356
•
The Journal ot Taxation
•
June 1974
TAX PROBLEMS OF
Corporations, stockholders
EDITED BY JAMES P. HOLDEN , J.D., & NORMAN S. SIEGEL, CPA
Conflicting definitions of "liabilities"
threatens some tax-free reorganizations
by MARILYN E. PHELAN
The assumption of "liabilities" in reorganizations and Section 351 transfers can
constitute boot and create taxable gain in an otherwise tax-free transaction. But
what are "liabilities" for this purpose? Recent cases have raised conflicting theories
about their nature (particularly for cash basis taxpayers), which can adversely affect
a wide range of corporate transfers. Dr. Phelan analyzes the impact of these late
developments in the reorganization area.
with conflicting determinations as to the definition of
"liabilities" under Section 357(c) pose
numerous unanswered questions as to
cash basis taxpayers when liabilities are
assumed in certain tax-free corporate
transfers. In Bongiovanni, 470 F.2d 921
(CA-2, 1972), the Second Circuit held
that Section 357(c) was meant to apply
to "tax" liabilities, i.e., liens in excess
of tax costs, particularly mortgages encumbering property transferred in a Section 351 transaction and not "accounting" liabilities, i.e., salary, bonus, and
other payables. According to Bongiovanni, "accounting" liabilities of a cashbasis taxpayer should not be liabilities
for tax purposes until paid. The Tax
Court rejected this theory in Thatcher,
61 TC No.4, stating there is no difference in the tax treatment of mortgages
and accounts payable transferred upon
incorporation. These conflicting decisions pose problems not only as to transfers under Section 351 but also as to
certain tax·free reorganizations under
Section 368 when cash-basis taxpayers
R
ECENT CASES
[Marilyn Phelan, CPA, DBA, of the
Texas Bar, is Assistant Professor of Accounting and Assistant Graduate School
Dean at Texas Tech University, Lubbock. A prior contributor to THE
JOURNAL, her articles h'ave also appeared
in Taxation for Lawyers, Taxation for
Accountants and other professional publications.]
Corporations
background in box on p. 358) became a
part of Section 357. Section 357(a) provide~ generally th~t when. a taxpayer
receIves property III certalll otherwise
nontaxable exchanges,2 the mere fact
that another party to the transaction
assumes a liability of the taxpayer or
acquires property of the taxpayer subject to a liability, will not cause the
transaction to become taxable. Further
the assumption of the liability or th~
acquisition of the property subject to a
mortgage will not be treated as other
property or money.3
There are two exceptions to the rule
of Section 357(a) that assumption of
liabilities will not be treated as other
p roperty or money. Section 357(b) pro.
vides that if the principal purpose of
the taxpayer with respect to the assump_
tion of the liabilities was a purpose to
avoid tax on the exchange, or if there is
no bona fide business purpose, then the
liabilities will be treated as money received. Further, Section 357(c) provides
that if the sum of the liabilities exceeds
the adjusted basis of the properties in a
S~ction 351 exchange or a D reorganizati:>n, the excess will be taxable as gain.
are involved in the transactions.
Aside from the problem of defining
"liabilities" for purposes of Sections
357(a) and (c), numerous other problems arising when liabilities are assumed
in corporate transfers. The extent to
which these problems relate to the
corporate reorganization is examined in
this article.
As the corporate reorganization nor·
mally results in a continuation of the
business activities of the previous corporation, liabilities are seldom liquidated. The acquiring corporation will
either assume liabilities of the acquired
corporation or will take property subject
to the liabilities. In a regular sale or
purchase of properties, the assumption
of liabilities by the purchaser is part of
the selling price.! However, in the taxfree reorganization, under Sections 357
and 368(a)(I) (C), assumed liabilities are,
for the most part, disregarded in computing taxable gain to the transferor
corporation. At first glance, then, the
assumption of liabilities in the corporate
reorganization would seem to present
few problems. However, the tax practitioner should be aware of certain
troublesome areas wherein liabilities will
constitute "boot" and thus, will create
taxable gain in an otherwise nontaxable transaction.
Section 357(b), in respect to tax avoidance, presents no serious problem for the
tax-free reorganization. It is obvious that
C:>ngress added the provision to assure
that relief would be granted only to
those transactions that were bona fide
business reorganizations. 4 In the typical
business combinations, the possibility of
finding lack of business is remote.
