New Regulations Under Section 108(e)(8); Creditor's Contribution of Debt to Debtor Partnership In Exchange For Equity Interest
Last November 17th, the Treasury and the Service issued final regulations (TD 9557) concerning the tax impact of a contribution of partnership indebtedness to a partnership in exchange for an interest in the partnership. These Regulations, effective for debt-for-equity exchanges occurring after 11/16/11, implement changes in Section 108(e)(8) that were adopted by Congress in the American Jobs Creation Act of 2004 (AJCA). Proposed Regulations had been issued on the subject in October 2008.
Section 108(e)(8) provides that where an outstanding indebtedness is satisfied by a partnership interest (capital or profits interests) of the debtor-partnership (or stock of the debtor corporation) to a creditor in satisfaction of a recourse or nonrecourse debt, the partnership (corporation) is retreated as having satisfied the debt for an amount of money equal to the FMV of the partnership interest (or stock). For partnerships, the amount of COD income recognized under Section 108(e)(b) must be included in the distributive shares of the taxpayers which were partners in the partnership immediately before the discharge. See Section 108(e)(6)(debt contributed to capital by shareholders). See also Rev. Rul. 91-31, 1991-1 C.B. 19 (cancellation of recourse versus nonrecourse debt). The legislative history under AJCA provides that Section 108(e)(8) applies to an exchange of debt for a partnership interest whether the liability is recourse or nonrecourse.
Final Regulations: General Rule
The general rule previously recited under Section 108(e)(8) is repeated under Treas Reg. §1.108-8(a). Under Treas. Reg. § 1.108-8(b)(1) the FMV of a partnership interest transferred by a debtor partnership to a creditor in satisfaction of the partnership's indebtedness (a debt-for-equity exchange) is determined by taking into consideration all of the facts and circumstances. A safe harbor contained in Treas. Reg. §1.108-8(b)(2)(i) provides that FMV will be the liquidation value of the partnership interest if certain conditions are met; (i) the creditor, the debtor partnership, and its partners treat the FMV of the indebtedness as being equal to the liquidation value of the interest for purposes of determining the tax consequences of the exchange; (ii) the debtor partnership transfers more than one equity interest to a creditor in exchange for debt, then each creditor, the partnership and its partners treat the FMV of each such interest transferred by the partnership to such creditors as equal to its liquidation value; (iii) the debt-for-equity exchange is an arm's-length transaction; and (iv) any 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 exchange) that has as a principal purpose the avoidance of COD income by the partnership. A prior requirement in the proposed regulations that the partnership had to maintain capital accounts in accordance with the substantial economic effect test to fall within the safe harbor was eliminated in the final regulations.
The final Regulations provide, as a clarification from the proposed regulations, that the liquidation-value safe harbor is available where the transaction involves related parties, provided that the debt-for-equity exchange has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests. On the other hand, under an anti-abuse rule contained in the final Regulations, the partnership cannot redeem and no person related to the partnership, i.e., under Sections 267 or 707(b), or to any partner, can purchase the debt-for-equity partnership 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.
Impact on Creditor
To the creditor swapping the debt instrument for a partnership interest, Section 721 will apply in general but the regulations acknowledge that Section 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership's indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued OID), i.e., items that would have given rise to ordinary income to the creditor and a deduction by the partnership.
The creditor’s basis in its partnership interest is determined under Section 722, which will be the partner’s adjusted basis in the debt plus any gain recognized on the contribution. For holding period, see Section 1223. The final regulations rejected allowing the creditor to treat the cancelled debt for partnership interest to bifurcate the “note” into a note for interest exchange and a bade debt. The Treasury and the Service viewed bifurcation in this context was inconsistent with Section 721 as well as the results attributable to a debt for stock scenario under the corporate rules. Still, it may be possible, i.e., consult your tax advisor, to claim a bad debt deduction prior to and separate from the exchange of debt for stock particularly if the debt can qualify for partial worthlessness.
Debt Cancelled for Deductible Items Such as Rent, Interest or Royalties
Under a Section 721 model, the issuance of a partnership interest for the cancellation of previously expensed items would be treated generally as ordinary income to the creditor and generate a deductible expense to the partnership.. The final Regulations change the model for reporting this exchange of consideration. A debtor partnership will not recognize gain on the transfer of a partnership interest to a creditor in a debt-for-equity exchange for unpaid rent, royalties, or interest that accrued on or after the beginning of the creditor's holding period for the indebtedness.
Minimum Gain Chargeback Impact
The final regulations provide that COD income from a discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes.
Treatment of Cancelled Installment Obligations
Section 453B generally provides that 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. Treas. Reg. §1.453-9(c)(2) provides that the contribution of an installment obligation to a partnership under Section 721 does not constitute a disposition. The Treasury and Service announced that this exception should 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. The creditor must instead recognize gain or loss under Section 453B. This would parallel treatment for the disposition of a ISO to a corporation for stock in a Section 351 transaction. This subject will be addressed in proposed regulations to be issued.
Special Allocation Rules for COD Income
While the proposed regulations did not address this area, it was the subject of prior rulings issued by the Service. First, in Rev. Rul. 92-97, 1992-2 C.B. 124, the Service held that an allocation of COD income that differs from the share of cancelled debt has substantial economic effect if (1) the deficit restoration obligations covering any negative capital account balances resulting from the COD income allocations can be invoked to satisfy other partners' positive capital account balances, (2) the requirements of the economic effect test are otherwise met, and (3) substantiality is independently established. In Rev. Rul. 99-43, 1999-2 C.B. 506 the Service warned that special allocations lack substantiality when the partners amend the partnership agreement to specially allocate COD income and book items from a related revaluation after the events creating such items have occurred, if the overall economic effect of the special allocations on the capital accounts does not differ substantially from the original allocations. The Service and Treasury were of the same view that based on the existing guidance no additional guidance on this subject was necessary in the final regulations pertaining to a debt in exchange for equity exchange.