Citations: Rev. Rul. 79-258; 1979-2 C.B. 143
Rev. Rul. 79-258
Under the circumstances described below, is gain recognized to a transferor corporation by reason of section 357(b) of the Internal Revenue Code of 1954 as a result of an assumption by the transferee corporation of a liability of the transferor corporation?
Corporation P, the stock of which is widely held, has been actively engaged in two separate businesses for more than 5 years. For good business reasons, P transferred the assets of one of its businesses to a newly formed subsidiary corporation, S, solely in exchange for all of the S stock and the assumption by S of the liabilities of P relating to the business transferred. Thereafter, P intended to distribute all the stock of S to the shareholders of P in a transaction that qualified under sections 368(a)(1)(D) and 355(a)(1) of the Code. The adjusted basis and the fair market value of the assets to be transferred by P to S, in the aggregate, exceeded the amount of the liabilities assumed by S. One of the liabilities P desired S to assume was a 4,000x dollar portion of a 25,000x dollar long-term debt to an insurance company that had been incurred by P in connection with the business transferred to S and had been outstanding for several years. P and S would be unable to apportion this debt, however, because the insurance company refused to relieve P of its primary liability for the repayment of the loan. From P's standpoint it was desirable to have S assume this 4,000x dollar liability, otherwise P would be reducing its assets by the amount of the value of the S stock, which was to be distributed to the P shareholders, without a reduction of its liabilities by the amount of the 4,000x dollar liability attributable to the business transferred to S. Thus, if S did not assume the 4,000x dollar liability, it could adversely affect P's future ability to borrow and its ability to pay off the portion of the indebtedness because of its disposition of the business transferred to S.
Therefore, in order to have S assume its proportionate share of the outstanding long-term debt, P negotiated a new long-term loan from a bank in the amount of 4,000x dollars on which it was primarily liable. As part of the assumption of the liabilities relating to the business transferred to S, P substituted the new 4,000x dollar long-term bank loan for the 4,000x dollar long-term insurance company loan. S assumed the long-term bank loan, and the bank relieved P of its primary liability for repayment. P retained the insurance company debt. The 4,000x dollars borrowed from the bank was used by P to pay off 4,000x dollars of the 25,000x dollar insurance company debt. Thereafter, P distributed the S stock to the P shareholders.
LAW AND ANALYSIS
The applicable sections of the Code and Income Tax Regulations thereunder are 368(a)(1)(D), 361, 355(a)(1), 357(a), 357(b), 1.368-2, 1.361-1, 1.355-1 and 1.357-1, relating to the assumption of liabilities in a reorganization.
Section 357(a) of the Code provides, in part, that, except as provided in section 357(b) and (c), if (1) the taxpayer receives property that would be permitted to be received under section 361 without the recognition of gain if it were the sole consideration, and (2) as part of the consideration, another party to the exchange assumes a liability of the taxpayer, or acquires from the taxpayer property subject to a liability, then such assumption or acquisition shall not be treated as money or other property, and shall not prevent the exchange from being within the provisions of section 361.
Section 357(b)(1) of the Code provides, in part, that if, taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption or acquisition was made, it appears that the principal purpose of the taxpayer with respect to the assumption or acquisition described in section 357(a) was a purpose to avoid federal income tax on the exchange, or if not such purpose, was not a bona fide business purpose, then such assumption or acquisition (in the total amount of the liabilities assumed or acquired pursuant to such exchange) shall, for the purposes of section 361 be considered as money received by the taxpayer in the exchange.
Section 357(b)(1) of the Code applies in two cases: (1) where under the applicable circumstances it appears that the principal purpose of the transferor in causing the assumption of the liability was to avoid federal income tax on the exchange; and (2) where there is no tax avoidance purpose but the assumption was not effected for a bona fide business purpose.
Section 357(b) deals with the transferor's purpose in causing the assumption and by stating that consideration must be given to "the nature of the liability and the circumstances in the light of which the arrangement for the assumption acquisition was made", requires that the determination of the transferor's purpose be made from an analysis of all of the facts and circumstances. See Simpson v. Commissioner, 43 T.C. 900, 916 (1965), acq., 1965-2 C.B. 6, wherein the court stated: "* * * we believe the indictment of this section is limited to transactions of this nature arranged primarily so that the assumption of the transferee's liability in the transaction itself results in tax avoidance for the transferor, or has no bona fide business purpose. We do not believe it was intended to require recognition of gain on bona fide transactions designed to rearrange one's business affairs in such a manner as to minimize taxes in the future, consistent with existing provisions of the law."
