Taxation Meets Bizarro World: Passthroughs and Debt Workouts

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1 Taxation Meets Bizarro World: Passthroughs and Debt Workouts In most transactions, there is a normal way to proceed from both a tax and economic perspective. Accordingly, experience often teaches seasoned tax practitioners the best way to address a situation in a way that will maximize their clients tax and economic positions. However, when a practitioner starts to consider the rules concerning debt workouts in the context of passthrough entities, one quickly learns that they are entering into Bizarro World. Anyone with a mis-spent youth (or well-spent depending on your perspective) will recall that Bizarro World was a world in the Superman comics in which everything is the opposite of how it is on Earth. 1 This article addresses some of the backwards tax and economic planning considerations that are often involved in debt workouts with passthrough entities. At the beginning, however, it is necessary to lay a framework (the Bizarro Code as it may also be called) which sets forth the legal background for debt workouts. In addition, this article considers debt workouts in the context of four different types of passthrough entities: partnerships, S corporations, trusts and REITs. 2 I. LEGAL BACKGROUND First and foremost, Section 61(a)(12) provides that gross income includes from the cancellation of indebtedness ( COD Income ). This provision is derived from the Supreme Court s decision in Kirby Lumber Co. 3, in which the Court held that the cancellation of indebtedness results in ordinary income to the taxpayer. If property is conveyed to a lender in satisfaction of a debt, the calculation of COD income will depend on whether the debt is recourse or nonrecourse. If property is conveyed in satisfaction of a recourse debt, the taxpayer has COD income equal to the extent that the fair market value ( FMV ) of the property is less than the debt. In Tufts 4, the Supreme Court held that the conveyance of property by a debtor to a lender in satisfaction of a nonrecourse debt results in gain (and not COD income) measured by the extent that the debt exceeds the taxpayer s basis in the property In the Bizarro world of Htrae ( Earth spelled backwards), society is ruled by the Bizarro Code which states Us do opposite of all Earthly things! Us hate beauty! Us love ugliness! Is big crime to make anything perfect on Bizarro World!. Bizarro bonds are Guaranteed to lose money for you. Other idiosyncrasies of Bizarro World are that it is a planet where alarm clocks dictate when to go to sleep, ugliness is beautiful and the world s greatest hero is a chalk- faced duplicate of Superman - one who everyone knows is really Bizarro Clark Kent. Taken to its extreme, debt workouts in Bizarro World will require the lawyer to pay the client for working through these issues. This is an idea that may catch on with some clients. The authors clearly revolt against this Bizarro result. Your authors know that a REIT is technically not a passthrough entity, but it resembles one and is viewed that way by many investors. And REITs provide some interesting forays into Bizarro World. 284 U.S. 1,10 AFTR 458 (1931). 461 U.S. 300, 51 AFTR2d (1983). -1-

2 In some situations, is it easy to tell when a debt is discharged the lender simply forgives all or a portion of the loan. The more common situation in a workout, however, involves the modification of the terms of the debt instrument to fit better the borrower s economic situation. The most important change in the law since the early 1990s is the adoption of new Regulations under Section 1001 to determine when a debt modification will be treated as an exchange of the original debt (the old debt ) for a new debt instrument (the new debt ). If such an exchange occurs, pursuant to Section 108(e)(10), the debtor is treated as having satisfied the old debt with an amount of money equal to the issue price of the new debt. The issue price of the new debt is determined under Sections 1273 and Generally, the new debt will be treated as having an issue price less than the face amount of the old debt if the interest rate on the new debt is less than the AFR. If the debt is publicly traded, its issue price will be the price at which the debt trades on the day the new debt is deemed to be issued. The Regulations under Section 1001 were a consequence of the Supreme Court s decision in Cottage Savings Association 5, in which the Court held that the exchange of mortgage portfolios by two savings and loan companies was a taxable event, notwithstanding that the mortgage portfolios were identical from an economic perspective. In response to questions concerning the application of Cottage Savings in the context of a debt modification, Treasury and the IRS issued Regulations (finalized in 1996) under which the alteration of the terms of the old debt will be deemed an exchange if there is a significant modification of the debt instrument. This involves a two-part test under which the change to the terms of the old debt is examined to determine, first, whether the change constitutes a modification and then, second, whether the modification is significant. A significant modification results in a Section 1001 taxable exchange of the old debt for the new debt. A. Modifications Under Reg (c)(1)(i), a modification generally means any alteration (including any deletion or addition, in whole or part) of a legal right or obligation of the issuer or holder of a debt instrument. The alteration may occur through an express agreement (oral or written), the conduct of the parties, or otherwise. Thus, even if the lender and the borrower never agree to change the terms in a debt workout, their conduct can result in a modification if their actions are different than the stated terms of a debt instrument. In essence, the Regulations adopt a hair trigger definition of a modification, since virtually any change in a debt instrument constitutes a modification. This approach is ameliorated, however, by the requirement that the modification be significant before the modification will be a taxable exchange. In addition to whether a modification has occurred, is the question of when the modification took place. The answer is often unclear. Under Reg (c)(6), an agreement to change a term of a debt instrument is a modification at the time the issuer and holder agree, even if the change is not immediately effective. If, however, the parties condition a change in a term of a debt instrument on reasonable closing conditions (such as regulatory, shareholder, or creditor approval), the modification occurs on the closing date. In addition, if a change in a term of a debt instrument occurs in bankruptcy, the modification occurs only if and when the bankruptcy plan becomes effective U.S. 554, 67 AFTR2d (1991). -2-

