The Treatment of Contingent Liabilities in Taxable Asset Acquisitions

(1) Whether the contingent liabilities can be deducted;

(2) Whether income to the buyer will be triggered; and

(3) Whether the imputed interest rules will apply.

(1) In Holdcroft, a corporation acquired assets from a partnership in exchange for common stock and the assumption of the partnership liabilities, including two tort claims filed against the partnership. This transaction was effected under the predecessor to section 351.

(2) The taxpayer-petitioner settled the tort claims and deducted the costs. At trial, the taxpayer argued that the corporation was the successor to the partnership and that it should be able to deduct amounts paid on the tort claims.

(3) The Eighth Circuit rejected this argument in holding that the claims arose out of the business of the seller, not the buyer.

(4) As a result, the cost of settling the tort claims was not a deductible operating expense or operating loss of the buyer’s business.

(5) The Court also held that it was of no consequence that the liabilities were contingent.

(6) NOTE: The Service has announced that it will not follow the Holdcroft decision in situations where the assets of a business are acquired in a section 351 transaction. Rev. Rul. 95-74, 1995-2 C.B. 36; See also Rev. Rul. 80-198, 1980-2 C.B. 113; Rev. Rul. 83-155, 1983-2 C.B. 38. Relying upon its ruling in Rev. Rul. 80-198, the Service, in Rev. Rul. 95-74, explained that the specific congressional intent of section 351(a), which is to facilitate the incorporation of ongoing businesses through a tax-free vehicle, would be frustrated if Holdcroft was followed under these circumstances.

(a) Hence, the Service will not disallow deductions under Holdcroft that arise out of pre-acquisition operations if the business was acquired in a section 351 transaction.

(b) However, Rev. Rul. 95-74 only explicitly applies to section 351 transactions and, therefore, the factor created in Holdcroft is still applicable to taxable transactions.

(c) Moreover, it is important to note that while the Service will not apply Holdcroft in section 351 transactions, courts may still continue to do so.

(7) In Notice 2001-17, 2001-09 I.R.B. 730, the Service announced that it will not follow Rev. Rul. 95-74 in certain tax shelter transactions defined under the Notice. See also Notice CC-2001-033a, (June 28, 2001) (advising field personnel on how to develop cases involving stock loss claims as described in Notice 2001-17, 2001-09 I.R.B. 730, on contingent liability tax shelters).

(a) The tax shelter transaction, which is intended to qualify under section 351, involves a transfer of a high basis asset to a controlled corporation in exchange for stock and the assumption of a liability with a present value only slightly less than the value of the transferred asset.

(b) The stock received in the transaction has a low fair market value because the value of the liability is almost equal to the value of the transferred asset

(c) However, the transferor’s basis in the transferee’s stock is not reduced by the assumed liability because the transferred liability is not treated as money received by virtue of sections 358(d)(2) and 357(c)(3).

i) Section 357(c)(3) excludes the amount of a liability, the payment of which would give rise to a deduction, from the determination of the amount of liabilities assumed.

ii) Section 358(d)(2) excludes liabilities described under section 357(c)(3) from being treated as money received by the taxpayer on the exchange.

(d) The transferor then sells the acquired stock for its fair market value, which is far less than the transferor’s basis in the stock, and claims a loss on the sale.

(e) For transfer’s after October 18, 1999, the Service will assert that such losses are disallowed because the transferor’s basis in the stock received is reduced under newly enacted section 358(h), which reduces stock basis by the amount of certain liabilities.

(1) In Illinois Tool Works, Inc. v. Commissioner, 117 T.C. No. 4 (2001), the court held that the payment of a patent infringement liability assumed by the buyer must be capitalized.

(a) In so holding, the court stated "[g]enerally, the payment of a liability of a preceding owner of property by the person acquiring such property, whether or not such liability was fixed or contingent at the time such property was acquired, is not an ordinary and necessary business expense." Id. at 11.

(b) The court rejected the taxpayer’s contention that the payment should retain its deductible character because it would have been deductible had it paid by the seller prior to the acquisition.

(c) The court also rejected the taxpayer’s argument that the payment of the liability should not be added to basis because the liability was highly spectulative and unexpected at the time of acquisition.

(d) Instead, the court held that the buyer was aware of the liability, the liability was expressly assumed in the purchase agreement, and the status of the liability was considered in determining the final purchase price.

