On November 15, the Internal Revenue Service issued final
Treasury Regulations (Regulations) under Section 108(e)(8) of the
Internal Revenue Code regarding the determination of the
cancellation of debt (COD) income to a partnership that transfers a
partnership interest to a creditor in satisfaction of a partnership
debt.
Pursuant to the American Jobs Creation Act of 2004, Public Law
108-357 (118 Stat. 1648), Section 108(e)(8) was amended to expand
its scope to include cancellation of partnership indebtedness.
Prior to the amendment, Section 108(e)(8) only applied to
cancellation of corporate indebtedness. As amended, if a debtor
partnership issues a capital or profits interest in the partnership
in exchange for its debt (recourse or nonrecourse), the partnership
is treated as having satisfied the debt with an amount of money
equal to the fair market value (FMV) of the partnership interest
issued to the creditor. The amount by which the discharged debt
exceeds the FMV of the partnership interest is COD income and is
included in the distributive shares of the partners in the
partnership immediately before the discharge.
The final Regulations provide that, for purposes of calculating
the COD income to a partnership, the FMV of a partnership interest
transferred to a creditor is its liquidation value. For these
purposes, the liquidation value of the partnership interest is
equal to the amount of cash that the creditor would receive with
respect to the 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
fair market value of those assets, and then liquidated.
However, under the final Regulations, this liquidation value can
be used to determine the FMV of a partnership interest only if the
following three conditions are met:
- The creditor, the partnership, and the partners treat the FMV 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.
- The exchange is an arm's-length transaction.
- Subsequent to the exchange, neither the partnership nor any person related to the partnership redeems the creditor's partnership interest as part of a plan to avoid COD income.
If the conditions are not satisfied, the determination of the FMV
of the transferred partnership interest will be based on all the
facts and circumstances.
The final Regulations also address treatment of debt-for-equity
exchanges under Section 721, confirming that the creditor does not
recognize a loss or a bad debt deduction upon the contribution of
debt to the partnership in exchange for a partnership interest. The
creditor's basis in the partnership interest received will be
increased by the adjusted basis of the indebtedness exchanged.
Similarly, while the partnership will have COD income to the extent
the amount of the debt exchanged exceeds the FMV of the partnership
interest issued, the partnership will have no gain or loss on the
transfer of the partnership interest. However, gain or loss may be
recognized by the creditor to the extent a partnership interest is
issued in exchange 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. The rationale for this exception is to protect
against the conversion of ordinary income into capital gain.
The final Regulations became effective on November 17.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.