Presentation on theme: "Contents Introduction Definition of Contingent Liabilities 3"— Presentation transcript:
0Contingent Liabilities in Taxable Transactions and Distributions ABA Section of Taxation , 2013 May Meeting Saturday, May 11, 2013PanelistsVictor Penico, Deloitte Tax LLP, moderatorDaniel White, Bryan Cave LLPMegan Fitzsimmons, Ernst & Young LLPRichard Starke, Office of Associate Chief Counsel (Corporate), IRS
1Contents Introduction Definition of Contingent Liabilities 3 Whether Liability is an Assumed Liability 4Assumptions in Taxable Asset Acquisitions 11Seller Treatment 11Buyer Treatment 18Assumptions in Section 301 Distributions 21Assumptions in Section 304 Transactions 25
3Definition of Contingent Liability Accrual basis taxpayer (I.R.C. §461(h)):“All events” have occurred which determine the fact of the liability (“fixed”),The amount of the liability can be determined with reasonable accuracy (“determinable”), and“Economic performance” has occurred.See Treas. Reg. § (a)(2)(i); Treas. Reg. § (c)(1)(ii)(A).Cash basis taxpayertaken in account when paid (other than certain pre-payments)Contingent liability vs. Asset “defect”
4Whether Liability is an Assumed Liability -- Assumption Factors Buyer’s operationsActivity performed by the buyerEvents under the buyer’s controlLiability arising from buyers decisionGoal is to separate the occurrence of the liability from the seller and the acquisition (i.e., not a seller liability)If it does not relate to the seller’s operation of the business, then the Buyer can deduct the paymentHoldcroft Transportation Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946)Albany Car Wheel v. Commissioner, 333 F.2d 653 (2nd Cir. 1964) (liability arose after acquisition due to buyer’s decision to close plant)TAM – acquisition and severance payllinois Tool Works v. Commissioner, 355 F.3d 997 (7th Cir. 2004)Holdcroft Transportation Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946)Corporation acquires assets of partnership in exchange for stock and assumption of liabilities—including two tort claims filed against the partnershipCorporation pays on the claims and deducts the paymentsCorporation argues it should be treated as stepping into the shoes of the partnership and therefore should be able to deduct the paymentsCorporation also argues it should be able to deduct the payments because the claims were contingentCourt holds: (i) claims did not arise out of buyer’s business; (ii) rather, expenses related to the seller’s business; (iii) buyer cannot deduct costs relating to seller; (iv) fact that liability was contingent does not matter; (v) buyer assumed the liability as part of the costs of the assets; (vi) section 381 – step into the shoes does not apply to section 351 transactions.TAM – acquisition and severance pay“To summarize, in the precedent requiring the buyer to capitalize, rather than deduct, the payment of an obligation, the events most crucial to creation of the obligation occur before the acquisition. Under these circumstances, the obligation is treated as a liability of the seller. By contrast, in cases allowing the buyer to take a deduction, the events most crucial to creation of the obligation occur after the acquisition. Under these circumstances, the obligation is a liability of the buyer. The difference in the cases is therefore the degree to which the obligation was fixed at the time of the acquisition.”“In the instant case, a liability for severance payments to Target's employees could arise only if employees were involuntarily terminated. As no employee had been terminated by the date of acquisition, no liability existed for New Target to assume. Further, Buyer neither expressly nor impliedly agreed to pay, as part of the acquisition, any severance payments it might later incur. Buyer was free to decide after the acquisition whether to terminate employees and become liable. Finally, some employees would not be entitled to severance under either the termination protection agreements or the personnel policy if other suitable jobs could be found for them.”Illinois Tool Works v. Commissioner, 355 F.3d 997 (7th Cir. 2004)Because the taxpayer knew of the pending patent infringement lawsuit, and agreed to pay that contingent liability in exchange for purchasing the company, the taxpayer was not entitled to currently deduct the judgment as a business expense.
