Sect. 108 and Cancellation of Debt Income: Navigating IRS Rules

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1 Sect. 108 and Cancellation of Debt Income: Navigating IRS Rules Wayne R. Strasbaugh Ballard Spahr LLP 1735 Market Street, 51st Floor Philadelphia, Pennsylvania October 5, 2011 ANY LEGAL ADVICE CONTAINED IN THESE MATERIALS WAS NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND SUCH ADVICE CANNOT BE USED BY ANY RECIPIENT, FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.

2 A. Basic Concepts - Types of Debt Sect. 108 and Cancellation of Debt Income: Navigating IRS Rules 1. Recourse Debt A transfer of property to the lender in satisfaction of a recourse debt does not necessarily release the obligor from liability 2. Nonrecourse Debt A transfer of property to the lender in satisfaction of a nonrecourse debt releases the obligor from liability 3. Exculpatory Debt An exculpatory debt is similar to a nonrecourse debt except that an item of property does not specifically secure the debt. An everyday example of an exculpatory debt would be the unsecured debt of a limited liability company, for which the members have no liability. B. Basic Concepts - Types of Income 1. Cancellation of debt (COD) income is ordinary income that is taxable at the maximum 35% rate but in some cases may be subject to exclusion from income under Section 108. Treas. Reg Capital gain income (including Section 1231 gain) is taxable at a lower rate (currently 15% maximum) 3. COD income is reported to borrowers by financial institutions and other lenders on Form 1099-C. If a lender acquires property in full or partial satisfaction of a business loan without cancellation of the debt, Form 1099-A must be filed. 4. Capital gain income (gross proceeds from the foreclosure of real estate) MAY be reported to borrowers on Form 1099-S at the lender s option C. Basic Concepts - COD Income May Arise from Transfers of Property 1. A transfer of property in satisfaction of recourse debt produces (generally capital or Section 1231) gain or loss measured by the difference between the fair market value of the property and its tax basis. Any remaining liability that is discharged is ordinary COD income. However, in the case of business property, a Section 1231 loss (which is usually ordinary) recognized on the transfer may offset the ordinary COD income to the extent the discharged debt is still reflected in the basis of the property. 2. A transfer of property in satisfaction of nonrecourse debt produces (generally capital or Section 1231) gain or loss measured by the difference between the outstanding amount of the debt and the tax basis of the property even where the value of the property is less than the amount of the debt. No COD income is produced. It also appears that an interest deduction is allowable to the borrower

3 only to the extent the fair market value of the property exceeds the principal portion of the debt. See Allan v. Commissioner, 86 T.C. 655 (1986), aff'd, 856 F.2d 1169 (8th Cir. 1988). 3. However, a partial discharge of a nonrecourse liability without any transfer of the property securing it DOES produce COD income even though the equity value of the property to the borrower may still be zero D. Basic Concepts - COD Income May Arise from Acquisitions of Debt 1. COD income may arise from an acquisition of debt by the obligor. That is, when a lender and borrower compromise the amount owing on a debt, the borrower is regarded as having acquired its own debt in exchange for its agreement to pay the reduced amount of the loan. Obviously, the debt is extinguished by such an acquisition. 2. COD income may also arise when a debt is acquired by persons related to the obligor or in anticipation of the establishment of such a relationship (persons that become related to the obligor within 6 months after the acquisition are deemed to have anticipated the formation of the relationship). For this purpose, greater than 50% ownership establishes a relationship, taking into account various constructive ownership rules that, for example, attribute equity ownership from one family member to another. 3. Acquisitions of debt by parties related to the obligor generally do not extinguish the debt under state law. Nevertheless, tax law treats the debt as if it has been extinguished and re-issued for an amount equal to the adjusted basis of the related property holder after the acquisition (if the obligation has been acquired within 6 months) or for the fair market value of the obligation (if the obligation has been acquired more than 6 months before formation of the anticipated relationship). 4. In related party acquisitions, the holder recognizes no gain or loss on account of the deemed extinguishment of the obligation, even though obligor recognizes COD income 5. Where the related party obligation is not actually extinguished and remains outstanding, the obligor deducts and related party holder accrues original issue discount (OID) income over remaining term of obligation E. Statutory Exclusions Under Section 108 of the Internal Revenue Code, COD income may be excluded from gross income under eight different statutory exclusions, five of which are described in greater detail below: 1. Bankruptcy 2. Insolvency

