Partnership Workouts Hot Topics Addendum

Partnership Workouts Hot Topics Addendum A. Section 108(e)(8) Application to Partnerships 1. In General. Code Section 108(e)(8) was expanded in 2004 to include discharges of partnership indebtedness. [Prior to such time, Code Section 108(e)(8) applied only to discharges of corporate indebtedness.] As amended, Code Section 108(e)(8) provides that for purposes of determining income of a debtor from discharge of indebtedness ( COD income), if a debtor corporation transfers stock or a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, such corporation or partnership shall be treated as having satisfied the debt with an amount of money equal to the fair market value of the stock or partnership interest. In the case of a partnership, any COD income recognized under Code Section 108(e)(8) will be included in the distributive shares of the partners in the partnership immediately before such discharge. a. Example: Partnership AB has two equal partners A and B. Partnership AB owns land worth $100, that is subject to debt in the amount of $70 owned to Lender. Lender agrees to contribute the debt to Partnership AB in exchange for a 50% partnership interest, which dilutes A and B to 25% each. Assuming the value of the 50% partnership interest is $50, Partnership AB recognizes COD income in the amount of $20 ($70 - $50), which must be allocated equally to A and B. 2. Valuation. The amount by which the contributed indebtedness exceeds the fair market value of the partnership interest transferred is the amount of COD income. For this purpose, Proposed Regulations under Code Section 108(e)(8) (REG 164370-05, October 31, 2008) allow the partnership and the creditor to value the partnership interest based on liquidation value. If the partnership satisfies the four conditions below, liquidation value equals the amount of cash that the creditor would receive with respect to the debt-for-equity interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and other intangibles) for cash equal to the fair market value of those assets, and then liquidated. The four conditions are: a. The partnership must maintain capital accounts in accordance with Treas. Reg. 1.704-1(b)(2)(iv); b. The parties must treat the fair market value of the debt as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-for-equity exchange; c. The transaction must be arm s-length; d. Following the exchange, the partnership does not redeem (nor does a related party purchase) the debt-for-equity interest as part of a plan at the

time of the exchange that has a principal purpose of avoiding COD income by the partnership. If the four conditions are not satisfied, all facts and circumstances are considered in valuing the debt-for-equity interest received by the creditor. 3. Example: (i) AB partnership has $1,000 of outstanding indebtedness owed to C. In an arm's-length transaction, C agrees to cancel the $1,000 indebtedness in exchange (debt-for-equity exchange) for an interest (debt-for-equity interest) in AB. AB's partnership agreement provides that its partners' capital accounts will be determined and maintained in accordance with the capital accounting rules in 1.704-1(b)(2)(iv). The fair market value of the $1,000 indebtedness is $700 at the time of the debt-for-equity exchange. Under 1.704-1(b)(2)(iv)(b), C's capital account is increased by $700 as a result of the debt-for-equity exchange. This amount equals the liquidation value of C's debt-for-equity interest, which is the amount of cash that C would receive with respect to that interest if AB partnership sold all of its assets for cash equal to the fair market value of those assets and then liquidated. C, AB partnership, and its partners treat the fair market value of the indebtedness as being equal to the liquidation value of C's debt-for-equity interest ($700) for purposes of determining the tax consequences of the debt-for-equity exchange. Subsequent to the debt-for-equity exchange, neither AB partnership redeems nor any person related to AB partnership purchases C's debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange which has as a principal purpose the avoidance of COD income by AB partnership. (ii) Because the for requirements set forth above are satisfied, the fair market value of C's debt-for-equity interest in AB partnership for purposes of determining AB partnership's COD income is the liquidation value of C's debt-for-equity interest, or $700. Accordingly, AB partnership is treated as satisfying the $1,000 indebtedness with $700 under section 108(e)(8). 4. Application of Code Section 721. The Proposed Regulations provide that in the case of a debt-for-equity exchange, the nonrecognition rule of Code Section 721 generally applies to the creditor s contribution of partnership indebtedness (other than unpaid interest or accrued OID) to the partnership in exchange for the partnership interest. However, Code Section 721 does not apply to transfers of partnership interests to a creditor in satisfaction of indebtedness for unpaid rent, royalties, or interest (including OID). As a result of the application of Code Section 721, the creditor s basis and holding period generally are determined under Code Sections 722 and 1223(1). [Note: Under this regime, the creditor s loss will be embedded in its partnership interest and recognized upon the ultimate disposition of such interest.] 5. Commentary. For critical commentary of the Proposed Regulations under Code Section 108(e)(8), see Comments on Behalf of the American Bar Association Section of Taxation dated May 4, 2009; Lipton, Prop. Regs. on Contributions of Partnership Debt Do Not Answer the Hard Questions, 110 J. of Tax n No. 02 (February 2009); Rubin, Whiteway and Finkelstein, Creditors Beware: Proposed