Further, there would normally be no tax
avoidance scheme. Basis of the assets acquired in a nontaxable reorganization is
the same as that in the hands of the
transferor. Thus, gain not recognized in
the exchange would be taxed later upon
a subsequent sale by the transferee (Section 362). Also, as stockholders receiving
stock from the transferee in a nontaxable reorganization have the same basis
as that in the stock given up (Section
358), there would presumably be no tax
avoidance scheme at the stockholder
level. Section 357(b) might pose a problem in one situation, however. The incurring of an assumed liability immediately prior and in anticipation of the
assumption has been held to indicate
a tax avoidance purpose. 5
Treatment under J57(a)
Excess of basis
The amendments of the law to nullify
the effects of the Hendler decision (see
Section 357(c), with respect to liabili·
ties assumed in excess of basis, sup'
T ax avoidance
posedly has no effect on any of the taxfree reorganizations except the D as it
specifically states that it is applicable to
exchanges " .. . to which Section 351
applies, or to which Section 361 applies
by reason of a plan of reorganization
within the meaning of Section 368(a)(I)
(D) . . . . " The D reorganization, then,
would be affected, but none of the other
tax-free reorganizations. However, Section 368(a)(2)(A) provides that if a
transaction qualifies both as an acquisition of assets for stock under Section
368(a)(I)(C) and as a transfer to a
controlled corporation under Section
368(a)(I)(D), it is treated as a Section
368(a)(I)(D) transaction. Consequently,
taxpayers may be misled as to the application of Section 357(c). They might
presume they have consummated a C reorganization when in reality it is a D
reorganization, and Section 357(c) will
apply. Also, what is supposedly an A or
a C reorganization may be a Section
351 transfer. For example, if a corporation transfers all of its properties to a
new corporation in a statutory merger
in exchange for control of the transfereecorporation'S stock and then distributes
the stock in complete liquidation, the
transfer would qualify as an A reorganization, but it would also qualify as a
Section 351 transfer. Likewise, if a
corporation transfers substantially all its
assets to a controlled corporation, the
transfer qualifies both as a C reorganization and as a Section 351 transfer.
Would Section 357(C) apply to these
transactions?
There are other problems. The acquired corporation in a C reorganization may retain the stock of the acquiring corporation and not liquidate. If
liabilities assumed by the acquiring corporation exceed the basis of the assets
to the acquired corporation, the stock
will have a negativ.e basis. Section 357(c)
might be applied by the courts to prevent such a possibility. In this respect,
the history of Section 357(c) is n::>teworthy.
Though Section 112(k) of the 1939
Code became Section 357 of the 1954
Code, Section 112(k) did not contain a
provision similar to Section 357(c). The
problem presumably solved by Section
357(c) was presented to the courts in a
case involving Section 112(k). In Easson,
294 F.2d 653 (CA-9, 1961), the taxpayer
transferred a building and land with a
fair market value of $320,000, but a tax
basis of only $87,000, to a newly-formed
corporation. The building and land
were subject to a mortgage of $247,000,
which was assumed by the corporation.
The Commissioner asserted that the
transaction provided gain to the taxpayer in the amount of $160,000, the
excess of liability assumed over adjusted
basis. The Tax Court agreed with the
Commissioner, stating that the taxpayer
would be forced to recognize gain of
$160,000 as the alternative would be a
negative basis in stock in the new corporation. The Ninth Circuit, on the other
hand, held for the taxpayer, asserting
there should be no objection to a negative basis.
Section 357(c) was added to the 1954
Code as a remedy to this problem. It
resolved the controversy of the Easson
case in favor of the Commissioner. However, as to tax·free reorganizations, it
applies only to the D reorganization.
It is not clear why the C reorganization was excluded from Section 357(c)
inasmuch as a negative basis could result
to the transferor corporation. 6 The
original version of the 1954 Code, with
respect to the C reorganization, required tlle transferor corporation to
liquidate.7 In the D, the transferor was
not required to liquidate, but only to
distribute stock received to its shareholders. Thus, under the original version of the Code, there would have been
no negative basis problem with respect to the C reorganization, only with
respect to the D. One commentator concluded in his article that this was the
reason only the D reorganization was
included in Section 357(c).8 This commentator is of the opinion that the
Senate revisers failed to note the interrelationship between the two sections
and the effects of their alterations thereon.9
In Crane, 331 U.S. 1 (1947), the Supreme
Court held that a seller must include the mortgage
on property sold in determining amount realized
on the sale. This was the case regardless of
whether the seller assumed the mortgage or acquired the property subject to the existing mort-
1
gage.
!!
These exchanges include: transfers of property
to a corporation where immediately after the
transfer the transferors are in control of the corporation (Section 351); a corporation, a party to
a reorganization, exchanges property, in pursuance of the plan of reorganization, solely for stock
or securities in another corporation, a party to the
reorganization (Section 361) ; a corporation
transfers property to a newly formed corporation
in receivership and bankruptcy proceedings (Section 371); and property of a railroad corporation
is transferred to another railroad corporation in
a receivership proceeding (Section 374).
3 This is not the case in certain other nontaxable
exchanges. In nontaxable exchanges of property
held for productive use or investment exehanges
of insurance policies and exchanges of stock for
stock in the same corporation (Sections 1031,
•
357
If the transferor corporation must
liquidate, the stock of the acquiring corporation will pass to the shareholders.
There would not, then, be a negative
basis problem. The shareholders would
transfer their basis in the stock of the
acquired liquidated corporation to the
stock received from the acquiring corporation. Because the acquired corporation is liquidated in an A reorganization, for example, there would not be a
negative basis problem in the A.
Assume X Corporation transfers assets
with a fair market value of $200,000 and
a tax basis of $80,000 to Y Corporation.
Y Corporation assumes liabilities of X
Corporation in the amount of $100,000
and gives X Corporation stock with a
fair market value of $100,000. Since X's
tax basis in its transferred assets was
only $80,000, laibilities assumed by Y
exceed tax basis by $20,000. The basis
of the stock in Y is the basis of assets
transferred less amount of liabilities
assumed. Basis of the stock would then
be $80,000 less $100,000, or a negative
basis of $20,000. If X Corporation does
not liquidate and distribute Y stock to
its shareholders, it will retain the stock
of Y which will have a negative basis.