The assumption of the liabilities of the transferor corporation is frequently an integral part of a corporate reorganization. This was recognized by Congress when it amended section 112 of the Internal Revenue Code of 1939 by amending subsection (k), the predecessor to section 357(b) of the Internal Revenue Code of 1954. The report of the House Ways and Means Committee accompanying the enactment of section 112(k) stated: "In typical transactions changing the form or entity of a business it is not customary to liquidate the liabilities of the business and such liabilities are almost invariably assumed by the corporation which continues the business." See H. Rep. No. 855, 76th Cong., 1st Sess., pp. 18, 19 (1939), 1939-2 C.B. 504.
In ISC Industries, Inc. v. Commissioner, T.C. Memo 1971-283, the taxpayer corporation, which was engaged in the consumer finance business, purchased a majority of the outstanding stock of a bakery with funds that the taxpayer had borrowed for use in its finance business. Shortly thereafter, the bakery corporation was merged with and into the taxpayer. Although the taxpayer's directors knew that the proposed acquisition was in violation of various loan agreements, it did not anticipate that its lenders would oppose the acquisition. Upon learning of the acquisition, however, a number of the taxpayer's lenders threatened to withdraw their credit unless (1) the consumer finance business was insulated from the bakery's operations and (2) the money used to purchase the bakery corporation's stock was returned for use in the finance business. Therefore, the taxpayer transferred the bakery's operating assets to a wholly-owned subsidiary while retaining most of the bakery's cash and other liquid assets. The taxpayer also placed a mortgage on the transferred bakery assets with the subsidiary assuming liability on the mortgage and the taxpayer retaining the mortgage proceeds for use in its finance business. The United States Tax Court concluded that the taxpayer's principal purpose in making the subsidiary assume the liabilities placed upon the transferred assets was not to avoid federal income tax on the transfer but rather was to protect the lines of credit for the taxpayer's finance business. Accordingly, section 357(b) of the Code did not apply to the subsidiary's assumption of the mortgage liability.
After the assumption by S of the new indebtedness in the transaction, both P and S were in the same net economic position as each corporation would have been had S been able to assume its proportionate share of the existing indebtedness. Since the bank loan was incurred by P solely in substitution for S's proportionate part of the existing indebtedness, which could not be assumed by S, and was an obligation of P at the time of the exchange, obtaining the bank loan and the subsequent transfer of that indebtedness to S in place of S's pro rata portion of the existing indebtedness was a normal adjunct to the corporate reorganization. No untaxed gain or other tax benefit resulted to P or S from the substitution of the indebtedness and the assumption of the new indebtedness by S.
In the instant case the facts do not lead to the conclusion that the principal purpose of the transaction was the avoidance of tax since the assets transferred were associated with the liability assumed and the acquisition of the indebtedness and its assumption by S were necessary in order that the transaction between P and S, which was supported by valid business reasons, could be effected. Further, the acquisition of the new indebtedness and its transfer to S were merely in substitution for the pro rata portion of the existing indebtedness that related to the business and operations of S. In this regard, the acquisition of the new indebtedness and its transfer to S in substitution for S's pro rata portion of the existing indebtedness is analogous to the assumption of existing indebtedness and is consistent with sound business practice since the transaction resulted in S assuming liability in an amount that properly relates to its business operations and which is properly satisfied from profits generated by those operations. The use by P of the proceeds of the new indebtedness to pay off part of the insurance company debt does not lead to the conclusion that tax avoidance was a principal purpose of the transaction. See ISC Industries, Inc. v. Commissioner.
Moreover, the acquisition of the new indebtedness by P and its assumption by S will not be viewed for federal income tax purposes as if S had obtained the new indebtedness and transferred the proceeds of the loan to P. In this regard it is immaterial that P and S may have been able to arrange their affairs in another manner. See Simpson v. Commissioner and ISC Industries Inc. v. Commissioner.
Based on all the facts and circumstances, section 357(b) of the Code does not apply to the assumption, and no gain or loss is recognized to P on the exchange with S under section 361(a).