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Tax issues to consider when a partnership interest is transferred.

By Colleen McHugh - Co‑Partner‑in‑Charge, Alternative Investments

There can be several tax consequences as a result of a transfer of a partnership interest during the year. This article discusses some of those tax issues applicable to the partnership.

Adjustments to the Basis of Partnership Property Upon a transfer of a partnership interest, the partnership may elect to, or be required to, increase/decrease the basis of its assets. The basis adjustments will be for the benefit/detriment of the transferee partner only.

• If the partnership has a special election in place, known as an IRS Section 754 election, or will make one in the year of the transfer, the partnership will adjust the basis of its assets as a result of the transfer. IRS Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner.
• The partnership will be required to adjust the basis of its assets when an interest in the partnership is transferred if the total adjusted basis of the partnership’s assets is greater than the total fair market value of the partnership’s assets by more than $250,000 at the time of the transfer.

Ordinary Income Recognized by the Transferor on the Sale of a Partnership Interest Typically, when a partnership interest is sold, the transferor (seller) will recognize capital gain/loss. However, a portion of the gain/loss could be treated as ordinary income to the extent the transferor partner exchanges all or a part of his interest in the partnership attributable to unrealized receivables or inventory items. (This is known as “Section 751(a) Property” or “hot” assets).

• Unrealized receivables – includes, to the extent not previously included in income, any rights (contractual or otherwise) to payment for (i) goods delivered, or to be delivered, to the extent the proceeds would be treated as amounts received from the sale or exchange of property other than a capital asset, or (ii) services rendered, or to be rendered.
• Property held primarily for sale to customers in the ordinary course of a trade or business.
• Any other property of the partnership which would be considered property other than a capital asset and other than property used in a trade or business.
• Any other property held by the partnership which, if held by the selling partner, would be considered of the type described above.

Example – Partner A sells his partnership interest to D and recognizes gain of $500,000 on the sale. The partnership holds some inventory property. If the partnership sold this inventory, Partner A would be allocated $100,000 of that gain. As a result, Partner A will recognize $100,000 of ordinary income and $400,000 of capital gain.

The partnership needs to provide the transferor with sufficient information in order to determine the amount of ordinary income/loss on the sale, if any.

Termination/Technical Termination of the Partnership A transfer of a partnership interest could result in an actual or technical termination of the partnership.

• The partnership will terminate on the date of transfer if there is one tax owner left after the transfer.
• The partnership will have a technical termination for tax purposes if within a 12-month period there is a sale or exchange of 50% or more of the total interest in the partnership’s capital and profits.

Example – D transfers its 55% interest to E. The transfer will result in the partnership having a technical termination because 50% or more of the total interest in the partnership was transferred. The partnership will terminate on the date of transfer and a “new” partnership will begin on the day after the transfer.

Allocation of Partnership Income to Transferor/Transferee Partners When a partnership interest is transferred during the year, there are two methods available to allocate the partnership income to the transferor/transferee partners: the interim closing method and the proration method.

• Interim closing method – Under this method, the partnership closes its books with respect to the transferor partner. Generally, the partnership calculates the taxable income from the beginning of the year to the date of transfer and determines the transferor’s share of that income. Similarly, the partnership calculates the taxable income from the date after the transfer to the end of the taxable year and determines the transferee’s share of that income. (Note that certain items must be prorated.)

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the interim closing method, the partnership calculates the taxable income from 1/1 – 6/30 to be $100,000 and from 7/1-12/31 to be $50,000. Partner A will be allocated $10,000 [$100,000*10%] and Partner H will be allocated $5,000 [$50,000*10%].

• Proration method – this method is allowed if agreed to by the partners (typically discussed in the partnership agreement). Under this method, the partnership allocates to the transferor his prorata share of the amount of partnership items that would be included in his taxable income had he been a partner for the entire year. The proration may be based on the portion of the taxable year that has elapsed prior to the transfer or may be determined under any other reasonable method.

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the proration method, the income is treated as earned $74,384 from 1/1 – 6/30 [181 days/365 days*$150,000] and $75,616 from 7/1-12/31 [184 days/365 days*$150,000]. Partner A will be allocated $7,438 [$74,384*10%] and Partner H will be allocated $7,562 [$75,616*10%]. Note that this is one way to allocate the income. The partnership may use any reasonable method.

Change in Tax Year of the Partnership The transfer could result in a mandatory change in the partnership’s tax year. A partnership’s tax year is determined by reference to its partners. A partnership may not have a taxable year other than:

• The majority interest taxable year – this is the taxable year which, on each testing day, constituted the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50%.

Example – Partner A, an individual, transfers his 55% partnership interest to Corporation D, a C corporation with a year-end of June 30. Prior to the transfer, the partnership had a calendar year-end. As a result of the transfer, the partnership will be required to change its tax year to June 30 because Corporation D now owns the majority interest.

• If there is no majority interest taxable year or principal partners, (a partner having a 5% or more in the partnership profits or capital) then the partnership adopts the year which results in the least aggregate deferral.

Change in Partnership’s Accounting Method A transfer of a partnership interest may require the partnership to change its method of accounting. Generally, a partnership may not use the cash method of accounting if it has a C corporation as a partner. Therefore, a transfer of a partnership interest to a C corporation could result in the partnership being required to change from the cash method to the accrual method.

As described in this article, a transfer of a partnership interest involves an analysis of several tax consequences. An analysis should always be done to ensure that any tax issues are dealt with timely.

If you or your business are involved in a transfer described above, please contact your Marcum Tax Professional for guidance on tax treatment.

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The US Department of the Treasury and Internal Revenue Service (IRS) recently issued  final regulations under section 1446(f) , a provision enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA) that generally imposes a withholding obligation on transfers of certain partnership interests (Note: All references to “section” are to the Internal Revenue Code of 1986, as amended (the “Code”) unless otherwise indicated). That provision, in conjunction with the enactment of section 864(c)(8) also under the TCJA, imposes a new statutory scheme in response to the ruling of the Tax Court in  Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner , 149 TC No. 3 (2017), aff’d, 926 F.3d 819 (DC Cir. June 11, 2019). The final regulations largely retained the rules set forth in the proposed regulations, with some additions and modifications. The following discusses some of the noteworthy provisions in the regulations.

SECTIONS 864(C)(8) AND 1446(F): IN GENERAL

Section 864(c)(8) generally provides that gain or loss derived by a nonresident individual or foreign corporation from the sale or exchange (or other disposition) of an interest in a partnership engaged in a US trade or business is treated as effectively connected income (ECI) to the same extent as such partner’s portion of distributive share of gain or loss that would have been ECI if the partnership had sold all of its assets at their fair market value as of the date of the partner’s sale or exchange. Section 864(c)(8) further provides that withholding is not required to the extent a transferor provides a nonforeign affidavit to the transferee, or if other regulatory exceptions are adopted (as discussed below).

Section 1446(f) generally requires a transferee of a partnership interest described in section 864(c)(8) to withhold 10% of the amount realized by the transferor. Moreover, if the transferee fails to withhold such amount, the partnership is required to deduct and withhold from distributions to the transferee a tax equal to the amount the transferee failed to withhold plus interest.

EFFECTIVE DATES

Generally, the final regulations apply to transfers of partnership interests occurring on or after 60 days after the final regulations are published in the Federal Register ( i.e. , December 2020). However, a partnership’s requirement to withhold amounts not withheld by the transferee applies to transfers that occur on or after January 1, 2022.

AMOUNT TO WITHHOLD

Amount realized.

The final regulations retained the definition of “amount realized” set forth in the proposed regulations, namely, that it generally includes (i) consideration paid by the transferee and (ii) the transferor’s share of partnership liabilities (determined under section 752 and the regulations promulgated thereunder). Thus, the amount realized includes any reduction in the transferor’s share of partnership liabilities. One commentator suggested the inclusion of any reduction to a transferor’s share of partnership liabilities could cause liquidity concerns when the amount of liabilities assumed exceeds the cash or other property exchanged in the transfer. Treasury and the IRS concluded that it was inappropriate to exclude a reduction in a transferor’s share of partnership liabilities from the amount realized, citing that such concerns are addressed in regulation 1.1446(f)-2(c)(3).

For purposes of determining the amount realized, the final regulations retain the look-through rule set forth in the proposed regulations for situations involving a transfer by a foreign partnership transferor that has a direct or indirect partner not subject to tax on gain from such transfer as a result of an applicable US income tax treaty. Specifically, the final regulations provide that a treaty-eligible partner is not a presumed foreign taxable person for purposes of determining the modified amount realized. A foreign partnership that provides a certification of modified amount realized must include, in addition to IRS Form W-8IMY ( Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting ) and a withholding statement, the certification of treaty benefits (on IRS Form W-8BEN ( Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals) ) or Form W-8BEN-E ( Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities) ), as applicable from each direct or indirect partner that is not a presumed foreign taxable person.

