IRS rules on cancellation of debt of a disregarded entity

Editor: Greg A. Fairbanks, J.D., LL.M.

On Dec. 11, 2020, the IRS released Letter Ruling 202050014, in which it ruled that a series of proposed transactions pursuant to a bankruptcy plan would not result in gain or loss to a corporation and that Sec. 61(a)(12) (before its redesignation as Sec. 61(a)(11) by Section 11051 of the law known as the Tax Cuts and Jobs Act, P.L. 115-97) and Sec. 108(a) did not apply to the cancellation of debt owed by its disregarded entity (DRE).

Facts of Letter Ruling 202050014

In Letter Ruling 202050014, a corporation, Distributing, was the common parent of a group that included corporations and DREs (the Distributing Group). Distributing directly owned 100% of LLC1, which was a DRE. LLC1 had outstanding debt consisting of first lien debt, second lien debt, and unsecured debt (the LLC1 debt). The LLC1 debt was not, and never had been, guaranteed by Distributing.

Pursuant to a proposed plan of restructuring, the Distributing Group contributed all the assets that it directly owned to LLC1, then LLC1 formed a new corporation (Newco) and contributed all of its assets to Newco in exchange for Newco stock, cash, and newly issued Newco debt. LLC1 then planned to distribute all of the property that it held to LLC1′s creditors in satisfaction of the LLC1 debt. Finally, LLC1 planned to liquidate, and any equity held by Distributing was canceled for no consideration.

Background of cancellation of nonrecourse debt: Tufts

Generally, when a lender cancels recourse debt in exchange for property that has fair market value (FMV) less than the amount of the debt canceled, the consequences are bifurcated. First, the debtor will recognize Sec. 1001 gain (or loss) to the extent that the FMV of the property received exceeds (or is less than) the basis of the property. Second, the debtor will recognize cancellation-of-debt (COD) income under Sec. 61(a)(11) in an amount equal to the excess of the adjusted issue price of the debt (within the meaning of Regs. Sec. 1.1275-1(b)) and the FMV of the property.

The consequences for the same transaction can be different if the debt is nonrecourse (i.e., debt where the lender is only permitted to seize the collateral specified in the loan agreement). Generally, if nonrecourse debt is canceled in exchange for the property that is subject to the debt, then the debtor will instead treat the amount of the debt as the amount realized in exchange for the property for purposes of Sec. 1001, even if the amount of the debt exceeds the value of the property exchanged. Thus, the debtor will have gain under Sec. 1001 to the extent the amount of the debt exceeds the basis of the property (Tufts gain), unless another provision of the Code (e.g., Sec. 361) provides for tax-free treatment (see Tufts, 461 U.S. 300 (1983)).

Therefore, Sec. 61(a)(11) (regarding COD income) and Sec. 108(a) (regarding exclusion of COD income) may not apply when there is a cancellation of nonrecourse debt in exchange for the property subject to that debt. This disparate treatment between recourse debt and nonrecourse debt makes it critical for taxpayers to determine whether debt is nonrecourse or recourse under these circumstances.

In Letter Ruling 202050014, LLC1 was a DRE of Distributing, and Distributing was not personally liable for any of the LLC1 debt. Then, in the proposed transactions, the LLC1 lenders canceled all of the LLC1 debt in exchange for all of the assets of LLC1. In the letter ruling, the IRS first ruled that the LLC1 debt was treated as a nonrecourse liability of Distributing for purposes of Regs. Sec. 1.1001-2. Therefore, the cancellation of the LLC1 debt fell under Tufts, resulting in an amount realized equal to the amount of the outstanding debt, and former Sec. 61(a)(12) and Sec. 108(a) did not apply to the cancellation of the LLC1 debt. Second, the IRS ruled that the potential Tufts gain would not be recognized by Distributing, provided that the proposed transaction qualified as a tax-free reorganization under Sec. 368(a)(1)(G).

