Editor: Kevin D. Anderson, CPA, J.D.
Partners & Partnerships
The IRS issued final regulations (T.D. 9557) that provide guidance on the recognition of discharge of indebtedness (DOI) income in partnership debt-for-equity transfers taking place on or after Nov. 17, 2011. The final regulations generally (1) allow partnerships to use liquidation value to determine the amount of DOI income; (2) provide that nonrecognition of gain or loss under Sec. 721 applies to the creditor’s contribution of the debt instrument in exchange for a capital or profits interest in the debtor partnership; and (3) add DOI income as a “first-tier” item for purposes of the minimum gain chargeback rules. (For prior coverage of these regulations, see News Notes, “Regs. Issued on Transfers of Partnership Interest to Satisfy Partnership Debt,” 43 The Tax Adviser 6 (January 2012).)
Sec. 108(e)(8) requires corporate taxpayers to recognize DOI income if they issue their own stock in satisfaction of their debt and the value of the stock issued is less than the debt amount on the date of the transfer. Before Oct. 22, 2004, it was unclear whether a similar rule applied to partnership debt-for-equity transfers, and, if so, how such a rule would apply. Section 896 of the American Jobs Creation Act of 2004, P.L. 108-357, amended Sec. 108(e)(8) to address partnership debt-for-equity transfers. Sec. 108(e)(8), as amended, provides that, if a partnership issues a capital or profits interest to a creditor in satisfaction of its recourse or nonrecourse indebtedness, it will be treated as having satisfied the indebtedness with an amount of money equal to the fair market value (FMV) of the interest. If the value of the interest issued is less than the amount of the debt, the partnership recognizes DOI income, which must be allocated to the taxpayers that were partners immediately before the transfer.
The Final Regulations
Under Regs. Sec. 1.108-8(b)(2), partnerships satisfying four safe-harbor requirements are allowed to use liquidation value to determine the amount of DOI income in a partnership debt-for-equity transfer. Liquidation value is defined as the amount of cash that the creditor would receive for the acquired interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going-concern value, and any other intangibles) for cash equal to the FMV of such assets and then immediately liquidated (see Regs. Sec. 1.108-8(b)(2)(iii)).
If a partnership (upper-tier partnership) holds an interest in another partnership (lower-tier partnership), the liquidation value of the lower-tier partnership is to be included in the liquidation value of the upper-tier partnership. Liquidation value can differ substantially from the market value of the partnership interest itself. For example, typically, a profits interest in a partnership will have a zero liquidation value upon issuance, but may have market value because of the expected profits the holder may be entitled to if the venture succeeds.
The Safe-Harbor Provisions
To qualify for the safe harbor under Regs. Sec. 1.108-8(b)(2), a partnership must meet the following four requirements:
Consistency requirement: The creditor, debtor partnership, and its partners must treat the FMV of the debt as being equal to the liquidation value to determine the tax consequences of the debt-for-equity transfer.
Extended consistency requirement: If, as part of the same overall transaction, the debtor partnership transfers more than one debt-for-equity interest to one or more creditors, then each creditor, debtor partnership, and its partners must treat the FMV of each debt-for-equity interest transferred by the debtor partnership to such creditors as equal to its liquidation value. (Without this requirement and the prior requirement, the IRS recognized, taxpayers could in some situations use both liquidation value and the FMV of the interest to decrease the amount of recognized DOI income.)
Arm’s-length terms: The terms with respect to the debt-for-equity transfer must be comparable to those that would be agreed to by unrelated parties negotiating with adverse interests.
Restriction on subsequent dispositions: Subsequent to the debt-for-equity exchange, the interest of the former creditor cannot be redeemed or sold to a related party of the debtor partnership or its partners as part of a plan that has a principal purpose of avoiding DOI income by the partnership. In defining relatedness, the regulations reference Secs. 267(b) and 707(b).
If taxpayers fail to meet the above safe-harbor requirements, the FMV of the partnership interest issued to the creditor will be determined based on all of the relevant facts and circumstances (see Regs. Sec. 1.108-8(b)(1)).