This example poses a pertinent question. Section 357(c) does not apply to
the C reorganization. However, it is COIlceivable that a court in such an instance
might apply the reasoning of the Tax
Court in the Easson case to accord taxable gain to the exchange. There is only
one alternative: taxable gain or a negative basis. Though the Ninth Circuit in
Easson held that there should be no
objection to a negative basis, this apparently was not a popular decision. It
did prompt Congress to add Section
357(c) to attempt to negate such a pos1035, and 1036), liabilities assumed by the transferee are treated as money received by the transferor.
• The subjective test to determine bona fide business purpose is not sufficiently clarified by the
decisions, however. Most cases on this point involve the close corporation. See, for example, Easson, 33 TC 963 (1960); 294 F .2d 653 (CA-9, 1961);
Weaver, 32 TC 411 (1959); Estate of Stoll, 38 TC
332 (1962) ; Wolf, Jr., 43 TC 652 (1965); a/f'd.,
357 F.2d 483 (CA-9, 1966); Simpson, 43 TC 900
(1965) .
5 See Drybrouyh, 42 TC 1029 (1964), a/f'd. in part
and rev'd. in part, 376 F.2d 350 (CA-6, 1967) and
Simpson, supra.
a See Cooper HNegative Basis," 75 Harvard Lew
Review 1352 (1962), pp. 1358-1360 for a complete
discussion of this point.
7 See H . Rept. 8300, 83rd Cong., 2d Sess., Section
3fi9 (c) (2) (1954).
8 Cooper. 'Negative Basis:' supra note 6 at 1360.
• The Senate amended Section 368 so that the
transferor corporation need not liquidate in the
C reorganization, but it made no change with respect to Section 357 (c).
358
•
The Journal of Taxation
Corporations
• June 1974
C reorganization is allowed a slight de- Second Circuit opinion in Bongiovanni,
problem in the C reorganization should
gree of freedom in reference to con- which held accrued liabilities were not
liabilities be assumed by the acquiring
sideration. Section 368 (a) (2) (B) provides included for purposes of applying Seccorporation. However, Section 368(a)(1)
that cash and other property will not tion 357(c) when cash basis taxpayers are
Solely-for·voting stock
(B) contains no similar provision. Thus,
destroy the tax-free status of the re- involved.
Section 368(a)(1), which discusses the any assumption of a liability of the
organization if at least 80% of the fair
In Bongiovanni, the taxpayer transacquisition of another corporation's transferor corporation in a B reorganiza_
market value of all the property of the ferred all the assets and liabilities of his
properties in exchange solely for all or tion presumably will violate the solely_
acquired corporation is obtained by the sole proprietorship to a corporation in
a part of acquirer's voting stock, disre- for-voting-stock requirement. However,
use of voting stock. Cash and other prop- exchange for all the stock of that corgards the assumption of a liability of the normally the assumption of liabilities
·erty may total 20% of the fair market poration. Because taxpayer used the
acquired corporation by the acquirer. would not be present in a B reorganiza_
value of the property transferred with- cash basis method or accounting to deterCongress obviously added this. provision tion inasmuch as it usually is simply a
out disqualifying the transaction as a mine income, the receivables had no tax
to the predecessor of Section 368{a)(1)(C) change in stock ownership.
tax-free acquisition. However, liabilities basis. Consequently, liabilities, includActually, since the 1954 Code, the
to eliminate any "solely for voting stock"
assumed by the acquiring corporation ing accounting liabilities, exceeded tax
are treated as cash (or "other property") basis in the assets. The Commissioner
in this instance for the purpose of mak- asserted taxable gain under Section
ing the statutory computation that 357(c); however, the Second Circuit
BACKGROUND: TREATMENT OF LIABILITIES ASSUMED IN REORGANIZATIONS
"other property" does not exceed 20% disagreed. It stated there is no justiof the fair market value of the property fication for making an accounting
Congress apparently was concerned
PRIOR TO the Hendler case, 303 U.S. a later case, Haass, 37 BTA 948
transferred. Section 368(a)(1)(C) states method inadvertently chosen by the tax564 (1938), the Bureau of Internal (1938), the Board of Tax Appeals held that the nontaxable aspects of this
that liabilities are not considered in de- payer determinative of the tax beneRevenue apparently did not consider that Hendler applied to unsecured, Section apply only to those transtermining whether the acquisition is sole- fits and disadvantages of that taxpayer.
actions that had a bona fide business
liabilities assumed in a tax-free re- as well as to secured liabilities. 3
ly for voting stock. However, this is in If the accrual method of accounting had
The Government's triumph in the purpose. The Regulations (29.112(k)organization as additional considerathe absence of other consideration. been used, the receivables would have
tion. 1 However, in Hendler, the Hendler case was short-lived. To the I, Reg. III) promulgated with respect
Should consideration other than voting had a tax basis, and no gain would
Supreme Court ruled that the as- extent of liabilities assumed, acquir- to Section 112(k) included the folstock be given, however small, then have been created under Section 357(c).