Letter Ruling 202050014 is not the first letter ruling in which the IRS has ruled the debt of a DRE was nonrecourse debt of a regarded entity. Under similar facts, the taxpayer in Letter Ruling 201644018 sought to engage in a proposed transaction pursuant to a bankruptcy. In Letter Ruling 201644018, the IRS also held that debt of a DRE, where the regarded owner was not personally liable, was treated as a nonrecourse debt of the regarded owner. The IRS also ruled that the cancellation of the DRE debt resulted in an amount realized under Sec. 1001 in the amount of the debt, that former Sec. 61(a)(12) and Sec. 108(a) did not apply, and any potential Tufts gain was eligible for nonrecognition treatment under Sec. 361(c).

Planning considerations

Based on Letter Ruling 201644018 and Letter Ruling 202050014, taxpayers may be able to support the position that debt owed by a DRE is nonrecourse debt of the regarded owner for purposes of Sec. 1001 and Regs. Sec. 1.1001-2. Due to the potential different tax treatment, taxpayers should give consideration as to which consequences apply to them based on their specific borrowing arrangements.

The following basic example illustrates the different potential results:

Base example: Taxpayer, a corporation, is the borrower of debt for U.S. federal income tax purposes that has a face amount of $100, and its assets have an FMV of $75 and a basis of $60. Taxpayer is insolvent under Sec. 108(d)(3) because its liabilities, $100, exceed the FMV of its assets, $75. In a debt workout, Taxpayer transfers all its assets to its creditors in satisfaction of the debt.

Scenario 1: Taxpayer is the legal borrower, and the debt is considered recourse debt. Taxpayer would recognize $15 of gain under Sec. 1001 related to its assets (the difference between the basis and the FMV of the assets transferred) and $25 of COD income (the difference between the FMV of the assets transferred and the amount of the debt).

Scenario 2: The legal borrower is a DRE owned by Taxpayer, and Taxpayer did not guarantee the debt; thus, the entire $40 of gain would be capital gain under Tufts (i.e., Tufts gain).

In Scenario 1, the $25 of COD income is potentially eligible for exclusion from income under Sec. 108, but it may also result in attribute reduction under Sec. 108(b). In Scenario 2, even though the gain is not eligible for Sec. 108 exclusion, if the taxpayer is able to structure the debt workout as a tax-free reorganization under Sec. 368, then the taxpayer may be able to avoid recognizing any of the Sec. 1001 gain (similar to the taxpayers in Letter Rulings 202050014 and 201644018) and would not have to reduce any of its attributes under Sec. 108.

Whether Scenario 1 or Scenario 2 applies to a taxpayer will depend on the specific facts, including which entity (i.e., a regarded entity or a DRE) is the primary borrower on the relevant borrowing arrangement. In addition, whether Scenario 1 or 2 is most beneficial will vary depending on a taxpayer’s circumstances. Furthermore, the determination of whether a debt of a DRE is nonrecourse debt of a regarded entity may depend on whether the regarded entity’s assets consist solely of the DRE borrower.

Other considerations related to Regs. Sec. 1.1001-3

A separate but related issue that arises is whether recourse debt of a DRE is considered nonrecourse debt of the regarded entity for purposes of Regs. Sec. 1.1001-3.

The IRS has also issued rulings related to this issue, and it should be considered anytime a taxpayer considers structuring into a borrowing that uses a DRE as the legal borrower (see Letter Rulings 201010015, 200709013, 200630002, and 200315001).

Generally, the regulations under Regs. Sec. 1.1001-3 provide rules for determining when an alteration to a debt obligation should be considered a realization event for the holders. Regs. Sec. 1.1001-3 generally treats a change in the terms of a debt instrument as triggering a deemed exchange if the change in the terms is a “modification” of the debt instrument and that modification is a “significant modification.” Under Regs. Sec. 1.1001-3, a change in an obligor of recourse debt is considered a significant modification (and therefore creates a deemed exchange of debt) unless any of several enumerated exceptions under Regs. Secs. 1.1001-3(e)(4)(i) apply, with one of the exceptions being that a change in obligor occurs in connection with a Sec. 381(a) transaction (see Regs. Sec. 1.1001-3(e)(4)(i)(B)). For nonrecourse debt, a change in obligor does not generally result in a significant modification. Therefore, determining whether debt is recourse or nonrecourse, and who is the obligor of the debt, is important in determining whether a significant modification has occurred under Regs. Sec. 1.1001-3.

