Incorporating an insolvent partnership: availability of the insolvency exclusion.

• Author: Weber, Mindy Tyson

A corporate taxpayer's cancellation of debt (COD) income is excluded under Sec. 108(a)(1)(B) to the extent of the corporation's insolvency (total liabilities in excess of the fair market value (FMV) of total assets). Sec. 108(d)(6) provides that, in the case of a partnership, insolvency determinations apply at the partner level rather than the partnership level. Therefore, to the extent a solvent partner receives an allocation of COD income from a partnership, the insolvency exclusion is not available.

However, based on a recent revenue ruling, the extent of a partnership's insolvency may be a significant factor in determining a partner's insolvency. In Rev. Rul. 2012-14, the IRS held that to the extent discharged excess nonrecourse debt generates partnership COD income allocated to the partners under Sec. 704(b) and the regulations thereunder, each partner should treat its allocable portion of the excess nonrecourse debt generating COD income as a liability when measuring insolvency.

If the partners receiving the COD income are solvent (and no other exclusions from COD income apply), the partners may be tempted to incorporate the partnership (or their partnership interests) prior to the COD income event to claim the insolvency exclusion at the corporate level. This item analyzes the merits of such an incorporation, as well as issues taxpayers and advisers should consider.

Example 1: Assume ABC LLC is a partnership for federal tax purposes, with three partners, A, B, and C. A, a private-equity fund, owns 80% of ABC. ABC has assets with an FMV of $300 and owes $500 to unrelated third parties, thereby making ABC insolvent by $200. ABC has negotiated a write-down of the debt with its creditors, whereby the creditors agreed to reduce the debt by $200, resulting in realized COD income of $200. Since the exclusions under Sec. 108(a) apply at the partner level, the partnership will include on the partnership return $200 of COD income that will flow through to the partners. Unless the partners qualify for an exclusion from COD income at the individual level, the COD income will be includible in the partners' taxable income. However, prior to the COD income event, A's attorney suggests that ABC check the box to elect treatment as a corporation before the COD income event to claim the insolvency exclusion at the corporate level. Alternatively, A's attorney suggests that A could transfer its 80% interest in ABC to a newly created corporation (Newco). Since the 80% interest in ABC would be Newco's only asset, Newco would be insolvent after applying Rev. Rul. 2012-14 and could exclude the COD income under the insolvency exception.

At this point, it remains unclear whether the partners and partnership intend to report the incorporation as a tax-deferred transaction under Sec. 351 or as a taxable incorporation under Sec. 1001. While an in-depth analysis of the application of Sec. 351 is beyond the scope of this article, it is important to determine the availability of Sec. 351 when incorporating an insolvent partnership, as well as the applicability of Secs. 362(e)(2), which limits built-in losses in Sec. 351 transactions, and 357(b)--(d), which govern the assumption of liabilities.

Whether undertaking a nontaxable or taxable incorporation, two significant issues should be considered before claiming the insolvency exclusion: (1) the extent to which Sec. 269 could apply to disallow the...