Posts Tagged ‘accountinga’

Late last week, the IRS announced that it will be publishing Revenue Ruling 2012-14, which will provide guidance for determining the amount of a partnership’s nonrecourse liabilities a partner is permitted to include in his measurement of insolvency for purposes of applying the exception to cancellation of indebtedness income found at I.R.C. § 108(a)(1)(B).

That’s quite the mouthful, so let’s break it down into more easily digestible parts so we can understand why Revenue Ruling 2012-14 may be important:

  • Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness. This is a natural and logical result, because being forgiven of a debt is an accession to wealth; if someone loans you $100 and you don’t pay it back, you’re $100 richer and should therefore recognize taxable income. As the economy and real estate values have tanked in the past few years, many taxpayers have been unable to service their loans or mortgages, bringing the COD rules to the forefront of the tax law.
  • Section 108(a)(1)(B) provides an exclusion to the general rule found in I.R.C. § 61, generally excluding discharged indebtedness from a taxpayer’s gross income if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) limits the amount of income excluded by reason of I.R.C. § 108(a)(1)(B) to the amount by which the taxpayer is insolvent.

What’s the point of the insolvency exclusion? Believe it or not, Congress can, at times, be rational. If a taxpayer cannot service his debt, it seems rather silly to tack on a tax bill for the amount of any forgiven loans. A taxpayer who owes more than they own should be given the opportunity to receive a “fresh start;” one that wouldn’t be possible if the forgiven debt was included in taxable income. Of course, that only makes sense if the taxpayer is insolvent at the time of the debt discharge. If the taxpayer is solvent, they presumably would have the ability to pay the tax associated with the debt discharge.

  • Section 108(d)(3) of the Code defines “insolvent” as the excess of liabilities over the fair market value of assets. That section further provides that whether a taxpayer is insolvent, and the amount by which the taxpayer is insolvent, is determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.
  • Unfortunately, nowhere does I.R.C. § 108 actually define the term “liabilities,” causing a bit of confusion when trying to determine whether a taxpayer who has benefitted from the cancellation of indebtedness is in fact insolvent.
  • Confusing matters even more, while C and S corporations must determine insolvency at the entity level, forgiven partnership debt doesn’t work that way. Instead, the partnership recognizes the COD, and any exclusion, including the insolvency exclusion, must be determined at the partner level. This means that the determination of insolvency must also be determined at the partners level when partnership debt is forgiven.

Combine all of these bullets, and a natural question arises: how does a partner in a partnership account for the partnership’s liabilities in determining whether their individual liabilities exceed the FMV of their assets, making them insolvent?

Keep in mind, a partnership can have two types of liabilities, recourse and nonrecourse. Recourse liabilities are those that one or more partners is personally liable for, and the responsible partner should certainly include his share of the partnership’s recourse liabilities in the computation of his insolvency in the event a partnership debt is forgiven.

But what about nonrecourse debt? Nonrecourse debt, as opposed to recourse debt, is a partnership liability for which no partner is personally liable. In other words, if the partnership fails to pay the debt, tough luck for the lender. Nonrecourse debt is most commonly seen as a mortgage: the lender retains the right only to foreclose on the mortgaged property; they cannot pursue the partnership for any deficiency in the event the FMV of the nonrecourse debt plummets below the principal balance of the debt.

So if a partnership has nonrecourse debt forgiven, are the partners entitled to include any portion of the nonrecourse debt in their individual computations of insolvency?

The answer, according to Revenue Ruling 2012-14, is yes. Building on the principles established in Rev. Ruling. 92-53, the IRS held that a partner may include two pieces of a partnership nonrecourse debt in their individual computation of insolvency:

1) the amount of the debt equal to the FMV of the property (meaning it’s a wash from an insolvency standpoint), and

2) any debt in excess of the FMV of the property, but only to the extent it is forgiven, and the income resulting from the forgiveness is allocated to that partner.

The specific fact pattern in the ruling is as follows:

X and Holdco, a corporation, are equal partners in PRS, a partnership. In Year 1, PRS borrows $1,000,000 from Bank and signs a note payable to Bank for $1,000,000 that bears interest at a fixed market rate payable annually. The note is secured by real estate valued in excess of $1,000,000 that PRS acquires from Seller, in part with the proceeds of the note. The note is a nonrecourse liability within the meaning of § 1.752-1(a)(2) of the Income Tax Regulations. Neither PRS nor its partners (X and Holdco) are personally liable on the note. 