In the four letter rulings mentioned above, the IRS has addressed the treatment of debt under Regs. Sec. 1.1001-3 when the named borrower of the debt changes its entity status from a regarded entity to a DRE, most recently in Letter Ruling 201010015. In Letter Ruling 201010015, the taxpayer held 100% of the stock of a subsidiary (Subsidiary 1), which was treated as a corporation for federal income tax purposes prior to a set of proposed transactions. Subsidiary 1 held third-party debt, and the taxpayer was not a guarantor on the debt. In Letter Ruling 201010015 the taxpayer proposed to engage in a set of transactions that would be treated as a reorganization under Sec. 368(a)(1)(D) in which Subsidiary 1 converted to a single-member limited liability company that would be treated as a DRE for federal income tax purposes. In the ruling, the IRS concluded that the proposed transaction resulted in a change in obligor for purposes of Regs. Sec. 1.1001-3 but that the change in obligor did not result in a significant modification under Regs. Sec. 1.1001-3 because the transaction qualified for the exception under Regs. Sec. 1.1001-3(e)(4)(i)(B) for Sec. 381(a) transactions. Importantly, and seemingly counterintuitive with the other parts of the holding, the IRS described the new DRE, instead of the DRE’s regarded owner, as the obligor of the debt.

The other three letter rulings under Regs. Sec. 1.1001-3 also ended up at the same conclusion that the IRS reached in Letter Ruling 201010015, however, under different reasoning. In Letter Ruling 200709013 the IRS ruled that the change in status of the legal borrower from a corporation to a DRE, and on a later date from a DRE to a partnership, resulted in a modification of the debt held by the legal borrower (because there was a change in obligor), but that modification was not a significant modification because the transaction qualified for exceptions under Regs. Sec. 1.1001-3(e)(4)(i). In Letter Ruling 200630002, the IRS held that there was not a significant modification when the legal borrower converted from a corporation to a DRE; however, the IRS in Letter Ruling 200630002 did not articulate why there was not a significant modification or whether the IRS considered this a change in obligor. Finally, in Letter Ruling 200315001, the IRS ruled that a legal borrower’s conversion from a corporation to a DRE did not even result in a modification because the legal rights and obligations referred to in Regs. Sec. 1.1001-3(c) are determined under state law, and the conversion from a corporation to a DRE would not affect the legal rights or obligations between the debt holders and the borrower.

These letter rulings are important for two reasons. First, any taxpayer looking to restructure its borrowings so that the legal borrower is a DRE should consider the effect of these letter rulings before pursuing any debt restructuring. Second, although the Regs. Sec. 1.1001-3 letter rulings are issued under a different set of regulations, the questions whether the debt issued by a DRE is considered recourse or nonrecourse and who the obligor is for tax purposes are relevant under Regs. Secs. 1.1001-2 and 1.1001-3. As previously noted by the New York State Bar Association (NYSBA) Tax Section, given that the Regs. Sec. 1.1001-3 letter rulings are a little unclear exactly who the obligor is when a debtor converts from a corporation to a DRE and whether the debt is considered changing from recourse to nonrecourse, some clarification from the IRS would be beneficial (see NYSBA Tax Section Rep’t No. 1383 and NYSBA Tax Section letter to IRS Commissioner Charles Rettig, “Comments on Workout-Related Relief in Response to COVID-19” (Aug. 17, 2020)). The issuance of Letter Ruling 202050014 simply reiterates the need for additional guidance from the IRS as to how to reconcile the treatment under these various letter rulings.

Key factor in entity structure

Even though there are unresolved issues, Letter Ruling 202050014 confirms to taxpayers that the IRS may treat debt issued by a DRE as nonrecourse debt to the regarded owner, at least for the purposes of Regs. Sec. 1.1001-2. The conclusion also gives additional importance to how taxpayers structure a new borrowing. Taxpayers should strongly consider these letter rulings when trying to determine whether they want to structure a borrowing with a regarded entity as the legal borrower or whether they prefer to have a DRE be the legal borrower of the debt.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.