1. There are many relevant questions that you should ask Rosita. Some of these questions are listed below:

• How much income does she have from the proprietorship?
• Does she have any sources of income other than the proprietorship? If so, how much and what kind of income?
• Does she ever experience a net operating loss from the proprietorship?
• Does she have capital gains from the proprietorship? If so, how much and how often?
• Is she aware of the nontax differences between the proprietorship and corporate forms of business organization?

pp. 9-2 to 9-6

2. Bill is not correct in his assessment of Susan and Valerie's tax situation. Form 1120 is the form used by corporations to determine Federal corporate income tax liability. Since (1) B&W Investments is not classified as a per se corporation (e.g. an incorporated entity, a joint-stock company, an insurance company, etc.) for Federal tax purposes, and (2) Susan and Valerie have not filed an election to treat B&W as a corporation for Federal tax purposes, Susan and Valerie are not required to file Form 1120. Instead, Susan and Valerie are treated as partners of a partnership and must file Forms 1065 and K-1. pp. 9-6 and 9-7

3. Loan may not make another election to treat the firm as a partnership since entities must generally wait 60 months before re-electing their tax classification. p. 9-7

pp. 9-2 and 9-3

5. General discussion. If White Company is a corporation, the $60,000 operating income ($100,000 income - $40,000 expense) will be subject to taxation at the corporate level. However, if White Company is a proprietorship, Mike will pay tax on all of the company's taxable income, and tax on the long-term capital gain will be limited to 20%.

a. Taxable income of the corporation will be $70,000 ($60,000 net operating income + $10,000 long-term capital gain). The corporate tax on $70,000 of taxable income is $12,500 [($50,000 X 15%) + ($20,000 X 25%)]. This leaves $57,500 after-tax income. If the corporation pays this amount as a dividend in the future, Mike will pay tax at whatever his personal tax rate is at that time.

b. The corporate tax on $70,000 of taxable income is $12,500 [($50,000 X 15%) + ($20,000 X 25%)]. Mike will pay tax of $27,720 ($70,000 X 39.6%). Mike's after-tax income will be $42,280 ($70,000 - $27,720). Total tax paid by Mike and the corporation will be $40,220 ($12,500 + $27,720).

c. If the corporation pays Mike a $70,000 salary, corporate taxable income will be $0. Mike will pay tax of $27,720 ($70,000 X 39.6%). His after-tax income will be $42,280 ($70,000 - $27,720).

d. If White Company is a proprietorship, Mike must pay tax on the $70,000 taxable income, regardless of the amount he withdraws from the business. His income tax will be $25,760 [($60,000 net operating income X 39.6%) + ($10,000 long-term capital gain X 20%)].

e. The result would be the same as in part d. Mike must pay tax on the taxable income of the business, regardless of the amount he withdraws.

pp. 9-2 to 9-4

6. Leasing some property to a controlled corporation may be a more attractive alternative than transferring ownership. Leasing provides the taxpayer with the opportunity of withdrawing money from the corporation without the payment being characterized as a dividend. If the property is donated to a family member in a lower tax bracket, the lease income can be shifted as well. If the depreciation and other deductions available in connection with the property are in excess of the lease income, the taxpayer would retain the property until the income exceeds the deductions.

f. $120,000 (Heron Corporation's basis in the equipment) and $4,000 (Heron Corporation's basis in the patent).

g. The answer would not change. There is no requirement that the transferors receive the same type of stock. Further, both common stock and most preferred stock qualify as "stock." However, if Edie received "nonqualified preferred stock," the realized gain would be recognized because this type of preferred stock is treated as boot.

h. The answer would not change. There is no requirement that the transferors be individuals.

pp. 9-8 to 9-11

8. a. $30,000.

b. $30,000.

c. $0. Even though Otis received $30,000 of boot, he has no recognized gain because the transaction produced a realized loss of $45,000. Losses are never recognized on § 351 transfers.

d. $315,000 [$345,000 (basis of property) - $30,000 (boot received)].

