Editor: Anthony S. Bakale, CPA, M. Tax.
Given the current economic downturn, it is not uncommon for debtors to renegotiate the existing terms of their liabilities, often resulting in cancellation of debt (COD) income. Generally, the exclusion provisions under Secs. 108(a)(1) and (2) (the bankruptcy and insolvency exceptions) would allow a corporation that recognizes COD income resulting from restructuring existing liabilities to defer or exclude the COD income at the entity level with minimal consequences to its shareholders. However, the Code looks at the COD of a partnership, or an LLC taxed as a partnership, in a very different light than it does COD of C corporations or, for that matter, S corporations. In this regard, partners in a partnership or members in an LLC taxed as a partnership may be subject to unexpected results.
COD Income: General Rules
In general, under the provision of Sec. 61(a)(12), COD income constitutes ordinary income and is subject to taxation at the time of discharge. However, provisions do exist to defer the tax impact by either electing to defer the recognition of COD income or excluding COD income at the cost of reducing certain tax attributes. Under the following circumstances, Sec. 108(a) provides exceptions to the general recognition of income rule:
- The taxpayer is in a title 11 bankruptcy case;
- The taxpayer is insolvent, but only to the extent of insolvency;
- The canceled debt is qualified farm debt incurred in operating a farm; or
- The canceled debt is qualified real property business indebtedness of a non-C corporation.
The cost of excluding COD income under one of the above exceptions is a reduction in the taxpayer’s tax attributes in accordance with Sec. 108(b)(2), which may include a reduction in net operating loss carryovers, tax credits, capital loss carryovers, bases of property owned by the taxpayer, passive loss carryovers, and foreign tax credit carryovers.
Under Secs. 705(a)(1)(A) and (B), regardless of whether a partner is able to exclude the COD income, the adjusted basis of a partner’s interest in the partnership is increased by the amount of COD income allocated to him or her. The decrease in partnership liabilities as a result of the discharge, however, will result in a decrease in the partner’s share of liabilities. Under Sec. 752, any decrease in the partner’s share of liabilities is considered a deemed cash distribution to the partner. Therefore, a partner may recognize gain under Sec. 731 to the extent deemed cash distributions exceed the partner’s adjusted basis in his or her interest in the partnership.
The recognition of gain under Sec. 731 is most likely to result in cases in which the amount of COD income allocated to a partner is less than the amount of debt the partner is deemed to be relieved of. A partnership may allocate to a partner COD income in accordance with the minimum gain chargeback rules under Regs. Sec. 1.704-2, the substantial economic effect rules under Regs. Sec. 1.704-1(b) (2), or the partner’s interest in the partnership. Accordingly, practitioners should carefully review the partnership agreement to determine the proper allocation of COD income and liabilities.
The bankruptcy exclusion has limited application to a partner because under Sec. 108(d)(6) the bankruptcy exception applies at the partner level and not at the entity level. Therefore, for the exception to apply, the partnership must be discharged of its liabilities in a bankruptcy proceeding, and the partner must also be a debtor in the bankruptcy proceeding or must be granted a discharge of indebtedness under an individual bankruptcy filing.
When the partner and not the partnership files for bankruptcy and the partner’s share of the partnership liabilities is discharged but the partnership remains liable for the debt, the partner is deemed to receive a cash distribution in the amount of the debt relieved, while the remaining partners are deemed to provide a cash contribution to the partnership via an increase in their share of the partnership’s liabilities. The partner will therefore recognize gain to the extent that the deemed distribution is in excess of his or her partnership’s basis.
Like the bankruptcy exception, the insolvency exception also applies at the partner level. Accordingly, the insolvency exception applies only to the extent the partner and not the entity is insolvent. Furthermore, the exclusion of COD income is limited to the amount of the partner’s insolvency.
Under Sec. 108(d)(3), insolvency is measured by determining the excess of liabilities over the fair market value (FMV) of assets immediately before the discharge of indebtedness. The partner may include his or her partnership interests in determining personal insolvency. However, there is uncertainty as to the impact the partnership’s nonrecourse liabilities may have on the calculation. In Rev. Rul. 92-53, the Service took the position that nonrecourse debt in excess of the FMV of the property that secures the debt is treated as debt for purposes of determining insolvency only to the extent such debt is discharged. Therefore, nonrecourse debt of an insolvent partnership may have little or no effect on a partner’s determination of insolvency.