sumption and payment of certain ing corporations would be allowed to lowing provision regarding business
liabilities are also considered to be other Consequently, the Second Circuit held
liabilities by the acquiring corpora- claim a stepped-up basis for prop- purpose:
property for the 20% test. For example, that accounting liabilities would not be
"In any suit or proceeding where
tion in an otherwise tax-free re- erty obtained in reorganizations beassume X Corporation transfers assets included in the definition of liabilities
organization would be taxable as fore the Hendler decision. As com- the burden is on the taxpayer to
with a fair market value of $500,000 to for purposes of determining if liabilities
"boot" to the acquired corporation. mentators have pointed out,4 often prove that an assumption of liabilities
Y Corporation for voting stock valued at exceed basis under Section 357(c). The
The Hendler decision has since been the " .. . Treasury Department would is not to be treated as 'other prop$400,000 and cash of $100,000. This exchange was held to be tax free. In
legislatively overruled, but it warrants have been unable to tax the 'should erty or money' under section l12(k),
transaction qualifies as a C reorganiza- Thatcher, the Tax Court rejected this
detailed consideration as background have been recognized' gain because of which is the case if the Commissioner
tion as "other property" is exactly 20% theory of the Second Circuit. The ·facts
the bar of the statute of limitations." determines that the taxpayer's purto the problem.
of $500,000. Assume, however, that in- of Thatcher reveal a cash basis partThe facts of the Hendler case re- However, taxpayers also had prob- pose with respect thereto was a purstead of voting stock valued at $400,000, Y nership incorporated and transferred
veal that Hendler Company trans- lems. There were some corporations pose to avoid Federal income tax on
Corporation gives X voting stock valued assets having a basis of $325,000; acferred its assets to Borden Company that had acquired properties through the exchange or was not a bona fide
at $300,000 and assumes $100,000 of liabil- counts payable of $164,000; and other
for stock, cash, and an assumption of a supposedly nontaxable corporate re- business purpose, and the taxpayer
ities of X Corporation. The transaction liabilities of $264,000 for stock in the
certain liabilities. Hendler distributed organization where liabilities had contests such determination by litigawould not qualify as a.C reorganization corporation. The Tax CQllrt held gain
all the stock and cash to its share- been assumed, but whose tax years tion, the taxpayer must sustain such
since liabilities asSumed would become of $103,000 would" have .to be recogholders and was dissolved_ Borden were still open. Consequently, both burden by the clear preponderance
"other property~' for purposes of the 20% nized inasmuch as" "liabilities exceeded
-(:r
Company assumed first mortgage taxpayers and the Treasury promoted of the evidence... ."6
test. Cash of $100,000 and liabilities as- tax basis of assets by. that amount.
bonds, bank loan, and accounts pay- legislation to alleviate the harmful 1 See S. M. 2723, III-2 CB 26 (1924); IT 2364,
VI-1 CB 13 (1927); Fashion Center Bldg Co.,
These conflicting decisions are critisumed of $100,000 exceed 20% of $500,able of Hendler, all of which it later effects of the Hendler decision.5
31 BTA 167 (1934).
000. Assume Y Corporation gives voting cal for a tax-free ·reorganization as
Congress effected relief from the 2 Section 112 (d) of the Revenue Act of 1928.
paid. Under the Revenue Act of
stock valued at $3-00,000 and assumes well as the Section 351 transfer. If a cash
1928,2 consideration not distributed Hendler case in the Revenue Act of Section 361 (b) of the 1954 Code is substantialliabilities of $200,000. The transaction basis corporation transfers assets and
to the shareholders in a reorganiza- 1939 by adding Section 112(k) which ly the same.
'In Bickford's Inc. 98 F.2d 568 (CA-2 1938),
again would · qualify· as a C reorganiza- liabilities in a D reorganization, the extion was taxable to the corporation. read:
the Commissioner wanted a corporate reortion . since no other consideration was tent of gain that will be recognized
The Commissioner thus asserted that
"Where upon an exchange the tax- ganization to be deemed nontaxable in order
to prevent the acquiring corporation from segiven by Y to X; consequently, the as- under Section 357(c) depends on· the
the liabilities assumed by Borden payer receives as part of the consid- curing a stepped-up basis in the assets of the
sumption of the liabilities, though it definition of "liabilities."
were taxable to Hendler as this con- eration property which would be acquired corporation. The court held for the
The question of contingent liabilities
exceeds 20% of $500,000, is disregarded.
sideration was not distributed. The permitted ... to be received without Commissioner in stating that Hendler did not
apply to liabilities which were not paid in the
is another problem. There is no definite
Commissioner only included the se- the recognition of gain if it were the year of the reorganization.
Defini';'g "liabilities"
answer as to whether or not the assumpcured mortgage bonds in the acquired sole consideration, and as part of the 4. Burke. Jr., and Chisholm, "Section 357: A
Recent cases interpreting Section tion of contingent liabilities is protected
corporation's income, asserting no de- consideration another party to the Hidden Trap in Tax-Free Incorporations,"
Ta~ Law Review, Vol. 25, No.2, January,
357(c) have posed unansweJed questions "by Section 357(a) and, if so, whether
ficiency with respect to the unse- exchange assumes a liability of the 1970, p. 213; Paul, Studies in Federal Ta",aas to what is ·included "'in the term .they are also included in determining
cured liabilities. The lower courts re- taxpayer or acquires from the tax- tion 138 (3rd ser., 1940).
