COD INCOME B TO ELECT, TO PARTIALLY ELECT OR NOT TO ELECT, THOSE ARE THE QUESTIONS

COD INCOME B TO ELECT, TO PARTIALLY ELECT OR NOT TO ELECT, THOSE ARE THE QUESTIONS I. APPLICATION OF SECTION 108 RELIEF TO PARTNERSHIPS. A. Passthrough of COD Income to Partners. Although a partnership is not a taxable entity, it computes its income as if it is and then passes its tax items through to its partners for inclusion on their individual returns. Section 108 can apply to partnership discharge of indebtedness income, but portions of Section 108 apply only at the partner level. Under Section 108(d)(6), Subsections (a) (relating to exclusions from income for bankruptcy, insolvency, qualified farm indebtedness, qualified real property indebtedness, and qualified principal residence indebtedness), (b) (relating to reduction of tax attributes), (c) (the special rules applicable to real property indebtedness), and (g) (the special rules applicable to qualified farm indebtedness) are applied at the partner level. B. Section 108 Exclusions. In general, under Section 108(a)(1), gross income of a taxpayer does not include income from the cancellation of indebtedness under five sets of circumstances: (i) the discharge occurs in a Title 11 case; (ii) the discharge occurs when the taxpayer is insolvent; (iii) the indebtedness discharged is qualified farm indebtedness; (iv) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness (QRPBI); and (v) qualified principal residence indebtedness (QPRI) discharged before 2012. Note that Section 108(a) is by its terms an exclusion provision ("gross income does not include") as opposed to a more common deferral (that is, nonrecognition) provision such as Section 1031(a) ("no gain or loss shall be recognized"). However, because of the rules in Section 108(b) that provide for a reduction in the taxpayer's tax attributes when Section 108(a)(1) applies, in many circumstances the overall effect of Section 108 will be that of deferral rather than exclusion. Nonetheless, it is important to remember that the Section 108(a) rule of exclusion can apply to a taxpayer who has few or no tax attributes to lose, and in those circumstances the exclusion provided by Section 108(a)(1) is permanent. C. Bankruptcy Example. A Florida LLC files a bankruptcy petition and, pursuant to the bankruptcy case, obtains a discharge of a partnership liability of $60,000 (effective for the partnership and the partners) in 2008. The partnership has three partners, Nick, Marvin and Bob, each with an equal 1/3 share of the partnership's income and losses. Assume further that Nick has filed his own Chapter 11 petition; Marvin is not in bankruptcy but has liabilities in excess of the fair market value of his assets of $15,000; and Bob is hopelessly solvent. To what extent will each of the three partners be entitled to relief under Section 108? [Section 108(d)(6) and Sections 108(a), (b), (c) and (g) are applied at the partner level.] Determine Applicability of Section 108 to $20,000 COD income allocable to each: 1. Nick (bankruptcy) 2. Marvin ($15,000 insolvent) 1

3. Bob (hopelessly solvent) 4. Assuming qualification, could Marvin (to the extent he is solvent - $5,000) and Bob (to the extent of $20,000) individually make a Section 108(c) election to exclude under QRPBI and reduce basis for the excess COD income? Yes, see Section 108(a)(2)(B). 5. Is Section 108(i) deferral possible? No, there has been no "reacquisition" of an "applicable debt instrument" during the 2009 or 2010 taxable years. A Florida LLC, taxed as a partnership, with three solvent members, borrows $6 million to finance an operating business which is discharged in the LLC's bankruptcy case in 2008. To what extent will each of the solvent (and not in bankruptcy) members be entitled to relief for their $2 million share of COD income under Section 108? Section 108(d)(6) and Sections 108(a)(b)(c) and (g) are applied at the partner level; no relief available). Exhibit AA@ contains an example of a typical financial restructuring of a partnership under Section 108. II. PARTNERSHIPS - ELECTIVE DEFERRAL B AND PARTIAL ELECTIVE DEFERRAL B OF COD INCOME UNDER SECTION 108(i). A. Section 108(i). In response to the economic crisis in 2008 and 2009, the American Recovery and Reinvestment Act of 2009 ("ARRA") added '108(i), which permits taxpayers to elect to defer COD income arising from the reacquisition of certain debt instruments after 2008 and before 2011. The COD income deferred pursuant to Section 108(i) with respect to the "reacquisition" of an "applicable debt instrument" during 2009 and 2010 only is included ratably over the five-tax-year period beginning: (i) for a reacquisition occurring in 2009, with the fifth tax year following the tax year in which the reacquisition occurs; or (ii) for a reacquisition occurring in 2010, with the fourth tax year following the tax year in which the reacquisition occurs. A reacquisition for this purpose, may be by cash, another debt instrument, modification of the debt instrument, for a partnership interest, or by contribution to capital. B. The Section 108(i) Election. In the case of a partnership, the deferral election B which is in lieu of the exclusions under '108(a)(1) B is made at the partnership entity level. Section 108(i) deferred income is accelerated if the partnership liquidates or sells substantially all of its asset, ceases to do business, or is in similar circumstances. The sale or exchange or redemption of an interest in an electing partnership is also an acceleration event. C. Effect of the Section 108(i) Election. If an election is made by a taxpayer, the deferred income is included ratably over a five-year period beginning in the fifth tax year after the debt discharge if the debt is discharged in 2009, or beginning in the fourth tax year after the discharge if the debt is discharged in 2010. For a calendar-year taxpayer, this means that the income is included ratably in years 2014-2018. The election is available on a debt-by-debt basis. If an election is made for any debt, no exclusion under Section 108(a)(1) is available for that debt. Any 2

