Use of Contingent Payments in Partnership Bankruptcies

Written by: Karrie L. Bercik, JD, LLM

In December 1994, the Internal Revenue Service issued Proposed Treasury Regulations regarding contingent payment debt instruments.1 Although the Proposed Regulations are not effective until 60 days after they are finalized, they may have a significant impact on future debt restructurings in bankruptcy. Particularly, the Proposed Regulations may inhibit the ability of a debtor in a single asset partnership bankruptcy to give the lender an equity participation in the property in lieu of interest.

Frequently, in a single asset debt restructuring the lender's indebtedness will be split into two new debts, one debt representing the secured portion of the original loan and the second debt representing the undersecured portion. The lender's secured portion will receive interest at a market rate while the undersecured portion will receive no interest. Once the property is sold (usually many years in the future), the lender receives a portion of the sales price in addition to the principal of the undersecured loan.

The problem may be illustrated as follows:

Example: ABCD, a limited partnership, owes Lender $6 million that is secured by a building. The fair market value of the building is $4 million. As part of a bankruptcy plan of reorganization, Lender agrees to accept two new loans. Note 1 has a principal amount of $4 million and an interest rate of 9%. Note 2 has a principal amount of $2 million and contains no interest. The loans mature in 10 years or when the property is sold or refinanced. If the property is sold or refinanced, Note 2 is to receive the first $1 million in proceeds.

Under the Proposed Regulations, ABCD would recognize significant cancellation of indebtedness ("COD") income as a result of the debt restructuring. Cancellation of a debt at less than its face amount creates COD income. In order to recognize COD income, there must be a "discharge" of a debt. What constitutes a discharge is governed by common law and Section 108.2 Additionally, Section 108 provides statutory exclusions to recognition of COD income for certain debtors and certain debts. Generally, Section 108(a) excludes from gross income, COD income of the taxpayer if the discharge occurs in bankruptcy. In the case of a partnership bankruptcy, COD income is only excluded under Section 108(a) to the extent that the partners themselves are in bankruptcy or insolvent. Thus, if any debt is discharged as a result of a partnership bankruptcy, COD income must be included in the partners' gross income unless one of the other statutory or common law exclusions applies.

In the above example, Lender's debt is replaced with two new debts under the plan. Section 108(e)(10) provides that if a debtor issues a debt instrument in satisfaction of a debt, the debtor shall be treated as having satisfied the old debt with an amount of money equal to the "issue price" of the new debt instrument. The "issue price" of the new debt instrument is to be determined under the original issue discount ("OID") provisions of Sections 1273 and 1274 (the "OID Rules").

Under the OID Rules, the issue price of Note 1 will be its face amount. Section 1273(b)(4) states that the issue price of a debt instrument that is issued for non-publicly traded property (such as a debt instrument) is the "stated redemption price at maturity". To the extent that the debt instrument has "adequate stated interest" (interest in excess of the AFR), the issue price under Section 1273(b)(4) will be the debt instrument's face amount. Thus, Note 1 does not contain OID, will not cause any COD income to be recognized and will be treated as satisfying $4 million of Lender's $6 million debt.

Lender will also receive in satisfaction of its remaining outstanding debt Note 2 with a $2 million face amount and a participating interest of $1 million that will be paid when the property is sold. Thus, it is expected that Note 2 will be fully paid plus interest (the $1 million participation right) upon the property's sale.

Because Note 2 does not contain any stated interest and contains a contingent payment, there is no guidance under the OID Rules as to the appropriate issue price of the debt instrument. Under the Proposed Regulations, the contingent payment to the Lender (the $1 million participation right) would be completely disregarded and only the discounted present value of the non-contingent payments under Note 2 (i.e., the present value of $2 million discounted at the AFR over a 10-year period) would be included as the issue price of Note 2.3 Thus, the issue price of the $2 million note would be $1,016,700 (assuming an AFR of 7%). In consequence, Note 2 would generate $983,300 of COD income. Lender's $2 million debt would be treated as being satisfied by $1,016,700. The partners of ABCD would have to recognize the $983,300 of COD income unless they were in bankruptcy or insolvent.4

Because the Proposed Regulations are not final, a taxpayer is not bound by them. The taxpayer may choose to apply the common law principles of debt discharge. As stated above, in order to recognize COD income there must be a "discharge" of the debt. A discharge occurs when based upon an identifiable event it is clear that the debt will not be repaid.5 The facts and circumstances surrounding an event must be assessed to determine whether such an "identifiable event" has occurred.6 If there is a reasonable anticipation that the debt will be repaid, there has been no discharge.7 Because there is a reasonable expectation that all of the Lender's debt will be repaid, the debt has not been "discharged."

Cases have adopted an open transaction approach to recognition of income generally where there are future contingent payments. In Brunet v. Logan, 283 U.S. (1931), the taxpayer sold her stock in a mining company for cash and future annual payments based upon the amount of ore sold. The IRS calculated the fair market value of the estimated future amount to be paid under the contract and presently included that amount in the taxpayer's gross income. The court agreed with the taxpayer that she should not currently recognize a taxable gain because the transaction was not closed. The court held that the income should be reported when the annual payments were later made rather than upon mere speculation as to their ultimate value.

Although the IRS and courts have used the open transaction doctrine sparingly, the open transaction doctrine may be appropriate in cases where there has been no debt discharged until the property is sold and the parties may determine whether the lender's debt has been fully repaid. If there is a reasonable expectation that the debt will be paid in the future, there has been no identifiable event indicating that the debt has been discharged. The transaction must remain open until the property is sold. Until the Proposed Regulations are finalized, partners of bankrupt partnerships may take the position that the debt restructuring does not generate any COD income and rely upon the open transaction doctrine.

1 See Proposed Treasury Regulations § 1.1275-4.

2 All Section references are to the Internal Revenue Code of 1986, as amended.

3 See Proposed Treasury Regulations § 1.1275-4(c). A hearing was held on March 16, 1995 regarding the Proposed Regulations. Discussions with the IRS have been very helpful regarding the problems the Proposed Regulations would create in partnership bankruptcies if they were finalized as proposed. It is expected that the Proposed Regulations will be changed as they relate to bankruptcy and workouts prior to being finalized.

4 The solvent partners may elect to exclude the COD income from gross income under the qualified real property business indebtedness exception contained in § 108. However, the property's basis would be reduced by the amount of COD income excluded. Thus, the qualified real property business indebtedness exception merely defers the gain recognition, it does not eliminate the income.

5 See temporary Treasury Regulations § 1.6050P-1T(b)(1).

6 Cozy v. Commissioner, 88 T.C. 435 (1987).

7 See IRS Market Segment Specialization Program Examination Technique Guides on Cancellation of Indebtedness (March 2, 1995).

Questions, comments or suggestions? kbercik@taxcounsellor.com

This Server Hosted by Nucleus Information Service