The burden of BILs.

The American Jobs Creation Act of 2004, Section 836, enacted Sec. 362(e)(2), to limit the importation of built-in losses (BILs) in Sec. 351 transactions. Specifically, Sec. 362(e)(2)(A) limits the aggregate adjusted bases of the contributed property to the property's fair market value (FMV) immediately after the transaction.

Sec. 362 is silent as to how FMV is determined; to date, the IRS has not addressed the issue. It appears two interpretations of existing authority are possible; they may present drastically different tax consequences, depending on the facts. The difference turns on whether the contributed assets' FMV should be predicated on the (1) combined total of each individual asset's FMV (individual asset method) or (2) consideration received by the transferor (i.e., the assumption of liabilities and the transferee corporation's stock) (gross-up method).

Individual Asset Method

This method is based on concepts similar to those contained in Sec. 704(c) and determines FMV on a property-by-property basis. Thus, the FMV of each asset would be determined immediately after the transaction; the total of those values would be compared to the aggregate basis of the contributed property immediately before the transaction, to determine if a BIL exists.

Example 1: A Corp. contributes, in a joint Sec. 351 transaction, multiple assets worth $100 in total (with a $95 basis) and $35 in liabilities to Newco, in exchange for 20% of Newco's stock. B Corp. contributes $1 to Newco for the remaining 80% of stock ("Additional facts" are discussed below to explain why A would participate in this transaction). Exhibit 1 at right illustrates the BIL analysis using the individual asset method.

The Sec. 351 transaction described in Example 1 does not result in the application of Sec. 362(e)(2), as the total FMV of the contributed assets exceeds their aggregate basis. Thus, Newco would take a carryover basis in the assets A contributed; A would take a $60 basis in Newco's stock.

Gross-up Method

This method is based on concepts similar to those contained in Sec. 382(h)(8) and would determine the effective purchase price received by the transferor as the FMV of the assets contributed in the transaction. As such, the assets' FMV immediately after the transaction would be limited to the assumed liabilities plus the value of the transferee corporation's stock, plus any other consideration received.

Example 2: The facts are the same as in Example 1. Exhibit 2 at right illustrates the BIL analysis, using the gross-up method.

The Sec. 351 transaction depicted in Example 2 above would result in the application of Sec. 362(e)(2), as the aggregate gross-up basis exceeds the total FMV of the contributed assets. Thus, Newco would reduce the basis of the contributed assets by $60 (from $95 to $35), while A would take a $60 basis in the Newco stock (absent a Sec. 362(e)(2)(c) election, discussed later).

Which Method Should Be Used?

Sec. 362(e)'s stated legislative intent is to limit the ability to duplicate losses. In the examples, A contributed assets with a $95 basis, while receiving only $35 consideration (Newco stock worth zero and a $35 liability assumption), for a total $60 loss. Using the individual asset method, this loss was contained in A's Newco stock ($60 basis, zero FMV). Thus, it would initially appear that the individual asset method satisfies Sec. 362(e)'s intent, in that A's economic loss should be realized only once (on A's disposition of Newco stock).

Conversely, under the gross-up approach, A's Newco stock would still have a $60 BIL; however, Newco's bases in the contributed assets was also reduced by $60. It would appear that the gross-up approach does not meet Sec. 362(e)'s legislative intent, as A's $60 BIL is effectively disallowed, considering Newco's corresponding basis.

However, it could be argued that the individual asset method in fact allows A to duplicate the loss, while the gross-up method actually satisfies Sec. 362(e)'s legislative intent.

Additional facts: The assets and liabilities A contributed to Newco were in an operating subsidiary, S, that A wished to divest due to S's continual operating losses. A was willing to sell all of S's assets solely for the assumption of liabilities, as the costs of shutting S down were substantial. A also realized that the disposition of S's assets would generate a $60 loss that could be used to offset A's other income, thereby generating approximately $24 tax savings.

