The Treatment of Contingent Liabilities in Taxable Asset Acquisitions

Originally published August 2001

By Mark J. Silverman and Kevin M. Keyes

TABLE OF CONTENTS

1. INTRODUCTION

2. TIMING OF DEDUCTIONS

   1. Accrual Method Taxpayers

   2. Cash Method Taxpayers

3. TREATMENT OF CONTINGENT LIABILITIES IN TAXABLE ASSET ACQUISITIONS

   1. Traditional Approach and Development

   2. Factors that Determine Whether Liability Has Been Assumed

   1. The Liability Results From Buyer's Operation

   2. Arises Out of Post Acquisition Events

   3. Buyer Aware of Liability

   4. When Did Legal Liability Arise

   5. Liability Reflected in Price

   6. Liability Expressly Assumed by the Buyer

   7. Balance Sheet Reserve

   8. Summary

4. TREATMENT OF ASSUMED LIABILITIES

   1. Seller's Treatment of an Assumed Liability

      1. Income Inclusion

      2. Offsetting Deduction

      3. Imputed Interest Income

      4. Summary

   2. Buyer's Treatment of Assumed Liabilities

      1. Capitalization Approach

      2. Deduction Approach

      3. Income Approach

      4. Summary

   3. Section 1060

      1. Overview

         1. Applicable Asset Acquisitions

         2. Allocation of Consideration

      2. Treatment of Assumed Contingent Liabilities Under Section 1060

         1. Seller's Treatment

         2. Buyer's Treatment

   4. Section 338(h)(10)

      1. Overview

         1. Result of Section 338(h)(10) Election

         2. Consequences of Section 338(h)(10) Election to Seller

         3. Consequences of Section 338(h)(10) Election to Buyer

      2. Treatment of Assumed Contingent Liabilities Under Section 338(h)(10)

         INTRODUCTION

         This outline discusses the Federal income tax treatment of contingent liabilities in the context of taxable asset acquisition transactions.

   1. First, the outline will provide a brief overview of the timing rules relating to deductions.

   2. Then, the outline will discuss the treatment of contingent liabilities in the context of taxable asset acquisitions. This topic is of particular interest, since the importance of contingent liabilities has increased dramatically in recent years. Common examples of contingent liabilities include environmental liabilities, employee health care and pension liabilities, and tort liabilities. The outline will highlight the factors traditionally relied on in determining whether a liability of the seller has been assumed by the buyer as part of an acquisition.

      1. Unfortunately, the treatment of contingent liabilities is currently uncertain due to the fact that traditional authorities are sparse and often contradictory.

      2. The parties face significant tax issues and risks where an acquisition involves contingent liabilities.

      1. The concerns of the seller include:

         (1) Whether additional gain must be recognized;

         (2) Whether the installment method will apply;

         (3) Whether an offsetting deduction can be claimed; and

         (4) Whether interest income will be imputed.

      2. The concerns of the buyer include:

         (1) Whether the contingent liabilities can be deducted;

         (2) Whether income to the buyer will be triggered; and

         (3) Whether the imputed interest rules will apply.

2. TIMING OF DEDUCTIONS

   1. Accrual Method Taxpayers

      1. An accrual method taxpayer may deduct an expense when:

         1. The "all events" test of section 461(h)(4) has been satisfied, and

         2. Economic performance has occurred.

      2. The all events test of section 461(h)(4) is satisfied when the liability is "final and definite in amount, fixed and absolute, and unconditional." United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), citing Security Flour Mills Co. v. Commissioner, U.S. 281, 287 (1944), Brown v. Helvering, 291 U.S. 193, 201 (1934) and Lucas v. North Texas Lumber Co., 281 U.S. 11, 13 (1930).

         1. The first two components of the above rule are referred to as the "all events" test, which originated in United States v. Anderson 269 U.S. 422 (1926), and is now codified in section 461(h)(4).

