Anthony V. Sexton KE

Transcription

1 DRAFT IN PROGRESS - October 23, Remains Subject to Ongoing Revision and Review The Uncertain (And Sometimes Nonsensical) Distinctions Between Recourse and Nonrecourse Liabilities Anthony V. Sexton This is a working draft of a paper to be presented at the 2017 University of Chicago Tax Conference. It remains subject to ongoing revision and review in all respects. Anthony Sexton is a partner in the tax group of Kirkland & Ellis LLP. His practice focuses primarily on the tax considerations relevant to distressed companies and their creditors in out-of-court workouts and bankruptcy reorganizations. The views in this paper are his own and do not reflect the views of Kirkland & Ellis LLP or any client of the firm. [Acknowledgments to come.]

2 DRAFT IN PROGRESS - October 23, Remains Subject to Ongoing Revision and Review 1. Introduction To most lawyers, debt can be cleanly divided into two groups: recourse or nonrecourse. An issuer of recourse debt can generally assert that debt against the borrower itself and seek recovery against anything the borrower owns; the issuer will only go unpaid to the extent the borrower, as a whole, has assets that are less than the amount of the debt. By contrast, issuers of a nonrecourse debt instrument are generally limited to the proceeds of certain specified collateral; if the collateral is worth less than the loan, the issuer has no further recourse against the borrower. This is a relatively straightforward distinction, with straightforward consequences, in the world of corporate law and debt finance: whether debt is recourse or nonrecourse essentially depends on the lender s state-law rights. That straightforward distinction may be subject to adjustment based on, among other things, credit support provided by third parties (such as letters of credit or surety bonds) or affiliates (such as the common situation of guarantees granted by other members of a borrower s corporate group or equityholder guarantees); circumstances where entities do not protect other parties from liability (such as general partners of a state law partnership); practical limitations on collection; nonrecourse carve-outs (such as so-called bad boy guarantees); state law overlays (such as whether a lender that ostensibly has a nonrecourse loan can nevertheless obtain a deficiency judgment, or, on the flipside, whether an ostensibly recourse loan is turned into a nonrecourse loan by operation of state law); and, in the bankruptcy context, certain provisions that operate to create a deficiency recourse claim in certain circumstances. Even when those distinctions are present, though, from a corporate law and debt finance perspective, the consequences of these credit support and secondary obligations are relatively straightforward and rational, and they all boil down to one thing: the lenders rights under state law. For tax lawyers, on the other hand, the distinction between recourse debt and nonrecourse debt can be far more difficult to pin down, and the consequences of that distinction can be extremely significant, highly irrational, and entirely detached from lenders state-law rights. The Internal Revenue Code (the Code ) 1 has no set definition of what constitutes recourse or nonrecourse debt. Indeed, the terms have different meanings depending on the statutory or regulatory provisions at issue, and there are particularly difficult questions regarding the proper treatment of debt borrowed by entities that are disregarded for U.S. federal income tax purposes ( DREs ), where such debt is recourse to the DRE under state law but not guaranteed by the DRE s regarded owner ( DRE Recourse Debt ). The most recent, and dramatic, development in this area occurred in 2016, when the Internal Revenue Service (the Service ) issued a Private Letter Ruling (the 2016 PLR ) 2 ruling that DRE Recourse Debt is nonrecourse debt for 1 Unless otherwise indicated, references to Sections are references to the Code or the Treasury Regulations thereunder, as appropriate. 2 PLR (Oct. 28, 2016). 1

3 purposes of Section and Tufts v. Comm r. 4 As discussed in more detail below, the 2016 PLR is at least in tension with prior rulings involving the application of Section Indeed, the better view is that the 2016 PLR is flatly inconsistent with those earlier rulings, which throws this area of law into a state of even greater uncertainty. In fact, it raises a question of whether debt may be recourse debt under Section while being nonrecourse under Section (or vice versa), an outcome that is, at a minimum, surprising. This uncertainty adds to a the fact that there are a number of cases where, setting the complexities created by the Code aside, the facts and circumstances involving any particular debt instrument and corporate structure may complicate a tax lawyer s analysis of whether debt is recourse or nonrecourse. In the face of this uncertainty, both issuers and creditors may face dramatically different tax consequences depending on whether a particular debt is treated as recourse or nonrecourse debt. These difference include, among other things: the availability of the bankruptcy and insolvency exclusions to cancellation of indebtedness income under Section 108(a) (which may spell the difference between a successful restructuring and administrative insolvency); the character and total amount of gain, income, loss, or deduction recognized in common restructuring transactions (including the allocation of such items in the partnership context); the application of Section 357(d); and the application of the at-risk rules. This paper discusses the potential uncertainties involved with characterizing debt as recourse or nonrecourse, particularly in the context of DREs, and analyzes the sometimes nonsensical tax consequences that distinction can have, particularly in the context of distressed companies. Finally, this paper proposes ways to fix some of the most problematic tax consequences in the current state of law. To be sure, others have traveled this path before, and other articles have explored the theoretical underpinning of the cancellation of indebtedness doctrine in general, as well as the development of the differing treatments between recourse and nonrecourse debt, in greater detail than this article sets out to do. 6 However, the 2016 PLR and other recent developments provide a 3 Governing the amount of gain or loss recognized in certain transaction when a transferor transfers property subject to indebtedness U.S. 300 (1983) (generally standing for the proposition that the amount realized in connection with turning over property subject to nonrecourse indebtedness is equal to the amount of such nonrecourse indebtedness, even if the property is worthless less than the amount of such nonrecourse indebtedness). 5 Governing the determination of whether a debt obligation has undergone a significant modification and, therefore, is deemed to be retired and reissued in exchange for a new debt instrument. 6 See, e.g., Cuff, Indebtedness of a Disregarded Entity, 81 Taxes 303 (2003) (discussing, among other things, the distinction between recourse and nonrecourse indebtedness and many of the consequences of such distinction); Cummings, The Disregarded Entity Is and Isn t (Disregarded), Tax Notes 743 (May 5, 2003) (evaluating the treatment of DRE Recourse Debt in the context of the significant modification rules in light of one of the private letter rulings discussed herein); Bennett, To Be or Not to Be, That is the Question : Disregarded Entities and Debt Modification, 81 Taxes 9 (Dec. 2003) (examining the treatment of DRE Recourse Debt in light of certain of the significant modification rulings discussed below); Hoffer, Give Them My Regards: A Proposal for Applying the COD Rules to Disregarded 2

