GPSolo Magazine - March 2004
Contributions, Distributions, And Assumption Of Liabilities
To combat an arcane international tax-shelter abuse, Congress amended sections 357 and 362 governing contributions of encumbered property to a corporation. The 1999 amendments were designed to shut down attempts to create artificial basis by manipulating the liability assumption rules.
Redefining assumption of liabilities. The 1999 Act left much of the existing statutory framework intact, but struck the reference in section 357(a) to a transferee “acquir[ing] . . . property subject to a liability.” Under current law, section 357(a) refers only to liabilities of the transferor that are assumed by another party to the exchange. Excess liabilities for purposes of section 357(c) are now defined as the sum of assumed liabilities in excess of the total basis of contributed property.
Simultaneously, Congress amended section 357(d) to provide a technical definition of “assumption.” Section 357(d) treats a recourse liability as having been assumed only if the transferee “has agreed to, and is expected to, satisfy such liability,” regardless of whether the transferor has been relieved of the liability. In effect, section 357(d)(1)(A) codifies the economic benefit theory underlying the section 1001 regulations. As a practical matter, it is no longer necessary for shareholders to furnish their own obligations to offset excess recourse liabilities. Thus, section 357(d) should generally eliminate the Lessinger/Peracchi zero-basis controversy. To avoid section 357(c) gain, the shareholder should agree to indemnify the corporation to the extent of any unassumed excess recourse liabilities secured by the contributed property.
Section 357(d)(1)(A) treats the transferor as retaining any recourse liabilities secured by contributed property unless the transferee specifically agrees to satisfy such liabilities. Welladvised taxpayers will carefully monitor any subsequent debt payments to ensure consistency with the parties’ initial treatment of the liability. By imposing a facts-and-circumstances test, section 357(d) requires closer attention to the related-party status of the transferor or transferee. By contrast, former section 357 was arguably intended precisely to avoid the need for such inquiry in routine transactions. While section 357(d)(1)(A) is perhaps technically more precise than the former liability assumption rule, it is likely to give rise to increased uncertainty and complexity. Because there is no objective measure of whether a related transferor has been relieved of a liability, regardless of the parties’ agreement, the economic benefit model of section 1001 may be misplaced in the context of section 351 transfers.
Section 357(d) does not alter the default rule that a transfer of property subject to a nonrecourse liability generally relieves the transferor of the liability, consistent with Tufts principles. The 1999 Act establishes a deemed assumption rule for cross-collateralized nonrecourse liabilities that may be varied by agreement. If a nonrecourse liability is secured by both acquired and nonacquired assets, section 357(d)(1)(B) presumes that the transferee has assumed the entire amount of the nonrecourse liability. Under the special rule of section 357(d)(2), the amount of the liability treated as assumed is reduced by the portion of such liability that an owner of other nonacquired assets securing the liability agrees with the transferee to, and is expected to, satisfy. The retained portion of the liability may not exceed the fair market value of nonacquired assets also subject to the same liability.
Preventing basis inflation. Under section 362(d)(1), the transferee’s basis in contributed property may not be increased above fair market value by reason of assumption of liabilities. Simultaneously, section 362(d)(2) further limits basis adjustments attributable to assumption of crosscollateralized nonrecourse liabilities. If the transferor is a tax-exempt entity or a foreign entity not subject to U.S. tax, section 362(d)(2) provides that the transferee’s basis increase in the contributed property is determined as if the transferee had assumed only a ratable portion of such liabilities based on the relative fair market values of the acquired and nonacquired assets. Although the special rule of section 362(d)(2) is unlikely to affect most non-abuse transactions, the fairmarket- value limitation under section 362(d)(1) is more widely applicable.
Section 362(d)(1) provides an overall limitation on section 362 basis adjustments when assumption of liabilities triggers recognition of section 357(c) gain. Under section 362(d)(1), the basis of contributed property may never be increased above its fair market value as a result of section 357(c) gain. Except as a general anti-abuse measure, Congress failed to explain the underlying purpose or operation of the fairmarket- value limitation.
Distributions of encumbered property: Should section 357(d) principles apply? Recently issued regulations under section 301 extend the liability assumption rules of section 357(d) to distributions of encumbered property to shareholders. Under sections 311(b) and 336(b), relief of liabilities in connection with distributions of encumbered property may also trigger recognition of corporatelevel gain. Although Congress did not consider the impact of the amended liability assumption rules on the distribution provisions, conforming amendments are necessary to restore parity between contributions and distributions of encumbered property.
Under section 301(b)(2), the amount of a section 301 distribution is generally reduced (but not below zero) by liabilities assumed by the shareholder or taken subject to in connection with the distribution. By analogy to the case law interpreting former section 357, a mechanical reading of section 301(b)(2)(B) arguably provided support for the position that a distributee should be treated as assuming a liability encumbering distributed property even though the primary obligor was not released from the liability.
When appreciated property is distributed, earnings and profits are adjusted upward to reflect the built-in appreciation inherent in such property; earnings and profits are then adjusted downward by the fair market value of the distributed property reduced by the amount of any liabilities assumed in connection with the distribution. If section 357(d) principles apply to section 301 distributions, it is important to clarify that the amount of liabilities taken into account for purposes of section 312 is determined in the same manner. Otherwise, the section 312 adjustment will no longer match the amount treated as a section 301 distribution under section 357(d) principles.
To restore parity between contributions and distributions of encumbered property, section 357(d) principles should arguably be extended to sections 311(b)(2) and 336(b). Under current law, the fair market value of distributed property is treated as not less than the amount of any liability encumbering the property. Thus, sections 311(b)(2) and 336(b) employ the fiction of a deemed sale of the distributed property for consideration equal to the transferor’s liabilities relieved. If the fair market value of the distributed property exceeds the underlying liability, sections 311(b)(2) and 336(b) are irrelevant.
Karen C. Burke is a Warren Distinguished Professor at the University of San Diego School of Law.
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