Cancellation-of-debt (COD) income can arise from the modification of an existing debt instrument. Practitioners should be familiar with the COD rules to ensure that modifications of a limited liability company's (LLC's) debts are not significant enough to cause the members to recognize COD income.
If a new debt instrument is issued in satisfaction of existing debt, the new debt is treated as having paid off the existing debt with an amount of money equal to the issue price (determined under the original issue discount (OID) rules of Secs. 1273 and 1274) of the new debt instrument. Significant modification of the terms of a debt instrument (e.g., a change in interest rate) is considered an exchange of the old debt for new debt (Regs. Sec. 1.1001-3(b)). The issue price of the new debt generates debt forgiveness income if its issue price is less than the balance of the old debt (Sec. 108(e)(10)).
Under the OID rules for nonpublicly traded debt, if the new debt has an interest rate at least equal to the applicable federal rate (AFR), the issue price of the debt is its stated principal amount (Sec. 1274(a)(1)). Accordingly, when the only modification of a debt instrument is lowering the interest rate, and the lowered rate is at least equal to the AFR, the restructuring will not result in COD income. However, if the interest rate is less than the AFR, the imputed principal amount (generally, the present value of all payments required under the terms of the debt discounted at the AFR) becomes the issue price of the new debt, resulting in COD income (Sec. 1274(a)(2)).
Practice tip: A significant modification may be treated as an exchange of debt instruments resulting in the recognition of COD income. Regs. Sec. 1.1001-3 provides extensive discussion of what constitutes the significant modification of a debt instrument.
Sec. 1274(b)(3) contains a special rule that applies to a "potentially abusive situation." This rule says the imputed principal amount of the new debt instrument issued in consideration for the old debt instrument is limited to the fair market value (FMV) of property pledged to secure nonrecourse debt (as opposed to the stated principal amount of the debt instrument). Based on this rule, an exchange (or modification) of nonrecourse debt could produce significant COD income in a debt restructuring when the value of the secured property is less than the stated principal of the debt. An exchange (or modification) of an outstanding debt instrument for a nonrecourse debt instrument is not a potentially abusive situation solely by reason of the receipt of the nonrecourse financing (Regs. Sec. 1.1274-3(b)(1)). As a result, the imputed principal amount of the debt instrument issued in the exchange is not limited to the FMV of the property.Deferral of Debt Forgiveness Income on the Repurchase of Debt
A debtor that repurchases its own debt instrument for less than the instrument's "adjusted issue price" realizes income equal to the excess of the adjusted issue price over the repurchase price. In addition, debt acquired by a related person described in Sec. 267(b) or 707(b) is treated as if it were acquired by the debtor. Fortunately, the American Recovery and Reinvestment Act of 2009, P.L. 111-5, temporarily permitted a business (including an LLC) that reacquires its own debt at a discount to elect to defer the resulting COD income for a period of four or five years and then spread that COD income over an additional five-year period. The intent was to allow financially strapped businesses to restructure debts without immediately recognizing COD income. The election under Sec. 108(i) was available for COD income triggered by qualifying debt reacquisitions that occurred in calendar years 2009 and 2010.
Observation: Final regulations under Sec. 108(i) were issued in July 2013 and largely reflected the provisions of the prior temporary regulations. However, the final regulations failed to provide guidance in several areas. For example, the IRS decided not to adopt a commenter's suggestion that the final regulations add a safe harbor providing that a debt instrument issued to acquire or improve real property held for rental purposes be considered to be issued in connection with a trade or business if certain requirements are met. Additionally, the final regulations failed to address how the trade or business requirement applies in the case of tiered passthrough entities.
If the Sec. 108(i) election was made for a debt reacquisition that occurred in calendar year 2009, the resulting COD income was deferred until the fifth tax year following the tax year in which the transaction occurred. Starting with that fifth tax year, the COD income is spread evenly over five tax years. If the election was made in calendar year 2010, the COD income was deferred until the fourth tax year following the tax year in which the transaction occurred. Starting with that fourth tax year, the COD income is spread evenly over five tax years. Consequently, the COD income is spread evenly over 2014-2018 whether the election was made in calendar year 2009 or 2010.
