PARTNERSHIP WORKOUTS

Transcription

1 PARTNERSHIP WORKOUTS Kevin Thomason Zupancic Rathbone Thomason, P.C. 511 N. Akard, Suite 411 Dallas, Texas Todd D. Keator Thompson & Knight LLP 1722 Routh Street, Suite 1500 Dallas, Texas BigTex Developer, LLC ( BigTex ), is a multi-member LLC formed to develop a new midrise office/retail building to become the official diamond district of Dallas, Texas (the Center ). In 2001, to develop the Center, the members of BigTex contribute $100 and BigTex borrows $900 from Money Bank on a full recourse basis. The Money Bank loan bears interest at 5% and is interest-only for the first 15 years. BigTex constructs the Center at a total cost of $1,000 and takes has an initial cost basis in Center of $1,000. BigTex elects to depreciate the Center under the alternative depreciation system (i.e., 40-year recovery period), resulting in annual depreciation deductions of $25 per year. Shortly after completion, the Center has a 98% occupancy rate. By 2011, the following events have occurred: (a) After 10 years of depreciation deductions ($250), BigTex s adjusted basis in the Center is $750; (b) Due to the declining economy, the Center s occupancy rate is down to 50%, the rents are no longer sufficient to service the loan to Money Bank, and BigTex defaults on the loan to Money Bank; and (c) Money Bank threatens to foreclose on the Center. A. Money Bank forecloses. At auction, an unrelated vulture fund bids $800 for the Center and wins. BigTex has no objections. What are the tax consequences to BigTex? BigTex is treated as selling the Center to Money Bank for $800, resulting in long-term capital gain of $50. See Treas. Reg (a)(2); Treas. Reg (c)(ex. 8); Crane v. Comm r, 331 U.S. 1 (1947); Freeland v. Comm r, 74 T.C. 970; Rev. Rul , C.B. 12. BigTex also realizes cancellation of indebtedness income ( CODI ) in the amount of $100. I.R.C. 61(a)(12). B. Assume instead that 20 years have passed since BigTex constructed the building, that BigTex s basis is $500, and that Money Bank bids in the Center at $550. Three months earlier BigTex received a credible offer to purchase the Center for $700, but Money Bank would not agree to release its lien to allow the sale. The bid price at auction is presumptively fair market value. Treas. Reg (b)(2). Thus, BigTex recognizes a $50 capital gain on the sale of the Center and has $450 of ordinary CODI. If BigTex doesn t like this result, BigTex may challenge the presumption and assert a higher FMV (e.g., $700), but BigTex will need clear and convincing evidence. Frazier v. Comm r, 111 T.C. 243 (1998). Would the offer 3 months earlier provide sufficient evidence? C. Back to the original facts, assume the foreclosure sale occurs on Aug. 1, 2011, and that local law allows a 6 month period for BigTex to redeem the Center. 1 When must BigTex recognize income from the foreclosure? 1 In reality, Texas provides no right of redemption for debtors. 1

2 BigTex should have the option of recognizing income from foreclosure either in 2011 (by waiving the right of redemption) or 2012 (upon expiration of the redemption period). R. Odell & Sons Co. v. Comm r, 169 F.2d 247 (3d Cir. 1948). D. Assuming BigTex is a calendar year partnership and realizes CODI on August 1, 2011, when will the individual members of BigTex realize their allocable shares of the CODI? December 31, IRC 706(a); Rev. Rul ; FSA E. Now assume the Money Bank loan is nonrecourse to BigTex. What are the tax consequences? BigTex is viewed as selling the Center to Money Bank for the principal balance of the debt ($900), regardless of the FMV of the Center. Comm r v. Tufts, 461 U.S. 300 (1983). F. The debt is still recourse, but BigTex agrees to convey the Center to Money Bank pursuant to a Deed in Lieu of Foreclosure. BigTex is highly adverse to any CODI. Because the principals of BigTex are major customers of Money Bank, BigTex is able to convince Money Bank to value the Center at $900, even though no one would pay more than $700 for it. What result? Same result. A deed in lieu also is treated as a sale. If the valuation is correct, BigTex recognizes capital gain of $150 and no CODI. Money Bank will be required to file Form 1099-A reporting the transaction, and will be required to state the FMV of the Center on the form. If Money Bank lists the value at $900 when it is worth no more than $700, Money Bank could be liable for penalties. The IRS is free to challenge the valuation in this instance. G. Assume 20 years have passed since BigTex acquired the Center, that the FMV of the Center is in fact $900, and that Money Bank acquires the Center pursuant to a deed in lieu. BigTex calculates its gain as $400. Assuming a tax rate of 25% for Section 1250 gain, BigTex calculates a tax liability of $100. BigTex has no cash to pay the tax. Can BigTex do a 1031 Exchange to avoid recognizing any gain in the foreclosure? The answer is not clear, but probably so. See Bradley T. Borden and Todd D. Keator, Workout-Driven Exchanges, 25 Tax Management Real Est. J. No. 2 (Feb. 4, 2009). BigTex should be able to assign its rights under the Agreement in Lieu of Foreclosure (that typically accompanies a deed in lieu) to a QI to get within the QI safe harbor, and should be able to use the $100 of tax it otherwise would have paid as a nice start to a down payment on a replacement asset. H. Continue assuming the debt is nonrecourse and that the FMV of Center is $750, but that BigTex would prefer to realize CODI (in order for its members to exclude it) instead of capital gain in the foreclosure. Money Bank is willing to assist BigTex and so agrees to (1) write-down the debt from $900 to $750, and (2) immediately thereafter acquire the Center pursuant to a deed in lieu. What result? 2