e. $345,000.

f. $0.

g. $60,000.

h. $0.

i. $90,000 [$300,000 (mortgage) - $210,000 (basis in property)].

j. $0. [$210,000 (basis in realty) + $90,000 (gain recognized) - $300,000 (liability transferred)].

k. $300,000 [$210,000 (basis of property) + $90,000 (gain recognized)].

pp. 9-9 to 9-11

9. a. $6,000 ordinary gain.

b. $30,000 [$30,000 (basis of inventory) + $6,000 (gain recognized) - $6,000 (boot received)].

c. $36,000 [$30,000 (basis of inventory) + $6,000 (gain recognized)].

d. Seth recognizes gain of $9,000 (the amount of cash received). The gain is ordinary income because of the § 1245 depreciation recapture provisions.

e. Seth has a basis of $45,000 in the Lark Corporation stock computed as follows: $45,000 (basis in the equipment) + $9,000 (gain recognized) - $9,000 (boot received).

f. Lark Corporation has a basis of $54,000 in the equipment, computed as follows: $45,000 (basis of the equipment to Seth) + $9,000 (gain recognized by Seth).

g. Pat has no recognized gain or loss. A secret process is property for purposes of § 351.

h. Pat has a basis of $15,000 in the Lark Corporation stock.

i. Lark Corporation has a basis of $15,000 in the secret process.

j. Kelly has no taxable income on the transfer.

k. Kelly has a basis of $30,000 in the Lark Corporation stock.

pp. 9-9 to 9-11

10. a. None of the three individuals will recognize gain. The nonrecognition provisions of § 351 apply to all the exchanges. Example 11

b. Clyde will recognize gain of $410,000 ($500,000 - $90,000) on the exchange. Example 10

c. Clyde would be well advised to avoid having his transfer considered a part of an integrated plan that also includes Jane's and Jon's transfers. If his transfer is considered independent of the others, not only would Jane and Jon be able to benefit from the § 351 provisions (i.e., their gains realized would not be recognized), but Clyde's loss of $90,000 ($500,000 - $590,000) could be recognized. p. 9-14

11. Were Lee's and Abby's transfers part of an integrated transaction?

• Was there an agreement between Lee and Abby regarding the transfers?
• Because Abby is Lee's daughter, can her stock be counted as Lee's in computing Lee's stock ownership?

p. 9-11

12. Is the secret process property for purposes of § 351?

• Is the letter of credit property?
• Would the transfers qualify under § 351?
• If the transfers qualify under § 351, will Kevin be taxed on the stock he received for the services he rendered to Crow Corporation?
• What is Crow's basis in the secret process and the letter of credit, if they qualify as property?
• Will Crow Corporation have a tax deduction for the value of the stock it transfers to Kevin in consideration of the services Kevin rendered to Crow prior to Crow's incorporation?
• How will Crow treat the transfer of stock for services rendered by Kevin?

p. 9-13

13. a. The transfers will qualify under § 351. Vera's stock is counted in determining control for purposes of § 351; thus, the transferors own 100% of the stock in Crane. All of Vera's stock, not just the shares received for the machinery, is counted in determining control because property she transferred has more than a nominal value in comparison to the value of the services rendered.

b. Dan recognizes no gain on the transfer of the land. His basis in the Crane stock is $60,000, his basis in the land. Vera recognizes gain of $50,000 on the transfer. Even though the transfer of the machinery qualifies under § 351, her transfer of services for stock does not. Vera has a basis of $80,000 in her Crane stock [$30,000 (basis of the machinery) + $50,000 (value of her services)].

c. Crane Corporation has a basis of $60,000 in the land and a basis of $30,000 in the machinery. Crane either has a deduction of $50,000 for the services provided by Vera, or it will capitalize the $50,000 as organization costs.

