AICPA Comments on Proposed Regulations Relating to the Application of Section 108(E) To

April 22, 2009

The Honorable Michael F. Mundaca The Honorable Douglas H. Shulman Acting Assistant Treasury Secretary Commissioner of Internal Revenue (Tax Policy) 1111 Constitution Avenue, NW 1500 Pennsylvania Ave., NW, 3120 MT Washington, DC 20044 Washington, DC 20220

Re: Comments on REG-164370-05, Relating to the Application of Section 108(e) to Partnerships and Their Partners

Dear Acting Assistant Secretary Mundaca and Commissioner Shulman:

The American Institute of Certified Public Accountants has reviewed the proposed regulations under section 108(e)(8) of the Internal Revenue Code which provide guidance with respect to the amount of discharge of indebtedness income recognized by a partnership on the transfer of a partnership interest to a creditor in satisfaction of debt, and the consequences to the creditor upon the receipt of the partnership interest.

Our comments make several requests not the least of which is a request to reconsider the creditor’s ability to deduct a loss for the amount by which the creditor's tax basis in the receivable exceeds the value of the partnership equity received. While we recognize that Treasury and the IRS may have felt constrained by the language of the statute or by the necessity to conform partnership treatment with corporate treatment, we offer alternative approaches.

Additional recommendations include: allowing the use of fair market value rather than liquidation value; clarifying in the minimum gain chargeback regulations that COD income is a first-tier item; applying the revaluation provisions in the proposed noncompensatory partnership option regulations to the debt-for equity exchange; and others. Requests for clarification include: the treatment of nonrecourse debt, including the application of the insolvency exception and section 7701(g); the treatment of an accrual basis creditor’s accrued interest income; the treatment of the debt-for-equity exchange under section 704(c); whether the "exchange" requirement of section 721 is satisfied when the partnership is insolvent; whether section 721 applies to the partnership when the exchanged debt is an unpaid rent or royalty obligation; and whether section 108(e)(7) applies to section 108(e)(8) transactions.

The AICPA appreciates the opportunity to comment on the proposed regulations. If you would like to discuss our comments, please contact Hughlene A. Burton, Chair of the Partnership Taxation Technical Resource Panel at (704) 687-7696 or [email protected]; Gretchen G. Foley, primary contributor to these comments at (202) 414-4622 or [email protected]; or Marc A. Hyman, AICPA Technical Manager at (202) 434- 9231 or [email protected].

Sincerely,

Alan R. Einhorn

1 Chair, Tax Executive Committee

CC: Steven G. Frost, Treasury Senior Counsel Mr. William J Wilkins, Chief Counsel-Designee, IRS Mr. Curtis G. Wilson, Associate Chief Counsel (P&SI), IRS Megan A. Stoner, Attorney, Office of Associate Chief Counsel (P&SI), IRS

2 THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Reg-164370-05, Proposed Regulations Relating to the Application of Section 108(e) to Partnerships and Their Partners

April 22, 2009

The American Institute of Certified Public Accountants (AICPA) has reviewed the proposed regulations under section 108(e)(8) of the Internal Revenue Code (the Proposed Regulations), which provide guidance with respect to the amount of discharge of indebtedness (COD) income recognized by a partnership on the transfer of a partnership interest to a creditor in satisfaction of debt (Debt-for-Equity Exchange), and the consequences to the creditor upon the receipt of the partnership interest (the Debt-for-Equity Interest). We respectfully submit the following comments on the Proposed Regulations:

1. Reconciling Section 721 Treatment to the Creditor with Section 108(e)(8) Treatment to the Partnership

Section 721(a) provides that no gain or loss shall be recognized to a partnership or any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. Thus, if section 721 applies to a transaction, it applies to both the partnership and the contributing partner. The preamble to the Proposed Regulations states that 1) section 721 applies to the Debt-for-Equity Exchange, 2) the creditor's capital account is increased by the fair market value (FMV) of the indebtedness exchanged, pursuant to reg. sections 1.704-1(b)(2) (iv)(b) and (d), and 3) the creditor's tax basis in its partnership interest is increased by its basis in the indebtedness exchanged. Thus, it appears that, from the creditor's perspective, the transfer is treated as a section 721 transaction in its entirety. The creditor is viewed as contributing the entire balance of the receivable to the partnership in exchange for a partnership interest, regardless of the value of the interest received. No loss is recognized by the creditor currently. The creditor's basis in its partnership interest is increased by its basis in the debt instrument, so the creditor recovers its loss as a capital loss when it disposes of its partnership interest.

Section 108(e)(8) provides that the partnership is viewed as paying money to the creditor to the extent of the value of the interest issued to the creditor in satisfaction of the debt. This implies that, from the partnership's standpoint, the transaction is not a section 721 transaction. Rather the transaction is treated as a payment of money to cancel the debt, a section 1001 transaction.