3 On the face of the transaction, BigTex has $150 of CODI. I.R.C. 61(a)(12). The subsequent transfer pursuant to the deed in lieu results in no gain or loss, because the face amount of the debt and BigTex s adjusted basis in the Center each are $750. However, the IRS would have strong grounds to disregard these steps and treat BigTex as having recognized a capital gain of $150 in the foreclosure. See 2925 Briarpark, Ltd. v. Comm r, 163 F.3d 313 (5 th Cir. 1999); Rev. Rul I. Instead, assuming the parties agree that the Center is worth only $750, and that Money Bank is willing to accept such amount in satisfaction of the debt, could BigTex pay $750 to Money Bank in complete satisfaction of the debt, and then turn around and sell the Center the next day for $750? This transaction probably results in $150 of CODI, although the answer is not clear. Id. J. Instead of threatening to foreclose, Money Bank decides to assist BigTex (and itself) by working out the debt. Thus, at a time when the Center arguably is worth $700, Money Bank agrees to write down the principal amount of the debt to $700. What are the tax consequences? BigTex realizes CODI in the amount of $200. IRC 61(a)(12); U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931). K. Assume the same facts, but instead Money Bank agrees to a discounted payoff of $700. Same result. Treas. Reg (a). L. Assume the same facts, but assume alternately that Money Bank either (i) significantly reduces the interest rate on the loan, (ii) significantly extends the term of the loan, or (iii) agrees to change the loan from recourse to nonrecourse. In all events, the interest rate on the loan remains above the Applicable Federal Rate ( AFR ). What result? These events all result in a significant modification of the loan. Treas. Reg As a result, BigTex is deemed to have exchanged the old loan (having the original terms) for the new loan (having the modified terms). Thus, BigTex will realize CODI to the extent the issue price of the old debt exceeds the issue price of the new debt. Here, because the debt is not publicly traded and because the interest rate is above the AFR, the issue price of the old and new debts should be the same, resulting in no CODI to BigTex. M. Assume the same facts, but that a member of BigTex guaranteed the entire $900 debt. Money Bank agrees to release the guarantor from the guarantee. Does the guarantor realize CODI? No. Zappo v. Comm r, 81 T.C. 77 (1983); Whitmer v. Comm r, 71 T.C.M (1996); Treas. Reg P-1(d)(7) (guarantor not treated as a debtor for 1099 reporting purposes). However, the release of the guarantee may result in a significant modification. Treas. Reg (e)(4). 3