4 3. Qualified Real Property Business Indebtedness ( QRPI ) (Noncorporate Taxpayers) 4. Purchase Money Debt Reduction 5. Lost Deductions Through Nonpayment 6. Qualified Farm Indebtedness 7. Qualified Personal Residence (before 2013) 8. Special Deferral Election for 2009 and 2010 F. Insolvency Exclusion 1. COD income is excluded to the extent the borrower is insolvent before the debt cancellation event. Insolvency is measured by the excess of the borrower s liabilities over the fair market value of its assets. 2. All assets are apparently included even those that are exempt from creditors. Carlson v. Commissioner, 116 T.C. 87 (2001); TAM (May 3, 1999). 3. Contingent liabilities are apparently subject to an all or nothing approach. That is, if it is more likely than not that the contingent liability will be paid, the contingent liability is wholly included. Otherwise, the contingent liability will not be included in measuring insolvency, even at some discounted amount. 4. Nonrecourse debt is included in full only if it is being discharged. Rev. Rul , CB The insolvency exclusion has an uncertain application to a partner s share of partnership liabilities. That is, if the partner is not liable for the partnership s liability and only shares in them by virtue of the tax law, why should it be considered in measuring the partner s insolvency? 6. Importantly, the insolvency test is applied at the partner level, such that the fact that a partnership (or LLC) is insolvent is not determinative. Conversely, the insolvency test is applied at the S corporation level without regard to the financial condition of the S shareholder. 7. The insolvency test is applied within a consolidated return group on a separate member basis and does not take into account the assets and liabilities of other group members 8. Under proposed regulations, the test would be applied at the owner level for grantor trusts and disregarded entities. Until final regulations are adopted, there is some uncertainty how the test would be applied under current law. Prop. Reg. Sec (April 12, 2011) (no inference as to current law).

5 G. Qualified Real Property Business Indebtedness ( QRPI ) (Section 108(c)) 1. The QRPI exclusion is available only for solvent noncorporate taxpayers 2. To qualify as QRPI, (c) an obligation must have been incurred or assumed in connection with real property used in trade or business; an obligation must be secured by real property; and an obligation must have been incurred or assumed before 1993 or incurred after 1993 for the construction or substantial improvement of real property 3. The exclusion for discharged QRPI is limited to the lesser of (1) the excess of the pre-discharge principal amount of the QRPI over the fair market value of the real property securing the QRPI and (2) the aggregate adjusted basis of all depreciable real property held by the borrower immediately before discharge. A no stuffing rule is intended to prevent an increase of the limitation by acquiring depreciable real property in contemplation of the discharge. 4. Perhaps most importantly, the QRPI exclusion is ELECTIVE H. Purchase Money Debt Reductions (Section 108(e)(5)) 1. This exception is limited to situations where the purchase money debt is reduced by the original seller. Reductions of the debt by a subsequent holder of the purchase money obligation do not qualify for this exclusion. 2. This exception is not elective. The purchaser will lose basis even if might prefer to include the COD income and shelter it with expiring net operating loss carryovers. 3. This exception will not apply if the purchaser is bankrupt or insolvent 4. However, consistent with the approach of applying the bankruptcy and insolvency exclusions at the partner level, Rev. Proc conceded that the bankruptcy or insolvency of a partnership would not be relevant in determining whether the purchase money debt reduction exception was available I. Lost Deductions Through Nonpayment (Section 108(e)(2)) 1. This exception operates in tandem with the statutory tax benefit rule contained in Section 111. See Rev. Rul ; Rev. Rul The tax benefit rule excludes income in the case where a prior year s deduction did not provide a tax benefit. Nevertheless, there is some uncertainty whether the Section 108(e)(2) exclusion is available where the timing of a deduction would be in the same year

