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Section 705(a)(1)(A) provides that a partner's basis in his partnership interest is increased by his share of taxable income of the partnership, and section 705(a)(1)(B) provides that such basis is increased by a partner's share of income "exempt from tax under this title."
As set forth below, the legislative history of the amendments to section 108 by the Bankruptcy Tax Act of 1980 clearly contemplated that the section 705(a) basis adjustment applies to discharge of partnership indebtedness excluded by a partner under section 108.
Recently, Babin v. Commissioner, 23 F.3d 1032 (6th Cir. 1994) affirmed a Tax Court memorandum decision denying such a basis increase. The tax years before the court were prior to the effective date of the Bankruptcy Tax Act amendments. Many practitioners are concerned because the courts did not explicitly confine their reasoning to pre-Bankruptcy Tax Act years.
Commission Track Number 415A. This proposal.
Add a new paragraph (D) to section 705(a)(1) to include discharge of indebtedness income excluded under section 108 to the items generating an increase in a partner's basis for his partnership interest.
The decision in Babin represents a continuation in the struggle among the courts, the Commissioner of Internal Revenue, and taxpayers to achieve an appropriate balance in the treatment of the cancellation of partnership indebtedness.
The leading case prior to the Bankruptcy Tax Act of 1980 was Stackhouse v. United States, 441 F.2d 465 (5th Cir. 1971), which held that the applicability of the various exemptions and exclusions from taxable income recorded by section 108 of the Internal Revenue Code to the cancellation of a partnership's indebtedness was to be determined at the partnership level, not the partner level. More important, the Fifth Circuit held that section 702, which required all partnership income to be allocated to the various partners, and required all partners to report on their individual tax returns their respective shares of each item of partnership income, gain, deduction, loss or credit, did not apply to cancellation of indebtedness income. Instead, the court held that cancellation of indebtedness income was taxable to the individual partners only through the mechanism of section 752, which treated a reduction in partnership debt as a constructive distribution of cash to each partner, and of section 731, which treated distributions of cash to a partner in excess of that partner's basis for his or her interest in the partnership as taxable income. In most cases, this income would be treated as long term capital gain.
As almost every commentator noted, this converted ordinary income eligible for section 108 or similar treatment into capital gain which was not eligible for such treatment. Althoughthis helped partners who would not have individually qualified for any of the exclusions under section 108 or comparable provisions of the law, since capital gains tax rates were at the time substantially below the tax rates for ordinary income, it prevented partners who were personally insolvent or bankrupt from claiming the benefits of section 108. The Section of Taxation consistently supported correction of this erroneous view.
In the Bankruptcy Tax Act of 1980, Congress adopted the Section position that it did not agree with the decision in Stackhouse. Cancellation of indebtedness income was to be allocated to the individual partners, just like any other item of partnership income. Each partner would then have the right to invoke the provisions of section 108 if any applied to him or her (e.g., because the partner was bankrupt or insolvent). As stated in the Senate Finance Committee Report, "[t]he effect of these provisions of the bill is to overturn the decision in Stackhouse v. U.S., 441 F. 2d 465 (5th Cir. 1971)" (fn. 159).
However, the overturning of Stackhouse was prospective only (generally, for transactions after December 31, 1980). Congress did not attempt to change the law retroactively, but it is fair to say that Congress assumed that the passage of time would eliminate any continuing vitality of the Stackhouse holding.
The Committee Report also made very clear how the basis of the partner's interest in the partnership was to be adjusted for cancellation of indebtedness:
"For example, assume that a partnership is the debtor in a bankruptcy case which begins March 1, 1981, and that in the bankruptcy case a partnership liability in the amount of $30,000 is discharged. The partnership has three partners. The three partners have equal distributive shares of partnership income and loss items under section 702(a) of the Code. Partner A is the debtor in a bankruptcy case; partner B is insolvent (by more than $10,000), but is not a debtor in a bankruptcy case; and partner C is solvent, and is not a debtor in a bankruptcy case.
Under section 705 of the Code, each partner's basis in the partnership is increased by $10,000, i.e., his distributive share of the income of the partnership (The $30,000 debt discharge amount constitutes income of the partnership for this purpose, inasmuch as the income exclusion rules of amended sec. 108 do not apply at the partnership level.) However, also by virtue of present law, each partner's basis in the partnership is decreased by the same amount (Code secs. 752 and 733). Thus, there is not net change in each partner's basis in the partnership resulting from discharge of the partnership indebtedness except by operation at the partner level of the rules of sections 108 and 1017 of the Code (as amended by the bill).
In the case of bankrupt partner A, the $10,000 debt discharge amount must be applied to reduce net operating losses and other tax attributes as specified in the bill, unless A elects first to reduce the basis of depreciable assets. The same tax treatment applies in the case of insolvent partner B. In the case of solvent partner C, such partner can elect to reduce basis in depreciable assets in lieu of recognizing $10,000 of income from discharge of indebtedness.
If A, B, or C elects to reduce basis in depreciable assets, such partner may be permitted, under the Treasury regulations, to reduce his basis in his partnership interest (to the extent of his share of partnership depreciable property), because the bill treats that interest as depreciable property. However, a partner may reduce basis in his interest in the partnership only if the partnership makes a corresponding reduction in the basis of the partnership property with respect to such partner (in a manner similar to that which would be required if the partnership had made an election under section 754 to adjust basis in the case of a transfer of a partnership interest" (fn. 160).
