Restructuring partnership debt may create unexpected results.

• Author: Milo, Angelina L.

Given the current economic downturn, it is not uncommon for debtors to renegotiate the existing terms of their liabilities, often resulting in cancellation of debt (COD) income. Generally, the exclusion provisions under Secs. 108(a)(1) and (2) (the bankruptcy and insolvency exceptions) would allow a corporation that recognizes COD income resulting from restructuring existing liabilities to defer or exclude the COD income at the entity level with minimal consequences to its shareholders. However, the Code looks at the COD of a partnership, or an LLC taxed as a partnership, in a very different light than it does COD of C corporations or, for that matter, S corporations. In this regard, partners in a partnership or members in an LLC taxed as a partnership may be subject to unexpected results.

COD Income: General Rules

In general, under the provision of Sec. 61(a)(12), COD income constitutes ordinary income and is subject to taxation at the time of discharge. However, provisions do exist to defer the tax impact by either electing to defer the recognition of COD income or excluding COD income at the cost of reducing certain tax attributes.

Under the following circumstances, Sec. 108(a) provides exceptions to the general recognition of income rule:

* The taxpayer is in a title 11 bankruptcy case;

* The taxpayer is insolvent, but only to the extent of insolvency;

* The canceled debt is qualified farm debt incurred in operating a farm; or

* The canceled debt is qualified real property business indebtedness of a non-C corporation.

The cost of excluding COD income under one of the above exceptions is a reduction in the taxpayer's tax attributes in accordance with Sec. 108(b)(2), which may include a reduction in net operating loss carryovers, tax credits, capital loss carryovers, bases of property owned by the taxpayer, passive loss carryovers, and foreign tax credit carryovers.

Under Secs. 705(a)(1)(A) and (B), regardless of whether a partner is able to exclude the COD income, the adjusted basis of a partner's interest in the partnership is increased by the amount of COD income allocated to him or her. The decrease in partnership liabilities as a result of the discharge, however, will result in a decrease in the partner's share of liabilities. Under Sec. 752, any decrease in the partner's share of liabilities is considered a deemed cash distribution to the partner. Therefore, a partner may recognize gain under Sec. 731 to the extent deemed cash...