6 as the discharge and the deduction was limited under Code floor or phase-out rules. 2. This exception usually is most often available to cash basis taxpayers because an accrual basis taxpayer will (subject to the economic performance rules) have deducted the expense without regard to payment 3. Because of the disconnect between the time of payment and the time of deduction, the availability of this exclusion for amortizable capital expenditures is doubtful J. Special Deferral Election for 2009 and 2010 (Section 108(i)) 1. This special deferral election (which has now sunset) was available for C corporations and any other person in connection with the conduct of a trade or business 2. The election was available for COD income realized from the reacquisition of debt instruments in 2009 or If the special deferral elected for either year, the COD income was deferred to 2014 and then spread over a five-year period through This election was available for bankrupt and insolvent taxpayers, as well as for solvent taxpayers that were also eligible to elect the QRPI exclusion. Making the Section 108(i) election precluded the use of any of these other COD income exclusions. 5. Although the provision sunset at the end of 2010 so that the relevant tax returns have now been filed, the election is still available for filed returns eligible for automatic 12-month Section 9100 relief. Rev. Proc K. Attribute Reduction (General Rule for Bankruptcy and Insolvency) 1. The taxpayer s attributes are reduced after the taxable income for COD year is determined. This ordering rule is significant in that it permits full use of any NOL carryovers to offset current year income. 2. After taxable income for the COD year is determined, the NOL carryover from the COD year and NOL carryovers from prior years are reduced in the order in which they arose 3. Next, business credits are reduced in the order in which they are taken into account under the Code at the rate of 33-1/3 cents for each dollar of exclusion. Note that the business credit carryover rules generally require the use of carryovers before current year credits.

7 4. Next, the minimum tax credits as of the beginning of the taxable year following the year of discharge are reduced at the rate of 33-1/3 cents for each dollar of exclusion 5. Next, the capital loss carryover from the COD year and the capital loss carryovers from prior years are reduced in the order in which they arose 6. Next, the basis of the taxpayer s property held as of the beginning of the year following the COD year is reduced to the extent it exceeds undischarged liabilities Basis reductions made to personal property or to any other property that is not real property are subject to recapture under Section 1245 as if the basis reductions were depreciation deductions (i) As a special trap for the unwary, the Section 1245 recapture taint may attach to the stock of a consolidated subsidiary to the extent its basis reduction exceeds the aggregate reductions made to the subsidiary s assets. (See summary of consolidated return tax attribute reduction below.) As a consequence, Section 1245 recapture income may be triggered by the cancellation of the tainted stock upon a future liquidation of the subsidiary even if such liquidation would otherwise be tax-free under Section 332. Basis reductions made to real property recapture are subject to recapture under Section 1250 to the extent the basis reduction exceeds the straightline depreciation that would otherwise be allowable with respect to the unreduced basis. Consequently, recapture from reductions to the basis of depreciable real property represents a vanishing tax detriment. 7. Next, the passive activity loss or credit carryovers from the COD year are reduced (the passive activity credit carryovers at the rate of 33-1/3 cents per dollar) 8. Next, the foreign tax credit carryovers to or from COD year are reduced at the rate of 33-1/3 cents per dollar 9. Finally and most importantly there is no recognition of any COD income excluded under the bankruptcy or insolvency exclusion that is not matched by an attribute reduction offset. This excluded income drops into a black hole. 10. Within a consolidated return group, Treas. Reg. Sec adopts a hybrid approach to the application of these general attribute reduction rules. Although a full consideration of the consolidated return regulations is beyond the scope of this outline, their general approach is to limit tax basis reduction to the assets of the member generating the COD income and to reduce the other tax attributes of that member first before reducing the non-basis tax attributes of the other group members.

8 If one of the assets of the COD income-generating member is stock of another member (that is, a lower-tier member) and both corporations are members of the same consolidated return group on the last day of the COD income recognition year or the first day of the following year, the stock basis reduction is treated as if it were excluded COD income with respect to the lower-tier member. The lower-tier member is accordingly required to reduce its tax attributes (including the basis of its assets) to offset its deemed excluded COD income. However, if the lower-tier member s tax attributes do not fully offset its deemed excluded COD income, the remainder drops into a black hole without requiring the reduction of the tax attributes of other group members. L. Attribute Reduction Election (Bankrupt and Insolvent Taxpayers) 1. Bankrupt and insolvent taxpayers may elect to offset all or part of their excluded COD income against depreciable property first 2. Any COD income that is not subject to election is thrown back to the General Rule described above 3. The depreciable property eligible for offset must be held as of the beginning of the year following the COD year 4. In contrast to the general rule, the basis of depreciable property is reduced pursuant to this election without regard to undischarged liabilities 5. Subject to certain conditions, a portion of the basis of an interest in a partnership holding depreciable property may be treated as depreciable property if the partnership agrees to reduce an equivalent amount of inside basis 6. A portion of the basis of stock of a consolidated subsidiary holding depreciable property may be treated as depreciable property if the subsidiary agrees to reduce an equivalent amount of inside basis This elective reduction to the basis of the subsidiary s depreciable property takes precedence over the look-through asset basis reduction within consolidated return groups that is required by the general attribute reduction rule described above. 7. A taxpayer may make a secondary election to treat real property inventory as depreciable property 8. Form 982 is used to make both the primary and secondary election M. Attribute Reduction (Qualified Real Property Business Indebtedness) 1. Taxpayers making the QRPI exclusion election are subject to mandatory reduction of the basis of depreciable real property (ONLY) that is held as of

