Recently issued sec. 108(e) (8) regulations: liquidation value safe harbor.

• Author: McGowan, John R.

An increasing number of businesses are finding it difficult to pay their debt obligations as a result of tight credit and a slow economy. In many cases, businesses are reducing debt by issuing ownership interests in the entities. Since 1993, when the Omnibus Budget Reconciliation Act (1) was enacted, the tax consequences for the issuance of corporate interests in exchange for debt have been clear. Cancellation of debt (COD) income results when the fair value of the corporate interest is less than the value of the debt. (2) Such clarity did not exist for partnerships.

In the American Jobs Creation Act of 2004, (3) Congress applied the corporate rule to partnerships by amending Sec. 108(e)(8). After Oct. 21, 2004, a partnership recognizes COD income when the value of partnership equity it transfers in a debt-for-equity exchange is less than the value of the debt it receives from the lender. But the 2004 statute left many questions unanswered. For example, how should partnerships determine the fair market value (FMV) of partnership interests issued to creditors? Instead of hiring appraisers to determine FMV, could partnerships use liquidation value? Could taxpayers recognize any losses upon the exchange of a debt interest for the partnership interest? What tax treatment would result when partnership interests are issued partly in exchange for accrued ordinary income items, such as unpaid interest, rent, or royalty income?

In 2008, the IRS issued proposed regulations under Secs. 108(e)(8) and 721, whereby COD income must be recognized whenever a partnership interest is issued in exchange for a debt interest at a discount. (4) In an effort to provide guidance for taxpayers, the proposed regulations introduced a "liquidation value safe harbor." Under this safe harbor, the FMV of the debt-for-equity interest will be deemed to be the liquidation value if (1) the debtor partnership determines its partners' capital accounts under Regs. Sec. 1.704-1(b)(2)(iv); (2) the creditor, debtor partnership, and its partners treat the indebtedness's FMV as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-for-equity exchange; (3) the debt-for-equity exchange is an arm's-length transaction; and (4) subsequent to the debt-for-equity exchange, neither the partnership redeems nor any person related to the partnership purchases the debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange that has as a principal purpose the partnership's avoidance of COD income. (5)

The IRS finalized the Sec. 108(e)(8) regulations on Nov. 11,2011. (6) The final regulations define the "liquidation value" of a partnership interest as the amount of cash that the creditor would receive if the partnership sold all of its assets for cash equal to their FMVs immediately after the creditor received the interest and then liquidated. (7)

A close inspection of these rules suggests that taxpayers are still largely on their own in coming up with the actual fair market or cash value of their assets to determine liquidation value. This article assists the practitioner by analyzing the definition of liquidation value in the literature on valuation. This article also addresses the part of the final regulations that forbids creditors from taking a bad debt deduction when they accept partnership interests in exchange for debt.

It is difficult for taxpayers to accept tax rules that require the recognition of ordinary income by a partnership on the one hand yet deny a corresponding ordinary tax deduction for the creditor. Accordingly, this article addresses the detrimental effect of tax rules that taxpayers perceive as unfair and/or overly complex. Finally, a detailed consideration of the remaining provisions in the final regulations is also included.

Basic Rules

The Sec. 108(e)(8) final regulations state that when a party transfers its creditor position to the debtor partnership in exchange for an equity interest, there is generally no gain or loss to the partnership, except that the partnership realizes cancellation of indebtedness (COD) income equal to the difference between the debt and the value of the interest received. (8) Moreover, the Sec. 721 approach is maintained whereby a debt-for-equity exchange may not be bifurcated to allow the creditor to recognize a loss or bad debt deduction as part of the exchange. (9)

Creditors Denied Bad Debt Deduction

The final debt-for-equity regulations under Secs. 1.08(e)(8) and 721 also incorporate the interest-first ordering rules, which require that any payment received in a debt workout be applied first against interest and then to principal. (10) This result seems especially unfair when an accrual-based creditor accrues interest income and pays the related tax. Upon a subsequent debt-for-equity exchange at a discount, not only does the creditor fail to receive the interest income from the partnership, but he or she also is denied a bad debt deduction. The bifurcation of the debt-for-equity exchange would address this concern. In recognition of the changing ownership interest from debt to equity, the creditor should be able to take a had debt deduction when the value of the ownership interest is less than the debt obligation.

A majority of people who commented on the proposed regulations spoke in favor of bifurcating the debt-for-equity exchange in cases where the FMV of the partnership interest is less than the debt obligation. (11) They argued that a bad debt deduction should be allowed for the difference between the FMV of the equity interest and the value of the debt obligation. The balance of the exchange could then be treated as a nontaxable exchange under Sec. 721. Similarly, in its comments on the proposed regulations, the AICPA questioned whether it was appropriate to deny the creditor an ordinary Sec. 166 bad debt deduction in such transac-tions. (12) The AICPA also pointed out how this treatment creates distortions for partnerships that do not exist for corporations. Although the IRS received many comments advocating bifurcation, it explicitly rejected this approach in the final regulations. (13)

The following example from the AICPA's comment letter on the regulations illustrates how a debt-for-equity exchange results in a higher outside than inside basis both before and after a creditor's interest is liquidated. This outcome is a direct result of the creditor's not being able to take a current bad debt deduction.

Example 1. Discrepancy with outside and inside basis: Suppose nonpartner individual A converts her $100x loan to the partnership into partnership equity worth $60x. Assume at the time of the conversion, individuals B and C are partners and the partnership's tax basis in its assets is $120x (which also equals B and C's combined outside basis). When A's $100x loan is converted into equity, B and C would have COD income of $40x. Accordingly, their outside basis would be increased by $40x and decreased by the $100x of debt extinguished under Sec. 752(13). As a result, B and C would have a combined outside tax basis of $60x ($120x + $40x - $100x). A would have an outside basis in her partnership interest of $100x. (14) After the conversion, the final result would be a total outside basis of $160x in the partnership and an inside basis of $120x.

If A's interest is later liquidated for $60x, she would claim a $40x capital loss. Next, assuming a Sec. 754 election was in effect and the mandatory basis adjustment rules apply, the partnership would have to reduce the inside basis of its assets by $40x. This $40x adjustment would reduce the inside basis of the assets to $20x. (15) The partners' combined outside basis would be $60x.

Practitioners have observed that the new rules prevent cash-basis taxpayers from converting ordinary income into capital gain upon contribution of unpaid interest and debt to the partnership in exchange for equity. (16) The problem is the way this objective is accomplished. The final regulations stipulate that the equity interest received by the creditor satisfies the interest obligation first. The balance of the equity interest satisfies the debt obligation. (17)

Example 2. Unpaid interest (cashbasis creditor): Assume A and B form partnership P. each contributing $500. P later receives a $1,000 interest-only note from...