B was willing to acquire S, but was unwilling to structure the acquisition as an asset deal. B wanted to preserve the bases in short-term assets (accounts receivable and inventory), which was $70 before the transaction. If B purchased the assets solely for that assumption, $35 of the purchase price would have been allocated to the short-term assets, resulting in $35 taxable income ($70 FMV--$35 allocated purchase price) and an approximately $14 tax liability once it acquired the assets. B was unwilling to acquire the assets knowing that a $14 tax bill would be incurred after acquisition. Further, an additional $25 of long-term tax bases (from the fixed assets and intangibles) would be lost in an asset transaction.

Thus, A and B agreed to an alternative structure in which S contributed all of its assets and liabilities to Newco in exchange for 20% of its stock; B contributed $1 to Newco. Essentially, A agreed to forgo the immediate $24 tax benefit resulting from an asset sale, for the possible capital appreciation in the Newco stock, while B permanently avoided an immediate $14 tax liability by allowing A to retain a 20% interest in Newco.

Based on these additional facts, it would appear that if an asset transaction had occurred, A would have incurred a $60 loss ($95 basis--$35 purchase price), while B would have had a $65 built-in gain (BIG) ($100 FMV of acquired assets--$35 purchase price). The combined tax effect would be a net $5 BIG.

By changing the structure to a joint Sec. 351 transaction and using the individual asset method, A's Newco stock has a $60 BIL ($60 basis--zero FMV), Newco has a $5 BIG ($101 FMV of assets--$96 basis) and B takes a basis equal to the $1 FMV of Newco's stock. The combined tax effect would be a net $55 BIL.

Based on the above, it would appear that using the individual asset method allows for A's $60 BIL to be duplicated and transferred to Newco, in direct conflict with Sec. 362(e)'s intent. However, using the gross-up method eliminates duplication of the $60 loss and would seem more appropriate under these circumstances.

Conclusion

Until judicial or administrative guidance is provided on which method to use, it may be advisable to determine if a BIL exists under either method. If it does, the tax adviser should consider whether to make a protective Sec. 362(e)(2)(c) election, to lessen the chance of the IRS later asserting an alternate valuation method. The Sec. 362(e)(2)(c) election allows the transferor to reduce the basis in the transferee's stock by the BIL, as opposed to the transferee reducing the basis in the assets received.

Under the additional facts presented, if A and Newco used the individual asset method to determine that no BIL existed on the transfer date, but the IRS later determined that the gross-up method was appropriate, Newco would likely owe additional taxes (as the asset bases would have been reduced, thereby reducing deductions). However, had A made a protective Sec. 362(e)(2)(c) election, the BIL would reduce A's basis in the Newco stock (which, presumably, would not have been sold at the time of the IILS examination; thus, no additional taxes would currently be due).

From L. Casey Weck, CPA, Oak Brook, IL

Exhibit 1: Individual asset method

                                FMV   Basis   BIG/(BIL)

BIL analysis:
Assets A contributed
 Accounts receivable            $40     $45        $(5)
 Inventory                       30      25          5
 Fixed assets                    10      20        (10)
 Intangibles                     20       5         15
 Total                         $100     $95         $5

Aggregate FMV of assets                $100
Aggregate bases of assets                95
Aggregate BIG/(BIL)                      $5

Basis in Newco stock:                     A          B
 Basis of assets contributed            $95         $1
 Less: liabilities assumed               35         --
 Basis in Newco stock                   $60         $1

Exhibit 2: Gross-up Method

Interpolated value of Newco stock:
 Cash B contributed to Newco           $1 (a)
 Newco stock B received                80% (b)
 Grossed-up value of Newco (a/b)       $1 (c)

BIL analysis:
% of stock A received                 20% (d)

Value of stock A received (c x d)      $0
 A's liabilities New(o assumed         35
 Total value A received               $35
 Total basis in contributed assets    $95
 BIG/(BIL)                           $(60)

Basis in Newco stock:                   A         B
 Basis of assets contributed          $95        $1
 Less: liabilities assumed             35        --
 Basis in Newco stock                 $60        $1