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Proliferating gains under Sec. 357(c); Letter Ruling 9032006 represents a literal reading of this section, but it is economically unsound.

Generally, a transfer of property to a corporation in exchange for corporate stock is not taxable to the shareholders if they are in control of the corporation immediately after the transfer. (1) However, if the total amount of liabilities transferred to a corporation by a shareholder exceeds the total adjusted basis of the properties transferred, the excess amount results in a taxable gain to that shareholder. For purposes of this rule, the transfer of liabilities includes both an assumption of liabilities as well as the transfer of property subject to liabilities even though no assumption occurs. In this article, a reference to either type of transaction applies equally to both. In applying Sec. 357(c), confusion exists about the correct application of this rule when the liabilities are collateralized by assets that are transferred in more than one Sec. 351 transaction. In 1987, the IRS issued Letter Ruling 8730063, (2) which provided a commonsense and economically correct solution to the problem by allowing the total amount of the liabilities to be allocated among the different Sec. 351 transfers. However, three years later, the Service issued Letter Ruling 9032006, (3) revoking, without explanation, the earlier ruling.

It appears that under Letter Ruling 9032006 the Service is taking the position that when a shareholder transfers the underlying property to different controlled corporations in separate Sec. 351 transactions, Sec. 357(c) will treat the shareholder as being relieved of the total amount of the liabilities in each separate transfer. This article will analyze the rationale of both rulings; examine some of the possible tax consequences of the Service's apparent position in Letter Ruling 9032006; and elaborate on the suggestion that the Service should revoke the 1990 letter ruling and reinstate its prior position.

Background

* Sec. 357(c)

The general rule of Sec. 357(a) is that the assumption of liabilities does not cause gain recognition. Rather, the assumption results in a reduction in the basis of the stock received from the transferee corporation. (4) However, in transactions in which the property has an adjusted basis that is less than the liabilities assumed, such a reduction would result in a negative basis in the stock to the extent of the excess liabilities. Sec. 357(c) was added to the Code in 1954 to correct this statutory deficiency. (5)

* Letter Ruling 8730063

Letter Ruling 8730063 was the Service's first written response to the question of how Sec. 357(c) ought to be applied in the context of multiple Sec. 351 transfers when all the assets transferred are collateralized by the same liabilities. The ruling's pertinent facts are listed below (dollar amounts have been added to more clearly demonstrate the results of the ruling).

* Holding wishes to acquire two businesses, R and Q, from Seller and operate the businesses in two separate subsidiaries, Green and Blue. Seller insists on a single sale to one corporation.

* Holding, Green and Blue jointly borrow $100 from a bank (with Holding receiving all the cash) to help finance the acquisition of R and Q. The bank loan agreement specifies that all, or nearly all, of the assets to be received by Holding from Seller are collateral for the $100 loan from the Bank. Holding acquires R for $80 and Q for $40.

* Holding transfers R to Green and Q to Blue in separate transactions that qualify as Sec. 351 transfers.

The Service ruled that no gain is recognized under Sec. 357(c) because

-- no new liabilities are assumed in Holding's transfer of R to Green and Q to Blue, since all three corporations remain totally liable for the bank loan throughout the entire transaction;

-- no asset becomes subject to any new liabilities due to the transfer; and

-- to determine if the liabilities transferred exceed the aggregate adjusted basis of the assets transferred, when a liability is secured by more than one asset, the liability should be properly allocated between the various securing assets.

Thus, two-thirds of the liability ($67) is allocated to the assets transferred to Green. Since these assets have an adjusted basis to Holding of $80, Sec. 357(c) is not applicable. The remaining one-third of the liability ($33) is allocated to Blue. Since these assets have an adjusted basis to Holding of $40, no Sec. 357(c) gain is created in this transfer either. Letter Ruling 8730063 takes a commonsense approach, which attempts to recognize the economics underlying the bank loan and the accompanying collateral.

* Letter Ruling 9032006

With no explanation or discussion, the Service revoked Letter Ruling 8730063, simply stating that ". . . it has come to our attention that the prior letter ruling was in error. Therefore, our prior letter ruling . . . is hereby revoked."

It is difficult to understand exactly what the Service's position is relative to this issue. The assumption must be that, under the facts of Letter Ruling 8730063, the Service would compare the entire $100 liability with the assets transferred to Green, resulting in recognition of $20 of Sec. 357(c) gain. In addition, the same $100 liability would be compared with the assets transferred to Blue, resulting in recognition of an additional $60 of Sec. 357(c) gain in that transaction. The end result is that in the aggregate, Holding is deemed to have been relieved of $200 of liabilities when the total amount owed to the bank is only $100 and the collateralized assets have a mere $120 fair market value (FMV). While a literal reading of Sec. 357(c) may support the position taken in Letter Ruling 9032006, it is difficult to imagine that this is how Congress intended the provision to be applied.