4 reason to take a fresh look at these issues, and they clearly illustrate the need for action to address the problems in this area of law. 2. Distinguishing Between Recourse and Nonrecourse Debt As noted above, neither the Code nor the Treasury Regulations set forth a comprehensive definition of the meaning of, or distinction between, recourse and nonrecourse debt, despite the distinction being key to the operation of numerous provisions of the Code and Treasury Regulations. The terms are generically referenced in the context of Sections and , and are specifically defined in context of Sections 704 and 752 (in a way that is clearly distinct from their general meaning outside of the partnership context). (a) Distinction Outside of the Context of Sections 704 and 752: Factual Analysis of Creditors Rights. (i) General Rule: If the Borrower is Personally Liable, the Debt is Recourse; Otherwise, the Debt is Nonrecourse. Regulations under Section 1001 rely on the distinction between recourse debt and nonrecourse debt to establish the consequences of various transactions. 7 Unfortunately, Entities, Tax Notes 327 (April 18, 2005) (among other issues, discussing the treatment of DRE Recourse Debt in the context of Section 108); Levy and Hofheimer, Bankrupt Partnerships and Disregarded Entities, Tax Notes 1103 (June 7, 2010) (performing an extensive analysis of the legislative history of both the federal income tax code and the bankruptcy code to evaluate the distortive effects that current tax rules, including the treatment of recourse and nonrecourse liabilities, have in certain restructuring contexts); Peaslee, Disregarded Entities and Debt Modifications, Tax Notes 1145 (March 7, 2016) (evaluating the distinction between recourse and nonrecourse debt, particularly with respect to disregarded entities, in the context of the debt modification rules, and proposing specific regulatory changes); Elliott, How Choice of Entity Changes Recourse Debt Classification Answer, 153 Tax Notes 618 (Oct. 31, 2016) (noting recent developments in this area); Lee-Lim and Bozkurt, Significant Modification of Debt Instruments: A Case Study, Tax Notes (April 11, 2017) (evaluating private letter rulings discussed below, and the treatment of DRE Recourse Debt in general, in the context of the significant modification rules through a number of examples); Henderson and Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (2017), , 404 (discussing consequences of recourse vs. nonrecourse distinction and discussing 2016 PLR); Geier, Tufts and the Evolution of Debt-Discharge Theory, 1 Fla. L. Rev. No. 3, 115 (1992) (evaluating history of the different treatment of recourse and nonrecourse debt and suggesting that the inconsistencies should be eliminated); Cunningham, Payment of Debt with Property--the Two-Step Analysis After Commissioner v. Tufts, 38 Tax Lawyer 575 (1985) (exploring history of treatment of dispositions of property in satisfaction of recourse and nonrecourse debt and arguing that distinction is justifiable on put/call option theory); Rosenberg, Better to Burn Out than to Fade Away? Tax Consequences on the Disposition of a Tax Shelter, 71 Cal. L. Rev. 87 (1983) (evaluating caselaw development between Crane and Tufts and proposing and evaluating various different approaches to the issue, including the tax benefit rule and treating certain amounts as cancellation of indebtedness income); Simmons, Nonrecourse Debt and Amount Realized: The Demise of Crane s Footnote 37, 59 Or. L. Rev. 42 (1980) (discussing caselaw development from Crane to the lower court decisions in Tufts and exploring the theoretical bases for including the full amount of nonrecourse debt in amount realized). 7 As discussed in greater detail below, Section relies on the distinction to determine the consequences of disposing of assets that are subject to liabilities, while Section relies on the 3