3 Exceptions. There are three major exceptions to the broad definition of a modification: 1. Terms of the instrument. First, under Reg (c)(1)(ii), an alteration that occurs by operation of the terms of a debt instrument is not a modification. These alterations could include an annual resetting of the interest rate on a debt instrument or may occur as a result of the exercise of an option, provided either to the issuer or holder, to change a term of the debt instrument. Likewise, if the original terms of an obligation require the issuer to maintain collateral having a specified value, any substitution of collateral that is required to maintain the value of collateral is not a modification. Nevertheless, even if provided in the original terms of the debt instrument, an alteration is a modification if it results in (1) the substitution of a new obligor, the addition or deletion of a co-obligor, or a change in the recourse nature of the instrument, or (2) an instrument that is not debt for federal income tax purposes. For example, a bond issued by a corporation may provide that an acquiror of substantially all of the corporation s assets may assume the corporation s obligations under the bond. On the occurrence of such an acquisition, the substitution of a new obligor is a modification, even though it occurs by operation of the terms of the bond. In addition, an alteration that results from the exercise of an option provided to an issuer or a holder of a debt instrument is a modification unless (1) the option is unilateral, and (2) for an option exercisable by a holder, the exercise of the option does not result in (or, for a variable or contingent payment, is not reasonably expected to result in) a deferral of, or reduction in, any scheduled payment of interest or principal. 2. Issuer s failure to perform. The second major exception to the broad definition of a modification involves the failure of the issuer to perform its obligations under the debt instrument. The IRS has provided confusing guidance. Reg (c)(4)(i) states that the failure of an issuer to perform its obligations under a debt instrument is not itself an alteration of a legal right or obligation and is not a modification. Although the issuer s nonperformance is not a modification, the agreement of the holder not to exercise its remedies under the debt instrument is a modification under Reg (c)(1). The Proposed Regulations provided that the holder s failure to exercise its remedies for more than a temporary period was a modification; this provision was severely criticized as unrealistic. Treasury and the IRS responded to this criticism by providing in Reg (c)(4)(ii) that, absent a written or oral agreement to alter other terms of the debt instrument, an agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right is not a modification unless and until the forbearance remains in effect for a period that exceeds two years following the issuer s initial failure to perform, plus any additional period during which the parties conduct good faith negotiations or the issuer is in bankruptcy. Although the two-year period during which a lender s waiver of its rights and remedies is not treated as a modification may seem generous, on further reflection the rule may not be very beneficial. In reality, a debt workout is often a rolling process, in which the debtor moves from one default to another, with the lender being requested to waive the defaults as they occur. This rule, however, starts the two-year clock running with the issuer s initial failure to perform, and implies that the initial default must be completely cured (and not waived) or else the clock keeps running. As a result, any defaults by the borrower more than two years after the initial default would be treated as a modification even if the lender waived the initial defaults. 3. Party s failure to exercise option. The third major exception to the broad definition of a modification, in Reg (c)(5), arises if a party to a debt instrument has an option to -3-

4 change a term of the instrument, but fails to do so. This could occur, for example, if the holder of a debt instrument has an option to increase the interest rate if the borrower s credit rating changes or the tax laws are altered and the holder fails to exercise this option. In contrast, the waiver of an automatic increase in the interest rate on a debt instrument by more than an insignificant amount would be a modification. B. Significant Modifications Even if a modification occurs, Reg (b) makes clear there is no taxable exchange unless the modification is significant. This determination is made under Reg (e), which includes eleven bright-line tests and safe harbors as well as a general rule that applies only if the bright-line rules do not. Except as otherwise provided under the bright-line rules, a modification is significant under the general rule only if, based on all of the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. In making this determination, all modifications to the debt instrument other than modifications subject to the bright-line rules are considered collectively, so that a series of modifications may be significant when considered together although each modification, if considered alone, would not be significant. For example, an obligation might provide that under certain circumstances the holder could cause the issuer to waive its call right. The bright-line rules (discussed in more detail below) do not deal with the elimination of a call right held by the issuer. Accordingly, under the general rule, the significance of this change would have to be determined on the basis of all the facts and circumstances. 1. The bright-line rules. As noted above, there are ten bright-line tests and safe harbors in Regs (e)(2) through (6) on which a taxpayer can rely. 1. Changes in yield. Under Reg (e)(2)(ii), a significant modification occurs if there is a change in the yield of a debt instrument by more than the greater of (1) one-quarter of 1% (25 basis points), or (2) 5% of the annual yield of the unmodified instrument. This rule generally applies only to debt instruments with fixed payments, certain debt instruments with alternative payment schedules, certain debt instruments with a fixed yield, and variable rate debt instruments ( VRDIs ). Whether the change in the yield of any other debt instrument, such as a debt instrument that provides for contingent payments, is significant, is determined under the general rule. For purposes of determining if there is a significant modification, the yield on the modified instrument is computed by reference to the adjusted issue price immediately before the modification. Since a reduction in principal reduces the total payments on the modified instrument, a reduction in the principal will usually result in a significantly reduced yield on the instrument. As a result, changes in principal amounts will often result in a significant modification. Example: A financially troubled borrower owes lender $10 million and cannot pay. The parties agree to reduce the debt to $7 million. The borrower will have $3 million of COD income, which will be either taxable under Section 61(a)(12) or excluded under Section 108; these consequences are known and predictable. If, however, the IRS takes the position that the remainder of the instrument should be classified as equity for tax purposes (because of the poor financial condition of the borrower), the remaining $7 million instrument could be reclassified, resulting in additional income to the borrower. A payment that does not result in a change in the yield may still cause a significant modification -4-

5 has not occurred. For example, a holder may pay an issuer to release the issuer s right to call a debt instrument. The payment to the issuer changes (reduces) the yield on the debt; whether this change in yield is significant would depend on whether the change was at least 25 basis points. If the change in yield is less than 25 basis points, there still could be a significant modification if the elimination of the issuer s call right were deemed significant under the general rule. 2. Changes in Timing of Payments. Under Reg (e)(3)(i), a modification that changes the timing of payments due under a debt instrument is significant if it results in the material deferral of scheduled payments. This deferral may occur either through an extension of the final maturity date of an instrument or through a deferral of payments due prior to maturity. Subject to the safe harbors discussed below, the materiality of the deferral depends on all the facts and circumstances, including the length of the deferral, the original term of the instrument, the amounts of the payments that are deferred, and the period between the modification and the actual deferral of payments. Reg (e)(3)(ii) provides a safe harbor for the deferral of payments, under which the deferral of one or more scheduled payments is not material if the deferred payments are unconditionally payable no later than the end of the safe harbor period. This deferral right applies to scheduled interest and principal payments as well as payments due at the maturity of the debt instrument. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for the lesser of five years or 50% of the original term of the instrument. If payments are deferred for less than the full safe harbor period, the unused portion of the period remains available for any subsequent deferral of payments. Although this safe harbor appears generous, there are two potential danger areas. First, the deferred payments must be unconditionally payable within the safe harbor period. Thus, for example, if one or more interest payments are deferred to maturity, and the maturity date of the obligation is more than five years away, the deferral is material. Second, if a debtor has good and bad years, and the lender defers interest payments from bad years to good ones, the cumulative effect of deferrals could surpass the lifetime right to defer payments due to an issuer for no more than five years. 3. Change in Obligor. Reg (e)(4)(ii) indicates that the substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Reg (e)(4)(i)(A) provides, however, that a change in the obligor of a recourse debt instrument generally is a significant modification, unless one of the following exceptions in Regs (e)(4)(i)(B) through (G) applies, as follows: a. The new obligor is an acquiring corporation (within the meaning of Section 381). b. The new obligor acquires substantially all of the assets of the original obligor. c. The new obligor on tax-exempt bonds is related to the original obligor (within the meaning of Section 168(h)(4)(A)) and the collateral securing the instrument continues to include the original collateral. a bankruptcy petition. 4. The change in obligor results from a Section 338 election or the filing of In the first two exceptions (a change of obligor described in Section 381 or an acquisition of substantially all of the assets of the original obligor), the change in obligor also must not result in a change in payment expectations or a significant alteration. Reg (e)(4)(i)(E) provides that a -5-

