225 DEBT WORKOUTS: THE PARTNERSHIP AND THE PARTNERS James B. Sowell KPMG LLP © 2012 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This outline is based, in part, on an article entitled Partnership Workouts: Is It That Time Again? that previously was published at 42 Tax Mgmt. Memo. (BNA) 414 (Sept. 10, 2001). That article was then expanded upon in Troubled Partnerships: Debt Workouts and Other Issues, 62 NYU Inst. on Fed. Tax’n 12-1 (2004). Copyright Tax Management, Inc., a Bloomberg BNA Company. Reprinted with permission. If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written. 225-1 225-2 James Sowell James Sowell is a principal in the Passthroughs group of the Principal Washington National Tax Washington National Tax practice of KPMG LLP. He focuses Direct line: 202-533-5710 Fax: 202-403-3821 primarily on tax issues relating to partnerships and REITs, and he E-mail: [email protected] leads the Real Estate practice for Washington National Tax. Prior to joining KPMG, Jim was with the national tax offices of other major accounting firms. Prior to that time, Jim was with the U.S. Department of Treasury (Office of Tax Policy) where he served first as an Attorney Advisor and then as an Associate Tax Legislative Counsel. While at the Treasury Department, Jim was primarily responsible for administrative guidance and legislation involving partnerships, real estate investment trusts, like-kind exchanges, and other issues. The many matters that Jim was involved in while at Treasury included the regulations relating to partnership mergers and divisions, the partnership basis adjustment regulations, the regulations relating to amortization of intangible property, and the legislation relating to taxable REIT subsidiaries. Prior to the Treasury Department, Jim was an associate at King & Spalding LLP in Atlanta, Georgia. Jim earned an LL.M. in taxation from New York University in 1991, a law degree (with high honors) from the University of Florida in 1990, and his bachelors in business administration (also with high honors) from the University of Florida in 1986. Mr. Sowell was Chief Tax Editor of the Florida Law Review and was a Graduate Editor of New York University’s Tax Law Review. Jim is a former Chairman of the Real Estate Committee of the American Bar Association (Tax Section) and is a former Vice Chairman of the Tax Policy Advisory Committee of the Real Estate Roundtable. He is a member of the National Association of Real Estate Investment Trusts, where he is an active participant on the Government Relations Committee. Jim also is a member of the BNA Tax Management Advisory Board (Corporate Tax and Business Planning) and is on the Board of Trustees for the Southern Federal Tax Institute. Jim has written articles for various publications and speaks at numerous conferences. 225-3 225-4 TABLE OF CONTENTS I. Introduction ........................................................................................................... 1 II. Income From Discharge Of Indebtedness .............................................................. 1 A. Transfers of Properties in Satisfaction of Recourse Liabilities ...................... 2 B. Transfers of Properties in Satisfaction of Nonrecourse Liabilities................. 3 1. In General .............................................................................................. 3 2. Planning for COD Income or Sale Gain ................................................. 4 C. Transfer of Properties in Satisfaction of Partially Recourse Liabilities ......... 6 1. Top Guarantee ........................................................................................ 7 2. Bottom Guarantee .................................................................................. 7 D. Release of a Guarantee .................................................................................. 8 E. Treatment of LLC Debt ................................................................................. 8 III. Discharge of Partnership Liabilities ..................................................................... 12 A. Allocation of Partnership Liabilities ............................................................ 12 1. Recourse Liabilities .............................................................................. 13 2. Nonrecourse Liabilities ........................................................................ 13 B. Allocation of Partnership Income in a Workout .......................................... 14 1. Substantial Economic Effect ................................................................ 14 2. Partnership Minimum Gain .................................................................. 15 3. Partner Minimum Gain ........................................................................ 16 4. COD Income and Minimum Gain ........................................................ 16 5. COD Income and Economic Effect ...................................................... 17 6. COD Income and Substantiality ........................................................... 21 7. Sale Gain and Section 704(c) ............................................................... 22 C. Deemed Distributions and Gain Recognition .............................................. 22 1. Deemed Distributions........................................................................... 22 2. Basis Increase for COD Income ........................................................... 23 3. Timing of Deemed Distribution ........................................................... 23 IV. Exclusion or Deferral of COD Income Realized by a Partnership ....................... 24 A. Bankruptcy and Insolvency ......................................................................... 24 1. Exclusion ............................................................................................. 24 a. In General ......................................................................................... 24 b. Bankruptcy ....................................................................................... 24 c. Insolvency ........................................................................................ 25 2. Reduction of Tax Attributes ................................................................. 32 a. General Attribute Reduction ............................................................. 32 b. Rules Applying to Basis Reduction .................................................. 32 c. Election to Reduce Basis First Under Section 108(b)(5)................... 33 B. Qualified Real Property Business Indebtedness .......................................... 35 1. Exclusion ............................................................................................. 35 a. In General ......................................................................................... 35 b. Equity Limitation .............................................................................. 37 225-5 c. Basis Limitation ............................................................................... 38 d. Identifying the Qualifying Portion of a Debt .................................... 38 2. Basis Reduction ................................................................................... 39 C. Temporary Deferral of COD Income in Debt “Reacquisitions” .................. 40 D. Purchase Money Debt Reduction ................................................................ 58 E. Exclusion of Lost Deductions ..................................................................... 58 V. Other Approaches ................................................................................................ 59 A. Acquisition of Debt by a Third Party .......................................................... 59 1. In General ............................................................................................ 59 2. Related Party Acquisition of Indebtedness ........................................... 60 3. Significant Modifications and Deemed Reissuance of Debt ................. 61 4. Acquisition of Debt by an Agent .......................................................... 64 B. Admission of a New Partner ....................................................................... 64 1. Admission of a Third Party as a Partner ............................................... 65 a. Direct Admission to the Debtor Partnership ..................................... 65 b. Admission to a Subpartnership ......................................................... 66 2. Admission of Lender as a Partner ........................................................ 68 a. Application of Section 721 ............................................................... 68 b. Partnership Debt-for-Equity Exchange ............................................. 71 c. Liability Shifts and Gain Recognition .............................................. 75 C. Elimination of Partner Debt ........................................................................ 76 VI. Passive Activity Rules ......................................................................................... 78 VII. At-Risk Rules ...................................................................................................... 78 VIII. Partner-Specific Issues ........................................................................................