Sec. 351 transfers involving boot and encumbered assets.

Under Sec. 351(b)(1), when consideration received in exchange for property transferred in a Sec. 351 transfer includes money or other property (i.e., "boot"), gain is recognized to the extent of the boot's fair market value (FMV). However, Sec. 351 is silent about how to allocate consideration received in an exchange, including boot, among the assets transferred. More importantly, although the IRS has issued guidance on multiple-asset transfers under Sec. 351, it has not addressed multiple-asset transfers involving encumbered assets. Two reasonable interpretations seem possible; the better result depends on the facts.

Rev. Rul. 68-55

In Rev. Rul. 68-55, the Service held that if multiple assets are transferred under Sec. 351, each asset is deemed transferred in exchange for a proportionate share of each category of consideration received (i.e., stock, liability assumption and boot). Because stock or liability assumption received in an exchange is protected under the Sees. 351(a) and 357(a) non-recognition rules, the real effect of Rev. Rul. 68-55 is on the allocation of boot among the multiple assets transferred. Under Sec. 351(b)(2), if boot is allocated to property with a realized loss, such loss would not be recognized. However, according to Sec. 351(b)(1), if it is allocated to property with realized gain, such gain would be recognized to the extent of the allocated boot's FMV.

Rev. Rul. 68-55 strives to provide a balanced approach for determining exactly which consideration is received for each asset transferred. As such, it addresses two concerns: (1) the netting of gains and losses realized in a Sec. 351 transfer involving multiple assets and (2) the arbitrary allocation of consideration among the multiple assets transferred.

For the first issue, the ruling is clear--receipt of boot might simply have no effect if netting were permitted. For the second issue, in the ruling, the IRS rejected the arbitrary allocation of consideration; this position was later reiterated and amplified in Rev. Rul. 85-164. The IRS's reasoning is quite apparent--the arbitrary allocation of consideration, particularly boot, may allow a taxpayer to allocate the boot to shift gain recognition away from gain assets and toward loss assets. Fortunately, in Rev. Rul. 68-55, the Service did not attempt to allocate boot only to gain assets.

Specific Liabilities

Unfortunately, Rev. Kul. 68-55 did not consider the effect if one or more of the assets transferred was encumbered. In fact, no ruling has.

Historically, the issue of Sec. 351 transfers involving specifically encumbered assets was of little practical importance, because receipt of boot in Sec. 351 transfers was rare, explaining the lack of guidance. However, many more Sec. 351 exchanges now involve boot, creating a need for such guidance.

As discussed above, there are two reasonable approaches to dealing with liabilities that encumber specific assets in a Sec. 351 transfer. The difference turns on whether liabilities should be allocated (1) to the specific assets with which they are associated (the "net method") or (2) among all the assets transferred, regardless of whether any relate to specific assets (the "gross method").

Both methods appear reasonable and balanced; neither seems to favor the IRS or the taxpayer every time. The tax consequences stem entirely from the facts.

The Net Method

If a liability is allocated to the specific asset with which it is associated, any remaining consideration (i.e., stock, assumption of other liabilities and boot) would presumably be allocated on the basis of relative net FMVs. Under Rev. Rul. 68-55, the net method appears not to allow netting of realized losses against realized gains, nor to allow an arbitrary allocation of consideration among the multiple assets transferred. In fact, it arguably appears to comply with normal business practice. For example, when one party assumes a liability as part of the consideration in a property acquisition, that assumption is part of the payment for the asset it encumbers.

Example: Limited liability company C transfers multiple assets worth $5,000 in total (with an aggregate tax basis of $4,000) and $3,000 of liabilities to new company N, for N stock worth $1,500, and $500 cash. Of the liabilities transferred, $2,800 specifically encumbers C's inventory, which represents $3,000 of the $5,000 aggregate value. Exhibit 1 at left shows how C would allocate its assets under Rev. Rul. 68-55, using the net method.

The Gross Method

If an association of a liability with a specific asset is ignored, each item of consideration is presumably allocated among the multiple assets transferred according to each asset's relative (gross) FMV. In contrast with the net method, the gross method may appear to be arbitrary, in that a liability associated with only one asset is treated as consideration for other assets with which it has no association. This appears less in line with normal business practices. Using the facts in the example, Exhibit 2 above shows the results of using the gross method of allocating assets.

Which Method Is Better?

Until the IRS provides guidance on this issue, either approach seems possible. Neither appears to threaten Rev. Rul. 68-55, nor always to favor either the taxpayer or the IRS. However, a literal reading of the ruling, combined with a correlation to Sec. 338 and the regulations there-under, appears to suggest that the Service favors the gross method.

The first paragraph of the ruling states, "each asset must be considered transferred separately in exchange for a portion of each category of consideration received. The fair market value of each category of consideration received is separately allocated to the transferred assets in proportion to the relative fair market values of the transferred assets." (Emphasis added.) Under Sec. 357(a)(2), liabilities assumed in a Sec. 351 transfer are simply another category of consideration received, much like stock and boot. The fact that Rev. Rul. 68-55 does not consider liabilities assumed as a category of consideration received, appears coincidental (i.e., it simply was not part of the facts). However, if part of the consideration in a Sec. 351 transfer includes a liability assumption, an allocation of this consideration exactly as Rev. Rul. 68-55 literally prescribes--in proportion to the relative FMVs of the transferred assets--would appear entirely appropriate.