6 significant alteration occurs if an alteration of a debt instrument would be a significant modification but for the fact that the alteration occurs by operation of the terms of the instrument. A change in payment expectations occurs if, as a result of a transaction, either (1) there is a substantial enhancement of the obligor s capacity to meet the payment obligations under a debt instrument, and that capacity was primarily speculative prior to the modification and is adequate after the modification, or (2) there is a substantial impairment of the obligor s capacity to meet the payment obligation under a debt instrument, and that capacity was adequate prior to the modification and is primarily speculative after the modification. Example: A recourse debt instrument with a 9% annual yield is secured by an office building. Under the terms of the instrument, a purchaser of the building may assume the debt and be substituted for the original obligor if (1) the purchaser has a specified credit rating and (2) the interest rate on the obligation is increased by ten basis points. If the purchaser acquires substantially all of the assets of the original obligor, the acquisition would not be a significant modification under Reg (e)(4)(i)(C). If the building is less than substantially all of the assets of the original obligor, a significant modification would have occurred. Thus, the tax effects of the transaction in the example could depend on whether the office building was held by a special-purpose entity. It seems odd that the tax consequences of a debt assumption would depend on the nature of the other assets of the debtor. Nevertheless, if the terms and conditions of the debt instrument are not modified in any other manner when the debt is assumed (i.e., if the interest rate on the loan is not changed), Section 1274 would not apply, so that the debt instrument would not be retested to determine whether it provides for adequate stated interest. 5. Addition or deletion of a co-obligor. A significant modification occurs when a co-obligor is added to or deleted from a debt instrument if the result is a change in payment expectations, as set forth in Reg (e)(4)(iii). Thus, for example, if a financially troubled corporation adds IBM as a co-obligor on a debt instrument, a change in payment expectations is likely; there might not be a change if instead a subsidiary of the financially troubled corporation became the coobligor. Where the addition or deletion of a co-obligor is part of a transaction or series of related transactions that results in a new obligor, the determination whether a significant modification has occurred is made under the rules discussed above. 6. Change in security or credit enhancement. Under Reg (e)(4)(iv), a change in payment expectations will mean that a significant modification has occurred with respect to recourse debt where the modification releases, substitutes, adds, or otherwise alters the collateral for a guarantee on, or other form of credit enhancement for, the debt. Thus, if a borrower obtains credit enhancement through a bank letter of credit, and a new letter of credit is obtained when the original bank encounters financial difficulty, a significant modification occurs if there is a change in payment expectations. For nonrecourse debt, any such modification generally is a significant modification without regard to a change in payment expectations. A significant modification does not occur, however, if (1) the collateral is fungible or otherwise of a type where the particular units pledged are unimportant, (2) a similar commercially available credit enhancement contract is obtained, or (3) the property that secures a nonrecourse debt is improved. 7. Change in priority of debt. A change in the priority of a debt instrument -6-

7 relative to other debt of the issuer is a significant modification if it results in a change in payment expectations under (Reg (e)(4)(v)). 8. Change from debt to equity. Reg (e)(5)(i) provides that a modification of a debt instrument that results in an instrument or property right that is not debt for federal income tax purposes is a significant modification. Solely for purposes of applying this rule, any deterioration in the financial condition of the obligor between the issue date of the unmodified instrument and the date of modification (as it relates to the obligor s ability to repay the debt) is not taken into account unless, in connection with the modification, there is a substitution of a new obligor or the addition or deletion of a co-obligor. This limitation on considering the financial condition of the borrower applies, however, only for purposes of determining whether a significant modification has occurred. If a significant modification has occurred for other reasons (e.g., the interest rate on a debt instrument is reduced), the Regulations would permit the IRS to re-test whether the resulting instrument is debt or equity for tax purposes. Because a significant modification usually will occur only where a borrower is financially troubled, the practical effect of this rule is a major risk that any modified debt instrument would be reclassified as equity for tax purposes. The conversion of debt to equity could have disastrous tax consequences to the issuer, particularly if the debt was supporting the negative capital accounts of the partners in a partnership. 9. Change in recourse nature. In general, a change in the nature of a debt instrument from recourse (or substantially so) to nonrecourse (or substantially so) is a significant modification, under Reg (e)(5)(ii)(A). Thus, for example, a legal defeasance of a debt instrument in which the issuer is released from all liability to make payments on the instrument is a significant modification. Likewise, if a borrower obtains a recourse loan that is secured by collateral, and the lender subsequently releases the borrower (but not the collateral) from liability, a significant modification has occurred. If an instrument is not substantially all recourse or not substantially all nonrecourse either before or after a modification, the significance of the modification is determined under the general rule, which will require consideration of the instrument both before and after the modification. Thus, for example, if a borrower obtains a $1 million recourse loan secured by collateral and the lender subsequently releases the borrower (but not the collateral) from $500,000 of the liability, whether a significant modification has occurred will be determined on the basis of all of the facts and circumstances. The same analysis would apply if the borrower had previously been recourse for only $500,000 of the $1 million loan and the borrower s recourse was increased or decreased. As a practical matter, the effect of this rule is that there could be tax consequences any time the recourse liability of the borrower is altered. There are two exceptions to this rule. First, a defeasance of a tax-exempt bond is not a significant modification even if the issuer is released from any liability to make payments under the instrument if the defeasance occurs by operation of the terms of the original bond and the issuer places in trust government securities or tax-exempt government bonds that are reasonably expected to provide interest and principal payments sufficient to satisfy the payment obligations under the bond. Second, a modification that changes a recourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. 10. Changes in covenants. Reg (e)(6) provides that the addition, deletion, or alteration of customary accounting or financial covenants is not a significant modification. If -7-

