Allocating COD income.

Facts: Fred contributes $10,000 and Ethel contributes $90,000 to form The Mertz Company, a general partnership holding rental property. Fred and Ethel allocate the partnership's losses, 10% and 90%, respectively. They share the partnership's income 50% each (income allocations do not first restore previous losses). Mertz maintains capital accounts in accordance with the regulations. Fred and Ethel agree to liquidate according to positive capital account balances. Under state law, Fred and Ethel are jointly and severally liable to creditors for all partnership recourse liabilities. Fred and Ethel do not agree to unconditional deficit restoration obligations; they are obligated to restore deficit capital accounts only to the extent necessary to pay creditors. Fred and Ethel have agreed to a qualified income offset and are treated as having a limited obligation to restore deficit capital accounts by reason of their liability to Mertz's creditors. * Mertz purchased apartment buildings for $1 million from an unrelated seller, paying $100,000 in cash and borrowing $900,000 from a bank (that is not the seller of the property).The note is a general Mertz obligation, and neither partner has been relieved of personal liability. The note is payable over six years, with interest due semi-annually. Fred and Ethel bear an economic risk of loss equal to $90,000 and $810,000, respectively, for the partnership's $900,000 recourse liability. They increase basis in their partnership interests accordingly. * In each of its first five tax years, Mertz had a net loss of $200,000. At the beginning of the sixth year, the fair market value (FMV) of the properties substantially declined. The creditor cancels the debt as part of a workout arrangement. Issue: What effect will the partnership's cancellation of debt (COD) income have on Fred and Ethel?

Analysis

Sec. 108(a) allows for the exclusion of COD income from gross income under certain conditions. The discharge of a partnership debt is recognized as income and allocated to the partners as a separately stated item. The Sec. 108 exclusion is applied at the partner level for any COD income. The partners must determine (based on their own circumstances) if all or part of their distributive shares of the COD income can be excluded from their gross incomes under Sec. 108(a).

If an allocation of a partnership's COD income is made to a partner and it has substantial economic effect, the partner increases his outside basis in his partnership interest. The partner will also receive a capital account increase.

Economic effect requires an allocation to be consistent with the partner's underlying arrangement. The safe harbor for establishing economic effect requires partners to maintain capital accounts according to Regs. Sec. 1.704-1 (b)(2)(iv) and liquidate according to positive capital account balances. Any partner with a deficit capital account must either agree to an unconditional deficit restoration obligation or satisfy the requirements of the alternate test for economic effect. The alternate test requires that the partnership agreement contain a"qualified income offset."

Allocations provided for in the partnership agreement will be respected if they have substantial economic effect. If the allocations fail to meet these requirements, they will be reallocated according to the partner's interests in the partnership.

In year 6, the partners' capital account balances are:

                              Fred       Ethel

Initial contribution        $ 10,000     90,000
Loss incurred
  years 1-5                 (100,000)   (900,000)
Balance at beginning
  of Year 6                  (90,000)   (810,000)
Allocation of Sec. 108
  income according to the
  partnership agreement      450,000     450,000
Capital balance
  after COD                 $360,000   $(360,000)

The allocation of losses during the first five years meets the economic effect requirements. In year 6, the $900,000 recourse liability is cancelled. The partnership recognizes $900,000 of COD income that must be allocated to Fred and Ethel as a separately stated item.

The partnership agreement provides for income to be allocated equally between Fred and Ethel. However, the allocation of $450,000 of the COD income to each of them does not have substantial economic effect. The cancellation of the debt eliminates both partners' obligations to restore a deficit capital account. Because the deficit restoration obligations were dependent on the cancelled debt, Fred and Ethel are not able to enjoy the economic benefit or bear the burden of an allocation of COD income exceeding $90,000 or $810,000, respectively.

Conclusion

For the partnership's allocations to have economic effect, the COD income must be allocated $90,000 to Fred and $810,000 to Ethel. This is the same as the decrease in the partners' shares of partnership liability.

Fred and Ethel receive a deemed distribution equal to $90,000 and $810,000, respectively, because of the decrease in the liability when the debt was cancelled. Fred and Ethel reduce their outside bases (but not below zero) by $90,000 and $810,000, respectively. Under the regulations, the deemed distribution occurs at the end of the partnership's tax year. Thus, Fred and Ethel have basis and no gain is recognized from the deemed distribution.

Variation

If Fred and Ethel agreed to unconditional deficit restoration obligations, they would have an obligation to restore deficit capital accounts not only to pay creditors, but also to satisfy the other partner's positive capital account balance on liquidation. In that case, the allocation of the COD income of $450,000 to Fred and Ethel would have economic effect and would, therefore, meet the substantial economic effect safe harbor (if substantiality is independently established).

Ethel would be obligated to contribute $360,000 to satisfy Fred's $360,000 positive capital account. She also would recognize a capital gain of $360,000 from the deemed distribution of $810,000 discharged partnership liability. Fred would have an outside basis of $360,000 and would not recognize any gain.

Editor's note: This case study has been adopted from "PPC Tax Planning Guide--Partnerships," 13th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1999.

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA