Integrity. Objectivity. Performance. Partnership Bankruptcy Tax Issues. June 22, 2010 Mark L. Farber Partner

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1 Integrity. Objectivity. Performance. Partnership Bankruptcy Tax Issues June 22, 2010 Mark L. Farber Partner

2 Partnership Bankruptcy Partnership v. Corporate Bankruptcy Increased use of LPs and LLCs Corporate Bankruptcy Retention of Assets and Liabilities Retention of Tax Attributes Partnership Bankruptcy Retention of Assets and Liabilities Partners Retain of Tax Attributes

3 Partnership Workouts Corp B Investment Bank C Each Partner Adj. Basis $133 Real Estate Adj. Basis $ liab. Share $333 Underwater FMV $ (b) cap. acct. <$200> Liability $1,000 LLC Bank A is solvent. Corporation B insolvent by $100,not taking into account its investment in PS. Investment Bank C has $300 in NOLs and is currently going through a bankruptcy reorganization under chapter 11.

4 Post Petition Tax Return and Liability The trustee of a partnership in bankruptcy is apparently responsible for filing the partnership s tax returns after for periods after the petition date. Post petition partnership income or gain will be passed through to the partners. Income is phantom income because the assets of the partnership cannot be used for distributions.

5 Basis in Undersecured Property Acquired by Lenders Foreclosures and deed in lieu of foreclosure are each treated as sales or exchanges of property. The creditor realizes a gain or loss equal to the difference between: The creditors tax basis in property received in satisfaction of undersecured debt less: The fair market value of the property at the time of acquisition

6 Forgiveness of Nonrecourse Debt When nonrecourse debt is forgiven in return for a transfer of the collateral, debtor recognizes section 1001 gain equal to the adjusted issue price of the debt less the adjusted basis of the property that secures the debt. A creditors foreclosure on property purchased with nonrecourse debt is considered a sale by the debtor partnership, and any gain would be allocated among the partners. A reduction in a nonrecourse liability without a surrender of collateral gives rise to COD income.

7 Applicability of COD Insolvency Exclusion Forgiveness of recourse debt When recourse debt is forgiven, a debtor recognizes COD income equal to the excess of adjusted issue price of debt over the property s fair market value. Forgiveness of guaranteed debt When a nonrecourse note is subject to a partial guarantee, the note should be split into recourse and nonrecourse notes.

8 Satisfaction of Old Debt with New Debt If a significant modification occurs in the new debt then an exchange will occur under Treasury Regulation Section The modified debt may become a non-effectively connected asset If the modified debt is treated as equity is this considered an acquisition of a partnership interest? Contingent Debt

9 Application of AHYDO rules Debt instruments issued with a more than five year term qualifies as AHYDO if the yield to maturity equals or exceeds the sum of the AFR for debt instruments at the time of issuance plus five percentage points Partnership Anti Abuse Regulations prevent the avoidance of the AHYDO rules through the use of issuers other than corporations

10 Interest and OID Accrual Involving Troubled Debtors Contingent Debt Regulations Troubled partnerships that deduct OID and troubled accrual method partnerships that deduct unpaid interest on a debt obligation should each consider the issues that bear on when a taxpayer must cease accruing interest and OID deductions

11 Issues Unique to Partnerships Partner s basis in its partnership interest Section 752 deemed contribution due to an increase in its share of liabilities Recourse Liabilities Nonrecourse Liabilities Allocation of Income IRC Section 704(b)

12 COD and Partnerships Recognition By Partnership Whether COD is realized and recognized in connection with a partnership debt restructuring is determined at the partnership level Recognition by Partners The section 108(a) exceptions to COD recognition and corresponding tax attribute reductions are applied at the partner level

<$200> Liability $1,000 LLC Bank A is solvent.

13 Partnership Workouts Corp B Investment Bank C Each Partner Adj. Basis $133 Real Estate Adj. Basis $ liab. Share $333 Underwater FMV $ (b) cap. acct. <$200> Liability $1,000 LLC Bank A is solvent. Corporation B insolvent by $100,not taking into account its investment in PS. Investment Bank C has $300 in NOLs and is currently going through a bankruptcy reorganization under chapter 11.

14 COD Income COD income recognized by a partnership is passed through by the partnership to its partners as an item of income under section 702(a) Each partner s allocable share of COD income increases that partner s basis in its partnership interest on a dollar for dollar basis.

15 COD Income The IRS has ruled that COD income allocated to a partner will increase the partner s basis in its partnership interest, notwithstanding the fact that the partner qualifies for the insolvency exception to COD income recognition. Each partner separately determines its eligibility to exclude its allocable share of COD income from its taxable income under section 108. Any required tax attribute reduction applies at the partner level.

16 Schedule P - List of Foreign Partner Interests in Partnerships

17 Schedule P - List of Foreign Partner Interests in Partnerships (Cont d)

18 Direct Allocations of Interest Expense Treasury Regulation Section T A foreign corporation that has a U.S. asset and indebtedness that meet the requirements of Sec T(b) or (c), as limited by Sec T(d)(1); shall directly allocate interest expense from such indebtedness to income from such asset in the manner and to the extent provided in Sec T.

19 Qualified Nonrecourse Indebtedness Treasury Regulation Section T(b) In the case of qualified nonrecourse indebtedness, the deduction for interest shall be considered directly allocable solely to the gross income which the property acquired, constructed, or improved with the proceeds of the indebtedness generates, has generated, or could reasonably be expected to generate.

20 Integrated Financial Transactions Treasury Regulation Section T(c) Direct allocations in the case of certain integrated financial transactions. Interest expense incurred on funds borrowed in connection with an integrated financial transaction shall be directly allocated to the income generated by the investment funded with the borrowed amounts.

21 Partnership Asset A foreign corporation that allocates its interest expense under the direct allocation rule of this paragraph shall reduce the basis of the asset that meets the requirements of Sec T (b) or (c) by the principal amount of the indebtedness that meets the requirements of Sec T(b) or (c). The foreign corporation shall also disregard any indebtedness that meets the requirements of Sec T(b) or (c) in determining the amount of the foreign corporation's liabilities under paragraphs (c)(2) and (d)(2) of this section and shall not take into account any interest expense paid or accrued with respect to such a liability for purposes of paragraph (d) or (e) of this section.

22 Basis Adjsutment Partnership Interest (B) Partnership interest. A foreign corporation that is a partner in a partnership that has a U.S. asset and indebtedness that meet the requirements of Sec T(b) or (c), as limited by Sec T(d)(1), shall directly allocate its distributive share of interest expense from that indebtedness to its distributive share of income from that asset in the manner and to the extent provided in Sec T. A foreign corporation that allocates its distributive share of interest expense under the direct allocation rule of this paragraph (a)(1)(ii)(b) shall disregard any partnership indebtedness that meets the requirements of Sec T(b) or (c) in determining the amount of its distributive share of partnership liabilities for purposes of paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section, and shall not take into account

TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004

TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004 WENDI L. KOTZEN BALLARD SPAHR ANDREWS & INGERSOLL, LLP 1735 Market Street, 51 st Floor Philadelphia, PA 19103-7599 kotzenw@ballardspahr.com