NYSBA Tax Section Submits Report on Assumption of Deferred Revenue by Buyer

I am pleased to submit the attached report of the Tax Section of the New York State Bar Association. The report requests guidance on an issue of longstanding uncertainty: the proper tax treatment by the buyer of the assumption of a deferred revenue liability of the seller in a taxable asset acquisition of a business.

By way of background, deferred revenue generally arises when a customer of the seller has made a prepayment under a contract to provide goods or services in the future. Under the accrual method of accounting, payments of this kind are generally includible in income by the seller, subject to certain exceptions. Under current law, the tax consequences to the buyer of assuming these types of liabilities are unclear, both when the seller elects or is otherwise permitted to defer the original prepayment under the Code (e.g., under Section 455) and when the seller is required to report the prepayment as current income. Based upon limited guidance over several decades, two predominant paradigms have emerged.

Under the first paradigm, the assumption of a deferred revenue liability is treated in the same manner as the assumption of any other contingent liability: the buyer includes the liability in its basis in the acquired assets, but only as it incurs the related expense. Under the second paradigm, the assumption is treated as a separate and distinct transaction: the buyer is treated as having purchased some of the assets from the seller in one transaction and receiving the rest of the assets from the seller as consideration for assuming the deferred revenue liability. In this second transaction, the buyer is effectively treated as "stepping into the shoes" of the seller. The deemed payment to the buyer is either subject to immediate tax or entitled to deferral to the same extent as the original prepayment from the seller's customer. In either case, the buyer would deduct (rather than capitalize) the related expenses.

The attached report argues that whether the liability in question concerns a prepaid obligation or some other contingency, the determination of which of the two paradigms should govern the assumption in a taxable asset acquisition of a business depends upon which of two conflicting tax rules is the proper one: the rule that governs the receipt of advance payments in the ordinary course of business for undertaking a contingent obligation or the rule that governs the assumption of such an obligation in a taxable asset acquisition. Although both transactions are essentially the same, they are subject to very different tax treatment. The reason is that the first rule rejects "accretion to wealth" as the guiding tax principle and the second does not.

In the case of contingent liabilities other than deferred revenue, the "no accretion to wealth" rule trumps the advance payment rule even though it would be possible to disaggregate a sale of assets into a series of constructive in-kind payments by the seller to the buyer as separate consideration for assuming each and every contingent liability. In the absence of any policy reason for treating the assumption of a deferred revenue liability in the same transaction any differently, we do not believe that a buyer should be charged with income when it assumes a deferred revenue liability because neither type of assumption results in any accretion of wealth.

For these and other reasons, the report recommends that future guidance adopt the contingent liability paradigm as a single unitary rule governing all assumptions of deferred revenue liabilities.

We appreciate your consideration of our recommendations.

This report¹ recommends that the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") issue guidance on an issue of longstanding uncertainty: the tax consequences to the buyer of assuming a deferred revenue liability in a taxable asset acquisition of a business. Although the recommendations in this report are limited to the tax treatment of the buyer, the report discusses the tax treatment of both the buyer and the seller in these transactions.

Deferred revenue is a type of liability. It generally arises in the ordinary course of business when a customer makes a prepayment to a vendor under a contract to provide goods or services. Under the accrual method of accounting, payments of this kind are generally includible in income by the vendor upon receipt, even though the value of the payment is offset by the vendor's obligation to provide the goods or services, the costs of which may be higher or lower.

For book purposes, the initial accounting treatment of a prepayment is the same as the initial accounting treatment of a loan: the vendor debits the asset side of the balance sheet by the amount of the prepayment and credits the liability side of the balance sheet by an equal amount of "deferred revenue".² When the vendor later provides the goods or services, it debits (i.e., reduces) the deferred revenue liability account on the balance sheet and reports a corresponding amount of revenue on the income statement. The amount reported as revenue on the income statement reflects the portion of the prepayment "earned" by the vendor during the period in question. As discussed later in this report, the tax treatment of certain limited categories of advance payments (e.g., prepaid subscription fees) is similar to their book treatment.

Under current law, the tax consequences to the buyer of assuming these types of liabilities are unclear, both when the seller elects or is otherwise able to defer the original prepayment under the Code³ and when the seller is required to report the prepayment as current income. Based upon limited (and often conflicting) guidance over several decades, two dominant paradigms have emerged.⁴

Under the first paradigm (the "Assumption Approach"), the assumption of a deferred revenue liability is treated in the same manner as the assumption of any other contingent liability:⁵ The seller includes the liability in its "amount realized" at its current value for purposes of computing its gain or loss on the date of sale⁶ and then treats the sale as a closed transaction.⁷ Depending on the type of liability, the seller usually claims an offsetting deduction or increase in basis.⁸ The buyer includes the liability in its basis in the acquired assets,⁹ but only as and when the liability becomes fixed or is otherwise properly taken into account for tax purposes.¹⁰ The general rationale for such treatment is that "the payment of a liability by a subsequent purchaser is not the discharge of a burden, which the law has placed upon him, but is actually as well as theoretically, a payment of the purchase price."¹¹ As such, the treatment of any future payments as nondeductible capital expenditures has been followed even when the contingent liability is settled for more than its expected value at the time of the sale.¹²

The rationale for this treatment is that deferred revenue is a form of liability, namely the liability to provide the contracted for goods or services. The liability is contingent rather than fixed.¹³ A deferred revenue liability is contingent in at least two respects. First, the cost of providing the goods or services under the customer contract is unknown -- the actual cost will almost invariably differ from the amount reflected as a liability at closing. Second, if the vendor fails to provide the goods or services, it will usually be required to refund all or a portion of the prepayment to its customer.