pp. 9-13 and 9-14

14. Perry recognizes a gain of $220,000 on the transfer [$320,000 (value of the stock received) - $100,000 (basis in the property)]. The transfer does not qualify under § 351. Although Perry originally owned 100% of Cardinal Corporation, Perry only owns 60% of Cardinal Corporation after the transfer [2,000 (shares originally owned) - 1,000 (shares transferred to Brittany and Julie) + 500 (shares acquired in the transfer), or 1,500 shares of a total of 2,500 shares]. (The ownership of Brittany and Julie cannot be counted because the attribution rules of § 318 do not apply to a § 351 transfer.) Example 18

15. a. Ann does not recognize a gain. Bob recognizes a gain of $15,000, the value of the services Bob rendered to the corporation. Bob does not recognize gain on the transfer of property to the corporation. Examples 15

b. Ann has a basis of $150,000 in the stock in Robin Corporation. Bob has a basis of $45,000 in his stock in Robin Corporation [$30,000 (basis in property transferred) + $15,000 (gain recognized)]. Figure 9-1

c. Robin Corporation has a basis of $150,000 in the property Ann transferred and a basis of $30,000 in property Tom transferred. Robin Corporation capitalizes $15,000 as organization costs. Figure 9­2 and Example 28

16. To be a member of the control group and aid in qualifying all transferors under the 80% test, a person contributing services must transfer property having more than a relatively small value in relation to the services performed. Stock issued for property of relatively small value compared with the value of the stock to be received for services rendered by the person transferring such property will not be treated as issued in return for property. The value of property transferred by Bob is less than 10% of the value of the services he provided. Bob will probably not qualify as a member of the control group. If Bob does not qualify as a member of the control group, Ann's transfer will also not qualify under § 351. Ann transferred property for only 70% of the stock. Therefore, both Ann and Bob would incur gain on the exchanges. Examples 16 and 17

17. In addition to her cash salary, Kim has ordinary income of $20,000 [20 (shares of stock in Azure Corporation) X $1,000 (value of each share)]. Azure Corporation has a § 162 deduction of $20,000. Example 28 and p. 9-19

18. Brady recognizes a gain of $30,000 on the transaction under § 357(c) [$180,000 (liability) - $150,000 (basis in the transferred property)]. Brady has a zero basis in the stock in Swift Corporation, computed as follow: $150,000 (basis in the property transferred to Swift Corporation) - $180,000 (liability) + $30,000 (gain recognized). Swift Corporation has a basis of $180,000 in the property computed as follows: $150,000 (basis to Brady) + $30,000 (gain recognized by Brady). Example 22

19. Did the exchange three years ago qualify as a nontaxable exchange?

What basis did Chris acquire in the land?

What basis will Chris have in the Amber Corporation stock?

How are the mortgages on the land treated for tax purposes?

Will the second mortgage be treated as "boot" under § 357(b) of the Code?

What basis will Amber Corporation have in the land?

pp. 9-8, 9-9, and 9-15

20. Lori recognizes no gain on the transfer. The problem considers the application of § 357(c) since liabilities would exceed basis in the assets if the trade payables are included as liabilities for purposes of § 357(c). Because accounts payable of a cash basis taxpayer that give rise to a deduction are not considered to be liabilities for purposes of § 357(c), liabilities do not exceed basis.

Lori has a basis of $40,000 in the stock in Green Corporation [$400,000 (basis in the assets transferred to Green Corporation) - $360,000 (liabilities assumed by Green Corporation)].

Green Corporation has a basis of $400,000 in the assets transferred to it by Lori. In considering whether Lori should transfer the trade accounts payable, she would guarantee a business deduction for her personal income tax return if she were to keep the obligation and in fact make the $120,000 payment. Further, her payment of the amount would provide a greater tax benefit than that falling to Green if she is in a higher income tax bracket than Green Corporation. For example, if Lori is in the 39.6% tax bracket and Green is in the 35% tax bracket, the deduction would provide a tax savings of $47,520 ($120,000 X 39.6%) to Lori versus a savings of $42,000 ($120,000 X 35%) to Green.