5 neither the Code nor the Treasury Regulations define what constitutes recourse or nonrecourse debt. Many authorities that have considered the question have generally focused on the straightforward dichotomy discussed under corporate and debt finance law: debt is recourse if it can be asserted against the borrower personally, and nonrecourse if it cannot be. 8 Additionally, examples under Section appear to incorporate that straightforward distinction by reference to the taxpayers at issue being personally liable (or not) on the debt being evaluated. The Seventh Circuit Court of Appeals drew a direct connection between Section (a)(2), which has language that clearly falls within this straightforward distinction, and the definition of nonrecourse debt in Racine v. C.I.R. 9 In Racine, a taxpayer incurred indebtedness to enable it to exercise certain stock option awards. Under Section (a)(1), a taxpayer is generally treated as receiving property (and, accordingly, is subject to tax on the receipt of such property) when it obtains a beneficial ownership in such property. That general rule is subject to various exceptions. One such exception is that (a) the transfer of an option to acquire property is not itself a transfer of the underlying property, and (b) vitally in Racine, if the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option. The indebtedness incurred by the taxpayer in Racine was recourse to the taxpayer, but the taxpayer asserted that the debt was, in substance, nonrecourse debt because the lender would always execute a margin call long before the acquired stock became worth less than the amount of the indebtedness. 10 The Seventh Circuit held that the debt was nevertheless recourse distinction in evaluating whether a change to a debt instrument constitutes a significant modification of a debt instrument. There are other provisions outside of the specific partnership context that 8 See, e.g., Coburn v. C.I.R., T.C. Memo (Dec. 6, 2005) (ultimately concluding it did not need to decide whether the debt at issue was recourse or nonrecourse to come to a conclusion, but citing Black s Law Dictionary for basing the distinction on the idea that [u]nlike collateral securing a nonrecourse liability, the collateral securing a recourse liability does not represent the only source of repayment ); FSA (Aug. 31, 2001) (evaluating whether a California limited recourse liability was nonrecourse, and noting that the rights of a creditor with respect to a limited recourse loan are not as great as the rights of a creditor with respect to a recourse loan ); Great Plains Gasification Associates v. C.I.R., T.C. Memo (Dec. 27, 2006) ( Indebtedness is generally characterized as nonrecourse if the creditor s remedies are limited to particular collateral for the debt and as recourse if the creditor s remedies extend to all the debtor s assets. ) (citing Raphan v. United States, 759 F.2d 879, 885 (Fed. Cir. 1985) ( Personal liability for a debt ( recourse indebtedness ) means all the debtor s assets may be reached by creditors if the debt is not paid. Personal liability is normally contrasted with limited liability ( nonrecourse indebtedness ), against which a creditor s remedies are limited to particular collateral for the debt. ). 9 Racine v. C.I.R., 493 F.3d 777 (7th Cir. 2007). 10 The taxpayer also asserted that the risk of loss exception of Section (a)(6) applied, which the court also disagreed with. That discussion is beyond the scope of this article. 4

6 indebtedness (and, accordingly, outside the scope of Section (a)(2)) because the taxpayer was personally liable on the full amount of the debt. 11 In CCA , 12 the IRS has held that this creditors rights-based distinction controls the application of Section 1001 to partnership liabilities, even if a different characterization would apply in the context of Sections 704 and 752 (discussed below). The taxpayer asserted that the debt was recourse for purposes of Section 1001 because of the member guarantees, i.e., that the Section 752 rules should control for purposes of Section The Service concluded that Section 752 is irrelevant to determinations under Section 1001, pointing out that (a) regulations under Section 704 and 752, along with the relevant preamble, made it clear that Section 1001 and Sections 704 and 752 have different tests. The Service concluded that classification of debt for purposes of Section 1001 is ultimately a fact-intensive analysis of the particular debt documents. Importantly, nothing about the Section 1001 analysis in CCA is limited to the partnership context (other than the holding that Sections 704 and 752 do not control). Finally, the Service has issued many private letter rulings and other authorities indicating that the recourse or nonrecourse nature of a debt obligation is based on an evaluation of creditors rights under state law. 13 Importantly, however, as discussed in further detail below, these authorities reach disparate conclusions with respect to the characterization of DRE Recourse Debt. (ii) It is Unclear Whether Equityholder Guarantees and Pledges, Or a Functional Analysis of Facially Nonrecourse Debt, Are Relevant. Although CCA purports to clearly distinguish between the application of Sections 704 and 752, on one hand, and Section 1001, on the other hand, certain of the factors identified as potentially relevant to the Section 1001 analysis in the CCA actually generate significant confusion. That is particularly true in light of the CCA s own comparisons to the circumstances in Great Plains. 14 In Great Plains, the Tax Court concluded that the partnership debt at issue was nonrecourse debt for purposes of Section The debt was not expressly recourse to the partnership, but it was secured 11 Id. at 781 ( Non-recourse debt describes an arrangement in which [] the lender agrees to look exclusively to the collateral, and never to dun the borrower for a deficiency if a sale of the collateral fetches less than the balance.... There is a big legal difference between secured debt and nonrecourse debt. A bank that lends $100,000 against a house appraised for $1 million is well secured, but unless the bank had agreed not to collect from the house s owner the loan is recourse. ) (emphasis in original). 12 June 19, See PLR (Apr. 11, 2003) (holding that the conversion of a corporation into a DRE did not cause the converted entity s debt to change from recourse to nonrecourse for purposes of Section ); PLR (July 28, 2006) (same); PLR (Mar. 2, 2007); PLR (Mar. 12, 2010); CCA F (Jan. 1, 2015); PLR ([DATE]) (holding that DRE Recourse Debt was nonrecourse debt for purposes of Section 1001) 14 Great Plains Gasification Associates v. Comm r, T.C. Memo (Dec. 27, 2006). 5