Accordingly, a buyer would not recognize income on the date of sale under this paradigm when it assumes a deferred revenue liability for the same reason it would not recognize income when it assumes any other type of fixed or contingent liability: like a loan, the assumption of a deferred revenue liability is not an accretion to wealth. In addition, the buyer would be required to capitalize (rather than deduct) the actual costs of fulfilling the underlying contracts whether or not they exceed the amount reflected as a deferred revenue liability on the date of sale.¹⁴

Under the second paradigm (the "Fragmentation Approach"),¹⁵ the assumption of the deferred revenue liability is treated as a separate and distinct transaction. The buyer is therefore treated as having purchased some of the assets in one transaction and as having received the rest of the assets in another transaction in consideration for assuming the deferred revenue liability. In this second paradigm, the buyer is effectively treated as "stepping into the shoes" of the seller, with the buyer becoming the vendor to the third party customer. This deemed payment to the buyer is either subject to immediate tax or entitled to deferral to the same extent as the original prepayment from the customer. In either case, the buyer would deduct (rather than capitalize) the actual costs of fulfillment whether or not they exceed the deferred revenue liability.

II. Summary of Recommendations

This report makes the following recommendations:

The proper tax treatment of the assumption of a deferred revenue liability by a buyer in a taxable asset acquisition is not a new issue. As described below, although Treasury, the IRS and the courts have considered this question in the past, no clear consensus has emerged. This section of the report begins with a very brief overview of the general rules governing the treatment of advance payments received from customers in the ordinary course of business. It then discusses the authorities governing the assumption of these types of liabilities in an asset acquisition, addressing both the tax treatment of the assumption itself and the tax treatment of subsequent costs incurred by the buyer to satisfy the assumed liability.

For financial reporting purposes, a vendor generally recognizes income only when it is earned, regardless of the date of payment. In general, therefore, a vendor will not report a prepayment from a customer pursuant to a contract to provide goods as services for more than one year as income until the vendor actually provides the goods or services. Until then, the prepayment remains a liability on the balance sheet. For book purposes, therefore, the initial receipt of an advance payment is not recognized as income because it does not represent any accretion to wealth.

For federal income tax purposes, an accrual-basis taxpayer generally recognizes income when "all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy."¹⁹ Ordinarily, a taxpayer's right to income is treated as "fixed" for this purpose when the taxpayer either performs the services or is entitled to payment. In general, therefore, accrual method taxpayers recognize income when it is paid, due or earned, whichever occurs first.²⁰

Both the Code and various IRS pronouncements provided limited relief from this rule in the case of certain types of advance payments:

• Periodical Subscriptions. Section 455 provides generally that a taxpayer who receives certain prepaid subscription amounts for newspaper, magazine or other qualifying periodicals is not required to recognize such prepayments until the taxable year the taxpayer has the obligation to furnish the newspaper, magazine or other periodical to which the prepayment relates.

• Membership Dues. Section 456 provides for limited deferral to membership organizations with respect to prepaid dues.

• Next Year Performance. To at least partially reconcile the tax and financial accounting treatment of payments received in one taxable year for goods or services to be provided or performed over more than one taxable year, Revenue Procedure 2004-34 generally permits taxpayers to defer the portion of any advance payment not attributable to the taxable year of receipt to the succeeding taxable year, but only to the extent the payments are not recognized as revenue for financial reporting purposes in the taxable year of receipt.

• Certain Advance Payments. Accrual method taxpayers may defer the recognition of income upon the receipt of advance payments for certain types of goods or services until the taxable year in which the amounts are properly accruable under the taxpayer's method of tax accounting, provided such method results in including the advance payments in gross income no later than the time such amounts are included in gross receipts for financial accounting purposes.²¹

Consider the following example:

The Fragmentation Approach would "fragment" the same transaction into two distinct transactions: (i) a taxable purchase of a portion of the assets by the buyer for a cash purchase price of $1.2 million (taking into account the projected $800,000 cost of fulfilling the prepaid contracts) and (ii) a separate $800,000 payment of the remaining assets from the seller to the buyer for assuming the deferred revenue liability.²⁴ The buyer would report the $800,000 payment as current income (unless eligible for deferral), claim a $2 million tax basis in the acquired assets and deduct the actual costs of fulfillment in the future.

The Tax Court held that the seller realized ordinary income equal to the unreported subscription fees at the time of the sale. The Eighth Circuit, however, held that the current income inclusion was "nullified by an offsetting deduction equal to the amount by which the gross sale price . . . was reduced by [ the ] assumption of the subscription liabilities. . . ." Accordingly, the seller in Pierce incurred no net tax attributable to the unreported subscription fees. Specifically, the deduction had the effect of increasing the seller's gain because the court segregated the assets deemed to fund the "Pierce payment" from the sale of the other assets, leaving fewer assets (and less basis) to offset the amount realized by the seller and thus increasing the seller's gain on the "sale" portion of the transaction. The seller therefore realized the same amount of income as the seller would have realized in the absence of any assumption.²⁶ Although the taxpayer in Pierce was the seller, the court implied that the buyer would recognize income upon receipt of the Pierce payment.

