he tax treatment of contingent liabilities transferred in a corporate sale or restructuring is often a problem for the parties involved. (A contingent liability is one that depends on an uncertain event, such as the settlement of a lawsuit.) Common examples of pending claims are suits against a company by a government agency, a customer or an employee, all of which can significantly affect the economics of a transaction. The amount of these liabilities will influence price negotiations and help determine the buyer’s basis and the seller’s gain or loss.
CPAs who advise clients and employers on these transactions will find the rules for how to treat fixed and determinable obligations well established; those for contingent liabilities are not. In taxable transactions, such liabilities can create difficulties for both the buyer and the seller. While there is less disagreement when the transfer is tax-free, some challenges remain there as well.
Example. Buyer Corp. purchases Seller Corp.’s assets for $1 million and assumes its $600,000 of business liabilities. If these obligations are not contingent as of the acquisition date, Seller has sales proceeds of $1,600,000 and Buyer has a $1,600,000 basis in the assets. But what if $300,000 of the liabilities depend on the outcome of a yet-to-be-settled lawsuit? It isn’t clear whether this amount should be considered part of the sales proceeds or what would happen if the parties settled the lawsuit for a different amount, say $200,000 or $500,000. It also isn’t clear how an indemnification agreement would affect the tax results. These issues may be critical in negotiating a purchase price.
Recent court decisions and new regulations have had a significant impact on the taxation of claims that change hands in both taxable and nontaxable transfers. This article will help CPAs understand the tax consequences to both the buyer and the seller as well as the character of the income—ordinary or capital gain—involved.
TIMING IS EVERYTHING
The deductibility of employee death benefits raises other concerns as well. In one case the court permitted a buyer to deduct payments resulting from a postacquisition death ( M. Buten & Sons, Inc., TCM 1972-44). But in another case where the death occurred before the acquisition, the buyer had to capitalize rather than deduct the payments ( David R. Webb Co., 77 TC 1134 (1981), aff’d 708 F2d 1254 (CA-7, 1983)).
In some instances the buyer’s tax treatment of contingent liabilities may not match the “book” or accounting treatment. For accounting purposes the buyer normally sets up a reserve account and capitalizes many anticipated costs. When the buyer pays the costs, it charges them against the reserve rather than expensing them. But if the liability results from decisions the buyer makes, it should be fully deductible. For example, severance liabilities the buyer incurs in an anticipated downsizing are likely candidates for a tax deduction even though the company doesn’t expense them on the income statement.
Treasury regulations section 1.338-5(b)(2)(iii) resolves this problem by eliminating the special definition of liability and stating that taxpayers should follow general principles of tax law in determining basis. Example 2 (described below) in those regulations concerns an assumed contingent environmental liability.
Example. A chemical manufacturer is obligated in year 1 to remediate environmental contamination. The liability is fixed and determinable, but economic performance (the actual decontamination work) will not occur until year 5. Smith acquires all the company’s stock in year 1 and makes a section 338 election. The assumed liability would be a basis adjustment for her in year 5. For the seller, economic performance occurs when the liability is included in the sale proceeds. In summary, the seller gets a year 1 deduction and an increase in sales price for the liability amount. Smith, the buyer, gets a basis adjustment but must wait until the decontamination work in year 5.
With the exception of this IRS effort to clear up the problem of applying the economic performance rules, these regulations are not helpful to CPAs in determining how to treat contingent liabilities in sales and restructurings, particularly since they refer to general principles of tax law—which most accountants were probably using all along—to resolve the other issues.
THE COURTS CHECK IN
ITW bought part of the DeVilbiss business from Eagle Industries for $139 million. One of the liabilities ITW assumed was a pending patent liability. After ITW performed its due diligence, the parties adjusted the purchase price downward by $1 million to cover the patent liability. A year later a jury awarded the plaintiff $17 million, including interest, to settle the patent case. Before trial, the IRS had allowed a deduction for accumulated interest and loss on disposal of some acquisition assets and ITW agreed to capitalize its original $1 million damage estimate. But this left nearly $7 million, which the IRS wanted the company to capitalize.
ITW argued the large judgment was a loss because both it and the seller had estimated the liability to be much smaller. ITW tried to convince the Tax Court that its intent at the point of acquisition should govern. Interestingly, this argument had found support in an earlier Tax Court decision, Pacific Transportation Co. (TC Memo 1976-41, vacated and remanded 483 F2d 209 (CA-9, 1973)). However, the Ninth Circuit Court of Appeals vacated that decision. ITW had hoped the Tax Court would stick with the intent approach since it could appeal the case at hand to a different circuit. But the court, relying instead on Webb , would not allow a deduction.
