Treasury Department Issues Final Regulations Clarifying Federal Income Tax Treatment of an Exchange of Partnership Debt for an Equity Interest in the Partnership
In recent years, the number of partnerships struggling with debt obligations has sharply increased. In many cases, the debtor partnership would offer the creditor an equity interest in the partnership in full or partial satisfaction of the debt. Several U.S. federal income tax consequences of such an equity-for-debt exchange had to be clarified. The IRS issued proposed regulations in 2008 providing guidance on the determination of cancellation of debt (COD) income recognized by a partnership that transfers a partnership interest to a creditor in satisfaction of the partnership’s debt.1 The proposed regulations also addressed the application of section 721 of the Internal Revenue Code of 1986, as amended (the “Code”) to a contribution of a partnership’s debt by a creditor to the partnership in exchange for an interest in the partnership. On November 15, 2011, the Treasury Department issued the final regulations (T.D. 9557), which make only slight modifications to the proposed regulations.
A. Guidance regarding the Interaction with Section 108(e)(8)
Section 108(e)(8) of the Code provides that for purposes of determining COD income, if a debtor corporation transfers stock or a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction of its recourse or nonrecourse debt, such corporation or partnership will be treated as having satisfied the debt with an amount equal to the fair market value of the stock or interest.2 In the case of a partnership, any COD income recognized will be included in the distributive shares of the partners in the partnership immediately before such discharge.
In general, the amount by which the debt exceeds the fair market value of the partnership interest transferred is the amount of COD income required to be included in the distributive shares of the partners. For this purpose, the final regulations provide that the fair market value of the partnership interest transferred to the creditor is the liquidation value of the partnership interest if three requirements3 are satisfied (the “Safe Harbor”).4
The three conditions for the Safe Harbor to apply are: (i) the creditor, the debtor partnership, and its partners must treat the fair market value of the debt as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the exchange (the “consistency requirement”); (ii) the debt-for-equity exchange must be an arm’s-length transaction (the “arm’s-length requirement”); and (iii) subsequent to the debt-for-equity exchange, neither the partnership redeems nor any person related to the partnership purchases the interest as part of a plan at the time of the debt-for-equity exchange which has as a principal purpose the avoidance of COD income by the partnership (the “anti-abuse provision”).5
The consistency requirement is intended to ensure consistent reporting by the creditor, the debtor partnership, and its partners. The amount of COD income computed under the Safe Harbor may differ from the amount computed using the fair market value of the partnership interest. Thus, in order for the partnership to use the Safe Harbor, the partnership and all of its partners must report consistently. The partnership must also apply a consistent valuation methodology to all equity issued in any debt-for-equity exchange that is part of the same overall transaction.
Under the arm’s-length requirement, as long as the debt-for-equity exchange has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests, this requirement is satisfied even if the transaction is between related parties.
The anti-abuse provision imposes a restriction on subsequent purchases of the equity interest by a person related to any partner (in addition to purchases by a person related to the partnership) as part of a tax-avoidance plan. Thus, the partnership cannot redeem and no person related to the partnership or to any partner can purchase the equity interest as part of a plan at the time of the debt-for-equity exchange that has as a principal purpose the avoidance of COD income by the partnership.6
The final regulations also address the application of the Safe Harbor rule to a partnership (upper-tier partnership) that directly or indirectly owns an interest in one or more partnerships (lower-tier partnership(s)). With respect to interests held in one or more lower-tier partnerships, the liquidation value of an interest in an upper-tier partnership is determined by taking into account the liquidation value of such lower-tier partnership interest. If the fair market value of the equity interest does not equal the fair market value of the debt exchanged, then general tax law principles shall apply to account for the difference.7
B. Application of Section 721 of the Code to Debt-for-Equity Exchanges
The regulations generally provide that the nonrecognition rule of section 721 of the Code applies to the debt-for-equity exchange. In general, the creditor does not recognize a loss or a bad debt deduction in the debt-for-equity exchange, and the creditor’s basis in the debt-for-equity interest is increased under section 722 of the Code by the adjusted basis of the debt.