Since a solvent partner may incur tax on his or her allocation of COD income while an insolvent partner may have no or little tax impact, the partnership often contemplates a special allocation of COD income to an insolvent partner. However, for a special allocation to be respected, the allocation must have substantial economic effect. In Rev. Rul. 99-43, the Service ruled that a last-minute amendment of a partnership agreement would not be respected because the special allocation of COD income to an insolvent partner lacked substantiality.
Qualified Indebtedness Exception
Under Sec. 108(a)(2), the qualified indebtedness exception does not apply if the discharge of farm or real property indebtedness occurs in bankruptcy or to the extent the taxpayer is insolvent. Whether an indebtedness constitutes qualified farm or real property business indebtedness is determined at the partnership level, while the election to exclude COD income is made at the partner level.
Sec. 108(c)(3) defines qualified real property indebtedness as indebtedness that:
- Was incurred in connection with real property used in a trade or business;
- Is secured by such real property;
- Is qualified acquisition indebtedness or was assumed before January 1, 1993; and
- Is the subject of an election by the taxpayer to have the qualified real property business indebtedness provision apply.
If the debt discharged meets the above four requirements, COD income resulting from the discharge may be excluded by a partner, other than a C corporation. The amount excluded may not exceed the outstanding principal amount of the debt immediately before the discharge less the FMV of business real property immediately before the discharge (value limit). The amount excluded also may not exceed the aggregate adjusted bases of the partner’s real property held immediately before the discharge (basis limit).
In accordance with Regs. Sec. 1.1017- 1(g)(2), a partner choosing to make the exclusion election and include his or her share of the partnership’s depreciable property within the election may be required to request and obtain consent of the partnership. If an election is made to include the partnership’s depreciable property, the partnership must reduce the electing partner’s basis of the applicable depreciable partnership property and, under Sec. 1017(d), must treat the basis reduction as accelerated depreciation. Given this recapture provision, the election may be of little or no benefit to a partner if the property is foreclosed upon or sold as part of the discharge soon after the discharge occurs.
Election to Defer COD Income Under the New Sec. 108(i)
Sec. 108(i) was enacted as part of the American Recovery and Reinvestment Act of 2009, P.L. 111-5. Unlike the above exclusions, this new provision permits a taxpayer to retain his or her tax attributes for future use while significantly deferring the recognition of COD income.
In accordance with Sec. 108(i), a taxpayer is permitted to make an election to defer COD income arising from a cancellation, reacquisition, or modification of a business debt occurring after December 31, 2008, and before January 1, 2011, and to include the COD in income ratably over a five-year period beginning in 2014. However, the COD income deferred will be accelerated and recognized as income in the tax year in which a taxpayer dies, liquidates, or sells substantially all its assets (including in a title 11 or similar case), ceases to do business, or similar circumstances. In the case of a partnership, COD income will also be accelerated in the case of a sale or exchange or redemption of an interest in a partnership by a partner or other person holding an ownership interest in such entity.
Under Sec. 108(i)(5)(B), the election is made on an instrument-by-instrument basis and, in the case of a partnership, it must be made by the partnership. Furthermore, Sec. 108(i)(5)(C) provides that if the debtor elects to defer COD income under the provisions of Sec. 108(i), it cannot take advantage of the exclusions under Sec. 108(a) listed above.
Because the partnership makes the election, no COD income is recognized by the partners. However, deferred COD income is allocated to the partners immediately before the discharge in the manner in which those amounts would have been included in the distributive shares of the partners under Sec. 704. Furthermore, the decrease in partnership liabilities as a result of the discharge is not taken into account for purposes of Sec. 752 to the extent it would cause a partner to recognize gain under Sec. 731.
A partnership or an LLC taxed as a partnership contemplating a debt restructuring should carefully consider the tax effects of Sec. 108. In the case of a corporation, the exclusion of recognizing COD income and the cost of tax attribute reduction are applied at the entity level. However, the insolvency and bankruptcy exclusion provisions of Sec. 108(a), along with the attribute reduction provisions, are not applied at the partnership level but are instead applied at the partner level. Therefore, COD income passes through to an individual partner and the partner generally cannot exclude it unless the partner is insolvent or bankrupt. In this case, COD income presents issues to a partner not in bankruptcy or who is solvent. In the case of the new provision, the deferral election under Sec. 108(i) is made at the partnership level, thereby binding all the partners. In this case, the election to defer COD income is mostly beneficial to a solvent partner who is unable to utilize the insolvency or bankruptcy exceptions. This may cause a dilemma to a partnership with both solvent and insolvent partners.
Accordingly, it is important to be aware of the tax consequences and consider all alternatives prior to restructuring any debt in order for partners to avoid the unexpected result of recognizing COD income and paying tax during a time of illiquidity.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.