IRS EXAMINES SITUATIONS IN WHICH PARTNERS' ALLOCATIONS OF COD INCOME AND CANCELED DEBT DIFFER.

Rev. Rul. 92-97

ISSUE

If a partner is allocated a share of the partnership's cancellation of indebtedness (COD) income that differs from the partner's share of the cancelled debt under section 752(b) of the Internal Revenue Code, does the allocation of COD income have substantial economic effect under section 704(b)?

FACTS

SITUATION 1. In year 1, A contributes $10x and B contributes $90x to form AB, a general partnership. A and B share the partnership's losses 10 percent and 90 percent, respectively, and share the partnership's income 50 percent each (i.e., income allocations do not first restore previous losses). The partnership maintains capital accounts under the rules of section 1.704- 1(b)(2)(iv) of the Income Tax Regulations, and the partners agree to liquidate according to positive capital account balances under the rules of section 1.704-1(b)(2)(ii)(b)(2).

Under applicable state law, A and B are jointly and severally liable to creditors for all partnership recourse liabilities. However, A and B do not agree to unconditional deficit restoration obligations as described in section 1.704-1(b)(2)(ii)(b)(3) of the regulations; they are obligated to restore deficit capital accounts only to the extent necessary to pay creditors. Thus, if AB were to liquidate after paying all creditors, and one partner had a positive capital account balance, the other partner would not be required to restore a deficit capital account to permit a liquidating distribution to the partner with a positive capital account balance.

Because the partners do not have unconditional deficit restoration obligations, the economic effect test of section 1.704- 1(b)(2)(ii)(b) of the regulations is not met. However, A and B agree to a qualified income offset and are treated under section 1.704- 1(b)(2)(ii)(c) as having a limited obligation to restore deficit capital accounts by reason of their liability to PB's creditors. Accordingly, the requirements of the alternate test for economic effect of section 1.704-1(b)(2)(ii)(d) are met.

AB purchases property for $1000x from an unrelated seller, paying $100X in cash and borrowing the $900x balance from an unrelated bank that is not the seller of the property. The note is a general obligation of the partnership, and no partner has been relieved from personal liability. The principal of the loan is due in 6 years; interest is payable semi-annually at the applicable federal rate.

A and B bear an economic risk of loss equal to $90X and $810x, respectively, for the partnership's $900X recourse liability and each increases basis in the partnership interest (outside basis) accordingly. See section 1.752-2 of the regulations.

The property generates $200x of depreciation each year for 5 years. All other partnership deductions and losses exactly equal the partnership's income, so that in each of its first 5 taxable years AB has a net loss of $200x. Under the partnership agreement, these losses are allocated 10 percent to A and 90 percent to B. The losses reduce A's capital account to negative $90x and B's capital account to negative $810x. At the beginning of year 6, after the fair market value of AB's property has substantially declined, the creditor cancels the debt as part of a work-out arrangement. Because of the cancellation of the debt, A and B are no longer treated as obligated to restore their deficit capital accounts.

SITUATION 2. The facts are the same as Situation 1, except that A and B agree to unconditional deficit restoration obligations as described in section 1.704-1(b)(2)(ii)(b)(3) of the regulations. A and B thus have an obligation to restore deficit capital accounts not only to pay creditors, but to satisfy the other partner's positive capital account balance on liquidation.

LAW AND ANALYSIS

Section 61(a)(12) of the Code requires the amount of a taxpayer's discharged debt to be included in gross income.

Under section 108(a) of the Code, COD income is excluded from gross income if the debt is discharged in a title 11 case, if the taxpayer is insolvent, or if the debt discharged is qualified farm indebtedness. If a partnership's liability is discharged, the partnership recognizes income equal to the amount of debt cancelled and must allocate that income to the partners as a separately stated item under section 702(a). Under section 108(d)(6), the section 108(a) exclusions are applied at the partner level to the COD income.