pp. 9-15 to 9-17

21. If the real estate is appreciated (i.e., value exceeds basis), either approach can result in gain being recognized. Since bonds (i.e., securities) are not covered by § 351, a sale of the real estate results. Under the mortgage scenario, § 357(b) would cause a boot result. One possible alternative is to use preferred stock. This would give Travis more security than common stock if the preferred has a liquidation preference. To be nontaxable, however, the transfer should be tied to the original incorporation. Otherwise, the 80% control requirement might not be satisfied. pp. 9-9, 9-10, and 9-16

22. a. Both §§ 357(b) and (c) are applicable. The land is subject to two mortgages that are in excess of basis, causing § 357(c) to be applicable. Rita would have a gain of $750,000 on the transfer pursuant to § 357(c). Section 357(b) also is applicable because Rita borrowed the $250,000 shortly before incorporating Pear and used the money for personal purposes. Section 357(b) would cause all the liabilities to be tainted; thus, Rita would have boot under § 357(b) of $1,000,000. Under § 357(b), Rita's realized gain of $1,250,000 [$1,500,000 (value of the stock received and release of mortgages) - $250,000 (basis in the land)] would be recognized to the extent of the boot, or $1,000,000. When §§ 357(b) and (c) both apply to the same transfer, § 357(b) dominates. Thus, Rita would have a recognized gain of $1,000,000 on the transfer. Pear Corporation would have a basis of $1,250,000 in the land, computed as follows: $250,000 (carryover basis from Rita) + $1,000,000 (gain recognized by Rita). Rita would have a $250,000 basis in her Pear stock, computed as follows: $250,000 (basis in the land) + $1,000,000 (gain recognized) - $1,000,000 (liabilities assumed by Pear Corporation). pp. 9-15 to 9-17

b. Section 357(b) would no longer be applicable since the second mortgage was not taken out by Rita; however, § 357(c) would apply. In this case, gain of $500,000 [$750,000 (mortgage) - $250,000 (basis in land)] would be recognized by Rita and Pear's basis in the land would be $750,000 [$250,000 (basis to Rita) + $500,000 (gain to Rita)].pp. 9-15 to 9-17

23. Section 357(b) applies to a "tax avoidance" purpose for transferring liabilities to a controlled corporation. Satisfying the "bona fide business purpose" is not difficult if liabilities were incurred in connection with the transferor's normal course of conducting a trade or business. The "bona fide business purpose" can cause difficulty if the liability is taken out shortly before the property is transferred, and the proceeds were utilized for personal purposes. This is a subjective test. Jean did not intend to transfer the credit charge to the corporation. She can argue that there was no tax avoidance purpose in her inadvertently transferring the liability to the corporation; thus, § 357(b) should not be applicable. There appears to be no "tax avoidance" purpose, but the liability was not incurred in connection with Jean's business. One consideration might be whether Jean will repay the corporation immediately after it pays the credit charge or whether the note has a long maturity date. P. 9-15

24. a. Sara does not recognize gain on the transfer. Jane has income of $15,000, the value of the services she renders to Wren Corporation.

b. Wren Corporation has a basis of $25,000 in the property it acquires from Sara and a basis of $10,000 in the property it acquires from Jane. It has a $15,000 business deduction under § 162 for the value of the services Jane renders. p. 9-13

25. a. Jane has income of $15,000 for the value of the services rendered.

b. Wren Corporation has a basis of $10,000 in the property it acquires from Jane. It must capitalize the $15,000 as an organizational expense.

Example 29

26. There are no tax consequences to Carol. Carol has no recognized gain and no accelerated cost recovery to recapture when she transfers the machinery to Lark Corporation in exchange for stock.