5Whether Liability is an Assumed Liability -- Assumption Factors Where liability arises post-acquisitionFor example, certain employee benefit casesWhere there is a contract in place at the time of the acquisition to pay death benefits when an employee diesIf employee dies after closing, then the liability should be a buyer liabilityEven though contract in place, it’s contingent because you know he will die eventuallyIf employee has already died and seller is obligated to pay, the buyer assumes the obligation—No deduction.M. Buten & Sons, Inc. v. Commissioner, 31 T.C.M. (CCH) 178 (1972)David R. Webb Company, Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983)M. Buten & Sons, Inc. v. Commissioner, 31 T.C.M. (CCH) 178 (1972)Corporation agreed to assume liabilities of partnership in section 351 transaction, including death benefits to surviving widowsCourt held no deduction for payments to widow of employee who died before the acquisition; Payments were deductible if employee died after the acquisitionDavid R. Webb Company, Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983)Buyer assumed sellers obligation to make pension payments to wide of previously deceased employeeCourt no deduction to buyer
6Whether Liability is an Assumed Liability -- Assumption Factors 3. Whether the buyer was aware of the liabilityIf buyer is aware of the claim at the time of the acquisition, there is no deduction for payment of the claim but if buyer unaware, buyer may be able to deduct the liabilityPacific Transport v. Commissioner, 29 T.C.M. 133 (1970), rev’d per curiam 483 F.2d 209 (9th Cir. 1973)But see Holdcroft. Court might not care whether the buyer knew of the liability and may instead look to when the liability arose. If the liability relates to the seller, then no deduction. See Illinois Tool Works v. Commissioner, 117 T.C. 39 (2001), aff’d 355 F.3d 997 (7th Cir. 2004).In Pacific Transport v. Commissioner, 29 T.C.M. 133 (1970), rev’d per curiam 483 F.2d 209 (9th Cir. 1973), a parent corporation liquidated its subsidiary (section 334(b)(2) and took assets and assumed the liabilities of the subsidiary, including a lawsuit that was asserted against the subsidiary.The parent corporation believed its risk exposure on the claim was remote.The parent corporation’s risk assessment was wrong and it ultimately had to pay the claim.Tax court held that a deduction should be allowed because the claim was speculative and remote.Appeals court reversed and held that contingency was irrelevant. Because the buyer was aware of the liability, payment of the claim was a cost of acquiring the assets.No exception to capitalization for bad bargains.
7Whether Liability is an Assumed Liability -- Assumption Factors Liability timingThis factor can be used to explain the tort cases. Courts have stated that legal liability for a tort arises when the tort occurs.Using this factor would lead a court to conclude that a pre-closing cause of action is a liability of the seller. If the buyer pays the liability, there is no deduction.Holdcroft and Pacific Transport support the notion that the contingent nature of the tort is not relevantCompare this result to the contract cases where the liability represents a contractual claim, not a tort.Albany Car Wheel Co.Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff’d 333 F.2d 653 (2nd Cir. 1964)There was a collective bargaining agreement that required payment of severance wages to employees upon a plant shutdown.The purchase agreement called for an express assumption of the severance pay liabilities.After the assets were transferred, the plant was shut down and severance payments were made by the buyer.Court held that the liability did not arise until after the closing when the plant shut down. Therefore the liability arose on the buyer’s side.Contract required payment upon certain contingent, future events. Liability arose when the event occurred.
8Whether Liability is an Assumed Liability -- Assumption Factors Whether the contingent liability is reflected in the priceIf the purchase price was reduced, then the liability looks like an assumed liabilityThis factor comes up often wherePurchase price based on balance sheetReserve on balance sheet (e.g., for employee medical benefits)Allows IRS to argue that the liability was reflected in the price
9Whether Liability is an Assumed Liability -- Assumption Factors 6. Buyer’s express assumptionIf the buyer expressly assumes a liability of the seller, courts generally conclude that the buyer is assuming the liabilityHowever, this factor alone is not fatal. In Albany Car Wheel the buyer expressly assumed a collective bargaining liability (severance pay in the event of a plant shutdown). However, the court said that the liability in fact was assumed
10Assumptions of Contingent Liabilities in Taxable Asset Acquisitions
11Assumptions in Taxable Transactions -- Seller Treatment Relief of liabilities is included in amount realized on sale or exchange of property. See (a)(1).Contingent liabilities lacking only economic performanceIn connection with the sale of a business, if purchaser “expressly assumes” liabilities arising out of business that would be incurred “but for” economic performance, then economic performances is deemed to occur when the liability assumption is included in amount realized. See (d)(5)(i).Contingent liabilities lacking fixed amount raise questions as to timing and amount of inclusion:Value at closing, include at closing? orValue once fixed, include once fixed?