Certification of Maximum Tax Liability

The final regulations adopt the procedure in the proposed regulations limiting the withholding amount based on the maximum tax liability the transferor would be required to pay on the gain attributable to the partnership interest transfer. Specifically, the procedure allows a transferee to withhold based on a certification received from the transferor containing certain information relating to the transferor and the transfer, including the transferor’s maximum tax liability. A transferee may rely on a certification received from a transferor that is a foreign corporation, a nonresident alien individual or a foreign partnership regarding the transferor’s maximum tax liability. In addition, the final regulations permit transferors that are foreign trusts to use the maximum tax liability procedure to reduce the amount otherwise required to be withheld. Similar to the approach taken with respect to foreign partnerships, such rules treat the foreign trust as a nonresident alien individual for purposes of computing its maximum tax liability.

OBLIGATION TO WITHHOLD

In general, as noted earlier, the transferee of a partnership interest must withhold a tax equal to 10% of the amount realized by the transferor on any transfer of a partnership interest unless an applicable exception applies (as discussed below).

The final regulations maintain this broad presumption, despite comments to the proposed regulations noting that such presumption may impose a withholding obligation on  any  transfer of a partnership interest, regardless of whether the partnership in question has assets in, or a connection to, the United States. Treasury and the IRS justified this broad approach in the final regulations by noting that a transferee will not know whether a transfer results in tax on gain without information from the transferor or the partnership. Therefore, the transferee must presume that a transfer is subject to withholding unless it obtains a certification establishing otherwise.

Given the broad application of the final regulations, even non-US partners in non-US partnerships may be caught up in the withholding requirements of partnership interest transfers. This can be a trap for the unwary because it is not always obvious whether a non-US entity or investment vehicle is, by default, classified as a partnership for US income tax purposes. For example, in the absence of a US entity classification election confirming its US income tax classification, the US income tax classification of Brazilian funds, such as FIMs ( fundos de investimento multimercado ) and FIPs ( fundos de investimento em participações ), depends on certain peculiarities of the given entity’s governing documents. Thus, investors and their advisors should be careful to consider the impact of the final regulations not only on US partnerships but also on non-US partnerships and investment vehicles.

The final regulations provide that a partnership is permitted to determine that it does not have a withholding obligation under the final regulations if it possesses a valid IRS Form W-9 ( Request for Taxpayer Identification Number and Certification)  for the transferor to establish the transferor’s non-foreign status, even if the transferee does not provide a withholding certificate to the partnership.

LIABILITY FOR FAILING TO WITHHOLD

As noted above, if a transferee fails to withhold any amount required to be withheld, the partnership must deduct and withhold from distributions to the transferee a tax in an amount equal to the amount the transferee failed to withhold, plus interest. A partnership may determine its withholding obligation by relying on information provided in a certification received from the transferee ( i.e. , a withholding certificate). Generally, a transferee is required to provide a partnership with a certification that it has complied with its partnership interest transfer withholding obligation, including whether it is relying upon an exemption from such withholding. The final regulations add a provision that any person required to withhold is not liable for failure to withhold, including any interest or penalties resulting therefrom, if such person establishes to the satisfaction of the IRS that the transferor had no effectively connected gain subject to tax on the transfer of the partnership interest. However, it may be difficult for the withholding agent to convince the IRS that no such taxable gain exists without cooperation from the transferor.

Because partnerships can become liable for deducting and withholding tax (and interest) that a transferee failed to withhold from a transferor, partnerships should consider reviewing their partnership agreements and due diligence requirements related to transfers of partnership interests. For instance, a partnership may include provisions in its partnership agreement that a transfer of a partnership interest may only be permitted if (among other customary requirements) a transferee provides a valid certificate establishing an exception to withholding or certifies that it will withhold on the transfer (accompanied by proof of such actual withholding).

RELIANCE ON CERTIFICATIONS PROVIDED BY TRANSFEROR, TRANSFEREE AND PARTNERSHIP

In order not to withhold or to withhold a reduced amount, a transferee is permitted to rely on a certification it receives from a transferor or the partnership unless it has actual knowledge that the certification is incorrect or unreliable. Moreover, the partnership may rely on a certification received from the transferee unless the partnership knows or has reason to know it is incorrect or unreliable. Such “reason to know” standard requires the partnership to review the certification to confirm that it does not have information suggesting the certificate is incorrect or unreliable. On that basis, transferees might consider including a pre-closing condition (and other relevant contractual provisions) in a purchase agreement that the partnership will confirm the certification from the transferor and/or the partnership will itself provide a certification.

WITHHOLDING EXCEPTIONS

The final regulations generally retain the withholding exceptions of the proposed regulations with certain modifications. Importantly, the transferor’s distributive share of ECI exception no longer requires effectively connected income or loss in a given tax year, and a new no trade or business exception has been adopted.

The final regulations do not include any withholding exceptions for: (i) disguised sales; (ii) transferors that are “withholding foreign partnerships” and “withholding foreign trusts” if they enter into a withholding agreement with the IRS; and (iii) earnout payments entitling the transferor to future payments based on specific goals or metrics.

Non-Foreign Status

The transferor may provide a certificate to a transferee certifying as to its non-foreign status. For that purpose, a certification of non-foreign status includes a valid IRS Form W-9. Moreover, a transferee may rely on a valid Form W-9 it already possesses from the transferor provided it meets the certification requirement as set forth in the final regulations.

The transferor may provide a certification that no gain will be realized by the transferor. Importantly, the transferor must certify that ordinary income attributable to property described in Code section 751 (“hot assets”) utilized in or attributable to a US trade or business would not be recognized in connection with the transfer.

Deemed Sale

A transferee (other than a partnership that is a transferee because it makes a distribution) may rely on a certification from the partnership that if the partnership sold all of its assets on the “determination date,” either: (1) the partnership would have no effectively connected gain, or if the partnership would have a net amount of such gain, the amount of the partnership’s net gain that would have been effectively connected gain would be less than 10% of the total net gain; or (2) the transferor would not have a distributive share of net gain from the partnership that would be ECI, or if the transferor would have a distributive share of ECI, the transferor’s allocable share of the partnership’s net ECI would be less than 10% of the transferor’s distributive share of the total net gain from the partnership. For this purpose, and generally, the “determination date” is the transfer date or any day that is no more than 60 days before the date of the transfer.

No US Trade or Business

Addressing comments to the proposed regulations, Treasury and the IRS included a new exception from withholding not included in the proposed regulations. Specifically, a transferee (other than a partnership that is a transferee because it makes a distribution) may rely on a certification from the partnership that it was not engaged in a US trade or business during the partnership’s tax year, up to and including the date of the transfer. Partnerships that invest in assets that do not give rise to ECI ( e.g. , corporations, real estate investment trusts, etc.) should find this exception useful.

Transferor’s Distributive Share of ECI

A transferee (other than a partnership that is a transferee because it makes a distribution) may rely on a certification from the transferor stating that: (a) it has held its partnership interest for the prior three tax years (the “look-back period”); (b) the transferor’s (and its related partners’ within the meaning of sections 267(b) and 707(b)) distributive share of gross ECI in each of the taxable years within the look-back period was less than $1 million in the aggregate; (C) the transferor’s distributive share of gross ECI in each of the years within the look-back period is less than 10% of its total distributive share of gross partnership income; and (D) the transferor’s share of ECI was timely reported on its tax return and all US taxes on such ECI were timely paid.

Notably, a transferor may only provide a certificate pursuant to that exception if it has received a Schedule K-1 from the partnership reflecting distributable gross income for each of the years within the look-back period. Importantly, unlike the proposed regulations, the final regulations do not require that the transferor have received an IRS Form 8805 ( Foreign Partner’s Information Statement of Section 1446 Withholding Tax ) and have effectively connected gain or loss, thus making this exception available for partners of partnerships without ECI. Practically, the use of this exception may be limited because some partnerships do not provide K-1s to their foreign partners unless and until the partnership derives ECI.

Certification of Nonrecognition by Transferor

A transferee may rely on a certification from the transferor stating that by reason of the operation of a nonrecognition provision of the Code, the transferor is not required to recognize any gain or loss with respect to the transfer of the partnership interest. The final regulations also contain a partial nonrecognition exception that may apply in certain circumstances.

Treaty Claims

A transferor may provide a certification to the transferee that it is not subject to tax on any gain upon transfer of the partnership interest because of an applicable tax treaty limiting the ability of the United States to tax income that does is not attributable to a permanent establishment. To avail itself of that exception, the transferor must make the certification on a valid IRS Form W-8BEN, or Form W-8BEN-E. In addition, the transferee must mail a copy of the certification to the IRS within 30 days of the transfer. Before making such certification for purposes of invoking the treaty claim exception, a transferor should consider other factors that may give rise to a permanent establishment, including whether the US office of the partnership constitutes a fixed place of business as defined by the applicable treaty.