8 the covenants that are changed are not covered by this provision, however, the impact of the change is determined using the facts and circumstances test. Thus, for example, whether a significant modification occurs because of the removal of a restriction on the borrower s right to sell property which is not an accounting or financial covenant would be determined under the general rule. 11. Tax-exempt bonds. Reg (f)(6) provides special rules for taxexempt bonds, defined in Reg (f)(5)(iii) as state or local bonds that satisfy the requirements of Section 103(a). The obligor of a tax-exempt bond is the entity that actually issues the bond and not a conduit borrower (as defined in Reg (b)) of the proceeds. In determining whether there is a significant modification of a tax-exempt bond, however, transactions between holders of the bond and a borrower of a conduit loan may be an indirect modification. For example, a payment by the holder of a tax-exempt bond to a conduit borrower to waive a call right may result in an indirect modification of the tax-exempt bond by changing its yield. A tax-exempt bond that does not finance a conduit loan is a recourse loan. A tax-exempt bond that finances a conduit loan also is a recourse debt instrument unless both the bond and the conduit loan are nonrecourse. Nevertheless, a tax-exempt bond is a nonrecourse debt if it is secured only by a trust holding government securities or tax-exempt government bonds reasonably expected to provide interest and principal payments sufficient to satisfy the issuer s payment obligations. The question is more difficult if a contingent modification is outside of the bright-line rules. For example, assume there will be a 50-basis-point adjustment to the yield on a debt instrument, but only on the occurrence of an event with a one-in-ten probability. The Regulations provide no guidance -8- C. Rules of application for significance The Regulations contain several rules of application for purposes of determining whether a modification is significant. 1. General Rule. Reg (f)(1)(i) provides that whether a modification of any term is a significant modification is determined under each of the bright-line rules and, if not specifically covered by those rules, under the general rule. For example, a deferral of payments that changes the yield on a fixed rate debt instrument must be tested twice, once under Reg (e)(2) to determine whether the change in the yield exceeds 25 basis points, and a second time under Reg (e)(3) to determine whether the deferral of payments is material. 2. Contingencies and deferrals. If a modification is of a type that would normally be tested under the bright-line rules but is effective only on the occurrence of a substantial contingency, whether the change is a significant modification would be determined under the general rule rather than the bright-line rules. Likewise, if a modification involving changes in the obligor or collateral for a debt instrument or changes in the nature of recourse for a debt instrument is effective on a substantially deferred basis, the determination of whether the change is a significant modification also is made under the general rule. These provisions could lead to unexpected results. Example: A borrower and lender agree that the interest rate on a debt instrument will be increased by 25 basis points, and the maturity date will be deferred by three years, if a specified event occurs. Although these changes would not be significant under the bright-line rules, the IRS could conclude that the changes were significant using the facts and circumstances test of the general rule.

9 concerning how the likelihood of the contingency should be taken into account. As a result, there could be substantially more risk any time a modification of a debt instrument is contingent or deferred. The Preamble to the Regulations does not explain why modifications that are per se not significant under the bright-line rules could possibly be treated as significant merely because the occurrence of the modifications depends on future events or is deferred. The policy underlying these rules is questionable. 3. Lesser included changes. Reg (f)(2) clarifies that if the degree of change specified in the bright-line rules is not met, a lesser included change is not a significant modification. For example, a 20-basis-point change in the yield on a debt instrument would not be a significant modification. 4. Cumulative effect. Two or more modifications that occur over any period of time are a significant modification if they would have resulted in a significant modification had they been done as a single change. Thus, for example, a series of two-year changes in the maturity date of a longterm debt instrument is a significant modification if, combined as a single change, the increase in the term of the debt instrument exceeds five years. The significant modification occurs when the cumulative modification would be significant. In testing for a change in the yield on a debt instrument, however, any modifications occurring more than five years before the date of the modification being tested are disregarded. 5. Changes in different terms. Modification of different terms of a debt instrument, none of which separately would be a significant modification under the bright-line rules, is not collectively a significant modification. For example, a change in the yield of a debt instrument by 20 basis points combined with the deferral of the maturity date of the instrument for one year would not be a significant modification. Although the significance of each modification is determined independently, in testing a particular modification it is assumed that all other simultaneous modifications have already occurred. D. Bizarro World The most important Bizarro impact of the significant modification rules is that in most situations, the creditor who is economically harmed by a significant modification of a debt instrument may have taxable income, whereas the debtor who is economically benefited will not. This result occurs because under Reg , in the deemed exchange that occurs between the creditor and the debtor when a debt is significantly modified, the debtor is deemed to issue a new debt instrument with an adjusted issue price equal to its face amount as long as the interest rate on the post-modification debt instrument is at least equal to the AFR. Similarly, the lender is deemed to receive back the new debt instruments with an adjusted issue price equal to its face amount as long as the modified debt instrument bears interest at the AFR or above. In the case of an initial lender who made a loan for cash, and who continues to hold the debt instrument and agrees to modify its terms significantly when the debtor is in financial trouble, this rule normally does not result in adverse tax consequences. The original lender will usually have a tax basis in the modified debt instrument equal to its face amount, so that the original lender will not recognize gain upon receipt of the new note that has a deemed value under Section 1274 equal to its face amount. The original lender may still not be happy with this result, however, because the modified debt instrument is worth less than the original debt instrument (in the example, it bears interest at a rate that is -9-

10 3% lower than the pre-modification debt instrument). Thus, it can be assumed that if the lender attempted to sell the post-modification debt instrument, the lender would receive somewhat less than the lender would receive in exchange for the pre-modification debt instrument. However, notwithstanding the fact that the modified debt instrument is likely worth less, the lender will not be able to recognize a loss, even though a taxable exchange has occurred. This result is Bizarro in that if a debt instrument is modified so that it is economically worth less, the borrower who benefits economically does not have income, while the lender who has suffered an economic loss cannot claim the loss, even though there has been a taxable exchange. What if the initial lender wanted to recognize its loss? In that case, the lender could have sold the debt instrument for its FMV prior to the modification. In the above example, the lender could have sold the debt instrument (which has a face amount of $100) for $60, thereby allowing the initial lender to claim a tax loss. The purchaser of the debt instrument would have a basis of $60 in an instrument that has a face amount of $100. Bizarro world reappears when the debt instrument is then modified. The purchaser has a basis of $60, and upon modification of the note, the purchaser receives a new note with a deemed value of $100 in a taxable exchange. Thus, the purchaser would recognize $40 of gain, even though the note (after the modification) is worth less than it was before the modification. This is truly a Bizarro concept, in that the value of the note decreases and the holder recognizes a gain! In addition to the overall Bizarro result that a creditor can be deemed to receive a debt worth more when changes are made that reduce its value, some of the specific aspects of the rules concerning debt modifications could only have originated in Bizarro world. The most prominent may be the treatment of contingent debt modifications. For example, assume that a borrower cannot pay a $1 million debt instrument, so the lender agrees to forgive the balance of the debt if and when the borrower actually pays $800,000. Of course, if the $800,000 is not paid, the borrower would continue to owe $1 million to the lender. The regulations provide that the determination whether a debt has been significantly modified if the modification is contingent is made on the basis of the facts and circumstances. There is minimal law on this issue, but it would appear that the contingent reduction of principal would be treated as a significant modification of the debt instrument because it provides the borrower an opportunity that did not previously exist, and that opportunity would have significant economic value. If the change is a significant modification, then the change would be deemed to occur when the revision is made to the debt instrument (and not when the loan is actually paid). As a result, the borrower could have COD income of $200,000 in this scenario even though it is far from certain that the borrower will not end up owing the full $1 million to the lender. The rules concerning debt extensions are also not completely logical. Under prior case law, any extension of the maturity of a debt instrument was not a significant modification of the debt because the borrower continued to owe the same amount and the lender s yield was unchanged. The regulations alter this result, causing a significant modification of a debt instrument merely as a result of an extension of maturity by the lesser of 5 years or half the term of the original debt instrument, whether or not the economic position of the parties has changed. The effect of this change could be gain recognition by any holder that acquired a debt instrument at a discount, although the holder will receive payments under modified debt instrument the exact same present value as the holder was entitled to receive under the unmodified debt instrument. In other words, the regulations cause a taxable event even though nothing has changed economically! -10-

