PARTNERSHIP'S DISTRIBUTION OF PARTNER'S INDEBTEDNESS IS TAXABLE EXCHANGE FOR THE PARTNER.

Rev. Rul. 93-7

ISSUE

If a partnership owns indebtedness that was issued by a partner and distributes the indebtedness to that partner, how is the distribution of the indebtedness treated for purposes of the Internal Revenue Code?

FACTS

During 1987, Corporation X issued indebtedness without original issue discount, at an issue price of 100x dollars, and a stated redemption price at maturity of 100x dollars. The indebtedness had a maturity date of August 1, 1993.

In 1989, PRS, a partnership, purchased the X indebtedness, without market discount for 100x dollars. X has a 50 percent interest in the capital, profits, and losses of PRS and is unrelated to any other partner of PRS (for purposes of section 108(e)(4) of the Code).

During 1992, PRS liquidated X's partnership interest by distributing only the indebtedness to X. At the time of the distribution, X's basis in its partnership interest was 25x dollars and the fair market value of the interest was 90x dollars. The indebtedness had a basis to PRS of 100x dollars and a fair market value of 90x dollars. In addition, at that time PRS had no section 751 assets and X had no share of the liabilities of PRS under section 752 of the Code. PRS has a section 754 election in effect.

LAW

Section 731(a) of the Code provides, in general, that when a partnership distributes money or other property to a partner, the partner does not recognize gain or loss. Section 731(a) also provides two exceptions to this rule:

First, a distributee partner will recognize gain to the extent that the amount of money distributed exceeds the adjusted basis of the partner's interest in the partnership immediately before the distribution. See also section 1.731-1(a)(1)(i) of the Income Tax Regulations.

Second, a distributee partner will recognize loss on the distribution if: (1) the distribution is in complete liquidation of the partner's interest in the partnership; (2) the property distributed to the partner consists solely of money, unrealized receivables (as defined in section 751(c) of the Code), or inventory (as defined in section 751(d)(2)); and (3) the adjusted basis of the partner's interest in the partnership immediately before the distribution exceeds the amount of money distributed plus the adjusted basis to the distributee of unrealized receivables or inventory (as determined under section 732). See also section 1.731- 1(a)(2) of the regulations.

Any gain or loss recognized under section 731 of the Code is considered gain or loss from the sale or exchange of the partnership interest of the distributee partner. Section 1.731-1(a)(3) of the regulations.

Section 731(b) of the Code provides that no gain or loss shall be recognized to a partnership on a distribution to a partner of property, including money.

Section 732(a) of the Code provides that the basis of property (other than money) distributed by a partnership to a partner other than in liquidation of the partner's interest shall be its adjusted basis to the partnership immediately before the distribution. However, the basis to the distributee partner of property shall not exceed the adjusted basis of that partner's interest in the partnership reduced by any money distributed in the same transaction.

Section 732(b) of the Code provides that the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest shall be an amount equal to the adjusted basis of the partner's interest in the partnership reduced by any money distributed in the same transaction.

Section 734(b) of the Code provides that if there is a section 754 election in effect, a partnership shall increase or decrease the adjusted basis of partnership property to take account of the gain or loss recognized by the distributee partner under section 731(a) or changes in the basis of the distributed property under section 732.

Section 61(a)(12) of the Code provides that gross income includes income from discharge of indebtedness.

In general, a solvent corporation will recognize income from the discharge of indebtedness if it repurchases its own indebtedness for an amount that is less than its adjusted issue price. Section 1.61- 12(c)(3) of the regulations.