Burke, Jr., and Chisholm, "Section 357:
"liability" for purpose 'of Sections· 35,7 if liabilities exceed basis for purposes of
jected the Commissioner's contention, payer property subject to a liability, 6ASee
Hidden Trap in Tax-Free Incorporations,"
but the Supreme Court, in a unani- such assumption or acquisition shall supra; Hearings before Committee on Ways
and 368(a)(1)(C) so far as cash basis 'tax- Section 357(c).
payers are concerned. In Thatcher; the
Liabilities arising from the reorganizamous opinion, held that the assump- not be considered as other property and Means on Revenue Revision, 76th Cong.,
Sess. 44 (1939).
tion of the liabilities constituted in- or money received by the tax- e1st
Tax Court stated there is no difference "tion itself are still another problem. In
This provision is virtually the same as the
in the tax :'treatment of mortgages and Southwest Consolidat.e.d Corporation~ 315
come to the acquired corporation. In payer. . . ."
present Reg. l.S57-l(c).
accounts payable, disagreeing with the U.S. 194 (1942), the Supreme Court held
sibility. It is questionable what a court
might hold in a future case should a
C reorganization produce a negative
basis to the transferor corporation. Of
course, if X acquires control of Y Corporation and distributes the stock under
Sections 354 or 355, a D reorganization
has occurred and Section 357(c) would
apply. X would have a taxable gain of
$20,000. In addition, if the stock is control stock but is not distributed to X's
shareholders, the transaction could also
qualify under Section 351 and again
Section 357(c) could cause taxable income to X of $20,000.
•
359
that liabilities arising from the reorganization itself are additional consideration
and are not covered by present Section
368(a)(1)(C) and Section 357(a). In that
case, security holders of the transferor
company, owning $440,000 face amount
of obligations, were paid off in cash. The
cash was raised during the reorganization by a loan from a bank, and the
loan was assumed by the transferee corporation. The Supreme Court held that
". . . in substance the transaction was
precisely the same as if respondent had
paid cash plus voting stock for the properties." The Court was of the opinion
that the debt assumed was not a liability
of the other corporation. In paying the
security holders and removing the lien
from the property, the rights of the
security holders were altered. Further,
the liability of the old corporation was
removed and another was substituted in
its place. The Court stated:
"Though the liability assumed had its
origin in obligations of the transferor,
its nature and amount were determined
and fixed in the reorganization. It therefore cannot be labelled as an obligation
of the 'other' or predecessor corporation."
The Southwest Consolidated case,
thus, limits the liabilities that can be
assumed without violating the "solely
for voting stock" requirement, or that
can be assumed without being deemed
additional consideration. Presumably,
under the Southwest Consolidated case,
liabilities arising from the reorganization
itself would not be included. However,
present query seems to center around
the type of liability arising from the reorganization. Certain reorganization expenses can be assumed for purposes of
Section 368(a)(I)(C) and Section 357(a)
according to Rev. Rul. 73-54, IRB 19735,10.
Rev . . Rul. 73-54 did not apply the
holding · of the Southwest Consolidated
case to certain reorganization expenses.
In this Ruling, advice was requested
whether the payment or assumption by
the acquiring corporation of valid reorganization expenses of the acquired
corporation or its shareholders violated
the solely-for-voting stock requirement
of Section 368(a)(1)(C). The facts of the
transaction revealed that the acquiring
corporation was to payor assume certain
expenses solely and directly related to
the reorganization including legal and
accounting expenses, appraisal fees, and
administrative costs of the acquired cor·
poration directly related to the reorgaw-
360
•
The Journal of Taxation
zation such as those incurred for printing, clerical work, telephone and telegraph, security underwriting and registration fees and expenses, transfer taxes,
and transfer agents' fees. The Service
-quoted the Southwest Consolidated case
in its Ruling; however, it stated that
<lther court decisionslO have held expenses arising in a reorganization not to
represent additional consideration. The
Service stated that although the acquired
corporation and its shareholders were relieved of the reorganization expenses
-otherwise attributable to them, they
would be receiving solely voting stock
of the acquiring corporation. Conse-quently, it was held that the payment or
assumption by the acquiring corporation
of valid reorganization expenses as listed
above would not cause the acquired
corporation or its shareholders to recognize gain or loss. The Service further
stated that the principles of its Ruling
were equally applicable to valid reorganization expenses paid or assumed
by the acquiring corporation in a B reorganization.
In Rev. Rul. 73-54, the IRS mentioned two exceptions; it stated that
expenses that are not solely and directly
related to the reorganization, the transfer of property of the acquired corporation for stock of the acquiring corporation, or the exchange of the stock interests of the shareholders of the
acquired corporation for stock of the
acquiring corporation, would constitute
"boot" if paid or assumed by the acquiring corporation. It listed various re<lrganizations expenses that would be
included in this group and thus would
-constitute "boot." These include: fees
incurred for investments or estate planning advice and those incurred by an
individual shareholder, or group of shareholders, for legal, accounting, or investment advice or counsel pertaining to
-participation in, or action with respect
to, the reorganization. Also, if the payment of an applicable state transfer tax
See Alcazar Hotel Inc., 1 TC 872 (1943); New
.Jersey Mortgage &: Title Co., 3 TC 1277 (1944);
Roosevelt Hotel Co., 13 TC 399 (1949).
""'11 The continuity of interest doctrine, created by
-the courts. is founded in the basic philosophy of
the tax-free reorganization, i.e., if a shareholder
-or corporation has Bubstantially the same invest-ment after a corporate exchange as before, there
.should be no tax imposed upon the transaction.