income deferred under '108(i) is allocated to the partners immediately before the discharge of indebtedness in the manner that the amounts would have been included in the partners' distributive shares under '704 if the income were recognized at the time of the discharge. Any decrease in a partner's share of liabilities as a result of the discharge is not taken into account for '752 purposes at the time of the discharge to the extent the '752 deemed distribution would cause the partner to recognize gain under '731. Thus, the deemed distribution is deferred with respect to a partner to the extent it exceeds the partner's basis; amounts so deferred are taken into account at the same time -- and to the extent remaining in the same amount -- as the partner recognizes '108(i) deferred income. D. Revenue Procedure 2009-37. Since the literal language of Section 108(i) precludes application of the exclusions provided by Section 108(a)(1) after the Section 108(i) election is made by the partnership, and the election is irrevocable, Section 108(i) at first blush seemed to create a tension between an electing partnership and its partners where the partnership included one or more insolvent or bankrupt partners along with one or more hopelessly solvent partners; that is, how would a partnership and its advisors decide whether or not to make the Section 108(i) election when making the election would be beneficial to some of the partners and detrimental to others? Fortunately, IRS published guidance under Section 108(i) has made the decision much easier. Rev. Proc. 2009-37 provides that a partnership "may make an election for any portion of COD income realized from the reacquisition of any applicable debt instrument." Further, a "partnership is not required to make an election for the same portion of COD income arising from each applicable debt instrument that it reacquires, but may make an election for different portions of COD income arising from different applicable debt instruments (whether or not part of the same issue)." Most importantly, it also provides: AA partnership that elects to defer less than all of the COD income realized from the reacquisition of an applicable debt instrument may determine, in any manner, the portion, if any, of a partner's COD income amount that is the partner's deferred amount and the portion, if any, of a partner's COD income amount that is the partner's included amount. Thus, for example, one partner's deferred amount may be zero while another partner's deferred amount may equal that partner's COD income amount (or any portion thereof). A partner may exclude from income the partner's included amount under [Section] 108(a)(1)(A), (B), (C), or (D), if applicable.@ See Rev. Proc. 2009-37, Section 4.04[3]. E. Allocation of Deferred COD Income Among the Partners. Any income that is deferred by reason of a Section 108(i) election is recognized ratably in years 2014-2018. That deferred income must be allocated among the partners according to how much they benefited from the deferral. Section 108(i)(6) provides: In the case of a partnership, any income deferred under this subsection shall be allocated to the partners in the partnership immediately before the discharge in the manner such amounts would have been included in the distributive shares of such partners under Section 704 if such income were recognized at such time. See Exhibit AB@ for a hypothetical example of a partnership=s election to apportion a partner=s deferred COD income amount and a partner=s included amount under Section 108(i), applying the principles of Revenue Procedure 2009-37. F. COD Income from the Acquisition of a Debt Instrument by a Related Party. A debtor can recognize COD income if its debt instrument is acquired at a discount by a related party. Section 3