7 by all of the assets of the partnership (and, it appears from the opinion, that the partnership would have been prohibited from acquiring any assets that would not be subject to that collateral). 15 The Tax Court also emphasized that none of the partners were liable on the debt, citing Section 752 (and applicable regulations); it is unclear how relevant that fact was to the Tax Court s ultimate conclusion. 16 The CCA stated that any implication created by Great Plains that Section 752 principles would control the Section 1001 analysis was erroneous. Nevertheless, the CCA emphasizes the fact that, unlike in Great Plains, the partnership s members personally guaranteed the debt in question and pledged the partnership s interests in support of that debt. Similarly, the CCA emphasizes that the debt in question was secured by all assets taxpayer will ever have, including rents, but that seemed to be true in Great Plains, as well. 17 There may be circumstances where pledges or guarantees by equityholders should be relevant to determinations under Section 1001 (both in and out of the partnership context). Similarly, it should be relatively straightforward to establish a rule with respect to the treatment that is nonrecourse on its face, but functionally recourse because it is secured by every asset a borrower will ever own. Unfortunately, the discussion in CCA and Great Plains doesn t add much certainty because of the lack of clarity in their analyses. These issues are discussed in greater detail below in the context of various hypothetical--and fairly common--situations. (iii) The Treatment of DRE Recourse Debt is a Difficult-to-Reconcile Quagmire. The largest area of uncertainty regarding the distinction between recourse debt and nonrecourse debt for purposes of Section 1001 has, since the advent of the check the box regulations and the proliferations of limited liability companies, been the proper characterization of DRE Recourse Debt, i.e., debt that is unquestionably recourse to a DRE under state law, but not guaranteed by the DRE s regarded parent. Commentators have generally focused on two potential views, which this paper will refer to as the creditors rights view and the tax formalities view. 18 Under the creditors rights view, DRE Recourse Debt should be treated as recourse debt for purposes of Section Under the tax formalities view, DRE Recourse Debt should be treated as nonrecourse debt for purposes of Section The general principle guiding the tax formalities view is that creditors only have recourse to a subset of the regarded parent s assets (i.e., the 15 Id. at It is worth noting that the taxpayer in Great Plains had filed tax returns consistent with the idea that the debt at issue was nonrecourse debt for purposes of Section Perhaps the CCA s distinction here is based on a belief that in Great Plains, the debt would be unable to reach rents from the collateral at issue. In light of the generally-applicable rules regarding proceeds of collateral, discussed below, such a distinction would not necessarily be accurate. 18 See, e.g., many of the sources noted in footnote [9]. To be clear, no negative connotations are intended by the tax formalities label. 6

8 assets owned by the DRE), which is analogous to creditors only having recourse to certain assets owned by an entity in a classic situation of nonrecourse debt. (A) Earlier IRS Authority Provided Consistent Support For Creditors Rights View, At Least in the Context of Significant Modifications. Several private letter rulings were issued in the context of the application of Section that arguably gave strong support to the creditors rights view. As discussed in greater detail below, under Section , debt that undergoes a significant modification is deemed to be exchanged for a newly-issued debt instrument. Under Section (e)(5)(A), if a debt changes from recourse debt to nonrecourse debt, such change is a per se significant modification unless one of two exceptions apply. One of these exceptions narrowly applies to defeasance of tax-exempt bonds, while the original collateral exception applies where the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. 19 Within that context, each of PLR , PLR , PLR , and PLR concluded that the conversion of a corporate issuer of debt to a DRE did not cause debt to be subject to a significant modification, although the precise rulings and whether the rulings specifically addressed the recourse or nonrecourse nature of the debt at issue shifted over time. Each of these private letter rulings is discussed below. (1) PLR : A Firm Adoption of the Creditors Rights View. In PLR , Parent was a corporation that engaged in Businesses A, B, and C. As part of a reorganization, Parent, which was the issuer of the applicable debt, merged with and into a newly-formed holding corporation, New Parent, with Parent surviving as a wholly-owned subsidiary of New Parent. Parent then converted to a limited liability company that was treated as a DRE. After this conversion, Parent (now referred to as LLC 1 in the private letter ruling), contributed certain assets to a new LLC (LLC 2) treated as a DRE, and distributed LLC 2 to New Parent. The ruling noted that none of the creditors state law rights or relationships vis-à-vis Parent/LLC 1 or New Parent would be altered by the restructuring and that no consents were necessary from the debtholders to effectuate the restructuring. 20 After citing Acquilino v. United States 21 and Morgan v. Comm r 22 for the proposition that federal tax law looks to State law to determine legal 19 Treas. Reg (e)(5)(B)(2)(i). The original collateral exception is discussed in additional detail below. 20 This point is perhaps most notable in that it appears that the debt permitted Parent/LLC 1 to distribute assets out from its credit to New Parent. The ruling specifically noted that nothing about the restructuring caused New Parent to be obligated on the debt U.S. 509, 513 (1960) U.S. 78, 82 (1940). 7