Webb involved a buyer’s assumption of an unfunded pension liability to the widow of a corporate officer. The court said both the patent liability in ITW and the pension liability in Webb were contingent obligations the buyers had been aware of before the acquisition and expressly assumed in the purchase agreements. Thus, the Tax Court said ITW should capitalize the judgment “whether or not such obligation was fixed, contingent, or even known at the time such property was acquired.”
The Tax Court’s use of Webb should not lead CPAs to conclude clients should capitalize all benefit payments that take into account preacquisition service. The annuity in Webb came from a nonqualified deferred compensation plan. The buyer anticipated it eventually would freeze the benefits under an existing defined benefit plan and add a profit-sharing plan. But the buyer did not immediately terminate the defined benefit plan. The company did not have to capitalize payments it made to the plan after the acquisition even though the payments took preacquisition service into account. In GCM 39274 the IRS did caution that had the company terminated the plan immediately, it could have capitalized the expenses, as in Webb .
THE KEY SELLER CASE
But the court also ruled the seller was entitled to an offsetting deduction. It reasoned the reduction in sales price to compensate the buyer for assuming the liability came out of the seller’s pocket. The Tax Court followed this deemed-payment approach in Commercial Security Bank (77 TC 145 (1981), acq.), and the new Treasury regulations seem to implicitly approve it.
How should the seller handle the income and deduction on its tax return? The income presumably could be capital gain—as an addition to the sales price. This result should not change even if the eventual payment is considerably larger than anticipated, as in the ITW case. Under the Arrowsmith rule (344 US 6 (1952)), the income’s character should refer to the original transaction. On the deduction side, if the seller could have deducted the payment before the sale, it should be deductible after. Thus, a non-C-corporation seller could obtain the tax benefit of an ordinary deduction and capital gain income. Normally, a C corporation seller would be indifferent unless it had an unused capital loss.
CPAs should note nothing in the regulations requires the buyer and seller to treat contingent liabilities consistently. In fact the suggestion to use general tax principles virtually invites buyers and sellers to choose the judicial authorities they prefer.
In an IRC section 351 tax-free transaction, contingent liabilities may present some problems. Such obligations generally are treated the same as other liabilities for purposes of determining whether their assumption is taxable as “boot” or additional proceeds. The IRS may tax contingent liabilities as boot under certain circumstances but has not applied these rules harshly. (See LTR 9343011 and revenue ruling 95-74, 1995-2 CB 36.)
Certain taxpayers desiring to avoid the basis reduction for liabilities may take the position that contingent obligations are not really liabilities under section 358(d). If they are successful in taking this position, this absence of basis reduction could create a capital loss upon subsequent sale of the stock. The IRS has focused attention on certain of these transactions which it views as tax shelters (see notice 2001-17, IRB 2001-9 and FSA 200134008). These transactions usually involve the transfer of a high-basis asset for stock and the assumption of a liability, such as deferred employee benefits. The value of the stock is minimal because of the present value of the assumed liability. The transferor typically sells the stock for its fair market value, resulting in a tax loss, and the transferee corporation claims a deduction when it makes payments on the liability. The IRS believes any purported business purposes for these transactions are far outweighed by the accelerated and duplicate tax deductions that result. CPAs should encourage clients to avoid such arrangements because the IRS will disallow losses and assess penalties.
PAYMENT OF SECTION 351 LIABILITIES
If a transferee pays an assumed liability, it may have to capitalize it (see Holdcroft Transportation Co., 153 F2d 323 (CA-8, 1946)). That would have been the certain conclusion before revenue ruling 80-199 (1986-2 CB 113). Since that ruling the IRS has relaxed its capitalization stance somewhat. For example, in TAM 9716001, a corporation was able to deduct the payment of an accrued vacation pay liability it had assumed in a 351 transaction. The IRS observed that the seller could have deducted the payment and pointed out that the vacation pay liability followed ordinary business practice. With contingent environmental liabilities, the buyer can deduct payments if the seller could have deducted them (revenue ruling 95-74, 1995-2 CB 36).
The deductibility of assumed liabilities is important for CPAs because the Internal Revenue Code contains no provision allowing a transferee corporation to deduct assumed liabilities in a section 351 exchange. This stands in contrast to the reorganization rules under section 381, which explicitly allow transferee deductions if the transferor could have deducted the amounts. In fact, in VCA Corporation (566 F2d 1192 (Ct. Cl. 1977)), the acquiring corporation in a statutory merger was permitted to deduct contingent liabilities even though it was entitled to partial indemnification from shareholders.
