Recently Issued Sec. 108(e)(8) Regulations: Liquidation Value Safe Harbor

By John R. McGowan, Ph.D., CPA, CFE; Troy Luh, Ph.D., CPA/ABV/CFF, M.S.; and Douglas Murphy, M. Acc.




  • Recently issued final regulations on partnership debt-for-equity exchanges contain a liquidation value safe-harbor method for valuing the partnership interest received in exchange for the cancellation of debt.
  • Under the liquidation value safe harbor, the value of the partnership interest is the amount of cash that the creditor would receive if the partnership sold all of its assets for cash equal to their fair market values immediately after the creditor received the interest and then liquidated.
  • Commentators have criticized the regulations, noting that they require partnerships to recognize COD income in a debt-for-equity exchange, while not allowing the creditor to recognize a bad debt expense.

An increasing number of businesses are finding it difficult to pay their debt obligations as a result of tight credit and a slow economy. In many cases, businesses are reducing debt by issuing ownership interests in the entities. Since 1993, when the Omnibus Budget Reconciliation Act 1 was enacted, the tax consequences for the issuance of corporate interests in exchange for debt have been clear. Cancellation of debt (COD) income results when the fair value of the corporate interest is less than the value of the debt. 2 Such clarity did not exist for partnerships.

In the American Jobs Creation Act of 2004, 3 Congress applied the corporate rule to partnerships by amending Sec. 108(e)(8). After Oct. 21, 2004, a partnership recognizes COD income when the value of partnership equity it transfers in a debt-for-equity exchange is less than the value of the debt it receives from the lender. But the 2004 statute left many questions unanswered. For example, how should partnerships determine the fair market value (FMV) of partnership interests issued to creditors? Instead of hiring appraisers to determine FMV, could partnerships use liquidation value? Could taxpayers recognize any losses upon the exchange of a debt interest for the partnership interest? What tax treatment would result when partnership interests are issued partly in exchange for accrued ordinary income items, such as unpaid interest, rent, or royalty income?

In 2008, the IRS issued proposed regulations under Secs. 108(e)(8) and 721, whereby COD income must be recognized whenever a partnership interest is issued in exchange for a debt interest at a discount. 4 In an effort to provide guidance for taxpayers, the proposed regulations introduced a “liquidation value safe harbor.” Under this safe harbor, the FMV of the debt-for-equity interest will be deemed to be the liquidation value if (1) the debtor partnership determines its partners’ capital accounts under Regs. Sec. 1.704-1(b)(2)(iv); (2) the creditor, debtor partnership, and its partners treat the indebtedness’s FMV as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-for-equity exchange; (3) the debt-for-equity exchange is an arm’s-length transaction; and (4) subsequent to the debt-for-equity exchange, neither the partnership redeems nor any person related to the partnership purchases the debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange that has as a principal purpose the partnership’s avoidance of COD income. 5

The IRS finalized the Sec. 108(e)(8) regulations on Nov. 11, 2011. 6 The final regulations define the “liquidation value” of a partnership interest as the amount of cash that the creditor would receive if the partnership sold all of its assets for cash equal to their FMVs immediately after the creditor received the interest and then liquidated. 7

A close inspection of these rules suggests that taxpayers are still largely on their own in coming up with the actual fair market or cash value of their assets to determine liquidation value. This article assists the practitioner by analyzing the definition of liquidation value in the literature on valuation. This article also addresses the part of the final regulations that forbids creditors from taking a bad debt deduction when they accept partnership interests in exchange for debt.

It is difficult for taxpayers to accept tax rules that require the recognition of ordinary income by a partnership on the one hand yet deny a corresponding ordinary tax deduction for the creditor. Accordingly, this article addresses the detrimental effect of tax rules that taxpayers perceive as unfair and/or overly complex. Finally, a detailed consideration of the remaining provisions in the final regulations is also included.