C. Obligations for Unpaid Rent, Royalties, and Interest
In general, when property is transferred as payment on debt, the transferor of such property is required to recognize gain or loss. The final regulations clarify that in a debt-for-equity exchange, if the partnership is treated as satisfying its debt for unpaid rent, royalties, or interest on debt (including accrued original issue discount (OID))8 with a fractional interest in each asset of the partnership, the partnership could recognize gain or loss equal to the difference between the fair market value of each partial asset deemed transferred to the creditor and the adjusted basis in that partial asset. However, the final regulations clarify that a debtor partnership will not recognize gain or loss upon the transfer of a partnership interest to a creditor in a debt-for-equity exchange for unpaid rent, royalties, or interest (including OID) that accrued on or after the beginning of the creditor's holding period for the indebtedness.
D. COD Income as First-tier Item for Minimum Gain Chargeback Rules
Treas. Reg. § 1.704-2(f)(6) provides that any minimum gain chargeback required for a partnership taxable year consists first of certain gains recognized from the disposition of partnership property subject to one or more partnership nonrecourse liabilities and then, if necessary, of a pro rata portion of the partnership’s other items of income and gain for that year. A similar rule applies to chargebacks of partner nonrecourse debt minimum gain pursuant to Treas. Reg. §1.704-2(i)(4).
The final regulations clarify that COD income arising from a discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes under Treas. Reg. §§1.704-2(f)(6), 1.704-2(j)(2)(i)(A) and 1.704-2(j)(2)(ii)(A).
E. Disposition of Installment Obligations
Section 453B of the Code provides rules regarding dispositions of installment obligations. Generally, if an installment obligation of a taxpayer is satisfied at other than its face value or the taxpayer distributes, transmits, sells, or otherwise disposes of an installment obligation, the taxpayer recognizes any deferred gain or loss. However, Treas. Reg. §1.453-9(c)(2) provides that the contribution of an installment obligation to a partnership under section 721 of the Code, for example, does not constitute a disposition.
The Preamble to the final regulations provides that the IRS and the Treasury Department believe that this exception does not apply to a creditor who disposes of an installment obligation of a partnership by contributing it to the debtor partnership, even if the transaction qualifies under section 721 of the Code. In that case, the creditor must recognize gain or loss under section 453B of the Code.9 Accordingly, the Preamble to the final regulations provides that the IRS and Treasury Department are proposing regulations under section 453B of the Code to clarify this issue.
The final regulations provide needed guidance on certain U.S. federal consequences of a debtor partnership’s debt that is being exchanged for a partnership’s interest. Due to the increasing number of partnerships struggling with their debt, this guidance is timely and necessary.
1A notice of proposed rulemaking and a notice of public hearing (REG-164370-05, 2008-46 IRB 1157) were published in the Federal Register (73 FR 64903) on October 31, 2008.
2Section 108(e)(8) was amended by section 896 of the American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1648), to include discharges of partnership debt.
3The proposed regulations issued in 2008 offered four requirements, the first of which was the capital account maintenance requirement. In the final regulations, however, the IRS and the Treasury Department have decided to remove this requirement from the liquidation value safe harbor because the maintenance of capital accounts is not necessary to the determination of the liquidation value of the partner’s interest.
4For this purpose, liquidation value equals the amount of cash that the creditor would receive with respect to the debt-for-equity interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles) for cash equal to the fair market value of those assets, and then liquidated.
5If these requirements are not satisfied, all of the facts and circumstances are considered in determining the fair market value of the debt-for-equity interest for purposes of applying section 108(e)(8) of the Code.
6The regulations refer to sections 267(b) and 707(b) of the Code for the meaning of “related” in the anti-abuse provision.
7Moreover, section 707(a)(2)(A) of the Code, as it relates to the treatment of payments to partners for transfers of property, will be considered, if appropriate.
8These items generally give rise to ordinary income to the creditor and a deduction to the partnership.
9This treatment is consistent with the corporate rules that require a creditor to recognize gain or loss under section 453B of the Code on the disposition of an installment obligation of a corporation to the debtor corporation in a transaction that qualifies under section 351 of the Code. Rev. Rul. 73-423, 1973-2 CB 161.