Rev. Rul. 80-199

ISSUE

Whether the term "liabilities" as used in sections 357 and 358(d) of the Internal Revenue Code prior to amendment by the Revenue Act of 1978, Pub. L. 95-600, 1978-3 C.B. (Vol. 1) 1, 88, on November 6, 1978, includes accounts payable deductible under section 162 of the Code.

FACTS

Individual A conducted a small contracting business as a sole proprietorship, the income of which was reported on the cash receipts and disbursements method of accounting. On January 1, 1978, A transferred to a newly organized corporation all of the assets of the sole proprietorship in exchange for all of the stock of the corporation, plus the assumption by the corporation of all of the liabilities of the sole proprietorship, in a transaction that met the requirements of section 351(a) of the Code. The transactor did not lack a business purpose. The assets transferred were tangible assets having a fair market value of $20,000 and an adjusted basis of $10,000, and accounts receivable having a fair market value of $30,000 and an adjusted basis of zero dollars. The liabilities assumed by the corporation consisted solely of accounts payable of the sole proprietorship in the face amount of $20,000. The accounts would have been deductible by A as ordinary and necessary business expenses under section 162 if A had paid them. The new corporation continued to utilize the cash receipts and disbursements method of accounting.

LAW AND ANALYSIS

The applicable sections of the Code are 351, relating to nonrecognition in a transfer to a corporation controlled by the transferor; 357, relating to assumption of liability; 358, relating to basis to distributees; and 362, relating to basis to corporations.

Section 357(a) provides, in part, as a general rule that the assumption of liabilities on the part of a corporate transferee in connection with a section 351 exchange, or the acquisition by the transferee of property subject to a liability in such an exchange, shall not be treated as a receipt of money or other property by the transferor.

Section 357(c)(1) prior to amendment by the Revenue Act of 1978 provides, in part, that in the case of an exchange to which section 351 applies if the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.

Section 358(a)(1) of the Code provides, in part, that in the case of an exchange to which section 351 applies the basis of the property permitted to be received under section 351 without the recognition of gain or loss shall be the same as that of the property exchanged (A) decreased by (i) the fair market value of any other property (except money) received by the taxpayer, (ii) the amount of money received by the taxpayer, and (iii) the amount of loss to the taxpayer which was recognized on such exchange, and (B) increased by (i) the amount which was treated as a dividend, and (ii) the amount of gain to the taxpayer which was recognized on such exchange (not including any portion of such gain which was treated as a dividend).

Section 358(d) of the Code prior to the amendment by the Revenue Act of 1978 provides that if as part of the consideration to the taxpayer, another party to the exchange, assumed a liability of the taxpayer, or acquired from the taxpayer property subject to a liability, such assumption or acquisition (in the amount of the liability) shall, for purposes of this section, be treated as money received by the taxpayer on the exchange.

Since the adjusted basis of the assets transferred by A to the corporation was $10,000 and the accounts payable assumed by the corporation was $20,000, the primary question for consideration is whether the transfer of the assets and liabilities of A's sole proprietorship to the corporation results in gain under section 357(c) of the Code. In Raich v. Commissioner, 46 T.C. 604 (1966), the Tax Court of the United States directed its attention to such a question in a case where the taxpayer transferred assets of a business conducted as a sole proprietorship, the income from which was reported on the cash receipts and disbursements method of accounting, to a newly formed corporation in exchange for all of the stock of the corporation plus the assumption by the corporation of all of the liabilities of the sole proprietorship (trade accounts payable and notes payable) in a transaction meeting the requirements of section 351(a). The court held that the trade accounts receivable had a zero basis, and that since the total liabilities, consisting primarily of trade accounts payable, assumed by the corporation were in excess of the adjusted basis of all of the assets transferred, the taxpayer (transferor) incurred a gain under section 357(c) (as it existed prior to the amendment by the Revenue Act of 1978). In Rev. Rul. 69-442, 1969-2 C.B. 53, the Service indicated that it would follow the decision in Raich v. Commissioner and apply section 357(c) to other situations involving similar facts.