108(e)(4) provides that the acquisition of indebtedness by a person related to the taxpayer (within the meaning of Section 267(b) or 707(b)(1)) is to be treated as the acquisition of the debt by the taxpayer. For purposes of this rule, related parties include not only direct family members (taxpayer, spouse, children, grandchildren, and parents) but also any spouse of the individual's children and grandchildren. In the entity context, two entities that are treated as a single employer under Section 414(b) or (c) are treated as related. Under Reg. 1.108-2(a), a debtor has COD income if its outstanding debt instrument is acquired at a discount by a related person from an unrelated person. The COD income recognized by the debtor depends on the cost of the debt instrument at the time of its acquisition. The debtor is deemed to issue a new debt instrument to the related holder at the time of the acquisition, and the new instrument will have an issue price equal to the cost of the old debt instrument. Under the OID rules, the related party that acquires the debt instrument would be required to recognize OID income, and the issuer would have OID deductions, during the remaining life of the debt instrument. This raises problems if the parties are not sufficiently "related" so that interest income can be offset by interest deductions. See Exhibit AC@ for a hypothetical example under Section 108 of the acquisition of a partnership=s debt instrument by a party related to a partnership. III. PARTNERSHIPS - "QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS@ ELECTION UNDER SECTION 108(C). A. The QRPBI Exclusion. Section 108(a)(1)(D) provides for an exclusion from gross income for discharged qualified real property business indebtedness of taxpayers other than C corporations. Generally, the effect of the exclusion for discharged qualified real property business indebtedness is to give an eligible taxpayer, not in bankruptcy or insolvent, an election to reduce the basis of depreciable real property by the amount of discharged qualified real property business indebtedness, in lieu of recognizing income. The exclusion for qualified real property business indebtedness can apply after application of the insolvency exclusion to the extent the taxpayer is rendered solvent by the discharge. Unlike the other exclusions under '108(a)(1), the exclusion for qualified real property business indebtedness is elective. The election is made pursuant to Section 108(c) on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness and (Section 1082 Basis Adjustment), attached to the taxpayer's return for the taxable year of the discharge. Under '108(d)(9)(B), the election can be revoked only with the consent of the IRS. B. The QRPBI Election. While the election is made at the partner level, the determination of whether the debt constitutes qualified real property business indebtedness is made at the partnership level. For purposes of making such determination, Revenue Ruling 76-86 provides support for the argument that real property that is "dealer inventory" is considered real estate assets "used in a trade or business" for purposes of the qualified real property business indebtedness exception set forth in Section 108(c). C. What is QRPBI? "Qualified Real Property Business Indebtedness" is indebtedness that meets all of the following conditions: 1) it was incurred or assumed in connection with real property used in a trade or business; 2) it is secured by such real property; 3) it was incurred or assumed at either of the following times: (a) before 1993; or (b) after 1992, if the debt is either (i) 4

qualified acquisition indebtedness, or (ii) debt incurred to re-finance qualified real property business debt incurred or assumed before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced); and 4) it is debt to which the taxpayer elects to apply these rules. D. Scope of the QRPBI Exclusion. It is important to note that this exclusion does not apply to a cancellation of debt in a Title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the cancellation. If qualified real property business debt is canceled in a Title 11 case, the taxpayer must apply the bankruptcy exclusion rather than the exclusion for canceled qualified real property business debt. If the taxpayer was insolvent immediately before the cancellation of qualified real property business debt, the taxpayer must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business debt. The amount of canceled qualified real property business debt that can be excluded from income is limited. If the taxpayer excluded canceled debt from income under the insolvency exclusion, the taxpayer must reduce his tax attributes to account for the amount of the canceled debt excluded under the insolvency exclusion before determining his limit on the exclusion of canceled qualified real property business debt. The exclusion for canceled qualified real property business debt is limited to the excess (if any) of: (i) the outstanding principal amount of the qualified real property business debt (immediately before the cancellation), over (ii) the FMV (immediately before the cancellation) of the business real property securing such debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property (immediately before the cancellation). In addition to this limit, the amount of canceled qualified real property business debt that can be excluded from income cannot exceed the total adjusted bases (determined after any attribute reductions under Internal Revenue Code Sections 108(b) and (g)) of depreciable real property held by the taxpayer immediately before the cancellation (other than depreciable real property acquired in contemplation of the cancellation). It is important to note that the recapture of basis reductions applies to the subsequent sale of reduced basis property and the QRPBI basis reduction is deemed to be attributable to depreciation deductions. Thus, if the property is later sold at a gain the portion of the gain attributable to QRPBI basis reduction is taxable as ordinary recapture income. E. What is ADepreciable Property@? For these purposes, "depreciable property" means any property eligible for depreciation or amortization but only if a basis reduction would reduce the amount of depreciation otherwise allowable for the period immediately following such reduction; at the taxpayer's election, real property which is stock in trade or inventory under '1221(a)(1) is also considered depreciable property. It is important to note that partnership interests are treated as depreciable real property to the extent of the partner's proportionate interest in the depreciable real property held by the partnership (provided the partnership makes a corresponding reduction in the basis of depreciable partnership real property with respect to that partner). However, a debtor/partner can reduce the basis of its partnership interest only if the partnership agrees to make a corresponding reduction to its basis in depreciable partnership property (i.e., similar to the adjustment under '754). IV. PROS AND CONS OF THE ELECTION TO DEFER. 5