Following Pierce, the IRS issued Revenue Ruling 68-112²⁷ and Revenue Ruling 71-450,²⁸ both of which presented the same issue. In Revenue Ruling 68-112, a taxpayer sold a newspaper business that had elected to report prepaid subscription income on a deferred basis under Section 455. The IRS ruled that the buyer's assumption of this liability gave rise to a deduction to the seller in an amount equal to reduction in the cash purchase price agreed to by the parties. The IRS equated the Pierce payment by the seller to the buyer with a direct payment by the seller to its customers to extinguish the assumed liability (which would have been deductible). In Revenue Ruling 71-450, IRS further ruled that the Pierce payment in Revenue Ruling 68-112 was includible in gross income of the buyer.²⁹

The Chief Counsel's office then issued an AOD³⁰ concerning the Pierce case, recommending that a petition for certiorari not be filed on the basis that Pierce and Revenue Ruling 68-112 were consistent so long as the Pierce payment reflected the entire amount of the prepaid subscription account not yet includible in income. The Chief Counsel correctly observed that "there is no necessary relationship between [the reserve account balance] and any reduction in the sales price of the assets" because the expected cost to the buyer of fulfilling the prepaid subscription contracts (like other contingent liabilities) may have differed from the amount reflected by the seller as a liability.

Between the issuance of these rulings, the Chief Counsel's office also released a GCM³¹ that revealed a longstanding rift between the IRS and the Justice Department on the validity of Pierce and Revenue Ruling 68-112. The Justice Department disagreed with the Fragmentation Approach to these transactions, stating that it "would be embarrassing if not futile" to litigate the issue presented in the GCM unless Pierce was appealed and Revenue Ruling 68-112 was revoked. It regarded the Fragmentation Approach as inconsistent with the business reality of a single capital transaction, as well as recent cases that had applied the Assumption Approach to liquidation transactions involving the assumption of deferred revenue liabilities.³² In the alternative, the Justice Department also argued that even if the Fragmentation Approach was correct, it should apply without regard to whether the seller's obligations were expressly assumed in the agreement. Finally, the Justice Department cited the potential for "whipsaw" under this approach, with sellers claiming a deduction for the Pierce payments and buyers failing to report the same payments as income.

The IRS nevertheless stood its ground, reiterating its position that the transaction was in substance two separate transactions, one a sale of a portion of the assets and the other a Pierce payment of the remaining assets. Although the IRS acknowledged that other authorities had rejected this approach in the non-recognition context, it argued that these transactions were distinguishable, largely on precedents that had applied the step transaction doctrine. Finally, while acknowledging the potential for "whipsaw", the IRS stated that if the purchase and sale agreement between the buyer and the seller reflected a deductible expense to the seller, the government had a "realistic basis" to argue that the buyer realized an equivalent amount of gross income.

Since then, the IRS has issued various rulings and other guidance consistent with the premise that a Pierce payment may arise, at least where the deferred revenue liability is taken into account in calculating the purchase price of the assets. For example, in PLR 8612050,³³ a Pierce payment arose because the deferred revenue liability was taken into account by the parties in the calculation of the seller's "net book value", which net amount was added to the purchase price to acquire stock of a corporation on which a Section 338 election was to be made.³⁴

In Revenue Ruling 55-675, the IRS endorsed the holding in Oxford Paper.³⁶ In the ruling, A and B were parties to similar leases with the same lessor. Because B's operations were unprofitable, B transferred certain supplies, equipment and cash to A in consideration for A's assumption of B's remaining obligations under the lease. The IRS ruled that A did not realize any income in the transaction. It also ruled that the tax basis of the acquired assets would be determined by reference to the amount of the assumed liabilities, but with no basis adjustment until the contingent lease liabilities became fixed and determinable.

The assignment of the leases in Oxford Paper and Revenue Ruling 55-675 are analogous to the assumptions of the deferred revenue liabilities in Pierce and Revenue Ruling 68-112. All four authorities involved the assumption of an unfavorable contract as consideration in a taxable asset acquisition. From the assuming buyer's perspective, a prepaid contract is an unfavorable contract because it requires the buyer to provide future goods or services to a customer at no cost. In both Oxford Paper and Revenue Ruling 55-675, the buyer was not treated as receiving any portion of the acquired assets as a separate Pierce payment from the assigning lessee for agreeing to the assignment. The assets transferred by the original lessee were instead treated as sold to the buyer in a capital transaction for consideration consisting of the lease assumption.

In a 2000 FSA,³⁷ a buyer had acquired the assets of a seller in a transaction described in Section 1060. As partial consideration, the buyer assumed the seller's deferred revenue liabilities. Consistent with the Assumption Approach, the IRS determined that (i) the seller had an immediate ordinary income inclusion equal to the deferred revenue liability, and (ii) the buyer was required to include the amount of the deferred revenue liability in the tax basis of the acquired assets. In addition, the IRS concluded that the deferred revenue liability "should also have been included in the amount realized upon the sale." Finally the IRS stated that "[t]he timing of the inclusion of amounts is determined under general principles of tax law." It is not entirely clear if this was intended to mean that the buyer would only capitalize the deferred revenue liability as and when the deferred revenue liabilities become fixed or something else. Significantly, and contrary to earlier rulings,³⁸ the FSA did not treat the assumption of the deferred revenue liability as a taxable event to the buyer.

