Contingent Purchase Price
How the application of a deduction allowance rule (section 461(h)) to original cost can delay the acquisition of basis for many buyers.
Octoberr 14, 2010
When a corporation makes a qualified stock purchase of the stock of another corporation, it can agree with the seller in some cases to make a section 338(h)(10) election. In such cases, the acquired corporation is treated as selling all of its assets to a new corporation for the price the acquirer paid for the stock plus the acquired corporation's liabilities. That election converts the stock sale into a deemed asset sale, which requires allocation of the deemed purchase price among the corporation's assets. That need to allocate purchase price confronts the acquirer with the same issue that confronts any purchaser of the assets of a business under section 1060, which also requires purchase price allocation among the assets, relying on the regulations under section 338: What is the purchase price?
461 (h): General Rule for Taxable Year of Deduction
Those regulations do not tell the acquirer what is the purchase price paid, but rather they defer to general principles of law. When the purchase price includes an agreement to do or pay something in the future, that part of the cost may not be includable in basis until economic performance occurs under section 461(h). This limitation can be a surprise to some tax professionals: to learn that section 461(h) applies not only to deductions (which it’s heading), but also to basis.
The link between section 461(h) and basis of purchased property is Reg. section 1.446-1(c)(1)(ii), which is the general accounting method regulations. For accrual-method taxpayers it requires that for all federal income tax purposes an item of expenditure can be taken into account only when both the all event test has been satisfied and economic performance has occurred under section 461(h).
This regulation dating to 1992, converts the economic performance rule for deductions into a limit on original cost basis. This limit becomes important when an accrual method buyer of property assumes a contingent liability in the purchase. Historically, it was thought that such a liability assumption entered into basis unless it was too contingent to be added to basis under general principles. See, for example, Albany Car Wheel, 40 T.C. 831 (1963). However, the economic performance test can produce very different results.
Example 1: Buyer pays $100 cash for manufacturing plant worth $100 (seller's basis is $50) subject to an environmental clean-up liability of $500 (present value based on section 483 principles), plus a fund that seller has built up containing $500 cash to be used for the cleanup. Buyer assumes contractual liability for the liability and agrees to hold seller harmless. Seller recognizes $50 gain ($100 + $500 – $50 – $500), and can claim an ordinary deduction of $50. Reg. § 1.461–4(d)(5). Buyer must recognize income of $400 at the time of the closing of its purchase ($500 – $100). Reg. § 1.338–6(b)(1) (applies to the stock purchase case but presumably is applied in the asset acquisition cases). Buyer takes a $500 basis in the cash and a zero basis in the plant. Buyer and seller report on the accrual method.
Obviously buyer and seller are treated very differently. Obviously buyer will be very unhappy, both due to recognizing income upon buying a plant and due to getting no basis in the plant. There are other ways the parties can structure the transaction to avoid these results. However, if structured as in the example, Seller is under the usual duty to recognize income at the earliest possible moment and to value the liability assumption for income purposes. But the Internal Revenue Service (IRS) takes the position that the buyer is assuming a liability to perform services in the future and does not have economic performance until it performs the services, and thus does not acquire basis for the $500 until that time. Reg. section 1.461-4(d)(4).
These issues have arisen most prominently in the cases of nuclear plants with nonqualified decommissioning funds. LTR 200243024. Perhaps few of us will be involved with selling nuclear plants. But the application of a deduction allowance rule (section 461(h)) to original cost basis is a fairly common issue that could delay the acquisition of basis for many buyers in section 338(h)(10) election cases, section 1060 business acquisitions or other purchases.
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Jasper L. Cummings, Jr., JD, is of counsel in the Raleigh office of Alston & Bird LLP. He practices in the areas of corporate taxation and has served as Associate Chief Counsel (Corporate), IRS. He can be reached at 919-862-2302.