4 N. Back to the original facts, but now assume that Money Bank does not want to foreclose (and take title to the Center) and also does not want to write-down the debt. Instead, Money Bank agrees to contribute the debt to the capital of BigTex in exchange for a 90% interest BigTex. Because the Center is the only asset in BigTex and it has a FMV of $700, the value of the 90% interest is $630. What are the tax consequences? BigTex is deemed to satisfy the debt with a membership interest worth $630, resulting in CODI of $270. IRC 108(e)(8). 100% of the CODI is allocated to the historic members of BigTex (i.e., everyone other than Money Bank). Id. Money Bank receives a capital account in BigTex equal to $630, and Money Bank s basis it its membership interest is $900. REG (October 31, 2008). Money Bank is viewed as having contributed the debt in a nonrecognition transaction under IRC 721. Therefore, Money Bank may not immediately recognize a bad debt deduction. Id. To avoid this result, Money Bank should write down the debt from $900 to $630 immediately prior to contribution (resulting in a bad debt deduction and $270 of CODI) and then should contribute the $630 debt to Big Tex for a 90% interest (resulting in no CODI). O. Alternatively, on Aug. 1, 2011, Money Bank and BigTex enter into a written agreement providing that if occupancy levels at the Center are not above 75% by Aug. 1, 2012, Money Bank will write down the debt to $700. At the time they enter into the agreement, the Dallas market for diamonds is continuing to decline. What result? BigTex should not realize CODI in BigTex should recognize CODI in 2012 only if Money Bank actually writes down the debt at such time. Jelle v. Comm r, 116 T.C. 63 (2001). P. Alternatively, on Aug. 1, 2011, Money Bank writes down the debt to $700, with an agreement from BigTex that if occupancy rates climb above 55% by Aug. 1, 2012, BigTex will pay $200 to Money Bank on such date. At such time, the Dallas market for diamonds is getting hot. BigTex realizes CODI of $200 in Id. Q. Alternatively, Money Bank tells BigTex that if BigTex pays $250 on Jan. 1 of each of the next 3 years, Money Bank will write-off the $150 balance of the loan upon receipt of the 3 rd installment, but if BigTex misses a payment, the full balance will be due. What result? BigTex probably has $150 CODI immediately. Treas. Reg R. Back to the original example, except now, instead of writing down the debt, Money Bank sells the debt to Slim Jim, a 51% Member of BigTex, for $700. What result? BigTex realizes CODI of $200. IRC 108(e)(4). S. Alternatively, what if Slim Jim owned only 49% of BigTex on the date he purchased the Money Bank loan, and 5 months later Slim Jim purchases another 2% interest in BigTex? 4

5 Same result. See Treas. Reg However, note that in the prior two examples Money Bank generally is not required to report CODI on IRS Form 1099-C. Treas. Reg P-1(d)(5). T. Continue assuming that Slim Jim is a 49% partner in BigTex, and that Slim Jim is not related to any other partners in BigTex. In year 1, Slim Jim issued a $100 note to Fat Albert. In year 2, BigTex purchased the debt from Fat Albert for $100. In year 3, BigTex redeems Slim Jim s interest in BigTex by distributing only the note issued by Slim Jim. At the time of the distribution, Slim Jim s basis in his partnership interest was $25 and the FMV of the interest was $90. The Slim Jim note had a basis to BigTex of $100 and a FMV of $90. Is the distribution tax-free to Slim Jim under IRC 731? No. Rev. Rul Upon the distribution, the debt is extinguished, and there is no mechanism for preserving gain or loss in the distributed property. Thus, IRC 731 does not apply. Instead, because there will be no opportunity for Slim Jim to recognize gain or loss at a future time, he must recognize capital gain to the extent the FMV of the debt ($90) exceeds his basis determined under IRC 732 ($25), or $65 of gain. In addition, Slim Jim must recognize $10 of CODI (the $100 IP of the debt over the $90 FMV price Slim Jim is deemed to satisfy the debt with). 2. The equal, individual Members of BigTex are as follows: Dirk, Tony, and JoshCo, Inc. (a C-corporation owned 100% by Josh). Each has guaranteed the $900 debt owed to Money Bank. Dirk s career is starting to take off but currently, the value of his assets ($200) is less than his total debts ($500). Tony has hit rock bottom and recently filed for bankruptcy his case is pending. JoshCo is solvent to the tune of $1,000. On August 1, 2011, at a time when the FMV of the Center is $300, Money Bank writes down the debt from $900 to $300, resulting in $600 of CODI for BigTex. The CODI is allocated $200 to each of Dirk, Tony and JoshCo. A. Can all of the BigTex members exclude their shares of CODI under IRC 108(a)(1)(B) since BigTex is insolvent? No. The 108 exceptions generally are determined at the individual partner/member level. IRC 108(d)(6). The results at the member level are as follows: Dirk: Dirk s liabilities ($500) exceed his assets ($200) by $300. Therefore, Dirk is insolvent by $300. IRC 108(d)(3). As a result, Dirk is able to exclude his entire $200 share of CODI under the insolvency exclusion. IRC 108(a)(1)(B). Tony: Because the discharge occurs while Tony is in bankruptcy, Tony is able to exclude his entire $200 share of CODI under the bankruptcy exclusion. IRC 108(a)(1)(A). JoshCo: JoshCo is not eligible for any of the exclusions and must recognize $200 of CODI. 5

