The American Jobs Creation Act of 2004 amended IRC §108(e)(8) to include discharges of partnership indebtedness occurring on or after October 22, 2004. Prior to the amendment, this section only applied to discharges of corporate indebtedness in exchange for stock.

If a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction for a recourse or non-recourse debt, then the fair market value (FMV) of the interest is treated as satisfying the debtor partnership’s indebtedness to the creditor.

The IRS has issued proposed regulations under §1.108-8 holding that the FMV of partnership interest transferred by the debtor partnership is equal to the “liquidation value” of the debt-for-equity interest.

The liquidation value equals the amount of cash the creditor would receive with respect to the interest if, immediately after the transfer, the partnership sold all of its assets for cash equal to the FMV of those assets and then liquidated. For purposes of this calculation, “assets” include goodwill, going concern value, and any other intangibles associated with the debtor partnership’s operations.

Under the proposed regulation, the following four conditions must be present for the FMV to equal liquidation value:

1. The debtor partnership determines and maintains its partner’s capital accounts according to the economic effect rules in Reg. §1.704-1(b)(2)(iv).
2. The creditor, debtor partnership and its partners treat the FMV of the debt as equal to the liquidation value of the debt-for-equity interest when determining the tax consequences.
3. The debt-for-equity exchange is an arm’s length transaction.
4. Following the debt discharge, neither the partnership redeems nor any person related to the partnership purchases the interest as part of a plan which has, as a principal purpose, the avoidance of COD income.

The IRC §721 non-recognition rule generally applies to the creditor’s contribution of partnership indebtedness. Exceptions include unpaid rent, royalties, or interest on indebtedness (including accrued original issue discount).

The creditor’s basis in its partnership interest will be the entire principal balance of the debt under IRC §722, and the creditor’s holding period in the debt-for-equity interest includes its holding period in the debt under IRC §1223(1).

For example, let’s say that Blue LLC has $1,000 of outstanding debt owed to Bill. In an arm’s-length transaction, Bill agrees to cancel the $1,000 debt in exchange for an interest in Blue LLC. Blue’s agreement provides that its members’ capital accounts will be maintained in accordance with the capital accounting rules in Reg. §1.704-1(b)(2)(iv). Bill’s liquidation value (the amount of cash Bill would receive if Blue LLC sold all of its assets for cash equal to the FMV of the assets and then liquidated) is $700.

For more information about how you may be able to maximize tax savings in light of this pending regulatory change, please contact your local CB&H real estate and construction tax professional.

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