Capital Markets Tax Quarterly - Volume 4, Issue 1 - Capital Gains Tax

Editor's Note

CMTQ couldn't help notice in mid-April when the stock market was "shocked, shocked" at a news report that President Joe Biden would propose increasing individual federal income tax rates on long-term capital gains to equal ordinary income rates (39.6% under Biden's proposal).¹ If only folks had read CMTQ last quarter, they would have realized this proposal was lurking in the wings.² We checked and the last time tax rates on long-term capital gains were higher was immediately before the 1978 Revenue Act during the Carter Administration when the effective long-term capital gain rate was 49%.³ And individual long-term capital gain and ordinary income tax rates have not been equal since the George H.W. Bush Administration, albeit at a much lower 28% rate. This recent capital gains "news" was good for several days of media reports, analysis and talking head air time and, some would say, increased volatility in the stock market--exactly what we need. Unfortunately for tax advisors as of this writing there is no legislative language for any of the President's tax proposals (which BTW are discussed below); for example the effective date of any change in individual long-term capital gain (and ordinary income) rates is currently unknown.⁴ So, dear reader, stay tuned. As always, CMTQ will continue to cover the ups and downs of the legislative process as it unfolds in 2021.

In the meantime, this CMTQ also covers a private letter ruling approving the settlement of debt without CODI in a bankruptcy, some highlights from recent tax proposals from President Biden's Administration, and more.

PLR 202050014: Another Ruling Supporting Debt Settlement Without CODI

In PLR 202050014 (the "Ruling"), the IRS blessed a tax-efficient bankruptcy reorganization, again blessing tax planning technology that is at least as old as 2016. The Ruling bolsters authority for the use of bankruptcy transactions as a means of settling debt without triggering cancellation of indebtedness income ("CODI").

First, the facts of the Ruling: A parent corporation ("Parent") owned all of the equity interests of two disregarded entities, LLC1 and LLC2. The substantial majority of the value of Parent was owned by LLC1 and its subsidiaries. Parent, LLC1 and LLC1's subsidiaries subsequently filed for bankruptcy, with LLC1 being the direct borrower of a significant portion of the group's debt. Significantly, the Parent was not a guarantor of LLC1's debt. Under the Ruling, Parent proposed to contribute its assets (including the equity and assets of LLC1 and LLC2) to a newly formed corporation ("NewCo"). Then, pursuant to the same plan, Parent distributed the equity of NewCo to creditors in satisfaction of a portion of LLC1's debt. The Ruling concludes that the LLC1 debt is treated as nonrecourse indebtedness, and the transaction as a whole satisfied the requirements to be treated as a "G reorganization."

Generally, debt of a disregarded entity is treated as owed by the disregarded entity's owner. However, there is uncertainty regarding whether indebtedness that is nominally recourse to the disregarded entity borrower is better treated as recourse indebtedness or nonrecourse indebtedness. On the one hand, because the debt is recourse indebtedness under local law, it is possible to view the indebtedness as recourse indebtedness of the owner. On the other hand, because creditors may only look to the assets of the disregarded entity in order to satisfy any claims, and not to the assets of the owner generally, the tax law may alternatively view the indebtedness as nonrecourse indebtedness of the owner. The difference in treatment is significant. Satisfaction of recourse indebtedness for an amount less than the principal amount of the indebtedness generally results in CODI. If certain requirements are met, CODI may be excluded from the owner's income if the owner is bankrupt or insolvent, although the price of such exclusion is a reduction of the debtor's tax attributes. Alternatively, satisfaction of nonrecourse indebtedness for an amount less than the principal amount of the indebtedness may in certain circumstances be treated as a sale of the collateral, resulting in gain rather than CODI.⁵ Although gain cannot be excluded under Section 108, gain may qualify for nonrecognition treatment where a transaction qualifies as a tax-free reorganization.

The Ruling illustrates the use of this principle. Although the Ruling does not indicate the dollar amounts at issue, the principles of the Ruling can be used to satisfy indebtedness to creditors without incurring CODI. Gain may be realized on the transaction to the debtors, but if the requirements are met to treat the transaction as a tax-free reorganization, the gain is not recognized. The end result is that no tax is owed by the creditors for settling their indebtedness for less than the face amount. Furthermore, because CODI is not applicable, tax attributes of the debtor are not reduced.

The issues addressed in the Ruling are similar to the transactions undertaken as part of a major bankruptcy for which a ruling was sought in 2016, part of which sought the same advice as that requested in the Ruling.⁶

Refresher in Info Letter 2020-0033: Short Sales Not UBTI

THE SHORT OF IT

On December 31, 2020, the IRS published Info Letter 2020-0033⁷ , confirming that, under certain circumstances, income of retirement plans that is attributable to a short sale of publicly traded stock through a broker is not subject to the unrelated business income tax under section 511 of the Code.⁸

Following, we summarize the applicable provisions of the Code relating to the taxation of unrelated business taxable income ("UBTI") and we briefly analyze the rulings that the IRS cited in Info Letter 2020-0033 in order to understand which income attributable to a short sale of publicly traded stock is excluded from UBTI.

UBTI – GENERAL BACKGROUND

Code section 511(a) imposes a tax on the UBTI of certain taxpayers that are otherwise exempt from federal income taxation under Code section 501(a).

Code section 512(a)(1) of the Code defines UBTI as gross income derived by any organization from any unrelated trade or business regularly carried on by it, less certain deductions which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in Code section 512(b). Section 512(b)(4) provides, in part, that UBTI includes certain income from "debt-financed property" as defined in Code section 514(b).

Footnotes

1 Including the 3.8% Medicare tax on investment income, the maximum federal income tax rate on long-term capital gains would be 43.4%. The maximum long-term capital gain rate would apply to individual taxpayers with incomes over $1 million.

2 See Vol. 03, Issue 1 and Vol. 3, Issue 2.

3 See Report to Congress on the Capital Gains Tax Reductions of 1978, US Treasury, Government Printing Office, Washington DC (1985). The report notes that the 49% maximum rate resulted from the combined effect of several Internal Revenue Code provisions.

4 For some interesting reading on legislative action and effective dates, see United States v. Carlton, 512 U.S. 26, at 30-31 (1994); Welch v Henry, 305 U.S. 134, at 146-147 (1931).

5 See Commissioner v. Tufts, 461 U.S. 300 (1983). Treas. Reg. section 1.1001-2(c), Ex. 7.

6 PLR 201644018.

7 INFO 2020-0033 (December 31, 2020).

8 All section references herein are to the Internal Revenue Code of 1986, as amended (the "Code")

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