Basic Rules

The Sec. 108(e)(8) final regulations state that when a party transfers its creditor position to the debtor partnership in exchange for an equity interest, there is generally no gain or loss to the partnership, except that the partnership realizes cancellation of indebtedness (COD) income equal to the difference between the debt and the value of the interest received. 8 Moreover, the Sec. 721 approach is maintained whereby a debt-for-equity exchange may not be bifurcated to allow the creditor to recognize a loss or bad debt deduction as part of the exchange. 9

Creditors Denied Bad Debt Deduction

The final debt-for-equity regulations under Secs. 108(e)(8) and 721 also incorporate the interest-first ordering rules, which require that any payment received in a debt workout be applied first against interest and then to principal. 10 This result seems especially unfair when an accrual-based creditor accrues interest income and pays the related tax. Upon a subsequent debt-for-equity exchange at a discount, not only does the creditor fail to receive the interest income from the partnership, but he or she also is denied a bad debt deduction. The bifurcation of the debt-for-equity exchange would address this concern. In recognition of the changing ownership interest from debt to equity, the creditor should be able to take a bad debt deduction when the value of the ownership interest is less than the debt obligation.

A majority of people who commented on the proposed regulations spoke in favor of bifurcating the debt-for-equity exchange in cases where the FMV of the partnership interest is less than the debt obligation. 11 They argued that a bad debt deduction should be allowed for the difference between the FMV of the equity interest and the value of the debt obligation. The balance of the exchange could then be treated as a nontaxable exchange under Sec. 721. Similarly, in its comments on the proposed regulations, the AICPA questioned whether it was appropriate to deny the creditor an ordinary Sec. 166 bad debt deduction in such transactions. 12 The AICPA also pointed out how this treatment creates distortions for partnerships that do not exist for corporations. Although the IRS received many comments advocating bifurcation, it explicitly rejected this approach in the final regulations. 13

The following example from the AICPA’s comment letter on the regulations illustrates how a debt-for-equity exchange results in a higher outside than inside basis both before and after a creditor’s interest is liquidated. This outcome is a direct result of the creditor’s not being able to take a current bad debt deduction.

Example 1. Discrepancy with outside and inside basis: Suppose nonpartner individual A converts her $100x loan to the partnership into partnership equity worth $60x. Assume at the time of the conversion, individuals B and C are partners and the partnership’s tax basis in its assets is $120x (which also equals B and C’s combined outside basis).

When A’s $100x loan is converted into equity, B and C would have COD income of $40x. Accordingly, their outside basis would be increased by $40x and decreased by the $100x of debt extinguished under Sec. 752(b). As a result, B and C would have a combined outside tax basis of $60x ($120x + $40x $100x). A would have an outside basis in her partnership interest of $100x. 14 After the conversion, the final result would be a total outside basis of $160x in the partnership and an inside basis of $120x.

If A’s interest is later liquidated for $60x, she would claim a $40x capital loss. Next, assuming a Sec. 754 election was in effect and the mandatory basis adjustment rules apply, the partnership would have to reduce the inside basis of its assets by $40x. This $40x adjustment would reduce the inside basis of the assets to $20x. 15 The partners’ combined outside basis would be $60x.

Practitioners have observed that the new rules prevent cash-basis taxpayers from converting ordinary income into capital gain upon contribution of unpaid interest and debt to the partnership in exchange for equity. 16 The problem is the way this objective is accomplished. The final regulations stipulate that the equity interest received by the creditor satisfies the interest obligation first. The balance of the equity interest satisfies the debt obligation. 17

Example 2. Unpaid interest (cash-basis creditor): Assume A and B form partnership P , each contributing $500. P later receives a $1,000 interest-only note from creditor C , who is a cash-basis taxpayer. P uses this note and its equity to purchase a $2,000 asset. At the end of the year, the asset decreases in value to $800. In addition, assume C has $200 of accrued, unpaid interest. P then issues C an interest in P worth $800 to satisfy the indebtedness. Under the regulations, the first $200 of the P interest received by C would be deemed to satisfy the $200 of accrued, unpaid interest. C would recognize $200 of ordinary income. P is deemed to have satisfied the remaining $1,000 of debt with the remaining $600 of P interest. P would recognize COD income of $400. C would be left with an outside basis in P of $1,200 ($1,000 carryover basis from the note, plus $200 basis from the accrued interest).

