Assumption of Liabilities in Taxable Asset and Sec. 338(h)(10) Acquisitions

Editor: Nick Gruidl, CPA, MBT

When a purchaser (P) acquires the assets of a target (T) in an applicable asset acquisition as defined in Sec. 1060 or acquires the stock of T and a joint Sec. 338(h)(10) election is made, the basis in the assets acquired will generally include T’s liabilities assumed in the transaction. However, determining the appropriate treatment of these liabilities is often a difficult task. This item addresses only the buyer’s treatment (P or new T in the case of a Sec. 338(h)(10) transaction), not the seller’s, in an acquisition.

Assumption of Liability

The first and most important step is to determine whether P has assumed a T liability. If P is able to establish that a liability did not exist at the time of the acquisition, the subsequent satisfaction of the liability would result in a deductible expense to P, subject to general tax law determining deductibility. Obviously, this result is favorable to P because the alternative to liability assumption generally results in 15-year amortization under the residual method for allocating the purchase price (Regs. Secs. 1.338-6 and 1.1060-1).

So how does one determine whether a liability exists at the time of the acquisition? Whether the liability is fixed or contingent is not determinative (Illinois Tool Works, Inc., 355 F3d 997 (7th Cir. 2004); David R. Webb Co., 708 F2d 1254 (7th Cir. 1983)). Rather, the existence of a T liability is generally enough to require capitalization. To determine whether a liability existed, the courts have generally looked to a number of factors, including:

• Did the liability result from P’s post-acquisition operations?
• What postacquisition events occurred related to the liability?
• Was P aware of the liability?
• When did the legal liability arise?
• Was assumption of the liability re-flected in the purchase price?
• Was the liability expressly assumed by P? and
• Other various factors (Keyes, “The Treatment of Contingent Liabilities in Taxable Acquisitions,” Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings (Practising Law Institute, 2007), vol. 5, pp. 27, 40–46).

Unfortunately, not all liabilities are easy to identify. Based on the various factors above, a reserve for unsettled litigation related to T’s preacquisition activities would clearly represent a liability assumed by P in the acquisition. However, the treatment of other reserves on T’s balance sheet is more difficult to determine.

Example: T manufactures widgets. A warranty is provided with each widget sold, and there are currently over 5 million widgets under warranty. In accordance with financial accounting principles, T has a warranty reserve liability. In addition, T has historically provided “goodwill” warranty services for widgets outside of the warranty period in order to maintain good customer relationships. The reserve is strictly an estimate of expected warranty costs that will be incurred on products under warranty and outside the warranty.

Should this reserve be considered a liability assumed by P? Presumably, P was aware of this potential liability; however, what if P does not expressly assume the liability and the actual liability does not legally arise until the widget is brought in for warranty service, which is a postacquisition event? What about the liability associated with goodwill warranty services? These seem clearly to fall within P’s postacquisition activity. Finally, with so many products under warranty, it seems reasonable to argue that ongoing warranty services provided on widgets are so intertwined with the ongoing P business that the postacquisition services relate to P’s operation and not T’s operation. Perhaps in this case, the warranty reserve is not a liability assumed by P, and the warranty costs incurred by P will result in immediate deductions to P as incurred.

As a result of this favorable treatment, purchasing taxpayers will look to report as many liabilities as possible as operating liabilities. Close attention needs to be paid to these liabilities, especially when the adviser is also a tax preparer and is subject to the Sec. 6694 more-likely-than-not standard.

Treatment of Assumed Liabilities

Once it has been determined that P assumes a T liability, the amount of the liability and the timing of taking it into account need to be determined. There are three categories for assumed liabilities: (1) liabilities for which the all-events test has been met and economic performance has occurred (e.g., accounts payable), (2) liabilities for which the all-events test has been met and economic performance has been met by the express assumption of the liability (Regs. Secs. 1.461-4(d)(5) (e.g., liability for the use of property) or (g)(1)(ii)(C) (e.g., accrued rebates)), and (3) contingent liabilities (i.e., T liabilities that have not yet met the all-events test). A fourth category exists for related assumptions of Sec. 404 liabilities; however, these liabilities are outside the scope of this item. Those interested in reading more on the subject should consider reviewing the analysis in Ginsburg and Levin, Mergers, Acquisitions, and Buyouts ¶304 (Aspen, July 2007).

With respect to the first two categories, P receives no deduction upon satisfaction of the liability but rather includes the liabilities in the basis of the acquired assets upon assumption. For contingent liabilities, P will generally include the assumed liability in basis only as the liability is satisfied. For Sec. 338 transactions, the regulations make this determination clear, citing application of general tax principles (Regs. Sec. 1.338-7(e), Example 1 (satisfaction of contingent liability results in P’s taking the liability into account as additional adjusted grossed-up basis)). In non-Sec. 338 transactions, an argument may be made that P receives a deduction under a similar analysis to that above related to the assumption of a liability; however, most practitioners would agree that satisfaction of the liability results in additional basis in the T assets acquired and not a P deduction. 

Then there is the liability that exists and is assumed as a result of T’s prepaid income or deferred revenue. The law in this area is not clear. One approach requires P to include the full amount of the deferred revenue as income in the year assumed, under the theory that T actually paid consideration to P for P’s assumption of the liability. (See Rev. Rul. 71-450 and James M. Pierce Corp., 326 F2d 67 (8th Cir. 1964).) Under this theory, the amount of consideration received (or deemed received) is income in the year of assumption, and if the consideration is deemed received by P it would presumably further increase the consideration paid to T in the acquisition. Fortunately, this method has thus far been limited to prepaid subscription income under Sec. 455. A second, and perhaps more reasonable, approach is found in Rev. Rul. 76-520, which requires P to include the actual amount incurred to satisfy the deferred revenue as additional purchase price only as incurred, which coincides with the normal treatment of contingent liabilities discussed above.

Conclusion

As with so much advice to clients, the devil is in the details. Did the purchaser truly assume a liability? Does that liability result in an immediate step-up in basis? One cannot assume that the tax treatment of liabilities will conform with financial reporting, and with stricter FIN 48 and Sec. 6694 standards it is more important than ever that tax advisers get it right.

EditorNotes

Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN

Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.

If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or nick.gruidl@rsmi.com.