When a COD transaction causes a reduction in the member's share of debt, the member's outside basis is reduced accordingly, but that reduction is usually offset by the outside basis increase from the member's allocable share of the related COD income. But if the Sec. 108(i) election was made, the recognition of the related COD income was postponed until 2014. To address this problem, Sec. 108(i)(6) states that to the extent a Sec. 108(i) election causes a reduction in a member's share of LLC liabilities (under the Sec. 752 rules) that triggers a taxable gain in the debt reacquisition year (under the Sec. 731 rules), the basis reduction (the "member's deferred Sec. 752 amount") is deferred until the related COD income is recognized. In effect, the member is allowed to include the deferred Sec. 752 amount in outside basis when the related COD income is recognized, even though the forgiven debt no longer exists (see Rev. Proc. 2009-37, §2.09).
A decrease in a member's amount at risk in an activity from a discharge of debt for which a Sec. 108(i) election was made is not taken into account in determining the member's amount at risk in the tax year of the reacquisition. Instead, the decrease is taken into account (at the same time and in the same amount) as the member recognizes the deferred COD income (Regs. Sec. 1.108(i)-2(d)(3)).
Note: Although basis and at-risk basis are adjusted as income deferred under Sec. 108(i) is recognized, the regulations provide that book capital accounts are adjusted for the COD income as if no election had been made (Regs. Sec. 1.108(i)-2(b)(2)(ii)).
Acceleration of Income
Certain LLC-level acceleration events require a member in an LLC who has made a Sec. 108(i) election to recognize his or her share of the LLC's deferred income in its entirety. Deferred items must be taken into account by the member in the tax year in which the electing LLC (1) liquidates; (2) stops doing business; (3) files a petition in a bankruptcy or similar case; or (4) sells, exchanges, or otherwise transfers (including contributions and distributions) substantially all of its assets. For this purpose, "substantially all" means assets representing at least 90% of the FMV of the LLC's net assets and at least 70% of the FMV of the LLC's gross assets held immediately prior to the sale, exchange, or other transfer (Regs. Sec. 1.108(i)-2(b)(6)(i)).
A sale, exchange, or other transfer by a direct or indirect lower-tier LLC or partnership owned by the electing LLC (lower-tier entity) of all or part of its assets is not treated as a sale, exchange, or other transfer of the assets of the electing LLC. However, a sale, exchange, or other transfer of substantially all of the assets of a transferee LLC or partnership, or of a lower-tier LLC or partnership that received assets of the electing LLC from a transferee LLC or partnership or another lower-tier LLC or partnership in a transaction governed all or in part by Sec. 721, is treated as a sale, exchange, or other transfer by the holder of an interest in that transferee LLC or partnership or lower-tier LLC or partnership of its entire interest in that transferee LLC or partnership or lower-tier LLC or partnership. A transferee LLC or partnership is an LLC or partnership that received all or part of an electing LLC's assets in a transaction governed all or in part by Sec. 721(a) (Regs. Sec. 1.108(i)-2(b)(6)(i)(B)).
A direct or indirect member's share of an electing LLC's deferred items is accelerated and must be taken into income in the tax year in which (1) the member dies or liquidates; (2) the member abandons his or her separate interest; (3) the member's separate interest is redeemed; or (4) the member sells, exchanges, transfers, or gifts his or her separate interest. If only part of the member's separate interest is sold, exchanged, transferred, or given away, a proportionate part of the member's share of the electing LLC's deferred items is accelerated and must be taken into income (Regs. Sec. 1.108(i)-2(b)(6)(ii)).
