Publications
02.17.12
Cancellation of Debt in a Partnership Context
On November 11, 2011, Treasury issued final regulations concerning the tax implications of contributing indebtedness to a partnership (or an LLC taxed as a partnership) in exchange for an interest in the partnership. The final regulations provide for an inconsistent view of a single transaction whereby the partnership may recognize cancellation of indebtedness (COD) income but the contributing partner does not recognize a loss: a situation where there is not symmetry in the treatment of the same item. Generally, where there is income, there is a corresponding deduction and vice versa. Such an inconsistent view of the same transaction has appeared in other areas of partnerships. For example, under Rev. Rul. 99-6, 1999-1 CB 432 (1/15/1999), situation 1, A and B are equal partners in AB, an LLC. A sells A's entire interest in AB to B for $10,000. After the sale, the business is continued by the LLC, which is owned solely by B. The sale of A’s interest is treated by A as the sale of a capital asset (i.e., A’s interest in the LLC). B is, however, deemed to have purchased A’s prorata share in the partnership assets, therefore taking a stepped-up basis in those assets.
Treasury Regulation § 1.108-8(a) provides, “For purposes of determining income of a debtor from discharge of indebtedness (COD income), if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness (a debt-for-equity exchange), the partnership is treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the partnership interest.” Accordingly, to the extent the FMV of the interest transferred to the creditor is less than the amount of the debt, COD income will arise. However, from the creditor’s perspective, the creditor will be deemed to have contributed the debt to the partnership in exchange for the partnership interest in a non-recognition transaction. Since the creditor is deemed to have contributed the debt to the partnership in a non-recognition transaction, the creditor will take a substituted basis in the partnership interest received. For example, AB partnership owes C $1,000. In return for forgiving the indebtedness, the AB partnership transfers an interest in the partnership worth $700 to C in complete satisfaction of the indebtedness. The AB partnership will recognize $300 of COD income and C will have a basis in his partnership interest equal to $1,000 assuming C’s basis in the indebtedness was equal to the face value of the instrument).
One potential planning opportunity would entail taking a partial bad debt deduction. As a general matter, a business bad debt may be partially written off where such debt is recoverable only in part. This would require the taxpayer/creditor having sufficient evidence to substantiate the partial worthlessness. Further, this planning would have to occur prior to entering into a transaction whereby the partnership is going to issue equity for the debt and may be well served to plan for the bad debt deduction prior to the execution of any documents dealing with a debt for equity transaction.
For any further information on any of the topics discussed herein please contact one of Argy’s transaction tax advisors: Dean Peterson at dpeterson@argy.com, Jeff Schragg at jschragg@argy.com or Darren Mills at dmills@argy.com.
1Interestingly, the tax court in Peco stated that treating the same item in two different ways could potentially “whipsaw” the government.
2The final regulations do provide for a safe harbor under which the FMV of the interest transferred to the creditor in satisfaction of the debt is deemed to be equal to the liquidation value of the partnership interest if four conditions are met. See Treasury Regulation § 1.108-8(b)(2)(i)
3See Treasury Regulation § 1.721-1(d)
4See IRC § 166(a)(2).
5Guidance about what constitute sufficient evidence is set forth in Treas. Reg. § 1.166-2. It should be noted that the regulation does not require legal action if the evidence is sufficient enough to substantiate the bad debt deduction.
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