[Federal Register Volume 73, Number 212 (Friday, October 31, 2008)]
[Proposed Rules]
[Pages 64903-64905]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-25851]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-164370-05]
RIN 1545-BF27


Section 108(e)(8) Application to Partnerships

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
application of section 108(e)(8) of the Internal Revenue Code (Code) to 
partnerships and their partners. These regulations provide guidance 
regarding the determination of discharge of indebtedness income of a 
partnership that transfers a partnership interest to a creditor in 
satisfaction of the partnership's indebtedness (debt-for-equity 
exchange). The proposed regulations also provide that section 721 
applies to a contribution of a partnership's recourse or nonrecouse 
indebtedness by a creditor to the partnership in exchange for a capital 
or profits interest in the partnership. This document also provides 
notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by January 29, 
2009. Outlines of topics to be discussed at the public hearing 
scheduled for February 19, 2009, must be received by January 27, 2009.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-164370-05), Room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
164370-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-164370-05). 
The public hearing will be held in the IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Megan A. Stoner, Office of Associate Chief Counsel (Passthroughs and 
Special Industries), (202) 622-3070; concerning submission of comments, 
the hearing, and/or placed on the building access list to attend the 
hearing, Richard Hurst, (202) 622-2949 (TDD Telephone) (not toll-free 
numbers) and his e-mail address is 
[email protected].

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to 26 CFR Part 1 under 
sections 108 and 721 of the Code relating to the application of section 
108(e)(8) to partnerships.
    Section 108(e)(8) was amended by section 896 of the American Jobs 
Creation Act of 2004, Public Law 108-357 (118 Stat. 1648), to include 
discharges of partnership indebtedness occurring on or after October 
22, 2004. Prior to the amendment, section 108(e)(8) only applied to 
discharges of corporate indebtedness. Section 108(e)(8), as amended, 
provides that for purposes of determining income of a debtor from 
discharge of indebtedness (COD income), if a debtor corporation 
transfers stock or a debtor partnership transfers a capital or profits 
interest in such partnership to a creditor in satisfaction of its 
recourse or nonrecourse indebtedness, such corporation or partnership 
shall be treated as having satisfied the indebtedness with an amount of 
money equal to the fair market value of the stock or interest. In the 
case of a partnership, any COD income recognized under section 
108(e)(8) shall be included in the distributive shares of the partners 
in the partnership immediately before such discharge.

Explanation of Provisions

1. Valuation of Partnership Interest Transferred in Satisfaction of 
Partnership Debt

    Section 108(e)(8) provides that for purposes of determining COD 
income of a debtor partnership, the partnership shall be treated as 
having satisfied the indebtedness with an amount of money equal to the 
fair market value of the interest transferred to the creditor. The 
amount by which the indebtedness exceeds the fair market value of the 
partnership interest transferred is the amount of COD income required 
to be included in the distributive shares of the partners in the debtor 
partnership immediately before the discharge.
    The IRS and the Treasury Department believe that provided certain 
requirements are satisfied, it is appropriate to allow the partnership 
and the creditor to value the partnership interest transferred to the 
creditor in a debt-for-equity exchange (debt-for-equity interest) based 
on liquidation value. For this purpose, liquidation value equals the 
amount of cash that the creditor would receive with respect to the 
debt-for-equity interest if, immediately after the transfer, the 
partnership sold all of its assets (including goodwill, going concern 
value, and any other intangibles associated with the partnership's 
operations) for cash equal to the fair market value of those assets, 
and then liquidated. If a partnership maintains capital accounts in 
accordance with the capital accounting rules of Sec.  1.704-
1(b)(2)(iv), the amount by which the creditor's capital account is 
increased as a result of the debt-for-equity exchange will equal the 
fair market value of the indebtedness exchanged. See Sec.  1.704-
1(b)(2)(iv)(b) and (d).
    Accordingly, the proposed regulations provide that for purposes of 
applying section 108(e)(8), the fair market value of a debt-for-equity 
interest is the liquidation value of that debt-for-equity interest, if 
(i) the debtor partnership determines and maintains capital accounts of 
its partners in accordance with the capital accounting rules of Sec.  
1.704-1(b)(2)(iv), (ii) the creditor, debtor partnership, and its 
partners treat the fair market value of the indebtedness as being equal 
to the liquidation value of the debt-for-equity interest for purposes 
of determining the tax consequences of the debt-for-equity exchange, 
(iii) the debt-for-equity

[[Page 64904]]

exchange is an arm's-length transaction, and (iv) subsequent to the 
debt-for-equity exchange, neither the partnership redeems nor any 
person related to the partnership purchases the debt-for-equity 
interest as part of a plan at the time of the debt-for-equity exchange 
which has as a principal purpose the avoidance of COD income by the 
partnership. If these conditions are not satisfied, all of the facts 
and circumstances are considered in determining the fair market value 
of the debt-for-equity interest for purposes of applying section 
108(e)(8).

