Research on U.S. Taxation
Project Two
Discharge of Indebtedness: Tax Effects on Partners and Partnership
Gary Cao
March 5, 1997
Outline
1. Case Facts
2. Definition of Issues
3. Conclusion
4. List of Authorities
5. Discussion
(1) History
(2) Current IRS Code Sections and Regulations
(3) Case Discussion
6. Summary
Appendix: List of References
1. Case Facts
Individuals A, B, and C are equal one-third partners in the ABC
Partnership. At December 31, 1996, the tax balance sheet of the ABC
Partnership was as follows:
Assets Liabilities
Building X $ 800,000 Bank X $1,100,000
Building Y 1,000,000 Bank Y 1,300,000
Building Z 1,500,000 Bank Z 1,800,000
Total Liab. 4,200,000
Partners' Equity
A Capital (300,000)
B Capital (300,000)
C Capital (300,000)
Total Equity (900,000)
Total Assets $3,300,000 Total Liab.&Eq'ty $3,300,000
The terms of liabilities were as follows:
-- The debt to Bank X was non-recourse, secured only by a mortgage on
Building X;
-- The debt to Bank Y was secured by a mortgage on Building Y, and by the
continuing guarantees of A (up to $100,000), B ($125,000), and C
($75,000);
-- The debt to Bank Z was recourse, secured by a mortgage on Building Z,
and endorsed by the partnership and all partners.
A and B are at all times solvent and not in bankruptcy. C is hopelessly
insolvent. The tax basis of each of the three buildings is $200,000 higher than
their respective fair market values.
In early 1997, the following transactions happened:
-- ABC Partnership quit claimed Building X to Bank X in full satisfaction and
release of the bank's mortgage;
-- With the consent of all other partners, C was released from his continuing
guarantee of the debt to Bank Y in exchange for cash payment to Bank Y
by C of $25,000; thereafter, Bank Y foreclosed on Building Y, and
collected $225,000 from A and B under their guarantees;
-- Bank Z foreclosed Building Z, and collected $100,000 each from A and B;
C paid nothing to Bank Z; A, B, and C were therefore released from their
guarantees.
2. Definition of Issues
The purpose of this paper is to analyze the income tax effect of the
1997 transactions to all parties (partnership and its three partners).
Building X had a tax basis of $800,000 and a fair market value of
$600,000. Bank X exchanged its non-recourse loan of $1,100,000 with
Building X.
Building Y had a tax basis of $1,000,000 and a fair market value of
$800,000. Bank Y exchanged its loan of $1,300,000 with Building Y, along
with $25,000 from C, $100,000 from A, and $125,000 from B. The
$1,300,000 debt consists two part: a non-recourse debt of $1,000,000 and a
recourse debt of $300,000 guaranteed by A, B, and C.
Building Z had a tax basis of $1,500,000 and a fair market value of
$1,300,000. Bank Z exchanged its recourse loan of $1,800,000 with Building
Z, along with $100,000 from A and $100,000 from B. C was released from his
guarantee without paying anything.
The questions is: what are the tax effects of the above three
transactions on the four parties (ABC Partnership, A, B, and C)?
3. Conclusion
(1) ABC Partnership
On Building X, since the non-recourse debt was $1,100,000 and
property's tax basis was $800,000, the Partnership had to recognize a debt
discharge income of $300,000.
On Building Y, the non-recourse part of the debt was $1,000,000,
exactly equals to the property's tax basis was $1,000,000. The recourse part
of debt was $300,000 (guaranteed by $100,000 from A, $125,000 from B, and
$75,000 from C), A paid his part of $100,000, B paid his part of $125,000,
only C was received a discharge of $50,000 (he paid $25,000 instead of
$75,000). ABC Partnership had no gain or loss.
On Building Z, since the recourse debt was $1,800,000 and the FMV
was $1,300,000, the difference of $500,000 was the amount discharged. Since
a loss of $200,000 incurred (as if ABC Partnership sold Building Z with tax
basis of $1,500,000 at FMV $1,300,000 to a third party and repaid this amount
to Bank Z, thus incurred loss) , ABC Partnership had to recognize a gain of
$300,000, which should be equally allocated to the three parties (A, B, and C);
while ABC Partnership endorsed the debt, since it is a pass-through entity, its
share of income will be eventually allocated equally to its three partners. ABC
Partnership had no gain or loss on Building Z.
