Tax consequences in partnership debt restructuring.

In determining the Federal income tax consequences of any debt restructuring, a four-step approach generally should be used.

1. Determine whether or not there has been a reduction or modification of debt, thereby raising the possibility of cancellation of indebtedness (COD) income.

2. Determine the applicability of existing statutory or judicial nonrealization rules.

3. Determine the applicability of the exclusion rules of Sec. 108(a)(1).

4. Determine the "cost" of any Sec. 108(a)(1) exclusion.

In applying these steps to partnerships, it should be noted that, under Sec. 703(a), a partnership is treated as an entity for purposes of computing its taxable income. Although COD income resulting from the discharge or modification of a partnership liability is recognized at the partnership level, the nonrealization rules may apply at either the partnership or partner level. The exclusion of any COD income recognized by the partnership is determined at the partner level, as is the cost of the exclusion. Further, the effects of Secs. 731 and 752(b) must be considered. Under Sec. 752, the reduction in a partner's share of partnership liabilities is treated as a deemed distribution of money to the partner. If a distribution (actual or deemed) exceeds a partner's basis, gain is recognized under Sec. 731. Should the reduction of debt be treated as COD income (all or a part of which might be excluded), the Sec. 752(b) basis reduction would generally be offset by the increased basis from the recognition of COD income.

When a lender modifies or discharges all or a portion of a partnership liability, COD income is recognized at the partnership level and generally is allocated to each partner in accordance with the partnership agreement, which may or may not correspond to the manner in which the underlying debt was shared among the partners. Under Sec. 702(a)(7) and (b), the COD income allocated to a partner retains its character as ordinary income. However, Sec. 704(b) may require a deviation from the partnership agreement if the allocations in the agreement do not have substantial economic effect or are not in accordance (or deemed in accordance) with the partners' partnership interests.

In that regard, any special allocation must be examined in light of Sec. 704(b). The allocation must have economic effect and the economic effect must be substantial, as per Regs. Sec. 1.704-1(b)(ii). Thus, the partner to whom the COD income is allocated must realize the economic benefit of such allocation. The general rule for economic effect requires that (1) proper capital accounts be maintained, (2) liquidating distributions be made in accordance with positive capital account balances and (3) a partner have a deficit restoration obligation (DRO), generally obligating the partner to restore any deficit capital account balance on the liquidation of the partnership. The partner can avoid the DRO but, in that case, generally cannot be allocated losses, to the extent the allocation would create a deficit capital account balance in excess of the amount the partner is obligated (or deemed obligated) to restore. hi Rev. Rul. 92-97, the IRS held that a special allocation of COD income would have economic effect as long as, among other things, DROs covering any negative capital account balances resulting from such allocation could be invoked to satisfy other partners' positive capital account balances.

With respect to the allocation of deductions attributable to nonrecourse debt, the Sec. 704(b) regulations provide detailed rules that must be satisfied in order for those allocations to be respected as in accordance with the partners' interests in the partnership. For example, on the forgiveness of nonrecourse debt, the minimum gain charge-back rules of Regs. Sec. 1.704-2(f) may require that income or gain be allocated to certain partners. Generally, the allocation of COD income or gain pursuant to such a chargeback will mirror the allocation of the underlying debt.

If there is debt reduction or modification that is not eligible for the nonrealization rules, the partners will increase the bases of their partnership interests under Sec. 705(a) by their distributive shares of partnership income or gain for the year. That increase, which operates notwithstanding the excludability of the COD income, flows out to the partners on the last day of the partnership's tax year under Sec. 706(a). That increase in basis generally will be offset by the amount of debt reduction under Sec. 752(b). In a straight-up partnership, each partner's basis increase and basis decrease generally will offset each other. If, however, the partners' income-sharing ratio differs from the liability-sharing ratio for the relieved debt, unanticipated results could arise, particularly because of Sec. 731. Under Sec. 731(a), a partner recognizes gain to the extent of any actual or deemed distribution of money in excess of basis. Because gain recognized under Sec. 731 is not COD income, the rules of Sec. 108 do not allow the partner to exclude the gain from income.

It is uncertain to what extent the cancellation of contingent debt generates COD income. In Hunt, TC Memo 1990-248, the Tax Court held that the relief of contingent debt did not give rise to COD income. Open to question is the degree to which a liability must be contingent in order to avoid COD income, as well as the determination of when a contingent debt ripens to a full-blown liability.

