| ||Contributions, Distributions, and Assumption of Liabilities: Confronting Economic Reality |
Karen C. Burke*
*Warren Distinguished Professor, University of San Diego School of Law; Smith College, B.A., 1972; Harvard University, M.A., 1975; Ph.D., 1979; Stanford Law School, J.D., 1982. The author acknowledges generous research support from the University of San Diego School of Law
To combat a relatively arcane international tax-shelter abuse, Congress recently amended sections 357 and 362 governing contributions of encumbered property to a corporation. The 1999 amendments were designed primarily to shut down attempts to create artificial basis by manipulating the liability assumption rules. Under one form of this tax-shelter gambit, a tax-indifferent party (e.g., a foreign corporation or tax-exempt entity) might cross-collateralize a liability of $100 with three zero-basis assets (each worth $100) and transfer each asset separately to three wholly-owned U.S. subsidiaries, subject to the same $100 liability. Under a literal reading of the relevant statutory provisions, each U.S. subsidiary would be deemed to assume the entire $100 liability and thus would be entitled to increase the basis of the contributed property from zero to $100, even though the transferor incurred no U.S. tax as a result of the liability assumption. Such transactions created duplicative or overstated basis in the transferee's hands, thereby resulting in excessive depreciation or mismeasurement of income.
Although it is far from clear that the targeted tax shelters were immune from successful challenge under prior law, the recent statutory amendments were intended to more accurately reflect the underlying economics of these corporate transactions. The amended liability assumption rules rely on a facts-and-circumstances test based on the parties' expectations concerning ultimate responsibility for payment of liabilities secured by contributed property. A transferor is deemed to be relieved of a recourse liability encumbering contributed property only if the transferee agrees to, and is expected to, satisfy the liability. By contrast, a nonrecourse liability is deemed to be assumed by the transferee except to the extent that the transferor agrees to satisfy the liability and retains other property securing the liability. In addition to redefining the meaning of an assumption, the 1999 legislation modified the basis adjustment provisions of section 362 to prevent inflation of the basis of contributed property. Even if amended sections 357 and 362 adequately address concerns related to abusive tax shelters, they will inevitably complicate a broad range of nonabusive transactions. Moreover, Congress suggested that Treasury consider extending the amended liability assumption rules to other provisions of the Code.
This article offers a critical assessment of the recent amendments to the liability assumption rules of section 357 and corresponding basis provisions of section 362. Part I explores the divergence between the former liability assumption rules and the "economic benefit" doctrine of the section 1001 regulations. Part II focuses on the technical definition of assumption of recourse and nonrecourse liabilities under amended section 357(d). Part III examines the corollary basis provisions of section 362, as modified to reflect the section 357(d) liability assumption rules. Part IV argues that by logical extension the amended liability assumption rules could also apply to corporate distributions of encumbered property, an area overlooked by Congress. The conclusion suggests that Congress should exercise caution in extending section 357(d) principles and reconsider the approach of ad hoc anti-abuse measures.