"The doctrine was established by the courts to prevent the use of sbort-term notes as consideration
in corporate reorganizations. It requires that the
persons who were owners of the enterprise prior
-to the reorganization have an interest in the con.
"tinuing' enterprise.
'l'
• June 1974
is solely that of a shareholder, payment
or assumption of such tax by the acquiring corporation will violate the solelyfor-voting-stock requirement.
As a last exception in its Ruling, the
Service stated that the Ruling would not
apply to a transfer by the acquiring
corporation of cash or property other
than voting stock to the acquired corporation or its shareholders with the intention that the acquired corporation or
its shareholders pay their expenses, even
if such expenses were directly related to
the reorganization. This last qualification means that reorganization expenses
directly and solely related to the reorganization can qualify under Section
368(a)(I)(C) and Section 357(a) but only
if the acquiring corporation pays them
itself. It cannot give cash to the acquired
corporation to achieve the same result.
Though this seems merely form over
substance, this presumably is in accord
with the Southwest Consolidated case.
There, the acquired corporation paid off
its note by a new loan arising during the
reorganization, the new loan then being
assumed by the acquiring corporation.
The Court held assumption of the new
loan by the acquiring corporation constituted "boot." It was the same as if
the acquiring corporation had paid cash
plus voting stock, according to the
Court. However, had the acquiring
corporation merely assumed the old
loan, it would have been tax-free.
The problem of whether certain
liabilities are included in the definition
of those qualified under Section 368(a)
(1)(C) becomes very acute in a C reorganization. Assume X Corporation
transfers assets with a fair market value
of $200,000 to Y Corporation for voting
stock of Y Corporation worth $14(},000
and the assumption by Y of liabilities
of X Corporation in the amount of
$60,000. The liabilities consist of: accounts payable, $14,000; accrued expenses, $5,000; mortgages payable,
$36,000; and reorganization expenses of
$5,000. If the reorganization expenses
are not covered by Section 368(a)(I)(C)
or Section 357(a), the assumption of the
$5,000 liability by X Corporation constitutes "boot." Since consideration other
than stock has been given, total liabilities assumed are treated as "other property" in determining whether additional
consideration constitutes more than 20%
of the fair market value of the properties transferred. Liabilities total $60,000,
which is more than 20% of the fair market value of the assets transferred; con-
sequently, the transaction does
qualify as a C reorganization.
Corporations
not
Other problems
The statutory merger or consolidation
the A reorganization, is less comple~
than the acquisition of substantially all
the assets of another corporation, the C
reorganization, in that assets and liabili_
ties of the acquired corporation automatically pass to the surviving corpora_
tion. In an A reorganization, the surviving corporation assumes the liabili_
ties of the acquired corporation as a
matter of law. Though the legal procedure required to transfer assets and
liabilities is not complex when a statutory merger or consolidation occurs, the
fact that all liabilities, unknown and
contingent as well, pass to the transferee
corporation as a matter of law is a distinct disadvantage of the A reorganization. The C reorganization, on the other
hand, permits the transferee corporation
to limit its assumption of liabilities of
the transferor corporation. However, if
the transferee corporation does not assume all liabilities of the transferor corporation, compliance with the state's
bulk sales statute is required.
Lastly, the Regulations warn that ex·
cessive liabilities assumed may cause the
equity of the acquired corporation to be
too small to satisfy the continuity of
interest requirementl l of a reorganization. Reg. 1.368-(2)(d) provides:
"Though an assumption does not pre·
vent an exchange from being solely for
voting stock for purposes of the defini·
tion of a reorganization contained in
section 368(a)(I)(C), it may in some cases,
so alter the character of the transaction
as to place the transaction outside the
purposes and assumption of the reo
organization provisions. . . ."
Reg. 1.368-2(d)(3) would approve an
assumption of liabilities as great as 50%
of the value of the transferred proper·
ties. However, should the assumption of
liabilities exceed this figure, the transaction could be attacked under the continuity of interest doctrine.
*
BINDERS
are available for THE JOURNAL OF
TAXATION. Each binder will hold 12
issues of the magazine. Price $4.
THE JOURNAL OF TAXATION, 512 N.
Florida Ave., Tampa, Florida 33602.
Accrued interest on convertihIes may not be deductible
REV. RUL. 74-127, IRB 1974-12, 7 denies
an interest deduction under certain circumstances on convertible debentures
from the date of the last interest payment to the end of the obligor corporation's fiscal year. This Ruling represents
a change in the Service's position on
this point as originally stated in IT
2884, XIV-l CB 151, and a clarification
of Rev. Rul. 68·170, 1968-1 CB 71.
When corporations issue debentures
that are convertible into its own stock
it has been their practice not to pay
any interest to the bondholder from the
date of the last interest payment if the
bondholder converts between interest
dates. Thus, for example, assume that
an accrual basis corporation issues 20year convertible debentures with interest
payable on April 1st and October 1st.
The corporation's fiscal year ends on
August 31. Interest payable on these
bonds may not be accrued as of August
31st since between August 31 and October 1 all the bondholders may convert
their debentures into stock, thus eliminating the corporation's liability for interest for this period. Even though this
is "unlikely:' the Service says that the
all-events test necessary for the accrual
has not been met. See Reg. 1.461-1(a)(2)
and Brown, 291 U.S. 193 (1934).
