On October 31, the Internal Revenue Service and the Department of the Treasury issued proposed regulations under Section 108(e)(8) of the Internal Revenue Code. These proposed regulations address both the calculation of a partnership’s discharge of indebtedness (COD) income when the partnership issues an interest in itself to a creditor in satisfaction of the partnership’s debt and the tax treatment to the creditor that exchanges its creditor position for an interest in the partnership. These regulations are proposed to be effective when finalized.

Section 108(e)(8) provides that if a debtor partnership transfers a capital or profits interest in itself to a creditor in satisfaction of the debt, the partnership is treated as having satisfied the debt with an amount of money equal to the fair market value of the partnership interest transferred.

Among other open issues, the statute did not state how to value the partnership interest transferred and the consequences to the contributing creditor. Proposed Treasury Regulation Sections 1.108-8(b) and 1.721-1(d) provide, at least in part, the federal government’s current position with respect to these questions. Prop. Treas. Reg. Section 1.108-8(b) provides a safe harbor for determining the fair market value of a partnership interest transferred in satisfaction of a debt. Under this safe harbor, the fair market value of the transferred partnership interest equals its liquidation value. The proposed regulation defines liquidation value as the amount of cash that the creditor would receive with respect to the transferred interest if, immediately after the transfer, the partnership sold all of its assets for cash equal to their fair market value and liquidated. To qualify for this safe harbor, the debtor partnership must maintain the partners’ capital accounts in accordance with Treas. Reg. Section 1.704-1(b)(2), the parties must agree to treat the fair market value of the partnership interest as being equal to the liquidation value, the debt-for-equity exchange must reflect an arm’s-length transaction, and, subsequent to the exchange, the debtor partnership cannot not redeem, directly or indirectly, the interest as part of a preconceived plan. If the partnership and the creditor do not meet the safe harbor, then the value of the partnership interest must be determined based on “all the facts and circumstances.”

Unfortunately, this safe harbor is very limited, in that it only values a capital interest in the partnership (compare this language to that in Revenue Procedure 93-27 defining a capital interest in a partnership for compensation purposes). This safe harbor does not contemplate valuing a partnership profits interest issued in exchange for the partnership’s debt. In many instances, a creditor is given a partnership interest with a preferred return or increased share of future profits to provide it with value equivalent to that of the note being contributed. In those cases, these regulations provide no guidance on valuing the issued partnership interest.

In addition, Proposed Treasury Regulation Section 1.721-1(d) provides that a debt-for-equity exchange generally is treated as a nonrecognition event from the creditor’s standpoint. This rule does not apply if the interest is transferred in satisfaction of unpaid rent, royalties, or interest (including original issue discount). This rule, therefore, precludes the creditor from receiving an immediate deduction if the amount of the debt outstanding exceeds the value of the partnership interest received. This leads to asymmetrical treatment for the partnership and the creditor. If the amount of the debt exceeds the fair market value of the partnership interest transferred, the partnership will recognize COD income to the extent of the excess. However, these proposed regulations provide that the creditor does not recognize a corresponding loss on an exchange. Instead, the creditor’s full basis in the debt is carried over to the received partnership interest.

This asymmetrical treatment works as follows: Assume Partnership X owes Y $500. In satisfaction of the $500 debt, Partnership X transfers to Y an interest in Partnership X worth $400. Upon receipt by Y, X’s current partners will recognize $100 ($500 debt less $400 payment) of COD income. Y, on the other hand, is not able to recognize its $100 loss. Instead, Y has a $500 tax basis in its Partnership X interest. Moreover, this deferral also results in Y forgoing a current (possible) ordinary deduction for a future capital loss.
One issue the Proposed Regulations fail to address is whether the creditor can engage in pre-transaction self-help to avoid the loss deferral described above. In other words, if, in the example above, Y before the contribution divided its debt into two separate notes consisting of a $400 note and a $100 note, could Y avoid deferring its $100 loss by exchanging the $400 note for an interest in Partnership X and canceling the $100 note? Similarly, is loss deferral the correct answer if Y is a bank that, for non-tax purposes, previously wrote the note down to $400 and recognized the $100 loss for book purposes? We hope that the IRS and Treasury will address these questions before finalizing these regulations.

The above Alert provides a cursory review of the proposed regulations and questions that we expect to be addressed in the upcoming hearings. If you have any questions or want further information, please contact the authors or any member of the Tax Practice.