The Revised Debt-for-Equity Exchange Regulations: Compliance - - PowerPoint PPT Presentation

The Revised Debt-for-Equity Exchange Regulations: Compliance Challenges

Anticipating Issues in Valuations of Partnership Interests Received, Bad Debt Deductions, Interest-Ordering and More Today’s faculty features:

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THURSDAY, NOVEMBER 1, 2012

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The Revised Debt-for-Equity Exchange Regulations: Compliance Challenges Seminar

• Nov. 1, 2012

James Hamill, Reynolds Hix & Co. jimhamill@rhcocpa.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

• Sect. 108(e)(8) Partnership Debt-

For-Equity Exchanges

 General COD rules  Debt-for-equity exchanges – General rules – Valuation issues – Sect. 721 applicability – Unpaid rent, royalties, interest – Minimum gain charge-backs – Dispositions of installment obligations – Allocations of COD income

7

General COD Rules

 Sect. 61 defines gross income.  Gross income is said to include income from discharge

(cancellation) of indebtedness,

 Various exceptions exist under Sect. 108 that may permit a

taxpayer to exclude COD income.

 Settling debt with property would: – Create COD, if the FMV of the property < Debt – Generally (also) be a taxable exchange of the property

8

Debt Forgiveness Issues

 Recourse debt – May be deemed a sale, when voluntary or involuntary

conveyance of security

– May also be COD income, even with conveyance  Non-recourse debt – Typically creates deemed sale/exchange on conveyance – May be COD, when partial non-recourse – 1099-C now asks (2009 and after) whether cancelled debt

was recourse or non-recourse

9

• Sect. 166 Loss For Creditor?

 Bad debt loss  May be partial loss, if business debt  Personal bad debt loss allowed, but as STCL 

6511(d) seven-year statute applies

 Loans made to an insolvent debtor are worthless when made,

and must be recast as capital contributions or gifts [Eckert, 283 US 140 (1931) and its progeny].

10

• Sect. 166 Losses

 Whether loan was in furtherance of a trade or business is a

factual question.

 A loss on a loan guarantee is tested the same as a direct loan –

was the taxpayer in the business of making guarantees? [Putnam, 352 US 82 (1956)]

11

Sale Or Exchange (Not COD)

 The receipt of any consideration creates a deemed sale or

exchange.

 The voluntary conveyance of property securing a debt, or a

foreclosure conveyance, triggers a deemed sale or exchange, for both recourse and non-recourse obligations.

12

Measurement Issues

 FMV > Basis is gain from sale  Debt > FMV is COD  1099 may include accrued interest; this is not part of COD if it

could be deducted when paid.

 Fair market value – Sale (bid) price at foreclosure presumed to be FMV, absent

clear and convincing proof

– See Frazier, 111 T.C. 243 (1998), for successful challenge

• f bid price

13

Sale Or Exchange: Non-Recourse Debt

 Proceeds are the full amount of the non-recourse debt, even if

FMV < NRD [Crane, 331 US 1 (1947), Tufts, 461 US 300 (1983) and Regs. 1.1001-2]

 Because

108 cannot apply, NRD creates the concept of “minimum gain” when the NRD exceeds the basis of the property securing the debt.

 Gain is “minimum” because it cannot be excluded under

108; recourse debt has no similar concept.

14

Debt-For-Equity Exchanges: Law

 Sect. 108(e)(8) – Extended to partnerships 10-22-2004 – Applies to transfer of capital or profits interest, for recourse

• r non-recourse debt

– Deemed transfer of money equal to FMV of interest for the

debt

 If there is COD, it is allocated to partners immediately pre-

discharge.

15

• Sect. 108(e)(8) Issues

 Debtor partnership – Any COD on exchange? – Is there a deemed exchange of partnership properties

represented by the interest?

 Creditor – Any bad debt loss allowed? – Basis of interest received?

16

• Sect. 108(e)(8) Regulations

 Proposed regulations issued 10-31-2008  Final regulations effective 11-17-2011  Key elements – Valuation safe harbor – Applicability of Sect. 721 – COD and minimum gain allocations

17

Valuation Of PS Interest

 COD is avoided if the FMV of the PS interest > Debt  FMV is generally subjective, and the exception may be of

limited practical utility if one anticipates challenges to claimed FMV.