Lark Corporation has a taxable gain of $75,000 on the sale of the machinery, all of which is ordinary income under § 1245. Lark has a basis of $20,000 in the machinery. The recapture potential of the machinery carries over to the corporation; thus, Lark has to take into account the § 1245 recapture potential originating with Carol.

p. 9-20 and Example 30

27. a. Rose Corporation will not recognize any income from the transfer of land and cash. It is a capital contribution, not taxed pursuant to § 118.

b. Rose will have a zero basis in the land. Section 362(c)(1)(B)

1. The cost of the property, $75,000, would be reduced by the $50,000 of cash donated by the city. Since Rose uses $25,000 of its own funds in excess of the $50,000 contribution, the basis of the property acquired will be $25,000. Section 362(c)(2)

pp. 9-21 and 9-22 and Example 32

28. Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road

Cincinnati, Ohio 45227

June 5, 1998

Ms. Emily Patrick

2624 Holkham Drive

Ivy, Virginia 22945

Dear Ms. Patrick:

This letter deals with the tax treatment that applies following the bankruptcy of Teal Corporation this year. Under the facts given, Teal Corporation was formed a number of years ago with an investment of $200,000 cash in return for which you received $20,000 in stock and $180,000 in 8 percent interest-bearing bonds maturing in nine years. Later, you lent the corporation an additional $50,000 on open account. During the corporation's existence, you were paid an annual salary of $60,000. Because our conclusion is based on these facts, please inform us if our understanding is inaccurate.

If the stock was issued pursuant to § 1244 of the Internal Revenue Code, you have a $20,000 ordinary loss on the worthless stock. Otherwise, the $20,000 investment in the stock results in capital loss treatment. A danger exists that the IRS could argue thin capitalization and reclassify the long-term debt as equity. This produces a capital loss on that portion of your investment. Also, it could contend that both the long-term debt (regardless of whether it can be deemed hybrid stock) and the $50,000 open account are nonbusiness bad debts and, therefore, short-term capital losses. If the IRS makes this assertion, we would recommend that you counter with the argument that the $50,000 open account is a business bad debt. To do this you need to show that the primary motive in lending the money to Teal Corporation was to protect your employment with the corporation. Further, if you are in the business of lending money or of buying, promoting, and selling corporations, you might be able to deduct both the $180,000 and the $50,000 as business bad debts which are treated as ordinary losses.

As this is a complicated situation, please call us if we may provide further assistance.

Sincerely,

Sarah Mitchell, CPA

pp. 9-22 and 9-23

29. Following the procedure used in Example 34 in the text, proceed as follows:

Consequently, the dividends received deduction for Red Corporation is $70,000 under the general rule. White Corporation claims a dividends received deduction of $140,000 because a net operating loss results when the Step 1 amount ($140,000) is subtracted from 100% of taxable income ($100,000). Blue Corporation, however, is subject to the taxable income limitation and is allowed only $112,000 as a dividends received deduction.

pp. 9-24 and 9-25 and Example 34

30. a. $18,000 ÷ 60 months = $300. To qualify for the election, the expenditure must be incurred before the end of the taxable year in which the corporation begins business. Amortization does not apply to the $3,600 of expenses that were incurred after the end of the taxable year.

b. ($21,600 ÷ 60 months) X 12 = $4,320.

c. $300 [same as a.]. The corporation's method of accounting is of no consequence in determining organizational expenditures that qualify for the election to amortize.

d. $4,320. [same as b.]

pp. 9-25 and 9-26 and Example 35

31. Except for the expenses related to the printing and sale of the stock certificates, all other expenses qualify for the § 248 amortization election. Thus, $7,200 ($2,400 + $1,200 + $3,600) divided by 60 months permits an amortization rate of $120 per month. For the six months in 1998, the deductible amount would be $720. Note that the $3,600 paid in January of 1999 is included in the write-off amount because year incurred (rather than the year paid) controls. Example 35 and pp. 9-25 and 9-26

32. Moose Corporation:

Tax on $44,000 is $6,600 ($44,000 X 15%).

Elk Corporation:

Tax on-$246,000

Deer Corporation:

Tax on-$1,420,000

Antelope Corporation:

Tax on-$22,000,000

p. 9-27

33. a. Yes. A brother-sister controlled group exists. The common ownership is 51%; thus, the 80% and the 50% tests are met.

