New IRS COD Rules Give Taxpayers Favorable Tax Planning Options

On August 17, 2009, the IRS released Revenue Procedure 2009-37, setting forth the rules for taxpayers that make the election to defer recognizing cancellation of indebtedness income ("COD Income") under newly-enacted Code Sec. 108(i). The election under Code Sec. 108(i) was added this year by the American Recovery and Reinvestment Tax Act of 2009. The new rules in Code Sec. 108(i) are effective for certain COD Income realized by taxpayers in connection with the "reacquisition" of the taxpayer's debt after December 31, 2008 and before January 1, 2011. COD Income realized by a taxpayer with respect to an eligible debt instrument is included in the taxpayer's gross income ratably over a five-taxable year, beginning with a taxpayer's fourth or fifth taxable year following the taxable year of the debt cancellation.

Taxpayers making the Code Sec. 108(i) election will experience a significant deferral of COD Income by avoiding the recognition of COD income in 2009 or 2010 and by taking into account the deferred COD Income beginning with their 2014 taxable year. This election is particularly useful for taxpayers that are not eligible for one of the more common COD Income exclusions, such as the exclusion for COD Income of insolvent taxpayers or the exclusion of COD Income for certain real estate indebtedness where the taxpayer makes an election to reduce their basis in the real property by the amount of the excluded COD Income.

This Alert focuses on the rules for making a Code Sec. 108(i) election for non-corporate taxpayers, i.e., partnerships and LLCs. For many taxpayers, these are the most meaningful rules in the Revenue Procedure. In addition, the Alert summarizes the procedural and other rules announced in this guidance.

WHY IS THE GUIDANCE IN THE REVENUE PROCEDURE IMPORTANT?

Apart from prescribing the procedural rules that must be followed for an effective Code Section 108 (i) election, the Revenue Procedure provides taxpayer-favorable guidance on the following issues:

• Partial Elections
  
  The Revenue Procedure allows taxpayers to make a Code Sec. 108(i) election for only a portion of COD Income realized with respect to an eligible debt instrument. To the extent that a taxpayer does not elect to defer 100 percent of the COD Income under Code Sec. 108(i), the taxpayer can utilize any other COD Income exclusion or election under Code Sec. 108(a)(1), e.g., the insolvency exclusion. Moreover, a taxpayer may make a separate election to exclude some or all of the COD Income arising from different eligible debt instruments. This gives taxpayers the option to make a Code Sec. 108(i) election for the COD Income attributable to debt instrument A and no election, or a different percentage election, for the COD Income attributable to debt instrument B. This flexibility makes the Code Sec. 108(i) a very important tool for taxpayers dealing with debt cancellation income by eliminating the need for an "all-or-nothing-election" for Code Sec. 108(i) COD Income. Under the Revenue Procedure, the election can be tailored to the needs of taxpayers best able to take advantage of Code Sec. 108(i).
• Special Allocation Of Code Sec. 108(i) Income
  
  A partnership, or any other entity taxed as a "partnership," that makes a Code Sec. 108(i) election for only a portion of the COD Income recognized with respect to the entity's debt instrument is also permitted to determine, "in any manner", the portion, if any, of each partner's share of the COD Income amount that is deferred under the special Code Sec. 108(i) rules. This classification is important to the partners because the non-Code Sec. 108(i) COD Income is eligible for any of the other COD income exclusions available to taxpayers under Code Sec. 108. The Revenue Procedure makes it clear that one partner's Code Sec. 108(i) COD Income amount may be $0.00 while another partner's Code Sec. 108(i) COD Income amount may be equal to 100 percent of that partner's share of the COD income. This rule is an attempt by the IRS to maximize the ability of partners to defer recognizing COD Income in the year of a debt reacquisition or restructuring. Fundamentally, it would permit a partnership to make a partner-by-partner Code Sec. 108(i) election, again permitting the exclusion to be used in a tax-efficient manner.
• An important procedural hurdle in the Revenue Procedure is that, in order for a partnership's election under Code Sec. 108(i) to be effective, the partnership must make a reasonable effort to obtain from each partner the information necessary to compute the partner's basis for the partner's partnership interest. Heretofore, partnership's rarely maintained information concerning their partners' adjusted basis for their interests in the partnership. In order to make the Code Sec. 108(i) election, however, partnerships will need to accumulate that information for their partners. The Revenue Procedure requires that the information should be in a written statement signed by the partner under penalties of perjury. A partnership's failure to comply with the basis reporting requirement will not invalidate the partnership's election, provided the partnership makes reasonable efforts to obtain the written statement before making the election.
• Protective Code Sec. 108(i) Elections
  