If an allocation of a share of a partnership's COD income is made to a partner, and the allocation has substantial economic effect, the partner increases outside basis under section 705(a)(1)(A) of the Code, receives a capital account increase under section 1.704-1(b)(2)(iv)(b)(3) of the regulations, and must determine, based on the partner's own circumstances, if all or part of the distributive share may be excluded from gross income under section 108(a).

Under section 722 of the Code, a partner's outside basis is increased by the amount of money and the adjusted basis of property contributed to the partnership. Under section 731(a), a partner recognizes gain from the sale or exchange of a partnership interest to the extent the partner receives a distribution of money from the partnership that exceeds the partner's outside basis immediately before the distribution. Under section 733, a partner's outside basis is decreased (but not below zero) by the amount of any distribution of money from the partnership. Under section 752(a), an increase in a partner's share of partnership liabilities is treated as a contribution of money by the partner to the partnership. Under section 752(b), a decrease in a partner's share of partnership liabilities is treated as a distribution of money by the partnership to the partner.

Although section 731(a) of the Code requires gain recognition if a distribution of money exceeds the distributee partner's outside basis immediately before the distribution, section 1.731-1(a)(1)(ii) of the regulations treats certain distributions as occurring at the end of the partnership's taxable year. Under section 1.731- 1(a)(1)(ii), advances or drawings of money or property against a partner's distributive share of income are treated as current distributions made on the last day of the partnership taxable year.

Under section 704(b) of the Code and the regulations thereunder, allocations of a partnership's items of income, gain, loss, deduction, or credit provided for in the partnership agreement will be respected if the allocations have substantial economic effect. Allocations that fail to have substantial economic effect will be reallocated according to the partners' economic interests in the partnership. The fundamental principles for establishing economic effect require an allocation to be consistent with the partners' underlying economic arrangement. A partner allocated a share of income should enjoy any corresponding economic benefit, and a partner allocated a share of losses or deductions should bear any corresponding economic burden. See section 1.704-1(b)(2)(ii)(a) of the regulations.

To come within the safe harbor for establishing economic effect in section 1.704-1(b)(2)(ii) of the regulations, partners must agree to maintain capital accounts under the rules of section 1.704- 1(b)(2)(iv) and liquidate according to positive capital account balances; in addition, any partner with a deficit capital account must either agree to an unconditional deficit restoration obligation as described in section 1.704-1(b)(2)(ii)(b)(3) (as in Situation 2) or satisfy the requirements of the alternate test for economic effect provided in section 1.704-1(b)(2)(ii)(d) (as in situation 1).

In situations 1 and 2, the allocations of losses to A and B in years 1 through 5 meet the economic effect requirements under sections 1.704-1(b)(2)(ii)(d) and 1.704-1(b)(2)(ii)(b) of the regulations. These allocations are thus within the economic effect safe harbor provided by the regulations under section 704 of the Code.

In year 6, when the $900x recourse liability is cancelled, the partnership recognizes $900x of COD income that must be allocated to A and B as a separately stated item under section 702(a) of the Code. In both Situations 1 and 2, A and B receive a deemed distribution of money equal to $90X and $810X, respectively, because of the decrease in their shares of the liability when the debt is cancelled. See section 752(b) and section 1.752-1(c) of the regulations. Under section 733, A and B reduce outside bases (but not below zero) by $90X and $810X, respectively, and under section 731(a), A and B recognize gain to the extent their respective distributions exceed their outside bases at the end of year 6.

