The Revised Debt-for-Equity Exchange Regulations: Compliance - PowerPoint PPT Presentation

Presenting a live 110-minute teleconference with interactive Q&A The Revised Debt-for-Equity Exchange Regulations: Compliance Challenges Anticipating Issues in Valuations of Partnership Interests Received, Bad Debt Deductions, Interest-Ordering and More THURSDAY, NOVEMBER 1, 2012 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: James Hamill, Tax Practice Director, Reynolds Hix & Co. , Albuquerque, N.M. Please refer to the instructions emailed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .

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The Revised Debt-for-Equity Exchange Regulations: Compliance Challenges Seminar Nov. 1, 2012 James Hamill, Reynolds Hix & Co. jimhamill@rhcocpa.com

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Sect. 108(e)(8) Partnership Debt- For-Equity Exchanges  General COD rules  Debt-for-equity exchanges – General rules – Valuation issues – Sect. 721 applicability – Unpaid rent, royalties, interest – Minimum gain charge-backs – Dispositions of installment obligations – Allocations of COD income 7

General COD Rules  Sect. 61 defines gross income.  Gross income is said to include income from discharge (cancellation) of indebtedness,  Various exceptions exist under Sect. 108 that may permit a taxpayer to exclude COD income.  Settling debt with property would: – Create COD, if the FMV of the property < Debt – Generally (also) be a taxable exchange of the property 8

Debt Forgiveness Issues  Recourse debt – May be deemed a sale, when voluntary or involuntary conveyance of security – May also be COD income, even with conveyance  Non-recourse debt – Typically creates deemed sale/exchange on conveyance – May be COD, when partial non-recourse – 1099-C now asks (2009 and after) whether cancelled debt was recourse or non-recourse 9

Sect. 166 Loss For Creditor?  Bad debt loss  May be partial loss, if business debt  Personal bad debt loss allowed, but as STCL 6511(d) seven-year statute applies   Loans made to an insolvent debtor are worthless when made, and must be recast as capital contributions or gifts [ Eckert , 283 US 140 (1931) and its progeny]. 10

Sect. 166 Losses  Whether loan was in furtherance of a trade or business is a factual question.  A loss on a loan guarantee is tested the same as a direct loan – was the taxpayer in the business of making guarantees? [ Putnam , 352 US 82 (1956)] 11

Sale Or Exchange (Not COD)  The receipt of any consideration creates a deemed sale or exchange.  The voluntary conveyance of property securing a debt, or a foreclosure conveyance, triggers a deemed sale or exchange, for both recourse and non-recourse obligations. 12

Measurement Issues  FMV > Basis is gain from sale  Debt > FMV is COD  1099 may include accrued interest; this is not part of COD if it could be deducted when paid.  Fair market value – Sale (bid) price at foreclosure presumed to be FMV, absent clear and convincing proof – See Frazier , 111 T.C. 243 (1998), for successful challenge of bid price 13

Sale Or Exchange: Non-Recourse Debt  Proceeds are the full amount of the non-recourse debt, even if FMV < NRD [ Crane , 331 US 1 (1947), Tufts , 461 US 300 (1983) and Regs. 1.1001-2]  Because 108 cannot apply , NRD creates the concept of “minimum gain” when the NRD exceeds the basis of the property securing the debt.  Gain is “minimum” because it cannot be excluded under 108; recourse debt has no similar concept. 14

Debt-For-Equity Exchanges: Law  Sect. 108(e)(8) – Extended to partnerships 10-22-2004 – Applies to transfer of capital or profits interest, for recourse or non-recourse debt – Deemed transfer of money equal to FMV of interest for the debt  If there is COD, it is allocated to partners immediately pre- discharge. 15

Sect. 108(e)(8) Issues  Debtor partnership – Any COD on exchange? – Is there a deemed exchange of partnership properties represented by the interest?  Creditor – Any bad debt loss allowed? – Basis of interest received? 16

Sect. 108(e)(8) Regulations  Proposed regulations issued 10-31-2008  Final regulations effective 11-17-2011  Key elements – Valuation safe harbor – Applicability of Sect. 721 – COD and minimum gain allocations 17

Valuation Of PS Interest  COD is avoided if the FMV of the PS interest > Debt  FMV is generally subjective, and the exception may be of limited practical utility if one anticipates challenges to claimed FMV.  The regulations provide a safe harbor. – Liquidation value is deemed to be FMV. – Four requirements must be satisfied. 18

Liquidation Value Defined  The amount of cash that would be received by the creditor if the partnership sold all assets at FMV and then liquidated  If the debtor is an upper-tier PS (UTP), then the value of the UTP includes the liquidation value of any lower-tier partnerships (LTPs) in which the UTP holds an interest. 19

Four Requirements For Safe Harbor  Creditor, debtor PS and all partners treat liquidation value as FMV (consistency).  If more than one interest is transferred as part of same plan, then all parties use liquidation value for each interest (cannot selectively use the safe harbor).  Terms are comparable to arm’s -length bargaining among unrelated parties with adverse interests (i.e., parties can be related but must satisfy this anti-abuse rule).  Post-exchange, no redemption of interest by PS or purchase by partners or parties related to partners if: – Pursuant to a plan existing at time of exchange – Principal purpose of plan is avoidance of COD by PS 20

Proposed Vs. Final Regulations  The proposed regulations require that the partnership maintain capital accounts pursuant to the Sect. 704(b) regulations.  These capital accounts determine rights to assets on liquidation for: – Economic effect safe harbor under the three-requirements or the alternate test – Deemed in accordance with the partners’ interest test for allocations of non-recourse deductions  But, they are not generally necessary to determine a liquidation value and were dropped from the final regulations. 21

Application Of Sect. 721  Sect. 721 overview – No gain or loss to partner or partnership upon exchange of property for an interest in the PS – Creditor and PS subject to Sect. 721 when debt is transferred in exchange for an interest  Creditor then has: – Substituted basis pursuant to Sect. 722 – No recognized Sect. 166 loss on exchange 22

Application Of Sect. 721 (Cont.)  Sect. 721 is regarded as a relief provision, as it protects against exchange gain.  But. it denies any loss to the creditor where there is COD (i.e., the FMV of the interest is less than the debt).  This then creates an asymmetric result – COD to partnership – Deferred loss to creditor 23