The IRS indicated its intention to revise the instructions to Forms W-8BEN and W-8BEN-E to describe the information required to be provided for making a treaty benefits claim for purposes of section 1446(f), including a treaty claim made with respect to a transfer of a publicly traded partnership (PTP) interest.

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Withholding and information reporting on the transfer of private partnership interests

November 2020

Treasury and the IRS released on October 7 Final Regulations (the Final Regulations ) under Sections 1446(f) and 864(c)(8). Section 1446(f), added to the Code by the 2017 tax reform legislation, provides rules for withholding on the transfer or disposition of a partnership interest. Proposed Regulations were issued in May 2019, which laid the framework for guidance on withholding and reporting obligations under Section 1446(f) (the Proposed Regulations). The Proposed Regulations also addressed information reporting under Section 864(c)(8); these rules were finalized in September 2020. The Final Regulations retain the basic structure and guidance of the Proposed Regulations, but with various modifications. 

The Final Regulations apply to both publicly traded partnerships (PTPs) and private partnerships. This insight summarizes some of the changes applicable to PTPs but primarily focuses on private partnerships. A separate detailed Insight will be circulated with respect to PTPs. 

The Final Regulations generally are applicable to transfers occurring on or after the date that is 60 days after their publication in the Federal Register. However, the backstop withholding rules only apply to transfers that occur on or after January 1, 2022.

PTPs . Significantly, beginning January 1, 2022, the Final Regulations will require withholding under Section 1446(f) on both dispositions of and distributions by PTPs. This is a significant evolution of these rules, which to date have not been extended to PTPs due to the informational and operational challenges associated with imposing withholding taxes in respect of publicly traded securities. As will be discussed in more detail in the separate alert, these challenges result from the expansion of withholding obligations to new parties (e.g., executing brokers) that traditionally may not have been withholding agents and a substantial expansion of the qualified intermediary (QI) obligations. 

Other partnerships . The Final Regulations retain the presumption that withholding is required unless an applicable certification is provided. However, they now provide a limitation on the transferee’s liability to the extent the transferee can establish the transferor had no tax liability under Section 864(c)(8). The Final Regulations also include new or expanded exceptions to the withholding requirements. These include the ability to rely on a valid Form W-9 to prove US status as well as a new exception from withholding for partnerships that are not engaged in a US trade or business.

Download the full publication Withholding and information reporting on the transfer of private partnership interests

The takeaway.

The Final Regulation package retains the basic approach and structure of the Proposed Regulations, with some modifications. Taxpayers (particularly minority partners and taxpayers in tiered structures) who are intending to either eliminate or reduce the withholding tax should be mindful of the time restrictions in order to be compliant with a reduction or elimination of withholding and the potential difficulty in obtaining information from a partnership and should plan accordingly.

• Final Regulations modify treatment of gain or loss on sale of partnership interest by foreign partner (October 21, 2020)
• PwC Client Comments re Section 1446(f) Proposed Regulations (July 12, 2019)
• Proposed regulations address tax withholding, information reporting on partnerships with US trade or business (May 31, 2019)

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Assignment Of Partnership Interest

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What is an assignment of partnership interest.

• Information about the partnership like the name of the business
• The type of interest being transferred
• The names and information of both the assignor and the assignee
• Information about the remaining partners

Common Sections in Assignments Of Partnership Interest

Below is a list of common sections included in Assignments Of Partnership Interest. These sections are linked to the below sample agreement for you to explore.

Assignment Of Partnership Interest Sample

Reference : Security Exchange Commission - Edgar Database, EX-10.37 15 dex1037.htm FORM OF AGREEMENT AND ASSIGNMENT OF PARTNERSHIP INTEREST , Viewed October 25, 2021, View Source on SEC .

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Bruce Burk practice is in the area of small business, labor and employment, contracts, real estate and civil litigation. Bruce has litigated over 40 trials as well as many appeals. He prioritizes client communication and satisfaction as well as delivering high quality work product.

Attorney Cory Barack specializes in business, real estate, probate, and energy law. He can help you with oil/gas leases, easements, property sales, drafting contracts and wills, setting up companies, and resolving disputes. He is licensed to practice law in Ohio and is located in Eastern Ohio.

Advised startups and established corporations on a wide range of commercial and corporate matters, including VC funding, technology law, and M&A. Commercial and Corporate Matters • Advised companies on commercial and corporate matters and drafted corporate documents and commercial agreements—including but not limited to —Convertible Note, SAFE, Promissory Note, Terms and Conditions, SaaS Agreement, Employment Agreement, Contractor Agreement, Joint Venture Agreement, Stock Purchase Agreement, Asset Purchase Agreement, Shareholders Agreement, Partnership Agreement, Franchise Agreement, License Agreement, and Financing Agreement. • Drafted and revised internal regulations of joint venture companies (board of directors, employment, office organization, discretional duty, internal control, accounting, fund management, etc.) • Advised JVs on corporate structuring and other legal matters • Advised startups on VC funding Employment Matters • Drafted a wide range of employment agreements, including dental associate agreements, physician employment agreements, startup employment agreements, and executive employment agreements. • Advised clients on complex employment law matters and drafted employment agreements, dispute settlement agreements, and severance agreements. General Counsel • As outside general counsel, I advised startups on ICOs, securities law, business licenses, regulatory compliance, and other commercial and corporate matters. • Drafted or analyzed coin or token sale agreements for global ICOs. • Assisted clients with corporate formations, including filing incorporation documents and foreign corporation registrations, drafting operating and partnership agreements, and creating articles of incorporation and bylaws. Dispute Resolution • Conducted legal research, and document review, and drafted pleadings, motions, and other trial documents. • Advised the client on strategic approaches to discovery proceedings and settlement negotiation. • Advised clients on employment dispute settlements.

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Selling Your Partnership Interest? Form 8308, and New Penalty Relief, May Apply

by Shawn Smith, Jeffrey McMichael

Beginning with tax year 2023, partnerships that sell or exchange partnership interests must report additional information to the IRS, both on Form 8308 “Report of a Sale or Exchange of Certain Partnership Interests” and on their Schedule K-1 disclosures. The additional information is intended to help partners determine their tax liability when selling or exchanging their interests.  In October 2023, the IRS released a revised version of Form 8308 that adds a new part IV requiring calculations of gain or loss on the sale or exchange of certain partnership interests. The completed Form 8308, including the new part IV, must be sent to the transferor and transferee partners by January 31, 2024. Commentators have expressed concern to the IRS because, in many cases, partnerships will not have all of the information required to complete part IV of Form 8308 by the January 31, 2024, deadline.  As a result, in mid-January 2024 IRS Notice 2024-19 granted penalty relief for taxpayers who are unable to furnish a completed copy of Form 8308 to the transferor and transferee partners by the January 31 deadline. However, the completed form is still due to the IRS on that date. Below offers guidance on Form 8308 and the new penalty relief.

What Information Is Needed on Form 8308 When a Partnership Sells or Exchanges an Interest?

Partnerships must generally file Form 8308 to report the sale or exchange by a partner of all of part of their partnership interest where any money or other property received in the sale or exchange is attributable to unrealized receivables or inventory items as defined in Section 751(a), more commonly referred to as “hot assets.” The partnership must attach the completed Form 8308 to its timely filed tax return (including extensions) and furnish copies to the transferor and transferee partners of the transaction. The October 2023 revision to Form 8308 affects transfers occurring on or after January 1, 2023, and has expanded the reporting requirements of parts I and II, and added new parts III and IV: 

• Parts I-III require the partnership to disclosure more information about the transferor and transferee partners, the record holder and beneficial owner of the partnership interest immediately before and after the transaction, and the date and type of transfer. 
• Section 751(a) for “hot assets,” taxed at ordinary rates up to 37%;
• Section 1(h)(5) for collectibles, taxed at higher capital gain rates up to 28%; and
• Unrecaptured 1250 gain for real property, taxed at 25%.

In addition, the partnership must disclose the above gains on the transferor partner’s 2023 Schedule K-1 that is filed with the partnership’s Form 1065 tax return. The amounts are disclosed in Boxes 20AB, 20AC and 20AD, respectively. If a partnership is required to file Form 8308 due to a sale or exchange described in Section 751(a) and its regulations, the partnership must furnish a statement to the transferor and transferee involved in the transaction by the later of:

• January 31 of the year following the calendar year in which the exchange occurred, or
• 30 days after the partnership has received notice of the exchange. 