         (1) The all events test is intended to protect against deductions that might never occur. Diversified Auto Services. Inc. v. Commissioner, 43 T.C.M. 701 (1982).

         (2) Generally, accrual for tax purposes is prevented if there exists a contingency with respect to a liability. See TAM 8741001, modified by TAM 9125001.

      3. The "economic performance" requirement was added to the all events test with the enactment of section 461(h) in 1984.

         1. Special rules apply where property or services are provided to the taxpayer.

         (1) Section 461(h)(2)(A)(i) provides that if the liability in question arises out of services to be rendered to the taxpayer by another person, economic performance occurs as the services are provided.

         (2) Section 461(h)(2)(A)(ii) provides that if the liability arises out of providing property to the taxpayer by another person, economic performance occurs as the person provides such property.

         (3) Section 461(h)(2)(B) provides that where the liability requires the taxpayer to provide property or services, economic performance occurs as the taxpayer provides such property or services.

         (4) Section 461(h)(2)(C) provides that if the liability requires a payment to be made to another person, and arises under any workman's compensation act or tort claims, then economic performance generally occurs as the payments are made.

      4. The timing of deductions may be controlled by other provisions.

         1. Section 404(a)(5) provides that contributions to a nonqualified deferred compensation plan are deductible only in the taxable year in which an amount attributable to the contribution is includible in the gross income of the employee.

         2. Section 267 may defer deductions between related parties.

         3. Treas. Reg. 1.461-1(a)(2) provides that an accrual method taxpayer cannot claim an immediate deduction for an expenditure that creates an asset with a useful life extending beyond the taxable year.

   2. Cash Method Taxpayers

      1. Cash basis taxpayers may generally claim a deduction in the year of payment, Treas. Reg. 1.461-1(a)(1), hence, the "all events test" described above does not apply.

      2. However, cash basis taxpayers are still subject to the capitalization rules of Treas. Reg. 1.461-1(a)(1) for any expenditure that results in the creation of an asset having a useful life extending beyond the taxable year.

      3. Moreover, cash basis taxpayers may be denied an immediate deduction if the cash outlay is used to prepay otherwise deductible expenses. For the treatment of such expenditure see Keller v. Commissioner, 725 F.2d 1173 (8th Cir. 1984); Rev. Rul. 79-229, 1979-2 C.B. 210.

3. TREATMENT OF CONTINGENT LIABILITIES IN TAXABLE ASSET ACQUISITIONS

   There exists significant uncertainty surrounding the treatment of contingent liabilities in taxable asset acquisitions.

   1. Traditional Approach and Development

      1. Almost every deal involves the existence of contingent liabilities. Most commonly, these liabilities take the form of environmental costs, pending or future tort claims, and employee costs (i.e., medical, retirement, and unemployment). However, determining the proper treatment of contingent liabilities in taxable asset acquisitions is a complex task due to the sparse and often conflicting authorities that have dealt with the topic. This section discusses both the Federal income tax treatment of contingent liabilities in taxable asset acquisitions and the issues and risks inherent in every taxable asset deal involving contingent liabilities.

      2. The issue of the proper treatment of contingent liabilities arises where a buyer purchases the assets of a business and after the acquisition, the buyer pays or incurs a liability that is attributable to the acquired business.

      3. Under these facts, it is not clear whether the liability is a liability of the seller that is assumed by the buyer or whether it is simply a liability arising after the acquisition that is properly treated as the buyer's liability.

      4. Thus, the threshold question is with whom did the liability arise? Specifically, is it a liability that arose only after the buyer had completed the transaction or is it a liability that originated with the seller and was assumed by the buyer as part of the transaction?

         1. If the buyer did not assume the liability as part of the acquisition then:

            (1) The buyer should get a deduction for the payment of the liability under the usual rules (i.e., deductible within whatever limitations apply, such as sections 404 or 461); and

            (2) The seller should remain unaffected.

         2. However, numerous issues arise if the liability is treated as seller liability assumed by the buyer, including:

            (1) What is...