12Assumptions in Taxable Transactions -- Seller Treatment Does relief of the liability give rise to a deduction at closing? Once fixed?See US v. Hendler, 303 U.S. 564 (1938); Pierce v. Comm’r, 326 F.2d 67 (8th Cir. 1964); Commercial Security Bank, 77 TC 145 (1981).Contingent liabilities lacking “all events”; events occurring after closing. Cf Holdcroft (post-closing events gave rise to deduction).
13Assumptions in Taxable Transactions -- Seller Treatment Why does Seller care?CharacterSeller has capital lossesSeller is an S Corporation or partnership.TimingA rule may defer corresponding deduction, e.g. 404(a)(5)
14Assumptions in Taxable Transactions -- Seller Treatment Example of assumed non-fixed contingent liabilityIn Year 1, S sells its business to P. The assets of the business include an office building located on contaminated land. No further contamination is continuing. The cost to remediate the land is unknown but is estimated by S and P to equal $20X.In Year 3, P settles the environmental remediation obligation for $50X.Does S include $20X in amount realized in Year 1? If so, can S deduct (or capitalize) the remediation expense? If not, can it do so in Year 3?Does S include $50X in amount realized in Year 3? Can S deduct (or capitalize) the remediation expense?See Commercial Security Bank, 77 TC 145 (1981), acq C.B. 1
15Assumptions in Taxable Transactions -- Seller Treatment Example of assumed non-fixed contingent liability (Compensation)At the end of Year 1, S sells its business to P. The liabilities of the business include a liability for accrued vacation pay assumed by the Buyer. The estimated balance for accrued vacation pay is $20X.Over the course of Year 2, P’s actual obligations paid related to the pre- acquisition accrued vacation pay is $50X.Under 404(a)(5), a deduction is generally denied under a nonqualified deferred compensation arrangement until the year in which the employee includes the compensation in income.Does S include $20X in amount realized in Year 1? If so, can S deduct the compensation expense in Year 1? In Year 2?Does S include $50X in amount realized in Year 2?See TAM (June 15, 1989)
16Assumptions in Taxable Transactions -- Seller Treatment Assumed liabilities lacking reasonable measurementExamplesEnvironmental claimsProduct liability claimsDeferred revenue (see James M. Pierce, 326 F.2d 67 (8th Cir. 1964); Rev. Rul )Unfunded deferred compensation (see Section 404(a)(5); TAM )Unfunded qualified pension liability (David Webb, 708 F.2d 1254 (7th Cir ); G.C.M )Retiree medicalExecutory contracts with above-market terms (Cf. Rev. Rul , Ex. C).
17Assumptions in Taxable Transactions -- Seller Treatment Installment Sale IssuesSection 453 generally permits reporting gain on the installment method if at least 1 payment is received in a year of the seller after the year of sale.If contingent liabilities are taken into account under the “wait and see” approach and liabilities are included in amount realized, is the assumption of contingent liabilities (constituting qualifying indebtedness) eligible for the installment method? Cf. Treas. Reg. §15a.453-1(b)(2)(iii). If so, how is basis recovered? See, e.g., Treas. Reg. §15a.453-1(c)(7 )(basis recovery with neither maximum price nor maximum term)If these are not taken into account under the installment method, are contingent liabilities under a “wait and see” treated like other liabilities assumed, generally increasing the gross profit ratio? See Treas. Reg. §15a.453-1(b)(2)(i).Burnet v. Logan, 283 U.S. 404 (1931) – are these circumstances “rare and unusual”?