Once again, if the remaining value of the partnership interest is less than the outstanding debt obligation, the taxpayer does not receive a bad debt deduction. Instead, the basis of the debt obligation is increased by interest income recognized by the creditor and carries over into the new basis of the partnership equity interest. 18

Example 3. Basis of debt carries over to equity interest: In year 1, I and T each contribute $500 cash to form the IT partnership. IT purchased some computers for $5,000 to use in the new web design business. The partnership financed the purchase of the computers with $500 of the equity and a note from R, the lender, for the remaining $4,500. At the end of year 3, IT desired to reduce its debt exposure and issued a partnership interest to the lender worth $4,000 in exchange for the note and outstanding interest. Assume that R was an accrual-basis taxpayer and had already accrued $600 of interest income at the end of year 3. The result is that the first $600 in value of the equity interest will be allocated toward the outstanding interest and create taxable income for R. The remaining $3,400 is applied to the debt obligation. This would also produce $1,100 ($4,500 $3,400) in COD income for the existing partners, I and T. The new basis of R’s partnership interest would be $5,100 ($4,500 carryover basis from debt obligation + $600 of interest).

Example 4. Unpaid interest (accrual-basis creditor): If C were an accrual-method taxpayer and had already recognized the interest income, the result of the transaction in Example 2 would be the same. The first $200 of the P equity interest C received would be deemed to satisfy the $200 of accrued, unpaid interest. Already having recognized $200 of ordinary income, C would not recognize this amount again. P would be deemed to have satisfied the remaining $1,000 of debt with the remaining $600 of P equity interest. P would recognize COD income of $400. Once again, C would be left with an outside basis in P of $1,200 ($1,000 carryover basis from the note, plus $200 basis from the accrued interest). The fact that C is an accrual-basis taxpayer only creates a timing difference for the recognition of the interest income by C .

Denial of Bad Debt Deduction Viewed as Unfair

An example of a common principle of fairness in the Code is where creditors recognize losses or bad debt expenses when debtors recognize COD income. 19 Both the proposed and final regulations under Sec. 108(e) failed to provide taxpayers with this traditional symmetry. Instead, creditors that contribute their debt are entitled to a carryover basis of their debt interest, even after recognizing ordinary income on interest receivable as part of the exchange.

This denial of a loss and bad debt deduction is viewed as even more unfair when an accrual-basis taxpayer is forced to recognize taxable income that he or she may never receive. This example illustrates a problem with the Sec. 108(e)(8) regulations in that they do not follow the matching principle that usually applies in the Code.

Matching Principle in the Code

Various commentators explain how the matching principle is often used to test whether an accounting method clearly reflects income. 20 For example, Sec. 267(a)(2) requires matching in cases where related taxpayers use different accounting methods. More specifically, one taxpayer may not take a deduction for an expense until the related taxpayer recognizes the corresponding income. Another example where the deduction of an expense is denied until the corresponding income is recognized is Sec. 404(d), under which payments of deferred compensation to independent contractors may not be deducted until the year when the contractors recognize the income.

A third example is Sec. 274(e)(2), which now requires that items be included in income before payments for entertainment expenses for goods, services, or facilities provided to officers, directors, or 10%-or-greater owners may be deducted. One final example where the Code adopted the matching principle is Sec. 83 and restricted stock awards. 21 The employer may deduct the compensation, and the employee must recognize the income when the shares are vested.

Unfair Tax Rules Can Promote Taxpayer Noncompliance With the Code

The complexity and perceived unfairness of tax rules, combined with the frustration of not receiving expected tax benefits, can motivate many normally law-abiding citizens to contemplate noncompliance with tax laws. 22 For example, National Taxpayer Advocate Nina Olson argued for the elimination of “tax traps” to promote voluntary tax compliance. Tax traps are anomalous tax rules that seem unfair, such as those that tax “phantom income” (i.e., income that the taxpayer did not really receive, or received and then lost, from an economic perspective). The denial of the bad debt loss deduction under the Sec. 108 regulations is a prime example of what Olson described as a tax trap. Olson also explained how tax traps can move taxpayers from trying to comply with the rules into the category of those looking for ways to avoid their tax obligations.