11 Finally, although the decline in the creditworthiness of the borrower is not, in and of itself, a significant modification of a debt instrument, the regulations appear to allow for the re-testing of a debt instrument as debt or equity if there is a significant modification combined with a decline in the creditworthiness of the borrower. Even though the partners in a partnership would legally continue to owe money to the lender, if the debt is modified so as to cause a significant modification (e.g., its maturity is extended), the debt could be recharacterized as equity for tax purposes, resulting in tax recapture merely as a result of a harsh economic climate. This is a situation in which form is completely governing over substance, which is the opposite of what should occur under sound tax rules. II. EXCLUSION FROM INCOME Assuming that a taxpayer has COD income, it is necessary to determine whether that income can be excluded. Section 108(a)(1) provides five circumstances in which COD income is excluded: 1. The discharge occurs in a Title 11 case. 2. The discharge occurs when the taxpayer is insolvent (but only to the extent that the taxpayer is insolvent) The indebtedness discharged is qualified farm indebtedness ( QFI ). 4. In the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness ( QRPBI ). 5. Qualified principal resident indebtedness ( QPRI ) discharged before Because the forgiveness of a single debt theoretically could satisfy several of these exceptions, there is a set of ordering rules. Section 108(a)(2) provides that (1) the Title 11 exclusion takes precedence over all other exclusions, (2) the insolvency exclusion takes precedence of the QFI and QRPBI exclusions, and (3) the principal residence exclusion takes precedence over the insolvency exclusion. A. Attribute Reduction Although COD income is excluded under Section 108(a)(1), a taxpayer pays a price for this exclusion through the reduction of tax attributes, including basis in certain circumstances. Under Section 108(b)(2), the following tax attributes are reduced in order: NOLs. General business credits. Minimum tax credits. Capital loss carryovers. 6 For this purpose, insolvency is the amount by which a taxpayer s liabilities exceed the fair market value of its assets. Section

12 Basis of depreciable property of the taxpayer, pursuant to Section Passive activity loss and credit carryovers. Foreign tax credit carryovers. These tax attribute reductions are generally made on a dollar-for-dollar basis, except that credits are reduced by 33 1/3 cents for each dollar of COD income excluded. Under Section 108(b)(5), a taxpayer may elect a basis reduction under Section 1017 in lieu of the other attribute reductions; this election is generally made on the taxpayer s return for the year in which the discharge occurs. If an election is made under Section 108(b)(5), the basis of property can be reduced to zero, whereas without this election, the basis of property cannot be reduced below the amount of any debt that encumbers the property. Again, there are several important ordering rules. First, the attribute reductions are made after the determination of the tax imposed for the tax year of the discharge. Thus, if a taxpayer has NOLs that can be used to offset the income from the year of the discharge, the taxpayer can fully use its NOLs to offset such income, and only the excess NOLs that were not used to offset the income for the year of discharge are reduced. Second, the reductions in NOLs and capital loss carryovers are made first in the loss for the tax year of the discharge and then in the carryovers to tax years in the order of the tax years from which each such carryover arose. Third, the reductions in general business credits and foreign tax credits are made in the order in which such carryovers are generally taken into account. B. Operating Rules Section 108(d) contains the operating rules for Section 108. First, an indebtedness of the taxpayer that can give rise to COD income is any indebtedness for which the taxpayer is liable or subject to which the taxpayer holds property. A debt discharge occurs in a Title 11 case only if the taxpayer is under the jurisdiction of the bankruptcy court and the discharge of indebtedness is granted by the court. An individual taxpayer is insolvent only if her liabilities exceed the FMV of her assets, and the amount by which the taxpayer is insolvent is determined immediately before the debt discharge. In a Title 11 case for an individual, the bankruptcy estate (and not the individual) is treated as the taxpayer for purposes of reducing NOLs and the basis in property. For a partnership, the determination whether the taxpayer is bankrupt or insolvent, and attribute reduction, all take place at the partner level (rather than the partnership entity level). In contrast, for an S corporation, the determination of bankruptcy or insolvency, and attribute reduction, all take place at the corporate level (Bizarro, isn t it!). Any loss or deduction of an S corporation that is disallowed for the tax year of the discharge is treated as an NOL for such tax year. In response to the Supreme Court s decision in Gitlitz, 7 Section 108(d)(7) and Section 1367(b)(2) were amended to clarify that COD income that is excluded by an S corporation under Section 108(a) is not taken into account in determining the basis of the shareholders stock in the S corporation U.S. 206, 87 AFTR2d (2001). -12-

13 C. The Section 108(e) general rules The most important aspect of Section 108 may be the so-called general rules in Section 108(e). Section 108(e)(1) provides that there is no insolvency exception to the general rule in Section 61(a)(12) except as provided in Section 108(a)(1)(B). Under Section 108(e)(2), COD income is not recognized to the extent that the payment of the liability would have given rise to a deduction. Thus, if a cash-method taxpayer is relieved of the obligation to pay interest on a mortgage loan, the taxpayer will generally will not have any COD income with respect to the forgiveness of the interest income. Pursuant to Section 108(e)(3), the amount taken into account with respect to any discharge is to be properly adjusted for unamortized premium and discount with respect to the debt. Section 108(e)(4) provides that the acquisition of indebtedness by a person related to the taxpayer (within the meaning of Section 267(b) or Section 707(b)(1)) shall be treated as the acquisition of the debt by the taxpayer. For purposes of this rule, related parties include not only direct family members (taxpayer, spouse, children, grandchildren and parents) but also any spouse of the individual s children and grandchildren. In the entity context, two entities that are treated as a single employer under Section 414 (b) or (c) are treated as related. Treasury and the IRS issued lengthy Regulations implementing these rules after the debt workouts in the 1990s. Under Reg (a), a debtor has COD income if its outstanding debt instrument is acquired by a related person from an unrelated person. The amount of COD income recognized by the debtor depends on the cost of the debt instrument at the time of its acquisition. The debtor is deemed to issue a new debt instrument to the related holder at the time of the acquisition, and the new instrument will have an issue price equal to the cost of the old debt instrument. Thus, the related party that acquires the debt instrument could be required to recognize OID income, and the issuer would have OID deductions, during the remaining life of the debt instrument. This may raise problems if the parties are not sufficiently related so that interest income can be offset by interest deductions. In addition, the Regulations under Section 108(e)(4) can also create COD income in the event of an indirect acquisition of a debt instrument, which occurs when a person who is unrelated to the debtor at the time of the acquisition of a debt instrument subsequently becomes related to the debtor. Under Reg (c)(3), if the holder acquired the debt instrument less than six months before the date the holder becomes related to the debtor, the holder is deemed to have acquired the indebtedness in anticipation of becoming related to the debtor. If the debt was acquired more than six months before the parties became related but within 24 months of that date, the determination of whether the indebtedness was acquired by the holder in anticipation of the parties becoming related is made using all of the facts and circumstances. The facts to be considered include the intent of the parties at the time of the acquisition, the nature of their contacts before the acquisition, the period of time for which the holder held the indebtedness, and the significance of the indebtedness in proportion to the total assets of the holder and its related parties. Reg (c)(2) Section 108(e)(5) provides a very useful planning tool for workouts. Under this provision, if the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced, and such reduction does not occur in a Title 11 case or when the purchaser is insolvent, and but for Section 108(e)(5) such reduction would otherwise have resulted in income, then the reduction is not treated as COD income but, rather, as an adjustment to the purchase price of the property in question. -13-

