Sec. 351: an alternative to taxable asset acquisitions.

In a business acquisition, the buyer will want to purchase assets so the amount being paid will be reflected in their bases and will be recovered through deductions related to those assets (depreciation, amortization, etc.). With the passage of the Revenue Reconciliation Act of 1993 (RRA), amounts paid for "Sec. 197 intangibles" may be amortized over a 15-year period. Although some might argue this will encourage taxable asset acquisitions, there are still many other unresolved issues that affect their tax consequences. The most significant is the treatment accorded contingent liabilities assumed as part of an acquisition. In many cases, restructuring the asset acquisition as a Sec. 351 transfer will avoid issues related to taxable asset purchases without significantly changing the economics of the transaction.

In order to convert a taxable asset acquisition to a Sec. 351 transfer, a new corporation ("Newco") is formed to which the Seller transfers the assets and the Buyer transfers the consideration that was to be paid for the assets Together, the Buyer and Seller ("Transferors") are the owners of Newco. In exchange for the assets, the Seller could receive some cash from Newco, even cash contributed by the Buyer, and Newco stock equal to the net value of the assets transferred. The Buyer would receive all of the Newco common stock. In addition, if the stock received by the Seller is preferred stock (as described in Sec. 1504(a)(4)), a corporate Buyer and Newco could join in filing a consolidated tax return.

Often, it is more advantageous to transfer the assets to a preexisting corporation ("Transferee"). The transfer of assets by the Seller in exchange for Transferee stock will be subject to Sec. 351, provided the preexisting Transferee shareholder(s) also transfer property for stock. In measuring whether the Transferors of property are in control of the Transferee, all stock owned in the Transferee immediately after the transfer is considered, even though some of the stock was held before the transfer. This structure is often referred to as an "accommodation transfer," since the preexisting shareholders are accommodating the Seller in order to satisfy the requirements of Sec. 35 1. In Rev. Proc. 77-37, the IRS has stated it will respect an accommodation transfer provided the amount of stock received equals or exceeds 10% of the value of the stock previously held.

Seller deferral

Taxable asset acquisition: In a taxable asset acquisition, the Seller can defer gain recognition by reporting the gain under the installment method. Under this method, gain from the sale is pro-rated and recognized in the year of payment in an amount equal to the payment multiplied by the gross profit ratio for the sale (Sec. 453). However, for deferred gain in excess of $5 million, interest will be charged in an amount equal to the underpayment rate in effect under Sec. 6621(a)(2) multiplied by the deferred tax liability (to the extent related to the deferral in excess of $5 million). The deferred tax liability is calculated without regard to the existence of any net operating losses (NOLs) at the maximum applicable tax rate (Sec. 453A(c)). In addition, if the installment obligation is pledged as security for a loan, it will be treated as sold, thereby eliminating the benefit of deferral (Sec. 453A(d)).

Sec. 351 transfer: The Seller defers gain recognition to the extent the money and value of other property received is less than the gain realized on the transfer (Sec. 351(a)). There is no interest charge on the deferral of gain and no deemed disposition on the monetization of the stock received. The Transferor will have a carryover basis in the stock received, increased by gain recognized in the transfer and decreased by any cash or other property received in the transfer (Sec. 358(a)(1)). As the stock is redeemed or sold, gain or loss is generally recognized in an amount equal to the difference between the stock's tax basis and the amount of the payment for the stock.

Seller financing

Taxable asset acquisitions: A Seller can help finance the acquisition by accepting the Buyer's note. Any interest payment (stated or accrued under original issue discount principles) would be deductible by the Buyer and includible in income by the Seller. As noted, there may be an interest charge to the Seller to the extent of the deferred tax liability under the installment sale rules. Sec. 351 transfer: A Seller may be able to finance the acquisition on more favorable terms by taking back preferred stock in a Sec. 351 transfer. This may allow the Buyer to file a consolidated return with Newco. To the extent the Seller receives dividends (essentially an interest equivalent) on the preferred stock, it may be able to deduct up to 80% of the dividends received. This may reduce the amount the Buyer would have to pay for the assets. Furthermore, it may be possible to structure the preferred stock such that it has a high dividend rate but low liquidation and redemption price ("liquidating preferred stock"). Sec. 1059(f) might apply such that the liquidating preferred stock would be subject to the extraordinary dividend rules. This would result in a recapture of the nontaxed portion of the dividends on disposition, but would enhance the deferral feature of using preferred stock in a Sec. 351 transfer. (Note that the Buyer would lose the deduction attributable to the interest payments under this approach.) Some combination of debt and equity may be used to obtain the benefits of both.