6 Of course, to the extent any of the members of BigTex exclude CODI under IRC 108(a), corresponding reductions in tax attributes will be required under IRC 108(b)(1). What if the members lack sufficient offsetting attributes? B. What if, immediately prior to the discharge, BigTex converted to a C-corp? Now could BigTex exclude all of the CODI? Maybe. Would the conversion have economic substance? C. Regarding Dirk, what if his assets were $450 instead of $200? Now Dirk is insolvent by only $50 and so may exclude $50 of CODI but must recognize the $150 balance. IRC 108(a)(3). D. What if a portion of Dirk s assets consisted of his home worth $200, and that under Texas law his home is exempt from the claims of creditors. What is the extent of Dirk s insolvency? Still just $50. Exempt assets count and are included in the computation of whether a taxpayer is insolvent. Carlson v. Comm r, 116 T.C. 9 (2001). [Note that Carlson is a departure from prior case law and IRS guidance on the topic and has been severely criticized by commentators.] E. Sticking with Dirk, assume that outside of his membership in BigTex, his only other assets are an antique beer stein worth $200 and an autographed Steve Nash jersey worth $200 but subject to nonrecourse debt of $400. Thus, immediately prior to Money Bank s write down, Dirk has assets worth $500 (including his 1/3 share of the assets of BigTex) and liabilities of $700 (including his 1/3 share of the liabilities of BigTex). No part of the nonrecourse debt is discharged. Is Dirk $200 insolvent? Is it appropriate to analyze Dirk s insolvency by reference to his separate shares of BigTex s assets and liabilities? Or should Dirk simply place one net value on his interest in BigTex? Assuming Dirk s share of the assets and liabilities of BigTex are properly taken into account, Dirk no longer meets the insolvency exception because nonrecourse debt in excess of the fair market value of the property it secures may not be taken into account in determining whether a taxpayer is insolvent. Rev. Rul Thus, the $400 nonrecourse debt in excess of the $200 FMV of the beer stein cannot be included, meaning Dirk has liabilities of $500 and assets of $500. F. What if instead of Money Bank writing down the BigTex debt the lender of the Steve Nash jersey debt wrote the debt down from $400 to $200? Now Dirk is insolvent by $200 because nonrecourse debt in excess of the FMV of the property secured by such debt is taken into account when such debt is being discharged. Id. Thus, Dirk has liabilities of $700 and assets of $500. G. Now assume that the Money Bank debt is nonrecourse, that all the members of BigTex are solvent not factoring in their shares of the Money Bank debt, and that the Money Bank debt is fully discharged. Can the members include their shares of the nonrecourse Money Bank debt as liabilities for purposes of determining whether they are insolvent? 6

7 The answer is unclear, but it seems that the members should be able to include their shares of such debt. Future guidance on the application of Rev. Rul to partnerships is allegedly forthcoming. H. Now let s assume that Tony, at the advice of his tax lawyer, purchased his membership interest in BigTex through a single-member disregarded LLC (RoMoCo), and that RoMoCo is the one in bankruptcy, not Tony personally. May Tony exclude his $200 share of CODI? No. Proposed Regulations issued on April 13, 2011 (REG ) state that the owner of the DRE must be in bankruptcy in order to utilize the bankruptcy exclusion (likewise for the insolvency exclusion). It is insufficient for a DRE to be in bankruptcy or insolvent. I. What if, instead of Tony being under the jurisdiction of the bankruptcy court, BigTex is the one in bankruptcy and Tony is the general partner who is 100% liable for BigTex s debts, and the bankruptcy court gratuitously discharges Tony s liability as GP at the same time that it discharges BigTex? In this situation, the bankruptcy exclusion should continue to apply to Tony even though he technically did not file for bankruptcy. Price v. Comm r, 87 T.C.M (2004). 3. Now assume that BigTex has only 2 very solvent and reputable members Tiger, Inc., a Louisiana corporation, and Mr. O. Duck, a citizen of Oregon. Money Bank writes down the $900 debt to $300, resulting in $600 of CODI allocable $300 apiece to Tiger, Inc. and Mr. Duck. A. Do the members have a means to exclude the CODI? Mr. Duck may be able to exclude the CODI under the exception for qualified real property business indebtedness ( QRPBI ). However, Tiger Inc. is ineligible for such exclusion as it does not apply to corporations. IRC 108(a)(1)(D). B. What must Mr. Duck prove to exclude the CODI as QRPBI? Mr. Duck must establish that the Money Bank debt is QRPBI and that he meets the specific and general limitations set forth in IRC 108(c). Generally, debt is QRPBI if it (A) was incurred by the TP in connection with real property used in a trade or business and is secured by such real property; (B) was incurred or assumed before 1/1/93, or if incurred or assumed after such date, is qualified acquisition indebtedness ; and (C) TP elects for the QRPBI exclusion to apply. For this purpose, qualified acquisition indebtedness includes debt incurred or assumed to acquire, construct, reconstruct, or substantially improve property. Under the specific limitation, the amount of CODI excluded cannot exceed the excess of the principal balance of the debt (immediately before discharge) over the FMV of the real property secured by such debt (reduced by the principal balance of any other QRPBI secured by such property). 7