14 One puzzling aspect of this provision is that it relates to purchase price reductions in favor of solvent debtors, but does not address the more common situation in which the purchase price owed for property by an insolvent or bankrupt debtor is reduced. (Bizarro?) This provision was added as part of the Bankruptcy Tax Act of 1980 (BTA) and was intended to supplement the long-standing common law that provided that the relief of a purchase money debt owed by an insolvent or bankrupt debtor was not treated as COD income but, rather, as an adjustment to the purchase price of the property. The IRS has stated that this rule applies to both solvent and insolvent debtors, but only in the case of a reduction of a purchase money obligation from the original debtor given to the original creditor. Thus, the IRS will not challenge a partnership s ability to avoid COD income from the reduction of its debt based on the solvency of the partnership, but the indebtedness must be a purchase money note from the original purchaser to the original seller. Furthermore, in order for this exclusion to apply, the debtor must reduce the basis of the acquired property. If the debtor lacks sufficient basis, the debtor must recognize COD income to the extent of the excess. Under Section 108(e)(6), if a debtor corporation acquires it s indebtedness from a shareholder as a contribution to capital, Section 118 does not apply, but the corporation is treated as having satisfied the debt with an amount of money equal to the shareholder s adjusted basis in the debt. This provision was also enacted as part of the BTA and was intended to address situations in which the debt represented an accrued expense previously deducted by the corporation. Section 108(e)(6) does not apply, however, when a partner contributes debt to a partnership without receiving an additional partnership interest in the exchange. There are a couple of rules in Section 108(e) that address the situation in which stock is issued in satisfaction of debt. The general rule is in Section 108(e)(8), which provides that if a debtor corporation transfers its stock to a creditor in satisfaction of its recourse or nonrecourse indebtedness, the debtor will be treated as having satisfied the debt with money equal to the FMV of the stock. Under Section 108(e)(7), if a creditor acquires stock of a debt corporation in satisfaction of debt, for purposes of Section 1245, the stock is treated as Section 1245 property and the aggregate amount allowed to the creditor as deductions under Section 166 (due to worthlessness of the debt) or as an ordinary loss on the exchange are treated as deductions for deprecation. These rules govern stock-for-debt exchanges even if the transaction otherwise would be treated as qualifying for a carryover basis under Sections 354, 355 or 356, or if stock of a parent corporation is used instead of stock of a subsidiary. In 2004, Congress extended the application of Section 108(e)(8) to partnerships. Under Section 108(e)(8)(B), if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, such partnership is treated as having satisfied the indebtedness with money equal to the FMV of the partnership interest. Any COD income recognized under this provision is included in the distributive shares of the taxpayers who were the partners in the partnership immediately before the debt was discharged. The IRS recently issued proposed regulations under Section 108(e)(8). The Proposed Regulations under Section 108(e)(8) set forth the tax consequences to both the transferee and the transferor when debt of a partnership is contributed in exchange for a partnership interest. -14-

15 Under Prop. Reg (a), for purposes of determining COD income, if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, the partnership is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the partnership interest received in exchange for the debt. For purposes of applying this rule, Prop. Reg (b)(1), a safe harbor, which if satisfied, provides that the FMV of a partnership interest transferred by a debtor partnership to a creditor in satisfaction of the partnership s indebtedness (a debt-for-equity exchange) is the liquidation value of the partnership interest, where liquidation value equals the amount of cash that the creditor would receive with respect to the interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill and other intangible assets) for cash equal to the FMV of those assets and then liquidated. The safe harbor is satisfied only if all of the following conditions are met: 1. The debtor partnership determines and maintains capital accounts of its partners in accordance with the capital accounting rules of Reg (b)(2)(iv); 2. The creditor, the debtor partnership, and its partners treat the FMV of the indebtedness as being equal to the liquidation value of the interest for purposes of determining the tax consequences of the 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 interest as part of a plan (at the time of the exchange) that has as a principal purpose the avoidance of COD income by the partnership. If all four of these requirements are not satisfied, then all of the facts and circumstances must be considered in determining the FMV of a partnership interest received in exchange for partnership debt. Prop. Reg (c) illustrates the calculation of COD income to the partnership as follows. Example: AB partnership has $1,000 of outstanding indebtedness owed to C. In an arm s-length transaction, C agrees to cancel the indebtedness in exchange for an equity interest in AB. AB maintains capital accounts in accordance with Reg (b)(2)(iv). At the time of the contribution, the FMV of the debt was $700 and the partnership gave C a capital account of $700. This equals the liquidation value of C s interest, which is the amount of cash that C would receive with respect to the interest if AB sold all of its assets for cash equal to the FMV of those assets and then liquidated. C, AB, and its partners all treat the FMV of the indebtedness as being equal to the liquidation value of C s interest. Subsequent to the exchange, neither AB redeems nor any person related to AB purchases C s interest as part of a plan at the time of the exchange. Because all four requirements are satisfied, the FMV of C s interest received in the exchange is deemed to be $700, so AB would have $300 of COD income. The second issue addressed in the Proposed Regulations is the tax consequences to the contributing creditor (who receives a partnership interest in exchange for debt). Prop. Reg (d) generally follows the nonrecognition rules of Section 721, so that no gain or loss is recognized on the transfer of debt (property) to a partnership in exchange for a partnership interest. The Proposed Regulations further provide, however, that Section 721 does not apply to the transfer of a partnership -15-