ANALYSIS

Section 731 of the Code provides for nonrecognition of gain or loss in the case of a distribution of property to a partner. The recognition is deferred until the partner disposes of the distributed property. The amount of the deferred gain or loss is preserved by the carryover and substitute basis rules of section 732. However, no deferral of gain is allowed for the distribution of money in excess of the basis of the partner's interest in the partnership, because the gain would permanently escape taxation. See S. Rep. No. 1622, 83d Cong., 2d Sess. 96 (1954)

When indebtedness of a partner is distributed to that partner, the debt is extinguished. Thus, just as in a situation involving the distribution of money, when debt is distributed by a partnership to its issuer, there is no mechanism for preserving gain or loss. Accordingly, current recognition of any gain or loss is appropriate. See Cora-Texas Manufacturing Co., Inc. v. U.S., 222 F. Supp. 527 (E.D. La. 1963), aff'd her curiam, 341 F.2d 579 (5th Cir. 1965), which concluded that the partnership nonrecognition rules for distributions of property did not prevent the recognition of a loss by a partner when a partnership distributed to a corporate partner that partner's preferred stock. See also Rev. Rul. 70-409, 1970-2 C.B. 79, and Walker v. Tomlinson, Civil Action No. 4185-5 (M.D. Fla. 1962), which both concluded that, for purposes of former section 333, a distribution of debt from a corporation to the shareholder who owed the debt to the corporation should be treated as a taxable event because there was no opportunity for recognition at a future time.

If a partnership owns indebtedness of a partner (either corporate or noncorporate), and the partnership distributes the indebtedness to the partner so that the debt is extinguished, the partnership distribution of property rules apply in their usual fashion to determine the consequences for the partnership. For the partnership, the distribution of the debt will not result in a gain or loss. Section 731(b) of the Code. If the partnership has a section 754 election in effect, or makes an election for the year of the distribution, the partnership must adjust the basis of its undistributed property as provided in section 734. This adjustment reflects the difference between the partnership's basis in the indebtedness and the basis the partner takes in the distributed indebtedness under section 732.

However, for purposes of determining the partner's tax consequences, a distribution of debt to the debtor partner is not a distribution within the meaning of section 731 of the Code. Instead, the partner will be treated as exchanging its partnership interest (or portion thereof) for the debt in a taxable transaction because there will be no opportunity for recognition at a future time. This will result in capital gain or loss to the extent the value of the partnership interest (or portion thereof), equal to the value of the debt, differs from the basis of the partnership interest (or portion thereof as determined under section 732).

In addition, the receipt of the indebtedness by a partner may require the partner to include in gross income discharge of indebtedness income under section 61(a)(12) of the Code. The partner is treated as having satisfied the debt for its fair market value, and the amount of discharge of indebtedness income is equal to the amount by which the issue price (adjusted for any premium or discount) of the indebtedness exceeds the fair market value of the indebtedness. Cf. Rev. Rul. 61-96, 1961-1 C.B. 68, which reaches the same conclusion on a corporation's distribution to a shareholder of the shareholder's indebtedness. Similarly, a deduction may be available to the partner if the fair market value of the indebtedness at the time of distribution exceeds its adjusted issue price. See section 1.163-4(c)(1) of the regulations.

Upon the distribution of the X indebtedness from PRS to X, PRS has a 75x dollars section 734 basis adjustment (100x dollars partnership basis in the X indebtedness less its basis to X of 25x dollars as determined under section 732). PRS does not recognize any gain or loss. X recognizes 65x dollars of gain (90x dollars fair market value of the indebtedness less 25x dollars basis in the partnership interest). Furthermore, X includes 10x dollars in gross income as discharge of indebtedness income (the 100x dollars issue price of the indebtedness less its 90x dollars fair market value at the time of the distribution).

HOLDING

If a partnership owns indebtedness of a partner, and the partnership distributes (in a liquidating or nonliquidating distribution) the indebtedness to the partner so that the debt is extinguished, the distribution of property rules will apply to determine the consequences for the partnership, and the partner will be treated as exchanging the partnership interest for the debt in a taxable exchange.

DRAFTING INFORMATION

The principal author of this revenue ruling is Channing E. Brackey of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Mr. Brackey on (202) 622-3070 (not a toll-free call).