If partners are jointly and severally liable for a partnership's liabilities, relief of a liability with respect to one partner (e.g., on a discharge in bankruptcy) should not give rise to COD income, since the debtor (the partnership) is still obligated on the debt. However, the liability would need to be reallocated among the partners under Sec. 752.

In effect, the debt is converted from recourse to nonrecourse with respect to the bankrupt partner. As a result of this "conversion" and the resultant shift in liabilities away from him to the other partners, gain will be recognized under Sec. 731 if the shift exceeds the relieved partner's outside basis. On any decrease in indebtedness, there will be a Sec. 752(b) deemed distribution (lowering basis), potential income (increasing basis) and potential Sec. 731 gain.

Although it is not always clear when COD income is generated, a few general rules can be noted. A transfer of property subject to a debt will cause COD income (if at all) at the time of the transfer. Nonproperty transfer cancellations of debt should occur when affirmative acts have taken place that fix the write-off The debtor's state of insolvency or bankruptcy should not constitute the triggering event. Therefore, the debtor's lack of ability to repay a liability should not, by itself, trigger COD income. However, when it becomes clear that a debt will never have to be repaid, COD income should arise.

In connection with partnerships, COD income generated by a partnership should flow through to its partners on the last day of the year (not on the date of cancellation), although the determination of partner insolvency (for purposes of the exclusion rules discussed later) should be made as of the date of the forgiveness.

It is important to distinguish between COD income and gain recognized on the disposition of property. Gain or loss from the disposition of property is not eligible for the exclusion or nonrealization rules. if encumbered property is disposed of, however, a portion of the transaction may be treated as creating COD income and a portion as creating either gain or loss from the property disposition. Generally, ff the debt is nonrecourse and the property is transferred with the debt, the amount of liability relief is an amount realized, thereby generating Sec. 1001 gain or loss. A bifurcation approach is employed if the debt is recourse.

Not all debt discharges or modifications result in COD income. Under Sec. 108(e)(2), no COD income will be realized on the cancellation or modification of a liability to the extent payment of the debt would have given rise to a deduction. If Sec. 108(e)(5) applies, no COD income will be recognized by the debtor; rather, the reduction will generally require an offset to the basis of the debtor's property under the purchase price adjustment rules.

In Rev. Proc. 92-92, the Service held that it would not challenge a partnership's treatment of a reduction of debt as a purchase price adjustment under Sec. 108(e)(5) regardless of the partnership's insolvency or bankruptcy, as long as no partner adopted a Federal income tax reporting position inconsistent with the partnership treatment and the other requirements of Sec. 108(e)(5) were satisfied.

The IRS appears to be willing to apply this requirement in a somewhat relaxed fashion. In Letter Ruling 9037033, the Service concluded that the purchase price adjustment rule of Sec. 108(e)(5) applied to an individual who purchased and immediately contributed assets to a wholly owned corporation.

If a debt reduction/modification is not eligible for any nonrealization rule, the exclusion rules should be reviewed for applicability. Generally, COD income can be excluded under Secs. 108 and 1017 if the debtor is able to satisfy one of three exclusion rules. 1. The debtor is insolvent; 2. The debtor is in bankruptcy; or 3. The property constitutes qualified farm indebtedness.

In applying these rules, the determination of insolvency or bankruptcy is made at the partner level. Pursuant to Sec. 108(e)(1), the insolvency exception of Sec. 108(a)(1)(b) is the exclusive insolvency exception on which taxpayers can rely.

Note that the pre-1980 case law should still be considered relevant to the definition of insolvency. See, e.g., Letter Ruling 9125010, in which the IRS noted that "the cases establishing the judicial insolvency exception provide meaningful guidance" in determining insolvency.

If the debtor is insolvent at the time of the debt reduction, COD income is excluded to the extent of insolvency. The definition of insolvency, contained in Sec. 108(d)(3), is "the excess of liabilities over the fair market value of assets." This determination is based on the assets and liabilities held immediately before the discharge.

Presumably, partners should look to their insolvency as of the date of the reduction, in accordance with Sec. 108(d)(3), rather than on the last day of the partnership's tax year when the income flows through to the partners under Sec. 706(a). The definition of liability, contained in Sec. 108(d)(1), is any indebtedness "for which the taxpayer is liable" and any indebtedness "subject to which the taxpayer holds property." The broad definition of liability could be read to encompass all recourse and nonrecourse debt, including debt indirectly allocated through a partnership, without regard to the value of any property securing the debt. However, in Rev. Rul. 92-53, the Service held that nonrecourse debt in excess of the value of property securing the debt is taken into account only to the extent the excess nonrecourse debt is discharged.