Recent reports on tax compliance propose that changing tax laws to provide more consistency across tax provisions would promote increased compliance. 23 In the context of financial derivatives in particular, one prime example of inconsistency is the tax rule that inadvertently changes ordinary losses into capital losses. The co-author of the Sec. 108(e) regulations indicated that the IRS understood these objections, but that the COD regulation project was not the appropriate forum to make these changes. 24 He added that it was an income tax and accounting issue. In summary, Congress should avoid the imposition of tax rules that communicate to taxpayers the impression that heads means the IRS wins and tails means the taxpayer loses.

Liquidation Value Safe Harbor

The IRS normally considers all the facts and circumstances of a transaction to determine whether it reflects economic reality and has a business purpose. However, in certain cases, the IRS permits a simpler accounting method for determining the tax effects of a transaction. 25 These types of exceptions are usually called “safe harbors.”

The proposed and final Sec. 108(e)(8) regulations include a safe-harbor provision called the “liquidation value safe harbor” (defined above).

The intent of the safe-harbor conditions is to ensure that all parties to the transaction use an arm’s-length standard to value the partnership equity interest issued in exchange for the debt. The premise is that the creditor would therefore not agree to an artificially inflated liquidation value that would help the existing partners avoid COD income. One problem with this premise is that the creditor does not have any motivation from a tax perspective to ensure the agreed-upon liquidation value of the equity interest is equal to the basis of the debt. The creditor will receive a carryover debt basis for the partnership equity interest in any event. Moreover, the creditor may not be willing to cooperate after being forced by the new regulations to recognize income for accrued interest that he or she does not receive in the current period.

The practicality of the liquidation safe-harbor provision has also been brought into question. For example, one practitioner noted how easily the arm’s-length requirement could be brought up during an IRS examination. 26 Once an IRS agent questions the comparability of the terms of the debt-for-equity transaction in an exchange between unrelated parties, it immediately becomes a facts-and-circumstances analysis.

Another problem is the actual calculation of the liquidation value for purposes of this safe harbor. Safe-harbor liquidation value is defined as the amount of cash the creditor would receive if the partnership sold all of its assets at their FMVs immediately after the creditor received the interest and then liquidated. The regulations do not provide any further guidance for taxpayers to compute liquidation value under this definition. Thus, the regulations can be interpreted to allow a taxpayer to use any reasonable method of determining the liquidation value of the business under the safe harbor, although this issue has yet to be addressed by the IRS or in the courts. In an effort to provide taxpayers practical assistance in the calculation of liquidation value under this safe harbor, the following section presents three commonly used approaches to value a business from the valuation literature.

Common Valuation Methodologies and Liquidation Value

The three common ways to value a business are the income, market, and asset approaches. Different methods are also applied under each approach. 27 The presence of certain facts and circumstances will guide the practitioner in choosing the appropriate valuation approach and method.

Income Approach

The most commonly used valuation approach is the income approach, which bases the company’s value on the present value of future earnings. To use this approach, there must be a history of positive operating results that are expected to continue. 28 Typically, when an income approach is used, it results in the recognition of goodwill value. Goodwill value, an intangible asset, is the company’s value in excess of the fair value of its net assets. 29 For example, assume that the present value of a company’s future earnings is calculated to be $100,000 and the fair value of the net assets is $30,000. Goodwill value would be $70,000, or the amount that the company’s value exceeded the fair value of its net assets.

The use of an income approach based on future earnings assumes that a company will continue as a going concern into the foreseeable future. This is contrary to the premise of liquidation value that assumes the assets of a company will be liquidated in the near future and there will be no recognition of goodwill value. The income approach, therefore, is not appropriate when there is a history of volatile or negative earnings, or the forecast of future earnings is negative. If marginal earnings are expected, a market or asset approach must be used.