At first blush, taxpayers are likely to view the deferral of COD income as favorable B why not pay tax in the future rather than today? This provision was intended by Congress to be a benefit for taxpayers who have COD income. Furthermore, this new rule was intended to allow lenders to dispose of the debt they have on their books by encouraging debtors to purchase it without immediate tax consequences. On further analysis, however, it seems that this election may be fully advantageous only in certain circumstances. Assume that a partnership has issued qualified real property business indebtedness ("QRPBI") that is secured by real estate. All of the partners are solvent, so that the partners are not permitted to exclude COD income under Section 108(a)(1)(B). Instead of electing to defer COD income pursuant to Section 108(i), the partnership and its partners can elect under Section 108(c) to exclude the COD income in exchange for decreasing the basis in the property that secures the debt (or, in certain situations, other depreciable real estate). As a practical matter, electing a basis reduction with respect to QRPBI usually will be more advantageous than electing to defer COD income under Section 108(i). This is because the "cost" of excluding the COD income with respect to QRPBI will be spread over the remaining useful life of the real property; whereas, the deferral under Section 108(i) is only for five years at most (until 2014), with the COD income being recognized in the following five years. Unless the remaining useful life of the real estate is severely limited-not usually the case if a property is overleveraged-it generally will be preferable to defer the COD income by making the election under Section 108(c) with respect to QRPBI. Thus, it can be anticipated that the holders of overleveraged real estate that are able to arrange for either the cancellation or the acquisition (at a discount) of their debt will not make the election permitted under Section 108(i). See "Recovery Act Allows Deferral of COD IncomeCTo Elect or Not?", by Richard M. Lipton (Journal of Taxation, Volume 110, Number 05, May 2009). However, in the aftermath of Rev. Proc. 2009-37, the Section 108(i) election becomes more attractive because the election is no longer a zero sum game as between the partners of the partnership; that is, a partnership with an insolvent partner can make a Section 108(i) election for the benefit of one or more of the other solvent partners but not for the insolvent partner. In such a case, the solvent partners would be able to benefit from Section 108(i) deferral while the insolvent partner would be able to avail herself of the exclusion provided in Section 108(a)(1)(B), which allows any insolvent taxpayer to exclude COD income to the extent of the insolvency. V. SHOULD A GUARANTOR REALIZE INCOME FROM THE CANCELLATION OF INDEBTEDNESS IF THE LIABILITY IS SETTLED FOR LESS THAN ITS FACE AMOUNT? A. Decided Cases. A guarantor should not realize COD income on the payment of the obligation at less than face value. Several courts have held that the application of the Kirby Lumber rules should not result in the realization of income upon the release of the taxpayer's obligation as a guarantor. For example, in Hunt v. Commissioner, T.C.M. 1990-248, the Tax Court explained: 6

AThe situation of a guarantor is not like that of a debtor who as a result of the original loan obtains a nontaxable increase in assets. The guarantor obtains nothing except perhaps a taxable consideration for his promise. Where a debtor is relieved of his obligation to repay the loan, his net worth is increased over what it would have been if the original transaction never occurred. This real increase in wealth may be properly taxable [under Kirby]. However where the guarantor is relieved of his contingent liability,... no previously untaxed accretion in assets thereby results in an increase of net worth. Payment by the principal debtor does not increase the guarantor=s net worth; it merely prevents it, pro tanto, from being decreased. The guarantor no more realizes income from the transaction than he would if a tornado, bearing down on his home and threatening loss, changes course and leaves the house intact.@ Hunt v. Commissioner, T.C. Memo. 1990-248 (citing Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968), acq., 1969-2 C.B. xxiv (same result). In Whitmer, TCMemo 1996-83, RIA TC Memo &96083, the Tax Court followed Hunt and Landreth in rejecting the Service's proposed taxation of a guarantor of a corporate liability who was able to discharge his obligation at less than face value. In Whitmer, the taxpayer was the sole shareholder and president of a corporation engaged in the business of selling insurance policies on a commission basis. Under the agency contract with the insurance company, a commission was paid in full when a policy was sold, although only part was deemed earned immediately. If the policy lapsed or was cancelled or not renewed before the commission was fully earned, the corporation was required to repay the unearned portion. The taxpayer had guaranteed the corporation's obligations under this contract and was personally liable. When the agency contract was terminated, the insurance company demanded repayment of $182,295. When the corporation failed to pay, the insurer sued both the corporation and the taxpayer, who asserted a number of typical counterclaims. The case was settled by the taxpayer's payment of $25,000 to the insurance company and the exchange of mutual releases. The IRS argued that the taxpayer's settlement of an obligation to pay $182,295 for only $25,000 resulted in $157,295 of COD income, even though he was only secondarily liable. Again, the Tax Court rejected the IRS= argument. B. Statutory Authority. An argument for the same result could be made based on the literal language of Section 108(e)(2), which provides that no COD income is recognized if the payment of the debt would result in a deduction. The rule is not limited to business or other ordinary deductions, but is broad enough to encompass nonbusiness bad debts and other capital losses. Nor is the rule limited to situations where the deduction accrues at the same timecor even in the same yearcthat the COD income is recognized. In the typical subrogation situation, the bad debt deduction that would arise as a result of the payment of the guaranteed obligation might be allowable immediately, or it might be allowable only after the guarantor makes reasonable efforts to collect from the prime obligor. Section 108(e)(2) covers both situations. Under some circumstances, the payment of the guaranteed debt would not be deductible as either an ordinary business expense or as a bad debt, but would be reflected in an increase in the basis of the stock or partnership interest in the primary obligor. Although the statute is not as clear as it should be, the additional basis will at some future point decrease a capital gain, increase a capital loss, or otherwise have the effect of 7