These safe-harbor requirements create certain compliance issues and opportunities. A partner’s refusal or failure to use the liquidation value would violate the consistency rule and cause the partnership to fail to qualify for the safe harbor. On the other hand, for partnerships that could meet all of the four safe-harbor requirements, these requirements have the effect of making the use of liquidation value to measure the amount of DOI elective. For example, taxpayers can simply choose not to use liquidation value and intentionally fail the safe harbor. This general flexibility may be a welcome option for some taxpayers.
The IRS also amended Regs. Secs. 1.704-2(f)(6), (j)(2)(i)(A), and (j)(2)(ii)(A), which provide taxpayers with the ordering rule for the types of income that make up a minimum gain chargeback. Before these final regulations, the regulatvided that minimum gain was to be charged back first from gains recognized from the disposition of partnership property subject to one or more partnership nonrecourse liabilities (first-tier item), and then, if necessary, from a pro rata portion of the partnership’s other items of income and gain for that year (second-tier item).
In a partnership debt-for-equity exchange, the minimum gain chargeback arises solely because of the cancellation of debt; thus, there is no property disposition. Accordingly, a pro rata portion of DOI was formerly included as a second-tier item, along with the partnership’s other income and gains. Under the final regulations, DOI income relating to partnership nonrecourse liabilities is included as a first-tier item in partnership debt-for-equity exchanges and in other situations involving DOI and a minimum gain chargeback. As a result, these amendments to Regs. Secs. 1.704-2(f) and (j) have a broader application than simply to partnership debt-for-equity exchanges and can affect allocations of DOI to partners in debt refinancings, debt modifications, and other situations generating DOI to a partnership and a reduction in minimum gain or partner minimum gain.
It also should be noted that, outside the minimum and partner minimum gain chargeback rules, the final regulations do not otherwise mandate a specific manner in which DOI should be allocated. In the preamble to the final regulations, the IRS indicated that previous guidance provides a framework for allocating DOI income among the partners, citing Rev. Ruls. 92-97 and 99-43.
Finally, the IRS amended the regulations under Sec. 721, which provide that neither a partner nor a partnership generally will recognize gain or loss on the contribution of property by a partner in exchange for an interest in such partnership. New Regs. Sec. 1.721-1(d) generally extends this nonrecognition treatment to partnership debt-for-equity exchanges.
However, under Regs. Sec. 1.721-1(d)(2), nonrecognition treatment does not apply to the extent the transfer of the partnership interest to the creditor is made in exchange for the partnership’s indebtedness for unpaid rent, royalties, or interest (including accrued original issue discount) that accrued on or after the beginning of the creditor’s holding period for the indebtedness. (Regs. Sec. 1.721-1(d)(3) requires that, in determining whether a partnership interest is transferred to a creditor in exchange for the partnership’s indebtedness for interest or accrued original issue discount, taxpayers follow the rules under Regs. Secs. 1.446-2 and 1.1275-2.) These items generally result in ordinary income to the recipient, and, without their exclusion from nonrecognition treatment, to the extent these items had not previously been included in the income of the creditor, nonrecognition treatment could have resulted in the conversion of ordinary income into capital gain.
With respect to the partnership, the preamble to the final regulations indicates that a partnership will not be treated as satisfying its indebtedness for unpaid rent, royalties, or interest on indebtedness with a proportionate share of each of its assets (which could result in the recognition by the partnership of gain or loss on the exchange of each such asset). According to the preamble, this nonrecognition treatment is in keeping with the intent of Sec. 721 to defer taxation on a contribution of property to a partnership.
The preamble also addresses the contribution of installment obligations to partnerships in debt-for-equity exchanges. To this end, the preamble states that Regs. Sec. 1.453-9(c)(2), which excludes a contribution of an installment obligation under Sec. 721 from the disposition rule of Sec. 453B, does not apply to contributions of an installment obligation to a debtor partnership. Therefore, such contributions would require the creditor to recognize gain or loss under Sec. 453B. The preamble states that the IRS will propose regulations under Sec. 453B to clarify this treatment.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.