Generally, a partnership must use a completed Form 8308 as the required statement. However, the partnership can also furnish a separate statement to the transferor and transferee that includes the required information to be shown on Form 8308 with respect to the Section 751(a) transaction.

What Type of Penalty Relief Does Notice 2024-19 Provide for Form 8308?

Notice 2024-19 acknowledges the concerns taxpayers have with being able to timely furnish the information required in part IV of Form 8308 to the transferor and transferee partners. Therefore, the IRS will not impose penalties under Section 6722 for failure to furnish a completed Form 8308 to the transferor and transferee partners of a Section 751(a) exchange by the January 31, 2024, due date.  However, keep in mind this penalty relief applies only to the partnership furnishing the Form 8308 to the transferor and transferee partners , not to attaching a completed Form 8308 to the partnership’s timely filed tax return (including extensions).

How Does My Partnership Qualify for Relief Under Notice 2014-19?

To qualify for relief under Notice 2024-19, the partnership must do the following:

• Timely and correctly furnish the transferor and transferee partners a copy of Form 8308 with parts I, II and III completed, or a statement that includes the same information, by the later of January 31, 2024, or 30 days after the partnership is notified of the Section 751(a) exchange; and
• Provide the transferor and transferee partners a copy of the complete Form 8308, including part IV, or a statement that includes the same information, by the later of the due date of the partnership’s Form 1065 (including extensions) or 30 days after the partnership is notified of the Section 751(a) exchange.

Taxpayers that were involved in a sale or exchange of their partnership interest should notify their tax professional of the transaction and determine if filing Form 8308 is required, then discuss next steps to comply with the new reporting requirements for tax year 2023. Contact Shawn Smith at [email protected] , Jeffrey McMichael at [email protected] or a member of your service team to discuss this topic further. Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.

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Assignment of Interest In LLC: Everything You Need to Know

Assignment of interest in LLCs happens when a member communicates to other members his/her intention to transfer part or all of his ownership rights in the LLC to another entity. 3 min read updated on February 01, 2023

Updated October 28, 2020:

Assignment of interest in LLCs happens when a member communicates to other members his/her intention to transfer part or all of his ownership rights in the LLC to another entity. The assignment is usually done as a means for members to provide collateral for personal loans, settle debts, or leave the LLC. The member (assignor) and the person assigned (assignee) sign a document called the Membership Assignment of Interest.

Why a Member May Want to Assign Interest

A member may choose to assign interest for a number of reasons.

• The assignment of interest may happen as collateral to a loan to one of the members.
• Some members can assign interest to settle debts. The assignment will be effective until the debt is cleared.
• An assignment of interest can also' be done  to a member's legal heirs , going into effect upon the death of a member. 

The Rights and Limitations of the Assignee

The laws governing LLC membership interest assignments vary considerably from one state to another. 

• Most states prohibit the assignee from participating in the LLC's operations or decisions unless the Articles of Organization have this provision.
• An assignee is protected from liability from the assignor until the assignee becomes a member in most states. However, the law in a few states, including California and Florida, states that the assignee does get the assignor's liability.
• Should the assignee become a member after the assignment, he is only entitled to the rights and restrictions the assignor had.
• The assignment usually gives the assignee the right to receive the assignor's share of the profits — but not necessarily the other rights.

The Rights and Limitations of the Assignor

• In many states, all LLC members have the right to assign membership interest.
• In most states, assigning interest does not necessarily lead to forfeiting of voting and management rights and can be temporary. Texas law, on the other hand, states that the assignor ceases to be a member of the LLC after the assignment.

The Rights and Limitations of Other Members

• All members of the LLC have to be notified of any type of assignment.
• Some states require the assignment of interest to be approved by all members.
• The new person who has been assigned interest does not necessarily become a member even if the assigner has decided to leave the LLC. The other members can decide whether to admit the assignee as a member or not. Should a member assign interest without the input of other members, the interest is normally limited to financial benefits.
• In a two-member LLC, one member can easily transfer the interest to the other. 

The Membership Interest Assignment Document

The LLC's operating agreement should explain the rights of members on issues of transfer of interest, and the agreement should be followed during the assignment process. The Membership Interest Assignment acts as a record of the agreement, and the LLC normally keeps a copy of the document. The law in most states does not provide a formal template of the Membership Interest Assignment document but lists what should be included in the document. The document should have the following details:

• Percentage of interest that will go to the assignee 
• Whether the assignee will have voting rights
• The signatures of the assignor and the assignee

Assignment of Interest Versus Selling Ownership Stake

The assignment of interest is typically different from selling the ownership stake . Selling a member's ownership stake in the LLC requires unanimous approval by the other members. A departing member may also assign his membership to another member.

If a member is being paid to transfer interest, this is treated for tax purposes as a sale, and the selling member's gains might be liable to capital gains tax. Even if a departing member is not paid for his interest, if the departure results in the assignee getting the departing members' share of liability, the departure is seen as an exchange or sale.

Assignment of Interest Versus Abandoning an LLC

If a member wants to withdraw interest in an LLC, he/she can choose to simply legally abandon the LLC in most states. The abandoning member should give some kind of notice to the other members explaining that he is abandoning membership. Abandoning membership does not usually require the approval of other members.

Abandoning an LLC does not absolve the member of liability he/she may have incurred when still a member.

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Court Rules on Gifting a Percentage of Partnership Interests Versus a Fixed Amount

Depending on the attorney and the wants of their client, gift transfer documents may indicate either a specific number of units or a percentage. They may also be “backed into” based on the dollar amount of the valuation conclusion via a formula clause.

This month’s highlighted business valuation case study reiterates the importance of drafting transfer documents so that the language within the documents matches the intentions of the attorney and their client. If the language does not match the intent, the client may be locked into specific details of a gift transfer that are different than originally planned.

If you require the perspective of a valuation services professional, we’d love to discuss how KSM can help. Please contact a member of our team or  complete this form .

5th Circuit Court of Appeals Upholds Tax Court Finding That Taxpayer Gifted a Percentage of Partnership Interests and Not a Fixed Amount

Nelson v commr., 2021 u.s. app. lexis 32741 (nov. 3, 2021).

“Mary P. Nelson and James C. Nelson appeal from the Tax Court’s denial of their petition for a redetermination of a deficiency of gift tax issued by the commissioner of Internal Revenue for the tax years 2008 and 2009. For the following reasons, we AFFIRM.”

Facts. Mary Pat and James Nelson sought to plan their estate and formed a limited partnership, Longspar Partners Ltd., in 2008. Mary Pat and James named themselves general partners, with a 0.5% interest each. The limited partners were Mary Pat and trusts for their daughters. The majority of Longspar’s assets were shares of stock in Warren Equipment Co., a holding company for several businesses. Mary Pat also contributed her limited partner interests to a trust where Mary Pat was the settlor, James the trustee, and their daughters the beneficiaries. The interests were transferred in two transactions, a gift and then a sale. The transfer agreement stated:

[Mary Pat] desires to make a gift and to assign to [the trust] her right, title, and interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of December 31, 2008 (the “Limited Partner Interest”), as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

The transfer agreement for the sale used largely the same language and was for a limited partnership interest having a FMV of $20 million. The qualified appraiser rendered a report valuing a 1% interest at $341,000. “The Nelsons’ attorney then used the fair market value as determined by the accountant to convert the dollar values in the transfer agreements to percentages of limited partner interests—6.14% for the gift and 58.65% for the sale.” The IRS audited the Nelsons’ gift tax returns and issued a deficiency notice of $611,208 for 2008 and $6,123,168 for 2009.

The Nelsons challenged in Tax Court, arguing that “they had sought to transfer specific dollar amounts through a formula clause and that the amount of interests transferred should be reallocated should the valuation change.” The Tax Court found that a 1% value was worth $411,235 and that the language in the transfer documents was not a valid formula clause that could support reallocation of the interests. “The Nelsons timely appeal the court’s finding that the transfers consisted of percentage interests, rather than fixed dollar amounts.”

Discussion. With the amount of gift tax, the nature of the transfer is determined by looking at the transfer documents. The language in the documents here expressly stated “fair market value” for purposes of determining the interests transferred. The appraiser thus determined the fair market value. “The Nelsons defined their transfer differently; they qualified it as the fair market value that was determined by the appraiser. Once the appraiser had determined the fair market value of a 1% limited partner interest in Longspar, and the stated dollar values were converted to percentages based on that appraisal, those percentages were locked, and remained so even after the valuation changed.” The Nelsons’ documents lacked specific language describing what should happen to any additional shares transferred if the valuation was sufficiently challenged.

