IRS Disagrees with Tax Court on Partner Excluding Debt Cancellation Income
The IRS has recently announced a non-acquiescence in four Tax Court cases involving the cancellation of partnership indebtedness. Generally, the discharge of indebtedness gives rise to gross income to the obligor. However, Code Section 108 provides a number of exceptions. Section 108(a)(1)(A) provides an exclusion if the cancellation of indebtedness arises in a Title 11 (Bankruptcy Court) case. In applying that section, Section 108(d)(6) provides that certain of the exceptions apply at the partnership level.
In a series of four cases involving partners of the same partnership, the partnership had borrowed approximately $20 million for the development of a continuing care facility. The debt was personally guaranteed by each of the general partners of the partnership, and the petitioners in each of the four cases were general partners of that partnership. Within three years of the borrowing, the partnership filed a voluntary Chapter 11 Bankruptcy Petition and the Bankruptcy Court appointed a trustee that took control of the partnership’s business. The trustee eventually negotiated an agreement which provided, among other things, for the general partners to make a contribution in exchange for a release from all claims. In the first case in the series, Gracia v. Commissioner, TC Memo 2004-147, the petitioner-general partner agreed to contribute $220,000 in the negotiated settlement and was released by the Bankruptcy Court from all claims in connection with the partnership debt, his personal guarantee, and any liability to creditors of the partnership relating to his partnership interest. Importantly, the Bankruptcy Court further ordered that the petitioner was “subject to the jurisdiction of the Bankruptcy Court.”
Ten years after the initial bankruptcy filing, the partnership issued the petitioners a K-1, allocating to the partner a share of the partnership’s COD income. The petitioners did not include the income on their tax returns and the IRS issued Notices of Deficiency indicating that the COD income was required to be reported and tax paid thereon.
The position of the IRS was that the partners were not themselves debtors in the Title 11 case, the partnership was, and under Section 108(d)(6) were not eligible for relief from the COD income. The Tax Court held to the contrary. The court noted that for purposes of Section 108, a Title 11 case is defined under Section 108(d)(2) as a case under Title 11 “but only if the taxpayer is under the jurisdiction of the court in such case.” The court further noted that while the petition involved the partnership, the Bankruptcy Court, in that case, discharged the liabilities of not only the partnership but the general partners and further, the Bankruptcy Court stated that the partners were subject to the jurisdiction of the Bankruptcy Court. Based on the plain language of the statute, the Tax Court held that the petitioners’ liability was discharged in a Title 11 case as defined in Section 108(d) and therefore the exclusion in Section 108(a) applied.
In the Action on Decision (AOD 2015-01) the IRS announced that it does not acquiesce in the case or its three companion cases because the taxpayer himself was not under the jurisdiction of the Bankruptcy Court in the Title 11 case “as a debtor.” These cases are interesting because it is generally assumed that under Section 108(d)(6), all partnership COD matters are passed through to individual partners and that the Section 108(a) exclusions are all determined at the partner level. Gracia and the companion cases indicate that this may not always be the case and that even though the partners themselves were not petitioners in the bankruptcy case, if their liabilities are discharged by the Bankruptcy Court, and if the court provides that these partners are subject to the jurisdiction of the Bankruptcy Court, the partners’ liabilities are discharged in the Title 11 case which, at least in the eyes of the Tax Court, make the resulting cancellation of indebtedness income excludable from gross income. While the IRS does not agree with the position, and the facts before the court were fairly specific as to the manner in which the discharge proceeded, the case does provide for some expansion of the ability to exclude COD income for partners in Title 11 bankruptcy cases.
This does not mean that partners can always walk away from cancelled partnership debt without consequences, even in the Title 11 case. Presumably this debt was included in the bases of the partnership interests of these general partners under Code Section 752, and the reduction of their share of partnership debt would be treated as a deemed distribution to them. The deemed distribution would be taxable to a partner to the extent it exceeds his basis in his partnership interest.