Treatment of COD income under secs. 704 and 752.
Rev. Rul. 92-97 held that a deemed cash distribution under Sec. 752(b) (through a reduction in a partner's share of a partnership liability), if integrally related to cancellation of debt (COD) income, will be treated as occurring at the end of the partnership tax year in determining whether gain is recognized under Sec. 731(a). Therefore, in most situations, no gain will be recognized, since the basis increase caused by allocating the COD income at the end of the tax year will offset the deemed cash distribution under Sec. 752(b). However, this will not always be the case, as indicated in the ruling's situation 2.
(This ruling is also discussed in the Tax Trends item, "Allocation of Partnership's COD Income May Have Substantial Economic Effect," TTA, Feb. 1993, at 137, and noted in the Tax Clinic item, "Tax Consequences in Partnership Debt Restructuring," TTA, Apr. 1993, at 245.)
Although the issue addressed in Rev. Rul. 92-97 deals with determining substantial economic effect under Sec. 704(b), in arriving at its conclusion the ruling expanded the scope of Regs. Sec. 1,731-1(a)(1)(ii), which states that advances or drawings of money or property against a partner's distributive share of income are treated as current distributions made on the last day of the partnership's tax year.
Since the COD income was integrally related to the Sec. 752(b) deemed cash distribution, the IRS reasoned that the deemed cash distribution was in the nature of an advance or draw against the COD income to be recognized at year-end, and thus was considered to be made on the last day of the partnership's tax year. Although one might argue that the Service "stretched" to make this conclusion, it is certainly a most reasonable result.
Rev. Rul. 92-97
A and B formed a partnership in which A contributed $10 and B contributed $90. They then borrowed $900 from a bank on a recourse basis and purchased property for $1,000. Only interest was due on the loan; the principal was all due and payable in six years. Other than depreciation, revenues equaled expenses. Depreciation deductions were $200 a year. Consequently, at the end of five years, the property was fully depreciated. A and B agreed that losses would be shared 10% by A and 90% by B. However, profits would be shared equally (that is, profits did not first offset prior loss allocations). In the beginning of year 6, as a result of a substantial decline in the property's value, the lender agreed to discharge the debt in full as part of a workout arrangement. As a result, there was $900 COD income.
Deficit restoration obligations
The ruling posed two situations. In both, the partnership agreement satisfied the requirements that capital accounts be maintained under the Sec. 704(b) regulations and that, on liquidation of the partnership or of a partner's interest, distributions would be made in accordance with the partners' positive capital account balances. However, in situations 1, in lieu of an unconditional deficit restoration obligation, the partnership agreement satisfied the alternate test for economic effect. Under this test:
* The losses charged to a partner's capital account (as adjusted for this purpose by the Sec. 704(b) regulations) cannot create or increase a deficit exceeding the partner's limited obligation, if any, to restore such deficit.
* The partnership agreement must contain a qualified income offset (QIO), which requires gross or net income allocations to the extent a partner's capital account unexpectedly becomes impermissibly negative.
On the other hand, in situation 2, the partnership agreement contained an unconditional deficit restoration obligation.
Thus, in both situations, the partnership agreement complied with the economic effect safe harbor provided by the Sec. 704(b) regulations.
Rev. Rul. 92-97 did not address whether the economic effect was substantial, as required by Sec. 704(b). Instead, the ruling stated that substantiality must be independently established.
Situation 1: reallocation required. The partnership had $900 of COD income in year 6 (other revenue still equaled other expenses). Under the partnership agreement, this amount was allocable $450 each to A and B. This meant that A's capital account would have a positive $360 balance and B's capital account would have a negative $360 balance.
Before the $900 debt was cancelled, B had (under the Sec. 752 regulations) an $810 share of the debt (90% x $900). Since B was fully liable for that amount if the partnership assets were insufficient, B's $810. negative capital account was fully supported by this limited obligation to contribute. However, once that debt was discharged, B's local law obligation to contribute was eliminated. Therefore, B's limited obligation to contribute under the economic effect alternate test became zero, causing B's capital account to become impermissibly negative.
In addition, an allocation to A creating a positive capital account would give A more income than he would be entitled to; if the partnership were terminated at the end of year 6 at net book value, A would receive nothing, since B was not obligated to restore his $360 deficit capital account to satisfy A's $360 positive capital account.
Thus, the ruling concluded that the allocation of the COD income in accordance with the partnership agreement lacked economic effect under Sec. 704(b). Therefore, the COD income had to be reallocated to A and B in accordance with the partners' interests in the partnership, which was 10% to A and 90% to B.
Could the ruling have reached the same result by applying the QIO? Probably not, since the QIO rules require that the QIO applies only if capital accounts become impermissibly negative as a result of certain unexpected distributions, required allocations or adjustments for depletion allowances.
Of course, in this situation, B's capital account became impermissibly negative due to an insufficient income allocation.
Situation 2: reallocation not required. Because of the unconditional deficit restoration obligation, the allocations under the partnership agreement of $450 to both A and B had economic effect. B had the obligation to restore his negative $360 capital account balance to repay A's positive $360 capital account balance if the partnership were to liquidate at net book value at the end of year 6.
Would the ruling's conclusions have been different if the $900 debt were nonrecourse? It appears not.
If A and B wished to allocate losses (including nonrecourse deductions), 10% to A and 90% to B and profits equally, the partnership agreement should have contained provisions that satisfied the safe harbor for allocating nonrecourse deductions. Since non-recourse deductions do not have economic effect, the only assurance that such allocations will be respected under Sec. 704(b) would be to meet this safe harbor. One safe harbor requirement is the minimum gain chargeback; in the event of a decrease in the partnership's minimum gain, items of income and gain (including gross income, if necessary) must be allocated before any other allocations to the partners in an amount equal to their share of the net decrease in partnership minimum gain.
Minimum gain safe harbor
In this new situation, the first $100 of deductions (equal to the capital contributions) would be considered recourse deductions and, under the partnership agreement, would be allocated 10% to A and 90% to B. The additional $900 of deductions would be non-recourse deductions as listed in the chart above.
In accordance with the partnership agreement, these deductions also would be allocated 10% to A and 90% to B. Thus, both A's $90 negative capital account and B's $810 negative capital account would be supported with their respective shares of the partnership's $900 minimum gain at the end of year 5.
At the end of year 6, the partnership's minimum gain would be $0. Since, at the end of the preceding tax year, the minimum gain was $900, in year 6 there would be a decrease in partnership minimum gain of $900; under the minimum gain charge-back requirement, items of income and gain (including gross income, if necessary) would first have to be allocated $90 to A and $810 to B before any other partnership agreement allocations were made. Therefore, the $900 COD income would be allocated 10% to A and 90% to B.
This allocation would be deemed to be in accordance with the partners' interest in the partnership. Accordingly, the deemed cash distribution early in the year under Sec.752(b) should be "integrally related" to the COD income and thus should be treated as occurring on the last day of the partnership tax year.
End Nonrecourse Property's Minimum of debt adjusted gain year balance basis increase 1 $900 $800 $100 2 900 600 200 3 900 400 200 4 900 200 200 5 900 0 200 Total $900
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|Title Annotation:||cancellation of debt|
|Author:||Kipper, Richard N.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1993|
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