Overall, ABC Partnership had to recognize an income from discharged
debts of $300,000. The insolvency only applied to the partners level, not to
ABC Partnership level. This $300,000 gain will be equally allocated to
partners A, B, and C at the end of 1997.
(2) Partner A
On Building X, A did not recognize any gain or loss. On Building Y, A
paid his portion of guarantee $100,000 and did not recognize any gain or loss.
On Building Z, A had an obligation to pay $100,000 (one-third of
$300,000, which is the amount of the debt $1,800,000 minus the building's fair
market value $1,300,000 and the $200,000 loss) and paid $100,000, therefore
he had no gain or loss on Building Z. However, at the end of 1977, A will
have to recognize $100,000 discharged debt income (one-third of $300,000
income for the ABC Partnership), which may be called a "phantom gain".
(3) Partner B
Partner B is in the same situation as Partner A on all of the three
transactions. At the end of 1997, B will have to recognize the discharged debt
income of $100,000.
(4) Partner C
On Building X, C did not recognize any gain or loss.
On Building Y, C had the obligation to pay $75,000 but actually paid
$25,000, therefore C had to recognize a gain of $50,000. On Building Z, C
had an obligation to pay $100,000 but actually paid nothing. In addition, ABC
Partnership will allocate its $100,000 (one-third of the total $300,000) to C, C
should have recognized a gain of $250,000. However, since C as a partner has
been in solvency, the amount of gain from discharged debt may be excluded
from his taxable income.
4. List of Authorities
1. IRC section 61(a)(12);
2. IRC section 108;
3. IRC section702;
4. IRC section 752;
5. IRC section 1001;
6. IRC section 1017;
7. Treasury Regulation section 1.1001-2(a)(2);
8. IRS Ruling 90-16;
9. Zarin v. Commissioner, 916 F.2d 110 (3rd Circuit 1990);
10. Commissioner v. Tufts, 461 U.S. 300 (1983);
11. Crane v. Commissioner, 331 U.S. 1 (1947);
12. United States v. Kirby Lumber Co., 284 U.S. 1 (1931);
13. Gershkowitz v. Commissioner, 88 T.C. 984 (1987);
14. Stackhouse v. United States, 441 F 2d 465 (5th Circuit 1971);
15. Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926);
16. Raphan v. United States, 758 F.2d 1132 (Federal Circuit 1985);
17. Fulton Gold Decision, 31 BTA 519 (1934);
18. Vukasovich Inc. v. Commissioner, 86 USTC 1 (1984).
5. Discussion
(1) History of tax issues on debt discharge:
(A) "Freeing of assets" analysis
In U.S. v. Kirby Lumber Co., the taxpayer challenged the Treasury
regulations that imposed a tax on the difference between the par value the
company received for its bonds and the lower price at which it subsequently
purchased and retired the bonds. Justice Holmes stated that the taxpayer made
a clear gain in the transaction because the transaction made available assets
that were previously offset by the bond obligations. The Court added that
there was no "shrinkage of assets" here as there was in Bowers v. Kerbaugh-
Empire Co. (1926). In this case, the Supreme Court first enunciated the
"freeing of assets" analysis of the tax consequences of the discharge or
cancellation of recourse indebtedness. Under this analysis, a taxpayer whose
liability for an indebtedness is discharged is treated as realizing an economic
benefit, taxable as ordinary income, to the extent that the discharge "frees"
assets of the taxpayer that would otherwise have been devoted to repayment of
the debt.
In a prior case, Gershkowitz v. Commissioner, the Tax Court held that
each limited partnership member of a larger partnership must recognize
discharge of indebtedness income under section 61(a)(12) as a result of a
transaction in which Prentice-Hall discharged debts owed by each limited
partnership member in return for a smaller payment. The court rejected a
taxpayer's argument that the income realized on the discharge should not be
recognized due to the insolvency exception to the discharge of indebtedness
rule. The court ruled that the insolvency exception must be applied at the
partner, not the partnership, level. The court noted that such income will
provide each partner with an increase in basis under section 705(a)(1)(A).