(2) In Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff’d, 333 F.2d 653 (2d Cir. 1.964), the court rejected the buyer’s attempt to capitalize costs associated with severance payments made to union employees pursuant to a collective bargaining agreement that arose upon the buyer’s decision to close a manufacturing plant.

(a) The court emphasized that the liability arose out of a new collective bargaining agreement that was negotiated on behalf of the buyer contemporaneously with the purchase of the business.

(b) The court also emphasized that the new agreement was substantially different from the seller’s old agreement to the extent that payments were contingent upon the buyer’s failure to provide adequate notice of a plant closing.

(c) Accordingly, the court held that the buyer’s obligation was of "such contingent character that it could not be considered part of the cost of the assets," and that any liability that became fixed in a later year was properly taken into account as a deduction.

(3) In TAM 9721002 (Jan. 24, 1997), the buyer expressly assumed the liabilities of the business. The Service determined that:

(a) [I]n the precedent requiring the buyer to capitalize, rather than deduct, the payment of an obligation, the events most crucial to creation of the obligation occur before the acquisition. Under these circumstances, the obligation is treated as a liability of the seller. By contrast, in cases allowing the buyer to take a deduction, the events most crucial to creation of the obligation occur after the acquisition. Under these circumstances, the obligation is a liability of the buyer. The difference in the cases is therefore the degree to which the obligation was fixed at the time of the acquisition.

(b) In the instant case, a liability for severance payments to Target’s employees could arise only if employees were involuntarily terminated. As no employee had been terminated by the date of acquisition, no liability existed for New Target to assume. Further, Buyer neither expressly nor impliedly agreed to pay, as part of the acquisition, any severance payments it might later incur. Buyer was free to decide after the acquisition whether to terminate employees and become liable. Finally, some employees would not be entitled to severance under either the termination protection agreements or the personnel policy if other suitable jobs could be found for them.

(c) Hence, this case more closely resembles cases in which the events most crucial to creation of the obligation occurred after the acquisition. Because no employee was terminated before the date of acquisition, no liability arose before the acquisition (even though the amount of New Target’s later liability for severance pay could be based on employment status and length of service with Target). Thus, the severance payments did not result from liabilities of Target, either fixed or contingent, that New Target could be treated as assuming in the acquisition.

(4) In Rev. Rul. 76-520, 1976-2 C.B. 42, the buyer acquired a newspaper business.

(a) The Service held that the costs of fulfilling prepaid subscriptions were assumed by the buyer and had to be capitalized because the liability related to the seller’s operation of the business.

(b) However, the Service also held that costs incurred for publication and distribution to news stands were deductible because they related to the buyer’s operation of the business.

(5) In FSA 19991068 (October 8, 1993), the buyer acquired the assets and assumed the liabilities of a packaging company.

(a) The Service concluded that the buyer must capitalize post-acquisition payments made for retiree health and life insurance benefits.

(b) The Service based its conclusion on the fact that the benefits were paid to retirees who had never worked for the buyer.

(c) Accordingly, the Service determined that "[Buyer’s] obligation to pay those benefits could not have arisen out of the operation of its business, but arose instead out of employment contracts the former employees had with the seller."

(d) The Service also concluded that expenses incurred by the buyer in closing a plant were deductible because the buyer was under no obligation to make post-acquisition closings and thus, the expenses incurred therefor were not liabilities assumed by the buyer.

(1) The liability is contingent because the employee will one day die.

(2) The liability should be a buyer liability if the employee dies after closing.

(3) However, the buyer has assumed the liability if the employee has died prior to the acquisition.

(1) In M. Buten & Sons, Inc. v. Commissioner, 31 T.C.M. 178 (1972), a corporation agreed to assume the liabilities of a partnership including death benefits payable to widows.

(a) The taxpayer was not allowed a deduction for death benefits payable to the widow of an already deceased partner.

(b) However, the taxpayer could deduct death benefits payable to the widow of a partner who died after the acquistion.

(2) In David R.Webb Company, Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983), the buyer assumed an obligation to make pension payments to the wife of an employee that had died almost twenty years prior to the acquisition.

(a) The court held that the obligation arose prior to buyer’s operation of the business.

(b) The buyer was, therefore, not permitted to deduct death benefits paid under this obligation.

(1) The Tax Court held that the liabilities were not assumed because they were too remote to be accounted for.

(2) The Ninth Circuit disagreed holding that the acquiring parent was aware of the liabilities at the time of the liquidation and, therefore, the liabilities constituted capitalized costs of the acquisition.

