The IRS has ruled in Rev. Rul. 2012-14 that, for purposes of measuring a partner's insolvency, each partner treats a discharged nonrecourse debt of the partnership as a liability based on the allocation of income from discharge of indebtedness (COD income).
The revenue ruling describes a situation in which a nonpartnership investor (X) and a corporation (Holdco) are equal partners in a partnership (PRS). In Year 1, PRS borrowed $1 million from a bank in exchange for a note with a stated principal amount of $1 million (the Note). The Note bore interest at a market rate and was secured by real estate that initially had a value in excess of $1 million. The Note was a nonrecourse liability under Treas. Reg. Sec. 1.752-1(a)(2), and neither PRS nor X and Holdco were personally liable on the Note.
In Year 2, the bank agreed to reduce the Note's principal amount from $1 million to $825,000, and the value of the real estate was $800,000. The PRS agreement provided that nonrecourse liabilities of PRS, as well as COD income, were to be allocated equally between X and Holdco.
COD income is generally included in a taxpayer's gross income, but an insolvency exception under Section 108 allows taxpayers to exclude COD income from gross income to the extent that they are insolvent. Section 108(d)(3) provides that a taxpayer is insolvent to the extent that its liabilities exceed the fair market value of its assets as determined immediately before a discharge of indebtedness. Section 108(d)(6) provides that, among other things, the insolvency exception is applied at the partner level rather than at the partnership level.
In 1992, the IRS ruled (Rev. Rul. 92-53) that the amount that a nonrecourse debt exceeds the fair market value of the property securing the debt (the nonrecourse excess) is treated as a liability for determining a taxpayer's insolvency only to the extent that such nonrecourse debt is discharged.
Thus, in Rev. Rul. 2012-14, the IRS had to apply Section 108(d)(3) and Rev. Rul. 92-53 to X and Holdco pursuant to Section 108(d)(6). The IRS ruled that for purposes of measuring a partner's insolvency under Section 108(d)(3), each partner treats the nonrecourse excess as a liability based on the allocation of COD income to such partner under Section 704(b).
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