Simultaneously, each partner will receive a constructive cash distribution equal
to his share of the discharged debt under section 752(b), which will reduce his
basis in an equal amount under section 733(1).
In Rule 155 proceedings, the Service determined that the deficiencies
were greater than in the original deficiency notice. The Service moved to
amend their answer accordingly. The taxpayers objected, arguing that the
Service's amended answer raised a new issue that would present them with
unfair prejudice. At trial, the Service had argued that a portion of the amount
of debt forgiven constituted ordinary income under the "freeing of assets"
theory set forth in United States v. Kirby Lumber Co. The Tax Court, though,
had rejected the Service's theory and found that, because the taxpayers had
transferred cash, rather than stock which secured the loan discharged, in
exchange for the discharge of the partnership's debts, the taxpayers were
required to recognize gain to the extent that the amount of debt discharged
exceeded cash transferred. Accordingly, each partner was required to
recognize gain (ordinary income) under section 702 to the extent of his
distributive share of the amount discharged.
(B) "Inclusion in basis" rationale
In Crane v. Commissioner, the court states that non-recourse debt
incurred to acquire property was properly includable in the basis of the
acquired property and in the amount realized upon sale. If the debt exceeded
the value of the property at the time of sale, a different result might be reached.
The Tufts court reasoned that, since Crane court permitted a non-recourse
borrower to include the amount borrowed in its basis for acquired property,
"symmetry" required that the same borrower to include the full unpaid balance
of the non-recourse debt in the amount realized on sale.
Mrs. Beulah Crane gained by bequest in 1932 a building and lot subject
to a mortgage with a principal of $255,000 and interest in default of $7,042.
The value of the property as appraised for estate tax purposes was the total
amount of the encumbrance, $262,042. For the next seven years, Crane
reported the net rentals as income and deducted taxes and interest paid on the
mortgage, and operating expenses. The arrearage of interest on the mortgage
increased to $15,858. In 1938, Crane sold the property to a third party for
$3,000, subject to the mortgage, and paid $500 in sale expenses. Crane
reported a taxable gain of $1,250. She alleged that the "property" she acquired
in 1932 was the property's equity, which was zero, that no depreciation could
be taken on zero value, and that half of the net proceeds of the sale were
reportable as income because the entire property was a capital asset.
The IRS determined that Crane had a taxable gain of $23,767. Crane's
original basis in the property was $262,042, including $55,000 which was
allocable to the land and the remainder to the building. The IRS then
subtracted depreciation, leaving a basis of $178,997. The proceeds of the sale
consisted of the $2,500 and the mortgage, totaling $257,500 ($54,471 was
allocated to the land and $203,029 to the building). The land was a capital
asset and the building was not, resulting in the net taxable gain indicated above.
The Tax Court agreed with the IRS that the building was not a capital asset but
otherwise held for the taxpayer, agreeing with Crane that the property she
received was the equity. The Second Circuit reversed.
The Supreme Court ruled that Crane realized $275,500 on the sale of
the property. The basis of property acquired by devise, Chief Justice Vinson
stated, is its appraised value at the time of the acquisition, undiminished by the
mortgage. "Property" is not merely the equity. The amount realized in a
disposition of property, the Court determined next, is money plus the market
value of property received. A mortgagor not personally liable for the debt who
sells property, the Court concluded, realizes a benefit equivalent to having been
paid cash and released from the obligation. The amount realized in this case,
therefore, was the net cash received ($2,500) plus the amount of the
encumbrance ($255,000).
(C) Fulton Gold Decision and IRS Position
The discharge of a portion of non-recourse debt encumbering retained
property did not give rise to current income, but instead resulted in a
corresponding reduction of the taxpayer's basis in the property.
In IRS Ruling 90-16, an insolvent borrower that transfers property
encumbered by recourse debt to the lender must recognize gain on the sale or
exchange to the extent of the property's fair market value. To the extent that
the recourse debt exceeds such value, the taxpayer realizes ordinary debt
discharge income (excludable to the extent it is insolvent).