9 beginning of year following the COD year. This rule dovetails with the limitation of the QRPI election to the amount of depreciable real property held by the electing taxpayer. 2. Though technically not subject to basis reduction, depreciable real property disposed of in the COD year is treated as if its basis has been reduced immediately before disposition 3. Taxpayers electing the QRPI exclusion may not make a secondary election to treat real property as inventory 4. In making the basis reductions, the basis of real property securing debt comes first 5. Subject to certain conditions, the electing taxpayer may reduce the basis of a partnership interest if the partnership reduces its inside basis in depreciable property. There is no analog to the basis reduction of stock of a consolidated subsidiary because corporate taxpayers may not elect the QRPI exclusion. 6. The basis of an interest in the partnership producing COD income is reduced first 7. Any remaining COD income from a partnership may be offset against other depreciable real property basis of the taxpayer, allowing for planning opportunities N. Transactional Exclusions 1. Debt-for-Debt Exchanges (Section 108(e)(10)) 2. Debt-for Stock Exchanges (Section 108(e)(8)) 3. Debt for Partnership Interest Exchanges (Section 108(e)(8)) 4. Contribution of Debt by an Existing Shareholder (Section 108(e)(6)) O. Debt-for-Debt Exchanges (Section 108(e)(10)) 1. Basic Terms Every debt instrument has an issue price, the determination of which varies with the circumstance of its issuance (i) (ii) Where a debt instrument is issued for money as a private loan between two parties, the issue price is the cash paid. A simple example would be a private loan of money to an individual. Where the debt instrument is issued as part of a public offering of debt for money, the issue price is the first price at which a substantial amount of the debt instruments are sold for money

10 (iii) (iv) (v) Where the debt instrument is issued as part of a public offering of debt for property, the issue price is the fair market value of the debt instrument as of the first date on which a substantial amount of the debt instruments are issued Where the debt instrument is not itself publicly traded but is issued for publicly traded property, the issue price is the fair market value of the publicly traded property as of the first date on which a substantial amount of the debt instruments are issued In other cases where neither the debt instruments issued nor the property acquired as consideration for the issuance are publicly traded, the issue price will either be an imputed issue price or the stated redemption price at maturity (SRPM) (c) (d) (e) Stated Redemption Price at Maturity (SRPM) is all payments due at the maturity of a debt instrument other than qualified stated interest (QSI) QSI is interest that is payable unconditionally at least annually at a single fixed rate. Interest holidays, increments in stepped interest rates or contingent interest cannot produce QSI. Original issue discount (OID) on a debt instrument represents the difference (if any) between its SRPM and its issue price Applicable federal rate (AFR) is the rate published monthly by the IRS that the Code essentially treats as a surrogate for an arm s length interest rate in calculating an imputed issue price for a debt instrument 2. The statute provides for the measurement of income in a debt-for-debt exchange and not for an exclusion per se (though recognition of zero income is a possibility) (c) In determining the amount of COD income, the debtor is treated as having satisfied its existing debt for amount equal to issue price of new debt If the issue price would otherwise be SRPM, the issue price is reduced by the amount of any unstated interest imputed under Section 483 EXAMPLE: Assume that a note originally issued with a principal amount of $100, interest of 10% payable annually and a term of three years is exchanged for a replacement note with a principal amount of $ payable at maturity, with no interest payable currently and a term of three years. Assume that 10% compounded annually is the AFR (such that the present value of the replacement note is determined to be $100) and that neither note is publicly traded.

