K-1 may not control whether debt is non-recourse for COD purposes
TAX ALERT |
When partnership indebtedness is discharged, the consequences to the partners often turns on whether the debt is considered recourse or non-recourse to the partnership. The discharge of recourse debt gives rise to cancellation of debt (COD) income. COD income is taxed as ordinary income and may be excludible under certain circumstances, such as if the partner is insolvent. In contrast, the discharge of non-recourse debt, in connection with a foreclosure of the loan or similar circumstances, is generally not treated as COD income but, instead, is treated as an amount realized from the sale of property securing the debt. Gain on the disposition of an asset is not eligible for any of the exclusions of income found in section 108 related to the cancellation of indebtedness. Although the special rules applicable to COD do not apply, the effects of an additional amount realized from a sale are often limited to an increase in capital gain (or a reduction in capital loss) rather than the realization of ordinary income. The preference of any individual partner for treating a debt as recourse or nonrecourse may vary depending on their individual circumstances. Preferences aside, however, the debt 'is what it is' – either recourse or nonrecourse.
Unfortunately, the law is still not clear as to whether partnership debt is treated as recourse or nonrecourse by reference to the creditor's theoretical ability to reach the partnership (which itself may be a limited liability company with little or no assets, making that theoretical recourse economically meaningless) or by reference to whether the creditor has recourse against any particular partner. The latter standard is used under section 752 for allocating partnership liabilities among partners for basis purposes, but may not apply in determining whether the debt is recourse or nonrecourse for purposes of the COD rules. Many practitioners believe that the limiting language found in the section 752 regulations preclude reliance on those rules to determine if debt is recourse for purposes of section 1001 and the COD rules. Still, there are some practitioners who believe there is substantial authority for the contrary view. In Chief Counsel Advice Memorandum 201525010, the IRS refused to apply the section 752 definitions of recourse and nonrecourse indebtedness for purposes of determining gain or loss under the COD income rules for partnership entities. This is a reminder that owners in an entity taxed as a partnership should not assume that the determination of recourse or nonrecourse indebtedness on a provided Schedule K-1 will govern the characterization of the income. Accordingly, it is important that owners of organizations contemplating a transfer of property to satisfy a debt, should discuss the tax consequences with their tax advisors before consummating a transaction.