2. Application of Section 721 to Debt-for-Equity Exchanges

    Generally, when property is transferred as payment on indebtedness 
(or in satisfaction thereof), gain or loss on the property is 
recognized. The IRS and the Treasury Department, however, believe that 
in the case of a debt-for-equity exchange, the nonrecognition rule of 
section 721 generally should apply to the creditor's contribution of 
partnership indebtedness (other than unpaid interest or accrued 
original issue discount) to the partnership in exchange for the 
partnership interest. Such a rule is consistent with the policies 
underlying section 721 to defer the recognition of gain or loss where 
persons join together to conduct joint business (including investment). 
Accordingly, the proposed regulations provide that with certain 
exceptions, section 721 applies to debt-for-equity exchanges.
    The proposed regulations provide that section 721 does not apply to 
the transfer of a partnership interest to a creditor in satisfaction of 
a partnership's indebtedness for unpaid rent, royalties, or interest on 
indebtedness (including accrued original issue discount). Moreover, 
these proposed regulations do not supersede the rules under section 
453B relating to dispositions of installment obligations. A separate 
guidance project addresses the application of section 721 to a 
partnership interest transferred in connection with the performance of 
services. See proposed regulations regarding partnership equity for 
services (70 FR 29675) (May 24, 2005).

3. Creditor's Basis in Partnership Interest

    Because the proposed regulations provide that section 721 applies 
to a debt-for-equity exchange, the basis of the creditor's interest in 
the partnership is determined under section 722. Section 722 provides 
that the basis of an interest in a partnership acquired by a 
contribution of property, including money, to the partnership shall be 
the amount of such money and the adjusted basis of such property to the 
contributing partner at the time of the contribution, increased by the 
amount (if any) of gain recognized under section 721(b) to the 
contributing partner at such time.
    The IRS and the Treasury Department believe that a creditor should 
not recognize a loss in a debt-for-equity exchange subject to section 
721 in which the liquidation value of the debt-for-equity interest is 
less than the outstanding principal balance of the indebtedness. 
Rather, the creditor's basis in the debt-for-equity interest received 
in the debt-for-equity exchange that is subject to section 721 will be 
increased by the adjusted basis of the indebtedness. The IRS and the 
Treasury Department request comments on alternative approaches.

4. Creditor's Holding Period in Partnership Interest

    Section 1223(1) provides, in general, that in determining the 
period for which the taxpayer has held property received in an 
exchange, there shall be included the period for which the taxpayer 
held the property exchanged, if the property has, for the purpose of 
determining gain or loss from a sale or exchange, the same basis in 
whole or in part in the taxpayer's hands as the property exchanged. 
Because the basis in the debt-for-equity interest received in a debt-
for-equity exchange that is subject to section 721 is the same as the 
creditor's basis in the debt under section 722, the debt-for-equity 
interest includes the creditor's holding period in the indebtedness 
under section 1223(1).

5. Request for Comments

    The IRS and the Treasury Department realize that there are other 
issues relating to debt-for-equity exchanges that are not addressed in 
these proposed regulations. One issue not addressed is whether any 
special allocation rules of COD income should apply where partnership 
indebtedness owed to a preexisting partner is satisfied with the 
transfer of a partnership interest. Another issue is whether COD income 
arising from a debt-for-equity exchange should be treated as a first-
tier item under Sec.  1.704-2(f)(6) for purposes of the minimum gain 
chargeback rules. A third issue is how the rules in the noncompensatory 
partnership options regulations relating to convertible debt interact 
with the rules in these proposed regulations under section 108(e)(8). 
The IRS and the Treasury Department request comments on these issues as 
well as other issues not addressed in these proposed regulations.

Proposed Effective Date

    These regulations are proposed to apply to debt-for-equity 
exchanges occurring on or after the date these regulations are 
published as final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, these regulations have 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and the Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for February 19, 2009, 
beginning at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, all visitors must enter at the Constitution Avenue 
entrance. In addition, all visitors must present photo identification 
to enter the building. Because of access restrictions, visitors will 
not be admitted beyond the immediate entrance area more than 30 minutes 
before the hearing starts. For information about having your name 
placed on the building access list to attend the hearing, see the FOR 
FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments by January 27, 2009. Outline of the topics to be 
discussed and the time to be devoted to each topic (signed original and 
eight (8) copies) by January

[[Page 64905]]

27, 2009. A period of 10 minutes will be allotted to each person for 
making comments. An agenda showing the schedule of speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Megan A. Stoner of the 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and the Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.108-8 is added to read as follows:


Sec.  1.108-8  Indebtedness satisfied by partnership interest.

