On June 19, 2015, the IRS released Chief Counsel Advice (CCA) 201525010, which interpreted whether Sec. 752 should be used to determine whether a partnership's debt is recourse or nonrecourse for purposes of the cancellation-of-debt (COD) income rules under Sec. 61.
The CCA was issued in response to an IRS examination of a California limited liability company (taxpayer) that bought and developed real property. The taxpayer was taxed as a partnership and had three members—an S corporation and two individuals. The taxpayer had one unsold parcel of property and had corresponding loans, or notes, to develop the property. The loans were secured by a second deed of trust to the property, but no principal payments were made. In the year under examination, the lender canceled the loans.
The case hinged on whether the canceled debt was recourse or nonrecourse to the taxpayer, as the tax treatment of COD income can vary greatly. If a debt is recourse, its forgiveness can sometimes lead to COD income taxed as ordinary income. While ordinary income treatment is not preferred, in certain circumstances COD income may be excluded from gross income under Sec. 108, such as when a taxpayer is insolvent. Discharge of nonrecourse debt, however, is treated as an amount realized from a sale of a property instead of COD income. The benefit is that any gain would receive capital gain treatment, but the downside is that the gain is not eligible for exclusion from gross income under Sec. 108.
The forgiven notes were at the center of the controversy of the case. The notes did not contain express language stating whether they were recourse or nonrecourse to the taxpayer. The notes also did not state whether the taxpayer would be unconditionally and personally liable for repayment if the collateral securing the notes was insufficient to fully repay the outstanding balance. The notes, however, were secured by irrevocable guarantees by each member. This fact was at the heart of the taxpayer's argument.
Secs. 61(a)(3) and (12) provide that gross income includes income derived from dealings in property and income from discharge of indebtedness, respectively. Sec. 108(a), however, allows a taxpayer to exclude a discharge of indebtedness from income in certain circumstances, including when a taxpayer is insolvent. If the taxpayer excludes COD income under this or another exclusion, Sec. 108(b)(2) requires the taxpayer to reduce certain tax attributes, including net operating losses (NOLs), to the extent of the excluded income.
Sec. 1001(a) states that gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis. When liabilities are discharged, Regs. Sec. 1.1001-2(a)(1) provides that the amount realized should include the amount of discharged liabilities. One exception to this regulation is Regs. Sec. 1.1001-2(a)(2), which states that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under Sec. 61(a)(12). To put it simply, when a property is foreclosed and the liability is recourse, the loan balance is considered proceeds of a sale to the extent of the property's fair market value, and the unpaid balance is income from the discharge of indebtedness. If the liability is nonrecourse, it is all proceeds from the sale.
Sec. 752 prescribes how liabilities affect a partner's basis, and its regulations discuss the definitions of recourse vs. nonrecourse debt. Regs. Secs. 1.752-2(a) and (b)(1) define a partner's share of a recourse liability as the extent to which the partner bears the economic risk of loss to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment to any person because that liability became due and payable.
Since the debt in the CCA was personally guaranteed by the members of the partnership, the taxpayer's position was that the debt was recourse under Sec. 752. The taxpayer believed that Sec. 752 determines whether a loan is recourse or nonrecourse for purposes of Sec. 1001.
The taxpayer reported the income from the discharge of indebtedness on Schedule K of Form 1065, U.S. Return of Partnership Income, and the income was passed through to the members on their respective Schedules K-1, Partner's Share of Income, Deductions, Credits, etc. The members were able to meet the insolvency requirements under Sec. 108 and thus were able to exclude all or a portion of the COD income from gross income. They did have to reduce their respective shares of the NOL, but this was still a net positive tax result for the members.
The IRS's Position
The examining agent argued that the debt was, in fact, nonrecourse and that Sec. 752 did not determine whether the debt was recourse or nonrecourse for purposes of Sec. 1001. If the debt was nonrecourse, the COD income would be reclassified as an amount realized from the sale or disposition of property. This would result in a gain to the partnership and no COD income. The members would not be able to exclude any part of the gain at the individual level via the income exclusion rules of Sec. 108.
The CCA concluded that the regulations under Sec. 752 do not determine whether a debt is recourse or nonrecourse to a partnership for the purpose of determining whether it has COD income. The regulations under Sec. 752 are limited to determining a partner's basis in the partnership, and the definitions of recourse and nonrecourse liabilities are not intended to extend to issues under Secs. 61 and 1001.
The CCA stated that, ultimately, determining whether the loan was recourse or nonrecourse for Sec. 1001 purposes required a factual analysis of the operating and loan documents and any relevant state law. The CCA did not conclude whether the loans in this case were recourse or nonrecourse but deferred to the taxpayer and the examining agent to further analyze the facts to make that determination.
While not providing a determination, the CCA did provide additional food for thought and seems to indicate the Chief Counsel's Office believes the debt in this case could be treated as recourse. It stated that even though the notes lacked language expressly imposing an unconditional personal liability on the taxpayer, they were secured by all the assets the taxpayer would ever have, including rents. The notes were also secured by a pledge of the members' interests in the taxpayer and a general assignment of the members' rights, title, and interest in and to the property. In the event of a default, a lender could act on the pledge and acquire all of the taxpayer's assets. Ultimately, according to the CCA, the combination of the members' personal guarantees and the general assignment of rights "may be sufficient for the loan to be recourse to the entity."
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
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