Small business tax solutions.

Q: How are contingent liabilities treated when assets and liabilities are transferred to a corporation?

A: In revenue ruling 95-74, the Internal Revenue Service ruled that contingent liabilities are not counted as liabilities for purposes of determining whether liabilities exceed the basis of assets transferred to a corporation. The issuance of this ruling is a positive development for taxpayers that incorporate assets subject to contingent liabilities.

Internal Revenue Code section 351 provides that no gain or loss is recognized on the transfer of property to a corporation by one or more persons--solely in exchange for stock of that corporation--if the transferors control the transferee corporation after the transfer. While the application of section 351 to various scenarios can be complex, in most cases involving incorporation of a going concern, the transfer will be tax-free.

Typically, the incorporation of an existing business involves the transfer of existing liabilities to the corporation. If so, the CPA must review IRC section 357 and apply it to the facts of the transaction. Under section 357(a), the general rule is that the transfer of assets subject to liabilities will not trigger gain recognition. Under IRC section 358, the "cost" of transferring assets subject to liabilities is that the transferee's basis will be reduced by the amount of the liabilities assumed.

Example 1. Allen transfers assets to corporation X in a transaction that otherwise qualifies under section 351. The assets have a fair market value of $50,000, a tax basis of $25,000 and are subject to $10,000 of liabilities. Allen recognizes no gain or loss on the transfer; however, Allen's basis in the stock received will be $15,000 rather than $25,000 because the basis is reduced by the liabilities assumed.

There are two exceptions to section 357(a). First, under section 357(c), gain will be recognized to the extent the liabilities transferred exceed the basis in the assets transferred.

Example 2. Allen transfers an asset to corporation X that has a fair market value of $50,000, a tax basis of $10,000 and is subject to $15,000 of liabilities. Under section 357(c), Allen will recognize $5,000 of gain, the excess of the liabilities over basis.

The second exception is found in section 357(b). It provides that the entire amount of liabilities assumed are taxable if they were incurred principally to avoid federal taxes. Section 357(b)'s aim is to dissuade taxpayers from trying to capitalize on section 357(c).

Example 3. Allen has an asset with a $50,000 tax basis. Allen borrows $50,000 against the asset and then transfers it--subject to the liability--to corporation X. Under section 357(c), no gain would be triggered because the liabilities do not exceed the tax basis. However, under section 357(b), the full amount of the liability assumed will become taxable to Allen.

Section 357(c)(3) specifically excludes the liabilities of a cash method taxpayer that the taxpayer has not yet been able to deduct. Without this rule, a cash method taxpayer might unknowingly trigger section 357 because the taxpayer would have no basis in its receivables and yet would have "liabilities" in the form of its payables. Because no tax benefit has been bestowed on the cash method taxpayer--the taxpayer has not yet deducted or capitalized the liabilities--section 357(c)(3) causes section 357 to have no effect.

The issue addressed in revenue ruling 95-74 is how contingent liabilities fit into section 357. In the ruling, a parent corporation ran several businesses, one of which had a manufacturing plant and land. The plant caused environmental damage that required soil and ground-water remediation. The parent wanted to transfer the plant and land to a subsidiary, with the subsidiary assuming the contingent liability for the cleanup costs.

The IRS concluded that the contingent environmental liabilities should not be included in calculating whether liabilities exceed basis under section 357. The rationale was that section 357(c) should not cause gain recognition when the transferor has neither received basis for the property nor deducted the liability. Rather, only when the debt has created some current or future tax benefit would section 357 be triggered. This conclusion is consistent with the application of section 357(c)(3) discussed above.

This revenue ruling has an added dimension. The IRS also allowed the subsidiary to "step in the shoes" of the parent and deduct the payments when incurred if the parent would have been allowed a deduction. This conclusion provides further positive authority for taxpayers transferring contingent liabilities.

BRYAN E. BLOOM, LLM, is a tax attorney with WRH Partners in Morristown, New Jersey. He is an author in the AICPA tax CEA series.