9 entitlements in property, and that the legal rights or obligations referred to in [Section] are rights that are determined under State law, the Service 23 concluded that, in light of the fact that none of the creditors state-law rights were effected, the restructuring did not result[] in either a change of obligor or a change in the recourse nature of the Debt for purposes of [Section] (c)(2)(i). This conclusion seems to be a firm endorsement of the creditors rights methodology of determining the recourse or nonrecourse nature of debt, at least for purposes of Section Notably, the Service did not discuss any implications that flowed from the fact that, following the conversion of Parent to a DRE of New Parent, New Parent was the obligor of the debt for U.S. federal income tax purposes. The Service also did not cite the original collateral exception as a basis for its ruling (or even mention the exception). 25 (2) PLR : A Partial Retreat. In PLR , Parent issued the applicable debt, which was recourse to Parent. As part of a restructuring, Parent (a) merged with a newly-formed wholly-owned subsidiary of a new holding corporation (the new holding corporation being referred to as New Parent) and (b) immediately after the merger, converted into a DRE. The two steps constituted an F reorganization. Parent (now LLC) remained liable on all of the debt that Parent issued, and the assets and liabilities of Parent/LLC after the restructuring was identical to the assets and liabilities of Parent/LLC immediately after the restructuring, other than the payment of certain cash amounts. Making essentially the same observations as in PLR , the Service concluded that the restructuring did not change the recourse nature of the debt and did not cause a significant modification. Unlike in PLR , the Service did not specifically conclude that there was no change in obligor. The Service did cite Section (e)(4) for the proposition that a change in obligor is a significant modification. The Service did not discuss the exceptions to circumstances where a change in obligor does not constitute a significant modification, including Section (e)(4)(i)(B) (the 381 Successor Exception ), which provides that the substitution of a Section 381 successor is not a significant 23 Specifically, the Financial Institutions & Products group at the Service. As noted below, this group is a different group than the group that issued the 2016 PLR. 24 As discussed in greater detail below, it is possible that the Service or tax payers could argue that this reasoning, along with similar reasoning in the other rulings discussed below, is limited to Section and does not apply to Section , despite there being no express basis in the statutory text of Section 1001, the text of the regulations (or the preambles thereto), any caselaw, or the rulings themselves, to draw a distinction between Sections and for this purpose. 25 As discussed in greater detail below, it is unclear whether the original collateral exception could have applied, for two reasons. First, in light of the distribution by Parent/LLC1 of LLC 2 to New Parent, the debt arguably was not supported by the same assets immediately before and immediately after the conversion of Parent. Second, it is unclear whether the original collateral exception can apply to unsecured debt, which is a question that turns on the importance of the secured by language in the provision. 8

10 modification if certain other requirements are met. It is unclear whether the Service s conclusion was based on the 381 Successor Exception or a conclusion that Parent remained the obligor on the debt for purposes of Section (e)(4)(i)(B), even though New Parent became the obligor on the debt for tax purposes. (3) PLR : A Firm Conclusion With Implicit Reasoning, But Potential Ambiguity. In PLR , Company, which was the issuer of the applicable debt, was a wholly-owned subsidiary of Parent. The debt was recourse to the Company (and was unsecured). The debt prohibited the Company from selling all or substantially all of its assets unless the purchaser/transferee assumed the debt (and other requirements were satisfied). In connection with a sale of an interest in Company, prior to such sale, on Date 1, Company converted to an LLC that continued to be taxed as a corporation ( Company LLC ). On Date 4, Company LLC distributed certain assets to Parent, and Parent assumed certain liabilities. On Date 5, Company LLC elected to be treated as DRE in a transaction that qualified as a liquidation under Section 332. After Date 5, but prior to the closing date of the sale transaction: (a) Company LLC distributed additional cash and assets to Parent, and Parent assumed certain liabilities; (b) Parent contributed cash to Company LLC in exchange for preferred units; (c) Parent contributed cash to a new subsidiary of Parent, Preferred Holdco, which contributed such cash to Company LLC in exchange for preferred units. The transaction in clause (c) caused Company LLC to become a partnership among Parent and Preferred Holdco. After making substantially the same observations regarding creditors rights that were made in PLR and PLR , the Service ruled that the transactions did not give rise to a significant modification. Notably, the Service noted that several steps of the proposed transactions involved the substitution of a new obligor on the applicable debt, but that each such substitution was of a kind covered by Section (e)(4)(i)(B) and (C). Thus, it appears that the Service did in fact conclude that the Section 332 liquidation of Company LLC resulted in a change in obligor from Company LLC to Parent. However, the Service did not address, or even mention, the treatment of the debt as recourse or nonrecourse, despite the change in obligor. The basis for the Service s conclusion that there was no significant modification is, therefore, somewhat unclear. The Service must have been of the view that Company LLC was a DRE for long enough to not view the debt as simply having converted from recourse debt of a corporation to recourse debt of a partnership, so the explanation doesn t appear to be that the Service did not account for a period in time where the debt constituted DRE Recourse Debt. Accordingly, the Service was either applying the creditors rights view with respect to the characterization of the debt as recourse or 9

