Partner loans: traps for the unwary.
When a partnership terminates, either because one partner purchased all the interests of the partnership or because all but one partner is redeemed, the partnership is deemed to distribute a portion of all its assets and liabilities to the remaining partner in liquidation of the partnership. Letter Ruling 200222026 provides that if a partnership has an outstanding partner loan on the termination date, the termination causes the debtor-creditor relationship to be merged and, as a result, the debt is extinguished. The partnership is viewed as transferring its assets to the creditor-partner in satisfaction of the debt. This treatment may create tax problems for the creditor-partner, but proper tax planning may be able to mitigate them.
Gain recognition and COD income: According to the letter ruling, the partnership is viewed as making a taxable transfer of its assets to the partner in satisfaction of the debt, rather than a nontaxable distribution. The partnership recognizes gain to the extent the amount realized exceeds the partnership's basis in the assets transferred.
The partnership also may have cancellation of indebtedness (COD) income, depending on whether the partner loan is recourse or nonrecourse. Under the partnership allocation rules, the COD income should be allocated to the partners who received the benefits of the deductions funded by the cancelled debt. In many cases, the deductions would have been allocated to the creditor-partner, so the COD income should be allocated to the creditor-partner. But to ensure the COD income is properly allocated, prior-year tax returns should be reviewed to determine who received the benefit of the deductions.
The partners will not be able to exclude their share of the COD income if they are solvent, even though the partnership may be insolvent. The Sec. 108(a) insolvency exclusion applies only when the partner is insolvent (i.e., when the partner has liabilities that exceed the fair market value (FMV) of his or her assets, excluding the interest in the terminated partnership).
Disallowed loss: If the partnership has any assets with a value less than tax basis, the partnership would recognize a loss on the transfer of those assets to the creditor-partner. Generally, the loss would be allocated to all the partners based on the manner in which the partners agreed to share losses under the partnership agreement. The loss would be deductible and would reduce the partners' bases in their partnership interests. However, if the creditor-partner owns more than 50% of the partnership, the partnership's loss could be disallowed under Sec. 707(b).
The letter ruling specifies how to treat the partnership, but it does not address how to treat the creditor-partner or the other departing partners. Here are some partner-level issues to consider.
Character mismatch: Under Sec. 1271(a)(1), the retirement of a debt may be treated as a sale or exchange of the debt for purposes of determining the tax consequences to the lender. For tax purposes, the receipt of partnership assets by the creditor-partner in cancellation of the loan may be viewed as a payment in "retirement" of the debt instrument. Because the letter ruling does not discuss the tax consequences to the creditor-partner, it is unclear whether Sec. 1271 applies to the cancellation of a partner loan. If Sec. 1271 applies, the creditor-partner would recognize a capital loss equal to the amount by which that partner's basis in the loan exceeds the value of the assets received from the partnership. The partner could not offset this loss against any COD income reported on his or her Schedule K-1. The loss could be permanently disallowed if the partner does not have enough capital gain to offset the capital loss before the expiration of the carryforward period.
Depreciation of acquired assets: The partnership termination should be viewed as partly taxable and partly nontaxable if the value of the partnership's net assets exceeds the balance of the partner loan. The transfer of assets to the creditor-partner should be viewed as a taxable transfer of assets in an amount equal to the balance of the loan. The partnership should be viewed as making a distribution of partnership assets and liabilities, to the extent the FMV of the partnership's net assets exceeds the balance of the loan.
In this case, the creditor-partner should have a blended basis in each asset received from the partnership. That partner would take a FMV basis in the assets received in cancellation of the debt, and a substituted basis in the distributed assets (assuming that the Sec. 707 disguised sale rules, the Secs. 704(c)(1)(B) and 737 "mixing bowl" rules and Sec. 751(b) do not apply).To compute depreciation deductions going forward, the creditor-partner will need to know which portion of each asset was acquired in a taxable exchange and which portion was acquired in the nontaxable distribution. This analysis is complex, particularly when no asset-by-asset appraisal is performed in connection with the partnership termination.
Permanently suspended losses and disappearing depreciable basis: As discussed, if any of the transferred assets have a built-in loss and the creditor-partner is related to the partnership, the loss could be disallowed at the partnership level. Any loss allocated to the departing partners would likely be disallowed permanently. Any loss allocated to the creditor-partner may be permanently disallowed too, if the creditor-partner does not sell the assets to an unrelated person for a gain. Because the disallowed loss reduces the partners' bases in their partnership interests, the partners cannot claim the loss on the liquidation of their interests, and the creditor-partner cannot recover the loss through a higher substituted basis in the distributed assets.
Tax Planning Before Termination
The effect of the termination on the partners, particularly the creditor-partner, should be analyzed well before the partnership termination, to avoid any unintended tax consequences. The creditor-partner may avoid gain recognition and COD income by making a tax-free transfer of his or her partnership interest or loan receivable to another taxpayer before the termination. A merger of the debtor-creditor relationship occurs only if the same taxpayer holds the receivable and the interest in the partnership. If the partnership interest or the receivable is transferred to another taxpayer before the termination, the tax treatment specified in the letter ruling should not apply. Alternatively, the creditor-partner could convert the loan to equity as far in advance of the termination as possible. However, if the partnership is insolvent, COD income could be triggered at that time under Sec. 108(e)(8).
The creditor-partner may avoid Sec. 1271 capital loss treatment on the loan receivable by writing down the debt in advance of the termination. The partial bad-debt deduction would be treated as an ordinary loss under Sec. 166. This loss reduces the creditor-partner's basis in the loan, so when the partnership terminates, that partner's loss on the loan would be limited to the excess of the basis he or she has in the loan at that time over the FMV of the assets received in satisfaction of the debt.
FROM GRETCHEN FOLEY, CPA, WASHINGTON, DC
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|Publication:||The Tax Adviser|
|Date:||Jul 1, 2006|
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