Incorporating an Insolvent Partnership: Availability of the Insolvency Exclusion

Editor: Mindy Tyson Weber, CPA, M.Tax.

Partners & Partnerships

A corporate taxpayer’s cancellation of debt (COD) income is excluded under Sec. 108(a)(1)(B) to the extent of the corporation’s insolvency (total liabilities in excess of the fair market value (FMV) of total assets). Sec. 108(d)(6) provides that, in the case of a partnership, insolvency determinations apply at the partner level rather than the partnership level. Therefore, to the extent a solvent partner receives an allocation of COD income from a partnership, the insolvency exclusion is not available.

However, based on a recent revenue ruling, the extent of a partnership’s insolvency may be a significant factor in determining a partner’s insolvency. In Rev. Rul. 2012-14, the IRS held that to the extent discharged excess nonrecourse debt generates partnership COD income allocated to the partners under Sec. 704(b) and the regulations thereunder, each partner should treat its allocable portion of the excess nonrecourse debt generating COD income as a liability when measuring insolvency.

If the partners receiving the COD income are solvent (and no other exclusions from COD income apply), the partners may be tempted to incorporate the partnership (or their partnership interests) prior to the COD income event to claim the insolvency exclusion at the corporate level. This item analyzes the merits of such an incorporation, as well as issues taxpayers and advisers should consider.

Example 1: Assume ABC LLC is a partnership for federal tax purposes, with three partners, A, B, and C. A, a private-equity fund, owns 80% of ABC. ABC has assets with an FMV of $300 and owes $500 to unrelated third parties, thereby making ABC insolvent by $200. ABC has negotiated a write-down of the debt with its creditors, whereby the creditors agreed to reduce the debt by $200, resulting in realized COD income of $200. Since the exclusions under Sec. 108(a) apply at the partner level, the partnership will include on the partnership return $200 of COD income that will flow through to the partners. Unless the partners qualify for an exclusion from COD income at the individual level, the COD income will be includible in the partners’ taxable income.

However, prior to the COD income event, A’s attorney suggests that ABC check the box to elect treatment as a corporation before the COD income event to claim the insolvency exclusion at the corporate level. Alternatively, A’s attorney suggests that A could transfer its 80% interest in ABC to a newly created corporation (Newco). Since the 80% interest in ABC would be Newco’s only asset, Newco would be insolvent after applying Rev. Rul. 2012-14 and could exclude the COD income under the insolvency exception.

At this point, it remains unclear whether the partners and partnership intend to report the incorporation as a tax-deferred transaction under Sec. 351 or as a taxable incorporation under Sec. 1001. While an in-depth analysis of the application of Sec. 351 is beyond the scope of this article, it is important to determine the availability of Sec. 351 when incorporating an insolvent partnership, as well as the applicability of Secs. 362(e)(2), which limits built-in losses in Sec. 351 transactions, and 357(b)–(d), which govern the assumption of liabilities.

Whether undertaking a nontaxable or taxable incorporation, two significant issues should be considered before claiming the insolvency exclusion: (1) the extent to which Sec. 269 could apply to disallow the intended benefits of the insolvency exclusions, and (2) the amount of liability actually assumed by the corporation, which in turn significantly impacts the amount of COD income realized inside rather than outside the corporation.

Application of Sec. 269 to Incorporation Before COD Income Event

Sec. 269 establishes an anti-abuse rule for acquisitions made to avoid or evade income tax. Specifically, Sec. 269(a) provides that when any person or persons acquire control of a corporation and the principal purpose of that acquisition is to evade or avoid federal income tax by securing the benefit of a deduction, credit, or other allowance that the person or corporation would not otherwise enjoy, the IRS may disallow the deduction, credit, or other allowance.

Acquisition of control: For the purposes of this rule, “control” means the ownership of stock possessing at least 50% of the total combined voting power of all classes of stock entitled to vote or at least 50% of the total value of shares of all classes of stock of the corporation (Regs. Sec. 1.269-1(c)). A “person” includes an individual, trust, estate, partnership, association, company, or corporation (Regs. Sec. 1.269-1(d)). Regs. Sec. 1.269-5(a) clarifies that the acquisition of control need only be by a person or persons and does not appear to require any relationship between the persons acquiring control, as long as the other requirements of Sec. 269 are met. For example, an acquisition by 100 unrelated individuals of 1% each of a corporation could result in acquisition of control for purposes of Sec. 269.

