Facts: Fred contributes $10,000 and Ethel contributes $90,000 to form The Mertz Company, a general partnership holding rental property. Fred and Ethel allocate the partnership's losses, 10% and 90%, respectively. They share the partnership's income 50% each (income allocations do not first restore previous losses). Mertz maintains capital accounts in accordance with the regulations. Fred and Ethel agree to liquidate according to positive capital account balances. Under state law, Fred and Ethel are jointly and severally liable to creditors for all partnership recourse liabilities. Fred and Ethel do not agree to unconditional deficit restoration obligations; they are obligated to restore deficit capital accounts only to the extent necessary to pay creditors. Fred and Ethel have agreed to a qualified income offset and are treated as having a limited obligation to restore deficit capital accounts by reason of their liability to Mertz's creditors. * Mertz purchased apartment buildings for $1 million from an unrelated seller, paying $100,000 in cash and borrowing $900,000 from a bank (that is not the seller of the property).The note is a general Mertz obligation, and neither partner has been relieved of personal liability. The note is payable over six years, with interest due semi-annually. Fred and Ethel bear an economic risk of loss equal to $90,000 and $810,000, respectively, for the partnership's $900,000 recourse liability. They increase basis in their partnership interests accordingly. * In each of its first five tax years, Mertz had a net loss of $200,000. At the beginning of the sixth year, the fair market value (FMV) of the properties substantially declined. The creditor cancels the debt as part of a workout arrangement. Issue: What effect will the partnership's cancellation of debt (COD) income have on Fred and Ethel?
Sec. 108(a) allows for the exclusion of COD income from gross income under certain conditions. The discharge of a partnership debt is recognized as income and allocated to the partners as a separately stated item. The Sec. 108 exclusion is applied at the partner level for any COD income. The partners must determine (based on their own circumstances) if all or part of their distributive shares of the COD income can be excluded from their gross incomes under Sec. 108(a).
If an allocation of a partnership's COD income is made to a partner and it has substantial economic effect, the partner increases his outside...