IRS Provides Guidance for Partnership COD/Partner Insolvency
Late last week, the IRS announced that it will be publishing Revenue Ruling 2012-14, which will provide guidance for determining the amount of a partnership’s nonrecourse liabilities a partner is permitted to include in his measurement of insolvency for purposes of applying the exception to cancellation of indebtedness income found at I.R.C. § 108(a)(1)(B).
That’s quite the mouthful, so let’s break it down into more easily digestible parts so we can understand why Revenue Ruling 2012-14 may be important:
- Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness. This is a natural and logical result, because being forgiven of a debt is an accession to wealth; if someone loans you $100 and you don’t pay it back, you’re $100 richer and should therefore recognize taxable income. As the economy and real estate values have tanked in the past few years, many taxpayers have been unable to service their loans or mortgages, bringing the COD rules to the forefront of the tax law.
- Section 108(a)(1)(B) provides an exclusion to the general rule found in I.R.C. § 61, generally excluding discharged indebtedness from a taxpayer’s gross income if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) limits the amount of income excluded by reason of I.R.C. §108(a)(1)(B) to the amount by which the taxpayer is insolvent.
What’s the point of the insolvency exclusion? Believe it or not, Congress can, at times, be rational. If a taxpayer cannot service his debt, it seems rather silly to tack on a tax bill for the amount of any forgiven loans. A taxpayer who owes more than they own should be given the opportunity to receive a “fresh start;” one that wouldn’t be possible if the forgiven debt was included in taxable income. Of course, that only makes sense if the taxpayer is insolvent at the time of the debt discharge. If the taxpayer is solvent, they presumably would have the ability to pay the tax associated with the debt discharge.
- Section 108(d)(3) of the Code defines “insolvent” as the excess of liabilities over the fair market value of assets. That section further provides that whether a taxpayer is insolvent, and the amount by which the taxpayer is insolvent, is determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.
- Unfortunately, nowhere does I.R.C. § 108 actually define the term “liabilities,” causing a bit of confusion when trying to determine whether a taxpayer who has benefitted from the cancellation of indebtedness is in fact insolvent.
- Confusing matters even more, while C and S corporations must determine insolvency at the entity level, forgiven partnership debt doesn’t work that way. Instead, the partnership recognizes the COD, and any exclusion, including the insolvency exclusion, must be determined at the partner level. This means that the determination of insolvency must also be determined at the partners level when partnership debt is forgiven.
Combine all of these bullets, and a natural question arises: how does a partner in a partnership account for the partnership’s liabilities in determining whether their individual liabilities exceed the FMV of their assets, making them insolvent?
Keep in mind, a partnership can have two types of liabilities, recourse and nonrecourse. Recourse liabilities are those that one or more partners is personally liable for, and the responsible partner should certainly include his share of the partnership’s recourse liabilities in the computation of his insolvency in the event a partnership debt is forgiven.
But what about non recourse debt? Non recourse debt, as opposed to recourse debt, is a partnership liability for which no partner is personally liable. In other words, if the partnership fails to pay the debt, tough luck for the lender. Non recourse debt is most commonly seen as a mortgage: the lender retains the right only to foreclose on the mortgaged property; they cannot pursue the partnership for any deficiency in the event the FMV of the nonrecourse debt plummets below the principal balance of the debt.
So if a partnership has non recourse debt forgiven, are the partners entitled to include any portion of the nonrecourse debt in their individual computations of insolvency?
The answer, according to Revenue Ruling 2012-14, is yes. Building on the principles established in Rev. Ruling. 92-53, the IRS held that a partner may include two pieces of a partnership nonrecourse debt in their individual computation of insolvency:
1) the amount of the debt equal to the FMV of the property (meaning it’s a wash from an insolvency standpoint), and
2) any debt in excess of the FMV of the property, but only to the extent it is forgiven, and the income resulting from the forgiveness is allocated to that partner.
The specific fact pattern in the ruling is as follows:
X and Holdco, a corporation, are equal partners in PRS, a partnership. In Year 1, PRS borrows $1,000,000 from Bank and signs a note payable to Bank for $1,000,000 that bears interest at a fixed market rate payable annually. The note is secured by real estate valued in excess of $1,000,000 that PRS acquires from Seller, in part with the proceeds of the note. The note is a non recourse liability within the meaning of § 1.752-1(a)(2) of the Income Tax Regulations. Neither PRS nor its partners (X and Holdco) are personally liable on the note.
In Year 2, when the value of the real estate is $800,000 and the outstanding principal on the note is $1,000,000, Bank agrees to modify the terms of the note by reducing the note’s principal amount to $825,000. The PRS partnership agreement provides for income to be allocated equally to X and Holdco under § 704(b) and the regulations thereunder. X and Holdco share PRS non recourse liabilities equally under § 1.752-3. At the time of the modification of the note, X and Holdco have no assets or liabilities other than their partnership interests in PRS. PRS’s sole asset is the real estate subject to the note, and PRS’s sole liability is the note.
The IRS held that of the $1,000,000 note, X and Holdco may each consider the following portion of the liability as part of their liabilities for purposes of measuring insolvency:
1. 50% of the $800,000 balance of the note equal to the FMV of the asset, or $400,000 each, and
2. The portion of the debt in excess of FMV that was forgiven, but only to the extent the COD income was allocated to X and Holdco, or 50% * $175,000 = $87,500
Thus, for both X and Holdco, in computing each partner’s insolvency, they may include $487,500 of partnership liabilities, and $400,000 of FMV from the partnership (each partner’s share of the asset.)
As a result, both X and Holdco are insolvent to the extent of $87,500, and each may exclude the $87,500 of COD allocated to them from PRS under I.R.C. § 108(a)(1)(B).