The following article is reprinted from The M&A Tax Report, Vol. 11, No. 11, June 2003, Panel Publishers, New York, NY.

357(d) PROPOSED REGULATIONS IN THE WORKS?

By Robert W. Wood

Section 357 contains rules governing the tax treatment of liabilities on various corporate transfers. Section 357(d) was enacted recently (in 1999) to provide rules for determining the amount of liability that will be treated as assumed for purposes of several code provisions, notably Sections 357, 358(d), 368(a)(1)(C), and 368(a)(2)(B). Put simply, Section 357(d) seeks to clarify a couple of issues, notably how much of a liability will be treated as assumed, where there are multiple assets securing a single liability and most (but not all) of those assets are transferred to a transferee corporation. A counterpart provision, Section 362(d) deals with allocating bases in the transferred property to the transferee.

Why do we care about this? Congress cared when it enacted these provisions because multiple transferees might be treated as assuming the same liability, and they might assert that the bases of multiple assets was increased by the same liability. That, in turn, would lead to overly high bases, and overly high depreciation deductions. So basically, here, we are talking about the fair measurement of assumptions of liability and the fair measurement of basis allocations. That sounds simple.

In May 2003, the Service published an advance notice of proposed regulations under these two provisions, giving a flavor of their current thinking. The statute contains a road map for what is to come. In general, a recourse liability is to be treated as assumed if the transferee has agreed (and is expected) to satisfy it, regardless of whether the transferor is relieved of the liability. I.R.C. Section 357(d)(1)(A). A non-recourse liability will be treated as assumed by the transferee of any asset subject to that liability. I.R.C. Section 357(d)(1)(B). However, the amount of non-recourse liability treated as assumed would be reduced by the lesser of (1) the amount of the liability the owner of the assets not transferred to the transferee and also subject to that liability has agreed, and is expected to satisfy; or (2) the fair market value of such other assets. Regulations are to be prescribed to carry out these provisions.

Non-Recourse Liabilities

The first step in a liability analysis is to determine if a liability is recourse or non-recourse. This appears to be based on the premise that for recourse liabilities, an agreement of the parties (and their expectations regarding the satisfaction of liability) serve as reliable predictors of which party will ultimately bear the burden of the liability. For non-recourse liabilities, on the other hand, the Code presumes that the transferee of the assets subject to that liability assumes the entire liability. That amount, though, will be reduced by the amount that an owner of other assets subject to that liability has agreed (and is expected) to satisfy, but only up to the fair market value of the assets owned by that other person that are subject to that liability.

The preamble to the advance notice points out that this basic notion is entirely consistent with the landmark cases Crane v. Commissioner 331 U.S. 1 (1947) and Tufts v. Commissioner 461 U.S. 300 (1983). The IRS chose not to issue proposed regulations, but rather to issue an advanced notice of proposed rule making, something that certainly sets forth the direction the Service is headed, but which invites comments before proposed regulations are issued.

Non-Recourse Conundrum

Predictably, the proposed regulations (when they are issued) are likely to draw a fundamental line between non-recourse liabilities and recourse ones. The Treasury is even considering the overall appropriateness of the presumption that a transferee of assets subject to a non-recourse liability is treated as assuming the entire non-recourse liability. Second, the IRS and Treasury are considering whether agreements between the transferor and the transferee regarding satisfaction of non-recourse liabilities (other than limited exceptions described in the Section 357 (d)(2)) should even be respected. The IRS and Treasury are also considering whether the rules concerning the amount of a non-recourse liability treated as a assumed by a transferee should be based solely on the parties' agreement as to who will ultimately bear the non-recourse liability. This brings into focus the central question whether rules for non-recourse liabilities should be moved more closely to conform to those applying to recourse liabilities.

With these general thoughts by the Service, a couple of summaries are still possible.

Non-Recourse Liability and No Agreement

Where there is a non-recourse liability, and no agreement between the parties, the transferee will be treated as assuming the entire amount of the liability. So, suppose that P owns asset A having a basis of 0 and a fair market value of $100, and asset B with a basis of zero and a fair market value of $400. Assume that both these assets secure a non-recourse liability for $500. Lets say that P also owns asset C, having a basis of 0 and a value of $500. If P transfers asset A and asset C to corporation S (newly formed) in exchange for 100% of S's stock in a Section 351 transaction, and assuming P and S don't have an agreement as to the satisfaction of the non-recourse liability, what happens? S is treated as assuming the entire non-recourse liability, so P recognizes $500 of gain. (The gain recognition is provided for in Section 357(c)).

Even though this may seem like an obvious result, the IRS has indicated that this simple rule may not reflect the underlying economics of the property transfer. After all, P may default on the non-recourse liability, and the lender may move to foreclose on asset A. The advance notice indicates that the IRS is considering a rule suggesting that where the transferee and the transferor have no agreement regarding the non-recourse liabilities, the transferee will not necessarily be treated as assuming the entire amount of the non-recourse liability.