Effective use of tax basis

and preserving deductions

Taxable asset acquisitions: One of the more significant differences between a taxable asset acquisition and a Sec. 351 transfer is the treatment of contingent liabilities. In a taxable asset acquisition, contingent liabilities are accounted for as additional purchase price when such liabilities become fixed and determinable. As a result, the payment of the liability by the Buyer increases its purchase price, which is allocable to the asset acquired and the Buyer does not receive a deduction on the payment of an assumed liability that would otherwise be deductible. The IRS appears to have concluded in Letter Ruling, (TAM) 9195001 that the Seller would have a deduction, if appropriate, which will offset the additional amount realized on the asset sale.

Significant contingent liabilities may have the effect of a bargain purchase resulting in a basis in Class III assets of less than fair market value (FMV). Because, inventory and accounts receivable are Class III assets, there may be income recognition soon after the sale on the collection of the receivables and the sale of inventory. Once the contingent liability becomes fixed and determinable, the Buyer will receive a deduction to the extent the adjustment to purchase price is attributable to assets no longer held by the Buyer.

Under prior law, the Service attempted to allocate purchase price away from depreciable or amortizable assets and towards nonamortizable assets or goodwill and going concern value. With the enactment of Sec. 197, buyers are more likely to allocate purchase price to Sec. 197 intangibles to take advantage of the 15-year amortization. The RRA Conference Report for Sec. 197 indicates that the residual method specified in regulations under Secs. 338 and 1060 will be modified to include Sec. 197 intangibles in Class IV. Therefore, a purchase price must first be allocated to the assets included in Class I through Class III up to their FMVs before any amount can be allocated to the Sec. 197 intangibles. The IRS is now more likely to allocate purchase price to assets in Class III with no useful life or a useful life in excess of 15 years (e.g., land and buildings), rather than Class IV.

Sec. 351 transfer: The transfer of assets in a Sec. 351 transaction avoids many of the problems associated with the assumption of contingent liabilities in a taxable asset acquisition. Although not entirely clear, more recent IRS authorities issued in situations similar to Sec. 351 support the deductibility of payments on contingent liabilities assumed by Newco in a Sec. 351 transfer (Letter Rulings 8934002 and 9343011). Obviously, a deduction for payments of assumed liabilities is preferable to an adjustment to purchase price that can only be recovered through future depreciation and amortization deductions.

The impact of the assumption of contingent liabilities in a Sec. 351 transfer also avoids the possible writedown in the tax basis of accounts receivable and inventory. In a Sec. 351 transfer, basis is determined by reference to the Seller's basis in the assets transferred increased by any gain recognized by the Seller. Under this approach, full basis in the accounts receivable and inventory would be preserved (presumably with any gain recognized by the Seller allocable to the other assets acquired).

Because it is unclear how the increase in basis for recognized gain is allocated to the assets transferred, any reasonable method should be acceptable. In certain instances, a methodology could be adopted that would allocate the increase in the tax basis of acquired assets to depreciable and amortizable assets. (See the example on page 427 for a comparison of Secs. 1060 and 351.) Before Sec. 197 was enacted, the benefit associated with increasing the basis of depreciable or amortizable assets was significant when compared to the application of the residual method of Sec. 1060. With the enactment of Sec. 197, this benefit is not as significant; however, a Sec. 351 transfer preserves the deduction for the payment of assumed liabilities.

When Sec. 197 intangibles are transferred in a Sec. 351 transactions, Newco continues the Seller's amortization over the remaining 15-year amortization period, to the extent the basis in the Sec. 197 intangible equals the adjusted basis of such asset in the Seller's hands. Newco begins a new 15-year period with respect to any increase in tax basis attributable to gain recognized by the Seller. Under certain anti-churning rules, Sec. 197 does not apply,

Effective use of tax attributes

including tax basis

Taxable asset acquisitions: The Seller's tax attributes (e.g., NOL carryforwards and alternative minimum tax credits) remain with the Seller and can be used to offset any gain recognized on the sale of assets. The basis of the assets is determined by reference to the purchase price paid, which is allocated to such assets under the residual method prescribed by Sec. 1060. To the extent any asset had a tax basis in excess of FMV (i.e., a built-in loss) such loss would be recognized by the Seller and could be used to offset gain or, if the losses are greater than the gains, would contribute to its NOL to be carried forward.