8 Under the general limitation, the amount of CODI excluded cannot exceed the aggregate adjusted bases of depreciable real property held by the TP. C. Mr. Duck tells you that his only other asset is a 75% limited partner interest in JerryWorld, LP, the only asset of which is a modest football stajum (a stadium to the rest of the world). The other 25% is held by 6 unrelated individuals. Mr. Duck s AB in the LP interest is $600, and JerryWorld s AB in the stajum is $800. Assume BigTex s basis in the Center is $200. Does Mr. Duck qualify? Possibly. The determination of whether debt is QRPBI is made at the partnership (not partner) level. Here, the Money Bank debt appears to meet the definition of QRPBI. Also, the amount of CODI being excluded does not exceed the specific limitation. Regarding the general limitation, Mr. Duck must treat his interests in BigTex and JerryWorld as depreciable real property to the extent of his proportionate share of BigTex s and JerryWorld s basis in depreciable real property (i.e., $100 for BigTex and $600 for JerryWorld), provided that Big Tex and JerryWorld consent to a corresponding reduction in inside basis in the Center and stajum with respect to Mr. Duck. Mr. Duck will be required to request consent from BigTex because it is debt of BigTex being discharged, and will be required to request consent from JerryWorld because he owns more than a 50% interest in the capital and profits of JerryWorld. However, neither BigTex nor JerryWorld is required to grant consent because Mr. Duck does not own a large enough % in either entity. See Treas. Reg (g)(2)(ii) (partnership must grant consent where requested by partner owning more than 80% capital and profits interest or, if partnership owned by 5 or fewer individuals, by partner owning more than 50% capital and profits interest). Assuming the partnerships grant consent, each will be required to write down inside basis of depreciable real property, but only with respect to Mr. Duck. Thus, BigTex should reduce Mr. Duck s share of the inside basis of the Center to $0, and JerryWorld should reduce his share of inside basis to $400. D. Now assume that originally, way back in 2001, BigTex incurred $400 of debt and used $100 of equity to construct the Center at a total cost of $500. In 2006, when the FMV of the Center was $1,000, BigTex refinanced the debt with Money Bank and issued a note for $900 secured by the Center (thus pulling out $500 of refinance proceeds). Today in 2011 the Center is worth $300 and Money Bank is willing to write-down the debt to $300, resulting in $600 of CODI. Mr. Duck would like to exclude his $300 share of the CODI under the QRPBI exclusion. Can he? Not entirely. The original debt appears to have been QRPBI. Therefore, the refinancing debt also is QRPBI, but only to the extent it does not exceed the amount of the original debt being refinanced ($400). Thus, $400 of the refinancing debt is QRPBI, but the $500 excess is not. 8

9 Of the $600 debt being discharged, can Mr. Duck take the position that the first $400 is QRPBI so that he may exclude $200? Might the IRS argue that the first $500 is not QRPBI, so that Mr. Duck may exclude only $50? Does the answer lie somewhere in the middle (e.g., 4/9 of the $600 write-down is QRPBI)? E. Now assume that BigTex, for liability purposes, originally constructed the Center in a single-member disregarded LLC wholly-owned by BigTex. Money Bank made the $900 loan directly to BigTex, secured by 100% of the membership interests in the LLC (the LLC agreement contained special purpose entity language beneficial to Money Bank). Is the loan still QRPBI for Mr. Duck? The answer is not clear. It depends on whether the loan is secured by real property. Does security in the form of 100% of the membership interests of an SPE qualify? F. Tiger, Inc. is upset that it is ineligible for the QRPBI exclusion. A few months later, Tiger experiences another discharge of debt secured by real property owned directly by Tiger ( Tigerland ), and Tiger, Inc. desperately wants to exclude the CODI. Can Tiger argue that a common law exception to CODI exists that would allow Tiger to reduce its basis in Tigerland rather than recognizing CODI? Perhaps, although this is a risky argument that the IRS is opposed to. Fulton Gold Corp. v. Comm r, 31 B.T.A. 519 (1934) held that where a TP settles a nonrecourse (NR) debt for less than its principal amount, the TP doesn t recognize CODI, but instead must reduce its basis in the collateral. The rationale was that the freeing of assets theory of Kirby Lumber did not apply. The Supreme Court in Tufts endorsed Fulton Gold in dicta ( We are not presented with and do not decide the contours of the cancellation-of-indebtedness doctrine. We note only that our approach does not fall within certain prior interpretations of that doctrine. In one view, the doctrine rests on the same initial premise as our analysis here an obligation to repay but the doctrine relies on a freeing-ofassets theory to attribute ordinary income to the debtor upon cancellation. [See Kirby Lumber]. According to that view, when nonrecourse debt is forgiven, the debtor s basis in the securing property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. [See Fulton Gold]. Initially, the IRS agreed with Fulton Gold (see PLR , applying Fulton Gold to determine that the discharge of the secured nonrecourse indebtedness where there is no personal liability on the part of [the TP] is not a discharge of indebtedness solely for purposes of section 61(a)(12) of the Code and does not result in discharge of indebtedness income to [the TP]. ). Later, in Rev. Rul , the IRS rejected Fulton Gold where the FMV of the collateral exceeded the principal amount of the NR debt that was reduced. This was probably the correct result because in that situation, the TP experiences a freeing of assets. In Rev. Rul , the IRS extended the rationale of to a situation where the principal amount of the NR debt exceeded the FMV of the collateral. The IRS argued that Tufts and Gershkowitz (discussed below) had effectively superseded Fulton Gold, and that a NR debt should be treated the same as any other debt, regardless of the FMV of the collateral. In Gershkowitz v. Comm r, 88 T.C. 984 (1987), the Tax Court concluded that the settlement of a NR debt of $250,000 for a $40,000 cash payment, where the FMV of the collateral was only $2,500, resulting in $210,000 of CODI. 9

