Partner loans: traps for the unwary.

• Author: Foley, Gretchen

Generally, liquidating distributions of property are tax free under the partnership distribution rules. A 2002 letter ruling suggests that an otherwise nontaxable partnership liquidation may be taxable when the partnership has an outstanding loan from the continuing owner.

When a partnership terminates, either because one partner purchased all the interests of the partnership or because all but one partner is redeemed, the partnership is deemed to distribute a portion of all its assets and liabilities to the remaining partner in liquidation of the partnership. Letter Ruling 200222026 provides that if a partnership has an outstanding partner loan on the termination date, the termination causes the debtor-creditor relationship to be merged and, as a result, the debt is extinguished. The partnership is viewed as transferring its assets to the creditor-partner in satisfaction of the debt. This treatment may create tax problems for the creditor-partner, but proper tax planning may be able to mitigate them.

Partnership-Level Consequences

Gain recognition and COD income: According to the letter ruling, the partnership is viewed as making a taxable transfer of its assets to the partner in satisfaction of the debt, rather than a nontaxable distribution. The partnership recognizes gain to the extent the amount realized exceeds the partnership's basis in the assets transferred.

The partnership also may have cancellation of indebtedness (COD) income, depending on whether the partner loan is recourse or nonrecourse. Under the partnership allocation rules, the COD income should be allocated to the partners who received the benefits of the deductions funded by the cancelled debt. In many cases, the deductions would have been allocated to the creditor-partner, so the COD income should be allocated to the creditor-partner. But to ensure the COD income is properly allocated, prior-year tax returns should be reviewed to determine who received the benefit of the deductions.

The partners will not be able to exclude their share of the COD income if they are solvent, even though the partnership may be insolvent. The Sec. 108(a) insolvency exclusion applies only when the partner is insolvent (i.e., when the partner has liabilities that exceed the fair market value (FMV) of his or her assets, excluding the interest in the terminated partnership).

Disallowed loss: If the partnership has any assets with a value less than tax basis, the partnership would recognize a...