16 interest to a creditor in satisfaction of a partnership s indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued OID). Furthermore, according to the Preamble, the Proposed Regulations do not supersede the rules under Section 453B relating to the disposition of installment obligations. Reserved for future guidance are the consequences of a transfer of a partnership interest in exchange for a debt related to services performed for a partnership. (There also may be tax consequences to the other partners under Section 752 due to the contribution of debt to capital.) Consistent with the analysis that Section 721 applies to a debt-for-equity exchange, the Preamble to the Proposed Regulations further provides that the basis of the creditor s interest in the partnership is determined under Section 722. Under that provision, the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership is equal to the amount of money contributed and the adjusted basis of such property to the contributing partner at the time of the contribution, increased by the amount (if any) of gain recognized under Section 721(b) to the contributing partner at such time. Furthermore, Section 1223 provides, in general, that in determining the period for which a taxpayer has held property received in an exchange, the holding period will include the period for which the taxpayer held the property exchanged if the property has, for purposes of determining gain or loss from a sale or exchange, the same basis in whole or in part in the taxpayer s hands as the property exchanged. Because the basis in the partnership interest received in a debt-for-equity exchange that is subject to Section 721 is the same as the creditor s basis in the debt under Section 722, the holding period for the interest includes the creditor s holding period for the indebtedness. The theory underlying this aspect of the Proposed Regulations is that the contributing creditor should not recognize a loss in a debt-for-equity exchange subject to Section 721, even if the partnership is required to treat the exchange as giving rise to COD income. The drafters of the Proposed Regulations, however, apparently did not want nonrecognition to apply when the asset that is contributed is a right to receive ordinary income, such as unpaid rent, royalties, or interest (including accrued OID). Furthermore, the Proposed Regulations do not distinguish between situations in which ordinary income has already been accrued by the creditor (such as OID, or rent accrued by an accrual-method landlord) and situations in which such ordinary income has not yet been recognized (e.g., by a cash-method lender or landlord). The Proposed Regulations do not indicate why nonrecognition is inappropriate in situations in which ordinary income previously has been recognized with respect to a debt contributed to a partnership. D. Section 108(c) QRPBI Special rules also are provided in Section 108(c) with respect to QRPBI excluded under Section 108(a)(1)(D). Under Section 108(c)(1)(A), amounts that are so excluded are applied to reduce the basis of depreciable real property of the taxpayer. The amount excluded, however, may not exceed the excess (if any) of the principal amount of the debt immediately before the discharge over the FMV of the real property, reduced by the outstanding principal balance of any other QRPBI secured by such property. In addition, the amount excluded may not exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge. For purposes of Section 108, QRPBI is indebtedness that was incurred or assumed by the taxpayer in connection with real property used in a trade or business which is secured by such real property, and unless the debt was incurred or assumed before January 1, 1993 is qualified acquisition indebtedness with respect to which the taxpayer elects to have Section 108(a)(1)(D) apply. Thus, unlike COD income arising in the context of a bankruptcy or when the taxpayer is insolvent, QRPBI is excluded only if the taxpayer so elects. For purposes of this rule, qualified acquisition indebtedness means debt -16-

17 incurred or assumed to acquire, construct, reconstruct or substantially improve real property that is secured by such debt. A reacquisition of a debt instrument includes a debt-for-debt exchange, which can occur if there is a significant modification of a debt instrument or the acquisition of a debt instrument by a related party. If a debtor issues a debt instrument in satisfaction of its indebtedness, the debtor is treated as having satisfied the indebtedness with an amount of money equal to the issue price of the newly issued debt instrument. The issue price of such newly issued debt instrument generally is determined under Sections 1273 and The new debt instrument will have OID equal to the excess (if any) of the debt instrument s stated redemption price at maturity over its issue price. In general, an issuer of a debt instrument with OID may deduct for any tax year an amount of OID equal to the aggregate daily portions -17- E. Section 108(i) Deferral Congress recently added a new deferral option for taxpayers. Under Section 108(i)(1), an eligible taxpayer may elect that COD income with respect to the reacquisition of an applicable debt instrument during the period after 2008 and before 2011 (i.e., during 2009 and 2010) is included ratably over the five-tax-year period beginning: 1. For a reacquisition occurring in 2009, with the fifth tax year following the tax year in which the reacquisition occurs. 2. For a reacquisition occurring in 2010, with the fourth tax year following the tax year in which the reacquisition occurs. For purposes of applying these rules, an applicable debt instrument is defined in Section 108(i)(3) as any debt instrument issued by a C corporation or by any other person in connection with the conduct of a trade or business by such person. A debt instrument is broadly defined to include any bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness within the meaning of Section 1275(a)(1). There is no guidance in either the Code or the legislative history as to the meaning of a trade or business for purposes of this provision, but presumably this would include debt issued in connection with the acquisition of depreciable rental real estate. It is unclear, however, whether the rental of undeveloped land will qualify as a trade or business for purposes of Section 108(i). A reacquisition also is broadly defined in Section 108(i)(4), and includes any acquisition of an applicable debt instrument by either the debtor that issued (or is otherwise the obligor under) the instrument or a person related to that debtor (determined using the rules under Section 108(e)(4)). An acquisition of an applicable debt instrument includes, without limitation, the following: 1. An acquisition of the debt instrument for cash. 2. The exchange of the debt instrument for another debt instrument (including the deemed exchange resulting from the modification of a debt instrument). 3. The issuance of corporate stock or a partnership interest in exchange for the debt instrument. 4. The contribution of a debt instrument to capital. 5. The complete forgiveness of a debt instrument by a holder of such instrument.

18 of the OID for days during such tax year. Without a special rule, a taxpayer who is deemed to issue a new debt instrument at a discount (for example, as a result of a significant modification of the debt instrument) would not have to include COD income but would have been entitled to OID deductions. To address this point, Section 108(i)(2)(A) provides that any otherwise-allowable deduction for OID with respect to the newly issued debt instrument that accrues during the period in which the COD income is being deferred, and does not exceed the amount of the related deferred COD income, is deferred and allowed as a deduction ratably over the fiveyear period during which the COD income is being recognized. Presumably, this rule also would apply if a person related to the taxpayer acquired the debt instrument and a new debt instrument was deemed to have been issued pursuant to Reg (g). COD income that is deferred under Section 108(i)(1), as well as any related OID deduction that is deferred under Section 108(i)(2)(A), generally is accelerated and taken into income in the tax year in which the taxpayer (1) dies, (2) liquidates or sells substantially all of its assets (including in a Title 11 bankruptcy or similar case), (3) ceases to do business, or (4) is in similar circumstances. In the case of a bankruptcy under Title 11 or a similar case, any deferred items are taken into income as of the day before the petition is filed. Deferred items are accelerated in a case under Title 11 where the taxpayer liquidates, sells substantially all of its assets, or ceases to do business, but not where a taxpayer reorganizes and emerges from a Title 11 case. For a partnership or other pass-through entity, this acceleration rule also applies to the sale, exchange, or redemption of an interest in the entity by a holder of such interest. Treasury and the IRS are authorized to issue Regulations as may be necessary or appropriate for purposes of applying Section 108(i), including rules (1) extending the acceleration provisions where appropriate, (2) requiring reporting of the election and such other information as required, including on subsequent returns, and (3) for the application of this provision to partnerships, S corporations, and other pass-through entities, including the allocation of deferred deductions. In Rev. Proc , the IRS discussed how the election to defer COD income is to be made by a partnership. Specifically, Section 108(i)(5)(B)(iii) provides that the election to defer COD income must be made by the partnership. This statutory provision is inconsistent with the other elections for partnerships in the COD arena, such as the election for QRPBI which is made at the partner level, as well as the determination of insolvency and bankruptcy (also made at the partner level). Moreover, the statutory rule often would place general partners in an untenable position, because a deferral of COD income that was favorable for corporate partners (not eligible for QRPBI) or solvent partners was equally unfavorable for insolvent partners or partners who could take advantage of QRPBI, who would not be allowed the more-favorable treatment due to a partnership election. The IRS solved this problem in Rev. Proc by adopting an election treatment for partnerships that borders on, well, the Bizarro. Specifically, a partnership is allowed to elect to defer a portion of the COD income that is allocable to certain partners, and not elect deferral with respect to the COD income that is allocated to other partners. In other words, an election can be made that results in tax benefits to some partners without providing a detriment to other partners that would be disfavored by the election, and income allocations can also favor certain partners without harming other partners. Any student of Section 704(b) will quickly realize that this approach appears to be contrary to the general rules for determining whether allocations have substantial economic effect (particularly the substantiality prong of this test), but Rev. Proc appears to be an intentional departure from such general rules. In other words, in order to address a problem in applying Section 108(i), the IRS adopted a Bizarro rule that is favorable for most partnerships (which means that it is unlikely that anyone will ever object). -18-