10 Here, Tiger, Inc. may argue that it has no CODI to the extent an undersecured nonrecourse debt encumbering Tigerland is reduced to the FMV of Tigerland. In such case, Tiger, Inc. would reduce basis in Tigerland by the amount of CODI excluded. But to the extent the debt is reduced below the FMV of Tigerland, Tiger, Inc. s net worth increases, and Tiger should recognize CODI to such extent. See also Rev. Rul (ruling that the reduction of an undersecured nonrecourse debt by a lender who was not the seller of the property does not qualify as a purchase price reduction under IRC 108(e)(5)). This position is not free from doubt. G. Back to the original example, but assume that Money Bank also sold the Center to BigTex five years ago (i.e., seller financing), and now has written the debt down from $900 to $300. Does BigTex realize $600 of CODI? No. IRC 108(e)(5). The discharge instead is treated as a purchase price adjustment, and BigTex must reduce its basis in the Center accordingly. Note that IRC 108(e)(5) applies at the partnership level. Rev. Proc ; TAM Also, a partnership that is bankruptcy or insolvent still is eligible for the exception provided its partners are solvent. Id. Does the purchase price reduction exception gut Tiger, Inc. s argument under Fulton Gold? H. Back to the original example, but assume Money Bank instead is willing to restructure the $900 loan as a $400 A Note and a $500 B Note. The B Note is payable after the A Note and only out of profits from the ultimate sale of the Center. Due to the unlikelihood of the B Note ever being repaid, the parties agree to report the transaction as generating $500 of CODI. Does the B Note cause Money Bank to become a partner in BigTex? Probably not. PLR Now assume that BigTex is a general partnership, the sole general partners of which are Jack and Arnie. Jack contributes $90 while Arnie contributes only $10. They agree to share losses in the same ratio (90/10) but all income on a 50/50 basis (i.e., income allocations do not first restore previous losses). Jack and Arnie are jointly and severally liable to all creditors for partnership recourse liabilities but otherwise do not have unconditional deficit restoration obligations. However, the partnership agreement contains a QIO (and meets the alternate test for economic effect). BigTex purchases property for $1,000, paying $100 cash and borrowing $900 on a recourse basis. Jack and Arnie share the loan $810 and $90, respectively. In each of its first 5 years, Big Tex generates a loss of $200 per year. At the end of 5 years, Jack s capital account is ($810) and Arnie s capital account is ($90). At such time, the FMV of the property has dropped precipitously, and the lender agrees to cancel the debt in full. Thus, Arnie and Jack are no longer required to restore their deficit capital accounts. A. Will the 50/50 allocation of $900 of CODI be respected for tax purposes? No. Rev. Rul A 50/50 allocation would result in Jack having a capital account of ($360) (negative $810 plus $450) and Arnie having a capital account of $360 (negative $90 plus $450). IRS ruled this allocation cannot have 10

