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Debt discharge guidance issued.

Regulations were proposed on Mar. 22, 1991 to interpret Sec. 108(e)(4), which had been enacted in the Bankruptcy Tax Act of 1980 to prevent taxpayers from avoiding discharge of debt through purchase of the debt by a related party. When a person related to the debtor directly or indirectly acquires outstanding indebtedness from a person unrelated to the debtor, the debtor must recognize income from the discharge of indebtedness, to the extent required by Secs. 61(a)(12) and 108. Any income recognized is measured by reference to the fair market value (FMV) of the indebtedness on the acquisition date. A related person is generally defined as a person related within the meaning of Sec. 267(b) or 707(b)(1), as well as members of a controlled group of corporations.

The proposed regulations define an indirect acquisition as a transaction in which a holder of outstanding indebtedness becomes related to the debtor, if the holder acquired the indebtedness in anticipation of becoming related to the debtor. The holder is considered to have acquired the debt in anticipation of becoming related if (1) the indebtedness was acquired less than six months before the relationship is created or (2) on the date the holder becomes related to the debtor, the debtor's indebtedness represents more than 25% of the total gross assets (not including cash and certain short-term investments) of the holder or holder group.

An acquisition in anticipation of a relationship is presumed if the holder acquired the debt more than six but less than 24 months before the relationship is created; however, the taxpayer may rebut this presumption. The holder is treated as if it sold the indebtedness to an unrelated party on the day before the acquisition date. As a result, the holder's basis in the debt is the debt's FMV on the acquisition date.

If a debtor realizes income from the discharge of indebtedness under these rules (regardless of any exclusion under Sec. 108(a)), the debtor is treated as having issued new debt to the related holder on the acquisition date with an issue price equal to the FMV of the debt on that date. Any difference between this deemed issue price and the stated redemption value at maturity is treated as original issue discount.

The proposed regulations apply to transactions occurring on or after Mar. 21, 1991. There is an exception for indebtedness with a stated maturity date less than one year after the acquisition date, if the debt is actually retired on or before the stated maturity date. An exception also exists for certain acquisitions by security dealers in the ordinary course of business.

Voluntary debt restructuring transactions were facilitated by the publication of Rev. Rul. 91-31 and release of proposed amendments to the Sec. 1274 and 1275 regulations on May 7, 1991. Rev. Rul. 91-31 provides that the reduction in the principal amount of an undersecured nonrecourse debt by the debt holder, who is not the seller of the property securing the debt, results in debt discharge income under Sec. 61(a)(12). Typically, the ruling applies to a third-party lender who financed the purchase or construction of the property by the debtor.

Before the ruling was issued, some tax advisers feared that renegotiation of a debt principal balance could be a taxable exchange with Sec. 1001 consequences. Debt discharge treatment under Sec. 61(a)(12) means that the exclusions in Sec. 108(a)(1) are available if the discharge occurs when the debtor is insolvent or in a bankruptcy proceeding. Insolvent for this purpose means the excess of debt over the FMV of the taxpayer's assets, excluding assets that are "exempt property" protected under the bankruptcy laws.

The proposed amendments to the Sec. 1274 and 1275 regulations clarify that a modification of an outstanding debt instrument is not a "situation involving nonrecourse financing," which could result in the principal amount being treated as lower than the stated amount, even if the stated interest rate is at least equal to the adjusted federal rate (AFR). In such a case the issue price of the renegotiated instrument could not exceed the FMV of the property securing the debt.

Before this favorable guidance was issued in May, many practitioners believed that debt discharge treatment, with the potential Sec. 108 exclusion, could not be obtained for nonrecourse debt. They reasoned that Rev. Rul. 90-16 and IRS Letter Ruling 8735065 only permitted bifurcation of recourse debt in order to obtain Sec. 61(a)(12) treatment and the resulting Sec. 108(a) exclusions.
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Author:Buehler, Alan S.
Publication:The Tax Adviser
Date:Jan 1, 1992
Words:756
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