Market Approach

The market approach determines a company’s value by using the sales of the same or similar companies under the same or similar market conditions. To use a market approach, there must be a sufficient number of market transactions to make a reasonable comparison. The IRS favors this method because it is based on actual transactions of similar assets. 30

The practical application of this method can be challenging as it may be difficult to find companies comparable in size, structure, product makeup, etc. It can also be difficult to defend a value based on market transactions if the value is challenged by the IRS or in litigation. Each transaction can be scrutinized and attacked as not being perfectly comparable to the subject company.

The market approach may or may not provide evidence of goodwill value. Although applying the market approach usually results in the recognition of goodwill value, in rare cases, the company’s market value approximates or is less than its asset value, indicating a lack of goodwill.

Asset Approach

Companies may also be valued using an asset-based approach, under which the company is valued based on the fair value of its underlying net assets. Net assets are defined as the total assets minus liabilities. An asset-based approach is appropriate when the company has significant tangible assets such as buildings, land, equipment, or other fixed assets. Real estate holding companies and asset-holding companies are usually valued based on an asset approach. Also, an asset approach is appropriate for companies that have a volatile earning history or where future earning capacity is limited.

An asset-based approach usually results in the lowest value for a company. If either an income or market-based approach results in a value below an asset-based approach, an asset-based approach would be used to determine value. This implies that an investor would not sell his or her interest at a price below what the company’s net assets (assets minus liabilities) would sell for at fair value. For example, if the value using the income approach and market approach resulted in a company value of $200,000 and the value based on an asset-based approach was computed to be $250,000, the assets-based approach would be selected. In other words, a business owner would not sell a company holding net assets valued at $250,000 for $200,000.

Two primary methods are considered to be asset-based methods: the net asset value method and the liquidation value method. Both methods determine the company’s value based on the value of the underlying assets. The primary difference is the assumptions made about the continuation of the business.

Net asset value: The net asset value assumes that the company will continue to operate in the foreseeable future and meet future obligations. It assumes that the assets will be sold in a hypothetical sale as part of a going concern. 31 Going-concern value typically assumes sufficient time to find a buyer willing to pay the seller the assets’ fair value, which results in a value significantly higher than liquidation value. No pressure or compulsion is assumed on behalf of the buyer or seller. Since the assets’ book value typically does not represent FMV, it is not unusual to recognize substantial capital gains on the company’s fixed assets. This is particularly true with assets such as land and buildings that have significantly appreciated from their book amounts.

Liquidation value: Liquidation value assumes that the business will not continue in the future, but the assets will be liquidated over a limited period of time. With the limited exposure to the market, the assets are typically sold at a price significantly less than FMV. Fixed assets often require a year or more to realize full FMV on the open market. The lower market price results from a limited exposure to potential buyers as well as reduced marketing efforts by the seller. Liquidation value is typically appropriate when the company is facing bankruptcy and will not continue as a going concern. Once the valuation expert has determined that liquidation value is the valuation methodology, the expert should select from one of two premises of value: (1) orderly liquidation or (2) forced liquidation.

Orderly Liquidation

An orderly liquidation assumes that the assets do not have a full amount of time, but do have a reasonable amount of time, to be sold on the open market. It is the value of an asset sold on a piecemeal basis with reasonable exposure to the market. 32 This usually takes place within six to nine months. 33 To value the assets under this method, the company must have the ability to stay in business for the appropriate length of time. This approach is not appropriate if the company lacks the funds or ability to stay in business for at least six months. An orderly liquidation assumes sufficient time to advertise and market the sale of the assets to the appropriate buyers.

Forced Liquidation

In a forced liquidation, the seller has limited time to liquidate the assets and pay off the creditors. This approach is appropriate when the company lacks the ability to stay in business long enough to ensure an orderly liquidation, which results in receiving a reduced amount for the assets. This type of value is based on the amount received in a quick sale, such as an auction or sale on the courthouse steps. Forced liquidation value can be difficult to estimate since a number of assumptions must be made and may vary from one appraiser to the next.