11 nonrecourse, or the Service was relying on the Original Collateral Exception (again, without citing it or even mentioning it, which the author views as highly unlikely). 26 (4) PLR : Ambiguity Continues. In PLR , Parent wholly owned Subsidiary 1, which, in turn, directly and indirectly owned various entities, including DREs, a partnership, 27 and corporations. Subsidiary 1 was the issuer of various debt, including both unsecured debt and debt secured by pledges of the stock of certain of Subsidiary 1 s subsidiaries. Certain of the debt was also guaranteed by certain of Subsidiary 1 s subsidiaries. In connection with a restructuring, Subsidiary 1 converted into a DRE (LLC 6). Various restructuring steps were undertaken with respect to LLC 6 s direct and indirect subsidiaries, ultimately resulting in a distribution of stock to LLC 6, a further distribution of such stock from LLC 6 to Parent, and an external distribution of such stock from Parent to Parent s shareholders. All of these steps were undertaken in a D reorganization. Pursuant to the transactions, the Service noted that LLC 6 s assets and liabilities immediately before after the transactions were the same as Subsidiary 1 s assets and liabilities immediately before the transactions (and immediately before Subsidiary 1 was converted to LLC 6). 28 The Service issued effectively the same ruling that it issued in PLR , again, without addressing the recourse or nonrecourse nature of the debt. (B) Other Authorities: Toward the Tax Formalities View of DRE Recourse Debt. After the release of the four rulings discussed above, tax practitioners could be forgiven for thinking that the better view of the law and the better assumption regarding 26 As discussed further below, it is unclear whether the Original Collateral Exception would properly apply given the various distributions of assets on Dates 4 and after Date 5 but prior to Company LLC s conversion to a partnership. It is difficult to draw any conclusions, in part, because the timeline of the various dates is unknown. 27 It is somewhat unclear in the ruling why the identified partnership was not treated as a DRE for U.S. federal income tax purposes. Subsidiary 1 wholly owned LLC 1, which in turn wholly owned LLC 2 and LLC 3. Each of LLC 1, LLC 2, and LLC 3 was a DRE--presumably of Subsidiary 1, since LLC 1, a DRE of Subsidiary 1, was the sole owner or LLC 2 and LLC 3. LLC 2 and LLC 3 owned LLC 4, which was also a DRE--again, presumably of Subsidiary 1, since all of LLC 4 s owners were DREs of Subsidiary 1. The ruling goes on to state that LLC 1 and LLC 4--each apparently DREs of Subsidiary 1--owned Partnership 1. Partnership 1 should also be a DRE of Subsidiary 1. In any case, to fill out the structure, Partnership 1 wholly owned Subsidiary 2, a corporation, which in turn wholly owned Subsidiary 3, another corporation. Partnership 1 also wholly owned LLC 5, a DRE. Subsidiary 3 and LLC 5 each owned an interest in Partnership 2 (which is properly treated as a partnership, not a DRE). 28 This conclusion is questionable from an economic perspective. It may be true that LLC 6 continued to own the stock of LLC 1, but certainly LLC 6 s indirect ownership of many other subsidiaries was eliminated. The ruling indicates that the transactions did not result in the addition or deletion of any coobligors or guarantors on the debt; the facts of the ruling are difficult to follow, in that regard. 10

12 the Service s position was that the creditors rights view of the treatment of DRE Recourse Debt had carried the day. That would certainly be true for purposes of Section and, without any firm reason to distinguish between Section and other Section 1001 purposes, probably for purposes of Section 1001 more broadly. However, the Service began chipping away at that view, culminating in the 2016 PLR, when the Service unambiguously set forth its position that DRE Recourse Debt is nonrecourse, at least for purposes of Section (1) AM : Conversion from Corporation to Partnership Involves Change in Obligor Under Section AM involved the conversion of a foreign subsidiary of a U.S. corporation from a corporation to a partnership. The Service memorandum addressed multiple issues, including whether the conversion, and the transactions deemed to occur as a result of the conversion pursuant to Sections (c)(1)(i) and (g)(1)(ii), resulted in a significant modification of the debt issued by the corporation. The Service held that the conversion (and deemed transactions) did result in a change in obligor. Specifically, even though the obligor on the debt was the same for corporate law purposes before and after the transaction, for tax purposes, the conversion resulted in a distribution of all assets and liabilities to issuer s owner, followed by a contribution to a new partnership. The Service went on to note that the change in obligor did not result in a significant modification. Although the Service did not discuss whether the debt was nonrecourse debt, the Service noted that this conclusion would be true regardless. If the debt was nonrecourse, a mere change in obligor does not result in a significant modification; if the debt was recourse, at each step, the new obligor (the owner of the issuer, and then the new partnership) owned all of the assets and liabilities of the original issuer. 30 The memorandum is notable because it reinforces the fact that the Service had abandoned its analysis from the early Debt Modification Rulings that held that there was no change in obligor because the obligor remained the same under state law. The conclusion is particularly striking because it appears to provide further support for the idea that transitory changes that occur as a result of changes in entity classification are relevant to determinations made under Section , even if those transitory changes have no economic consequences and no impact on creditors. 29 August 26, See Treas. Reg (e)(4)(i)(C). The Service went on to note that it was unlikely that the conversion would result in a change in payment expectations and there would be no significant alteration of the obligations. 11