Finally, the IRS has followed the Assumption Approach in non-recognition transactions involving the assumption of deferred revenue liabilities. In these cases, the IRS has generally ruled that the transferor realizes ordinary income upon relief from a deferred revenue liability and that the transferor is not entitled to any deduction for the Pierce payment. In GCM 37873,³⁹ for example, a partnership with deferred revenue liabilities attributable to membership subscriptions incorporated in a tax-free transaction under Section 351. In connection with the transaction, the taxpayer paid the transferee corporation to assume the liability. While acknowledging that a deduction would have been allowed if the transaction had been bifurcated into a separate transfer of assets and a separate payment to extinguish a liability, the IRS nevertheless treated the transfer as "a single integrated plan to effect a unified transaction -- the incorporation of P's business".⁴⁰

Similarly, in GCM 39413,⁴¹ the taxpayer (a publisher with deferred subscription revenue under Section 455) transferred its operating assets and liabilities to a new corporation in exchange for 100% of the common stock. The ruling declined to follow Pierce, distinguishing both Pierce and Revenue Ruling 68-112 as involving "outright sales to third parties." Finally, in Revenue Ruling 76-520,⁴² the IRS ruled that a parent corporation that received assets of a subsidiary subject to deferred revenue liabilities in a liquidation subject to Section 334(b)(2) of the 1954 Code was required to capitalize (rather than deduct) the costs of fulfillment and realized no income from the assumption, both of which are consistent with the principles of the Assumption Approach.

IV. Discussion of Recommendations

Deferred revenue has been treated as a contingent liability in a number of authorities involving asset transfers. First, in Revenue Ruling 76-520,⁴⁵ a buyer in the publishing business purchased stock of corporation and then liquidated it under Section 334(b)(2) of the 1954 Code, resulting in a tax-free basis step-up under the law in effect at that time. In the liquidation, the buyer legally assumed the obligation to fulfill the prepaid subscription obligations of the acquired corporation. The issue in the ruling was whether the buyer could deduct the costs of fulfillment. The IRS ruled that the buyer was required to capitalize these costs, citing cases involving contingent liability assumptions other than deferred revenue.⁴⁶ Second, as described more fully in Section III.B.2., supra¸ the IRS has followed the Assumption Approach in other taxable and tax-free assets transfers involving the assumption of deferred revenue liabilities or liabilities similar to deferred revenue liabilities. Third, both IRS guidance and Pierce strongly suggest that fragmentation is appropriate even in the case of deferred revenue only when the documentation of the sale of assets either reflects the assumption of the liability as separate asset transfer or establishes a readily determinable reduction in the cash purchase price of the other assets.⁴⁷ In the absence of such a finding, the Assumption Approach would presumably govern the assumption.

As the Eighth Circuit described it:

If this is the rationale, however, the same can be said of any other contingent liability assumed in an asset sale that is susceptible of valuation.⁵¹ Nevertheless, no authorities we are aware of have recast a fixed or determinable reduction in the cash purchase price in a taxable asset acquisition of a business to reflect the assumption of a contingent liability as a constructive payment from the seller to the buyer in a separate transaction, resulting in current income and future deductions to the buyer as opposed to future amortizable basis in the acquired assets.⁵²

If an accrual method taxpayer receives an advance payment in the ordinary course of business as consideration for agreeing to a contingent obligation, it generally must report the payment as income even though it has not yet earned the right to it.⁵³ If the same taxpayer assumes such an obligation in a taxable asset acquisition, it does not have income. Although both transactions are essentially the same, they are subject to very different tax treatment.⁵⁴ The reason is that the first rule rejects accretion to wealth as the guiding tax principle and the second does not.

Suppose, for example, that X receives a guaranty fee in the ordinary course of business. X must report the fee as current income even though the value of the payment is fully offset by the expected cost to X of assuming the contingent payment obligation to the borrower. Now suppose that before the borrower defaults, X sells its business to Y subject to the guaranty. Y is not treated as having received an imputed guarantee fee from X. Y is instead treated as acquiring assets subject to a contingent liability. The reason is that the assumption of X's obligation does not represent an accretion to wealth to Y. Although the same would be true if X had simply paid the same fee to Y in the ordinary course of business, the absence of any accretion to wealth would not prevent Y from recognizing income.

In the case of contingent liabilities other than deferred revenue, the "no accretion to wealth" rule trumps the advance payment rule even though it would be possible to disaggregate the transaction into a series of constructive in-kind payments by the seller to the buyer as separate consideration for assuming each and every contingent liability. For example, a taxpayer who receives a cash payment from a third party for agreeing to make contingent payments to fund a future environmental claim related to a parcel of land has current income under the accrual method of accounting even though it would avoid any income inclusion by assuming the same liability as consideration to acquire the land.

In the absence of any policy reason for treating the assumption of a deferred revenue liability in the same transaction any differently, a buyer should not be charged with income when it assumes a deferred revenue liability.⁵⁵ Neither type of assumption results in any accretion of wealth. We note that this "no economic benefit" analysis was among the principal rationales for our recommendation in the 1990 NYSBA Report that the buyer should not be charged with income under the Fragmentation Approach when it assumes a contingent liability in a taxable asset acquisition.⁵⁶

Nevertheless, both IRS guidance and the Pierce decision strongly suggest that the Fragmentation Approach only applies under current law when the assumption of the deferred revenue liability is either reflected in a separate agreement or when the precise impact of the deferred revenue liability on the cash purchase price can be established from the purchase and sale agreement.⁵⁷ One plausible explanation for imposing such a requirement is that a broader Pierce approach to these assumptions would otherwise be unadministrable. We certainly agree that a broader application of the Fragmentation Approach would be very difficult to administer. Unless it is applied more broadly, however, it will invariably produce a number of undesirable consequences.