Partnership Debt-For-Equity Regulations Deny Your Tax Loss (November 15, 2008) (paper presented at ABA Tax Section Meeting May 2009). Common criticisms include: a. In the case of the issuance of a profits-only partnership interest, the use of liquidation value to determine fair market value will always result in COD income equal to 100% of the principal balance of the exchanged debt because the liquidation value of a profits-only interest normally is $0. In this situation, another valuation methodology would be preferable. b. Creditors should receive a partial bad debt deduction on the debt-forequity exchange by deeming the creditor to have written off immediately prior to the Code Section 721 exchange the portion of the debt that exceeds the fair market value of the partnership interest received. Otherwise, the creditor s loss is unjustifiably deferred and likely converted from ordinary to capital. c. The Proposed Regulations should relax the limitations (the four conditions) for use of liquidation value. d. The Proposed Regulations should be clarified to provide more flexibility for pre-existing partners to recapitalize partnership debt (owed to the partners) into equity while avoiding COD income. The result should mimic Code Section 108(e)(6) as applicable to contributions of debt by pre-existing shareholders to corporations. B. Revenue Ruling 92-53 Applicable to Partnerships 1. In General. Revenue Ruling 92-53 generally provides that the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent under Code Section 108(d)(3), but only to the extent that the excess nonrecourse debt is discharged. Thus, to the extent the excess nonrecourse debt is not discharged, it is not considered a liability for purposes of determining insolvency. 2. Issue. If a partnership s nonrecourse debt is discharged, can the partners include their individual shares of such debt in calculating their personal insolvency? 3. Future Guidance. IRS 2010-2011 Priority Guidance Plan indicates that the IRS will issue future guidance on the application of Revenue Ruling 92-53 to partnerships. C. Bankruptcy or Insolvency of a Disregarded Entity Proposed Regulations 1. Prior Taxpayer Positions. Some taxpayers have taken the position that the bankruptcy exception is available if a grantor trust or disregarded entity is under the jurisdiction of a bankruptcy court, even if its owner is not. The argument is

that because, for Federal income tax purposes, the disregarded entity is disregarded and the taxpayer is the owner of the disregarded entity's assets and liabilities, the taxpayer is properly seen as being subject to the bankruptcy court's jurisdiction. Furthermore, some taxpayers have taken the position that the insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. 2. Proposed Regulations. Proposed Regulations issued on April 13, 2011 (REG- 154159-09) rebuke these taxpayer arguments. Under the proposed regulations, subject to the special rule for partnerships under Code Section 108(d)(6), the insolvency exception is available only to the extent the owner of the grantor trust or disregarded entity is insolvent. Likewise, under the proposed regulations, it is insufficient for the grantor trust or disregarded entity to be subject to the bankruptcy court's jurisdiction. Thus, subject to the special rule for partnerships under section 108(d)(6), the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court's jurisdiction. 3. Clarification for Partnerships. Finally, the proposed regulations provide that, in the case of a partnership, the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. Thus, for example, if a partnership holds an interest in a grantor trust or disregarded entity, the applicability of section 108(a)(1)(A) and (B) to discharge of indebtedness income of the grantor trust or disregarded entity is tested by looking to the partners to whom the income is allocable. If any partner is itself a grantor trust or disregarded entity, the applicability of section 108(a)(1)(A) and (B) is determined by looking through such grantor trust or disregarded entity to the ultimate owner(s) of such partner. D. Canal Corporation v. Commissioner, 135 T.C. 9 (2010) 1. Importance. Partnership workouts often involve allocating partnership debt to specific partners to increase basis or avoid a constructive distribution. The Canal case places additional restrictions on partners ability to shift debt allocations. 2. Summary of Canal. In Canal Corporation v. Commissioner, the Tax Court recently held that a related contribution to and distribution from a partnership resulted in a disguised sale of property, and that the debt-financed distribution exception did not apply. In Canal, Chesapeake owned 100% of WISCO, and WISCO owned appreciated assets that GP desired to purchase. To consummate the transaction, the parties agreed to use a leveraged partnership ( LLC ) pursuant to which: (1) WISCO contributed assets worth $775 million, (2) GP contributed assets worth $376 million, (3) LLC borrowed $755 million, and then (4) LLC distributed 100% of the $755 million loan proceeds to WISCO. GP guaranteed the debt, but in an attempt to attract 100% of the debt allocation, WISCO provided an indemnity to GP (although GP never requested it). Chesapeake and WISCO treated the distribution as non-taxable on the theory that it was a debt-