Example 44

b. No. Black and White Corporations would not be a controlled group if Luis owns no stock in Black Corporation. The common ownership would then be only 46%. In addition, Ahmad and Sara would own only 46% of White Corporation; thus, the 80% test also would not be met.

pp. 9-29 and 9-30 and Figures 9-3 and 9-4

34. Wren, Robin, and Finch Corporations are part of a combined group.. pp. 9-29 to 9-32 and Example 47

35. General discussion. A brother-sister group exists if both the 80% total ownership test and the 50% common ownership tests are met. See Example 37 for an illustration of these tests.

a. A brother-sister group does exist. Both the 80% and 50% tests are met, as shown below:

b. A brother-sister group will not exist if Tom sells 10 of his shares in Cardinal Corporation to Sam. While the 80% total ownership test will continue to be met, the 50% common ownership test will not be met, as show below:

c. Several tax advantages will be gained if Tom sells 10 of his shares in Cardinal Corporation to Sam. The special rules that apply to computation of the income tax liability will no longer apply, so each corporation will be able to start at the bottom of the corporate rate schedule. In addition, the limitations that apply to the accumulated earnings credit and the AMT exemption will no longer apply. P. 9-28

d. December 15, 1998

Mr. Tom Roland

3435 Grand Avenue

South Point, OH 45680

Dear Mr.Roland:

I have considered the tax and nontax consequences that will result if you sell 10 shares of your Cardinal Corporation stock to Sam. There are several negative provisions that apply to affiliated corporations. If you sell 10 shares of your Cardinal Corporation stock to Sam, Eagle and Cardinal Corporations will no longer be affiliated corporations. As a result, the special rules that apply to computation of the corporate income tax liability will no longer apply, so each corporation will be able to start at the bottom of the corporate rate schedule. This can result in a substantial tax savings. In addition, the limitations that apply to the accumulated earnings credit and the AMT exemption will no longer apply.

There are two additional factors that you should consider. First, you will realize a $3,000 gain on the sale of your Cardinal Corporation stock. Under current laws, if you held the 10 shares for one year or less, the gain would be taxed at your current marginal rate of 31%. If your holding period is more than one year, but not more than 18 months, the tax rate on the gain is 28%; if more than 18 months, then 20% applies.

The second factor you should consider is that a sale of 10 of your shares to Sam will give him 60% ownership of Cardinal and will give him voting control of the corporation.

As indicated above, there are both tax and nontax factors that you should consider before making your decision.

Sincerely,

Anna Kerr, CPA

pp. 9-28 to 9-31

36. Corporations Amber and Sand are members of a brother-sister controlled group of corporations. Although the more-than-50% common ownership is met for all five corporations, corporations Tan, Beige, and Purple are not members because at least 80% of the stock of each of these corporations is not owned by the same five or fewer persons whose stock ownership is considered for purposes of the more-than-50% identical ownership requirements.

Examples 44 to 46

37. Corporations Jay and Shrike may not file Form 1120-A. Sales for Jay exceed $500,000; Shrike is a member of a controlled group. Martin Corporation may file Form 1120-A. p. 9-32

38. Net income per books is reconciled to taxable income as follows:

pp. 9-34 to 9-36 and Example 48

39. Taxable income is $100,000.

pp. 9-34 to 9-36 and Example 48

Example 48

• Identifying which expenditures qualifying as start-up costs and/or organization costs.
• Currently deducting versus capitalizing the cost of certain furniture, display equipment, and office equipment.
• Proper depreciation methods and periods for capitalized assets.
• The deductibility of the employee training sessions.
• The proper withholding tax filing requirements regarding employee's salaries.
• Accrual versus cash basis taxpayer, as well as, the timing of certain payments (e.g. bonuses, profit-sharing, etc.).
• Determination of a proper year-end for tax purposes.
• Dividend policy / avoidance of the Accumulated Earnings Tax.
• Deferred compensation/group insurance plans for employees.

41.

