New Tax Law Mandates Basis Reduction for Depreciated Assets Transferred to Corporations in Certain Transactions

The new American Jobs Creation Act of 2004 (P.L. No. 108-357; H.R. 4520), signed by the President on October 22, 2004, revises the basis rules for certain transfers in corporate organization, reorganization and liquidation transactions of assets that have a fair market value (FMV) less than the transferor's basis ("depreciated assets").    The new rules apply only where, in the aggregate, the transferor's basis in the transferred assets exceeds their fair market value ("aggregate depreciated asset transfers").  During congressional consideration of the legislation, this provision evolved from a very narrowly focused provision so that as enacted it applies in three different fairly common planning contexts (effective for transactions after October 22, 2004):  (1) transactions in which a corporation is first formed or in which assets are transferred to a corporation by one or more transferors who receive stock and are in control of the corporation after the transfer (§351 transfers); (2) transfers in a reorganization in which the transferor was not, but the transferee will be, subject to U.S. tax with respect to income realized from the assets; and (3) distributions to a U.S. parent corporation from an 80 percent or greater foreign subsidiary in liquidation.

Operation of the New Rules and Need For Appraisals 

In the case of aggregate depreciated asset transfers in the first situation and involving a transfer from a person subject to U.S. tax, the transferee corporation's basis in the transferred depreciated assets is reduced to the extent of the aggregate amount by which the transferor's aggregate basis in all transferred assets exceeds their aggregate FMV.  Thus, if a transferor transfers only one asset, which has a $60 FMV and a $100 basis, the transferee will take an FMV basis in the asset.  If the transferor transfers two assets, one with a $60 FMV and a $100 basis and the other with a $100 FMV and a $90 basis, the transferee will take a $70 basis in the first asset and a $90 basis in the second asset.  It should be noted that the rule does not apply unless the aggregate FMV of all assets transferred by a given transferor is less than the transferor's aggregate basis in those assets.  Thus, if a transferor transfers two assets, one with an $80 FMV and a $100 basis and the other with a $100 FMV and an $80 basis, the transferee will take a $100 basis in the first asset and an $80 basis in the second asset because the aggregate $180 FMV of the transferred assets is not less than the transferor's aggregate $180 basis in them. 

In the case of aggregate depreciated asset transfers in §351 transactions involving transferors not subject to U.S. tax, a similar rule applies except that: (1) all assets from transfers not subject to U.S. tax are aggregated in determining whether an aggregate depreciated asset transfer has occurred, and (2) if there is an aggregate depreciated asset transfer, the basis of each asset becomes its FMV.  Similarly, in the case of aggregate depreciated asset transfers in the second and third situations, the basis of each asset becomes its FMV.  Needless to say, the new rules put a premium on obtaining defensible appraisals of assets transferred in the types of transactions covered by the new rules.

The original impetus for these new rules was to prevent taxpayers from taking advantage of the rules governing tax-free organizations to realize a double benefit from a single economic loss: once from the transferee's eventual sale of the depreciated asset and again from the transferor's sale of the stock acquired as consideration in the organization exchange.  For some reason, Congress apparently was not concerned with the fact that there can be double taxation when appreciated assets are transferred.

Election to Reduce Stock Basis in §351 Transfers 

The legislation, as enacted, contains a special election that, if made, modifies the general rule that the transferee takes a reduced basis in any depreciated asset transferred in a §351 aggregate depreciated asset transfer involving a transferor subject to U.S. tax.  Under that special election, which must be elected by both the transferor and the transferee corporations, the transferee corporation takes a carryover basis in all transferred assets and the transferor takes an FMV basis in the stock in the transferee corporation.  In many cases, it will be advisable to make the election because the transferee may dispose of, or take depreciation deductions with respect to, the transferred depreciated assets long before the transferor is likely to dispose of the transferee's stock.  In these situations, the present value of the tax savings attributable to the higher asset basis will outweigh the present value of the increased gain (or reduced loss) from eventual disposition of the stock.  However, in situations in which the transferor does not alone control the transferee corporation, the different levels at which the tax consequences are realized could lead to intense negotiations as to whether the election should be made.

Planning to Minimize Effect of Rule

When multiple properties are transferred to a transferee in a potential aggregate depreciated asset transfer, it may in some cases be possible to sell to the transferee -- rather than exchange for stock -- at least some depreciated assets so as to prevent the transaction from being covered by the new rule.  However, without careful planning, there is a significant risk that any such sale will be stepped together with the exchange, in which case the new rule would continue to apply to the purported sale (with the sale proceeds being treated as "boot") or, even worse, disqualifying the entire transaction from tax-free treatment.  If such a sale is recognized as a separate transaction, it would permit the transferor (subject to the existing limitations on the recognition of losses if the transferee is sufficiently related to the transferor) to realize the tax benefits from the economic loss sooner.  It should be kept in mind, however, that the character of a loss on the sale of the depreciated asset could be different from -- and less favorable to the transferor than -- the character of a loss on any eventual sale of the stock. 

If the transferor is a foreign corporation, a loss on the sale of the depreciated asset may have no immediate U.S. tax consequences but could result in a loss for foreign tax purposes.  A loss would reduce the earnings and profits of the selling foreign corporation, which at some point could affect the amount of a distribution that is treated as a dividend, which may or may not be advantageous, depending on the particular facts and circumstances. 

Conclusion

In each of these contexts, i.e., §351 transactions, reorganizations, and liquidations of 80 percent owned foreign subsidiaries consideration must be given to whether or not it would be beneficial to transfer separately depreciated assets in a sales transaction.  All of the facts and circumstances of the particular transaction must be carefully analyzed to determine whether such an approach would be advantageous.  In addition, in any case involving a §351 transaction, consideration must be given to whether it would be more beneficial to make the special election provided under the law, under which the transferee corporation would take a carryover basis but the transferor's stock basis would be reduced.