18Contingent Liabilities -- Buyer Treatment BasisTreat liability as cost of the assets.Add to the assets’ basis when the liability becomes fixed, determinable, and economic performance satisfied.Capitalization approach has the greatest support in the case lawSee Webb v. Commissioner, 77 T.C (1981), aff’d, 708 F.2d 1254 (7th Cir. 1983). Unfunded pension liability assumed in asset acquisition; payments treated as cost of acquired assetsSee also Holdcroft, Pacific Transport, M. Buten & Sons.Uncertain whether buyer can treat a portion of the payments as interest
19Contingent Liabilities -- Buyer Treatment DeductionBuyer gets a deduction when the liability is fixedAlbany Car Wheel, 333 F.2d 653 (2d Cir. 1964)Agreement specifically said liability to pay severance in the event of a plant shutdown was assumedBut court said that facts showed that the liability was not assumed and the buyer had made a decision that resulted in the liability to pay severance (i.e., shutting down the plant).United States v. Minneapolis and St. Louis Railway Co., 260 F.2d 663 (8th Cir. 1958)Suggests deductibility method but can also be read as saying nothing was assumedF&D Rentals, Inc., 365 F.2d 34 (7th Cir. 1966)Court said in dicta that taxpayer could deduct if payment had been made
20Assumptions in Section 301 Distributions and Section 331/336 Liquidations
21Assumptions in Distributions -- Distributing Corporation Treatment Effect on transfer of assetsNo effect on gain recognized under 311(b) or gain or loss recognized under 336Gain (or loss) is recognized based on asset fmv.But see 311(b)(2) and 336 (b) (asset fmv is not less than amount of liabilities assumed)Query whether assumed contingent liabilities included in 311(b)(2) and 336(b) determinationQuery effect if amount of liability once fixed, determinable and economic performance satisfied is different from amount in initial determinationDeductibilityPre-General Utilities repeal authorities do not permit deduction.See Rev. Rul , Arcade Restaurants 7 TCM 563 (1948), GCM 38,271Query whether gain recognition/deemed sale model of 311(b) and 336(a) militate for deductibility
22Assumptions in Distributions -- Distributee Treatment Effect on transfer of assetsNo effect on basis of assets received under 301(d) and 334(a)Basis is determined by reference to asset fmvDeductibilityNo deduction allowed. Sole effect is to reduce amount of distribution. Rev. Rul See also GCM (“Consequently, since no payment or adjustment is specifically made here as compensation for liability assumption, since no payment or adjustment is justified, and since none is required, we believe it improper to treat one as having been effected.”)
23Assumptions in Distributions -- Distributee Treatment Effect on amount of distributionReduces amount of distribution under 301(b)(2)(g) requires that liability be assumed within meaning of 357(d)For 331 liquidations, assumed liability be “known” at time of distribution. Rev. RulQuery whether this is an accrual “fixed and determinable” standard. Query also whether economic performance must be satisfied at time of distribution. Rev. Rul allows reduction for present value of a future liability.For 331 liquidations, distributee allowed a capital loss in year liability becomes fixed, determinable and economic performance satisfied to extent liability did not previously reduce amount of distribution. Rev. RulQuery whether similar principles apply for 301 distributions. Since 301 is to determine economic benefit to shareholders, perhaps assumed contingent liabilities should reduce amount of distribution at time of distribution.
25Assumptions in Section 304 Transactions -- Transferor Corporation Treatment Effect on amount of distributionQuery whether 357(c) has any relevance for whether assumption of a contingent liability should be taken into account under 304Maher indicates no dividend to transferor at time of assumption when transferor remains secondarily liable because economic benefit to transferor is “too speculative”Query whether incorporation of section 357(d) principles into 301 under (g) for assumptions flowing in opposite direction suggest a different answerQuery whether contingent liabilities for which transferor does not retain secondary liability are also “too speculative”If assumption of contingent liability results in distribution of some amount at time of assumption, query result when assumed liability once fixed, determinable, and economic performance satisfied differs in amount. Can there be increases or decreases to the amount of the distribution at the later date.