Furthermore, a change from a taxpayer's present method of accounting
for the deductibility of interest accruing
on convertible debentures between interest payment dates to the method of
Rev. Rul. 74-127, is considered a change
of accounting method to which Sections
446 and 481 apply.
IT 2884 permitted the corporate obligor to accrue the interest for its fiscal
year ending between interest payment
dates, but it had to include in its subsequent year's income interest which was
taken as a deduction and which it did
not have to pay due to cancellation.
This Ruling has now been revoked.
Rev. Rul. 68-170, arrived at a conclusion similar to Rev. Rul. 74-127, but
did not contain the explanation.
fr
Recent 531 cases put
premium on preparedness
Two RECENT DECISIONS underscore the
necessity of a successful corporation's
taking steps each year to forestall the
imposition of the 531 penalty tax on
accumulated earnings. And a third points
up the procedural care that is needed in
setting forth a complete claim for refund from that tax.
Detailed plans
In Cheyenne Newspapers, Inc., CA-lO,
3/12/74, afJ'g. TCM 1973-52, the tax-
•
361
perhaps a tiny group dominates the
whole operation of the business. In that
setting informality is the natural order
of things. It may just never occur to the
managers to record their decisions on
the need to retain earnings for special
purposes. By the time the Service is
ready to lower the penalty tax it's too
late for explanations about the use for
which the accumulations were intended.
No records, no evidence of business
needs.
payer was faced with the penalty on
earnings it had accumulated during several years in the mid-60s. The corporation claimed that it needed all of the
retained earnings to finance the operation and expansion of its business. It
pointed to the need for working capital Lack of records
over a six-montll period, special reRecently this was the problem which
serves to be used in case of labor dis- c~ught up a heavy machinery corporaputes or natural disasters, the modern- tIon. It accumulated earnings and claimization of its plant the purchase of an ed that they were needed for a variety
off-set printing press and the publication of purposes ranging from replacement of
of a Sunday edition.
e~uipment to .setting up a pension plan
It had already begun the moderniza- With past service credits. But there were
tion of the plant during the years in no records which outlined the details
question. So the Service accepted that of any of these plans. The corporation's
project as a legitimate need for accumu- counsel explained the lack of minutes
lations but it whittled away or complete- by saying that the board of directors was
ly undercut all of the other justifications in session every time that the controllby the corporation.
ing shareholder sat at his desk. The
To support the need for six-month's court rejected this explanation. Someoperating capital it called in as an times a close corporation might actually
expert witness an executive from an- have had plans for the earnings in spite
other newspaper who admitted that she of the lack of records. But accepting sel£had never made a detailed study of the serving testimony without supporting
corporation'S operation or financial documents would allow some executives
statements. So the courts accepted the to concoct business needs long after the
Service's accounting analysis which show- earnings were retained, Bahan Textile
ed a need for working capital for only Machinery Company, 453 F.2d 1100
three months. The courts also rejected (CA-4, 1972).
the need for reserves in case of labor
disputes or natural disasters. There was Procedural problem
no history of emergencies of this sort
The most common procedural probwhich would justify the accumulations. lem in relation to the penalty tax is
Finally-and this is the important lesson providing a statement of business needs
for other taxpayers-the accumulations to the Service so that the burden will
could not be supported by the proposals shift to it in the Tax Court. But this
to purchase an offset press to start pub- shouldn't lead practitioners to forget
lication of a Sunday edition, even basic procedural rules. Recently, in John
though both plans became realities in P. Lynch Company, DC Cal., 2/27/74,
later years. The corporation couldn't an incomplete refund claim resulted in
produce specific plans evidenced by the the unnecessary payment of an accumuminutes of the directors' meetings or lated earning tax.
other corporate records from the years
The corporation was in almost a state
in question. Since the corporation of suspended animation. Some of its
could not show that it had definitely property had been taken over by the
and seriously undertaken these projects Government and other assets had to be
in those tax years, the vague possibility replaced. The managers were weighing
that they would actually be completed the alternatives open to them when they
did not make them a reasonable need of received an offer for the business that
the business. The courts refused to use they couldn't refuse. It was near the
hindsight and protect the accumulations close of the tax year when the deal
from tax just because the projects ac. jelled and the shareholders decided to
tually were completed.
liquidate immediately. However, there
This is the particular problem of the was no distribution of the earnings beclose corporation where one man or fore the end of the tax year. The Serv·
362
Thelournal of Taxation
June 1974
ice imposed the penalty tax on the
grounds that a corporation in the process
of liquidation had no need to retain
earnings. The corporation paid the tax
and filed a refund claim. The refund
claim concentrated solely on the reasonable needs of the business before the
decision to sell and liquidate was reached. It didn't mention that the corporation had made liquidating distributions
shortly after the close of its tax year.
Liquidating distributions qualify for the
dividends paid credit against the accumulated earnings and these distributions were made within the grace period
after the close of the tax year prescribed in Section 563. Nonetheless since
there was no mention of these distributions in the refund claim, a district
court refused to recognize their existence or give them any effect in the
refund suit. It thought ·that the Service
had the right to consider at the administrative level all the possible grounds
for the refund. So it simply agreed with
the Government that the taxpayers had
no need to retain earnings once the
resolution to liquidate had been adopted
and completely denied the refund.
