Assumption of Liability: Tax Treatment and Consequences

An assumption of liability occurs when one party, such as a buyer, agrees to take on the existing debts or obligations of another party, typically a seller. This arrangement is a common element in business and real estate transactions, covering financial duties from loans and mortgages to contractual commitments.

Tax Treatment in Corporate Formations

When an individual transfers property to a corporation they control in exchange for stock, the transaction is often tax-free under Internal Revenue Code Section 351. If the corporation also assumes the transferor’s liabilities, specific rules apply. Under IRC Section 357, the corporation’s assumption of liabilities is not considered taxable “boot,” which is non-qualifying property that can trigger tax liability for the transferor.

This non-taxable treatment has exceptions. If the primary reason for the assumption was to avoid federal income tax or lacked a legitimate business purpose, the entire liability amount is treated as taxable boot. This prevents using a corporate formation to cash out of an investment tax-free, such as by taking out a large personal loan against the property right before the transfer.

Another exception applies when the assumed liabilities are greater than the tax basis of the transferred property. In this case, the transferor must recognize a taxable gain equal to the excess amount. For example, if an asset with a $50,000 tax basis is transferred to a corporation that assumes a $70,000 liability, the individual recognizes a $20,000 taxable gain. This rule ensures the transferor does not have a negative basis in their new corporate stock.

Tax Consequences in Asset Sales

In an asset sale, where a business purchases the individual assets of another company, the assumption of liabilities has direct tax consequences for both parties. For the seller, any liabilities the buyer takes on are included in the total “amount realized” from the sale. This increases the sale price for tax purposes, which can lead to a larger taxable gain or a smaller deductible loss. The character of that gain is determined on an asset-by-asset basis.

From the buyer’s perspective, the assumed liability is treated as part of the cost of acquiring the assets. This amount is added to the cash paid to establish the total purchase price, which is then allocated among the various assets acquired, such as equipment, inventory, and goodwill. This allocation establishes the tax basis for each asset, which is the value from which future depreciation and amortization deductions are calculated.

The allocation of the purchase price, including assumed liabilities, impacts the buyer’s future tax obligations. A higher basis in depreciable assets can provide significant tax benefits. For instance, allocating a larger portion of the purchase price to equipment with a shorter recovery period allows the buyer to take larger depreciation deductions sooner.

Handling Contingent Liabilities

Contingent liabilities are potential obligations that are not fixed or certain at the time of a transaction, such as pending lawsuits or future warranty claims. The tax treatment for these is deferred for both parties because the liability has not yet met the “all-events test,” which requires it to be fixed and determinable for tax purposes.

For the buyer, a contingent liability cannot be included in the tax basis of the acquired assets at the time of the sale. The buyer can only add the amount of the liability to the basis of the assets once the contingency is resolved and payment is made. The tax benefit is delayed until the liability becomes a certainty and is paid.

For the seller, the contingent liability does not initially increase the amount realized from the sale, which defers any potential tax impact. When the buyer eventually pays the liability, the payment may be treated differently for the seller. Depending on the nature of the original transaction, the seller might recognize a subsequent capital gain or be entitled to an ordinary deduction.

Documenting the Assumption in Agreements

Formalizing the assumption of liabilities in a written contract, like an asset purchase agreement, is an important step. The agreement must be explicit and unambiguous to prevent future disputes and provide clear evidence for the intended tax treatment. Vague language can complicate the tax reporting of the transaction.

The agreement should contain a detailed list or precise description of the specific liabilities the buyer is assuming. It is also important to include a clear statement that all other liabilities, known or unknown, are retained by the seller. This exclusionary language protects the buyer from inheriting unexpected debts.

It is also useful for the agreement to distinguish between “assuming” a liability and taking an asset “subject to” a liability. When a buyer assumes a liability, they become personally obligated to the creditor. If a buyer takes an asset “subject to” a liability, they are not personally responsible for the debt, but the creditor retains the right to seize the asset if the seller defaults.