Based on the Proposed Regulations, it appears that the IRS and Treasury Department do not believe that the creditor should be entitled to a loss when the debt is converted to partnership equity. However, the preamble requests comments on alternative approaches. We respectfully request that the IRS and Treasury Department consider the policy reason for treating the transaction as a section 721 transaction from the creditor's perspective, but as a section 1001

3 transaction from the partnership's perspective. We question whether it is appropriate to deny the creditor an ordinary section 166 bad debt deduction.1

Although the preamble does not (beyond a reference to section 721) explain why the creditor is denied a bad debt deduction, we suspect it is an attempt to conform the partnership result to the corporate result.2 When debt is exchanged for stock, there is no bad debt deduction. Lidgerwood Manufacturing Co. v. Commissioner, 229 F. 2d 241 (2dCir. 1956), cert. denied, 351 U.S. 951 (1956). This rule may work well for corporations, but it creates distortions for partnerships. It creates a basis in the partnership interest that is higher than the basis inside the partnership. As shown in a simple example, this can result in an inside/outside basis disparity before and after the creditor's interest is liquidated.

For example, suppose individual A, a nonpartner, converts its $100x loan to the partnership into partnership equity worth $60x. Assume at the time of the conversion, individuals B and C are partners and the partnership's tax basis in its assets is $120x.3 When the $100x loan is converted to equity, B and C would have COD income of $40x. Their outside bases would be increased by $40x, and decreased by the debt extinguished ($100).4 After the conversion, B and C's combined outside tax basis would be $60. A would have a basis in the partnership interest of $100x. Immediately after the conversion, the partners' combined outside basis would exceed inside basis by $40x.

If A's interest is later liquidated for the $60x, A would claim a $40x loss, but the partnership would need to reduce its basis under section 734(b)(2)(A) by $40x.5 The $40x basis adjustment would reduce the inside basis of partnership property to $20.6 The inside basis resulting from the debt contribution would be $20x, and the partners' combined outside basis would be $60x. Thus, the partnership would have a $40x inside/outside basis disparity after A's interest is liquidated as well, which is clearly a distortion.

To avoid such distortions, we request that Treasury and the IRS consider whether the transfer of the receivable by the creditor can be bifurcated into two transactions – (1) a section 721 transfer to the extent of the FMV of the receivable, and (2) a debt cancellation transaction to the extent the creditor's basis in the receivable exceeds FMV. We request that Treasury and the IRS consider treating the transaction as a cancellation of the debt rather than a retirement of the debt, as defined by section 1271. We understand that achieving this result may require a more liberal interpretation of the statutory language.

1 Unless stated otherwise, we assume that the creditor partner is an individual taxpayer or a corporation that would be entitled to an ordinary bad debt deduction under section 166 if the debt were cancelled. We also assume the creditor is not a bank or other taxpayer who may be able to take a partial bad debt deduction as a reduced value of the debt is established. 2 Additionally, it appears Treasury and the IRS may be concerned as to whether they have statutory authority under section 108(e)(8) for such a result. 3 B and C's combined outside tax basis would be $120. 4 Section 752(b). 5 This example assumes a section 754 election has been made or the mandatory basis adjustment rules apply. 6 $120x initial basis of partnership assets, less cash of $60x, less $40 section 734(b) adjustment.

4 Alternatively, we request that Treasury and the IRS consider treating the transaction as a payment of cash in cancellation of the debt from the creditor's perspective as well. Under this view, the creditor could be viewed as receiving cash equal to the FMV of the debt, then recontributing that cash to the partnership in exchange for an interest.

2. Use of FMV Instead of Liquidation Value for the Debt-for-Equity Interest

The Proposed Regulations state that the amount of the contribution by the creditor is the FMV of the indebtedness transferred to the partnership. The FMV of the indebtedness is equal to the value of the interest received. The value of the interest received by the creditor is the liquidation value when the partnership maintains section 704(b) capital accounts, the transaction is arm’s- length, the interest received is not redeemed for a COD income avoidance purpose, and all parties use the same value. The final regulation should confirm that this safe harbor is optional and does not apply if any of the parties use FMV valuation rather than liquidation value.

3. The Final Regulations Should Contain an Example Involving Nonrecourse Debt

In determining the amount of COD and insolvency, nonrecourse debt is taken into account.7 The insolvency exception, however, is determined at the partner level.8 Section 7701(g) adds further confusion for nonrecourse debt situations. Section 7701(g) provides that, in determining the amount of gain or loss (or deemed gain or loss) with respect to any property, the FMV of such property shall be treated as not being less than the amount of any nonrecourse indebtedness to which the property is subject.