The fact that the trust did return excess units was irrelevant and was the type of “subsequent occurrence” that “this court” has said is “off limits” when valuing the value of a gift. ( Succession of McCord, 461 F.3d at 626.) For tax purposes, the value at the date of the gift was determined to be the amount of the gift. With a formula clause, the transaction was still closed even if a reallocation occurs. “The reallocation clauses thus allow for the proper number of units to be transferred based on the final, correct determination of valuation.” Both parties agreed that the transfer was complete at the date of the gift. The Nelsons attempted to draft a formula clause but failed to do so.

The interpretation of the transfer documents was not changed by looking at any objective facts outside of the language of the documents. The documents were not ambiguous, and the Nelsons’ interpretation was not reasonable as a matter of law. The Nelsons’ interpretation would amount to changing and overriding the language in the transfer documents and Texas law did not allow for that. The subjective intent of the contracts considering the estate planning intent would not be allowed. “To support the Nelsons’ reading, we would be required to disregard significant differences between these contracts and the transfer documents used in similar cases.”

The appraisal was delayed, but that had no bearing on the nature of the transfers. It does mean that the trust might have a claim against Mary, or the trust and Mary might have a claim against the appraiser. Also, “the lack of concern demonstrated for the tardy appraisal is yet another indicium of subjective intent which similarly cannot be considered under Texas’ parole evidence rule.”

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Disposal and acquisition of partnership interests: tax

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Disposal and acquisition of partnership interests: tax

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• GAINS & LOSSES

Taxing the Transfer of Debts Between Debtors and Creditors

• C Corporation Income Taxation
• NOL & Other Tax Attributes
• Individual Income Taxation

T he frequent transfer of cash between closely held businesses and their owners is very common. If the owner works in the business, the transfer is likely to be either a salary to a shareholder/employee or a Sec. 707(c) guaranteed payment to a partner. Alternatively, the transfer may be a loan. As long as the true substance of the transaction is a loan, it will be respected for tax purposes. 1

The cash flow is not exclusively from the businesses to the owner. Many owners prefer to capitalize their closely held business with a combination of equity and debt. Once again, these loans will be respected and not reclassified as equity if they are bona fide loans.

In the normal course of business, these loans are repaid. The receipt of the repayment will be tax free except to the extent it is interest. However, in difficult economic conditions, many of these loans are not repaid. To the extent that the creditor cancels the obligation, the debtor has cancellation of debt (COD) income under Sec. 61(a)(12). This income is taxable unless the taxpayer qualifies for an exclusion under Sec. 108. In other cases, the debt is transferred between the parties either as an independent transaction or part of a larger one. This article reviews these transactions.

Two basic types of transfers have created significant tax issues. In the first, the debtor transfers the debt to the creditor. If the debtor is the owner of a business and the business is a creditor, the transfer appears to be a contribution. If the business is the debtor and the owner is the creditor, the transfer can be a distribution, liquidation, or reorganization. The other type of transfer is from the creditor to the debtor. Again, the transaction can take the form of a contribution if the creditor is the owner, or it can take the form of a distribution, liquidation, or reorganization if the creditor is the business.

Debtor-to-Creditor Transfers

Corporations.

The two seminal cases that established the framework for analyzing the transfer of a debt obligation from a debtor to a creditor are Kniffen 2 and Edwards Motor Transit Co. 3 Arthur Kniffen ran a sole proprietorship and owned a corporation. The sole proprietorship borrowed money from the corporation. For valid business reasons, Kniffen transferred the assets and liabili ties of the proprietorship to the corporation in exchange for stock of the corporation, thereby transferring a debt from the debtor to the creditor. The transaction met the requirements of Sec. 351.

The government argued that the transfer of the debt to the creditor was in fact a discharge or cancellation of the debt (a single step), which should have been treated as the receipt of boot under Sec. 351(b) and taxed currently. The taxpayer argued that the transfer was an assumption of the debt and, based on Sec. 357(a), should not be treated as boot.

The Tax Court acknowledged that the debt was canceled by operation of law. However, it did not accept the government’s argument as to the structure of the transaction. Instead, it determined that two separate steps occurred. First, the corporation assumed the debt. This assumption was covered by Sec. 357(a). After the assumption, the interests of the debtor and creditor merged and the debt was extinguished. Since the transfer was not for tax avoidance purposes, Sec. 357(b) did not apply. The result was a tax-free Sec. 351 transaction, except to the extent that the assumed debt exceeded the bases of the assets transferred, resulting in gain under Sec. 357(c). This decision established the separation of the debt transfer from its extinguishment.

Edwards Motor Transit Co. cites, and is considered to have adopted, the approach in Kniffen . For valid business reasons, the owners of Edwards created The Susquehanna Co., a holding company, and transferred Edwards’ stock to it under Sec. 351. Susquehanna borrowed money from Edwards to meet certain financial obligations. To eliminate problems that arose from having a holding company owning the stock of an operating company, the owners merged Susquehanna into Edwards under Sec. 368(a)(1)(A). The government acknowledged that the basic transaction was a nontaxable merger. However, the government wanted the company to recognize income as a result of the cancellation or forgiveness of the debt. The Tax Court ruled for the taxpayer, on the grounds that the debt transfer (from debtor to creditor) was not a cancellation of the debt. The ruling cited Kniffen as authority for this conclusion.

On its surface, Edwards Motor Transit affirmed the decision and reasoning in Kniffen . The Tax Court stated, “The transfer by the parent corporation of its assets to Edwards [its subsidiary] . . . constituted payment of the outstanding liabilities . . . just as surely as if Susquehanna had made payment in cash.” This statement relied on both Kniffen and Estate of Gilmore. 4 In Gilmore , a liquidating corporation transferred a receivable to its shareholder who happened to be the debtor. In that case, the court ruled the transaction was an asset transfer and not a forgiveness of debt. The court based its conclusion in large part on the fact that no actual cancellation of the debt occurred.

The statement in Edwards Motor Transit quoted above, however, is inapposite to the conclusion in Kniffen . A payment is not a transfer and assumption of a liability. Since Susquehanna was deemed to have used assets to repay the debt, the Tax Court should have required Susquehanna to recognize gain to the extent that the value of the assets used to repay the debt exceeded their bases. The conclusions in Kniffen and Edwards are consistent only in their holdings that these debt transfers were not cancellations of debts that would result in COD income. In Kniffen, the court ruled that the debt was assumed and then extinguished. In Edwards, the court ruled that the extinguishment of the debt constituted repayment.

It is possible that the Tax Court reached the correct outcome in Edwards Motor Transit but for the wrong reason. In Rev. Rul 72-464, 5 a debtor corporation merged into the creditor corporation in a tax-free A reorganization under Sec. 368(a)(1)(A). The ruling concluded that the debtor corporation did not recognize any gain or loss on the extinguishment of the debt within the acquiring corporation. General Counsel Memorandum (GCM) 34902 6 provided the detailed analysis behind the conclusion.

The GCM cited both Kniffen and Edwards 7 and adopted their underlying rationale. Specifically, it concluded that the basic transaction (the reorganization) results in a transfer of the debt to the acquiring corporation. It is after the transfer that the debt is extinguished by the statutory merger of interests. The transfer is an assumption of debt, which is nontaxable under Sec. 357(a). Therefore, the transferor (debtor corporation) recognizes no gain or loss.

This is exactly what happened in Ed wards . The debt was assumed, not repaid. Therefore, the Tax Court should have reached the conclusion that the transaction was nontaxable under Sec. 357(a) and not have relied on the questionable authority of Estate of Gilmore 8 or concluded that the debt was repaid.

Liquidations

The transactions discussed up to this point have been either tax-free corporate formations (Sec. 351) or tax-free reorganizations (Sec. 361). In a different transaction that is likely to occur, the creditor/shareholder liquidates the debtor corporation.

If the transaction is not between a parent and its subsidiary, taxability is determined by Secs. 331 and 336. Prior to 1986, the outcome might have been determined by Kniffen and Edwards . With the repeal that year of the General Utilities 9 doctrine (tax-free corporate property distributions) and the enactment of current Sec. 336, the outcome is straightforward. Under Sec. 336, the debtor corporation that is liquidated recognizes its gains and losses. Whether the liquidated corporation is treated as using assets to satisfy a debt requiring the recognition of gain or is treated as distributing assets in a taxable transaction under Sec. 336, all the gains and losses are recognized.

The taxation of the shareholder is a little more complex. First, the shareholder must determine how much it received in exchange for the stock. The most reasonable answer is that the shareholder received the value of the assets minus any debt assumed and minus the face amount of the debt owed to it by the liquidated corporation. This amount is used to determine the gain or loss that results from the hypothetical sale of stock under Sec. 331. Second, the shareholder must determine what was received for the debt, whether assets or the debt itself. The amount received in payment of the liquidated corporation’s debt is a nontaxable return of capital. If the shareholder is deemed to have received the debt itself, then the debt is merged out of existence. The basis of all the assets received should be their fair market value (FMV) under either Sec. 334(a) or general basis rules.

