Final partnership debt-for-equity regulations.

• Author: Anderson, Kevin D.

The IRS issued final regulations (T.D.9557) that provide guidance on the recognition of discharge of indebtedness (DOI) income in partnership debt-for-equity transfers taking place on or after Nov. 17, 2011. The final regulations generally (1) allow partnerships to use liquidation value to determine the amount of DOI income; (2) provide that nonrecognition of gain or loss under Sec. 721 applies to the creditor's contribution of the debt instrument in exchange for a capital or profits interest in the debtor partnership; and (3) add DOI income as a "first-tier" item for purposes of the minimum gain chargeback rules. (For prior coverage of these regulations, see News Notes, "Regs. Issued on Transfers of Partnership Interest to Satisfy Partnership Debt," 43 The Tax Adviser 6 (January 2012).)

Background

Sec. 108(e)(8) requires corporate taxpayers to recognize DOI income if they issue their own stock in satisfaction of their debt and the value of the stock issued is less than the debt amount on the date of the transfer. Before Oct. 22, 2004, it was unclear whether a similar rule applied to partnership debt-for-equity transfers, and, if so, how such a rule would apply. Section 896 of the American Jobs Creation Act of 2004, P.L. 108-357, amended Sec. 108(e) (8) to address partnership debt-for-equity transfers. Sec. 108(e)(8), as amended, provides that, if a partnership issues a capital or profits interest to a creditor in satisfaction of its recourse or nonrecourse indebtedness, it will be treated as having satisfied the indebtedness with an amount of money equal to the fair market value (FMV) of the interest. If the value of the interest issued is less than the amount of the debt, the partnership recognizes DOI income, which must be allocated to the taxpayers that were partners immediately before the transfer.

The Final Regulations

Under Regs. Sec. 1.108-8(b)(2), partnerships satisfying four safe-harbor requirements are allowed to use liquidation value to determine the amount of DOI income in a partnership debt-for-equity transfer. Liquidation value is defined as the amount of cash that the creditor would receive for the acquired interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going-concern value, and any other intangibles) for cash equal to the FMV of such assets and then immediately liquidated (see Regs. Sec. 1.108-8(b)(2) (iii)).

If a partnership (upper-tier partnership) holds an interest...