Revenue Ruling 2002-83: Tax Treatment of Liabilities

The Internal Revenue Service (IRS) provides guidance on complex tax matters through Revenue Rulings, which interpret the tax code for specific circumstances. One area requiring such clarification is the formation of a new business, particularly how future obligations are treated. Revenue Ruling 2002-83 addresses the tax treatment of contingent liabilities when transferred to a new corporation. This guidance is significant for structuring business formations, but proposed regulations issued in early 2025 may make this ruling obsolete for future transactions.

The Transaction Addressed by the Ruling

At the heart of the ruling is a Section 351 exchange. This allows a person to transfer property to a corporation for stock without immediate gain or loss, provided they “control” the corporation afterward. Control means owning at least 80 percent of the voting stock and 80 percent of all other stock classes.

The transaction becomes complex with a “contingent liability,” an obligation that is not yet fixed but may arise later. Examples include potential environmental cleanup costs or obligations from a pending lawsuit. Unlike a standard account payable, the timing and amount are unknown when the liability is assumed.

The ruling addresses a business transferring all its assets to a new corporation for all of its stock. As part of this exchange, the new corporation also assumes the contingent liabilities of the business. The central question is how assuming these uncertain future obligations affects the tax calculations for both parties.

The IRS Holding and Rationale

The ruling’s central holding is that these contingent liabilities are not considered “liabilities” for two key calculations. They are disregarded under Section 357, which can trigger gain to the transferor, and Section 358, which reduces the transferor’s basis in the stock received. This conclusion prevents an immediate negative tax impact on the person forming the corporation.

The IRS’s rationale is grounded in the economic reality that these obligations have not yet matured into fixed debts. Because the transferor had not yet deducted or capitalized these costs, they have not resulted in any prior tax benefit. Treating them as liabilities for basis reduction purposes would unfairly penalize the transferor.

The guidance aligns with the principle that the new corporation is essentially stepping into the shoes of the old business. This approach is consistent with other IRS rulings and supports the policy of not discouraging corporate formations by creating a tax barrier.

Tax Consequences for the Transferor

For the person transferring assets, the ruling has favorable tax consequences, primarily impacting the basis calculation for the stock received. The transferor’s basis in the stock is determined by the basis of the assets transferred and is not reduced by the assumed contingent liabilities.

For example, if a sole proprietor transfers assets with a $500,000 tax basis and the corporation assumes $100,000 in potential cleanup costs, the transferor’s stock basis remains $500,000. The contingent liability is disregarded for this calculation.

Another consequence is that assuming these liabilities does not trigger immediate taxable gain. A transferor recognizes gain only if assumed liabilities exceed the total basis of transferred assets. Since these contingent liabilities are not counted, they cannot trigger this rule.

Tax Consequences for the Transferee Corporation

The new corporation that assumes the liabilities also faces specific tax implications. The corporation’s basis in the assets it receives is a “carryover basis,” meaning it takes the same basis in the assets that the transferor had. This rule is governed by Section 362.

The most significant consequence relates to the tax treatment when the corporation eventually pays the contingent liability. The payment is not added to the basis of the acquired assets. Instead, the corporation treats the payment as if it incurred the liability in its own business operations, allowing it to either deduct the payment as an expense or capitalize it.

For example, a payment to settle a tort claim would likely be a deductible business expense under Section 162. However, a payment for an environmental cleanup that adds value to land might need to be capitalized under Section 263.

This treatment ensures the tax outcome follows the economic reality of when the expense is incurred. It allows the corporation to receive a tax benefit for the payment, preventing the cost from being permanently lost for tax purposes.