19 F. Bizarro Implications There are a number of Bizarro aspects to the various rules under Section 108 concerning exclusions from income. First, the fact that a taxpayer will usually be harmed by making the election under Section 108(b)(5) to reduce basis in assets if COD income is excluded is somewhat odd, because usually elections are favorable, not harmful. However, because the basis of property can be reduced to zero in the case of a Section 108(b)(5) election but only to the amount of debt that encumbers the property if the election is not made, the election often is not as favorable as it would seem. Second, it is very unusual for an S corporation to be preferable to a partnership from a tax planning perspective, but this clearly is the case in the event of a debt workout. The determination of insolvency is made at the corporate level in the case of an S corporation, but it is made at the partner level in the case of a partnership (or any other business entity taxable as a partnership, like an LLC). Because a workout frequently occurs when the legal borrower (in this case, the partnership or S corporation) is financially challenged, it would make sense if the insolvency determination were made at the level of the borrower. However, even though the lender has no recourse against the partners in a partnership (or the members of an LLC), solvency is still determined at their level in the case of a partnership. Thus, if a tax practitioner is advising a client with respect to choice of entity, one of the important caveats is always that if the venture is not successful, an S corporation may be better than a partnership. Third, the related party rules under Section 108(e)(4) create some very odd tax results in situations in which the holder of debt becomes related to the borrower after the debt is acquired at a discount. There can be either a nonrebuttable or a rebuttable presumption that the debt was acquired in anticipation of the parties becoming related, even if the acquirer had not even an inkling that it would ever become related to the debtor at the time the acquisition occurred. Fourth, a serious flaw in the statutory framework is the lack of a partnership analog to Section 108(e)(6). If a partner desires to improve the balance sheet of a partnership that is financially challenged, it makes no sense for the partnership to recognize income when the debt is contributed to capital. Furthermore, if the partner simply contributes capital to the partnership, and the capital is then used to pay off the debt, there does not appear to be any COD income (although the IRS might challenge a circular flow of cash, even though this approach is needed to avoid a Bizarro tax result). The fact that a partner must actually contribute cash to a partnership to eliminate a debt owed to the partner, instead of simply contributing the debt instrument to capital, is another Bizarro aspect of debt workouts in the partnership arena. Moreover, this Bizarro result does not occur if the borrower is an S corporation instead of a partnership or an LLC. In that event, Section 108(e)(6) will apply, and the S corporation will only have COD income if the shareholder s basis is less than the face amount of the debt instrument. In the partnership context, however, the partner s basis in the debt instrument is meaningless all that matters is whether the FMV of the partnership interest that is received (or, more accurately, deemed to be received since nothing is transferred in the case of a contribution to capital) is more than the face amount of the debt. Since a contribution of debt to capital usually occurs only when the partnership is financially challenged, there could be COD income when the debt is contributed to the capital of a partnership or LLC (but not when the debt is contributed to the capital of an S corporation). The proposed regulations under Section 108(e)(8) add their share of Bizarro results, including particularly the divergent rules under which (1) a partnership that acquires a debt instrument in exchange for a partnership interest recognizes gain, but (2) the contributing partner cannot recognize its loss until later. Because insolvency is tested at the partner level, this means that in most cases the partners will -19-

20 recognize income unrelated to the timing of loss recognition by the creditor. If, instead, the creditor simply sold the note to a third party who was willing to hold a partnership interest, the creditor would recognize its loss. Moreover, even if the creditor is willing to hold a partnership interest in lieu of the debt, the creditor will be sorely tempted to sell the debt to an unrelated third party and, then, after the third party acquires a partnership interest, acquire the partnership interest from the third party. A series of rules that depend upon the order in which steps are implemented is certainly Bizarro. Even more odd is the special deferral election under Section 108(i). First, Congress enacted this provision to aid distressed companies due to the current recession, but many taxpayers who need to take advantage of this provision are either insolvent or fiscally challenged. Because the election under Section 108(i) is exclusive, it can be assumed that many financially-challenged persons will not make the election, including particularly S corporations that are eligible to determine insolvency at the entity level. A partnership may be tempted to make the election if COD income is going to be currently recognized due to the solvency of its partners, but this means that the partnership is simply deferring the recognition of income which will be taxed at maximum marginal rates. If debt is nonrecourse (discussed below), the partnership will usually be better off if it can convey property in satisfaction of the debt in order to recognize capital gains instead of ordinary income. In other words, the Section 108(i) election will often be a trap for the unwary, which is a Bizarro way for Congress to address the tax aspects of debt workouts; particularly when Congress intent was to help the taxpayer. III. BASIS MODIFICATIONS The IRS has issued lengthy Regulations concerning the basis adjustments which must be made when COD income is excluded, including particularly Regulations concerning QRPBI. Under Section 1017(a), if COD income is excluded under Section 108(b)(2)(E) (attribute reduction, fifth order of priority), Section 108(b)(5) (optional basis reduction instead of reducing other attributes), or Section 108(c)(1) (exclusion of COD relating to QRPBI), then the excluded COD must reduce the basis of any property held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurred. The amount of the reduction, and the properties to which such basis reduction applies, is determined under Regulations, provided that any reduction pursuant to Section 108(b)(5) or Section 108(c)(1) may be applied only to depreciable property. The general rule for basis reductions under Section 1017 is set forth in Reg (a), which provides that a taxpayer must reduce the adjusted basis of property held on the first day of the tax year (but not below zero) in the following order, to the extent of the excluded COD income: 1. Real property used in a trade or business or held for investment, other than real property held as inventory, that secured the discharged indebtedness immediately before the discharge. 2. Personal property used in a trade or business or held for investment (other than inventory, accounts receivable, and notes receivable) that secured the discharged indebtedness immediately before the discharge. 3. Remaining property used in a trade or business or held for investment (other than inventory, accounts receivable, and notes receivable) that did not secure the discharged indebtedness. -20-

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