reducing income in the same way as a deduction (e.g., increased depreciation deductions). The no-income-if-deductible policy behind the provision also extends to these situations, i.e., where the payment of the obligation would be reflected in additional basis. The argument that capital losses or additions to basis are covered by Section 108(e)(2) is strengthened by looking at the source of the rule, Section 346(j)(2) of the Bankruptcy Code. It was clearly intended that a debt which, had it been paid, would have produced a tax benefit, would not result in income for state tax purposes if it were cancelled. This covers capitalized expenditures. The same rule is inherent in Section 108(e)(2). C. IRS Published Guidance. In Private Letter Ruling 201027035, the IRS followed the reasoning of the courts in the Hunt, Landreth and Whitmer cases in a situation where a debtor negotiated with a creditor to pay off a debt at a discount. The IRS found that because the debtor=s obligation under the debt instrument was contingent only and not fixed, the negotiated prepayment reduction would not generate cancellation of indebtedness income. VI. SECTION 108(D)(3) AND THE DEFINITION OF AINSOLVENCY@ - IS A GUARANTY OF INDEBTEDNESS COUNTED AS A ALIABILITY@ FOR PURPOSES OF THE INSOLVENCY EXCEPTION? A. Insolvency Exception. Section 108(a)(1)(B) allows any insolvent taxpayer to exclude COD income to the extent of the insolvency. The "cost" of this exclusion is limited to attribute reduction, and if the taxpayer does not have any (or sufficient) attributes to reduce, the COD income is still excluded. However, neither the statutory language of Section 108(d)(3) nor the Committee Reports specify which assets and which liabilities are taken into consideration for purposes of determining insolvency. The courts have imposed a high burden of proof for contingent liabilities B such as a guaranty of indebtedness. B. Decisional Authority and Test. The Tax Court and Ninth Circuit require that the taxpayer prove by a preponderance of the evidence that he or she will be called upon to pay a contingent liability before it may be included in the insolvency determination. For example, in Merkel v. Comr., 192 F.3d 844 (9th Cir. 1999), the court held that the taxpayer's guaranty of a nonrecourse note did not count as a liability for purposes of '108(a)(1)(B) because, as of the date of discharge of indebtedness, that taxpayer's obligation to pay the obligation was not ripe. This is an all-or-nothing-at-all approach that rejects the analysis used in bankruptcy that would discount the value of contingent liabilities by the probability of their occurrence. Thus, for purposes of Section 108(a)(1)(B), a taxpayer who asserts that a "Guaranty" of indebtedness should be counted as a liability in determining insolvency must prove by a preponderance of the evidence that he or she will be called upon to pay that "Guaranty" obligation claimed to be a liability. L:\DOCS\014\03\154151202.DOC 11/3/10 FICPA - Partnership COD Income Outline Final 8

PARTNERSHIP COD INCOME B TO ELECT, TO PARTIALLY ELECT OR NOT TO ELECT, THOSE ARE THE QUESTIONS Presented to the Florida Institute of Certified Public Accountants 2010 Florida Institute on Federal Taxation Conference Hilton in Walt Disney World Resort in Orlando November 3, 2010 Prepared by: Richard B. Comiter, Esq. Domenick R. Lioce, Esq. Mark Wisniewski, Esq.