Partnership interest issued for debt: discharge of indebtedness or contribution to capital?

The restructuring of debt is a transaction potentially fraught with tax consequences - and tax uncertainties. The Bankruptcy Tax Act of 1980 reworked many of the tax rules in this area, not only for bankrupt debtors, but also for solvent and insolvent debtors outside of bankruptcy. One of the main contributions of the 1980 Act was a partial, and generally taxpayer-favorable, codification of the rules relating to when a corporation's satisfaction of its indebtedness by the issuance of its own stock - a so-called "stock-for-debt exchange" - would (and would not) give rise to income from the discharge of indebtedness.

The 1980 Act recognized the existence of a "stock-for-debt exception," under which a debtor corporation participating in such an exchange would often not realize income from the discharge of indebtedness even if the value of the stock issued by the corporation was materially less than the amount of debt canceled. Statutory changes to the treatment of stock-for-debt exchanges were made in 1984, 1986, 1990 and 1993, however, and the net result of all that tinkering is that there is no longer a "stock-for-debt exception" to the realization of income from the discharge of indebtedness. If a corporation issues stock to a creditor in satisfaction of its indebtedness, the corporation is treated as having satisfied the indebtedness with an amount of money equal to the value of the stock; if that value is less than the amount of debt canceled, income is realized.

The rules for corporations that issue their own equity (i.e. stock) in satisfaction of their debt, if not always favorable, are at least relatively clear. On the other hand, there has always been substantial uncertainty as to whether the same rules applied to partnerships. Or, to put it differently, is there a "partnership-interest-for-debt exception" to the realization of income from the discharge of indebtedness? The Internal Revenue Code is ambiguous on this question and, depending on whether the rules for corporations were liberal (as they were in the years immediately after 1980) or not (as they are now), taxpayers and the Internal Revenue Service have waffled on whether they did or did not want the analogous corporate rules to apply to partnership transactions. There are a number of theories under which a "partnership-interest-for-debt exception" might exist, including the argument that the exchange of debt for a partnership interest constitutes a nontaxable contribution to partnership capital. In the 16 years since passage of the 1980 Act, the issue has never come to a definitive resolution in court.

Bear in mind that we are considering here solely the consequences to the "debtor side" of the transaction; the issue of whether the exchanging creditor recognizes gain or loss on the receipt of corporate stock or a partnership interest can be the subject for another article. Bear in mind as well that a determination that a partnership-interest-for-debt exception does exist might not, in a particular case, result in a transaction that was wholly non-taxable to the debtor partnership or its partners; there are also other provisions of the Code that could come into play and cause "recapture" of previously claimed losses (or nontaxable distributions).

The Tax Court appeared to have an opportunity recently to resolve once and for all the question of whether or not there is a partnership-interest-for-debt exception. Unfortunately for those to whom the issue is of either practical or academic interest, the court bypassed the opportunity, finding that no partnership interest was actually issued to the creditor in the court. Parker Properties joint Venture v. Commissioner (June 19, 1996).

Parker Properties Joint Venture was formed in 1983 as a partnership between Nicholson Enterprises Inc., Philip D. Winn & Associates Inc. and E.S.L. Corp. ("ESL"). ESL, a wholly owned subsidiary of Empire Savings, Building & Loan Association, had a 50% interest in Parker Properties. The partners in Parker Properties made only nominal capital contributions to the lip and the bulk of the partnership's capitalization was provided in the form of a $12 million loan from Empire. The loan proceeds were used to develop a real estate project in Parker, Colo.

In April 1987, at a time when values in the real estate market were declining and Parker Properties owed approximately $9.3 million to Empire, Empire was acquired by Commercial Federal Savings & Loan Association. Shortly after the acquisition, Commercial met with the other partners in Parker Properties and expressed its desire to liquidate its positions as a creditor of and a partner partnership. Commercial acknowledged that it would be willing to accept less than the outstanding loan balance to accomplish this liquidation.

Early drafts of the agreements between Commercial and the partnership stated that ESL (now a subsidiary of Commercial) was willing to sell its interest in the partnership for $10.000 and that Commercial was willing to accept approximately $5.9 million "in full settlement and satisfaction of [the] loan balance." However, the attorney for the partnership re quested that the transaction be structured to include a "contribution to the capital of the partnership" of $3.4 million of debt (the excess of the $9.3 million debt balance over the $5.9 million to be paid to Commercial); this contribution would be made by Commercial on behalf of ESL, its subsidiary which was a partner in the partnership. Immediately after this contribution was effected, the remaining $5.9 million of debt was repaid by the partnership and ESL sold its partnership interest to the other partners for $10,000. The partnership reported no income with respect to the $3.4 million of debt, taking the position that its debt reduction "resulted from a contribution to capital rather than from debt relief." By contrast, Commercial reported the transaction as a cancellation of a portion of the partnership's indebtedness.

The Internal Revenue Service took the position that, in substance, there had been no contribution of the $3.4 million of debt to the capital of the partnership, but rather an unadorned cancellation of indebtedness. Since the court agreed with\this view, it never addressed the question ' of whether a "true" contribution of indebtedness to the capital of a partnership would be effective in avoiding income from the discharge of indebtedness.

In reaching its conclusion, the court looked primarily to the fact that Commercial had consistently wanted to terminate its entire relationship with Parker Properties, both as a creditor and as a partner. Commercial did not want to acquire any additional interest in Parker Properties by means of the purported contribution. Moreover, after the contribution, ESL sold its entire interest for the same nominal price of $10,000 that had been negotiated before the contribution structure had been imposed on the parties' documents. Under these circumstances, the transactions constituted merely a cancellation of the partnership's debt.

It is probably well that the Tax Court decided this case as it did. The conceptually difficult legal question of whether a partnership-interest-for-debt exception exists should not be resolved in a case in which the court is predisposed by factual "imperfections" to decide against the taxpayer. When the right case is presented, it will be time enough to consider this issue and its interaction with the other intricacies of partnership taxation. For now, we are all on notice that any attempt to invoke such an exception should be grounded in the issuance of partnership interest that is meaningful in terms of its economic rights and: temporal duration. Beyond that, we still just don't know!

Ronald A. Morris and Elliot Pisem, members of the New York bar, are partners in the law firm of Roberts & Holland LLP, New York City and Washington, D C.

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