Proposed Regulations on Partnership Interest Transferred to Creditor in Debt-for-Equity Exchange
| Proposed Regulations on Partnership Interest Transferred to Creditor in Debt-for-Equity Exchange |
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The IRS has issued proposed regulations that provide guidance under Code Sec. 108(e)(8) on the determination of cancellation of debt (COD) income of a partnership that transfers a partnership interest to a creditor in satisfaction of the partnership's debt (debt-for-equity exchange). The proposed regulations also provide that the Code Sec. 721 nonrecognition rule applies to a contribution of a partnership's recourse or nonrecourse debt by a creditor to the partnership in exchange for a capital or profits interest in the partnership. The proposed regulations would be effective when published as final regulations. Background. Under Code Sec. 108(e)(8), to determine income of a debtor from COD, if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse debt, the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value (FMV) of the stock or interest. For a partnership, any COD income recognized is included in the distributive shares of its partners immediately before the discharge. Under Code Sec. 721, with some exceptions, no gain or loss is recognized to a partnership or any of its partners when property is contributed to the partnership in exchange for a partnership interest. Under Code Sec. 722, the basis of a partnership interest acquired by a contribution of property, including money, to the partnership is the amount of the money and the adjusted basis of the property to the contributing partner at the time of the contribution, increased by the amount (if any) of gain recognized under Code Sec. 721(b) to the contributing partner at that time. Proposed Code Sec. 108 regulations. The proposed regulations would provide that for purposes of applying Code Sec. 108(e)(8), the FMV of a debt-for-equity interest would be the liquidation value of that debt-for-equity interest, if: (1) The debtor partnership determines and maintains capital accounts of its partners in accordance with the capital accounting rules of Reg. § 1.704 1(b)(2)(iv); The liquidation value would equal the amount of cash that the creditor would receive for the debt-for-equity interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the FMV of those assets, and then liquidated. If a partnership maintains capital accounts complying with the capital accounting rules of Reg. § 1.704 1(b)(2)(iv), the amount by which the creditor's capital account would be increased as a result of the debt-for-equity exchange would equal the FMV of the debt exchanged. (Prop Reg § 1.108-8(b)(1)) If the above conditions aren't satisfied, all of the facts and circumstances would be considered in determining the FMV of the debt-for-equity interest under Code Sec. 108(e)(8). (Prop Reg § 1.108-8(b)(2)) Proposed Code Sec. 721 regulations. In a debt-for-equity exchange the Code Sec. 721 nonrecognition rule generally would apply to the creditor's contribution of partnership debt to the partnership in exchange for the partnership interest. (Prop Reg § 1.721-18(d)(1)) The proposed regs would provide that Code Sec. 721 doesn't apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership's debt for unpaid rent, royalties, or interest on debt (including accrued original issue discount). The rules under Code Sec. 453B (dealing with dispositions of installment obligations) wouldn't be superseded. Prop Reg § 1.721-18(d)(2)) The basis of the creditor's interest in the partnership would be determined under Code Sec. 722. A creditor wouldn't recognize a loss in a debt-for-equity exchange subject to Code Sec. 721 in which the liquidation value of the debt-for-equity interest is less than the outstanding principal balance of the debt. Instead, the creditor's basis in the debt-for-equity interest received in the debt-for-equity exchange would be increased by the adjusted basis of the debt. The debt-for-equity interest would include the creditor's holding period in the debt under Code Sec. 1223(1) tacking rule. Comments are requested. IRS requests comments on the treatment of debt-for-equity exchanges under the proposed regulations, including (i) whether any special allocation rules of COD income should apply where partnership debt that is owed to a preexisting partner is satisfied with the transfer of a partnership interest; (ii) whether COD income arising from a debt-for-equity exchange should be treated as a first-tier item under Reg. § 1.704 2(f)(6) for purposes of the minimum gain chargeback rules; and (iii) how the rules in the noncompensatory partnership options regs relating to convertible debt interact with the rules in the proposed regulations under Code Sec. 108(e)(8). |