  The Revenue Procedure sets forth the circumstances under which a taxpayer can make a protective election under Code Sec. 108(i) where the taxpayer reported that a particular transaction in the year did not result in the realization of COD Income. If the taxpayer follows these rules, the taxpayer's properly-made protective election is treated as a valid, irrevocable election under Code Sec. 108(i) in the case where the IRS later determines the transaction resulted in COD Income.
• Curing Defective Elections
  
  The Service will treat a Code Sec. 108(i) election as effective if the taxpayer files the election with their federal income tax return filed on or before September 16, 2009 using any reasonable procedure to make the election. This provision generally will affect fiscal year filers with a fiscal year ending before the release of the Revenue Procedure. An election that does not meet the requirements of the Revenue Procedure will not be effective, however, unless the taxpayer, on or before November 16, 2009, files an amended return and complies with all of the requirements of the Revenue Procedure.

OVERVIEW OF THE GUIDANCE IN THE REVENUE PROCEDURE

The election provided in Code Sec. 108(i) is available for taxpayers that recognize COD Income from a "reacquisition" of their "applicable debt instrument" after December 31, 2008 and before January 1, 2011. A taxpayer making the election is permitted to defer the recognition of the COD Income for the year of the "reacquisition" and include it in income ratably, generally beginning in the taxable year commencing January 1, 2014. If the reacquisition transaction results in the deemed issuance of a new debt instrument with original issue discount because of a Treas. Reg. Sec. 1.1001-3 deemed exchange and issuance, the taxpayer's deductions for the OID on the new debt are deferred.

The term "reacquisition" as used in Code Sec. 108(i) is broadly defined to include most transactions by which a taxpayers restructure an existing debt instrument including, for example, the payoff of the outstanding debt for cash or other property, the exchange of the old debt instrument for a newly-issued debt instrument, and the forgiveness of all or a portion of the outstanding balance of a debt instrument.

The Revenue Procedure generally requires that the taxpayer make the election by including a statement with their return for the year of the reacquisition that clearly identifies the relevant debt instrument. The election, once made, is irrevocable. If a taxpayer makes the election under Code Sec. 108(i), the other COD exclusions in Code Secs. 108(a)(1)(A) (discharge in a Title 11 case), (B) (insolvent taxpayer), (C) (qualified farm indebtedness) and (D) (qualified real property business indebtedness of a taxpayer other than a C corporation) are unavailable for the COD Income deferred under Code Sec. 108(i).

Partial Elections

The Revenue Procedure permits a taxpayer to make the Code Sec. 108(i) election for only a portion of the COD Income attributable to an eligible debt instrument. It does not require an all-or-nothing Code Sec. 108(i) election for the debt instrument. To the extent that the taxpayer recognizes COD income in excess of the portion for which the Code Sec. 108(i) election was made, the taxpayer can use any of the other Code Sec. 108(a) exclusions to avoid reporting COD Income currently.

Generally, the taxpayer can make different percentage elections under Code Sec. 108(i) for different debt instruments.

Special Rules Applicable To Partnerships Making Code Sec. 108(i) Elections

Prior to the release of this guidance, there was concern that partnerships would have difficulty deciding whether to make the Code Sec. 108(i) election. The effect of the election on the partners can be very different, depending on partner-specific facts. Because the Code was clear that the partnership was required to make the election, and the effect of the Code Sec. 108(i) elections was not always advantageous to all partners, practitioners were concerned how partnerships would decide to make, or refrain from making, the election. More importantly, practitioners were concerned also about the non-tax risks to the general partner from making, or refraining from making, the election. The flexibility of the rules in the Revenue Procedure should remove that risk, although partnerships must still be careful in communicating the availability of the Code Sec. 108(i) options and in gathering the required partner-level information needed to comply with the procedural rules of the Code Sec. 108(i) election.