It should be noted that both an orderly liquidation and forced liquidation assume a certain amount of compulsion in the company’s liquidation. However, in a forced liquidation, the company loses a significant amount of control in the sale of the assets. Further, assets in an uncompleted form such as inventory are considered sold as is, and not subject to further processing. Again, in a forced liquidation, the company is assumed to lack the ability or funds to convert those assets, thus reducing the company’s overall asset value.

A number of steps are necessary to determine a company’s value using either of the liquidation value methods. 34 To value a company using the liquidation method, a balance sheet must be prepared as close to the valuation date as possible. If interim statements are necessary, they must be current and adjusted for accruals and deferrals such as depreciation and accrued interest.

After a balance sheet is obtained, the assets and liabilities must be adjusted to their liquidation values. The size of the adjustment is affected by whether an orderly or forced liquidation is assumed. Again, the assumption of a forced liquidation usually results in a lower value of the company assets and thus a lower overall value.

The appraiser then determines the amount of proceeds, before taxes and selling costs, which would be received as the result of the asset liquidation. The proceeds are then reduced by the company’s direct and indirect expenses. The value is then adjusted for any net income or net loss to date. The estimated liquidation values of the liabilities are subtracted from the estimated proceeds to arrive at an estimated net proceeds amount. This amount is adjusted for any potential tax liability and capital gains that exist as a result of income from operations and the hypothetical liquidation of the assets (although recognition of a capital gain is rare using liquidation value). The net liquidation value should be discounted to present value if the estimated liquidation time period is more than 30 days. Finally, the appraiser determines if any discount should be applied to the final value, such as a discount to reflect a minority interest or to reflect a lack of marketability.

Impact of Valuation Method on Amount of COD Income Under the Sec. 108(e)(8) Regs.

The liquidation value safe harbor in the new regulations allows taxpayers to use an estimate of the amount of cash that would be received from the liquidation of a partnership at fair value. In addition, the regulations stipulate that the estimate must satisfy the arm’s-length standard as negotiated between parties with adverse economic interests. There is also a prohibition of any subsequent purchase or disposition of the partnership equity interest by a related party in an effort to avoid COD income. However, as shown from the valuation literature, there is a great deal of latitude on the resulting estimate of fair value depending on the valuation method chosen.

The most commonly used valuation method is the income approach, which relies on earnings to estimate fair value. In cases where earnings are volatile, a market-based approach would be used. Using the market approach will usually result in higher fair value estimates. The liquidation value method typically results in the lowest value of any of the commonly used valuation methods. Of the two liquidation methods, the orderly liquidation method is more commonly used. A general rule of thumb is that an orderly liquidation will net less than half of fair value and a forced liquidation will net one-fourth of fair value. 35

Use of liquidation value can have a significant tax impact on the amount of COD income that should be recognized when a partnership equity interest is transferred to a creditor in exchange for outstanding debt. Typically, the liquidation value approach is used when companies are facing liquidation through bankruptcy or other distressed sales transactions. More often, practitioners will select either the income or market approach, which will lead to higher estimates of value. There is an inverse relation between the estimate of value for the equity interest and the amount of COD income recognized by the existing partners on the exchange of debt for equity.

Other Provisions Under 108(e)(8) Regs.

Debt From the Performance of Services

If the debt arose from the performance of services, the regulations handle this in the same manner as if the debt arose from a note. However, the final regulations warn against sneaking in disguised payments for services and getting Sec. 721 nonrecognition treatment. The regulations state that all facts and circumstances are considered in determining the FMV of the partnership interest transferred as compared with the note’s FMV. If the FMV and partnership interest differ in value, general tax principles could apply to alter the tax treatment to the extent of that difference, and Sec. 707(a)(2)(A), as it relates to the treatment of payments to partners for transfers of property, will be considered if appropriate. 36

Installment Obligations

The preamble to the final regulations notes that proposed regulations under Sec. 453(b) are forthcoming to determine whether a creditor must recognize any deferred gain or loss when a creditor contributes an installment obligation to the debtor partnership, even if the transaction otherwise qualifies under Sec. 721. The regulations note that this treatment would be consistent with the treatment of a creditor of a corporation that contributes an installment obligation to a debtor corporation. 37