Since the incorporation represents a transfer of property to a corporation in exchange for stock of the corporation, there is no reason to conclude that the transfer of assets, whether under Sec. 351 or Sec. 1001, falls outside the purview of Sec. 269 acquisitions.

Securing an allowance the transferor would not otherwise receive: Regarding the second requirement, Regs. Sec. 1.269-1(a) provides that the term “allowance” refers to anything in the Code that has the effect of diminishing tax liability. The term includes, among other things, a deduction, credit, adjustment, exemption, or exclusion. Thus, the exclusion under Sec. 108(a) would fall under the definition of an “other allowance.” Further, Regs. Sec. 1.269-3(a) provides that it is immaterial by what method or by what conjunction of events the benefit was sought. Thus, a person acquiring control of a corporation may be treated as securing the benefit of a deduction, credit, or other allowance within the meaning of Sec. 269 even though it is the acquired corporation that actually includes the deduction, credit, or other allowance in determining its tax.

In the case of the insolvency exception, a solvent partner in a partnership cannot exclude the COD income, whereas a corporation can. As a result, the acquisition of control of the corporation would appear to provide an exclusion the shareholders would not receive.

Principal purpose to evade or avoid income tax: Regs. Sec. 1.269-3(a) provides that if the purpose of evading or avoiding federal income tax exceeds in importance any other purpose for a transaction, it is considered the principal purpose. The regulations also provide that the determination of the purpose for an acquisition requires scrutiny of all circumstances under which the transaction occurred.

To ascertain the potential impact of Sec. 269 on a transaction, the first consideration should be whether a tax was evaded or avoided. If so, it must be determined whether the evasion or avoidance was the acquisition’s principal purpose. A taxpayer could argue that because of the basis reductions required under Sec. 108(b), the transaction resulted in a timing difference rather than a true exclusion of income, since the basis reductions result in a loss of future deductions. However, the basis reduction limitation of Sec. 1017(b)(2) calls that argument into question.

Example 2: Assume under the facts in Example 1 that the adjusted tax basis of ABC’s assets was $100 and there were no other tax attributes. Following the COD income event, ABC retained $300 in debt and would have a required basis adjustment under Sec. 108(b) of $200. However, under Sec. 1017(b)(2), the basis adjustment would be limited to $0 because ABC’s liabilities immediately after the COD income event exceed the $100 adjusted tax basis of ABC’s assets.

Assuming that the exclusion of COD income would represent avoidance or evasion of income tax, next consider whether the principal purpose of the incorporation is the ability to claim the insolvency exception. This is a facts-and-circumstances determination that requires looking at the business purpose for the incorporation as well as pre- and post-incorporation activities and transactions. For example, if following, or in connection with, the incorporation and COD income event, ABC disposed of its operating assets and liquidated, it may be difficult to establish that the exclusion of the COD income was not the principal purpose. Furthermore, the incorporation and subsequent liquidation (actual or de facto) may represent a transitory incorporation and be disregarded for tax purposes.

There are a number of factors that might help establish that the exclusion of COD income by the corporation was not the principal purpose of the incorporation. First and foremost, a strong nontax business purpose for the incorporation would be strong evidence.

For example, assume ABC is bringing in new investors and leadership to help the company stay in business. Assume further that those investors would agree to invest only in an entity taxed as a C corporation. Perhaps the investors are foreign or tax-exempt investors that want to avoid the administrative complications of receiving Schedules K-1, or perhaps the investors simply prefer operating under the corporate form. It seems reasonable to conclude that incorporating a business to attract new investors to save the business represents a substantial business purpose. However, whether this or any other purpose outweighs the importance of the exclusion of COD income at the corporate level is subject to IRS scrutiny.

Other factors would include the insolvency of the shareholders. If the shareholders are insolvent, the corporation’s exclusion may not provide a benefit to the corporation that the shareholders did not also have. Also, the proximity of the COD income event to the incorporation is likely important. If the incorporation occurs before any consideration or negotiation of a COD income event, it would be more difficult for the IRS to argue that the principal purpose of the incorporation was exclusion of COD income.

Clearly, taxpayers and advisers should carefully consider the potential that Sec. 269 would apply to the incorporation of an insolvent partnership that occurs contemporaneously with a COD income event.

