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NEWS & INSIGHTS
Publications
10 NOV 2008
IRS Issues Proposed Regulations On Cancellation of Indebtedness in Exchange for a Partnership Interest
ARTICLE TAX ALERT
by Lisa Merrill and Lawrence Tannenbaum
In 2004, the Internal Revenue Code was amended to add a provision to the income tax rules for debt discharge to address the circumstance when a partnership issues a capital or profits interest to a creditor in satisfaction of recourse or nonrecourse debt. That Code provision provides that the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value of the partnership interest issued to the creditor. The amount by which the discharged debt exceeds the value of the partnership interest is cancellation of debt (COD) income, and included in the distributive shares of the partners. Further, the proposed regulations provide that, generally, the creditor does not recognize gain or loss upon the contribution of the debt in exchange for a partnership interest. On October 31, 2008, the IRS issued proposed regulations providing guidance for this rule. Value of Partnership Interest Under the proposed regulations, the fair market value of the partnership interest issued to the creditor is equal to the “liquidation value” of the partnership interest (i.e., the amount of cash that the creditor would receive with respect to the interest if immediately after the issuance of the interest to the creditor, the partnership sold all of its assets and liquidated) provided that the following conditions are met: The partnership maintains capital accounts in accordance with the regulations under IRC 704(b). The creditor, the partnership and the partners treat the fair market value of the debt as being equal to the liquidation value of the partnership interest issued to the creditor for the purposes of determining the income tax consequences of the exchange.
http://www.dlapiper.com/indebtedness_cancellation/
11/19/2008
DLA Piper | Publications | IRS Issues Proposed Regulations On Cancellation of Indebted...
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The exchange is an arms-length transaction. Subsequent to the exchange, the partnership does not redeem, and no person purchases, the creditor’s partnership interest as part of a plan to avoid COD income. This rule will, effectively, allow the parties to an arms-length exchange of debt for a partnership interest to gain certainty on the tax treatment of the exchange. Of course, there may be other tax consequences to the partners arising from the partnership's reduction in debt which would need to be addressed. Nonrecognition Treatment The proposed regulations provide that, generally, the creditor will not recognize any gain or loss on the contribution of the debt to the partnership in exchange for a partnership interest. However, this rule does not apply to debt for unpaid rent, royalties or interest on indebtedness. Thus, creditors should be wary that they may suffer interest income with no offsetting loss on the transaction, even if the fair market value of the partnership interest is well below the loan principal. In issuing the proposed regulations, the IRS acknowledged that a number of issues are not addressed. These include Whether there should be a special allocation of COD income if the debt is owed to a pre-existing partner; Treatment of COD income from a partnership interest/debt exchange for the purposes of the minimum gain chargeback rules; and Interaction of the proposed regulations with the rules on noncompensatory stock options and convertible debt. The IRS requests comments on these issues as well as on the proposed regulations.
http://www.dlapiper.com/indebtedness_cancellation/
11/19/2008