SITUATION 1 ANALYSIS

The AB partnership agreement provides for income to be allocated equally between A and B. However, in situation 1, the allocation of the partnership's COD income $450x to A and $450x to B, which would cause A's capital account to equal $360x (negative $90x plus $450x) and B's capital account to equal negative $360x (negative $810x plus $450x), cannot have economic effect even though the partners maintain capital accounts and liquidate according to positive capital accounts. The cancellation of the debt eliminates both partners' obligations to restore a deficit capital account, and neither partner has an independent deficit restoration obligation that could be invoked to satisfy the other partner's positive capital account. Because the partners' deficit restoration obligations were dependent on the cancelled debt, A can neither enjoy the economic benefit of an allocation of COD income exceeding $90X nor bear the economic burden of an allocation of COD income of less than $90x. Similarly, B can neither enjoy the economic benefit of an allocation of COD income exceeding $810x nor bear the economic burden of an allocation of COD income of less than $810x. See section 1.704-1(b)(5), example 15(iii), of the regulations. Thus, for the partnership's allocations of the COD income to have economic effect, the COD income must be allocated $90x to A and $810x to B, which is the same ratio as the decrease in A's and B's shares of partnership liability.

When the COD income is properly allocated, the outside bases of A and B are increased under section 705(a)(1)(A) of the Code by $90x and $810x, respectively, for their distributive shares of the partnership's COD income. Under section 108(d)(6), A and B individually determine if any portion of their distributive shares is excluded from gross income. Under section 705(a)(2), the outside bases of A and B are decreased by $90x and $810x, respectively, for their distributions of money under section 752(b) resulting from the cancellation of the debt. A and B recognize no gain under section 731 in year 6 because the distributive shares of COD income provide an outside basis increase for each partner sufficient to cover the distribution of money to that partner. Because of the integral relationship between the COD income and the section 752(b) distribution of money from the cancelled debt, section 1.731- 1(a)(1)(ii) of the regulations treats the distribution of money to each partner from the cancellation of the debt as occurring at the end of AB's taxable year as an advance or drawing against that partner's distributive share of COD income.

SITUATION 2 ANALYSIS

In situation 2, the allocation of the partnership's COD income $450x to A and $450x to B, which causes A's capital account to equal $360x and B's capital account to equal negative $360x, has economic effect and, therefore, meets the substantial economic effect safe harbor if substantiality is independently established. Because B's deficit restoration obligation is not dependent on the cancelled debt and can be invoked to satisfy A's positive capital account, the allocation of COD income results in B incurring an obligation to contribute $360x to satisfy A's $360x positive capital account. Similarly, if the COD income were allocated so that A had a deficit capital account balance, A would incur an obligation to contribute the amount of the deficit to satisfy B's positive capital account.

Under section 705(a)(1)(A) of the Code, the outside bases of A and B are increased by $450x each, for their distributive shares of the partnership's COD income. Under section 108(d)(6), A and B individually determine if any portion of their distributive shares is excluded from gross income. This allocation, which is not in proportion to the partners' shares of the cancelled debt under section 752(b), causes B to recognize a $360x capital gain under sections 752(b) and 731(a). Although B's outside basis is increased under section 705(a)(1)(A) for B's $450x distributive share of COD income, the $810x distribution of money resulting from the decrease in B's share of the partnership liability exceeds B's outside basis by $360x.

B recognizes gain even though the distribution of money from the cancellation of the debt is treated under section 1.731-1(a)(1)(ii) of the regulations as occurring at the end of AB's taxable year. Because of the application of section 1.731-1(a)(1)(ii), however, A does not recognize gain in SITUATION 2. A's outside basis is increased by the allocation to A of $450x of the partnership's COD income, so the $90x distribution of money resulting from the decrease in A's share of the partnership liability does not exceed A's outside basis. After adjustment for the $90x distribution, A has an outside basis of $360x.

HOLDING

An allocation to a partner of a share of the partnership's cancellation of indebtedness income that differs from the partner's share of the cancelled debt under section 752(b) of the Code has substantial economic effect under section 704(b) if (1) the deficit restoration obligations covering any negative capital account balances resulting from the COD income allocations can be invoked to satisfy other partners' positive capital account balances, (2) the requirements of the economic effect test are otherwise met, and (3) substantiality is independently established.

DRAFTING INFORMATION

The principal author of this revenue ruling is Susan Pace Hamill of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Ms. Hamill at (202) 622-3050 (not a toll-free call).