It has been suggested that the Service issued Letter Ruling 9032006 in reaction to its defeat in Lessinger. (6) In that case the Second Circuit ruled in favor of the taxpayer by using a nonliteral interpreation of Sec. 357(c). Even though the issue in Lessinger is not closely related to the facts in Letter Ruling 8730063, the suggestion is that the Service does not want to be in the position of allowing nonliteral readings of Sec. 357(c) in its own rulings while it is seeking a legislative reversal of Lessinger. (7)

Implications for

Sec. 351 Transactions

Whatever the Service's motivation for issuing Letter Ruling 9032006, the results of the ruling make little economic or tax sense. Holding is treated as recognizing a $20 gain in the transfer to Green and a $60 gain in the transfer to Blue, even though Holding's true economic gain in the two transactions is $0. (Since Holding purchased the assets immediately prior to the Sec. 351 transactions, it had a cost basis in the assets equal to their FMVs.) The consequences of this position can become even more bizarre on examination of other issues, such as the possibility of multiple gains, the character of the gains and basis considerations. In order to understand these results, the pertinent statutory scheme needs to be reviewed.

* Statutory review

Under the language of Sec. 357(c), the liability in excess of basis test is applied separately for each exchange. If the entire amount of the liability must be treated as fully collateralized by the assets in each of the transfers, the only logical extension is that multiple gains must be recognized, limited in part only by the number of Sec. 351 transfers involved. The statute additionally provides that the character of the recognized gain is to be determined by the nature of the assets transferred in that particular exchange. (8) However, if the asset is transferred from a shareholder who owns more than 50% of the corporation's stock and the asset is depreciable in the hands of the corporation, all the gain becomes ordinary. (9)

In addition to the amount and character of the recognized gain, basis considerations must also be examined. In the hands of the transferee corporation, the asset takes a carryover basis, increased by the gain recognized by the transferor. (10) Since the amount of gain in a Sec. 357(c) transaction is determined by reference to the amount of the liabilities, the basis of the asset in the hands of the corporation is stepped up to the amount of the liabilities.

Thus, under the Service's approach, an asset will be assigned a basis that is in excess of its FMV in virtually every instance. (11) Finally, in every Sec. 357(c) transaction, the basis of the stock received in the exchange is $0 in the hands of the transferor.

* Multiple gains

The application of these rules to an extension of the ruling's facts illustrates how little tax and economic sense results from this position.

Example 1: Assume the same facts as in Letter Ruling 8730063. The $100 debt has been collateralized with three assets, R, Q and S. Holding acquires the three assets for $40 each. Holding then transfers assets R and S to Green and asset Q to Blue.

Since Sec. 357(c) compares the aggregate liabilities with the aggregate basis of all assets transferred in each separate Sec. 351 transaction, Holding must still recognize a $20 gain in the transfer to Green and a $60 gain in the transfer to Blue. However, if Holding transfers the three assets to three different subsidiaries in separate Sec. 351 transactions (i.e., R is transferred to Green, Q to Blue, and S to Red), Holding must recognize three separate gains of $60 each. On the other hand, if all three assets are transferred to the same subsidiary in a single Sec. 351 transaction, Holding will not recognize any gain under Sec. 357(c) since the $120 aggregate basis of the assets transferred exceeds the $100 collateralized debt.

These results occur, of course, because the total amount of debt treated as transferred is a function of the number of Sec. 351 transactions that are involved. Thus, the approach taken by the ruling causes the amount of taxable gain to be a function of the number of Sec. 351 transactions involving the assets rather than the amount of inherent economic gain.

* Character of gain and basis considerations

In addition to the problem of multiple recognized gains because of multiple Sec. 351 transfers, this approach may also result in other problems when the transfers involve different types of assets.

Example 2: Corporation X has a capital loss carryover that is going to expire this year. During the year, X purchases two nondepreciable capital assets, A and B. A has an FMV of $80 and B has an FMV of $60. X uses the two assets as security for a $100 loan. Subsequently, in two separate Sec. 351 transactions, X transfers A to corporation T and B to corporation S. Under the Service's reasoning, X recognizes a gain of $20 on the transfer of A and a $40 gain on the transfer of B. These gains are offset with the expiring capital loss. At the same time, X still retains economic control over the two assets through its two subsidiaries. Furthermore, the basis of each asset has been stepped up to $100 even though their FMVs are only $80 and $60, respectively. Thus, X has effectively extended the capital loss carryover period by storing up the loss in two assets that it continues to control economically. (Of course, if X did not want to acquire new assets, it could have used two capital assets that it already owned as security for the $100 loan.)

