Proliferating gains under Sec. 357(c); Letter Ruling 9032006 represents a literal reading of this section, but it is economically unsound.

• Author: Stewart, Dave N.

Generally, a transfer of property to a corporation in exchange for corporate stock is not taxable to the shareholders if they are in control of the corporation immediately after the transfer. (1) However, if the total amount of liabilities transferred to a corporation by a shareholder exceeds the total adjusted basis of the properties transferred, the excess amount results in a taxable gain to that shareholder. For purposes of this rule, the transfer of liabilities includes both an assumption of liabilities as well as the transfer of property subject to liabilities even though no assumption occurs. In this article, a reference to either type of transaction applies equally to both. In applying Sec. 357(c), confusion exists about the correct application of this rule when the liabilities are collateralized by assets that are transferred in more than one Sec. 351 transaction. In 1987, the IRS issued Letter Ruling 8730063, (2) which provided a commonsense and economically correct solution to the problem by allowing the total amount of the liabilities to be allocated among the different Sec. 351 transfers. However, three years later, the Service issued Letter Ruling 9032006, (3) revoking, without explanation, the earlier ruling.

It appears that under Letter Ruling 9032006 the Service is taking the position that when a shareholder transfers the underlying property to different controlled corporations in separate Sec. 351 transactions, Sec. 357(c) will treat the shareholder as being relieved of the total amount of the liabilities in each separate transfer. This article will analyze the rationale of both rulings; examine some of the possible tax consequences of the Service's apparent position in Letter Ruling 9032006; and elaborate on the suggestion that the Service should revoke the 1990 letter ruling and reinstate its prior position.

Background

* Sec. 357(c)

The general rule of Sec. 357(a) is that the assumption of liabilities does not cause gain recognition. Rather, the assumption results in a reduction in the basis of the stock received from the transferee corporation. (4) However, in transactions in which the property has an adjusted basis that is less than the liabilities assumed, such a reduction would result in a negative basis in the stock to the extent of the excess liabilities. Sec. 357(c) was added to the Code in 1954 to correct this statutory deficiency. (5)

* Letter Ruling 8730063

Letter Ruling 8730063 was the Service's first written response to the question of how Sec. 357(c) ought to be applied in the context of multiple Sec. 351 transfers when all the assets transferred are collateralized by the same liabilities. The ruling's pertinent facts are listed below (dollar amounts have been added to more clearly demonstrate the results of the ruling).

* Holding wishes to acquire two businesses, R and Q, from Seller and operate the businesses in two separate subsidiaries, Green and Blue. Seller insists on a single sale to one corporation.

* Holding, Green and Blue jointly borrow $100 from a bank (with Holding receiving all the cash) to help finance the acquisition of R and Q. The bank loan agreement specifies that all, or nearly all, of the assets to be received by Holding from Seller are collateral for the $100 loan from the Bank. Holding acquires R for $80 and Q for $40.

* Holding transfers R to Green and Q to Blue in separate transactions that qualify as Sec. 351 transfers.

The Service ruled that no gain is recognized under Sec. 357(c) because

-- no new liabilities are assumed in Holding's transfer of R to Green and Q to Blue, since all three corporations remain totally liable for the bank loan throughout the entire transaction;

-- no asset becomes subject to any new liabilities due to the transfer; and

-- to determine if the liabilities transferred exceed the aggregate adjusted basis of the assets transferred, when a liability is secured by more than one asset, the liability should be properly allocated between the various securing assets.

Thus, two-thirds of the liability ($67) is allocated to the assets transferred to Green. Since these assets have an adjusted basis to Holding of $80, Sec. 357(c) is not applicable. The remaining one-third of the liability ($33) is allocated to Blue. Since these assets have an adjusted basis to Holding of $40, no Sec. 357(c) gain is created in this transfer either. Letter Ruling 8730063 takes a commonsense approach, which attempts to recognize the economics underlying the bank loan and the accompanying collateral.

* Letter Ruling 9032006

With no explanation or discussion, the Service revoked...