Origin-of-the-claim test. A line of cases supports determining the character of litigation income by referring to the origin of the claim at issue. For example, a taxpayer recognized an ordinary loss from selling IRC section 1231 property. Three years later he received a settlement from a related antitrust action. The proceeds were ordinary income because the original transaction was taxed in this manner. Under this same approach, litigation income may be capital if the claim relates to the acquisition or disposition of property. If a settlement agreement does not allocate total damages among several claims, a court may be forced to make the allocation.
In Dye (566 F2d 1192 (Ct. Cl. 1977); see also Durkee , 162 F2d 184, Raytheon , 144 F2d 110 and Sager Glove, 311 F2d 210), the Tenth Circuit Court of Appeals applied the origin-of-the-claim test to distinguish between ordinary and capital income. The court found that some of Dye’s claims were for impairment to her capital while others related to ordinary income. For example, claims for the diminished value of assets and excessive transfer fees in connection with securities transactions were held to relate to capital; claims for lost interest on bonds, excessive margin interest charges and punitive damages related to ordinary income. The district court, on remand, had to allocate amounts to the above categories because the parties did not make an allocation in their settlement agreement. To avoid this problem CPAs should advise taxpayers to allocate litigation income between capital and ordinary claims.
One troublesome issue is whether a claim based on lost profits is ordinary or capital since goodwill, a capital asset, is computed by capitalizing profits. In theory using lost profits as a factor in determining the damage to goodwill should not alter the character of the recovery (see Inco Electroenergy, TC Memo 1987-437, citing Raytheon ). However, the courts will examine the facts of each case to determine whether the essence of the taxpayer’s claim is lost profits or capital impairment. For taxpayers the answer is probably easier when the claim is for the total destruction of a business—lost profits are a common way to capitalize the entity’s value (as in Durkee and Raytheon ).
New test: Sale or exchange? Nahey (99-2 USTC 50, 967 (CA-7, 1999), aff’g 111 TC 256) determined the character of litigation income without using the origin-of-the-claim test. The court decided that damages were ordinary rather than capital because settling a lawsuit does not constitute a sale or exchange. This decision is a potentially devastating blow to capital gains treatment because it suggests litigation proceeds can never be capital in nature.
Wehr Corp. sued Xerox for breach of contract and fraud, seeking lost profits. While the suit was pending, Wehr’s majority shareholder offered to sell the company to Brian Nahey, its president, for $100 million in a leveraged buyout. The sale was actually made to two S corporations Nahey owned. The accounting firm for the S corporations viewed the suit as too speculative to be valued on the books. Nevertheless, in a settlement six years later Xerox paid Nahey’s S corporations approximately $6 million. He reported the settlement as a capital gain.
Nahey conceded that if the company had not changed hands the settlement would have been taxed as ordinary income. But he argued the purchased suit was a capital asset. The court said the suit’s character was irrelevant because Nahey did not sell it.
Nahey tried to bring himself under the origin-of-the-claim test by arguing his claim originated with the leveraged buyout. The appeals court dismissed this argument saying “a corporate acquisition should not affect the tax treatment of any claims that are transferred in the acquisition.” While this principle sounds good at first, it ignores at least two problems:
If an acquisition shouldn’t change a claim’s character on the income side, why does the IRS insist it does on the expense side? It is clear that the IRS often requires capitalization of an expenditure that would have been deductible had the business not changed hands. Judge Cudahy, in a separate opinion, pointed to the Ninth Circuit Pacific Transportation decision requiring capitalization and said, “ Pacific Transportation is on all fours with the present case except that it involves the expense side rather than the income side.”
The principle that an acquisition doesn’t change an income claim’s character can exalt form over substance. What if Nahey had sold the claim before it was settled? Nahey apparently would allow capital gains treatment. If a sale or exchange is what is required to convert ordinary income to capital gains, some taxpayers may find Nahey to their liking.
CPAs will find pending claims are more difficult to handle in taxable sales. A buyer who must capitalize may find tax recovery stretched over 15 years. Most buyers probably have already been deducting pending liability claims if the item normally would have been deductible. ITW will discourage this practice. However, to the extent CPAs can encourage buyers to postpone incurring future expenses until after the acquisition, it may be possible to bypass ITW .
Sellers usually prefer to pass
on contingent liabilities to buyers if the parties can agree
on purchase price reductions. If they can’t, CPAs may have to
advise a seller to retain the liability to keep it from being
a deal-breaker. The liability then should produce a tax
deduction if the seller could have deducted it but for the
acquisition. However, if the payment would have to have been
capitalized or if the acquisition was a stock sale, a capital
loss should be the result under the Arrowsmith
doctrine. When the buyer satisfies the seller’s debt,
Arrowsmith can produce a capital gain to the
seller. But the seller also has made a constructive payment
that may be an ordinary deduction. This combination can
produce a positive tax effect for non-C-corporation sellers.