Example 2 assumes that A and B are not depreciable assets. If they are depreciable, Sec. 1239 will recharacterize the gain as ordinary, since X owns over 50% of S and T. In this case the same technique still works if X has a net operating loss carryforward. In addition, both T and S would own a depreciable asset with a basis of $100, which, again, is in excess of the value of the asset.

* Tax avoidance motive

Although the letter rulings and these examples all deal with the acquisition of assets that are subsequently transferred in Sec. 351 transactions, this discussion also applies to situations in which the taxpayer uses assets it already owns to collateralize the loan. If the taxpayer does use assets already owned, the Service may assert a tax avoidance motive. It is doubtful that the Service would attempt to assert tax avoidance when the taxpayer uses the loan proceeds to acquire the assets. However, if assets already owned were used as security and these assets were transferred immediately after obtaining the loan, the Service might view the entire transaction as a tax avoidance technique. If a tax avoidance motive is found, Sec. 357(b) takes precedence over Sec. 357(c), and the liabilities are treated as boot received in the transaction. Thus, the amount of gain recognized in each transaction is the lesser of (1) the boot allocated to each asset or (2) the actual gain realized on each asset. Under certain circumstances, the taxpayer may actually prefer the application of Sec. 357(b) since, under that provision, the recognized gain is limited to the gain realized in the transaction. (12) Thus, by espousing an approach that requires computation of gain based on the full amount of liabilities in each Sec. 351 transaction, the Service has unwittingly created several apparently unforeseen problems.

Extension of the IRS's Rationale

In addition to the problems that arise under Sec. 357(c), a literal interpretation of the statute can also create similar consequences with respect o other corporate provisions, such as Secs. 311(b)(2), 336(b), 355(c)(2)(C) and 361(c)(2)(C).

* Sec. 311(b)(2)

When a corporation makes a nonliquidating distribution of appreciated property to a shareholder, the corporation recognizes gain on the distribution. The amount of gain recognized is the excess of the FMV of the property over the adjusted basis of the property in the hands of the distributing corporation. (13) A special rule provides that if a liability exceeds the FMV of the property, the FMV shall be deemed to be not less than the liability. (14) If the liability is collateralized by several assets, it is highly probable that the amount of the liability exceeds the FMV of each individual asset. Thus, if the rationale of Letter Ruling 9032006 is applied to a transaction involving the distribution of an appreciated asset, it is very likely that the gain the corproation must recognize is the amount of the liability in excess of the individual asset's basis.

A potential problem exists because Sec. 311(b)(2), as it incorporates Sec. 336(b), contains almost the same problematic language as Sec. 357(c). The pertinent language of Sec. 357(c) reads:

[I]f the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property. . . . (Emphasis added.)

The critical language of Sec. 336(b), as it is incorporated by Sec. 311(b)(2), is:

If any property distributed . . . is subject to a liability or the shareholder assumes a liability . . . in connection with the distribution. . . . (Emphasis added.)

In both subsections, the application of the statute is based on a transfer of property that is subject to a liability or a transfer of property when there is an assumption of the liability. Hence, a literal reading of Sec. 311(b)(2) creates the same problems as when this rationale is applied to Sec. 357(c). Example 3 illustrates this.

Example 3: Corporation X has two assets, A and B. A has an FMV of $300 and an adjusted basis of $100; B has an FMV of $300 and an adjusted basis of $50. Both of the assets are collateral for a $500 bank loan. If X makes a nonliquidating distribution of A to a shareholder, Sec. 311(b)(2) (which treats the FMV as not less than the liability) is applicable. The liability to which the property is subject ($500) exceeds the FMV of the property ($300). Therefore, the FMV is deemed to be not less than the liability ($500). The consequence is that X must recognize a gain of $400 ($500 - $100). If X also makes a nonliquidating distribution of B to a shareholder, using the same rationale, X would recognize a gain of $450 ($500 - $50). The same $500 liability would be compared to B's FMV.

The end result is that X is deemed to be relieved of $1,000 of liabilities and, thus, a total taxable gain of $850 is created when the total economic gain is only $450.

* Other applications

When property is distributed in a complete liquidation, gain is recognized by the liquidating corporation as if the property had been sold to the distributee at its FMV. (15) As in the case of a non-liquidating distribution, the FMV of the property distributed in a complete liquidation is deemed to be not less than the liability. (16) A literal reading of Sec. 336(b) creates the same problems as discussed above.