13 (2) PLR : Silence That, In Highsight, Potentially Indicated Shifting Views. In PLR , 31 Parent was the parent of a consolidated group, and whollyowned Sub 1, a corporate member of the consolidated group. Sub 1 wholly owned DE, a DRE. Parent directly and indirectly owned various other subsidiaries as well. DE was the issuer of the relevant debt. Sub 1 guaranteed the debt. Parent incorporated NewCo and contributed Sub 1 to NewCo. After that contribution, Sub 1 converted to an LLC treated as a DRE of NewCo. The Service ruled that these steps constituted an F reorganization. Parent then merged with and into NewCo in a transaction that the Service ruled constituted an A reorganization. Most of the rulings in PLR related to the elimination of certain excess loss accounts and deferred intercompany gains that existed with respect to the Sub 1 stock prior to the transactions in the ruling. But two points are significant with respect to the evolution of the Service s view on DRE Recourse Debt. 32 First, the Service noted that, in connection with the conversion of Sub 1 to a DRE, the debt that was issued by DE becam[e] non-recourse to NewCo under applicable state law. That is a curious observation, in that the debt was always non-recourse with respect to NewCo for state law purposes. The Service may have intended to indicate that the debt became nonrecourse debt of NewCo for federal income tax purposes, because (a) in light of the conversion of Sub 1 to a DRE, the debt became NewCo debt for tax purposes; and (b) there was no recourse to NewCo for state law purposes, because NewCo, unlike Sub 1, did not guarantee the debt. Second, in the normal litany of disclaimers where the Service indicates that it was not ruling on anything not addressed by the ruling, the Service specifically stated that no opinion was expressed with respect to whether the transactions caused the DE s debt to undergo a significant modification under Section (e). (3) CCA F: Reliance On An Example in the At- Risk Regulations To Support A Tax Formalities View. Although the facts are mostly redacted in CCA F, 33 Company E, which was the issuer of the applicable debt, was apparently a DRE of Company B. The CCA was evaluating, among other things, whether the discharge of Company E s liabilities in bankruptcy gave rise to sale gain under Section 1001 and Tufts, or cancellation of indebtedness income that could be excluded under Section 108. As discussed below, under current law and Service interpretations thereof, the answer to that question turned 31 June 28, It is worth noting that this ruling was issued by the Corporate branch of the Service, while the significant modification rulings discussed above were issued by Financial Institutions and Products. 33 September 10,

14 on whether the DRE Recourse Debt issued by Company E, but not guaranteed by Company V, was recourse or nonrecourse for purposes of Section Without any significant analysis, or citation of the debt modification rulings discussed above, the Service concluded that the tax formalities view of DRE Recourse Debt controlled. In other words, Company E s debt was nonrecourse debt for purposes of Section because (a) the assets and liabilities of Company E were treated as owned by Company B and (b) Company E s debt was not recourse under state law with respect to Company B. To support this conclusion, the Service cited to Section (b)(6), Ex. 6, which provides that DRE Recourse Debt constitutes qualified nonrecourse financing secured by real property with respect to the regarded parent of the DRE for the purposes of applying the at-risk rules. Applying an example of the at-risk rules for purposes of determining the characterization of debt as recourse or nonrecourse for purposes of Section 1001 is misguided. The general purpose of the at-risk rules is to limit individual taxpayers from claiming losses with respect to activity for which they have no risk of loss. Generally, if an activity is supported by financing that is recourse to a partner, that liability can be factored into the amount with respect to which the partner is at risk, and, therefore, can support deductions. Section 465(b)(6)(A) provides a special rule, applicable solely in the context of real estate transactions, pursuant to which a taxpayer may be deemed to be at risk with respect to qualified nonrecourse financing. Example 6 of Section (b)(6) should be viewed within, and limited to, that very specific framework. 35 (4) Section : The Preamble to the Regulations Addressing the Application of the Insolvency Exclusion to DREs Sends Additional Signals. Explaining the significance of Section requires a detour into Section 108 (which figures prominently in the discussion below regarding the ramifications of the recourse/nonrecourse distinction) and the application of Section 108(a) with respect to financially distressed DREs. 36 In general, Section 108 provides various rules regarding the treatment of cancellation of debt income ( CODI ). Perhaps most importantly, Section 108(a) provides 34 As discussed below, the distinction in treatment also presumes that Company E s assets are turned over to creditors in satisfaction of such creditors claims. The redacted CCA is unclear whether this is what occurred: one portion of the CCA appears to impute a deemed sale, even though the property itself may have continued to be owned by Company B following the discharge of indebtedness. 35 Peaslee has specifically noted the distinction between the policy driving determinations under Section 465 and Section See Peaslee, Disregarded Entities and Debt Modifications, Tax Notes at (Mar. 7, 2016). As discussed below, Peaslee appears to go on to argue that the same basis of distinction applies as between Section and , which is where he and the author part ways on this subject, in large part because of the implications on the application of Section The regulation also applies to grantor trusts. 13