Sec. 338 rules: Although, arguably, this seems counterintuitive from a business perspective, Sec. 338 and the regulations thereunder specifically endorse the gross method. Sec. 338 generally provides that, on certain requirements and on a joint election of a buyer and a seller, the sale and purchase of a target corporation's shares may be treated as a sale and purchase of the "old" target corporation's assets by a "new" target corporation, followed by a deemed liquidation of the "old" target.

The purchase price for the target is generally computed using the price paid for the target stock acquired and its liabilities. Specifically, according to Sec. 338(b), the target's assets are treated as purchased for an amount equal to the grossed-up basis of its stock, as adjusted under the regulations by its liabilities and other relevant items. The purchase price is then allocated among the target's assets by class of asset, and within each class, based on relative FMVs.

Regs. Sec. 1.338-4(e) computes gain or loss on each asset in a deemed sale by reference to the aggregate deemed sale price (ADSP) allocated to that asset. Regs. Sec. 1.338 4(b) defines ADSP as the sum of the grossed up amount realized on the sale to the purchasing corporation of its recently purchased target stock, plus the old target's liabilities. Regs. Sec. 1.338-6(b) allocates ADSP to the target's assets by asset class. ADSP is first reduced by the class 1 assets (cash). The balance is then allocated to class II assets in proportion to the FMVs of those assets at such time, then allocated among class 111 assets in such proportion, etc., all the way through to class VII. Regs. Sec. 1.338-6(a)(2) defines an asset's FMV as its gross FMV, ignoring mortgages, liens, pledges or other liabilities.

The allocation of consideration, including a target's liabilities, in proportion to the assets' gross FMVs is illustrated in Regs. Sec. 1.338-6(d), Example 1. This example demonstrates the IRS's position that, for Sec. 338 elections, liabilities assumed are part of the purchase price allocated to the target's assets based on their gross FMVs. Nowhere within the regulations under that section is it appropriate to net an asset with any related liability; instead, aggregate liabilities assumed are allocated to the assets acquired based on their gross FMVs, without regard to their nature. The question is whether a parallel should be drawn between Rev. Rul. 68-55 and Sec. 338, inasmuch as assumed liabilities are a form of consideration received in each, and each provides that consideration received is allocated in accordance with the FMV of the assets exchanged/acquired.

Commentary: There appears to be no similar correlation of the net method to relevant tax law. Although little commentary exists on either method, the net method was advocated as reasonable by Rabinovitz, "Allocating Boot in Sec. 351 Exchanges," 24 Tax. L. Rev. 337 (1969), p. 345-346. Rabinovitz cited regulations under former Sec. 334(b)(2) as support for his rationale. Sec. 334(b)(2) was the predecessor to Sec. 338. Unlike regulations under Sec. 338, the regulations under old Sec. 334(b)(2) provided that the allocation to a target's assets was made in proportion to their net FMVs (FMV less any specific mortgage or other pledge to which they were subject). However, it appears that the IRS determined that the net approach under Sec. 334(b)(2) was improper, inasmuch as Sec. 338 was later enacted to provide the opposite (i.e., the allocation to the target's assets is made in proportion to their gross FMVs (determined without regard to mortgages, liens, pledges or other liabilities)).

Sec. 334(b)(2) existed at the time Rev. Rul. 68-55 was drafted, and at the time of the Rabinovitz article. Thus, it is understandable that Rabinovitz might conclude the net method was reasonable. However, the IRS appears to have affirmatively changed its position on the netting issue with the enactment of Sec. 338, and, as such, explicitly resolved the related netting matter for this section. However, it has not issued similar guidance for Rev. Rul. 68-55.

Exhibit 1: Asset allocation using the net method

                                    FMV of
Asset            Assets'    % of    stock       Cash     Liabilities
transferred        FMV      FMV    received   received     assumed

Accounts
receivable
(A/R)              $300      14      $210         $70          $28

Inventory *         200       9       135          45           18

Payroll,
property and
equipment
(PP&E)              700      32       480         160           64

Goodwill          1,000      45       675         225           90

Totals           $2,200    100%    $1,500        $500         $200

                 Total               Gain/
Asset            amount     Tax      (loss)       Gain
transferred     realized   basis    realized   recognized

Accounts
receivable
(A/R)              $300     $300        --          --

Inventory *         200      200        --          --

Payroll,
property and
equipment
(PP&E)              700      700        --          --

Goodwill          1,000       --    $1,000        $225

Totals           $2,200   $1,200    $1,000        $225

* The inventory is first netted with its associated $2,800 liability
before determining how much of the stock and boot will be allocated
to each asset.

Exhibit 2: Asset allocation using the gross method

                                   FMV of
Asset           Assets'    % of    stock        Cash     Liabilities
transferred       FMV      FMV    received    received     assumed

A/R                $300       6       $90         $30         $180

Inventory         3,000      60       900         300        1,800

PP&E                700      14       210          70          420

Goodwill          1,000      20       300         100          600

Totals           $5,000    100%    $1,500        $500       $3,000

                 Total               Gain/
Asset            amount     Tax      (loss)       Gain
transferred     realized   basis    realized   recognized

A/R                $300     $300         --          --

Inventory         3,000    3,000         --          --

PP&E                700      700         --          --

Goodwill          1,000       --     $1,000         100

Totals           $5,000   $4,000     $1,000        $100

FROM BRIAN E. KELLER, CPA, OAK BROOK, IL