Assumption of Liabilities in Incorporation

Assuming the taxpayer has a sufficient level of comfort that Sec. 269 does not apply, the other question that must be answered is whether the corporation genuinely assumed the liabilities that are discharged following the incorporation. To the extent the debt is not assumed, because it is deemed to be either discharged immediately before the incorporation or not genuinely assumed, the COD income event occurs outside the corporation. Whether a liability is assumed in a transaction is based on the facts and circumstances surrounding the assumption. Courts have looked to a variety of factors in determining whether the liability was truly assumed, focusing on the genuineness of the liability purportedly assumed and factors such as:

1. Whether the liability is in excess of the property’s FMV;
2. Whether the terms of the liability are negotiated at arm’s length;
3. Whether the debtors have sufficient financial resources to repay the liability; and
4. Whether the parties intend that the debtor-creditor relationship be established and the liability repaid (see Taube, 88 T.C. 464 (1987); Roe, T.C. Memo. 1986-510, aff’d by unpub. order (8th Cir. 4/1/88); and In re Stroupe, No. 83-1955 (Bankr. M.D. Fla. 1986), aff’d, 101 B.R. 760 (M.D. Fla. 1988)).

The status of a liability as nonrecourse does not necessarily limit assumption of the liability in a transaction. However, its nonrecourse nature does require a more in-depth analysis. For example, the courts have disregarded assumption where (1) the purported liability was nonrecourse and significantly exceeded the value of the property transferred, and (2) the payment of the liability would occur only out of future profits of the business (see Estate of Baron, 83 T.C. 542 (1984), aff’d, 798 F.2d 65 (2d Cir. 1986); Wildman, 78 T.C. 943 (1982); and Snyder, T.C. Memo. 1985-9).

Further, a liability has been disregarded where no payments of principal or interest were made on the debt (Finoli, 86 T.C. 697 (1986)). In Finoli, the question was whether a purported liability was created upon acquisition of equipment. The same analysis would apply to an assumption by a corporation of an existing liability. The question is not whether the liability had ever been valid, but rather whether it represented a genuine liability at the time the corporation assumed it. This question is of particular concern where a corporation purports to assume a liability discharged in whole or in part shortly after assumption.

With respect to Sec. 351 transfers in particular, Sec. 357(d) provides rules for determining whether, and to what extent, a liability is considered assumed for the purposes of Sec. 357(a) and certain related provisions. However, nothing in Sec. 357(d) appears to override the fact that a liability must be genuine before it is considered assumed under Sec. 357.

Factors to consider in determining liability assumption: Because the facts and circumstances surrounding every incorporation differ, no list of factors is all-encompassing. However, as addressed above in part, taxpayers and advisers should consider the following:

1. How extensive have negotiations been with creditors on a discharge?
2. How much time elapsed between incorporation and discharge?
3. Were any interest or principal payments made following the incorporation?
4. What was the nontax business purpose for the incorporation?
5. Will the business continue following the discharge?

Incorporation of less than all LLC units: Looking at the incorporation of less than 100% of the LLC (80% in the example above), the question differs slightly, but the analysis remains the same. If, for example, 80% of the units were transferred to a new corporation, the LLC would remain taxed as a partnership, albeit resulting in a technical termination. Therefore, the LLC would still realize COD income. Yet, the same issues arise, including (1) whether the LLC’s stated liabilities at the time of the transfer were genuine; and (2) whether the COD income event, in substance, occurred prior to the transfer.

Check-the-box incorporations and state law conversions: It could be argued that an assumption in a “check-the-box” incorporation or state law conversion into a corporation should be looked at differently than an actual assumption of liabilities because the debtor does not change from a legal perspective and no express assumption occurs. That argument appears weak. The deemed transfers that occur due to a tax election or conversion result in the same tax consequences as actual transfers for basically all federal income tax purposes. Thus, the argument that a deemed assumption would be looked at differently than an actual assumption does not appear to be based on relevant federal income tax authorities.

Conclusion

Incurring COD income at the partnership level may provide significantly different, and potentially detrimental, tax results to owners in a partnership than would incurring COD income at the corporate level. As a result, it may appear tempting to incorporate an insolvent partnership before the occurrence of the COD income event in the hopes of receiving the benefit of the insolvency exception. Prior to proceeding, taxpayers and advisers should carefully consider the tax implications of such an incorporation, as tax traps may exist.

EditorNotes

Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.