11 economic effect because cancellation of the debt eliminates both partners obligations to restore deficit capital accounts, and neither partner has an independent deficit restoration obligation. The CODI must be allocated $810 to Jack and $90 to Arnie to have substantial economic effect. Thus, where there are deficit capital accounts in the full amount of the CODI and no obligation to restore the deficit, the only allocation of CODI that can have economic effect is an allocation in accordance with the manner in which the partners shared the losses attributable to the liability (i.e., 90/10). This is the safest approach. See also S. Rep. No , at 21 (1980). Note that the result of Rev. Rul is exactly the same as if the debt had been nonrecourse and a minimum gain chargeback applied. B. Now assume Jack and Arnie have unlimited deficit restoration obligations. Now the allocations have substantial economic effect. Id. Jack s unlimited deficit restoration obligation can be invoked to satisfy Arnie s positive capital account. Does Rev. Rul mean that partners either must have unlimited deficit restoration obligations or agree to allocate CODI in the same proportions that they share partnership debt? Are different allocations permitted as long as the partners do not end up with negative capital accounts? C. Now assume that Jack and Arnie originally contributed $1,000 each to BigTex and agreed to share all profits and losses 50/50. BigTex borrows $8,000 (nonrecourse) and purchases nondepreciable property for $10,000. After 1 year, the FMV of the property has fallen to $6,000, but the loan balance remains $8,000. The lender reduces the loan principal to $6,000, and Arnie contributes an additional $500 to be used to pay deductible workout fees (all of which are allocated to Arnie). At such time, Jack is utterly insolvent. The partners amend the partnership agreement to specially allocate the entire $2,000 of CODI and $3,000 of the $4,000 book loss to Jack, and $1,000 of the book loss to Arnie. Afterwards, each partners capital account is reduced to $0. These allocations fail the substantiality test. Rev. Rul IRS ruled the allocations are not substantial because all of the CODI is allocated to Jack, who is insolvent, resulting in no immediate tax payable by either Jack or Arnie. Without the allocation, Arnie would have paid tax on his $1,000 share of the CODI, and both partners capital accounts would have wound up in the same place zero. Further, the partners specially allocated an additional $2,000 of book loss to Jack, which offset the CODI allocation. Economically, the situation is identical to what would have happened if the CODI and book loss were allocated 50/50. But by creating offsetting special allocations, the partners were able to eliminate tax with no change to their economic deal. Thus, the allocations are shifting allocations and lack substantiality. D. Now assume instead that Jack guarantees the debt (so it is all allocated to him), that immediately after acquisition the property drops in value to $5,000, and that the lender agrees to write-down the debt to $5,000. How should the CODI be allocated? 11

12 Presumably 50/50 ($1,500 to Jack and $1,500 to Arnie), even though the debt was allocated entirely to Jack. Thus, both of their capital accounts would increase to $2,500. Here, it does not seem necessary to allocate CODI in the same ratio that the members share the debt (ala Rev. Rul ). If the property was then sold for its $5,000 FMV, BigTex would recognize a $5,000 loss that would also be allocable 50/50 to Jack and Arnie, reducing their capital accounts to $0. This is consistent with their economic deal. E. Going back to the example in C, assume that Jack guaranteed the $8,000 debt, and that the property has been depreciated down to $7,000 of basis, and that the last $1,000 of depreciation deductions were allocated entirely to Jack as a partner nonrecourse deduction. At a time when the FMV of the property is $6,000, the bank reduces the loan balance from $8,000 to $6,000, resulting in $2,000 of CODI. How must the CODI be allocated? Now, the cancellation of $2,000 of debt causes a reduction in Jack s partner nonrecourse debt minimum gain from $1,000 to $0. Thus, the reduction triggers the partner nonrecourse debt minimum gain chargeback provision. Treas. Reg (i). To satisfy the chargeback, the following ordering rules apply: First, allocate gain from the disposition of the property subject to the nonrecourse debt that is giving rise to minimum gain. Second, a pro rata portion of each of the partnership s other items of income and gain is used to satisfy the requirement. Treas. Reg (j)(2). Note that CODI is not a first priority item used to satisfy the minimum gain chargeback. Here, there is no gain to allocate to Jack. Instead, Jack must be allocated a pro rata portion of each of BigTex s items of income and gain until he has been allocated $1,000 to chargeback minimum gain. The balance of the CODI not allocated to Jack in the minimum gain chargeback must be allocated to Jack and Arnie under the LLC agreement (here, 50/50). 5. Now assume that instead of forming BigTex to acquire the Center, Dirk, Tony and Josh (individually) pool their money to purchase the Center from Due Diligence Syndications, Inc. ( DDSI ) for $1,500 as tenants-in-common (TICs) (each owns 1/3). Each pays $200 cash and assumes a 1/3 share of a $900 nonrecourse loan (secured by the Center) to purchase the property. The 3 TICs have no time or desire to manage the property, and so agree to master lease the Center to a wholly-owned subsidiary of DDSI for annual fixed rental payments. A few years later, rents from the real tenants of the Center are not sufficient to enable the master tenant to pay rents under the master lease to the TICs. In fact, DDSI experiences the same issue with 200 other properties that it master leased from 200 other TIC groups it sold properties to. Thus, DDSI and all of its master tenant affiliates file for bankruptcy. A. Dirk, Tony and Josh do not want to lose the property to bankruptcy. Unfortunately, the initial bankruptcy filing occurs while Dirk is in Germany for the summer, and Tony and Josh cannot reach him. Thus, Tony and Josh decide to hire a lawyer to protect their collective interests during the bankruptcy. They front the legal fees as well as debt-service payments on a 50/50 basis. A few months later they are able to contact Dirk, and Dirk promptly reimburses Tony and Josh for his 1/3 share of such costs. Also, it is nearly impossible to get all 3 TICs together for a phone call, so they appoint Josh as communications agent to handle all correspondence with the lawyers and other third parties and also payment agent 12

