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    Locke Lord QuickStudy: Federal Income Tax Considerations for Debt Workouts During an Economic Downturn – Partnership Considerations Supplement

    Locke Lord Publications

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    The discussion in this Quick Study Supplement outlines select federal income tax issues partnership borrowers may face in debt restructurings.1 As noted in our debt restructuring overview Quick Study, a borrower generally recognizes income—cancellation of debt (“COD”) income or Section 1001 income—when its debt is discharged or satisfied at a discount.

    Bankruptcy and Insolvency Exceptions

    In certain circumstances, it can be more difficult for a partnership borrower to mitigate the impact of COD income compared to a corporate borrower because a number of the applicable COD income exceptions are applied at the partner and not the entity level. For example, a corporation can potentially avoid recognizing COD income if it is insolvent or bankrupt. However, in the partnership context, the insolvency and bankruptcy exclusions are applied at the partner-level, not the partnership level, even though the COD income is initially calculated at the partnership level. Thus, the impact on partners in a partnership that experiences a COD income event can vary depending on whether such partners are solvent, insolvent, or bankrupt.2

    Partnership Incorporation

    If a partnership desires to avoid allocating COD income to its partners, such partnership may consider incorporating prior to the COD event. Once incorporated, any COD income would be “trapped” within the corporation and it may be easier for the corporation to utilize one of the COD income exceptions. There are, however, two principal potential limitations on the effectiveness of the partnership incorporation strategy—the liabilities in excess of basis rules and the risk of the Internal Revenue Service disregarding the incorporation.

    While the incorporation of a partnership generally can be accomplished in a tax-deferred manner, an incorporation may still give rise to taxable income to the extent that the aggregate amount of liabilities ‎transferred to the corporation exceeds the aggregate tax basis of all property ‎so transferred (“Section 357(c) income”)‎. Consequently, a partnership borrower should review the potential for the creation of Section 357(c) income in detail when an incorporation transaction is being considered (and whether the amount of such income is greater or less than the potential COD income).3

    Incorporating a partnership simply to avoid COD income also creates significant risk that it could be challenged by the Internal Revenue Service, especially where a partnership is incorporated close to the occurrence of a COD event. The Internal Revenue Service could challenge the incorporation using a variety of arguments ‎‎(e.g., business purpose, economic substance, a Code Section 269 disallowance, and a substance over form argument). A partnership borrower and its tax advisors will need to review these risks in detail.

    In addition to the above limitations, the effect of the potential loss of pass-through status for income tax purposes resulting from the incorporation should be considered.

    Partner Lenders

    If a lender is already a partner (or related to a partner) in a partnership, then the discharge of such ‎debt will often result in an allocation of any resulting COD income specifically to the lender-partner (rather than to all partners) due to the ‎recourse nature of the debt for partnership tax purposes. The problem with this scenario is that the lender-partner would be ‎allocated COD income which is ordinary in nature and, unless the lender can take the position that it is in the business of lending,4 it may only be allowed to recognize a capital loss on ‎its loan, creating a tax-rate mismatch in certain instances or the inability to offset a capital loss against an ordinary income amount.

    Discharge of Debt via Partnership Interest Issuance

    A partnership borrower is generally not able to utilize the capital contribution exclusion that is sometimes available for corporate borrowers, pursuant to which a lender contributes debt to the corporation without a corresponding issuance of shares by the corporation to such lender. A partnership borrower generally may, however, utilize the debt-for-equity conversion exclusion. As a result, if a partnership issues a partnership interest to a lender in exchange for debt forgiveness, the partnership will generally recognize income to the extent that the amount of the debt exceeds the fair market value of the interest transferred. The admission of the lender as a partner may also have collateral consequences, including, without limitation, a recapture of prior debt financed deductions, a reallocation of partnership liabilities among the partners, and an adjustment in nonrecourse deduction sharing ratios. If a partnership has a large number of lenders (e.g., its loan has been syndicated) and/or existing partners, then such partnership will need to consider whether the admission of such lenders will implicate certain “publicly traded partnership” (“PTP”) rules.5

    PTP Qualifying Income Issues

    If a PTP relying on the “qualifying income” exception under Internal Revenue Code Section 7704(d) recognizes COD income, such PTP will need to determine whether that COD income is “qualifying income” under such Internal Revenue Code Section. Revenue Procedure 2012-28 sets forth a safe harbor pursuant to which the Internal Revenue Service will not challenge a PTP’s determination that COD income is “qualifying income” if such income “is attributable to debt incurred in direct connection with activities of the PTP that generate qualifying income” (determined by any reasonable method).6

    Given the various income tax issues that result from a restructuring of its debt, a partnership borrower should consult tax advisors before engaging in such a restructuring. For additional information and context, please contact one of the authors.

    Links to the additional more detailed discussions referenced in the overview Quick Study are provided here for your convenience: “C” Corporation Considerations, “S” Corporation Considerations, and Lender Considerations.

    Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19. 


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    1. This Supplement is not intended to be a comprehensive or complete discussion of all tax issues a partnership borrower may face in a debt restructuring scenario, and is intended only to provide a high-level summary of certain federal income tax issues.
    2. While there could be limited factual circumstances under which a borrower partnership could specially allocate COD income, a special allocation of COD income to partners who can take advantage of partner-level COD income exclusions would likely be challenged by the Internal Revenue Service. A borrower partnership will want to carefully review its income and loss allocation provisions as COD income may ‎impact its partners in a disproportionate or unexpected manner depending on the facts. ‎In addition, an insolvent or bankrupt partner may still recognize income with respect to a COD event that is attributable to resulting shifts in partnership-level indebtedness under Internal Revenue Code Section 752.
    3. As a potential indicator of possible Section 357(c) income, a partnership may examine the capital account balances of its partners. If the partners have negative capital accounts, that could suggest that Section 357(c) income may arise with respect to an incorporation of the partnership. ‎If a partnership determines that an incorporation is desirable, but that Section 357(c) income would be triggered on such incorporation, the partnership and its partners could potentially remedy such situation by contributing additional property (including cash) to the partnership prior to the incorporation so that the transferred liabilities no longer exceed the aggregate basis of the contributed property. This may or may not be a feasible strategy, and may not be advisable since the partners would put additional capital at risk in the enterprise.
    4. Depending on the specific factual circumstances of the lender,  a lender may not be able to or want to take such a position.
    5. Unless the partnership can satisfy an available PTP exception or safe harbor, such partnership will be treated as a “C” corporation for federal income tax purposes. An event which causes a partnership to fail to satisfy any such PTP exception or safe harbor will raise the partnership incorporation issues discussed ‎above. A common PTP safe harbor requires the partnership to not have more than one hundred partners. As such, the admission of a large number of such lender partners can create issues with ‎respect to such partnership’s ability to continue to qualify as a flow-through entity for federal ‎income tax purposes. In such event, the partnership may need to rely on a more restrictive PTP safe harbor, which, in turn, may limit the ability of partners to transfer their interests in such partnership on a going forward basis.‎
    6. For these purposes, the tracing approach used in Treasury Regulation Section 1.163-8T will be deemed a ‎reasonable method, but a method that allocates COD income based solely on a ratio of qualifying ‎gross income to total gross income will ordinarily not be deemed reasonable.

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