In applying section 108(e)(8), the value paid for the debt should be FMV of the partnership interest whether determined by the liquidation value safe harbor or otherwise. The final regulations should clarify that the insolvency rule and the deemed nonrecourse valuation of section 7701(g) have no application in determining the amount paid by the partnership under section 108(e)(8).

We believe that the cancellation of nonrecourse debt in a Debt-for-Equity Exchange that gives rise to COD income should invoke the minimum gain chargeback rules of reg. sections 1.704- 2(b)(2) and 1.704-2(f). Comments were requested on whether COD income arising from a Debt- for-Equity Exchange should be treated as a first-tier item under reg. section 1.704-2(f)(6) for purposes of the minimum gain chargeback rules. Currently, under reg. sections 1.704-2(f)(6) and 1.704-2(j)(2)(ii)(A), gains on the sale of assets are allocated to the partners before any items of partnership income, but COD income is not. We believe that the COD income recognized by the partnership should be allocated under reg. sections 1.704-2(f)(6) and 1.704-2(j)(2)(ii)(A) before any other item of partnership income. The COD income should be allocated to the partners who received the allocation of nonrecourse deductions funded by the debt. For example, if the debt is partner nonrecourse debt because the loan was made by an existing partner, we believe the COD income should be specially allocated back to the lending partner, assuming that the nonrecourse deductions were properly allocated to the lending partner under reg. section 1.704-2(i). If the Debt-for-Equity Exchange produces both a gain and COD income,

7 See Rev. Rul. 92-53, 1992-2 C.B. 48. 8 Section 108(d)(6). 5 a pro-rata portion of these two items should be allocated to the partners under reg. sections 1.704-2(f)(6) and 1.704-2(j)(2)(ii)(A) in proportion to their minimum gain chargeback amounts.

Given the questions that arise with respect to nonrecourse debt, an example involving nonrecourse debt should be added to the final regulation.

4. Application of Section 721 to Debt-for-Equity Exchange with an Insolvent Partnership

When a partnership is insolvent before and after the Debt-for-Equity Exchange, it appears the value of the partnership interest issued to the creditor is zero. In this case, it is not clear whether the "exchange" requirement of section 721 is satisfied. Section 721 may not apply to the creditor because the creditor does not receive anything of value in satisfaction of the debt. If section 721 does not apply, is the creditor viewed as canceling the debt and is the creditor entitled to a section 166 bad debt deduction?

Proposed regulations under sections 332, 351 and 368 (the No Net Value Regulations) provide that, in the case of a corporate formation, reorganization, and liquidation, the nonrecognition rules do not apply unless there is an exchange of net value. While the No Net Value Regulations do not apply to partnership transactions under section 721, the preamble requested comments on whether similar principles should apply in partnership transactions.

We understand a shareholder's loss on the contribution of debt to a corporation is deferred under the principles of section 108(e)(6) if no stock is issued. However, section 108(e)(6) does not apply to partnerships.

We request that Treasury and the IRS indicate whether a contribution of debt to an insolvent partnership is a section 721 transaction, and, if not, whether section 166 may be applicable to cause the creditor to recognize an ordinary deduction on the exchange. Treasury and the IRS should explain whether an exchange occurs if the value of the partnership interest received by the creditor in the Debt-for-Equity Exchange is zero.

5. Exclusion of Interest Income from the Scope of the Proposed Regulations

The Proposed Regulations provide that section 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership's recourse or nonrecourse indebtedness for unpaid rent, royalties, or interest on indebtedness. The exclusion of interest from COD income under the Proposed Regulations is similar to the rule in section 351(d)(3). Section 351(d)(3) provides that interest on indebtedness of the transferee corporation that accrued on or after the beginning of the transferor's holding period for the debt shall not be considered as issued in return for property. This provision provides that the transfer of interest income on debt evidenced by a security to the debtor corporation is immediately taxable to the holder and not deferred, but appears to be limited to the interest that accrued after the transferor acquired the debt.

The reference to reg. sections 1.446-2(e) and 1.1275-2(a) in the Proposed Regulations may suggest that a transfer of any accrued interest receivable to a partnership is not subject to section 721. However, when an accrual basis creditor transfers a debt instrument to a partnership, it 6 would have already recognized the accrued interest income. This interest income should not be taxed twice. While we generally agree that the exclusion of interest income from section 721 treatment is useful to prevent the conversion of ordinary income into capital gain, we believe that the basis of the creditor's partnership interest should reflect the amount of interest income already recognized by the creditor as of the date of the transfer. We request that Treasury and the IRS clarify the treatment of interest in a Debt-for-Equity Exchange by an accrual basis creditor.