Example 5. Installment obligation similar to corporations: Assume P purchases an asset from C in an installment sale for $500, $100 owed each year. During year 3, after P has already paid $200 to C, P realizes it cannot make these payments anymore and offers C an interest in P for $200. C accepts this. If the proposed regulations under Sec. 453(b) are consistent with the treatment of a debtor corporation, then C will recognize $100 of loss on the disposition of the installment obligation. C’s outside basis in his interest in P will be $200. P will recognize $100 of COD income.

Example 6. Installment obligation differs from corporations: If the new Sec. 453(b) regulation’s treatment of installment obligations is different from corporate treatment, then in the above example C will most likely not recognize any gain or loss. Instead, C’s outside basis in his interest in P will be $300, thus deferring any potential loss until he disposes of the interest. P will again recognize $100 of COD income.

Gain or Loss to Partnership

Finally, the final regulations make clear that in a debt-for-equity exchange where the partnership has not disposed of any of its assets, the partnership should not be required to recognize gain or loss on the transfer of a partnership interest in satisfaction of its indebtedness for unpaid rent, royalties, or interest that accrued on or after the beginning of the creditor’s holding period for the indebtedness. 38


The tax treatment afforded the creditor in a debt-for-equity exchange under the new Sec. 108(e)(8) regulations has received widespread criticism. When the fair value of the equity interest received by a creditor is less than the value of the debt interest exchanged, no bad debt deduction is allowed. Furthermore, when interest has accrued on the debt instrument prior to the exchange, the creditor must recognize ordinary income. The denial of the bad debt deduction along with the requirement to recognize ordinary income contravenes the matching principle that is pervasive throughout the Code. Olson, the national taxpayer advocate, testified before Congress recently about the negative compliance effect of tax rules that are viewed as being unfair or overly complex. Moreover, she argued that the existence of tax traps can move taxpayers from those trying to comply with the rules into the category of those looking for ways to avoid their tax obligations. Various commentators have hinted that the IRS may address this perceived inequity in upcoming regulation projects. The authors think this change would improve equity in the Code and improve taxpayer compliance.

The second major feature of the new regulations concerning liquidation value received a more positive response from commentators and taxpayers. However, a common sentiment was that the liquidation value of the interest for purposes of the Sec. 108(e)(8) safe harbor needed further refinement. 39 This article reviewed the practical calculation of liquidation value from the valuation literature. Depending on which approach is used (income, market, or asset), which method is selected (net asset or liquidation), and which premise of value is used (orderly liquidation or forced liquidation), the final determination of liquidation value can vary greatly. It is reasonable to assume an orderly liquidation would take place. Specific industry and market conditions would guide the practitioner in choosing the right approach and method to determine liquidation value. Finally, there is an inverse relation between the estimate of value for the equity interest and the amount of COD income recognized by the existing partners on the exchange of debt for equity. Those methods or approaches that value the equity interest higher will produce smaller amounts of COD income.


Authors’ note: Thanks to Bob Crnkovich for his helpful remarks regarding this article.


1 Omnibus Budget Reconciliation Act of 1993, P.L. 103-66.

2 Sec. 108(e)(8).

3 American Jobs Creation Act of 2004, P.L. 108-357.

4 REG-164370-05.

5 Regs. Sec. 1.108-8(b)(2)(i).

6 T.D. 9557.

7 Regs. Sec. 1.108-8(b)(2)(iii).

8 Regs. Sec. 1.108-8(a).

9 Regs. Sec. 1.721-1(d).

10 This rule is incorporated through a cross-reference in Regs. Sec. 1.721-1(d)(3) to Regs. Secs. 1.446-2 and 1.1275-2.

11 Rubin, Whiteway, and Finkelstein, “Final Partnership Debt-for-Equity Regs Deny Creditors’ Losses,” 135 Tax Notes 81 (April 2, 2012).