 The regulations provide a safe harbor. – Liquidation value is deemed to be FMV. – Four requirements must be satisfied.

18

Liquidation Value Defined

 The amount of cash that would be received by the creditor if the

partnership sold all assets at FMV and then liquidated

 If the debtor is an upper-tier PS (UTP), then the value of the

UTP includes the liquidation value of any lower-tier partnerships (LTPs) in which the UTP holds an interest.

19

Four Requirements For Safe Harbor

 Creditor, debtor PS and all partners treat liquidation value as

FMV (consistency).

 If more than one interest is transferred as part of same plan,

then all parties use liquidation value for each interest (cannot selectively use the safe harbor).

 Terms are comparable to arm’s-length bargaining among

unrelated parties with adverse interests (i.e., parties can be related but must satisfy this anti-abuse rule).

 Post-exchange, no redemption of interest by PS or purchase by

partners or parties related to partners if:

– Pursuant to a plan existing at time of exchange – Principal purpose of plan is avoidance of COD by PS

20

Proposed Vs. Final Regulations

 The proposed regulations require that the partnership maintain

capital accounts pursuant to the Sect. 704(b) regulations.

 These capital accounts determine rights to assets on liquidation

for:

– Economic effect safe harbor under the three-requirements

• r the alternate test

– Deemed in accordance with the partners’ interest test for

allocations of non-recourse deductions

 But, they are not generally necessary to determine a liquidation

value and were dropped from the final regulations.

21

Application Of Sect. 721

 Sect. 721 overview – No gain or loss to partner or partnership upon exchange of

property for an interest in the PS

– Creditor and PS subject to Sect. 721 when debt is

transferred in exchange for an interest

 Creditor then has: – Substituted basis pursuant to Sect. 722 – No recognized Sect. 166 loss on exchange

22

Application Of Sect. 721 (Cont.)

 Sect. 721 is regarded as a relief provision, as it protects against

exchange gain.

 But. it denies any loss to the creditor where there is COD (i.e.,

the FMV of the interest is less than the debt).

 This then creates an asymmetric result – COD to partnership – Deferred loss to creditor

23

No “Bifurcation” Allowed

 Practitioners requested that the debt-for-equity exchange be

split.

– Debt cancellation 

61(a)(12) COD to debtor



166 bad debt to creditor

– Exchange of remaining debt for equity  Treasury rejected this, requiring self-help actions before the

exchange if the creditor wants a loss (equal to COD piece of exchange).

24

Example: Non-Partner Creditor

Creditor is owed $800,000. Partnership interest transferred with FMV = $500,000 Partnership: $300,000 COD income Creditor: Zero loss. Basis of partnership interest = $800,000. The $300,000 loss is deferred, and the character may later be capital.

25

Example: Variation

Same facts as previous example, but the creditor (1) charges off $300,000 of the debt before the debt-for-equity exchange, and (2) exchanges the $500,000 remaining debt for equity. Partnership: $300,000 COD income Creditor: $300,000 bad debt loss (allowed if a business debt) Creditor: $500,000 basis in partnership interest

26

Example: Creditor Partner

Mary and Rex form the RM partnership. Mary contributes $500,000 for 1/3 interest. Rex contributes $1 million for 2/3 interest. RM’s asset value drops from $1.5 million to $1.2 million ($300,000,

• r 20%, decline).

So far, there is no tax effect.

27

Example: Creditor Partner (Cont.)

Mary and Rex form the RM partnership. Both contribute $500,000 for ½ interest. Rex also loans RM $500,000. RM’s asset value drops from $1.5 million to $1.2 million ($300,000,

• r 20%, decline)

Rex agrees to exchange his debt for an additional 1/3 interest (now he has 2/3 total).

28

Continuation Of Example

Rex’s 1/3 interest has a liquidation value of $400,000 (1/3 of $1.2 million). The exchange triggers $100,000 of COD income ($500,000 debt for $400,000 equity). Rex’s $100,000 loss on the debt is deferred into his partnership interest.

