Basis of debt obligations in certain transactions.

On Dec. 20, 2005, the IRS released Rev. Rul. 2006-2, which revoked Rev. Rul. 74-503 generally as of that date. According to Rev. Rul. 74-503, a corporation (transferor) had no basis in its own stock, and under Sec. 362(a) had no basis in stock received from a controlled corporation (transferee) in exchange for the transferor's own stock in a transaction to which Sec. 351 applies. However, Rev. Rul. 2006-2 notes that it is inappropriate to apply Sec. 362(a) to determine a transferor's basis in transferee stock received in exchange for the transferor's own stock. Rev. Rul. 2006-2 further states that the other conclusions reached in Rev. Rul. 74-503--including whether the transferor and the transferee each have zero basis in stock received in the exchange--are "under study" by the IRS.

Exchange of Debt Obligation

The IRS addressed a similar transaction in Rev. Rul. 68-629, in which a transferor contributed its own debt obligation (rather than its own stock) to a transferee. In the revenue ruling, the IRS took the position that, because the transferor incurred no cost in making its debt obligation, the transferor had no basis in its own obligation. Although this position has not changed since Rev. Rul. 68-629 was issued, different courts have reached inconsistent decisions on the appropriate adjusted basis of a transferor's own debt obligation and the effect of such debt in a Sec. 351 exchange.

In 1971, the Tax Court examined this issue in which a transferor contributed its own debt obligation to a transferee in exchange for transferee stock in a transaction to which Sec. 351 applied (Alderman, 55 TC 662 (1971)). It ruled that because the transferor incurred no cost in making its debt obligation, the transferor's basis in such debt obligation was zero. The court also stated that the transferee's basis in the transferor's debt obligation was zero, presumably relying on Sec. 362(a). Although the transaction at issue occurred in 1963, the court cited Rev. Rul. 68-629, temporarily solidifying the IRS's position.

In 1989, the Second Circuit considered a similar transaction in which a transferor exchanged its own debt obligation for transferee stock in a transaction to which Sec. 351 applied, but reached a somewhat different conclusion (Lessinger, 872 F2d 519 (2d Cir. 1989)). Similar to Alderman, the Second Circuit held the transferor had no basis in its own debt obligation, noting that liabilities by definition generally do not have basis in tax law. However, unlike Alderman, it asserted the transferee should have basis in the transferor's debt obligation equal to the face amount of such debt obligation, "because [transferee] would have to recognize income upon ... payment of the debt if it had no basis in the obligation." The court clearly stated that Sec. 362(a) "cannot be applied" to determine the transferee's basis in the transferor's debt obligation. As a result, under the Second Circuit's approach, the transferor takes a zero basis in the transferee's stock, while the transferee takes a basis equal to the face amount of the transferor's debt obligation.

In 1998, the Ninth Circuit considered a similar transaction, but reached a conclusion that was different from both the Tax Court and the Second Circuit (Peracchi, 143 F3d 487 (9th Cir. 1998)). In its decision, the Ninth Circuit concluded that the transferor has basis in its own debt obligation equal to the face value of such debt obligation, because the transferor increased its "economic investment" in the transferee by the amount of its debt obligation. Consequently, the transferor's contribution of its own debt obligation to the transferee in exchange for transferee stock resulted in the transferor having basis in the transferee stock equal to its basis in its debt obligation (Sec. 358(a)), and the transferee having an equal amount of basis in the transferor's debt obligation (Sec. 362(a)).

Observations

Despite the Second and Ninth Circuit decisions, Rev. Rul. 68-629 continues to be the IRS's position on a transferor's basis in its own debt obligations. Accordingly, there are conflicting authorities on a transferee's basis in a transferor's debt obligation, which clearly has value to transferees.

While Rev. Rul. 2006-2 is not directly applicable because it deals with transferor stock, it may provide insight as to how the IRS might treat a similar transaction involving a transferor's debt obligations. Nonetheless, the IRS should consider revisiting Rev. Rul. 68-629 while it is studying the other issues in Rev. Rul. 74-503, to clarify how to treat properly a transferor's debt obligations in transactions similar to those in Rev. Rul. 68-629.

FROM ROBERT S. BLACK II, AND JOHN MICHALOWSKI, CPA, WASHINGTON, DC