(3) The court further held that the contingency was irrelevant, stating that no exception to capitalization treatment applies where "taxpayers enter into bargains, proceed under a mistake of, law, or fail to realize the substance or amount of the liability assumed."

(1) The taxpayer argued that it ought to be permitted to deduct the payment of an assumed potential patent infringement liability because both the likelihood of the liability vesting and the amount of the liability if vested were highly speculative.

(2) The court disagreed, stating that the liability "was a contingent liability that petitioner was aware of prior to the acquisition of assets and liabilities from [the seller] and that petitioner expressly assumed in the purchase agreement." Id. at 17.

(a) In Nahey, the court rejected the taxpayer’s claim for capital gains treatment and held that settlement proceeds paid to the buyer for a liability arising out of the seller’s operation of the business constituted ordinary income to the buyer when received.

(b) In so holding, the court stated: "In some of the cases that Nahey cites, the court may have misclassified an expenditure (he points chiefly to Pacific Transport Co. v. Commissioner, . . .) and treated an ordinary expense as a capital one. If so (and we needn’t decide), those cases are incorrect."

(c) Judge Cudahy concurring opinion argues that "Pacific Transport is on all fours with the present case except that it involves the expense side rather than the income side." Accordingly, Judge Cudahy acknowledges that it is inequitable for the government to assert capitalization in the expense context and ordinary income in the income context when the claims at issue are the complete inverse of one another.

(d) In Illinois Tools Works, supra, the Tax Court recently declined to rule upon the statues of Pacific Transport. Instead, the court ruled that the issue was controlled by David R Webb, which is the main Seventh Circuit case regarding the treatment of assumed liabilities.

(2) Holdcroft, supra, Pacific Transport, supra, and Illinois Tool, supra, support this conclusion.

(3) These cases also indicate that the contingent nature of the claim is irrelevant.

(1) In Albany Car Wheel Co., supra, there was a collective bargaining agreement that required payment of severance wages to employees upon a plant shutting down.

(a) The purchase agreement called for an express assumption of the severance pay liability.

(b) After the acquisition, the plant was shut down and severance payments were made by the buyer.

(c) The court held that the liability did not arise until after the buyer had closed the plant.

(d) The contract that required payment upon certain events was contingent upon a future event; the liability arose only after the plant was closed down.

(e) Thus, the buyer’s payments of severance costs were deductible because the contingency occurred from the buyer’s operation of the business since the liability arose from the buyer’s decision to close a manufacturing plant without giving the contractually required notice.

(f) This decision is instructive because it indicates that:

i) The facts and circumstances of the transactions override the express assumption of a liability;

ii) A contingent liability arising in contract may not treated as an assumed liability; and

iii) A deduction is appropriate if the action that triggers the contingency is within the buyer’s control (in this case, shutting down the plant).

(2) The same result was reached in United States v. Minneapolis & St. Louis Ry. Co, 260 F.2d 663 (8th Cir. 1958).

(a) The seller was in negotiations with a labor union for retroactive wage increases.

(b) The balance sheet contained a reserve for the retroactive wages to be paid once a settlement was reached.

(c) The agreement with the union was reached after closing; the liability arose at that point.

(d) The court held that there was no liability of the seller to assume and the buyer’s payment of the retroactive wages was deductible.

(e) NOTE: The balance sheet reserve was not an issue in the case.

(1) There is a reserve on the company’s balance sheet prior to the acquisition for the amounts of a liability that is not currently deductible (e.g., employee retirement and medical benefits owed);

(2) Where the purchase price is based upon the company’s balance sheet (e.g., book value of assets minus the anticipated cost of liabilities); and

(3) Where there is a clear reduction in purchase price allowing the Service to argue that the liability is reflected in the cost.

(1) The Eighth Circuit affirmed the Tax Court in upholding a buyer-taxpayer’s deduction for retroactive wage increase payments.

(2) The court held that the liability could not have been assumed because it did not exist at the time of acquisition.

(3) This case implies that an express assumption of liabilities will not result in capitalization if the facts and circumstances of the liability indicate that the liability could not have been assumed.

(1) The purchase agreement required that the buyer procure a release of the seller’s liability under a union contract for severance pay.

(2) The buyer procured the release by entering into a new contract for severance pay, which had terms that substantially differed from the seller’s contract.

(3) The court held that the liability had not been assumed because the liability arose out of the buyer’s conduct, which obligated the buyer under its own contract.