41. continued

41. continued

41. continued

41. continued

42.

Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road

Cincinnati, Ohio 45227

March 24, 1998

Mr. Herbert Anson

6455 West Barr Ave.

St. Paul, MN 55164

Dear Mr. Anson:

You have asked me to advise you concerning the tax issues related to your use of Gander Corporation's jet for vacation travel. You asked the following specific questions.

• Will you have to report income based on your use of the jet?
• Will Gander Corporation be allowed to deduct expenses related to your use of the jet?

In a similar situation, the IRS recently ruled that a corporation may deduct expenses to the extent that the use of corporate property was reported as compensation to the employee. Therefore, Gander should treat the value of your use of the corporate jet as compensation to you, and you should report that amount as income. Gander Corporation may deduct expenses related to your use of the jet, but the expense deduction is limited to the amount reported as compensation to you.

Thank you for consulting my firm on this matter. Please call my office if you wish to discuss the matter further. I look forward to assisting you when tax issues arise in the future.

Sincerely,

Patrick Keller, CPA

NOTE TO THE INSTRUCTOR. Since this letter is meant for a client, no legal citations are included. Authorities in point include the following:

IRS Technical Advice Memorandum 9715001, 10-31-96.

Reg. § 1.61­21(g).

Reg. § 1.274­2(b)(1)(i) and (2)(i).

§ 274(e)(2).

44.

Hoffman, Raabe, Smith, and Maloney, CPAs

5101 Madison Road

Cincinnati, Ohio 45227

October 10, 1998

Ms. Fay Holmes

Corporate Tax Accountant

Salisbury Group, Inc.

P.O. Box 71

Concord, NC 28026

Dear Ms. Holmes:

This letter is in response to your inquiry regarding the potential gain recognition to Salisbury Group, Inc. on the incorporation of Concord Corporation. There was a clear sense that the environmental damage (and the associated liability) existed at the time the Salisbury chemical operation was transferred to Concord. Concord, in fact, incurred $32 million to later clean up the site. However, even though Salisbury uses the accrual method of accounting, it had not charged any costs against its income to reflect the potential or contingent liability prior to the transfer.

As you are aware, the basic issue is whether the potential environmental remediation liabilities assumed by Concord on its incorporation are treated as liabilities for purposes of § 357(c)(1). Rev. Rul. 95-74 (1995-2 CB 36) concludes that the liabilities are not considered liabilities under § 357(c)(1) because they had not been accounted for by the Salisbury Group before the transfer. Section 357(c)(3) states that for purposes of the excess liability rule, the assumption of or taking property subject to a liability whose payment by the transferor would give rise to a deduction is excluded as a liability. Given that Concord claimed a deduction for a portion of the $32 million cost, which is supported by Rev. Rul. 80-198 (1980-2 C.B. 113), this portion of Concord's payment falls clearly within the scope of § 357(c)(3), and thus, is excluded. Even though a literal reading of § 357(c)(3) does not support the position taken in Rev. Rul. 95-74, the IRS reasoned that it should.

The IRS concluded that the rationale for excluding certain deductible liabilities from the scope of § 357(c)(1) also applies to liabilities that give rise to capital expenditures. According to Rev. Rul. 95-74, "including in the § 357(c)(1) determination those liabilities that have not yet given rise to capital expenditures (and thus have not yet created or increased basis) with respect to the property of the transferor prior to the transfer also would result in an overstatement of liabilities. Thus, such liabilities also appropriately are excluded in determining liabilities for purposes of § 357(c)(1) since their inclusion would result in the overstatement of liabilities." In this case, the contingent liabilities assumed by Concord had not been taken into account by Salisbury Group prior to the transfer. Consequently they had neither given rise to deductions for Salisbury nor resulted in the creation of basis in any property of Salisbury. The contingent environmental liabilities are not treated as liabilities under § 357(c)(1).

Should you have any further questions or need to clarify our conclusions, do not hesitate to contact me.

Sincerely,

Nancy M. Ferguson, CPA

Partner

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