(D) Commissioner v. Tufts
A general partnership of Tufts and four other persons borrowed a
$1,851,500 non-recourse mortgage loan from a savings association to
construct an apartment complex, which was completed in 1971. Due to the
partners' capital contributions to the partnership and income tax deductions for
their allocable shares of ordinary losses and depreciation, the partnership's
claimed adjusted basis in the property in 1972 was $1,455,740. Because of an
unanticipated reduction in rental income, the partnership was unable to make
the payments due on the mortgage. Each partner thereupon sold his interest to
a third party Bayles, who assumed the mortgage. The fair market value on the
date of transfer did not exceed $1,400,000. Each partner reported the sale on
his income tax return and indicated a partnership loss of $55,740. The
commissioner, however, determined that the sale resulted in a partnership gain
of approximately $400,000 on the theory that the partnership had realized the
full amount of the non-recourse obligation. The Tax Court upheld the
deficiencies, but the Fifth Circuit reversed.
Supreme Court Justice Blackmun noted that when the mortgagor's
obligation to repay the mortgage loan is canceled, he is relieved of his
responsibility to repay the sum he originally received and thus realizes value to
that extent within the meaning of section 1001(b). Justice Blackmun stated
that a taxpayer must account for the proceeds of obligations he has received
tax-free and has included in basis. The full amount of the non-recourse
mortgage is an amount realized to the taxpayers on sale of the property even
though it is greater than the fair market value of the property.
Justice Blackmun stated, the legislative history indicates that the fair
market value limitation of section 752(c) was intended to apply only to
transactions between a partner and his partnership under sections 752(a) and
(b), and was not intended to limit the amount realized in a sale or exchange of
a partnership interest under section 752(d). In a concurring opinion, Justice
Sandra Day O'Connor suggested that the Court should have viewed the
transaction as being bifurcated in the same manner as if recourse debt had been
involved.
(E) Zarin v. Commissioner
David Zarin had $3.4 million gambling debts owed to Resorts
International, who eventually settled for $500,000. The Service contended
that the difference represented discharge of indebtedness income under section
108(e) and that Zarin owed $5.2 million (including interests) in taxes.
Judge Cohen, writing for a divided Tax Court, sustained the position of
the Service. However, Judge Cowen, writing on behalf of a divided Third
Circuit, has reversed the Tax Court, holding that Zarin did not have any
income from cancellation of indebtedness under section 108(e). The court
ruled that neither of the alternative requirements of section 108(d) was satisfied
because under New Jersey law the gambling debt was not enforceable by
Resorts and because the "chips" received by Zarin did not represent
"property." Citing N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939),
Judge Cowen found that the transaction was a contested liability, which when
satisfied by the debtor, does not produce any taxable income. However, if the
debt was enforceable, Zarin should recognize the income from debt
forgiveness.
(F) Raphan Case
The Pomponio brothers transferred some land to their corporation, the
James Buchanan Corp. (JBC), with plans to develop it. A partnership, James
Buchanan Associates, was formed, and a group of New York investors
contributed cash to the partnership. Originally, the partnership was supposed
to hold the land, but in the end the corporation held nominal title, because of
Virginia's usury limits for non-corporate borrowers. The Pomponios
personally guaranteed the bank loan to the corporation for developing the
property. Two of the New York investors, Benjamin and Myrna Raphan,
claimed deductions for their share of the interest on the loan and increased
their partnership basis by their share of the loan. The Service disallowed their
resulting loss deductions, but the Claims Court upheld them. The Claims
Court concluded that JBC held the property solely as agent of the partnership.
It also concluded that the Pomponios' loan guarantee did not make them
personally liable on the loan, so the Raphans were entitled to step up their basis
by their share of the debt. The government appealed.
Judge Kashiwa, writing for the Federal Circuit, has affirmed the lower
court's holding that JBC was the partnership's agent but reversed its holding
that the Pomponios were not personally liable on the loan guarantee. The
court said that the lower court's holding on the agency question was not clearly
erroneous.
Regarding the loan guarantee, the appeals court found that the
Pomponios made the guarantee in their capacity as partners. The court stated,
"The view that a partner cannot guarantee partnership debt in his capacity as
partner because he then becomes a creditor is insupportable." The Pomponios
were clearly acting as partners, the court reasoned, since they did not act at
arm's length and charge for the guarantee. The court rejected the Raphans'
argument that a loan guarantee is a secondary liability and thus can never
create personal liability. Secondary liability refers to the order in which a
creditor may pursue his remedies, the court said, not the extent of the
guarantor's liability. The Pomponios guaranteed a debt that was non-recourse
as to the partnership, the court said, and they thus became personally liable.