If the liquidated corporation is a subsidiary of the creditor/shareholder, the results change. Under Sec. 337, a subsidiary recognizes neither gain nor loss on the transfer of its assets in liquidation to an 80% distributee (parent). Sec. 337(b) expands this rule to include distributions in payment of debts owed to the parent corporation. Therefore, the subsidiary/debtor does not recognize any gain or loss.

The parent corporation (creditor) recognizes no gain or loss on the liquidation of its subsidiary under Sec. 332. The basis of the transferred property in the hands of the parent is carryover basis. 10 This carry­over basis rule also applies to property received as payment of debt if the subsidiary does not recognize gain or loss on the repayment. 11 In other words, the gain or loss is postponed until the assets are disposed of by the parent corporation.

One important exception to the nonrecognition rule is applied to the parent corporation. Under Regs. Sec. 1.332-7, if the parent’s basis in the debt is different from the face amount of the debt, the parent recognizes the realized gain or loss (face amount minus basis) that results from the repayment. Since this regulation does not mention any exception to the rules of Sec. 334(b)(1), the parent corporation is required to use carryover basis for all the assets received without adjustment for any gain or loss recognized on the debt.

This discussion of liquidations assumes that the liquidated corporation is solvent. If it is insolvent, the answer changes. The transaction cannot qualify under Secs. 332 and 337. The shareholder is not treated as receiving any property in exchange for stock; therefore, a loss is allowed under Sec. 165(g). The taxation of the debt depends on the amount, if any, received by the shareholder as a result of the debt.

Partnerships

The taxation of debt transfers involving partnerships is determined, in large part, by Secs. 731, 752, and 707(a)(2)(B). Specifically, the taxation of transfers by debtor partners to the creditor/partnership is determined by the disguised sale rules of Sec. 707(a)(2)(B), whereas transfers by debtor partnerships to a creditor/partner fall under Secs. 731 and 752.

Sec. 707(a)(2)(B) provides that a transfer of property by a partner to a partnership and a related transfer of cash or property to the partner is treated as a sale of property. The regulations specify the extent to which the partnership’s assumption of liabilities from the partner is treated as the distribution of the sale price.

Regs. Sec. 1.707-5 divides assumed liabilities into either qualified liabilities or unqualified liabilities. A qualified liability 12 is one that:

• Was incurred more than two years before the assumption;
• Was incurred within two years of the assumption, but was not incurred in anticipation of the assumption;
• Was allocated to a capital expenditure related to the property transferred to the partnership under Temp. Regs. Sec. 1.163-8T; or
• Was incurred in the ordinary course of business in which it was used, but only if all the material assets of that trade or business are transferred to the partnership.

The amount of qualified recourse liabilities is limited to the FMV of the transferred property reduced by senior liabilities. Any additional recourse liabilities are treated as nonqualified debt.

If a transfer of property is not otherwise treated as part of a sale, the partnership’s assumption of a qualified liability in connection with a transfer of property is not treated as part of a sale. The assumption of nonqualified liabilities is treated as sale proceeds to the extent that the assumed liability exceeds the transferring partner’s share of that liability (as determined under Sec. 752) immediately after the partnership assumes the liability. If no money or other consideration is transferred to the partner by the partnership in the transaction, the assumption of qualified liabilities in a transaction treated as a sale is also treated as sales proceeds to the extent of the transferring partner’s share of that liability immediately after the partnership assumes the liability. 13 Following the assumption of the liability, the interests of the debtor and creditor merge, thereby extinguishing the debt. The result is that generally the full amount of these assumed liabilities are part of the sale proceeds. 14

The assumed liabilities that are not treated as sale proceeds still fall under Sec. 752. Since the transaction results in a reduction of the transferor’s personal liabilities, the taxpayer is deemed to have received a cash distribution equal to the amount of the debt assumed under Sec. 752(b). Given that the debt is immediately extinguished, no amount is allocated to any partner. The end result is that the transferor must recognize gain if the liability transferred exceeds the transferor’s outside basis before the transaction, increased by the basis of any asset transferred to the partnership as part of the transaction.

A partnership may have borrowed money from a partner and then engaged in a transaction that transfers the debt to the creditor/partner. The first question is whether the initial transaction is a loan or capital contribution. Sec. 707(a) permits loans by partners to partnerships. The evaluation of the transaction is similar to one to determine whether a shareholder has loaned money to a corporation or made a capital contribution. The factors laid out in Sec. 385 and Notice 94-47 15 should be considered in this analysis.

Assuming the debt is real and it alone is transferred to the creditor/partner, the outcome is straightforward. The partner is treated as having made a cash contribution to the partnership under Sec. 752(a) to the extent that the amount of debt exceeds the amount allocated to the partner under the Sec. 752 regulations. If part of the debt is allocated to other partners, these other partners are treated as receiving a deemed cash distribution.

If the transfer is part of a larger transaction, then the analysis is a little more complex. The transfer of the other assets is governed by Secs. 737, 731, and 751. Sec. 737 requires a partner to recognize gain if, during the prior seven years, the partner had contributed property with built-in gain to the partnership and the current FMV of the distributed property exceeds the partner’s outside basis. The partner is treated as recognizing gain in an amount equal to the lesser of (1) the excess (if any) of the FMV of property (other than money) received in the distribution over the adjusted basis of such partner’s interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (2) the net precontribution gain of the partner. The outside basis is increased by the amount of the deemed contribution because the partner assumed a partnership liability. After any gain under Sec. 737 is determined, the general distribution rules of Secs. 731 and 751(b) apply to the transaction. In effect, the transfer to a creditor/partner of a partnership debt owed to the partner is treated the same as any liability assumed by the partner. The extinguishment of the debt should not result in additional tax consequences.

Creditor-to-Debtor Transfers

In addition to debtor-to-creditor transfers, there are creditor-to-debtor transfers. The outcome of these transactions is determined by the two-step analysis in Kniffen . The creditor is treated as having transferred an asset to the debtor/owner. After the transfer, the interests of the debtor and creditor merge, resulting in the extinguishment of the debt. This extinguishment is generally nontaxable since the basis of the debt and the face amount are equal. 16 The result changes if the basis in the hands of the creditor and the adjusted issue price of the debtor are not equal. 17

One of the initial pieces of guidance that addressed this question was Rev. Rul. 72-464. 18 In this ruling, the debt was transferred in a nontaxable transaction. Consequently, the recipient (the debtor) had a carryover basis in the debt. Since this basis was less than the face amount, gain equal to the difference was recognized. This ruling did not explain the reasoning behind the gain recognition or the potential impact if the value of the debt was different from its basis. 19 These items were addressed in Rev. Rul. 93-7. 20

Rev. Rul. 93-7 analyzed a transaction between a partnership and a partner, here designated P and A , respectively. A was a 50% partner. This percentage allowed A to not be a related party to P under Sec. 707(b). P also had no Sec. 751 assets, and A had no share of P ’s liabilities under Sec. 752. These were excluded because they did not affect the reasoning behind the taxation of debt transfers. A issued a debt with a face amount of $100 for $100. P acquired the debt for $100. When the debt was worth $90, it was distributed to A in complete redemption of its interest, which had an FMV of $90 and outside basis of $25. In other words, a creditor/partnership distributed debt to the debtor/partner.

The debt was an asset, a receivable, in the hands of P . When it was distributed to A , P determined its taxation under Sec. 731(b), which provides that no gain or loss is recognized by a partnership on the distribution of property. The application of Sec. 731(b) in this transaction followed directly from Kniffen , which treated the transfer of a debt as a separate transaction from any extinguishment that follows the transfer. Under Sec. 732, A ’s basis in the transferred debt was $25. 21

The basis rules of Sec. 732 assume that a built-in gain or loss on distributed property is realized and recognized when the recipient disposes of the property. In this situation, the distributed debt was extinguished, and therefore no future event would generate taxable gain or loss. Consequently, this extinguishment became a taxable event. In this specific case, A recognized gain of $65 ($90 FMV – $25 basis) and COD income of $10 ($100 face − $90 FMV.) The ruling did not spell out the reasoning for the recognition of both gain and COD income. It is the correct outcome based on Regs. Sec. 1.1001-2. Under that regulation, when property is used to satisfy a recourse obligation, the debtor has gain equal to the difference between the value of the property and its basis, and COD income equal to the difference between the amount of debt and the value of the property used as settlement. The distributed debt is property at the time of the distribution, and the rules of Regs. Sec. 1.1001-2 should apply.