In Focht v. Commissioner, 68 T.C. 223 (1977), acq., page 1, this Bulletin, the taxpayer, in 1970, transferred to a newly-formed corporation all of the assets of a business conducted as a sole proprietorship, the income of which was reported on the cash receipts and disbursements method of accounting, in exchange for all of the stock of the corporation plus an assumption by the corporation of all of the liabilities of the sole proprietorship in a transaction meeting the requirements of section 351(a) of the Code. These liabilities consisted of the liabilities actually assumed by the corporation as well as liabilities to which certain of the property transferred was subject. The liabilities assumed by the corporation consisted primarily of trade accounts payable. The Internal Revenue Service treated all of the liability obligations including the accounts payable as liabilities within the meaning of section 357(c), and determined that the taxpayer incurred a gain, by reason of section 357(c), in the amount by which the liabilities assumed by the corporation exceeded the adjusted basis of the assets transferred. The Tax Court of the United States held that an obligation should not be treated as a liability, under sections 357 and 358(d), to the extent that its payment would have been deductible (under section 162) if made by the transferor. The court held that section 357(c) did not apply to the account payable liabilities for this reason and overruled its prior decision in Raich on this point.

The Service will follow the decision in Focht.

HOLDING

No gain is realized by A on the exchange of property for stock by reason of section 357(c) of the Code because the accounts payable assumed by the corporation would have been deductible by A as ordinary and necessary business expenses under section 162 in the taxable year paid if A had paid these liabilities prior to the exchange. A's basis in the stock received in the exchange of property for stock under section 358(a)(1) is the $10,000 basis that A had in the property transferred to the corporation. No adjustment to such basis is made under section 358(a)(1)(A)(ii) because of the assumption by the corporation of the $20,000 in accounts payable inasmuch as section 358(d) does not apply to the accounts payable. Likewise, no adjustment to such basis is made under section 358(a)(1)(B)(ii) because section 357(c) does not apply to the accounts payable.

Transactions which occur on or after November 6, 1978 will be governed by sections 357(c) and 358(d) as amended by the Revenue Act of 1978.

COURT DECISIONS THAT THE INTERNAL REVENUE SERVICE WILL NOT FOLLOW

The Service will not follow the rationale of the decision of the United States Court of Appeals for the Ninth Circuit in Thatcher v. Commissioner, 533 F.2d 1114 (9th Cir. 1976) which involved a transaction similar to the facts of this revenue ruling. The court agreed with the Service that the transferors must recognize gain under section 357(c) of the Code on the incorporation transfer, but the court also concluded that the transferor should receive a deduction for trade accounts payable discharged by the transferee corporation to the extent of the accounts receivable or the gain recognized under section 357(c), whichever is less.

The Service also will not follow the rationale of the decision of the United States Court of Appeals for the Second Circuit in Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir. 1972), involving a similar transaction and which held that the term "liabilities," as used in section 357(c) of the Code, did not include all liabilities which are included for accounting purposes, but was meant to apply only to what might be called "tax" liabilities, that is, liens in excess of tax costs, particularly mortgages encumbering property transferred in an exchange within the meaning of section 351. The above mentioned language offers no clear guidance as to the meaning of the terms "accounting" liabilities and "tax" liabilities or to making a distinction between them. For example, to the extent that the Bongiovanni decision could be interpreted as suggested by Footnote 6 in Thatcher as holding that "liabilities" for the purpose of section 357(c) means only "the excess of secured debts over the transferor's adjusted basis in the assets transferred" (italics supplied), the Service would view such an interpretation as being unduly restrictive of the term "liabilities."

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 69-442 is revoked.

Further, this revenue ruling is not to be relied upon for an interpretation of the term "liability" for any provision of the Code or Income Tax Regulations thereunder, other than sections 357 or 358(d), because in Focht the Tax Court properly limited its interpretation of the term to those sections.

SECTION 7805(b) OF THE CODE

Pursuant to the authority contained in section 7805(b) of the Code, this revenue ruling will not be applied to a transferee corporation that, pursuant to section 362(a)(1) of the Code, increased the basis of the property acquired in a transaction to which section 351 applied by the amount of the gain recognized by the transferor on such transfer under section 357(c) and Rev. Rul. 69-442. Thus, a transferee corporation will not be required to reduce the basis in the property received by the amount of such gain recognized by the transferor unless a claim for refund or credit relating to the gain is filed by the transferor because of the revocation of Rev. Rul. 69-442.