Partial Elections By Partnerships. Under the Revenue Procedure, a partnership generally is permitted to make the same partial Code Sec. 108(i) election as other taxpayers with respect to COD Income recognized with respect to its eligible debt, i.e., elect to treat less than 100 percent of the COD Income as deferred under Code Sec. 108(i). More importantly, the partnership can determine on a partner-by-partner basis how much of the COD Income is attributable to the COD Income deferred under Code Sec. 108(i) ("Deferred COD Income") and how much is COD Income that is not deferred under Code Sec. 108(i). A partner's share of the COD income that is not Deferred COD Income is eligible for exclusion or deferral under the other Code Sec. 108 relief rules. The only limitation on the special allocation of the Deferred COD Income to the partners is that all of the COD income (without regard to the amount deferred under Code Sec. 108(i)) be allocated to the partners in the partnership immediately before the reacquisition in the same manner as the income would be included in their distributive shares. The Revenue Procedure does not even incorporate a test of "reasonableness."

As you can see, the partial election rule makes the Code Sec. 108(i) election far more useful to partnerships than it might otherwise have been and avoids the type of intractable deadlock that might have arisen in the above case where the election was advantageous to one member and disadvantageous to the other members.

By contrast, an S corporation's COD income deferred under Code Sec. 108(i) is shared pro rata only among those shareholders that are shareholders of the S corporation immediately before the reacquisition transaction. The special partnership allocation rule is unavailable to S corporation shareholders.

Partners' Deferred Section 752 Amounts. The Revenue Procedure contains a set of rules to avoid triggering taxable gain to Code Sec. 108(i) electing partners where the debt restructuring otherwise would result in a constructive cash distribution under Code Sec. 752. Under these rules, a decrease in a partner's share of partnership liabilities resulting from a Code Sec. 108(i) debt reacquisition is not treated as a current distribution of money to a Code Sec. 108(i) electing partner (that is, a partner with a Deferred COD Income Amount) under Code Sec. 752. This Code Sec. 752 deferred amount is equal to the lesser of the amount of the partner's Deferred COD Income amount or the gain that the partner would have recognized in the year of the debt reacquisition and assuming that the Deferred COD Income amount for the partner is $0.

Tiered Partnerships. The Revenue Procedure specifies that an upper-tier partnership receiving a K-1 from a lower-tier partnership reporting COD income that was deferred under Code Sec. 108(i) is permitted to allocate the Deferred COD Income among its partners "in any manner", provided that the COD Income is allocated only to pre-reacquisition partners in the upper-tier partnership. Because the Deferred Code Sec. 752 amount is calculated only for a partnership's direct partners, however, there is no further adjustment to account for the adjusted basis or other tax attributes of the upper-tier partners. The indirect partner could take into account his share of the special Code Sec. 752 adjustment.

Initial And Continuing Filing Responsibilities. The Revenue Procedure requires detailed information from all taxpayers concerning the eligible debt instrument and the reacquisition transaction as part of the Code Sec. 108(i) election statement. In addition, it mandates that the taxpayer file an annual statement, beginning with the taxable year in which the eligible debt is reacquired and ending when all of the Code Sec. 108(i) deferred items have been recognized.

In the case of partnerships, making the Code Sec. 108(i) election, these reporting responsibilities are expanded in two important ways. First, the partnership must furnish the partners with a detailed calculation of their share of the COD Income that was subject to the Code Sec. 108(i) election, their share of any deferred OID, and the partner's deferred Code Sec. 752 amount. The partnership is required to retain this information as part of its books and records. Second, to implement the requirements of the Revenue Procedure concerning the calculation of a partner's deferred Code Sec. 752 amount, the partnership is required to make "reasonable efforts," prior to making the Code Sec. 108(i) election, to secure from each partner with a deferred amount for which it does not have the information necessary to compute the partner's basis in its partnership interest (and its deferred Code Sec. 752 amount) a written statement signed, signed under penalties of perjury, that includes this information. Each partner with a deferred amount must provide this written statement to the partnership within 30 days of the date of request by the partnership. Generally, a partner's failure to supply the information does not invalidate the election provided that the partnership made reasonable efforts to obtain the information and otherwise complies with the requirements of the Revenue Procedure.