financed distribution under Treasury Regulation Section 1.707-5(b). However, the parties (as well as third party rating agencies) treated the transaction as a sale for financial accounting purposes. The IRS argued that the transaction was a disguised sale for tax purposes. The facts of the case indicate that WISCO attempted to severely limit the circumstances in which it would be called upon to pay the indemnity. First, the indemnity covered only the principal of LLC s debt, due in 30 years, and not interest. Second, GP agreed that GP first had to proceed against LLC s assets before demanding indemnification from WISCO. Third, the agreement provided that WISCO would receive a proportionately increased interest in LLC if WISCO had to make a payment under the indemnity. Finally, no provision in the indemnity obligation required WISCO to maintain a certain net worth for any period of time. Although WISCO initially owned assets equal in value to 21% of the indemnity obligation, WISCO was free to dispose of those assets (by distribution or otherwise) at any time. The Tax Court ruled in favor of the IRS, finding that a disguised sale occurred. Specifically, the Tax Court held that WISCO did not bear economic risk of loss for LLC s debt because the anti-abuse rule of Treasury Regulation Section 1.752-2(j) disregarded WISCO s obligation to indemnify GP. 1 The Tax Court reasoned as follows: The parties agreed that WISCO would indemnify GP in the event GP made payment on its guaranty of the LLC s $755.2 million debt. GP did not require the indemnity, and no provision of the indemnity mandated that WISCO maintain a certain net worth. WISCO was chosen as the indemnitor, rather than Chesapeake, after PWC advised Chesapeake s executives that WISCO s indemnity would not only allow Chesapeake to defer tax on the transaction, but would also cause the economic risk of loss to be borne only by WISCO s assets, not Chesapeake s. Moreover, the contractual provisions reduced the likelihood of GP invoking the indemnity against WISCO. The indemnity covered only the loan s principal, not interest. In addition, GP would first have to proceed against the LLC s assets before demanding indemnification from WISCO. In the unlikely event WISCO had to pay on the indemnity, WISCO would receive an increased interest in the LLC proportionate to any payment made under the indemnity. 1 The parties argued as follows: Chesapeake contends that WISCO s indemnity of GP s guaranty imposes on WISCO the economic risk of loss for the LLC debt. Respondent concedes that an indemnity agreement generally is recognized as an obligation under the regulations. Respondent asserts, however, that WISCO s agreement should be disregarded under the anti-abuse rule for allocation of partnership debt. It is important (and beneficial) that the IRS conceded that the indemnity generally would work to shift the debt to the indemnitor, subject to application of the anti-abuse rule.

* * * Chesapeake maintains that WISCO had sufficient assets to cover the indemnity agreement. WISCO contributed almost all of its assets to the LLC and received a special distribution and a 5- percent interest in the LLC. Moreover, Chesapeake contends that WISCO did not need to have a net worth covering the full amount of its obligations with respect to the LLC s debt. WISCO s assets after the transfer to the LLC included the $151.05 million intercompany note and the $6 million jet. WISCO had a net worth, excluding its LLC interest, of approximately $157 million or 21 percent of the maximum exposure on the indemnity. * * * We may agree with Chesapeake that no Code or regulation provision requires WISCO to have assets covering the full indemnity amount. We note, however, that a partner s obligation may be disregarded if undertaken in an arrangement to create the appearance of the partner s bearing the economic risk of loss when the substance of the arrangement is in fact otherwise. WISCO s principal asset after the transfer was the intercompany note. The indemnity agreement did not require WISCO to retain this note or any other asset. Further, Chesapeake and its management had full and absolute control of WISCO. Nothing restricted Chesapeake from canceling the note at its discretion at any time to reduce the asset level of WISCO to zero. In fact WISCO s board, which included many Chesapeake executives, did cancel the note and issued an intercompany dividend to Chesapeake in 2001.... We find that WISCO s agreement to indemnify GP s guaranty lacked economic substance and afforded no real protection to GP. 2 Because the Tax Court held that WISCO did not bear the economic risk of loss for the LLC debt, the Tax Court held that the distribution was taxable as a disguised sale. 3. Lessons. Partners seeking to use guarantees to allocate debt must be careful that the guarantees withstand scrutiny under the anti-abuse rule. In particular, based on Canal, the guarantee should satisfy the following conditions: a. The guarantee should cover both principal and interest. b. The guarantor should not receive an increased interest in the partnership if called upon to pay the guarantee. 2 135 T.C. 9 (2010).

c. The guarantor should not represent to third parties that the transaction was in fact a sale for financial accounting or other purposes. d. The guarantor should have sufficient assets to cover the guarantee in the event the guarantor is called upon to pay. The Canal decision indicates that the guarantor need not have assets covering the full indemnity amount; however, the law is unclear as to the requisite level of assets required. In light of Canal, some commentators have suggested having assets equal to at least 50% or even 100% of the obligation. 3 e. The guarantee should require the guarantor to maintain a sufficient level of net worth for the term of the guarantee. E. PMTA 2010-05 PMTA 2010-05 addresses whether tenants-in-common who undertake joint activities during a workout have become partners in a de facto partnership for federal income tax purposes. For a discussion of the tax issues, see Thomson and Keator, IRS Offers Lenience for Beleaguered Tenancy-in-Common Investors, J. Real Est. Tax n (4 th Quarter 2010) (attached). 3 See Sam Young, Court Misguided in Accuracy-Related Penalty Decision, Practitioners Say, Tax Notes Today (August 9, 2010) (quoting Robert Willens); Practitioners Discuss How Canal Crossed the Leveraged Partnership Line, 2011 TNT 64-2 (April 4, 2011) (Eric Sloan stating that most people today require 100 percent net worth ).