Despite the seemingly straightforward definition of insolvency, in practice the insolvency determination can be difficult to make and highly theoretical. Owing in part, to a lack of guidance, unanswered questions remain. These issues are particularly acute for partnerships. Therefore, debtor partnerships and partners should consider obtaining appraisals to support their claims of insolvency.

Although tax attributes should not be considered in computing the value of assets, goodwill should be included. Assets that are exempt from creditors' claims for state law purposes are not to be included in determining whether liabilities exceed fair market value.

If the debtor is in a Title 11 case, all COD income is excluded, regardless of insolvency. A "Title 11 case" is defined as a case under Title 11 of the United States Code, but only if the taxpayer is under the jurisdiction of the court in the case and the discharge is granted by the court or is pursuant to a plan approved by the court. Note that included in Title 11 are Chapter 7 (liquidation) and Chapter 11 (reorganization) cases. The bankruptcy exception takes precedence over the insolvency exception. In the partnership context, the bankruptcy exclusion applies only if the partner is bankrupt.

A partnership Title 11 filing will not bestow the benefits of Sec. 108 on the partnership; Sec. 108(d)(6) provides that the rules of Sec. 108(a), (b) and (g) are to apply at the partner level, making a partnership bankruptcy irrelevant.

If the debt discharged is qualified farm indebtedness (QFI), the exclusion under Sec. 108(a)(1)(c) is limited to the sum of the taxpayer's "adjusted tax attributes" and the basis of the taxpayer's trade or business and income property. QFI must have been incurred in connection with a farming trade or business, with at least half of the taxpayer's gross receipts for the three prior years attributable to the trade or business of farming.

Assuming that a reduction of debt can be excluded under the insolvency, bankruptcy or QFI rules, the price of such exclusion must be ascertained. Generally, the cost is the reduction of the partners' tax attributes by the amount of excluded COD income. Sec. 108(b)(2) provides that, unless an election under Sec. 108(b)(5) is made, the reduction is to be made "in the following tax attributes in the following order": * Net operating losses (NOLs) (dollar for dollar). * General business credit carryovers (33 1/3 cents on the dollar). * Capital loss carryovers (dollar for dollar). * Basis reduction in assets (dollar for dollar). * Foreign tax credit carryovers (33 1/3 cents on the dollar).

Amounts suspended under the passive loss, investment interest expense and at-risk rules are not included in the list of tax attributes in Sec. 108(b)(2) i.e., they do not comprise any part of NOLs or basis), and therefore technically are not subject to reduction.

Under Sec. 108(b)(4), attribute reductions are to be made after the determination of tax imposed for the year of discharge. If insufficient attributes exist, the COD income can be excluded without cost.

In the absence of a Sec. 108(b)(5) election, the basis attribution reduction is of both depreciable and nondepreciable property and is limited (under Sec. 10 1 7(b)(2)) to the excess of the aggregate of the bases of the taxpayer's property immediately after discharge over the aggregate of the taxpayer's liabilities immediately after discharge.

Note that, with regard to partnership interests, the Code is silent as to whether the basis reduction is to be made to the inside basis, the outside basis, or both.

Notwithstanding these rules, debtors can elect to reduce the basis of depreciable property under Sec. 108(b)(5) before reducing other attributes. The election generally is due on the taxpayer's return (Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness) for the year of discharge or at some other regulatorily prescribed time; is revocable only with IRS consent; is made at the partner level; and can be made as to all or part of the reduction. If the Sec. 108(b)(5) election is made, the postdischarge basis over liability limitation of Sec. 1017(b)(2) does not apply.

Generally, an election under Sec. 108(b)(5) will be made if the debtor anticipates income in the near future and wishes to preserve NOLS and other attributes and when the limitation of Sec. 1017(b)(2) would not apply.

The Code provides that a partner's interest in a partnership is treated as depreciable property only to the extent of the partner's interest in the partnership's depreciable property. However, this rule applies only if there is a corresponding decrease in the partnership's basis in depreciable property with respect to such partner. In making the requisite reduction, the principles of Sec. 754 are to be used to reduce basis, as if Sec. 743 applied.

This reduction requirement might allow a partner some flexibility in "picking and choosing" the assets to which the reduction will apply. For example, a partnership controlled by the debtor-partner (or with respect to which the partner is on friendly terms) might "agree" to make the reduction only for certain partnership property, presumably those assets that will not be sold in the near future.