The responsibility imposed on the partnership, as a predicate to a validly filed election, to "reasonably" inquire into the partners' basis for their interests in the partnership exposes two procedural issues presented by this Revenue Procedure.

First, how can a general partner be confident that the efforts undertaken to obtain the information from its partners are "reasonable" within the meaning of the Revenue Procedure? More to the point, unless the partnership is confident it has the required basis information, how much time in advance of the filing of the return and the making of the Code Sec. 108(i) election must the partnership begin to request the information from its partners and document its efforts?

Second, does the general partner have any responsibility to inquire whether it would be advantageous for the partnership to make a Code Sec. 108(i) election for any portion of the partnership's COD Income. How do you make the determination in the case of a partnership with indirect partners owning interests through pass-through entities? In many cases, the organizational documents give the general partner the exclusive authority to make elections on behalf of the partnership. Given that the making of the election is likely to impose added information and compliance costs on the partnership, and, in a multi-tier partnership structure, it may not be obvious whether there are any partners who would benefit from a Code Sec. 108(i) election, should the general partner its members concerning the making of a Code Sec. 108(i) election or should it simply react if a request is made. In either case, would the partnership be permitted to assess the marginal costs of making the election and continuing information requirements directly against the members benefited thereby?

Summary Of The Other Important Rules In The Revenue Procedure

Code Sec. 108(i) Elections For Foreign Corporations And Partnerships. The Revenue Procedure also sets forth the rules for a foreign corporation (either a controlled foreign corporation or a non-controlled Code Sec. 902 corporation not otherwise required to file a US tax return) and for foreign partnerships not otherwise required to file US tax returns. Non-filing foreign partnerships generally must file a partnership tax return for the taxable year in which the election is made or statements are required under the Revenue Procedure and send K-1's to its partners. The controlling domestic shareholder(s) (or common parent of the controlling domestic shareholder(s), if applicable) of a controlled foreign corporation or a non-controlled Code Sec. 902 corporation not otherwise required to file a return of tax in the US may make the Code Sec. 108(i) election on behalf of the foreign corporation. In order to do so, the controlling domestic shareholder must attach a statement identifying the foreign corporation and otherwise meeting the requirements of the Revenue Procedure to its federal income tax return for the taxable year for which the Code Sec. 108(i) election is made.

Impact Of The Code Sec. 108(i) Election On The Calculation Of A Corporation's Earning's And Profits. The Service gave notice of its intention to issue Regulations that will provide a corporation's Deferred COD Income increases earnings and profits in the taxable year that it is realized and not in the taxable year or years that the Deferred COD Income is includible in gross income, deferred OID deductions generally will decrease earnings and profits in the taxable year or years in which the deduction would otherwise be allowed without regard to the Code Sec. 108(i) election, and OID deductions that are deferred increase or decrease adjusted current earnings under Code Sec. 56(g)(4) in the taxable year or years that the income or deduction is includible or deductible in determining taxable income.

Protective Code Sec. 108(i) Elections. The Revenue Procedure specifies the manner in which the taxpayer can make a protective Code Sec. 108(i) election in two instances. First, where the taxpayer makes a Code Sec. 108(i) election the taxpayer can also specify a greater amount than the amount specified in the election to be treated as a Code Sec. 108(i) deferred COD Income in the event that the Service subsequently adjusts the amount of the COD Income reported by the taxpayer. Special reporting rules apply to partnerships. Second, a taxpayer is expressly permitted to make a protective Code Sec. 108(i) election for an eligible debt instrument where the taxpayer concludes that a particular transaction does not result in the realization of COD Income and reports the transaction on its federal return consistent with that determination. The making of a protective election under this rule requires that the taxpayer attach the protective election to its tax return for the year of the reacquisition of the eligible debt instrument and make additional disclosures thereafter.

The attorneys at Cozen O'Connor have experience in dealing with all of the tax issues involved in a debt restructuring, whether on behalf of borrowers or lenders.

www.cozen.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.