona fide non-tax purpose and were tied to acquiring tax-exempt securities.
- The court deferred to the Tax Court’s factual findings on purpose and substance and found no clear error warranting reversal.

## Legal Principles

- In transfers to a controlled corporation, if a principal purpose of the corporation’s assumption of liabilities is tax avoidance, I.R.C. § 357(b) applies and the assumed liabilities are treated as money received by the transferor, increasing recognized gain notwithstanding § 357(c).
- Determination of “principal purpose” under § 357(b) is a factual inquiry; appellate review gives deference to supported Tax Court findings.
- Interest is generally deductible under I.R.C. § 163, but deductions may be denied or limited when the overall borrowing arrangement lacks economic substance as indebtedness for a genuine profit-seeking purpose and is structured mainly to obtain tax benefits, including pairing interest deductions with investment in tax-exempt securities.
- Courts may look to the transaction as a whole (substance over form) in evaluating both liability-assumption consequences and interest-deduction claims.

## Conclusion

The court sustained deficiencies by treating liability assumptions in Drybrough’s incorporations as taxable “boot” under § 357(b) due to a tax-avoidance purpose and by upholding the Tax Court’s disallowance or limitation of interest deductions where the borrowing and use of proceeds principally served tax-driven objectives rather than bona fide business financing.


Drybrough v. Commissioner, 376 F.2d 350 (6th Cir. 1967)