Tax

Liability Assumption in a Spin-Off

Spin-offs are more popular, yes -- but they also create some thorny accounting issues.
Robert WillensSeptember 21, 2001

Most spin-offs are component parts of a “D” reorganization. This means that the spin-off is preceded by a transfer (by the distributing corporation) of assets and liabilities (to the controlled corporation). The stock is then parsed out to the distributing corporation’s shareholders. Normally, the conveyance of assets is undertaken in exchange for stock in the controlled corporation and the assumption of an appropriate amount of the parent’s liabilities.

Occasionally, the parent also receives ”boot” — property other than stock and securities in the controlled corporation. In these cases, the parent’s gain, associated with the transferred assets, must be recognized — in an amount not in excess of the boot. An exception occurs if such boot is distributed, in pursuance of the plan of reorganization, to the parent’s shareholders or creditors. Then the receipt of boot will not trigger gain recognition at the parent level, so long as such boot is conveyed with an expedition consistent with orderly procedure to the parent’s shareholders and creditors. In these cases, gain recognition is inappropriate because the parent functions merely as a ”conduit.” Thus, the boot ultimately passes on its way to the true parties in interest: its shareholders and creditors.

The parent can be saddled with gain recognition, however, in the liability-assumption phase of the transaction. This cannot be obviated by a distribution, either. Hence, in cases where the liabilities assumed exceed the aggregate basis of the assets transferred, Sec. 357(c) provides, flatly, that such excess shall be treated as a gain. Moreover, liabilities assumed include liabilities, the payment of which would give rise to a deduction or a capital expenditure. Such liabilities are excluded in cases where the transaction is an incorporation to which Sec. 351 applies. But these liabilities are not excluded where the incorporation is one to which Sec. 361 applies — where the incorporation occurs in connection with a spin-off that’s part of a “D” reorganization. See Sec. 357(c)(3)(A) and Rev. Rul. 95-74.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The IRS has ruled that gain recognized under Sec. 357(c) does not have the collateral effect of preventing the controlled corporation from satisfying the ”active business” test of Sec. 355(b)(2)(C). Normally, that test is flunked if the business relied upon to satisfy the active business requirement of Sec. 355(b) was acquired within the five-year pre-distribution period in a transaction in which gain or loss was recognized (in whole or in part). In Rev. Rul. 78-442, however, the IRS concluded, properly, that this rule is intended to prevent the acquisition of a business from an outside party in a taxable transaction within the five-year period preceding the distribution. It was not intended to apply to the acquisition of a business by the controlled corporation from the distributing corporation. Accordingly, the acquisition does not violate Sec. 355(b)(2)(C), even though a gain was recognized in the transaction by virtue of Sec. 357(c). See also Rev. Rul. 69-461.

In addition, under Sec. 357(b), liabilities assumed will be treated as boot if, based on all the surrounding circumstances, the taxpayer’s principal purpose, with respect to such assumption, was to avoid federal income tax or was not a bona fide business purpose. In these cases, all of the liabilities assumed are considered money received, not merely the tainted liability, the assumption of which triggered the application of Sec. 357(b). (If, in these cases, the taxpayer is required to go to court to prove the ”purity” of its motives, with respect to the assumption, the burden of proof imposed on the taxpayer is unusually steep. It must sustain such burden by a ”clear preponderance” of the evidence (see Sec. 357(b)(2)). Moreover, unlike ”conventional” boot, the gain recognition associated with the receipt of ”liability boot” cannot be ”purged” through a distribution.

Sec. 357(b) can apply in cases where the proceeds of a borrowing (particularly a borrowing undertaken in contemplation of the spin-off) is separated from the obligation to repay such borrowing. Thus, the section might apply in cases where the parent undertakes such a ”midnight” borrowing, retains the proceeds of such borrowing, and has the subsidiary assume responsibility for the repayment of the loan. This incriminating scenario will not invoke Sec. 357(b), though, where the acquisition and assumption of the debt is analogous to the assumption of existing indebtedness. Thus, in Rev. Rul. 79-258, the parties (the parent and the soon-to-be spun-off subsidiary) were unable to apportion (because the lender would not relieve the parent of primary liability with respect to such borrowing) a liability that had been incurred ”in connection with” the business to be transferred to the subsidiary.

Accordingly, the parent negotiated a new loan which the subsidiary duly assumed, and the money borrowed was retained by the parent and was used to pay off a portion of the old loan that the lender would not permit the subsidiary to assume. At issue was whether the parent would be viewed, under Sec. 357(b), as having received an amount of boot equal to all of the liabilities the subsidiary assumed in connection with the transaction. The ruling concluded, due to the absence of a tax- avoidance purpose (with respect to the assumption), that Sec. 357(b) would not be a factor here. The absence of a tax-avoidance purpose was evidenced by the fact that the assets transferred to the subsidiary were associated with the liability assumed. In addition, the acquisition of the new debt and its assumption by the subsidiary were necessary so that the spin-off, which was supported by valid business purposes, could be effected.

4 Powerful Communication Strategies for Your Next Board Meeting