Additionally, we request that Treasury and the IRS clarify, through regulation or administrative guidance, the treatment of the cancellation of liabilities for unpaid rents and royalties. Treasury and the IRS should clarify whether the partners should recognize gain on the transfer of an appreciated capital interest in satisfaction of a rent or royalty obligation. Rev. Rul. 2007-40 suggests that the use of an appreciated capital interest to pay a deductible item will result in gain. The revenue ruling is distinguishable, however, in that it involved the actual distribution of appreciated property.

6. Application of the Noncompensatory Option Rules to the Treatment of the Debt-for- Equity Exchange under the Proposed Regulations

Comments were requested on how the rules in the noncompensatory partnership option regulations relating to convertible debt interact with the rules in the Proposed Regulations. Under the proposed noncompensatory option regulations, no gain or loss is recognized by the partnership or the partners when an interest is transferred to a noncompensatory option holder. Rather, the unbooked, unrealized appreciation in partnership assets is allocated first to the option holder's section 704(b) capital account to reflect its right to share in partnership capital, to the extent that right exceeds the amount the option holder paid to acquire and exercise the option.9 We believe that similar principles should apply to all Debt-for-Equity Exchanges (i.e., that the application of the rules should not be limited to convertible debt). Accordingly, we believe that existing partners who give up their capital in favor of the creditor should not recognize gain on the transfer of that capital as long as that capital is used to pay debt principal and not a deductible item such as interest, rent or royalties. The partnership should be entitled to revalue its assets and allocate capital to the creditor as necessary to book-up its section 704(b) capital account to fair market value under any reasonable method, including a method that allocates some unrealized appreciation to the creditor.

We note that, in situations in which the Proposed Regulations would likely apply, there would more likely be unrealized losses than unrealized appreciation. As discussed above, we request that Treasury and the IRS consider bifurcating a Debt-for-Equity Exchange into a section 721 transfer to the extent of the FMV of the receivable and a bad debt deduction under section 166 for the creditor’s basis in the receivable in excess of FMV. With this approach, there would be few situations requiring reconciliation with the noncompensatory partnership option regulations because the interests would have no section 704(b)-tax basis differences.

If, instead, no deduction under section 166 is allowed for the excess of basis over FMV, complications arise because the interest would likely have a negative section 704(c) layer. The creditor would contribute a receivable with a built-in tax loss, but the receivable is immediately

9 Proposed reg. section 1.704-1(b)(2)(iv)(s)(2). 7 extinguished. Since the built-in loss relates to property that no longer exists, it appears section 704(c) allocations cannot be made to allocate the tax loss to the creditor. The built-in tax loss is locked into the creditor's partnership interest. We recommend that Treasury and the IRS confirm this result through the final regulations or administrative guidance.

To reconcile this treatment with the noncompensatory option regulations, the creditor's section 704(b) capital account would need to be credited with the tax basis of the receivable contributed. Then, the unrealized loss in partnership assets would need to be allocated first to the creditor to reduce the creditor's section 704(b) capital account to FMV.

7. Application of Section 108(e)(7) to Section 108(e)(8) Transactions

Section 108(e)(7) provides that certain amounts realized by a creditor upon the disposition of stock received in a Debt-for-Equity exchange should be treated as ordinary income. Under this provision, the amount of bad debt deductions claimed by the creditor on the indebtedness is recaptured as ordinary income when the creditor disposes of the stock. Section 108(e)(7)(E) provides that similar rules may apply to partnerships under regulations prescribed by the Secretary. It appears Congress granted regulatory authority to extend the application of section 108(e)(7) to partnerships, but no regulations have been issued.

Did Congress grant Treasury regulatory authority to apply section 108(e)(7) to the partnership interest received in the Debt-for-Equity Exchange? If the creditor is denied an ordinary loss on the Debt-for-Equity Exchange, it appears that section 108(e)(7) could not apply, unless the debt were written down by the creditor before the Debt-for-Equity Exchange.

If section 108(e)(7) applied to the Debt-for-Equity Exchange, it appears that any partnership interest received by the creditor would be treated as section 1245 property and that the creditor would have ordinary income recapture when it disposed of its partnership interest. It appears the amount of recapture would be limited to the amount of any bad debt deductions and ordinary loss claimed with respect to the debt

As discussed above, we request that Treasury and the IRS consider the policy reason for denying the creditor's ordinary loss on the Debt-for-Equity Exchange. Perhaps Treasury and the IRS want to prevent tax rate arbitrage in cases where the creditor recovers its bad debt loss through partnership distributions. However, it appears Treasury and the IRS can prevent arbitrage by applying section 108(e)(7) to subsequent partnership distributions and the creditor's disposition of its partnership interest. The final regulations could provide that the creditor's ordinary loss would be recaptured as ordinary income when the bad debt loss is recovered.