The exact bounds of this exception are not yet clear, but the advanced notice suggests that a proposed rule might call for the transferee to be treated as assuming a pro rata amount of the non-recourse liability, determined on the basis of the fair market value of the assets securing the liability that are transferred to the transferee, as compared to the total fair market value of all of the assets securing the liability that are owned by the transferor immediately before the transfer.

Agreements on Non-Recourse Liabilities

In many case, of course, there will be an agreement as to the satisfaction of the non-recourse liabilities. What happen, though, if there is no transfer of the assets subject to the liability, but there is still an agreement? Even if there is an explicit agreement to satisfy a non-recourse liability, the party agreeing to discharge that liability apparently is not treated as assuming it if the property to which that non-recourse liability is subject is not transferred.

This caused the IRS to state that perhaps non-recourse and recourse liabilities should be treated the same for this purpose, so that any explicit agreement to assume a liability would be treated as such even in the absence of a transfer of the underlying property. This is just being considered, of course, and Treasury specifically asked for comments on this proposal. Nonetheless, it is good news, and seems to carry the possibility that the often formal (and sometimes academic) distinction between recourse and non-recourse liabilities may be giving way to economic reality.

If this does occur, of course, the effect of the agreement in on the owner of the property that is not transferred has to be considered. The advance notice walks though an example of how this would work. Predictably, there would be some reduction in the amount of the liability treated as still the problem of the owner of the property to which the non-recourse liability attaches.

Subsequent Transfers of Property Subject to Non-Recourse Debt

The advance notice also deals with what should happen if the property securing the debt should be transferred a subsequent time. Once again, the suggestion in the advance notice is that the IRS is considering whether the amount that is treated as assumed by a subsequent transferee should be determined by reference to the rules for non-recourse liability, since the original lenders' rights continued to be non-recourse, or under the rules for recourse liabilities (because the first transferee agreed, and was except, to satisfy the liability.

This analysis can get quite complicated. For example, lets say that P owns asset A (having a value of $50), and asset B (having a value of $100). Both these assets secure a non-recourse liability for $100. In year one, P transfers asset A to S1, a newly formed corporation, in exchange for all of its stock in a Section 351 transfer. S1 agrees with P to satisfy $20 of the non-recourse liability. In addition, P agrees to indemnify S1 to the extent it has losses in excess of $20 that are attributable to the non-recourse liability.

In year two, S1 transfers asset A to S2, a newly formed corporation, in exchange for 100% of the stock of S2 in a transfer to which Section 351 applies. Here, S1 and S2 have no agreement regarding the satisfaction of the non-recourse liability to which asset A is subject. What result? A couple of possibilities are apparently being considered. One is that $20 of the non-recourse liability assumed by S1 could be treated as though it were a recourse liability of S1. Thus, S2 would be treated as assuming no portion of the liability in accordance with Section 357(d)(1)(A).

Another approach is to have to the $20 of non-recourse liability assumed by S1 treated as a non-recourse liability of S1, so S2 would be treated as assuming $20 of the liability. It's not yet clear which way the Service will come out on this.

Agreements To Go Beyond Expectations

Okay, this is a bit of a head-scratcher. What if one party agrees to satisfy liabilities, but the expectation is that this party will not actually make good on at least some of its obligations? Or, put more simply, suppose that a transferor of assets subject to a non-recourse liability requires more than one transferee to agree to satisfy the same liability? Clearly, every party is not going to end up satisfying the whole liability.

Here, it seems reasonable that the expectations of the parties should be taken into account in apportioning the liability. The IRS is apparently considering a rule that would provide that where a transferee has agreed to satisfy a liability greater than the amount it is in fact expected to satisfy, that lesser expected amount will be treated as the amount of the liability agreement. There are some conditions expected to apply to this sensible rule, but if this fact-based apportionment rule comes about it would be a decided improvement.

What is an Agreement?

One would think it would not be necessary to specify exactly how a transferor and transferee can agree to apportion liabilities. Nonetheless, the advance notice suggests that the IRS is considering whether there should be explicit requirements for what constitutes an agreement between the transferor and the transferee regarding a liability.

Conclusion

The rules regarding the assumption of liabilities, and transfers of properties subject to liabilities, have always been a little confusing to taxpayers. Much like discharge of a debt concepts in general, many taxpayers (and some advisors) just don't get this whole area. Take a transaction as simple as a Section 351 exchange, for example, and mix in some debt issues, and the problem can suddenly become complicated, and even potentially disastrous.

So, seeing that the Service is approaching this issue, and particularly doing so in an advance notice asking for guidance in sorting out this area before issuing proposed regulations, seems sensible.

357(d) Proposed Regulations in the Works?, Vol. 11, No. 11, The M&A Tax Report (June 2003), p. 5.