11 (i) The imputed issue price of replacement note will be $100 (essentially the present value of its SRPM using the AFR as its discount rate) and there is no COD income. The debtor will deduct $33.10 as original issue discount (OID) over the term of the replacement note, and the holder will include a corresponding $33.10 as OID income. (ii) (iii) If AFR were 11%, the imputed issue price of the replacement note would be less than $100 and COD income would be recognized on the exchange of notes. The COD income recognized by the debtor would be matched by additional deductions of accrued OID over the term of the replacement note. If the replacement note were publicly traded and had a fair market value (i.e. issue price) of less than $100, there would be COD income regardless of the adequacy of the yield of the note comparison to AFR Proposed Regulations (Notice of Proposed Rule Making REG ) would significantly broaden the definition of publicly traded if adopted in their current form. 3. Deemed Exchanges of Debt Instruments (Treas. Regs. Sec ) (c) Treasury regulations governing exchanges of debt were issued in 1996 as an outgrowth of Cottage Savings Assn. v. Commissioner, 499 U.S. 554 (1991). The Cottage Savings case suggested that a hair trigger rule applied in determining whether a deemed exchange occurred when a change occurred in the terms of an obligation. The regulations focus on modifications and whether modifications are significant. Any alteration to a debt instrument is a modification except that modifications occurring by operation of the terms of a debt instrument are not alterations. The number of significant modifications is more limited (i) (ii) (iii) (iv) A change in yield of more than de minimis amount (25 basis points) A change in the timing of payments. However, the regulations provide a safe harbor for an extension of the term by the lesser of 5 years or 50% of original term. A substitution of a new obligor on recourse instruments A substitution of a substantial amount of collateral on nonrecourse instruments

12 (v) Certain other changes (e.g. subordination) that change payment expectations (d) The result of a deemed exchange is, as in an actual exchange, measurement of potential COD income under Section 108 (e)(10) P. Debt-for-Stock Exchanges (Section 108(e)(8)) 1. This statutory provision is also a rule for measuring COD income and not an exclusion per se (c) (d) (e) The debt is deemed satisfied to the extent of the fair market value of the stock received by the lender in the exchange The provision is a tiny residue of a common law stock-for-debt exception from the recognition of COD income that was whittled away by the Bankruptcy Tax Act of 1980 and subsequent statutes. See Capento Sec. Corp. v. Commissioner, 47 B.T.A. 691 (1942), aff'd 140 F.2d 381 (1st Cir. 1944); and Commissioner v. Motor Mart Trust, 156 F.2d 122 (1st Cir. 1946). The former common law rule provided for a complete exclusion regardless of the valuation of the stock received. Where the exchange would otherwise be governed by Section 351 (that is, where the creditor obtains control of the stock-issuing corporation in exchange for the debt), Section 351 does not protect the creditor from recognition of gain or loss unless the debt the creditor exchanges is a security. Section 351 (d)(2). In the case of an S corporation where the creditor becomes a shareholder (or increases its percentage ownership by reason of the exchange), it is necessary to elect to close the books to avoid an allocation of COD income to the creditor Is there a different result if a new corporation is formed by the creditor and debtor and the assumption and discharge of the debt occur simultaneously? Cf. Kniffen v. Commissioner, 39 T.C. 553 (1962); Sec. 357(d). (i) (ii) EXAMPLE: Debt with a principal amount of $100 is exchanged for stock of debtor worth $90, and the debt is extinguished. COD income of $10 is recognized. EXAMPLE: Debt with a principal amount of $100 is contributed to Newco by the creditor and assets subject to the debt are contributed by the debtor. The debtor potentially recognizes gain under Section 357(c) prior to the extinguishment of the debt by merger of the estates of debtor and creditor, but that gain is likely to be capital gain and not ordinary income.

13 Q. Debt-for-Partnership Interest Exchanges (Section 108(e)(8)) 1. This statutory provision is also a rule for measuring COD income and not an exclusion per se (c) (d) (e) (f) A partnership debt (whether recourse or nonrecourse) is deemed satisfied to the extent of the fair market value of a profits or capital interest received. Under 2008 proposed regulations, liquidation value may be used to determine the fair market value of a partnership interest if capital accounts are maintained under IRC Section 704, valuation by partners and partnership is consistent, and certain other requirements are met. The statutory extension of the existing stock-for-debt rule to partnerships was a consequence of enactment of American Jobs Creation Act of 2004 (AJCA). The prior common law was assumed by many practitioners to contain a complete debt-for-partnership interest exclusion from COD income recognition that paralleled the nonrecognition rule for the contribution of the debt under Section 721. Any COD income that is recognized is under the statutory language is allocated to the partners immediately before the discharge exchange, but the allocation of the COD income among such partners would continue to be governed by Section 704 COD income would presumably be allocated first as a chargeback of minimum gain if nonrecourse debt was discharged. Other COD income needs to be allocated in a way consistent with deemed distributions to the partners that occur from the reduction of debt under Section 752 and also in a way that satisfies the substantial economic effect tests of the Section 704 regulations. EXAMPLE: Assume that a debt of $100 is exchanged for a 10% profits and capital interest worth $90. COD income of $10 is allocated in accordance with partnership percentage interests prior to the issuance of the new interest. There will be a deemed distribution of $10 under Section 752 among the partners in accordance with the partners shares of the debt discharged. The allocation of COD income should be structured in a way that will match the deemed distributions. Proposed regulations (Prop. Regs. Sec ) issued in 2008 indicate that the creditor/contributor will recognize no gain or loss on the exchange by reason of Section 72l. This loss of a partial bad debt deduction upon a contribution has been criticized by many commentators, particularly where the creditor as a current partner is required to share in the allocated COD income. Self-help planning that employs two-step transactions (partial forgiveness of debt followed by contribution of remaining portion