*
New decisions
Certiorari announcement.
Redemption for private annuity. The
Eighth Circuit held · that the transfer of
taxpayer's stock in one corporation to
a related corporation for payment of
a lifetime annuity was a dividend when
the second corporation sold the stock to
the first for cash and notes. Fehrs Finance Co., cert. den., 4/15/74.
Acquiescence announcements.
Reasonable salary. The taxpayer claimed
$18,000 as a salary deduction for a stockholder employee. The IRS disallowed
$13,000, but the court reduced the disallowance to $11,000. The entire $100
a month salary paid to one stockholderemployee was allowed in full. In the
same case, the corporation was found to
be a qualified bank and therefore not
subject to the personal holding company
provisions. Austin State Bank, 57 TC
180, acq., IRB 1974-14. American
Foundry, 59 TC 231, acq., IRB 1974-14.
Corporations required to make estimated payments. (Ann.)
Corporations that expect to have a net
tax due of $100 or more must file Forms
1120-ES. Ann. 74:18, IRB 1974-8.
Withdrawals were dividends. (DC)
A district court jury after considering
the facts finds that withdrawals made
by taxpayer-doctor from his service corporation were dividends as opposed to
loans. Epperson, DC Wis., 11/24/73.
Merger allowed because of continuity Of
interest. (CA)
The Commissioner attacked a statutory merger of an Ohio state chartered
savings and loan association, with a
limited amount of par value capital
stock outstanding in addition to savings
accounts, into taxpayer, a mutually
owned federal savings and loan association, whose capital consisted solely of
savings accounts. Such merger was disputed because it was contended that the
requirement for a "continuity of proprietory interest" was not met. The district court held against the Commissioner and >concluded that a tax free reorganization was effected.
Held: Affirmed. There is a continuity
of interest between shareholders of the
merged association and those of taxpayer, the surviving association, because
each shareholder of the merged entity
acquired an interest that was definite
and material and represented a substantial part of the stock that was given
up. West Side Fed'l Savings and Loan
Ass'n., CA-6, 3/29/74.
Active trade or business requirement is
met. (Rev. Rul.)
A corporation can meet the active
trade or business requirements of Section
355(b) by liquidating a wholly owned
subsidiary which meets those requirements and acquiring the subsidiary's
business in a tax free transaction. Rev.
Rul. 74-79, IRB 1974-7.
Cash received in lieu of fractional
shares. (Rev. Rul.)
In an "F" reorganization, the cash
received in-lieu of fractional shares will
be treated as a distribution in redemption of fractional share interests so long
as it is not, in fact, separately bargained
for consideration. Rev. Rul. 74-36, IRB
1974-4, 7.
Acquisition qualifies as a "B" reorgan-
ization. (Rev. Rul.)
A "B" reorganization includes the
acquisition by a corporation of all the
outstanding shares of an unrelated corporation solely in exchange for 20% of
its voting shares. Section 301 applies to
a distribution by the acquired corpora-
tion of 30% of the value of its assets;
Rev. Rul. 74-35, IRB 1974-4.
Oral agreement did not negate 80%
control test under Section 1239 (DC) ..
Taxpayers, husband and wife, owned '
100% of the stock of a corporatiori.
Before March, 1967, an oral agreement:
was made to sell one third of the cofJ
porate stock to an employee. On Jun¢(
27, 1967, taxpayers sold depreciabl~'
property to the corporation and on Sept.;
29, 1967, the transfer of stock to the:\
employee was finally consumated. Th~
Commissioner contended that gain o#:;;
the real estate sale was taxable as o~':.)i
dinary income pursuant to Section 1239~l
Taxpayers contended that Section 123~;.,
was inapplicable since the pre-Marqt·,
1967 oral agreement with the employe$~
bought the number of shares under the,:'
requisite 80%.
.
Held: For the Commissioner. At th~i,'
time of the realty sale, the employe~.\
did not beneficially own one third 08"
the corporate stock. The transfer dat~'
was not fixed, the entitlement to div~1i
dends was not specified and the eIil,~\
ployee had no right to exercise voting.
rights in the stock. Although there wa~i
an oral agreement, the transaction wa'~.
still in the development stage. Brow'1j]
DC N.. C., 3/6/74.
Interest-bearing warrants received fori.
services performed are current asset~~
in determining accumulations penoltj.~~
(TC)
.'
Taxpayer, engaged in paving contrac~i
work for municipalities, was paid wi~'
interest-bearing special assessment wa*?
rants. The Commissioner imposed a~,
accumulations penalty, contending tha.~·
the interest-bearing warrants were curt
rent assets, and as such, the current a#:)
. sets were in excess of current liabilitie~
in an amount more than that require~,
for the corporation'S working capita,~!
needs an~ other reasonable busine~~
needs.
Held: For the Commissioner. The war.~;i
wants are current assets, as they arE;\\l
readily marketable and, in fact, taxpayer,,"
had sold some of them in prior year§t·:\
They were included as current assets o~:,'
taxpayer's financial statements, taxpaye!'"
would not have b~.~n able to obtain :i\'~
surety bond if these warrants had n6~h
been considered current assets by the,!
surety fiompany, and taxpayer ha&'
treated the warrants as current assets;,
Ready Paving &- Construction Co., 61:.
TC No. 86.