In Rev. Rul. 93-7, the value of the debt was less than the face amount. A debt’s value could exceed its face amount. In that case, the revenue ruling indicated, a deduction for the excess value may be available to the partner as a result of the deemed merger. In Letter Ruling 201105016, 22 the IRS ruled that a taxpayer was entitled to a deduction when it reacquired its debt at a premium as part of a restructuring plan. Rev. Rul. 93-7 cited Regs. Sec. 1.163-4(c)(1), and Letter Ruling 201105016 cited Regs. Sec. 1.163-7(c). Both regulations state that the reacquisition of debt at a premium results in deductible interest expense equal to the repurchase amount minus the adjusted issue price. Regs. Sec. 1.163-4(c)(1) applies to corporate taxpayers, while Regs. Sec. 1.163-7(c) expanded this treatment to all taxpayers. Based on these regulations and the treatment of the distribution as an acquisition of a debt, an interest expense deduction should be permitted when the value exceeds the amount of debt, whereas COD income is recognized when the value is less than the amount of the debt.

In Rev. Rul. 93-7, the partnership was the creditor, and the debt was transferred to a debtor/partner. The reverse transaction can occur, in which a creditor/partner transfers debt to the debtor/partnership in exchange for a capital or profits interest. Sec. 721 applies to the creditor/partner. Therefore, no gain or loss is recognized. However, Sec. 108(e)(8)(B) applies to the debtor/partnership. Sec. 108(e)(8)(B) provides that the partnership recognizes COD income equal to the excess of the debt canceled over the value of the interest received by the creditor. This income is allocated to the partners that owned interests immediately before the transfer. The partnership does not recognize gain or loss (other than the COD income) as a result of this transaction. 23 The value of the interest generally is determined by the liquidation value of the interest received. 24 If the creditor receives a profits interest, the liquidation value is zero, and therefore the partnership recognizes COD income equal to the amount of debt transferred.

Corporate Transactions

Debt transfers between corporations and shareholders are just as likely as transfers between partners and partnerships. If the transferor is a shareholder or becomes a shareholder as a result of the transaction, Secs. 1032, 118, and 351 provide basic nontaxability. However, Sec. 108 overrules these sections in certain cases.

If the shareholder transfers the debt to the corporation as a contribution to capital, Sec. 108(e)(6) may result in the recognition of COD income by the corporation. Under Sec. 108(e)(6), the corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness. Therefore, the corporation has COD income amount equal to the excess of the face amount of the debt over the transferor’s basis in the debt immediately prior to the transfer. In most cases, the face and basis are equal, and no COD income is recognized. If the transfer is in exchange for stock, Sec. 108(e)(8)(A) provides that the corporation is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the stock. Therefore, the corporation recognizes COD income equal to the excess of the face value of the debt over the value of the stock received. In many cases, the value of the stock is less than the debt canceled, and therefore COD income is recognized. Sec. 351 provides that 80% creditor/shareholders recognize neither gain nor loss if the debt is evidenced by a security. If Sec. 351 does not apply, the creditor/shareholder may be able to claim a loss or bad-debt deduction.

Rev. Rul. 2004-79 25 provides a detailed analysis of the transfer of debt from a creditor corporation to a debtor shareholder. The analysis is similar to the one for partnership distributions covered by Rev. Rul. 93-7, discussed previously.

Modifying the facts of Rev. Rul. 2004-79, assume that a shareholder borrows money from his corporation. The face amount of the debt is $1,000, and the issue price is $920. The original issue discount (OID) of $80 is amortized by both the corporation and the shareholder. At a time when the adjusted issue price and basis are $950 but the FMV is only $925, the corporation distributes the debt to the shareholder as a dividend.

From the corporation’s point of view, this is a property dividend. Rev. Rul. 2004- 79 cites Rev. Rul. 93-7, but it could just as easily have cited Kniffen . As a property dividend, the transaction’s taxa tion to the corporation is governed by Sec. 311. Since the value in the revenue ruling was less than the basis, the corporation recognized no gain or loss. If the value had appreciated, the corporation would have recognized gain equal to the appreciation.

The shareholder receives a taxable dividend equal to the value of the debt; consequently, the debt has a basis equal to its FMV of $925. Since the debt is automatically extinguished, the shareholder is treated as having satisfied an obligation in the amount of $950 with a payment of $925. Therefore, the shareholder must recognize $25 of COD income.

A second fact pattern in the revenue ruling is the same, except the value of the distributed debt is $1,005. Under these facts, the shareholder would be entitled to an interest expense deduction under Regs. Sec. 1.163-4 or 1.163-7 in the amount of $55 ($1,005 − $950). In other words, the shareholder is deemed to have reacquired its own debt for a payment equal to the basis that the distributed debt obtains in the transaction.

The conclusions of Rev. Rul. 2004-79 are consistent with those in Rev. Rul. 93-7. They follow the reasoning of Kniffen .

Another transaction that could occur involving shareholder debt is a liquidation of the corporation, resulting in a distribution of the debt to the debtor/shareholder. The results should be similar to those in Rev. Rul. 2004-79. The corporation that distributes the debt is taxed under Sec. 336. Therefore, the corporation recognizes gain or loss depending on the basis of the debt and its FMV. This is the same result as in the dividend case, except that the loss is recognized under Sec. 336 instead of being denied under Sec. 311. The shareholder’s basis in the debt is its FMV under Sec. 334(a). The shareholder recognizes COD income or interest expense, depending on whether the basis is less than or greater than the adjusted issue price of the debt. These results flow from the regulations under Secs. 61 and 163 and are consistent with the conclusions in the above revenue rulings.

The results change slightly if the liquidation qualifies under Secs. 332 and 337. The IRS discussed these results in Chief Counsel Advice 200040009. 26 Sec. 332 shields the parent from recognition of income on the receipt of the debt. Sec. 337 shields the liquidating corporation from recognizing gain or loss on the transfer of the debt to its parent corporation. The basis is carryover basis under Sec. 334(b). Then, because the debt is extinguished, the parent recognizes either COD income or interest expense on the extinguishment of the debt. As in the prior revenue rulings and Kniffen , the extinguishment has to be a taxable event because the elimination of the carryover basis prevents the parent corporation from having a taxable transaction in the future involving this debt. These results are consistent with prior decisions.

The results discussed for a parent/subsidiary liquidation should also apply if the debtor/corporation acquires a corporation that owns its debt in a nontaxable asset reorganization. In this case, Sec. 361 replaces Secs. 332 and 337. The extinguishment of the debt is a separate transaction that should result in recognition of income or expense.

Acquired Debt

So far, this article has discussed transactions between the debtor and creditor. Now it turns to how the holder of the debt acquired it. In many cases, the holder acquired the debt directly from the debtor, and the acquisition is nontaxable. In other situations, the debt is outstanding and in the hands of an unrelated party. The holder acquires the debt from this unrelated party. In these cases, Sec. 108(e)(4) may create COD income.

Under Sec. 61, if a debtor reacquires its debt for less than its adjusted issue price, the debtor has COD income. Sec. 108(e)(4) expands on this rule: If a party related to the debtor acquires the debt, the debtor is treated as acquiring the debt, with the resulting COD income recognized. Related parties are defined in Secs. 267(b) and 707(b)(1).

The regulations provide that the acquisition can be either direct or indirect. A direct acquisition is one by a person related to the debtor at the time the debt is acquired. 27 An indirect acquisition occurs when the debtor acquires the holder of the debt instrument, where the holder of the debt acquired it in anticipation of becoming related to the debtor. 28 The determination of whether the holder acquired the debt in anticipation of becoming related is based on all the facts and circumstances. 29 However, if the holder acquires the debt within six months before the holder becomes related to the debtor, the acquisition by the holder is deemed to be in anticipation of becoming related to the debtor. 30

In the case of a direct acquisition, the amount of COD income is equal to the adjusted issue price minus the basis of the debt in the hands of the related party. In the case of indirect acquisitions, the calculation depends on whether the debt is acquired within six months of being acquired. 31 If the holder acquired the debt within six months of being acquired, the COD income is calculated as if it were a direct acquisition. If the holder acquired the debt more than six months before being acquired, the COD income is equal to the adjusted issue price minus the FMV of the debt instrument on the date that the holder is acquired.

When a debtor reacquires its own debt, in addition to reporting COD income, the debtor has the debt extinguished as a result of the merger of interests. When a related party acquires the debt, the debtor has COD income, but the debt remains outstanding. In these cases, the debtor is treated as issuing a new debt instrument immediately following the recognition of the COD income for an amount equal to the amount used to calculate the COD income (adjusted basis or FMV 32 ). If this issue price is less than the stated redemption price at maturity of the debt (as defined in Sec. 1273(a)(2), the difference is OID that is subject to the amortization rules of Sec. 1272.