First, if current law in fact requires either an actual payment from the seller to the buyer to assume the deferred revenue liability or other evidence from the purchase and sale agreement that the buyer actually reduced the cash purchase price by a specified amount to reflect the assumption, then current law is effectively elective.

Consider the following example:

Second, as the IRS has already acknowledged,⁵⁸ the deferred revenue liability on the balance sheet bears no necessary relationship to the expected cost of its assumption. While it may be that certain buyers and sellers will be able to identify and value any contingent liabilities related to prepaid income, this is likely to be the exception rather than the rule. Much more likely is that the parties will not assign any value to these liabilities in the governing agreements.

Third, the expected costs of fulfillment of the buyer and the seller may actually differ. For example, the buyer may intend to operate the business in a different manner than the seller, or may have access to other resources not available to the seller (e.g., more efficient machines and/or a more skilled workforce) to fulfill the prepaid contracts. If so, the size of the Pierce payment projected by the buyer may differ from the size projected by the seller.

Fourth, the parties will usually not have adverse interests in negotiating the agreed value of the contingent liabilities, so an agreed value would not usually reflect true arm's length bargaining. The buyer would desire to minimize the agreed value in order to minimize the resulting Pierce payment.⁵⁹ The seller would often be indifferent because the seller's deduction will generally offset the seller's income inclusion (although if the seller had unusable capital losses a larger agreed value would be beneficial because of the resulting increased capital gain and ordinary deduction).⁶⁰

Finally, it makes no sense for the tax treatment of the parties to the transaction to depend upon such vagaries of the negotiating history as whether the price was reduced to reflect a contingent liability. A buyer will often bid a price for a business without even telling the seller what factors went into the price. And even if the contingent liability is discovered by the buyer during the course of the negotiations after a tentative price has been offered, future changes to the offered price may be based on an overall evaluation of numerous factors by the buyer without any explicit statement of how each factor affected the offer. In any event, there is no logical policy reason that the tax results should depend upon whether the buyer explicitly, as opposed to implicitly, reduced its price for the contingent liability.

The Assumption Approach avoids all of this complexity because the rules governing the assumption of other contingent liabilities leave the transaction "open" to the buyer. The basis adjustment is simply suspended until the liability becomes fixed, obviating the need to value the liabilities at closing. Already the default rule governing both fixed and contingent liabilities, it will be much simpler to administer. The Assumption Approach also conforms to the general expectation that buyers do not recognize immediate income in a purchase of assets.⁶¹

Under the Assumption Approach, S again incurs no net tax at closing because the $15 of additional "amount realized" attributable to the contingent liability is fully offset by a $15 deduction or positive basis adjustment. B has no income at closing and an initial tax basis in the acquired assets of $X-$15. Over Years 1-3, B increases its basis in the acquired assets by $15 of fulfillment costs, to a total of $X. B therefore has no gross income at closing and claims $X of deferred depreciation over the useful life of the acquired assets.

The chart in Exhibit B of this report includes a useful summary of the net tax consequences of each approach to the buyer and the seller.

If, contrary to our recommendation, Treasury and the IRS determine the Fragmentation Approach should apply to certain taxable asset acquisitions of a business involving the assumption of a deferred revenue liability, we recommend that future guidance clearly identify the precise circumstances under which it will apply, in all cases on a mandatory rather than elective basis. We also recommend that the buyer and the seller should be required to report the Pierce payment on their tax returns and to be bound by such determination. Consistent with the current rules under Section 1060, however, the actual amount of any Pierce payment reportable by each party should be permitted to differ, reflecting each party's determination of the expected costs of fulfillment. Treasury and the IRS should also consider whether the presumptive amount of any Pierce payment should be the amount of the deferred revenue liability reflected on the GAAP balance sheet of the seller. Finally, any such guidance should clarify whether the medium of the Pierce payment consists of a pro rata portion of each of the acquired assets, a specific asset designated by the parties or first any cash being acquired.

² Although deferred revenue usually involves a prepayment of cash, it may involve a current receivable equal to the full amount due from the customer. In such a case, the vendor would debit accounts receivable rather than cash.

³ Unless indicated otherwise, all "Section" references are to the Internal Revenue Code of 1986, as amended (the "Code"), and all "Treas. Reg. §" references are to the Treasury regulations promulgated under the Code, both as in effect on the date of this report.

⁴ Exhibit A of this report provides detailed examples of the tax consequences to the buyer of both of these approaches.

⁵ Although the tax treatment of the assumption of a contingent liability in an asset acquisition is relatively clear, some uncertainly remains even to this day. Although a detailed discussion of the treatment of contingent liabilities in asset acquisitions is beyond the scope of this report, the treatment described in this report reflects what we believe to be current law. For a fuller discussion of the law in this area, see Jodi J. Schwartz, It Doesn't Get Easier Than This? Liabilities and Asset Sales Reexamined, Tax Forum No. 641 (Oct. 1, 2012); Ginsberg, Levin & Rocap, Mergers, Acquisitions & Buyouts ¶ 304 (2012); Glenn R. Carrington, Tax Accounting in Mergers and Acquisitions, ¶ 401-406 (2010); Robert Willens, Assumed Liabilities vs. Postacquisition Obligations, 117 Tax Notes 53 (Oct. 1, 2007); Daniel Halperin, Assumption of Contingent Liabilities on Sale of a Business, 2 Fla. Tax Rev. 673 (1996); Alfred D. Youngwood, The Tax Treatment of Contingent Liabilities in Taxable Asset Acquisitions, 44 Tax Law. 765 (1991); New York State Bar Association Tax Section, Report on the Federal Income Tax Treatment of Contingent Liabilities in Taxable Asset Acquisition Transactions (Nov. 1, 1990), reprinted in 49 Tax Notes 883 (Oct. 16, 1990) (the "1990 NYSBA Report"); Michael L. Schler, Sales of Assets After Tax Reform: Section 1060, Section 338(h)(10), and More, 43 Tax L. Rev. 605 (1988).

