Category: Bankruptcy, Insolvency & Debt Discharge;
Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts: Issues 2) What are the tax ramifications to TP and the bankruptcy estate if TP buys the interests in the Negative Partnerships from the trustee for a nominal sum? 3) What are the ramifications to TP and the bankruptcy estate of the foreclosures? Answers: 2) It seems clear that a sale of the Negative Partnerships to the debtor, even for a nominal sum, would be treated as a taxable transaction to the estate giving rise to gain equal to the negative capital accounts. (This assumes the capital accounts represent tax basis before consideration of partnership liabilities.) 3) A foreclosure of property subject to nonrecourse debt gives rise to a deemed sale of the property for an amount equal to the total outstanding indebtedness. A foreclosure of property subject to recourse debt gives rise to a deemed sale of the property for an amount equal to the fair market value of the property and cancellation of debt (COD) income to the extent of the difference between the fair market value of the property and the outstanding debt. If the foreclosure occurred during the pendency of the bankruptcy estate, the tax consequences would flow to the estate; if the foreclosures occurred afterwards, the consequences would flow to the debtor. COD income, if any, could possibly be excluded under the insolvency/bankruptcy exception. Discussion: Issue 1 Several courts have considered the issue of whether an abandonment of assets under 11 USC §554 should be given §1398(f)(2) nonrecognition treatment under the theory that the bankruptcy estate has terminated with respect to the abandoned assets. The majority of those cases ruled that §1398(f)(2) applies to the abandonment such that the there is no gain or loss to the estate as a result of the abandonment transaction. See Samore v. Olson, 930 F2d 6, (8th Cir., 1991); In Re McGowan, 95 Bankr. 104; but compare In re A.J. Lane & Co., 133 Bankr. 264. There has been a considerable amount of controversy among those knowledgeable in this area as to which is the proper view with a number of heavyweight commentators aligned on each side of the issue. Regulations were issued in May of this year which resolve the issue at least with respect to abandonments of passive activities and those activities subject to the at-risk rules of IRC §465. The regulations follow the result of Olson and McGowan and reject the conclusion in A.J. Lane. Regulation Section 1.1398-1(d) provides as follows. (d) Transfers from estate to debtor. (1) Transfer not treated as taxable event. If, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange), the transfer is not treated as a disposition for purposes of any provision of the Internal Revenue Code assigning tax consequences to a disposition. The transfers to which this rule applies include transfers from the estate to the debtor of property that is exempt under section 522 of title 11 of the United States Code and abandonments of estate property to the debtor under section 554(a) of such title. (2) Treatment of passive activity loss and credit. If, before the termination of the estate, the estate transfers an interest in a passive activity or former passive activity to the debtor (other than by sale or exchange) --The estate must allocate to the transferred interest, in accordance with §1.469-1(f)(4), part or all of the estate's unused passive activity loss and unused passive activity credit (determined as of the first day of the estate's taxable year in which the transfer occurs); and (ii) The debtor succeeds to and takes into account, beginning with the debtor's taxable year in which the transfer occurs, the unused passive activity loss and unused passive activity credit (or part thereof) allocated to the transferred interest. Notice that this regulation literally applies only to passive activities or former passive activities. Regulation §1.1398-2 provides essentially the same rules with respect to activities subject to the at-risk rules of IRC §465. Presumably, the Negative Partnerships would come under the jurisdiction of either or both these regulations by virtue of being passive activities and/or investments subject to the at-risk rules. Assuming that the abandoned partnership interests are either passive activities or at-risk activities, it seems clear that a bankruptcy law abandonment by the trustee would result in no gain or loss to the trustee or the debtor and the debtor would simply "step into the shoes" of the bankruptcy estate. Discussion: Issue 2 As a matter of pure speculation, it would seem that one could argue that a "sale" for say, $1, is not a sale in substance, and the transaction should be treated instead in accordance with its substance (i.e., an abandonment). I cannot locate any evidence that this issue has ever been considered. Accordingly, I can only say that such a position must be regarded as risky at best given the clear language of the statute and regulations. Discussion: Issue 3 With respect to foreclosures of property subject to nonrecourse debt, the Supreme Court ruled in the case of Commissioner v. Tufts, 461 US 300 (1983), that the entire amount of debt is included as an amount realized from sale irrespective of the fair market value of the property. In essence, the entire nonrecourse mortgage constitutes an amount realized on the foreclosure even if the mortgage greatly exceeds the value of the property. With respect to foreclosures of property subject to recourse debt, Revenue Ruling 90-16 requires that the foreclosure transaction be split into two pieces: a) the foreclosed property is deemed sold for an amount equal to its fair market value; and b) assuming that the debtor's personal liability is extinguished, COD income results to the extent of the difference between the total debt and the value of the underlying property. One question is who is responsible for the tax consequences of the foreclosures, the debtor or the estate? It seems to me that the answer comes down to timing. There are no special bankruptcy tax rules to control the timing of foreclosure income; accordingly, it seems that to the extent the foreclosures occurred during the pendency of the bankruptcy estate, the tax ramifications of the foreclosures should flow to the estate. If the foreclosures occurred afterwards, the consequences should flow to the debtor. COD income resulting from relief of recourse liabilities could possibly be excluded under the §108(a) bankruptcy/insolvency exception. COD income can be excluded under §108(a) if a) the debtor is insolvent before and after debt relief or b) the debtor is in bankruptcy. An additional factor must be considered in this case because entities, partnerships and S corporations, are involved. Who must be insolvent or bankrupt in order to exclude COD income under §108(a), the partnership or the partner, the S corporation or the shareholder? §108(d)(6) provides that for partnerships, the insolvency/bankruptcy exception applies at the partner level, in essence the partner must be insolvent/bankruptcy in order to exclude COD income under 108(a). §108(d)(7) provides that for S corporations, the insolvency/bankruptcy exception applies at the corporate level, in essence the corporation must be insolvent/bankrupt in order to exclude COD income under 108(a). To the extent COD income is excluded under §108(a), there must be a corresponding reduction of various tax attributes including net operating losses, basis of depreciable assets, suspended passive activity losses, and other items set forth at §108(b). These tax attributes are reduced on a dollar-for-dollar basis to correspond to the amount of excluded COD income. |
