Impact of anticipated COD income on investors joining existing partnerships.

• Author: Dodge, Justin
• Position: Cancellation of debt

When appreciated property is contributed to a partnership, the precontribution gain is accounted for under Sec. 704(c), which provides that income, gain, loss, and deduction for property contributed to the partnership by a partner are shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value (FMV) at the time of contribution. As a result, the contributing partner continues to bear the tax burden from any precontribution gain of contributed property. Sec. 704(c) addresses only contributed property with a precontribution gain. It does not address a precontribution gain associated with a liability.

The idea of a precontribution gain related to a liability may not seem logical. However, in these unique economic times, it is not only possible, it may become more prevalent in the short term. As financially distressed companies search for ways to restructure, lenders may be willing to settle their loans for less than their face value, which would result in cancellation of debt (COD) income. If this restructuring involves a new investor and the formation of a new partnership or a contribution of cash to an existing partnership, the anticipated COD income resulting from the restructuring and settled debt is effectively a precontribution gain even though it is associated with a liability instead of property. There is currently no statutory guidance that addresses a precontribution gain associated with a liability.

If property subject to a debt in excess of the property's FMV is contributed to a newly formed partnership, Sec. 752(c) appears to help resolve this problem. Under Sec. 752(c), a liability to which property is subject will, to the extent of the FMV of such property, be considered as a liability of the property's owner. The phrase "to the extent of the FMV of such property" seems to require that the encumbrance be fragmented. The portion not in excess of FMV apparently becomes a partnership liability for purposes of Sec. 752, while the excess, which clearly is not a Sec. 752 partnership liability due to Sec. 752(c), presumably continues to be viewed as a liability of the contributing partner.

Applying the FMV limitation of Sec. 752(c) to a partnership liability is also likely to prevent the entire liability (or at least the excess of the liability over the value of the property) from being recognized as a liability of the partnership for any tax purposes. Consequently, it appears the liability that is in excess of the property's FMV would not be included in the amount realized by...