29

Let’s Compare The Examples

First, Rex was an all-equity partner. Second, we changed that to ½ equity, ½ debt, with a subsequent conversion to all equity. In both cases, no loss is allowed and will not be until the partnership sells assets or the partners sell an interest. But, the debt first/equity later strategy creates COD income on the exchange, which is capitalized into the basis of the interest.

30

What To Do?

 Perhaps Rex’s debt was always equity? – Application of general debt-to-equity principles – Best suited to a fact pattern with no payments ever made,

high debt-to-equity, and so on

 IRS (and the Tax Court) do not believe that a taxpayer can

argue substance over form, as the taxpayer chose the form.

31

What To Do? (Cont.)

 If the entity were a corporation (C or S), Rex should be able to

contribute the debt to capital, avoiding COD under Sect. 108(e)(6).

 Treasury seems to believe that because Sect. 108(e)(6) is a

corporate-only provision, all partnership transactions must fit

• Sect. 108(e)(8).

32

Non-Application Of Sect. 721

 Sect. 721 does not apply to a transfer of an interest for unpaid

rent, interest, royalties.

 Thus, the creditor has gain (ordinary) for the FMV of the interest

received.

 This rule applies only for items that accrued after the start of the

debt’s holding period.

 However, the partnership still has Sect. 721 protection for the

transfer of the interest.

33

Exchange For Unpaid Interest

 In determining to what extent a PS interest was transferred for

interest owed to the creditor:

– The general determination rules of Regs.

1.446-2 apply.

– If the interest is OID, the general rules of Regs.

1.1275-2 apply.

34

Minimum Gain Chargebacks

 A MGC is required for the “deemed in accordance with the

partners’ interests” safe harbor.

– Safe harbor for non-recourse deductions – Allows negative

704(b) book capital, because it will be eliminated with chargeback

 The MGC rules specify the tier of gain allocated as MGC – Generally, gain from disposition of property – Final regulations require that, where there is COD, the first-

tier MGC is COD related to the debt in question.

35

Installment Obligations

 Generally, disposition of an installment obligation is a taxable

event [ 453B].

 An exception applies to a transfer of the installment obligation

to a partnership in a Sect. 721 transaction.

 Treasury proposes to eliminate this exception when the debtor

is the partnership.

36

Installment Obligations (Cont.)

Rex sells real property for $1 million, payable $100,000 down with an installment note for $900,000. Rex’s basis in the property is $500,000. The GP% is 50%; Year 1 gain is $50,000. Rex transfers the obligation to a partnership for an interest – gain is deferred.

37

Installment Obligations (Cont.)

Rex sells real property to ABC partnership for $1 million, payable $100,000 down with an installment note for $900,000. Rex’s basis in the property is $500,000. The GP% is 50%; Year 1 gain is $50,000. Rex transfers the obligation to ABC partnership for an interest.

38

Installment Obligations (Cont.)

Treasury proposes to accelerate the gain on Rex’s note when the ABC partnership is the debtor. Note that ABC partnership has a FMV ($1 million basis in the purchased property) Thus, the treatment is asymmetric, if Rex is allowed to defer the gain on the obligation of the partnership.

39

Allocations Of COD Income

 Sect. 108(e)(8) says that any COD income is reported by the

pre-discharge partners.

 Thus, when the creditor is not a partner before the debt-for-

equity exchange, any COD is allocated to partners other than the former creditor.

 If the creditor is a partner pre-exchange, the creditor also has

potential COD income.

40

Allocations Of COD Income (Cont.)

 In general, partnership COD income is allocated under the

economic effect test.

– Income is allocated to the partner(s) who benefit from that

income.

– COD income has a benefit to those who have cancelled

their share of the debt.

– Thus, COD income should generally be allocated based

upon how the cancelled debt was shared.

41

Allocations Of COD Income (Cont.)

 Revenue Ruling 92-97 permits an allocation of COD income

different than debt shares, when a DRO is triggered to match benefits with the COD allocation.

 Revenue Ruling 99-43 does not permit a revision to the

agreement to have SEE when it occurs after the related events have occurred.

42