Rev. Rul. 2004-79 provides a simple example of this transaction. In the ruling, a parent corporation, P , issued $10 million of debt for $10 million. After issuance, S , a subsidiary of P , purchased the debt for $9.5 million. Under Regs. Sec. 1.108-2(f), P had to recognize $500,000 of COD income ($10 million face − $9.5 million basis to S ). After this recognition, P was treated as having issued the debt to S for $9.5 million. Therefore, $500,000 of OID was amortizable by P and S . If S later transfers the debt to P , the previously discussed rules determine the taxation of the transfer using S ’s basis ($9.5 million + amortized OID).

Secs. 61 and 108(e)(4) apply only if the debt is acquired for less than the adjusted issue price. If the acquisition price is greater than the adjusted issue price, the acquiring party treats this excess as premium and amortizes it, thereby reducing the amount of interest income recognized by the holder.

Installment Obligations

An installment obligation differs from other obligations in that the holder recognizes income when cash is collected in payment of the obligation. The rules describing the taxation of installment obligations were rewritten as part of the Installment Sales Revision Act of 1980, P.L. 96-471. Under old Sec. 453(d) (new Sec. 453B(a)), if the holder of an installment obligation distributes, transmits, or disposes of the obligation, the taxpayer is required to recognize gain or loss equal to the difference between the basis in the obligation and the FMV of the obligation. There is an exception to this rule for distributions in liquidation of a subsidiary that are exempt from taxation under Sec. 337.

Prior to the Code revision, the regulations permitted the transfer of installment obligations without gain recognition if the transaction was covered by either Sec. 721 or 351. 33 Although the regulations have not been revised for the Code change, the IRS continues to treat Secs. 721 and 351 as overriding the gain recognition provision. 34

If the transaction results in transfer of the obligation either from the creditor to the debtor or from the debtor to the creditor, the tax result changes. The seminal case is Jack Ammann Photogrammetric Engineers, Inc. 35 In it, the taxpayer created a corporation to which he contributed $100,000 in return for 78% of the corporation’s stock. He then sold his photogrammetry business to the corporation for $817,031. He received $100,000 cash and a note for $717,031. He reported the sale under the installment method. When he was still owed $540,223 on the note, he transferred it to the corporation for stock of the corporation worth $540,223. He reported this as a disposition under Sec. 453(d) and recognized the deferred gain. Later, he filed a claim for refund, arguing that Sec. 351 prevented recognition of the deferred gain. After allowing the refund, the IRS assessed a deficiency against the corporation, arguing that the corporation came under Sec. 453(d). The corporation argued that, under Sec. 1032, it was not taxable. The Tax Court ruled for the IRS.

The Fifth Circuit reversed the decision. The underlying reasoning was that the disposition by the shareholder and the extinguishment of the debt in the hands of the corporation were separate transactions. The extinguishment did not fall under Sec. 453(d). The court indicated that the IRS should have assessed the tax against the shareholder.

Following this case, the IRS issued Rev. Rul. 73-423. 36 In this ruling, a shareholder transferred an installment obligation from Corporation X back to the corporation in a transaction described in Sec. 351. The ruling concluded that the transfer was a satisfaction of the installment agreement at other than face value under Sec. 453(d)(1)(A) and that the shareholder was required to recognize gain without regard to Sec. 351. The corporation had no gain or loss under Sec. 1032 and Ammann .

Sec. 453(d) is now Sec. 453B(a), and the rule has not changed. Therefore, if a creditor transfers an installment obligation to the debtor in an otherwise tax-free transaction, the obligation is treated as satisfied at other than its face value, and the creditor is required to recognize gain or loss as discussed in Rev. Rul. 73-423. 37

New Sec. 453B(f) covers transactions in which installment obligations become unenforceable. This section covers the extinguishment of an installment debt through a merger of the rights of a debtor and creditor. The Code treats these transactions as dispositions of the obligation with gain or loss recognized. When the debtor and creditor are related, the disposition is at FMV but no less than the face amount.

If the debtor of an installment obligation engages in a transaction in which the creditor assumes the debt, the results are consistent with those of transactions involving obligations other than installment notes. The debtor is deemed to have received cash equal to the amount of the debt. This is fully taxable unless exempted by Sec. 357, 721, or a similar provision. The creditor falls under Sec. 453B(f), with the extinguishment treated as a taxable disposition of the obligation for its FMV (which for related parties is no less than the face amount).

Business entities often incur debts to their owners, and, conversely, the owners incur liabilities to their business entities. In numerous transactions these obligations are canceled for consideration other than simple repayment of the debt. Based on Kniffen , these transactions are treated as a transfer of consideration followed by an extinguishment of the debt. If a shareholder’s debt to his or her controlled corporation is transferred to that corporation along with assets, the transaction may be tax free under Secs. 351 and 357(a). If a shareholder/creditor receives the related corporate debt in a distribution or liquidation, Sec. 311 or 336 determines the corporation’s taxation.

The cancellation of a partner’s debt to the partnership is generally governed by the distribution rules, including the constructive sale or compensation rules of Sec. 707(a)(2). When a partner cancels the partnership’s debt, the partner has made a contribution to capital. This can have consequences to all partners since the total liabilities are decreased and the partners’ bases are decreased under Sec. 752.

In most cases the merger of debtor and creditor interests is nontaxable. However, if the basis of the debt or receivable does not equal the face amount of the debt, income or loss is recognized. The exact amount and character of the income or loss depends on factors discussed in this article. It is important for the tax adviser to identify those cases in which the debt transfer is not tax free.

1 Invalid loans to shareholders have been reclassified as dividends.

2 Kniffen , 39 T.C. 553 (1962).

3 Edwards Motor Transit Co. , T.C. Memo. 1964-317.

4 Estate of Gilmore , 40 B.T.A. 945 (1939).

5 Rev. Rul. 72-464, 1972-2 C.B. 214.

6 GCM 34902 (6/8/72). The GCM also refers to Sec. 332, which will be dis cussed later.

7 As the GCM points out, by using Sec. 357(a), taxpayers could achieve the same outcome in C reorganizations.

8 See Chief Counsel Advice 200040009 (10/6/00), which suggests Estate of Gilmore ’s requirement of a formal cancellation of debt before COD income is recognized may no longer be valid.

9 General Utilities & Operating Co. v. Helvering , 296 U.S. 200 (1935).

10 Sec. 334(b)(1).

12 Regs. Sec. 1.707-5(a)(6).

13 If the partnership transfers money or other consideration in the transaction, the amount treated as sales proceeds may be limited under Regs. Sec. 1.707-5(a)(5)(i)(B).

14 Under Regs. Sec. 1.707-5(a)(3)(ii), a partner’s share of liabilities is reduced by liabilities assumed that are anticipated to be reduced. Based on Kniffen and Edwards , the reduction will be anticipated.

15 Notice 94-47, 1994-1 C.B. 357.

16 See, e.g., IRS Letter Ruling 8825048 (3/23/88).

17 The transaction that gives rise to the difference and the taxation that results are discussed later.

18 Rev. Rul. 72-464, 1972-2 C.B. 214. Although this is a debtor-to-creditor transfer, the result is the same.

19 See GCM 34902 (6/8/72).

20 Rev. Rul. 93-7, 1993-1 C.B. 125.

21 If the partnership makes a Sec. 754 election, the partnership has a Sec. 734 adjustment of $75 ($100 inside basis – $25 basis after distribution).

22 IRS Letter Ruling 201105016 (2/4/11).

23 Regs. Sec. 1.108-8, effective Nov. 17, 2011.

24 See the Regs. Sec. 1.108-8(b)(2) safe-harbor rule.

25 Rev. Rul. 2004-79, 2004-2 C.B. 106.

26 CCA 200040009 (10/6/00).

27 Regs. Sec. 1.108-2(b).

28 Regs. Sec. 1.108-2(c)(1).

29 Regs. Sec. 1.108-2(c)(2).

30 Regs. Sec. 1.108-2(c)(3).

31 Regs. Secs. 1.108-2(f)(1) and (2).

32 Regs. Sec. 1.108-2(g).

33 Regs. Sec. 1.453-9(c)(2).

34 See IRS Letter Rulings 8824044 (3/22/88) and 8425042 (3/19/84).

35 Jack Ammann Photogrammetric Engineers, Inc. , 341 F.2d 466 (5th Cir. 1965), rev’g 39 T.C. 500 (1962).

36 Rev. Rul. 73-423, 1973-2 C.B. 161.

37 Although this revenue ruling involved a corporation, the IRS believes the same rule applies to partnerships. Treasury is currently working on a revision of the regulations to clarify the results. See the preamble to Regs. Sec. 1.108-8, T.D. 9557 (11/17/11).

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