Example 4: Assume the same facts as in Example 3. If X Corporation completely liquidates by distributing assets A and B, X must compute the gain on each asset separately. Since both A and B are subject to the $500 liability, X would recognize a gain of $400 on A and a gain of $450 on B.

As above, the result makes little economic sense. A taxable gain of $850 results from an economic gain of $450.

Similar statutory language is contained in Sec. 361(c)(2)(C), which deals with distributions of appreciated property by a corporation to its shareholders in a tax-free reorganization, and Sec. 355(c)(2)(C), which deals with transfers to shareholders in tax-free corporate separations. Thus, the same unwarranted tax consequences that have been illustrated with respect to Secs. 311(b)(2) and 336(b) could also exist if the Service's rationale is applied to these provisions.

Conclusion

The IRS's position in Letter Ruling 9032006 is not logical and has no correlation with the underlying economics involved in Sec. 351 transactions. As has been demonstrated, the position currently being taken by the Service results in (1) a taxable gain that may be far in excess of any inherent economic gain, (2) a zero basis in the stock received, which is unwarranted if the recognized gain exceeds the economic gain in the transaction, and (3) a basis in the property received by the controlled corporation that is in excess of the property's FMV. In addition, if the rationale in Letter Ruling 9032006 is extended, it could be argued that this same interpretation should be applied to other corporate statutory provisions with equally confusing and economically inappropriate results.

The Service may be correct in concluding that the results of Letter Ruling 9032006 represent a literal reading of Sec. 357(c). However, no one has seriously suggested that such a reading reflects congressional intent. If this issue were to be litigated, almost certainly no court would uphold this untenable position.

Previously, it has been suggested that Letter Ruling 9032006 was issued as a prelude to the Service's seeking a legislative reversal of Lessinger. (17) While the Service may be justified in pursuing this legislative reversal, doing so in this manner creates many more problems than are solved. Thus, it is incumbent on the IRS to take action and revoke this economically unsound letter ruling.

To provide some certainty to the area, the Service should either issue a revenue ruling or initiate the promulgation of a regulation that allows an allocation of a liability among the various collateralized assets as was originally promulgated in Letter Ruling 8730063. If the Service is not willing to rethink its current position, most likely this issue will end up being litigated, resulting in an unproductive use of both the taxpayers' and the government's time and limited resources.

(1) Sec. 35(a).

(2) IRS Letter Ruling 8730063 (4/29/87).

(3) IRS Letter Ruling 9032006 (4/29/90).

(4) Secs. 357(c) and 358(a)

(5) See Woodsam Associates, Inc., 16 TC 649 (1951), aff'd, 198 F2d 357 (2d Cir. 1952) (42 AFTR 505, 52-2 USTC P9396). In this pre-Sec. 357(c) case, the Tax Court treated the excess liability amount as income. The decision most likely led to the promulgation of Sec. 357(c) as part of the 1954 Code.

(6) Sol Lessinger, 872 F2d 519 (2d Cir. 1989) (63 AFTR2d 89-1055, 89-1 USTC P9254), rev'g 85 TC 824 (1985).

(7) Sheppard, "Allocation of Liabilities: You Can't Get Thre from Here," 50 Tax Notes 23 (1/7/91), at 24.

(8) Sec. 357(c)(1)(B). If more than one asset is transferred in the transaction, the examples in Regs. Sec. 1.357-2(b) illustrate that the amount of gain allocated to each is based on the relative FMVs of the transferred assets, determined at the time of the transfer.

(9) Sec. 1239(a), (b) and (c).

(10) Sec. 362(a)(l).

(11) Since the asset is only one of a bundle of assets that has been used as collateral in obtaining the loan, it is very likely that the amount of the total liability exceeds the FMV of the assets tranferred in each separate Sec. 351 transaction.

(12) An interesting question arises as to whether or not the taxpayer could assert a tax avoidance motive. At least some authority exists for just such a twist in Mcdonald's Restaurants of Illinois, Inc., 688 F2d 520 (7th Cir. 1982) (50 AFTR2d 82-5750, 82-2 USTC [paragraph]9581), in which the court upheld the taxpayer's argument that the transaction should be collapsed under the step-transaction doctrine.

(13) Sec. 3119(b)(1).

(14) Sec. 311(b)(2).

(15) Sec. 33(a).

(16) Sec. 336(b).

(17) Sheppard, note 7.
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Author:Randall, Boyd C.
Publication:The Tax Adviser
Date:Feb 1, 1992
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