The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 3, October 2000, Panel Publishers, New York, NY.

ALTERED STATES: NEW (AND NOT SO NEW) RULES ON LIABILITY ASSUMPTIONS

By Robert W. Wood

Most businesspeople recognize that the transfer of assets to a corporation in exchange for a controlling stock interest will generally not be taxable. Certainly tax professionals know this.

Usually, even paranoid professionals don't obtain IRS letter rulings on this particular topic, the chances of making a mistake seem so small. Embodied in Code Section 351, this is one of the easiest to understand and most widely used provisions in the Code. If property is transferred to a corporation in exchange for a controlling stock interest of that corporation, the transfer is eligible for Section 351's tax-free treatment even where the transferee assumes (or takes "subject to") a liability of the transferor, in connection with the transfer.

Despite Section 351's simplicity, it is where there are liabilities assumed (or taken subject to) in the transaction that things start to get sticky. Under Section 357(c), a gain will be recognized, even though the transaction is described in Section 351 if the liabilities exceed the basis of the assets conveyed. This liability vs. basis determination is made on a transferor by transferor basis. (See Revenue Ruling 66-142) In other words, each person is looked at separately.

Normally, in a Section 351 transaction, the transferee corporation inherits the transferor's basis in the property conveyed to the corporation. However, the transferee is entitled to increase that carryover basis by an amount equal to the amount of any gain recognized by the transferor on the transfer. In situations where the recognized gain is not subject to U.S. tax (perhaps where the transferor is a foreign person), or where the gain can be sheltered by expiring capital losses, it can actually be desirable to trigger a gain in what might otherwise be a tax-free transaction.

After all, in light of the basis step-up afforded to the transferee, it can be to one's advantage to insure that the Section 351 transaction creates a recognized gain to the transferor. A tax-free step-up (if it can be arranged) is always a good thing.

Triggering Gain

A relatively simple way to achieve this result is for a taxpayer to obtain a loan secured by multiple properties. A transfer of one of such properties to a transferee in a Section 351 transaction will create an excess liability gain because each such property is, for tax and other purposes, considered subject to the entire liability. As such, it stands to reason in each case of this type that this entire liability will exceed the basis of the property conveyed.

The IRS and Congress have long had an interest in attempting to guard against these seemingly unwarranted basis step-ups. After all, in a case where the gain is sheltered by expiring capital losses, such a basis step-up can have the effect of "converting" capital losses into ordinary deductions. As a result of more recent focus on this problem, tax legislation snuck last year in as part of the Miscellaneous Trade and Technical Corrections Act of 1999 (P.L. 106-36). This legislation includes several important provisions.

The basic goal of this legislation was to eliminate the distinction between the assumption of a liability, and the acquisition of an asset subject to a liability. The legislative history to the law indicates that Congress was concerned that taxpayers might structure transactions to take advantage of uncertainties regarding liabilities.

For example, the Senate Finance Committee report suggests that where more than one asset secures a single liability, some taxpayers might take the position that, on a transfer of the assets to different subsidiaries, each subsidiary could count the entire liability in determining the basis of the asset. This "interpretation" of such transfers, said the Senate Finance Committee, would arguably result in a duplication of tax basis, or in assets having a tax basis exceeding their market value. That would lead to excessive depreciation deductions, etc. The idea was to eliminate such possibilities.

Recourse Liability Treatment. A recourse liability will be treated as assumed in cases where the transferee has agreed to satisfy the relevant indebtedness and such agreement is evidenced by a reasonable expectation, whether or not the transferor in fact has been relieved of the liability. I.R.C. §357(d)(1)(A). Where more than one person agrees to satisfy a liability (or portion thereof) only one would be expected to satisfy the liability (or portion thereof). Put simply, no double counting.

Treatment of Nonrecourse Debt. Non-recourse debt will be treated as assumed by the transferee of any asset subject to such debt. However, the amount of the debt treated as assumed will be reduced by the amount which the owner of other assets (not transferred in the transaction and subject to the debt) has agreed to satisfy. I.R.C. §357(d)(2)(A). How does one determine whether a person has agreed to satisfy a liability? Predictably, an "all facts and circumstances" test applies. If an agreement exists stating that a person will satisfy the debt, then the person will be assumed to do so absent contrary facts.

Basis vs. Fair Market Value. On the basis side of the ledger, the legislation provides that in no event will the basis of property be increased to an amount in excess of its fair market value, by reason of gain recognized as a result of a liability assumption-an outcome clearly possible under prior law. See I.R.C. §357(d)(2)(B).

Gain Recognition. Where gain is recognized by a transferor as a result of a transferee's assumption of non-recourse debt, and no person is subject to U.S. tax on such gain, then the recognized gain is recomputed. The recognized gain (for purposes of gauging the extent of the basis step-up available to the transferee) will be computed as if the liability assumed was equal to the ratable portion of the liability that the asset transferred represents in relation to the other assets securing that liability. I.R.C. §362(d)(2).

Effective Now

Hopefully reading these rules doesn't send shock waves through your system. These changes apply to transfers after October 18, 1998, so you may have been making transfers subject to this beefed-up version of Section 357 without knowing it.

Environmental Remediation and Asbestos Removal: More INDOPCO Trash? (Part One), Vol. 9, No. 3, The M&A Tax Report (October 2000), p. 7.