Denial of Contingent Liability Loss Deduction
Although in the past the government won a number of important victories in its ongoing attempt to stop abusive tax transactions, it has continued to lose on contingent liability transactions. Recently, however, the Court of Appeals for the Federal Circuit reversed a lower court decision that may substantially affect future contingent liability cases. Coltec Industries recognized significant gain when it sold several of its subsidiaries. To offset this gain it followed a simple tax-savings strategy; it created a subsidiary, Garrison, which received stock in exchange for a $14 million contribution. Garlock, another Coltec subsidiary, transferred its contingent liability for asbestos claims, some assets and a $375 million note from another subsidiary to Garrison in exchange for common stock. The amount of the note and the contingent liability were approximately equal. Garlock then sold the Garrison stock and recognized a loss of $378.7 million. When Garlock took a loss deduction, the IRS denied it. The Court of Federal Claims disagreed with the IRS and permitted the loss deduction. The IRS appealed. Result. For the IRS. The service presented two arguments against the loss deduction. The first was a technical argument involving the interaction of liabilities and basis, which was contained in IRC sections 357(b), 357(c) and 358. The second was a general argument about whether the transaction had sufficient economic substance to be respected. Liabilities and basis. IRC section 358(d)(1) addresses liabilities assumed as money paid resulting in a decrease in basis. The claims court held that contingent liabilities were not liabilities for purposes of section 358. The Federal Circuit Court of Appeals disagreed; it held that contingent liabilities, for purposes of that section, were liabilities. However, section 358(d)(2) exempts liabilities excluded under section 357(c)(3). The appeals court had to determine whether these contingent liabilities excluded liabilities under section 357(c)(3) and whether section 357(b) overrode the exclusion. The government contended that the section 357(c)(3) exclusion applies to liabilities only if they are transferred with the business that created them and if they give rise to a deduction. Although admitting Congress probably intended to limit the exclusion to transfers of businesses and their liabilities, the court rejected the government's argument because the section does not expressly contain this limitation. The government also said that under section 357(b) assumed liabilities are treated as boot (usually cash). Although section 357(b) does overrule section 357(c) for liability assumption purposes, section 358 refers to section 357(c)(3) only for its definition of an excluded liability. Therefore, section 357(b) was not relevant in the case and it did not matter that the taxpayer had assumed the liabilities only to avoid taxes. …