⁶See generally Section 1001; Treas. Reg. § 1.1001-2(a)(1).

⁷Cf. Treas. Reg. § 1.1001-1(g)(2)(ii) ("Only in rare and extraordinary cases will the fair market value of the contingent payments be treated as not reasonably ascertainable"); Temp. Treas. Reg. § 15a.453-1(d)(2)(iii) (open transaction method may be used "only in those rare and extraordinary cases involving sales for a contingent payment obligation in which the fair market value of the obligation . . . cannot reasonably be ascertained"); Treas. Reg. § 1.338-4(d)(1) ("In order to be taken into account in [aggregate deemed sale price ("ADSP")], a liability must be a liability of target that is properly taken into account in amount realized under general principles of tax law that would apply if old target had sold its assets to an unrelated person for consideration that included the discharge of its liabilities. See § 1.1001-2(a).").

⁸See, e.g., Commercial Security Bank v. Comm'r, 77 T.C. 145 (1981) acq. 1986-2 C.B. 1; James M. Pierce Corp. v. Comm'r, 326 F.2d 67 (8th Cir. 1964); Treas. Reg. § 1.461-4(d)(5)(i); Treas. Reg. § 1.461-4(g)(1)(ii)(C); see also Ginsberg, Levin & Rocap, Mergers, Acquisitions & Buyouts ¶ 304.01 (2012).

⁹But see Nahey v. Comm'r, 196 F.3d 866 (7th Cir. 1999) ("In some of the cases that Nahey cites, the court may have misclassified an expenditure (he points chiefly to Pacific Transport Company v. Comm'r, 483 F.2d 209 (9th Cir.1973) (per curiam)), and treated an ordinary expense as a capital one. If so (which we needn't decide), those cases are incorrect").

¹⁰See, e.g., Rev. Rul. 55-675, 1955-2 C.B. 567; David R. Webb Co., Inc. v. Comm'r, 708 F.2d 1254, 1256 (7th Cir. 1983) (there is a "well-settled general rule that when an obligation is assumed in connection with the purchase of capital assets, payments satisfying the obligation are non-deductible capital expenditures"); Pacific Transport Company v. Comm'r, 483 F.2d 209 (9th Cir. 1973), cert. denied, 415 U.S. 948 (1974); Holdcroft Transportation Co. v. Comm'r, 153 F.2d 323 (8th Cir. 1946). See also Treas. Reg. § 1.338-5(e)(1) ("In order to be taken into account in AGUB, a liability must be a liability of target that is properly taken into account in basis under general principles of tax law that would apply if new target had acquired its assets from an unrelated person for consideration that included discharge of the liabilities of that unrelated person.").

¹¹Pacific Transport Company v. Comm'r, 483 F.2d 209, at 214 (9th Cir. 1973), cert. denied, 415 U.S. 948 (1974).

¹² In Illinois Tool Works Inc. v. Comm'r, the Seventh Circuit considered the proper treatment of the payment of a contingent liability by a taxpayer that had assumed the liability in connection with an acquisition of assets. The ultimate amount of the liability exceeded what the parties had anticipated, though the parties were aware of the existence of the liability at the time of acquisition. The court held that the buyer was required to capitalize the entire liability into the basis of the acquired assets. 355 F.3d 997 (7th Cir. 2004). In Pacific Transport Company v. Comm'r, the Ninth Circuit reached a similar result even though neither party was aware of the contingent liability at the time of the acquisition. 483 F.2d 209 (9th Cir. 1973).

¹³See 1990 NYSBA Report (citing Pierce (discussed infra) as authority for proposition that buyer does not recognize net income when the buyer assumes a contingent liability).

¹⁴ For the tax treatment of "excess" fulfillment costs, see generally Illinois Tool Works Inc. v. Comm'r, 355 F.3d 997 (6^th Cir. 2004), and Pacific Transport Company v. Comm'r, 483 F.2d 209 (9^th Cir. 1973).

¹⁵See GCM 34418 (2/3/1971) (using the word "fragmentation" when analyzing a taxable asset acquisition in which the buyer assumes a deferred revenue liability).

¹⁶ If the seller was not permitted to defer the original prepayment, the contractual obligation is not a deferred revenue liability for tax purposes. In this report, we nevertheless refer to these contractual obligations as deferred revenue liabilities.

¹⁷ This report does not address the special tax accounting rules governing long-term contracts under Section 460 or the special rules governing "ceding" commissions in certain insurance and reinsurance transactions in light of the substantial amount of guidance under the Code and Treasury Regulations addressing such transactions.

¹⁸ As discussed below in Section III.B.1, a Pierce payment is a payment (actual or deemed) from the seller to the buyer in consideration for the buyer's assumption of the seller's deferred revenue liability.

¹⁹ Section 451; Treas. Reg. § 1.451-1(a).