Transactions wholly governed by Sec. 721 in which a member's share of the LLC's deferred items can continue to be allocated to that member are generally not acceleration events for purposes of Sec. 108(i). Similarly, like-kind exchanges of property by an electing LLC are generally not acceleration events. (However, to the extent boot is received in the exchange, a portion of the transferred property will be treated as sold.) A technical termination of an LLC under Sec. 708(b)(1)(B) is also not an acceleration event since the terminating LLC's Sec. 108(i) election remains in effect for the new LLC. Other nonacceleration events are described in Regs. Sec. 1.108(i)-2(b)(6)(iii).
Section 5 of Rev. Proc. 2009-37 requires electing LLCs to attach statements to their tax return until all implications of the election have been accounted for. These annual statements must be attached to the LLC's Form 1065, U.S. Return of Partnership Income, for years following the year the election is made. For those years, electing LLCs must also supply annual information statements to affected members (as attachments to their Schedule K-1).Acquisitions of Related-Party Debt
The direct or indirect acquisition of debt by a person related to the debtor from a person who is not related to the debtor produces COD income measured by the difference between the outstanding balance of the debt acquired and its FMV (Sec. 108(e)(4)). A related person includes family members, more than 50% owned corporations, and more than 50% owned partnerships or LLCs, as well as certain trust and beneficiary relationships (Secs. 267(b) and 707(b)(1)). A direct acquisition occurs if a person related to the debtor acquires the indebtedness from a person who is not related to the debtor. An indirect acquisition occurs when the holder of outstanding debt becomes related to the debtor if the holder acquired the debt in anticipation of becoming related to the donor (Regs. Sec. 1.108-2(c)).
When the debt is acquired within six months of the parties' becoming related, there is a presumption that the debt was acquired in anticipation of the parties' becoming related. When the debt is acquired six months or more before the parties become related, the transaction must be disclosed on a tax return if the indebtedness is more than 25% of the FMV of the holder group's (i.e., the acquiring party and all persons related to the acquiring party before and after the acquiring party becomes related to the debtor) gross assets or the indebtedness is acquired within 24 months of the date the parties become related. An exception applies when one party acquires related-party debt with a maturity date within one year of the acquisition date and the debt is, in fact, paid off on or before the maturity date (Regs. Secs. 1.108-2(c)(3), (4), and (5); Regs. Sec. 108-2(e)).
Example: G owns 60% of both N LLC and B LLC. Nand B are both classified as partnerships for federal taxes. B owes L Bank $175,000, which is due on Dec. 23, year 2. On Dec. 31, year 1, N acquires the debt from L Bank for $150,000. On Dec. 20, year 2, B pays N $175,000. Since the maturity date was within one year of the acquisition date, no income was recognized at that time. However, because N bought the note at a discount of $25,000, it will recognize $25,000 of short-term capital gain under Sec. 1271(a)(1) when the note is paid off.Transfer of LLC Interest to Satisfy Debt
When a debtor LLC transfers an interest in its capital or profits to a creditor in satisfaction of its recourse or nonrecourse debt, the LLC is treated as satisfying the debt with money equal to the FMV of the transferred interest (Sec. 108(e)(8)). If the satisfied debt exceeds the FMV of the LLC interest, the excess is COD income includible in the distributive shares of the members of the LLC who were members immediately before the debt discharge.
Regulations under Sec. 108(e)(8) address how to determine the amount of COD income that arises upon the issuance of an interest in an LLC classified as a partnership to a creditor in satisfaction of LLC debt (i.e., an LLC debt-for-equity exchange). The regulations provide a safe-harbor rule under which the FMV of the exchanged LLC interest is deemed to equal its liquidation value (the amount the creditor would receive if the LLC sold all its assets for FMV and liquidated). The Sec. 721 nonrecognition rule generally applies to such LLC debt-for-equity exchanges. The regulations provide a reasonably simple set of rules that can be applied to LLC debt-for-equity exchanges and contain no complicated rules for situations where LLCs and lenders are related parties.
This case study has been adapted from PPC's Guide to Limited Liability Companies, 20th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.