In Year 2, when the value of the real estate is $800,000 and the outstanding principal on the note is $1,000,000, Bank agrees to modify the terms of the note by reducing the note’s principal amount to $825,000. The PRS partnership agreement provides for income to be allocated equally to X and Holdco under § 704(b) and the regulations thereunder. X and Holdco share PRS nonrecourse liabilities equally under § 1.752-3. At the time of the modification of the note, X and Holdco have no assets or liabilities other than their partnership interests in PRS. PRS’s sole asset is the real estate subject to the note, and PRS’s sole liability is the note.

The IRS held that of the $1,000,000 note, X and Holdco may each consider the following portion of the liability as part of their liabilities for purposes of measuring insolvency:

 1. 50% of the $800,000 balance of the note equal to the FMV of the asset, or $400,000 each, and

2. The portion of the debt in excess of FMV that was forgiven, but only to the extent the COD income was allocated to X and Holdco, or 50% * $175,000 = $87,500 

Thus, for both X and Holdco, in computing each partner’s insolvency, they may include $487,500 of partnership liabilities, and $400,000 of FMV from the partnership (each partner’s share of the asset.)

As a result, both X and Holdco are insolvent to the extent of $87,500, and each may exclude the $87,500 of COD allocated to them from PRS under I.R.C. § 108(a)(1)(B).

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In the not-too-distant future, it’s entirely possible that jet packs will replace Segways as America’s preferred mode of personal travel, online dating will create matches so perfect as to eliminate the thrill of romantic conquest, and Republicans will rule the White House, Senate, and House of Representatives.

Martin Sullivan, who writes about tax as well as anyone, takes on the final possibility and reaches a surprising, but completely accurate, conclusion: even if Mitt Romney wins the presidential election this November and Republicans keep the House and retake the Senate, Romney’s proposed sweeping tax cuts are unlikely to become law.

And why not?

Because as we discussed here, tax cuts come at the price of reduced revenue, and given the current and budgeted deficit, lost revenue is something America can ill afford at the moment.

As a reminder, Romney is proposing to extend the Bush tax cuts, while also tacking on a 20% across-the-board reduction to each marginal rate. In addition, he would eliminate the tax on interest, dividends and capital gains for taxpayers earnings less than $200,000, eliminate the estate tax and the AMT, and cut the corporate rate to 25%.

Even if Democrats continue to control the Senate, Romney would be able to circumvent having his proposals blocked in the Senate by presenting them as “budget reconciliation bills,” essentially giving Romney carte blanche to enact any desired tax legislation.

But as Sullivan posits, Romney’s cuts are unlikely to become law due to their staggering price tag: $480 billion in lost revenue in 2015 alone. To enact his proposals without adding to the deficit, Romney would have to generate tax revenue elsewhere. To that end, he has privately disclosed his desire to broaden the tax base by eliminating some popular deductions, but Romney would have to do away with all of the popular deductions listed below, and many more, to cover the cost of his cuts. These deductions represent a mix of those backed by special interest groups (the mortgage deduction), and those that promote philanthropy (the charitable contribution deduction.)  As a result, as Sullivan points out, “there is nothing in history to suggest that this is even a remote political possibility.”

Table 1. Official Revenue Estimates of Major Tax Expenditures

Tax Expenditure Fiscal 2015

Deduction for mortgage interest $113 billion
Charitable deduction $57 billion
Deduction for state and local taxes $85 billion
Exclusion for employer-provided health benefits $176 billion

Source: Joint Committee on Taxation, ‘‘Estimates of Federal Tax Expenditures for Fiscal Years 2011-2015,’’ Jan. 17, 2012, Doc 2012-894, 2012 TNT 11-21.

Sullivan goes on to nicely summarize the reality of our current economic morass and its impact on tax policy:

And that means that even if Romney wins and Republicans are running Congress, it is unlikely Washington will go on a tax cutting frenzy. Republicans may be unconstrained by Democrats, but they will be constrained by themselves. Basebroadening tax reform is not a battle of partisan politics but of special interest politics. And special interests will still be alive and well after a Republican sweep. If the Republicans try anything too gimmicky with how they score the tax cuts, alarm bells will sound in the bond market — something a president with close ties to Wall Street is unlikely to tolerate.

No doubt there will be spending cuts in social programs, but one must believe most of the savings will be devoted to deficit reduction. This is not 1981. This is not 2001. The next president, regardless of whether it is Obama or Romney, must put federal finances on a sustainable path. It is hard to see how a President Romney could propose a plan that significantly cuts taxes. If his plan must be revenue neutral, or close to it, the amount of rate reduction it can achieve will be severely limited.

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