12 See AICPA Comments on REG-164370-05, Proposed Regulations Relating to the Application of Section 108(e) to Partnerships and Their Partners (April 22, 2009).

13 Preamble to T.D. 9557.

14 Carryover basis of debt obligation exchanged for partnership equity interest.

15 Initial inside basis of $120x less cash of $60x, less $40x Sec. 734(b) adjustment.

16 See Elliott and Dalton, “Treasury Finalizes Debt-for-Equity Regs,” 133 Tax Notes 939 (Nov. 21, 2011), where this concern was expressed by Phillip Gall, co-managing principal of the passthroughs group in Deloitte Tax LLP’s National Tax Office.

17 See note 10.

18 Preamble to T.D. 9557.

19 Schneider and O’Connor, “Is It the End or Just the Beginning: Planning With the Final Partnership Debt-for-Equity Regulations,” 28 Tax Management Real Estate Journal 39 (February 2012).

20 See Maples and Turner, “Matching Deductions to Payments,” Journal of Accountancy, p. 59 (Oct. 2006); Willins, “IRS Joins FASB on Severance Pay,” Journal of Accountancy, p. 32 (March 1995).

21 See Petra and Dorata, “Restricted Stock Awards and Taxes: What Employees and Employers Should Know,” Journal of Accountancy, p. 44 (Feb. 2012).

22 Olson, Statement Before the Hearing on Complexity and the Tax Gap, “Making Tax Compliance Easier and Collecting What’s Due,” Committee on Finance, U.S. Senate (June 28, 2011).

23 White, Testimony Before the Subcommittee on Government Organization, Efficiency, and Financial Management, Committee on Oversight and Government Reform, “Sources of Noncompliance and Strategies to Reduce It,” House of Representatives (April 19, 2012).

24 Elliott, “Treasury Finalizes Debt-for-Equity Regs With Implied Circular Flow of Cash,” 2011 TNT 221-1 (Nov. 16, 2011).

25 For example, to eliminate disputes in determining the proper treatment of expenditures to maintain, replace, or improve wireless communication network assets, the IRS created special safe-harbor treatment for these assets, see Rev Proc. 2011-28, 2011-18 I.R.B. 743.

26 Michael J. Grace, managing director at Milbank, Tweed, Hadley & McCloy LLP, speaking at a BNA Tax Management luncheon. See Elliott, “IRS Takes Hard Line on Interest-First Ordering Rules in Debt-for-Equity Regs,” 133 Tax Notes 1460 (Dec. 19, 2011).

27 Statement on Standards for Valuation Services issued by the AICPA Consulting Services Executive Committee, p. 16 (June 2007).

28 Rev. Rul. 68-609, 1968-2 C.B. 327.

29 IRS, “Business Valuation Guidelines.”

30 IRS, Valuation Training for Appeals Officers Course Book.

31 Fishman, Pratt, Griffith, and Hitchner, 2 PPC’s Guide to Business Valuation 7-2 (PPC 2012).

32 Hitchner, Financial Valuation, Applications and Models, p. 37 (John Wiley & Sons 2011).

33 Fishman, Pratt, Griffith, and Hitchner, 2 PPC’s Guide to Business Valuation 7-5.

34 Id., pp. 7-6–7-10.

35 Bernstein, “Pick Your Poison: Fair Market Value, Orderly Liquidation Value or Forced Liquidation Value (Jan. 9, 2009), retrieved on June 1, 2012.

36 Regs. Sec. 1.108-8(b)(1).

37 Preamble to T.D. 9557.

38 Regs. Sec. 1.721-1(d)(2).

39 See Rubin, Whiteway, and Finkelstein, “Final Partnership Debt-for-Equity Regs Deny Creditors’ Losses,” 135 Tax Notes 81 (April 2, 2012).



John McGowan is a professor in the Department of Accounting at Saint Louis University in St. Louis. Troy Luh is an associate professor in the George Herbert Walker School of Business and Technology at Webster University in St. Louis. Douglas Murphy is a J.D. candidate at Saint Louis University. For more information about this article, contact Professor McGowan at


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