Academic journal article Journal of Accountancy

Taxation of Pending Claims: How to Handle Liabilities When Selling or Restructuring a Business

Academic journal article Journal of Accountancy

Taxation of Pending Claims: How to Handle Liabilities When Selling or Restructuring a Business

Article excerpt

EXECUTIVE SUMMARY

* A CORPORATION THAT IS SOLD OR RESTRUCTURED faces significant uncertainty about how the government will tax contingent liabilities such as environmental, tort and similar obligations. This is particularly true for taxable transactions involving a liability that depends on the outcome of a lawsuit or similar event.

* AN IMPORTANT QUESTION REGARDING THE DEDUCTIBILITY of a liability is: Did it arise after the transaction or did the buyer assume the seller's liability? If the event that triggered the liability took place after the acquisition, the buyer should be entitled to a deduction.

* THE COURTS HAVE BEEN INVOLVED IN DECIDING HOW a buyer should treat amounts in excess of the original estimated liability. In Illinois Tool Works, a suit was settled for an amount much larger than the original estimates. The Tax Court said ITW should capitalize the judgment.

* IN TAX-FREE ACQUISITIONS THE SUCCESSOR ENTITY should carry on the predecessor's tax accounting for contingent liabilities as if nothing had occurred. The new entity simply steps into the old company's shoes. However, contingent liabilities may present some problems in an IRC section 351 tax-free reorganization.

* ANOTHER ISSUE SURROUNDING COMMERCIAL LITIGATION claims is the character of the income--capital gain or ordinary income. CPAs can apply the origin-of-the-claim test to help settle this question. For example, litigation income may be capital if the claim relates to the acquisition or disposition of property.

The tax treatment of contingent liabilities transferred in a corporate sale or restructuring is often a problem for the parties involved. (A contingent liability is one that depends on an uncertain event, such as the settlement of a lawsuit.) Common examples of pending claims are suits against a company by a government agency, a customer or an employee, all of which can significantly affect the economics of a transaction. The amount of these liabilities will influence price negotiations and help determine the buyer's basis and the seller's gain or loss.

CPAs who advise clients and employers on these transactions will find the rules for how to treat fixed and determinable obligations well established; those for contingent liabilities are not. In taxable transactions, such liabilities can create difficulties for both the buyer and the seller. While there is less disagreement when the transfer is tax-free, some challenges remain there as well.

Example. Buyer Corp. purchases Seller Corp.'s assets for $1 million and assumes its $600,000 of business liabilities. If these obligations are not contingent as of the acquisition date, Seller has sales proceeds of $1,600,000 and Buyer has a $1,600,000 basis in the assets. But what if $300,000 of the liabilities depend on the outcome of a yet-to-be-settled lawsuit? It isn't clear whether this amount should be considered part of the sales proceeds or what would happen if the parties settled the lawsuit for a different amount, say $200,000 or $500,000. It also isn't clear how an indemnification agreement would affect the tax results. These issues may be critical in negotiating a purchase price.

Recent court decisions and new regulations have had a significant impact on the taxation of claims that change hands in both taxable and nontaxable transfers. This article will help CPAs understand the tax consequences to both the buyer and the seller as well as the character of the income--ordinary or capital gain--involved.

TIMING IS EVERYTHING

In determining the tax treatment of a liability, CPAs will find the question of when it arose to be crucial. If the event triggering the liability occurred after the acquisition, the buyer should be entitled to a deduction as soon as it meets the all-events test (the fact of the liability is fixed and the amount is determinable). For example, in one case the Tax Court allowed a buyer to deduct severance wages under a union agreement. …

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