16 Dec IRS Releases Final Rules Applying Section 108(e)(8) COD Income to Partners and Partnerships
On Nov. 15, 2011 the Internal Revenue Service (IRS) released guidance on the application of the Section 108(e)(8) to cancellation of indebtedness (COD) income of partners and partnerships (the “Guidance”). See T.D. 9557. The new rules are effective Nov. 17, 2011.
Generally, Section 108(e)(8) provides that when a partnership transfers a capital or profits interest to a creditor in satisfaction of the partnership’s indebtedness, the partnership will be treated as having satisfied the indebtedness with cash of a value equal to the fair market value of the partnership interest transferred to such creditor. COD income exists if the value of the partnership interest transferred is less than the indebtedness cancelled. COD income realized on such a transfer, if any, is allocated to the partners of the partnership based on their distributive shares immediately before such cancellation. The Guidance clarifies that the value of partnership interest transferred is equal to the liquidation value of such interest so long as – (1) all parties involved in the exchange (i.e. the creditor, debtor, partnership etc) consistently treat the value as being the liquidation value; (2) the partnership uses a consistent valuation methodology in all debt for equity exchange that are part of the same transaction; (3) the debt for equity exchange is made at arm’s length (can be satisfied even if the parties are related); and (4) following the debt for equity exchange, neither the partnership nor any related person purchases the partnership interest as a part of a plan that existed as of the time of the debt for equity exchange in a transaction that’s principal purpose is the avoidance of COD income.
The Guidance also address the application of Internal Revenue Code Section 721 relating to a creditor’s contribution of a recourse or nonrecourse indebtedness to a partnership in exchange for a capital or profits interest. Generally, the nonrecognition rule of Section 721 applies in a debt for equity exchange and the creditor will not recognize a loss or bad debt deduction in such an exchange. The creditor’s basis in the partnership interest received is increased by the adjusted basis of the indebtedness. Ordinary income items, such as rent, royalties and interest cannot, however, be cancelled in a nonrecognition transaction under Section 721, unless such obligations arose before the beginning of the creditor’s holding period for the indebtedness.
Finally, the Guidance address how to allocate income arising from a partnership’s discharge of indebtedness as a minimum gain chargeback. The Guidance provides that COD income arising in the discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes.
The Guidance and new regulations will contain a few examples to demonstration application of these rules.