Sec. 351 transfers: The treatment of tax attributes in a Sec. 351 transfer is identical to the treatment in a taxable asset acquisition in that the tax attributes remain with the Seller. If gain is recognized by the Seller, the Seller's tax attributes may be used to offset such gain. However, in a Sec. 351 transfer, no loss can be recognized by the Seller on the transfer of a built-in loss asset. Instead, Newco retains the built-in loss in the asset transferred and the Seller applies the high basis in the asset to the stock received from Newco. This has the effect of transferring the built-in loss to Newco while preserving the benefit of the loss to the Seller (albeit in the form of a capital loss). Proposed regulations under Sec. 382 may apply "as the context may require" to limit Newco's ability to use the recognized built-in loss if the built-in loss on all the assets transferred is "material."

Another benefit of a Sec. 351 transfer is the possibility that, in a consolidated setting, the Seller may be able to use some portion of its NOL carryforwards to shelter the built-in gain on the assets transferred. Sec. 384 prohibits the use of preacquisition NOL carryforwards to shelter built-in gains on assets received in certain tax-free reorganizations. Sec. 351 transfers of built-in gain property to a loss corporation or a member of its group are not described in Sec. 384. Thus, subsequent gain may be offset by preacquisition NOLs. Sec. 351 transfers are generally respected even if the recipient of the gain property sells the transferred property; see Rev. Rul. 88-32. Note that Secs. 269 and 1503(f) may apply in certain cases to disallow the use of Newco's consolidated group's preacquisition NOLs. Generally, these rules can be avoided with careful planning, provided the acquisition of assets is for valid business reasons.

Conclusion

As with most mergers and acquisitions transactions, the most tax effective structure for an asset acquisition depends largely on the particular facts involved and the business concerns of the parties involved. The 15-year amortization of Sec. 197 intangibles increases the benefits associated with a taxable asset acquisition. However, the tax treatment of contingent liabilities assumed in a taxable asset acquisition may convert otherwise deductible payments into amounts that must be amortized over 15 years.

With careful tax planning, an asset acquisition may be structured to meet the requirements of Sec. 351, thereby preserving the deduction related to the payment of certain contingent liabilities. In addition, a Sec. 351 transfer may provide an effective means of deferring gain on the sale of assets while using the tax attributes of the Seller and possibly the Buyer.

Example : Preserving Tax Benefits
Tax balance sheet
                         Adjusted             Gain/
                          basis      FMV      loss

Assets:
Cash                      $  500   $   500   $    0
Accounts receivable        1,000     1,000        0
Inventory                  1,750     2,500      750
Plant and equipment        1,600     2,000      400
Building                     850       600    (250)
Land                         100     1,650    1,550
Patents                      200       750      550
Goodwill/going concern         0     3,000    3,000
Total                     $6,000   $12,000

Liabilities:
Accounts payable (A/P)               1,000
Loans                                3,000
OPEB liability                       1,000
Environment liability                2,500

Sec. 1060 allocation

Purchase price is $4,500 plus assumption of liabilities. The
purchase price
to be allocated is $8,500 ($4,500 [cash] + $1,000 [A/P] +
$3,000 [loans]).

                                           Allocated
                           FMV     Class     basis
Assets:
Cash                      $  500      I    $   500
Accounts receivable        1,000    III      1,000
Inventory                  2,500    III      2,500
Plant and equipment        2,000    III      2,000
Building                     600    III        600
Land                       1,650    III       ,650
Patents                      750     IV         50
Goodwill/going concern     3,000     IV        200
Total                    $12,000            $8,500

Sec. 351

Seller receives cash of $2,000 plus preferred stock with a fair
market
value of $2,500.
                         Total                            Newco
                        gain on    Adjusted   Allocated   asset
                         assets     basis      gain(*)    basis
Assets:
Cash                     $    0   $  500        $    0    $  500
Accounts receivable           0    1,000             0     1,000
Inventory                   750    1,750           240      1990
Plant and equipment         400    1,600           128     1,728
Building                      0      850             0       850
Land                      1,550      100           496       596
Patents                     550      200           176       376
Goodwill/going concern    3,000        0           960       960
Total                    $6,250   $6,000        $2,000    $8,000

(*) Allocated to assets based on their relative gain.