    (a) In general. For purposes of determining income of a debtor from 
discharge of indebtedness (COD income), if a debtor partnership 
transfers a capital or profits interest in the partnership to a 
creditor in satisfaction of its recourse or nonrecourse indebtedness (a 
debt-for-equity exchange), the partnership is treated as having 
satisfied the indebtedness with an amount of money equal to the fair 
market value of the partnership interest.
    (b) Determination of fair market value--(1) In general. For 
purposes of paragraph (a) of this section, the fair market value of a 
partnership interest transferred by a debtor partnership to a creditor 
in satisfaction of the debtor partnership's indebtedness (debt-for-
equity interest) is the liquidation value of the debt-for-equity 
interest, where liquidation value equals the amount of cash that the 
creditor would receive with respect to the debt-for-equity interest if, 
immediately after the transfer, the partnership sold all of its assets 
(including goodwill, going concern value, and any other intangibles 
associated with the partnership's operations) for cash equal to the 
fair market value of those assets and then liquidated, if--
    (i) The debtor partnership determines and maintains the capital 
accounts of its partners in accordance with the capital accounting 
rules of Sec.  1.704-1(b)(2)(iv);
    (ii) The creditor, debtor partnership, and its partners treat the 
fair market value of the indebtedness as being equal to the liquidation 
value of the debt-for-equity interest for purposes of determining the 
tax consequences of the debt-for-equity exchange;
    (iii) The debt-for-equity exchange is an arm's-length transaction; 
and
    (iv) Subsequent to the debt-for-equity exchange, neither the 
partnership redeems nor any person related to the partnership purchases 
the debt-for-equity interest as part of a plan at the time of the debt-
for-equity exchange which has as a principal purpose the avoidance of 
COD income by the partnership.
    (2) Exception. If the requirements in paragraph (b)(1) of this 
section are not satisfied, all the facts and circumstances will be 
considered in determining the fair market value of a debt-for-equity 
interest for purposes of paragraph (a) of this section.
    (c) Example. The following example illustrates the provisions of 
this section:

    Example. (i) AB partnership has $1,000 of outstanding 
indebtedness owed to C. In an arm's-length transaction, C agrees to 
cancel the $1,000 indebtedness in exchange (debt-for-equity 
exchange) for an interest (debt-for-equity interest) in AB. AB's 
partnership agreement provides that its partners' capital accounts 
will be determined and maintained in accordance with the capital 
accounting rules in Sec.  1.704-1(b)(2)(iv). The fair market value 
of the $1,000 indebtedness is $700 at the time of the debt-for-
equity exchange. Under Sec.  1.704-1(b)(2)(iv)(b), C's capital 
account is increased by $700 as a result of the debt-for-equity 
exchange. This amount equals the liquidation value of C's debt-for-
equity interest, which is the amount of cash that C would receive 
with respect to that interest if AB partnership sold all of its 
assets for cash equal to the fair market value of those assets and 
then liquidated. C, AB partnership, and its partners treat the fair 
market value of the indebtedness as being equal to the liquidation 
value of C's debt-for-equity interest ($700) for purposes of 
determining the tax consequences of the debt-for-equity exchange. 
Subsequent to the debt-for-equity exchange, neither AB partnership 
redeems nor any person related to AB partnership purchases C's debt-
for-equity interest as part of a plan at the time of the debt-for-
equity exchange which has as a principal purpose the avoidance of 
COD income by AB partnership.
    (ii) Because the requirements in paragraph (b)(1) of this 
section are satisfied, the fair market value of C's debt-for-equity 
interest in AB partnership for purposes of determining AB 
partnership's COD income is the liquidation value of C's debt-for-
equity interest, or $700. Accordingly, AB partnership is treated as 
satisfying the $1,000 indebtedness with $700 under section 
108(e)(8).

    (d) Effective/applicability date. This section applies to debt-for-
equity exchanges occurring on or after the date that these regulations 
are published as final regulations in the Federal Register.
    Par. 3. Section 1.721-1 is amended by adding paragraph (d) to read 
as follows:


Sec.  1.721-1  Nonrecognition of gain or loss on contribution.

* * * * *
    (d) Debt-for-equity exchange--(1) In general. Except as otherwise 
provided in section 721 and the regulations under section 721, and 
notwithstanding Sec.  1.108-8(a), section 721 applies to a contribution 
of a partnership's recourse or nonrecourse indebtedness by a creditor 
to the debtor partnership in exchange for a capital or profits interest 
in the partnership.
    (2) Exception. Section 721 does not apply to the transfer of a 
partnership interest to a creditor in satisfaction of a partnership's 
recourse or nonrecourse indebtedness for unpaid rent, royalties, or 
interest on indebtedness (including accrued original issue discount). 
For rules applicable to a determination of whether a partnership 
interest transferred to a creditor is treated as payment of interest or 
accrued original issue discount, see Sec. Sec.  1.446-2(e) and 1.1275-
2(a), respectively.
    (3) Effective/applicability date. This paragraph (d) applies to 
debt-for-equity exchanges occurring on or after the date that these 
regulations are published as final regulations in the Federal Register.

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E8-25851 Filed 10-30-08; 8:45 am]
BILLING CODE 4830-01-P