15 for various circumstances where CODI will be excluded from a taxpayer s taxable income, at the cost of a reduction in various specified tax attributes of the under Section 108(b) (as well as members of the taxpayer s consolidated group--under certain circumstances, partnerships owned by the taxpayer or the taxpayer s consolidated group--under associated Treasury Regulations). To greatly simplify things, the most important of these exclusions are the bankruptcy exclusion under Section 108(a)(1)(A), which applies where CODI arises in connection with a taxpayer s bankruptcy, and the insolvency exclusion under Section 108(a)(1)(B), which excludes CODI from income to the extent of the taxpayer s balance sheet insolvency. Key to the application of these rules is the identity of the applicable taxpayer. Prior to Section , some taxpayers and practitioners took the position that the bankruptcy and insolvency exclusions were tested at the DRE level. In other words, if the DRE issuer of discharged debt was in bankruptcy or was insolvent, the exclusions would apply even if the DRE s regarded owner was not bankrupt or insolvent. 37 Section This approach mirrors the approach applied to S-Corporations, where the exclusions are tested at the S-Corporation level. See Code 108(d)(7). By contrast, the Code is clear that the exclusions are tested at the partner level in the case of partnerships. See Code 108(d)(6). Although a full treatment of this is beyond the scope of this paper, the author is unwilling to let this distinction go entirely unaddressed. From the author s perspective, the right rule to apply to all flow-through and disregarded entities is the rule that applies to S-Corporations, i.e., these exclusions should be tested at the entity from which the CODI arises, and the appropriate consequences should then flow up to the entity s owners. Two primary counterarguments typically are asserted. First, as Peaslee and others note, the bankruptcy and insolvency exclusions are intended to measure the taxpayer s ability to pay a tax associated with CODI, and the insolvency of an entity with limited liability does not necessarily inform a taxpayer s ability to pay the tax liability. Notably, the Service and Treasury relied on this argument in promulgating Section , and the Service has relied on this argument in other interpretations of the insolvency exclusion. Second, the taxpayer-owner of a flow-through entity should not enjoy the benefit of debtfunded deductions (which may offset ordinary income) while being able to later exclude CODI if the taxpayer is not itself bankrupt or insolvent. In response, as an initial matter, there is no basis to distinguish between S-Corporations and other flowthrough or disregarded entities; one set of the rules or the other should be adjusted. The reason the author believes an entity-level determination is more appropriate in all cases because the owner-level methodology, and the arguments supporting it, do not give adequate deference to the real consequences of applying the exclusions at the owner level. Specifically, owner-level testing (a) may serve as inducement for unnecessary bankruptcy filings; (b) may invite aggressive tax planning efforts by the owners of flow-through entities that may be detrimental to creditors; (c) is administratively far more difficult to handle; and (d) most importantly, the tax liability resulting from the CODI may well cause the taxpayer to be subject to severe financial distress. Notably, the application of the insolvency exclusion at the owner level does not include the tax liability that the owner will owe if the insolvency exclusion does not apply: in other words, the tax liability itself can easily cause the owner to become insolvent or go bankrupt, and from that, there is no relief. The last of these considerations can factor prominently into restructuring matters involving oil and gas master limited partnerships, where comparatively unsophisticated investors can end up in a situation where they are allocated a ruinous amount of CODI--including in their retirement accounts, where the CODI will be treated as UBTI. In short, the author s view is that the standard counterarguments to entity-level measurement of the bankruptcy and insolvency exclusions should yield to a general principal of financial mercy. Recapturelike rules (in lieu of owner-level black-hole CODI) may be appropriate to address situations involving owners that have managed to offset ordinary income with deductions attributable to the debt being 14

16 9, however, makes it clear that the bankruptcy and insolvency exclusions are tested at the level of the regarded owner. If the DRE is in bankruptcy but the owner is not, or if the DRE is insolvent but the owner is not, the exclusions do not apply, even if the resulting tax liability in fact renders the owner bankrupt or insolvent. The final regulations were generally consistent with the approach in the proposed regulations that were adopted on April 13, The text of the regulation is not determinative with respect to the question of whether DRE Recourse Debt is recourse or nonrecourse for other purposes, although it is generally consistent with a tax formalities worldview. The preamble, on the other hand, arguably provides additional insight. 39 In addressing comments, the preamble noted that commentators had recommended clarifications regarding the treatment of DRE-issued debt for purposes of calculating the insolvency exclusion, and that the Service and Treasury are of the view that DRE-issued debt is nonrecourse debt of the borrower for purposes of applying the insolvency exclusion. 40 The effect of the Treasury Regulation and the preamble is purportedly to treat DRE-issued debt (whether it is recourse or nonrecourse to the DRE) in a kind of hybrid fashion for purposes of the insolvency exclusion. Relying on the principles of Revenue Ruling , the regarded owner is able to include, in determining its insolvency, an amount of the DRE s debt equal to (a) the fair market value of the DRE s assets (or, if the DRE debt is, in fact, nonrecourse with respect to the DRE, the value of the liabilities securing the debt), plus (b) the discharged amount of the excess nonrecourse debt. Permitting the owner to include the discharged portion of the excess nonrecourse debt cancelled. All of that said, the Service and Treasury have said their piece on this issue. Absent a change in law or in the regulations, the current rules are clear Fed. Reg TD 9771 (June 10, 2016). 40 Id. ( [T]he Treasury Department and the IRS are of the view that indebtedness of a grantor trust or a disregarded entity is indebtedness of the owner for purposes of section 108(d)(1); assuming the owner has not guaranteed the indebtedness and is not otherwise liable for the indebtedness under applicable law, such indebtedness should generally be treated as nonrecourse indebtedness for purposes of applying the section 108(a)(1)(B) insolvency exclusion; and accordingly the principles of Revenue Ruling apply to determine the extent to which such indebtedness is taken into account in determining the owner s insolvency under section 108(d)(3). ). 41 Rev, Rul (Jun. 18, 1992) (holding that for purposes of applying the insolvency exclusion, nonrecourse indebtedness is treated as indebtedness of the taxpayer to the extent of (a) the fair market value of the property plus (b) the amount of such excess that is discharged, which is referred to as excess nonrecourse debt ). As discussed below, Revenue Ruling (May 29, 2012) expanded Revenue Ruling to apply to partnership debt, by permitting partners to include the excess nonrecourse debt in each partner s determination of insolvency to the extent CODI with respect to such debt would be allocated to the partner under Section 704(b). Revenue Ruling is discussed in greater detail below. 15