Since the general partners (the Pomponios) were thus liable on the debt, the
limited partners, including the Raphans, were not entitled to step up their basis
by a share of that debt, under regulation section 1.752-1(e).
(G) Other Relevant Cases
In Bowers v. Kerbaugh-Empire Co., the court concluded that the
company's loss did not eliminate its liability, but the diminution of the loss,
attributable to the decline in value of the marks, did not constitute gain to the
taxpayer.
In Vukasovich Inc. v. Commissioner (1984), Ninth Circuit Judge
Goodwin stated that the income from the cancellation of indebtedness (equal to
the difference between what Vukasovich borrowed and what it paid back) was
ordinary income under section 61(a).
(2) Relevant IRS Code Sections and Regulations
IRC section 61(a)(12) states that gross income includes the income
from discharge of indebtedness.
IRC section 108 (a)(1)(B) states that gross income does not include
any amount of debt discharge which occurs when the taxpayer is insolvent.
IRC section 1017 (a) states: if an amount is excluded from gross
income under section 108(a), such portion shall be applied in reduction of the
basis of taxpayer's property. Section 1017 (b)(2) adds: the reduction in basis
shall not exceed the excess of aggregate basis (immediately after the discharge)
over the aggregate liability (immediately after the discharge).
IRS Regulation section 1.1001-2 (a)(2) states: the amount realized on a
sale of other disposition of property that secures a recourse liability does not
include amounts that are (or would be realized and recognized) income from
the discharge of indebtedness under section 61(a)(12).
(3) Case Discussion
The above mentioned cases, IRS Code sections and regulations support
this paper's conclusion.
On non-recourse debt, the total amount of loan should be the amount
realized in the exchange or disposition, and the property's tax basis should be
deducted from the amount realized. The remaining difference should be
recognized as ordinary income from debt forgiveness.
On recourse debt, the total amount of loan should be the amount
realized, and the property's fair market value should be deducted from the
realized amount. Furthermore, if the FMV is less than the property's tax basis,
this difference (loss of basis) can be deducted from the income.
Kirby Lumber case states that the discharged debt should be treated as
an economic benefits, since the discharge frees taxpayers' assets that would
otherwise have been devoted to repayment of the debt.
Tufts case concludes that the full amount of the non-recourse mortgage
is an amount realized to the taxpayers on sale of the property even though it is
greater than the fair market value of the property.
Crane case concludes that the borrower should include the full unpaid
balance of the non-recourse debt in the amount realized on sale of property.
Raphan case concludes that the partners are personally liable when they
guarantee the partnership's debt.
Gershkowitz case concludes that the solvency exception must be
applied at the partner level, not at the partnership level, since the partnership is
a conduit entity.
Rule 155 concludes that each partner is required to recognize gain
(ordinary income) under section 702 to the extent of his distributive share of
the amount discharged.
6. Summary
The different treatments on non-recourse and recourse debt are
important in this case. The debt to Bank Y is consisted of two parts, one part
is recourse (guarantees of A, B, and C) and the other is non-recourse. In
addition, on the debt to Bank Z, even though the debt was endorsed by the
partnership and all three partners, since partnership is a conduit entity, partners
are responsible for the partnership's guarantee based on their distributive share.
Furthermore, the section 108 insolvency exception is only applicable to the
partner level, not to the partnership level, therefore the partnership should
recognize gain from discharged indebtedness.
Appendix: List of References
1. Kimberly S. Blanchard: Discharge of Non-Recourse Debt: A Re-
examination of the Distinction between Recourse and Non-Recourse Debt
and Related Issues, Tax Notes, February 18, 1991
2. Louis A. Del Cotto: Debt Discharge Income: Kirby Lumber Co. Revisited
under the "Transactional Equity" Rule of Hillsboro, Tax Notes, February
18, 1991
3. Mertens Law of Federal Income Taxation, Volume 2, Pub 1/96, section
11.07
4. Daniel Q. Posin, Federal Income Taxation, 1993, section 4.03 & 3.10
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