In Estate of Newman v. Commissioner (fn. 161), which involved a pre-1981 tax year, the Second Circuit followed Stackhouse and determined the applicability of section 108 at the partnership level. Initially, this seemed to favor the taxpayer, since the partnership was insolvent and the effect of the decision was that no income was realized at the partnership level as a result of the cancellation. However, the constructive distribution under section 752 now created a problem for the taxpayer. If that distribution exceeded his basis, it was taxable under section 731, notwithstanding that the cancellation of indebtedness income was being excluded under section 108.
Under section 705(a)(i)(B), a partner may increase the basis of his interest in the partnership by his share of the "income of the partnership exempt from tax under this Title [the 1954 Code] . . . " Under section 705(a)(i)(A), a partner may increase the basis of his partnership interest by his distributive share of the partnership's taxable income. If, as the taxpayer contended, either of these provisions applied, the basis increase would offset the distribution under section 731 to an extent sufficient to avoid tax under section 731. The Second Circuit balked at this and held that, since the income was not being included in income, section 705 did not apply. Therefore, the very income being excluded under section 108 at the partnership level turned out to be taxable under section 731 anyway. The Court thought that a contrary holding would be a "windfall" for the taxpayer. After the Bankruptcy Tax Act of 1980, section 108(b) prevents any windfall.
To the extent that the taxpayer in Newman was solvent and should not, as a policy matter, have been entitled to the benefits of section 108, the final result was not unreasonable, but the Court got to that result by adding together two incorrect holdings.
The decision in Newman involving the basis adjustment was recently applied in Babin v. Commissioner, 23 F.2d 1032 (6th Cir. 1994). In Babin, the partner was the insolvent person, and the Tax Court (which had never agreed with or otherwise followed Stackhouse) held that the partner was entitled to exclude his share of the partnership's cancellation of indebtedness income pursuant to section 108(a). However, the Tax Court then applied the Newman rationale and refused to allow the taxpayer to increase the basis of his interest in the partnership. The result was the same as in Newman; the taxpayer wound up being taxed on the amount of the cancellation of indebtedness income as capital gain through the application of sections 731 and 752. The Sixth Circuit affirmed this decision. It was held that section 705 did not apply because, as the result of the application of the exclusion under section 108, "petitioner did not receive any taxable income, [and] there was no distributive share of taxable income of the Partnership within the meaning of . . . section 705(a)(1)(A) . . ." The effect of section 108(b) after the Bankruptcy Tax Act of 1980 was not noted.
Although Babin involved tax years both before and after the effective date of The Bankruptcy Tax Act of 1980, it is fairly clear from the facts that the cancellation of indebtedness and partnership issues only arose in the earlier years. However, many practitioners are concerned that the reasoning could be applied to post-1980 years, notwithstanding unambiguous legislative history.
>From both the technical and the policy viewpoints, the basis adjustment in section 705(a)(1) is proper, and the judicial opinions to the contrary are unsound. Technically, the partner in Babin did realize his distributive share of cancellation of indebtedness income (fn. 162). Otherwise, there was nothing for section 108 to apply to at the partner level.
The perception that this provides the taxpayers with a windfall is erroneous. With few exceptions, the exclusion of income under section 108 is invariably accompanied by a reduction in other tax attributes, including the reduction of the basis of property held by the taxpayer. In effect, the exclusion is only a deferral.
In Babin, the court was concerned that the increase in basis under section 705(a)(1) would offset the distribution under section 752 and the taxpayer would permanently escape any tax whatsoever on the amount of income arising from the cancellation of the indebtedness (fn. 163). But after the Bankruptcy Tax Act of 1980 section 108(b) provides for a reduction of other tax attributes, such as net operating losses and the basis of other property of the taxpayer. That reduction in the other tax attributes is the Congressional method for preventing a windfall. Applying Babin now would double the tax consequences for the taxpayer. Not only would the taxpayer wind up paying tax on the cancellation of indebtedness because of the refusal of the courts to let him increase his basis under section 705(a)(1), but he will (if, following his loss in the courts, he was still sufficiently law-abiding to apply section 108(b)) pay that tax again when he sells the asset whose basis was reduced under section 108(b). At some point in time (provided he lives long enough), he will wind up reporting $2 of taxable income for each $1 of debt canceled. That is certainly neither good tax policy nor what Congress intended.
For seventeen years, taxpayers and their advisors have relied on the explanation of the operation of sections 108 and 705 as set forth in the legislative history of the Bankruptcy Tax Act of 1980. The Service and the Treasury Department lobbied heavily for that result. Moreover, the result is correct as a matter of theory. Taxpayers should not be saddled with the uncertainty created by the Babin decision. This problem would be obviated if the Internal Revenue Service issued an unequivocal announcement that it will not rely on Babin for taxable years subject to Section 108(b). A statutory fix would also be desirable, and should be retroactive.
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fn. 158: I.R.C. Section 108(d)(6).
fn. 159: S.Rep. No. 96-1035, 96th Cong., 2d Sess. 21, fn. 26 (1980).
fn. 160: Id. at 22, fn. 28.
fn. 161: 934 F.2d 426 (2d Cir. 1991).
fn. 162: It is not entirely clear whether clause (A) or clause (B) of section 705(a)(1) is the operative one, but the difference between the two is inimportant. Under the proposal being made here, a new clause (D) would be added, eliminating this ambiguity as well.
fn. 163: Prior to the enactment of Section 108(b) of the Internal Revenue Code, the Bankruptcy Act provided only limited basis reduction.
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Last updated June 1, 1997