This column continues the discussion of the allocation of cancellation of indebtedness income (COD Income) in the partnership context. As previously discussed1 the restructuring of a troubled loan secured by real property can result in COD Income to the owners of the real estate. When the real property is owned in a partnership or limited liability company (LLC), additional issues arise.
The Section 704(b) Regulations. The 704(b) Regulations2 provide no guidance or discussion as to how COD Income should be allocated by a partnership or LLC among its partners or members. A reasonable analysis of the Code and regulations is that the amount of COD Income allocated to a partner should be equal to the portion of the debt discharged which is allocated to the partner under Code Section 752.
The partner’s or member’s adjusted basis in his partnership or LLC interest would be increased by the COD Income allocated to him under Code Section 705(a)(1) and then reduced in an amount equal to the decrease in the partnership or LLC liabilities as a result of the debt discharge under Code Sections 752(b) and 733(b). This analysis results in the partner’s or member’s adjusted basis remaining unchanged and there would be no recognition of any additional amounts or income or gain under Code Section 731. This analysis assumes that the deemed distribution is not taken into account under Code Section 731(a) at the time of the debt discharge, but rather is taken into account at the end of the year.3
General Partnership or Joint Ventures. In the case of a typical general partnership or joint venture where the partners or joint venturers bear all items of income, gain, loss and deductions on the same proportionate basis, COD Income recognized by the partnership or joint venture will typically be allocated to the partners or joint venturers in accordance with their respective partnership or joint venture percentages. The decrease in the partnership’s liabilities resulting from the debt discharge would likewise be shared by the partners in accordance with their partnership percentages. As a result, a debt modification or exchange would not result in income to any partner in excess of any COD Income allocated to him by the partnership.
Limited Partnership. In the case of a limited partnership (or a general partnership or joint venture) in which the partners do not share all items on the same proportionate basis, the determination of how the partnership’s COD Income should be allocated among the partners will depend upon a variety of factors, the most significant of which are the nature of the debt (recourse or nonrecourse) and the extent to which a particular partner is personally guaranteeing for the repayment of the debt.
Nonrecourse Debt. If the debt discharged is a nonrecourse liability, the COD Income resulting from the discharge should be allocated to the partners in the same ratios in which the nonrecourse debt is allocated to them under Code Section 752. Allocating the COD Income in this manner means that the partners’ adjusted bases will be unaffected and the only income recognized by the partners will be the COD Income so allocated to them. Allocating the COD Income in this manner should be respected under Section 704(b) and the 704(b) Regulations.4
Recourse Debt. If the debt discharged is a recourse liability, the partners must decide whether the COD Income should be allocated in accordance with the manner in which the partners bore the economic risk of loss for the discharged debt immediately prior to the discharge. If the COD Income is allocated in accordance with the partners’ profit-sharing percentages, the partners who did not bear any economic risk of loss for the discharged debt (the “non-guaranteeing partners”) will be allocated COD Income with respect to a debt for which another partner bore the economic risk of loss.
While such an allocation might not prove to be burdensome to a non-guaranteeing partner who is insolvent (and thus can exclude such COD Income under Code Section 108(a)(1)(B)) or has net operating losses or passive active losses that can be used to offset such COD Income, the solvent and profitable non-guaranteeing partner would have a tax burden, being forced to recognize and pay tax on phantom income. In addition, an allocation of COD Income to the partners in accordance with their profit-sharing ratios will also result in a deemed distribution to the partners who bore the economic risk of loss for the discharged debt (“guaranteeing partners”) under Code Sections 731 and 752 in an amount greater than such partners’ shares of the COD Income, which could result in such partners recognizing additional gain under Code Section 731(a).
Based on this analysis, it is reasonable that COD Income should be allocated entirely to the guaranteeing partner(s) in the same proportions that the discharged debt was allocated to them under Code Section 752 immediately prior to the discharge. If the COD Income is allocated in this manner, the non-guaranteeing partners will not be allocated any phantom income and the guaranteeing partners’ adjusted bases in their partnership interests will remain unchanged. If the COD Income is allocated only to the guaranteeing partners, the partnership agreement should provide that any loss inherent in the partnership’s assets will, when recognized, be allocated solely to the guaranteeing partners to whom the COD Income was allocated. This ensures that any decline in value which the guaranteeing partners agreed to bear is allocated to their capital accounts, which allocation would offset the amount of COD Income previously allocated to them.5
Special Allocations of COD Income. In some cases, the partners may attempt to specially allocate the partnership’s COD Income to a partner who is insolvent and thus able to exclude such COD Income from his gross income under Code Section 108(a)(1)(B). While such an allocation may satisfy the economic effect test of Code Section 704 and the 704(b) Regulations, such allocation may not be “substantial,” in which event the IRS may ignore such allocation and reallocate the COD Income in accordance with the partners’ interests in the partnership.6
In Revenue Ruling 99-43,7 the IRS considered whether partnership allocations lacked substantiality under Reg. §1.704-1(b)(2)(ii) when the partners amended the partnership agreement to create offsetting special allocations of particular items after the events giving rise to the items occurred. In the fact pattern of the ruling, A and B amended the partnership agreement providing for an allocation of the entire $2,000 of the COD Income to B. B, an insolvent taxpayer, was eligible to exclude the income under Code Section 108.
Without the special allocation, A, who was not insolvent or otherwise entitled to exclude COD Income under Code Section 108, would pay tax immediately on the $1,000 of COD Income allocated under the agreement’s general sharing ratio. A and B also amended the partnership agreement to provide for a special allocation of the book loss resulting from a loss in the business. Because the two special allocations offset each other, B did not realize any economic benefit from the $2,000 of income allocation, even if the property subsequently appreciates in value.
According to the ruling, the economics of the agreement were unaffected by the paired special allocations. After the capital accounts of A and B are adjusted to reflect the special allocations, A and B each have a capital account of zero. Economically, the situation of both partners is identical to what it would have been had the special allocations not occurred. In addition, a strong likelihood exists that the total tax liability of A and B will be less than if the agreement allocated 50 percent of the $2,000 of COD Income and 50 percent of the $4,000 book loss to each partner. Therefore, according to Rev. Rul. 99-43, the special allocation of COD Income and book loss are shifting allocations under Reg. §1.704-1(b)(2)(iii)(b) and lack substantiality. The ruling also indicated that the allocations could be transitory allocations under Reg. §1.704-1(b)(2)(iii)(c) if the allocations occur during different partnership taxable years.
Peter M. Fass is a partner at Proskauer Rose.
1. P. Fass, “Real Estate Workouts—Tax Consequences When a Loan Is Modified,” New York Law Journal, Oct. 5, 2011.
2. See, generally, I.R.C. §704(b) and Reg. §1.704-1(b).
3. See, Rev. Rul. 92-97, 1992-2 C.B. 124; Rev. Rul. 94-4, 1994-1 C.B. 195.
4. See, Frankel, Lipton and Miller, Real Estate Workouts—A Step-by-Step Analysis (Practising Law Institute, 2008 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, (Volume Six) at 481, (hereinafter Frankel Article).
5. Frankel Article at 481-482.
6. See, Reg. §1.704-1(b)(2)(iii); Frankel Article at 481-482.
7. 1999-2 C.B. 506.