14 of debt) raises old-and-cold issues and the risk that the IRS will invoke its step transaction doctrine. (g) Proposed regulations indicate equity received for accrued interest or OID is taxable, even if the interest or OID has been accrued on the contributed obligation prior to the contributor/partner s ownership. Also, the proposed regulations would allocate the value of the equity received first to the accrued interest and OID before applying it in satisfaction of the principal of the obligation. R. Contribution of Debt by Existing Shareholder (Section 108(e)(6)) 1. This statutory provision is also a rule for measuring COD income and not an exclusion per se The contributing shareholder is treated as having satisfied the debt in amount equal to the shareholder s basis for the debt (i) (ii) (iii) (iv) If the shareholder is the original lender, the shareholder s basis should be equal to amount of debt, and no COD income would be created If the shareholder acquired the obligation at a discount after issuance or the obligation has accrued interest that has not been reflected in its basis because the shareholder holder is a cash basis taxpayer, COD income would be recognized by the corporation In the case of an S corporation, reductions to the basis of the obligation on account of S corporation losses that have been allowed to the shareholder are not taken into account. IRC Section 108(d)(7)(C). Technically, this rule appears to be available without regard to corporate solvency, but if the contribution of the debt does not make the corporation solvent, the transaction may not be a capital contribution and therefore may not be eligible to fall within this rule for the measurement of COD income. Compare Mayo, 16 TCM 49 (1957); Giblin, 227 F.2d 682 (5 th Cir. 1955) with Lidgerwood, 229 F.2d 241 (2d Cir. 1956). (1) If Section 108(e)(6) is inapplicable, the creditor should receive a bad debt deduction How to distinguish the capital contribution exception from the stock-fordebt exception

15 (i) (ii) (iii) (iv) Several private letter rulings have suggested that the distinction may simply be a matter of form. See LTR ; LTR ; LTR But cf. TAM The meaningless gesture cases, however, suggest that Section 351 may apply to some transactions that are in form contributions, in which case issuance of stock to the contributing shareholder will be imputed and the stock-for-debt exception will govern. See Rev. Rul Where the issuance of stock is not a meaningless gesture and no shares are issued, the contributing shareholder arguably has made a gift to the other shareholders in not obtaining an increased equity interest Application to partnerships? (1) It appears that there is no analog for the contribution of debt to a partnership by an existing partner (2) Because it appears that the contribution transaction will be treated as a partnership interest-for-debt transaction, proportionate contributions of partnership debt may result in COD income if there is no corresponding increase in equity value (3) EXAMPLE: A partnership holds property with a fair market value of $70 that is subject to a nonrecourse debt of $100 that is held proportionately by four partners. All of the partners contribute their respective shares of the debt, increasing partnership equity value (representing value of interests received) by $70. Apparently, $30 of COD income is recognized. S. Ambiguities in Application of the Statutory Provisions to Partial Debt Exchanges 1. EXAMPLE: An obligation of $100 with a basis of $100 is held by the sole shareholder of the corporation with a basis of $100. The shareholder contributes $50 of the obligation to a corporation. Is the transaction an exchange of $50 of debt for stock in a meaningless gesture transaction that is governed by Section 108(e)(8), in which COD income may be recognized depending on value of the shares of stock that are constructively received? Is the transaction a capital contribution of debt of $50 under Section 108(e)(6), in which no COD income is recognized because there is no formal exchange of the debt?

16 (c) (d) (e) Is the transaction an exchange of $100 of old debt for shares of stock and a new debt of $50 under Section 108(e)(10), such that there is a deemed exchange rule of the remaining $50 of debt (as well as a retirement of the contributed portion) under Treas. Regs. Sec ? Is the transaction a combination of alternative (c) with either of alternatives or? Does the codification of the economic substance doctrine under Section 7701(o) have any effect on the answer to these questions? May taxpayers be confident of the tax result in selecting a particular form for transactions of this type?

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