13 to collect all checks from the TICs and remit payments to the appropriate payees. Tony and Dirk do not give Josh any decision-making authority on their behalf. Have the TICs crossed the line and become partners? Maybe, but probably not. See PMTA B. Assume the Center emerges from bankruptcy, and our three TICs locate a new asset manager who is willing to manage the Center going forward. The new manager will only agree to manage the property for a fixed 4% fee and is not willing to assume the risks of the fixed master lease payments. However, if the existing master lease is cancelled, the sub-tenant leases also will be cancelled, and the parties fear one or two major tenants will utilize the opportunity to vacate the Center. Can the parties amend the existing master lease to become a cash-flow master lease that mimics the economics of a property management agreement (i.e., after retaining 4% of the gross rents from the property, the master tenant will remit the balance of the rents to our TICs)? Yes, they can do it, but not without tax consequences. In such scenario, there is a risk that the master tenant would be deemed an agent of the TICs. As a result, the arrangement could violate Rev. Proc (e.g., the restrictions against certain bad income as well as violation of certain unanimous voting requirements), thus causing the TICs to become partners for federal tax purposes. See GCM 39594; McNabb v. U.S., 47 AFTR 2d ; Amerco v. Comm r, 82 T.C. 654; Meagher v. Comm r, T.C. Memo C. Back to the original facts, but now assume there is no bankruptcy and that the Center is worth only $700, rents from the Center have dropped off dramatically, and the lender is threatening to foreclose. Our TICs are approached by Mr. Vulture, who offers the following deal: The TICs must contribute the Center, subject to the debt, to a new LLC in exchange for a 5% membership interest each (15% in the aggregate). Mr. Vulture will contribute $250 to the LLC, to be used to pay-down the debt from $900 to $650. LLC cash flow will be distributed first to repay Mr. Vulture $250 + a 15% preferred return and second 85% to Mr. Vulture and 5% to each of our 3 TICs. Each of the 3 TICs has a $0 basis in its TIC interest. The TICs readily agree. Is the roll-up transaction taxable to the TICs? Maybe. Generally, the TICs contributions to the LLC are nontaxable. IRC 721(a). However, the transaction may result in a disguised sale of the Center by the TICs to the extent they are relieved of their shares of the Center debt. See Treas. Reg Do you need more facts about the nature of the debt encumbering the Center to make a determination? Note that even if the transaction is a disguised sale, the TICs could recognize gain under IRC 731(a) to the extent they receive deemed cash distributions in excess of basis. In order to minimize gain from the roll-up, should the TICs take precautions to ensure that the Center debt remains allocable to them to the maximum extent possible? If so, how should they accomplish this goal? Id. See also Treas. Reg and Canal Corp. v. Comm r, 135 T.C. 9 (2010). Three years later, if the LLC sells the property for a nice profit, will the TICs be happy? 13

14 D. What if, instead of contributing equity to the LLC, Mr. Vulture and the TICs strike the following deal: Mr. Vulture will purchase the loan from the original lender for $650 and afterward will write-down the debt to $700. Immediately afterwards, the TICs will contribute the property to the new LLC (subject to the $700 debt) and Mr. Vulture will receive a 40% profits interest in the LLC. What result? The TICs have $200 of CODI. The contribution to the LLC coupled with the LLC s assumption of debt is either a disguised sale or a distribution under IRC 731. Note that 100% of the loan will be allocable to Mr. Vulture because he is the lender and also a member of the LLC. If the TICs desire to preserve their shares of the debt, they will need to guarantee it and indemnify Mr. Vulture. Query whether this will be sufficient in light of Canal DALLAS