IRS Proposes Regulations on Discharges of Partnership Debt

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By Wayne R. Strasbaugh, Esq. Ballard Spahr Andrew & Ingersoll LLP, Philadelphia, PA

On October 30, the IRS released proposed regulations implementing a 2004 statutory change to the federal income tax treatment of discharges of partnership debt. Under the statutory provision, §108(e)(8), partnerships that issue equity interests to their creditors in exchange for release of liabilities are deemed to satisfy the discharged debt with an amount equal to the fair market value of the interests issued. The remaining portion of the discharged debt is recognized as ordinary income by the partnership and allocated among its partners in accordance with the percentage interests that they held immediately before the debt was discharged. The term “fair market value” is undefined in the Code and regulatory guidance on its determination would be helpful to partnerships engaged in negotiating workout arrangements with their creditors in the current financial crisis.

If they meet certain criteria, partnerships will be able to use a liquidation value method in valuing equity interests under the proposed regulations. On the other side of the transaction, creditors will not recognize gain or loss except in the case where they receive an equity interest in payment of rent, royalties, or interest (including original issue discount). The creditor's tax basis for the discharged debt will be substituted for the basis of the partnership interest received, and the holding period for the partnership debt will generally be tacked to the holding period for the partnership interest. The IRS intends that the proposed regulations take effect prospectively, but it is likely that taxpayers will press for authorization to rely on them prior to adoption. It also appears likely that taxpayers will press for guidance that will authorize the use of alternative methods likely to produce higher equity valuations. A public hearing on the proposed regulations is scheduled for February 19, 2009, with written comments due January 27, 2009.

For more information, in the Tax Management Portfolios, see Manning, 710 T.M., Partnerships--Conceptual Overview, and Klig and Sloan, 712 T.M., Partnerships--Taxable Income; Allocation of Distributive Shares; Capital Accounts, and in Tax Practice Series, see ¶4010, Partnership Taxation -- Overview, and ¶4100, Limited Liability Companies.