²⁰See, e.g., Rev. Rul. 84-31, 1984-1 C.B. 127; Rev. Rul. 74-607, 1974-2 C.B. 149, obsoleted by Rev. Proc. 9429, 1994-1 C.B. 616. See also Treas. Reg. § 1.451-5 (treatment of certain advance payments).

²¹ Treas. Reg. § 1.451-5.

²² Exhibit A of this report also provides examples of the tax consequences to the buyer under the Assumption Approach and the Fragmentation Approach.

²³See supra note 10 and accompanying text.

²⁴See James M. Pierce Corporation v. Comm'r, 326 F.2d 67 (8^th Cir. 1964) (discussed below). See also generally, T.F.H. Publications, Inc., 72 T.C. 623 (1979), aff'd per curiam, 622 F.2d 597 (3d Cir. 1980); GCM 34418 (2/3/1971); TAM 200147032 (11/26/2001).

²⁵ 326 F.2d 67 (8th Cir. 1969).

²⁶ The same would be true if the assumption of the subscription liabilities had been subject to the rules governing other contingent liabilities. See supra notes 7-8 and accompanying text.

²⁷ 1968-1 C.B. 62.

²⁸ 1971-2 C.B. 78.

²⁹ Although the buyer presumably would have been eligible to defer the income under Section 455 (on the theory that the buyer would have been able to do so had it received these amounts directly from the subscribers), this question was not addressed in the ruling.

³⁰ 1972 AOD Lexis 464.

³¹ GCM 34418 (2/3/1971).

³² For a similar conclusion published after the GCM, see Rev. Rul. 76-520, 1976-2 CB 42 (rejecting Fragmentation Approach as applied to tax treatment parent corporation's receipt of assets subject to deferred revenue obligations of a subsidiary in a liquidation).

³³ 12/23/1985. See also PLR 8749076.

³⁴ The PLR states in part that "[e]ven though the instant transaction is a 'deemed' sale, rather than an 'actual' sale, this distinction does not dictate a result different from Pierce, and the holding of that case is applicable."

³⁵ 194 F.2d 190 (2d. Cir. 1952).

³⁶ 1955-2 C.B. 657.

³⁷ FSA 200048002 (12/04/2000).

³⁸See Rev. Rul. 71-450, 197-2 C.B. 78; PLRs 8612050 (12/23/1985), 8749076 (9/11/1987).

³⁹ 3/5/1979.

⁴⁰ Similarly, in GCM 34418, the Chief Counsel concluded that the Fragmentation Approach should not extend beyond taxable sales to non-recognition transfers. 2/3/1971.

⁴¹ 3/1/1985.

⁴² 1976-2 CB 42.

⁴³See, e.g., Rev. Rul. 55-675, 1955-2 C.B. 567; Rev. Rul. 76-520, 1976-2 C.B. 42. The first ruling was issued before the Pierce decision and the second ruling did not cite Pierce.

⁴⁴See, e.g., PLRs 8612050 (12/23/1985), 8749076 (9/11/1987).

⁴⁵ 1976-2 CB 42.

⁴⁶Magruder v. Supplee, 316 U.S. 394 (1942); Haden Co. v. Comm'r, 165 F.2d 588 (5th Cir. 1948); Pacific Transport Company v. Comm'r, 483 F.2d 209 (9th Cir. 1973), cert. denied, 415 U.S. 948 (1974).

⁴⁷Pierce, 326 F.2d at 69.

⁴⁸ 1990 NYSBA Report.

⁴⁹ 326 F.2d at 72.

⁵⁰ Rev. Rul. 71-450, 1971-2 C.B. 78.

⁵¹See Jodi J. Schwartz, It Doesn't Get Easier Than This? Liabilities and Asset Sales Reexamined, Tax Forum No. 641 (Oct. 1, 2012).

⁵²Id.

⁵³See Rev. Rul. 84-31, 1984-1 C.B. 127; see also Schlude v. Comm'r, 372 U.S. 128 (1963); American Automobile Ass'n v. U.S., 367 US 687 (1961); Automobile Club of Michigan v. Comm'r, 353 US 180 (1957).

⁵⁴ Michael L. Schler, Sale of Assets After Tax Reform, Section 1060, Section 338(h)(10), and More, 43 Tax. L. Rev. 605, 673 (1988). ("it is impossible to create a result that is consistent with each of two doctrines that are inconsistent with each other").

⁵⁵ In addition, many types of contingent liabilities not normally viewed as related to prepaid income, for example warranty obligations on previously-sold products and guarantees of third party debt, are difficult to distinguish from the type of liabilities at issue in Pierce.

⁵⁶ 1990 NYSBA Report (stating that "[The Buyer's] receipt of the value of the property which is the deemed premium for assuming the contingent liability is completely offset by the obligation to satisfy the liability" and that "this same logic has long prevented a borrower under a debt instrument from recognizing income.").

⁵⁷Pierce, 326 F.2d at 69.

⁵⁸See supra note 30 and accompanying text.

⁵⁹ The IRS would have just the opposite incentive.

⁶⁰ Another reason the Fragmentation Approach is problematic is that any obligation to "earmark" specific assets as the medium of payment for the separate assumption would be inherently arbitrary, as well as inconsistent with the principles of Section 1060.

⁶¹ We also note that it is unusual to disaggregate a single, unified transaction into separate parts and to tax those parts differently. In fact, the IRS made this very observation in the case of an assumption of a deferred revenue liability in a non-recognition transaction, expressing concerns under the step transaction doctrine and the potential for abuse given the relationships among parties in such transactions. See Section III.B.2., supra.

⁶² Michael L. Schler, Sale of Assets After Tax Reform, Section 1060, Section 338(h)(10), and More, 43 Tax. L. Rev. 605, 670-674 (1988). Compare 1990 NYSBA Report (income recognition upon assumption of general contingent liability does not assure "tax neutrality" -- and thus seems to be an impractical approach -- because of the timing difference of current income recognition and deferred cost recovery).

Facts:

Ignoring customer contracts, Seller owns a business consisting of two assets: $1 million in cash and $1 million in goodwill with a tax basis of zero. Immediately before the sale, the business has deferred revenue liabilities related to prepaid customer contracts of $1 million. Seller originally received the $1 million in the ordinary course of business as advance payments from customers on the contracts, which Seller was permitted to defer under the Code.

Seller agrees to sell the business subject to the deferred revenue liability to Buyer for $1.2 million. The agreed value of the deferred revenue liability is $800,000, which is the expected cost of fulfilling Seller's obligations on the prepaid contracts. In exchange for the acquired assets, Buyer pays $1.2 million and assumes the deferred revenue liabilities. Following the sale, Buyer incurs $800,000 in actual fulfillment costs.

Scenario 1: The Assumption Approach

Treatment of Buyer

Buyer treats the deferred revenue liability as a contingent liability. It therefore recognizes no income at closing and capitalizes (rather than deducts) the entire cost of fulfillment on the prepaid contracts as they are incurred. Buyer's initial tax basis in the acquired assets is $1.2 million, $1 million of which is allocable to the acquired cash and the remaining $200,000 of which is allocable to the acquired goodwill. As Buyer incurs the fulfillment costs, it increases its tax basis in the acquired goodwill by $800,000.

Treatment of Seller

Seller has an amount realized of $2 million, consisting of the $1.2 million of cash and $800,000 of assumed liabilities. Net of the seller's tax basis in the $1 million of cash, Seller realizes $1 million of capital gain, all attributable to the sold goodwill. Seller also has ordinary income of $1 million on triggering the deferred revenue, together with an ordinary deduction of $800,000. Seller therefore realizes $1 million of capital gain and $200,000 of ordinary income.

Note that if Seller had either retained the deferred revenue liability together with $800,000 of cash to fund the associated costs or satisfied the liability for $800,000 before the sale, its net after-tax proceeds following the sale of the business to Buyer would have been the same. It would have transferred $200,000 of cash and $1 million of goodwill for $1.2 million, resulting in $1 million of capital gain. Upon the satisfaction of the customer contracts, it would report $1 million of deferred revenue and $800,000 of deductible expenses, resulting in net ordinary income of $200,000.

Scenario 2: The Fragmentation Approach

Treatment of Buyer

Unlike Scenario 1, Buyer is treated as (i) purchasing $200,000 of cash and $1 million of goodwill for a cash purchase price of $1.2 million; and (ii) receiving an $800,000 Pierce payment for assuming the deferred revenue liability. Buyer's initial tax basis is therefore $2 million (rather than $1.2 million), $1 million of which is allocable to the cash and $1 million is allocable to the goodwill. Buyer realizes $800,000 of ordinary income upon receipt of the Pierce payment at closing, which it may defer to the same extent that Seller was permitted to do so when it received the original prepayment from its customers. Finally, Buyer deducts (rather than capitalizes) the $800,000 of fulfillment costs over the terms of the prepaid contracts. The $800,000 of ordinary income therefore offsets by the $800,000 of deductible fulfillment costs.

Note that if Buyer's actual fulfillment costs had been less than $800,000, Buyer would recognize income between the date of closing and the date of fulfillment equal to the difference.

Treatment of Seller

As in Scenario 1, Seller recognizes $1 million of ordinary income upon Buyer's assumption of Seller's performance obligations under the prepaid contracts and claims an ordinary deduction of $800,000 for the deemed Pierce payment. Seller is also deemed to have sold its remaining assets to Buyer (i.e., $200,000 of cash and $1 million of goodwill). Seller therefore realizes $1 million of capital gain and $200,000 of ordinary income.

Note that if Seller had either retained the deferred revenue liability together with $800,000 of cash to fund the associated costs or satisfied the liability for $800,000 before the sale, its net after-tax proceeds following the sale of the business to Buyer would have been the same.

Scenario 3: Consequences of Varying Fulfillment Costs

Assume instead that Buyer's actual fulfillment costs on the prepaid contracts are either $900,000 (Case 1) or $700,000 (Case 2), or higher or lower than the $800,000 Pierce payment assumed by both Buyer and Seller at closing.

Treatment of Buyer

If the Assumption Approach applies, the tax consequences to Buyer are the same as those described in Scenario 1 except that in Case 1, Buyer will have a $1.1 million rather than $1 million tax basis in the acquired goodwill (which the parties valued at $1 million) and in Case 2, Buyer will have $900,000 rather than $1 million of tax basis in the acquired goodwill.

If the Fragmentation Approach applies, the tax consequences to Buyer are the same as those described in Scenario 2, except that in Case 1 Buyer will have an additional $100,000 ordinary deduction to offset unrelated income (a current tax benefit to Buyer). In Case 2, the tax consequences to Buyer are also the same as those described in Scenario 2, except that Buyer will recognize an additional $100,000 in ordinary income (i.e., the difference between the $800,000 Pierce payment and the actual fulfillment costs of $700,000).

Treatment of Seller Buyer's actual fulfillment costs have no effect on Seller under either the Assumption Approach or the Fragmentation Approach.