Partnership Taxation in Bankruptcy

Most of the debtors involved in our restructuring work are corporations. On occasion, however, we find ourselves working on a matter involving a bankrupt partnership. Partnerships in bankruptcy raise a host of tax issues that differ from the issues we deal with in our typical corporate debtor work. In this article, we first discuss some basic elements of partnership taxation, and then review some of the tax issues unique to partnerships in bankruptcy.

Partnership Taxation in General

A partnership is not a tax-paying entity. Rather, it reports its income on an informational return, and this income flows through to its partners in accordance with the partnership agreement. The partners are liable for the tax on their allocable share of income from the partnership. Often, partnership agreements provide that cash may be distributed to the partners to enable them to pay the tax liability associated with their allocable share of partnership income.

When losses (rather than income) flow through to the partners, each partner can currently utilize the losses on its tax return, but only to the extent the partner has tax basis in its partnership interest. When losses exceed a partner's tax basis, the losses are suspended until the partner generates additional tax basis, for example, through additional capital contributions or, as discussed below, if additional partnership debt is assumed or the partner's “share” of partnership liabilities increases.

Additional significant tax points regarding partners and partnerships: A partner's tax basis in its partnership interest reflects 1) the tax basis of any assets the partner contributes to capital, 2) income and loss allocated to the partner, and 3) the partner's share of partnership liabilities. A partner's share of partnership liabilities is determined under complicated rules, but, generally, liabilities are allocated to the partner that bears the economic risk associated with the liability (for example, through a guarantee). Where no partner bears a direct economic risk (for example, where the debt is nonrecouse), the liabilities are allocated among the partners in accordance with their interests in the profits of the partnership.

A partner is deemed to receive a cash distribution from a partnership to the extent the partner is relieved of its share of partnership liabilities. In general, a partner is taxable to the extent cash distributions exceed the partner's tax basis in its partnership interest.

Partnership Workouts

Briefly, in a partnership workout, cancellation of indebtedness (COD) is determined at the partnership level, while the taxability of the COD is determined at the partner level. For example, if a partnership has two partners, one bankrupt and one not, and the partnership recognizes COD, the bankrupt partner will be able to exclude its share of the COD from income, while the non-bankrupt partner will be currently taxable on its share of the COD. A partner may also be required to report capital gain to the extent the partner is relieved of partnership debt in an amount greater than its tax basis in its partnership interest.

Procedurally, when a partnership files for bankruptcy protection, no new taxable entity is created for federal income tax purposes, no new federal taxpayer identification number is required, and the partnership's tax year does not close.

The trustee in bankruptcy is responsible for filing the partnership's informational tax returns for post-petition periods. Any taxable income generated by the partnership is passed through and taxed to the partners in accordance with the partnership agreement, provided that, the allocation has economic substance. Under the Bankruptcy Code, however, the partnership is not permitted to distribute cash or other assets to enable the partners to satisfy their tax liabilities.

Significantly, the state law dissolution of a partnership does not terminate the partnership for tax purposes. Rather, a partnership remains in existence for federal income tax purposes until all of its affairs have been wound up. Thus, if partners attempt to abandon their partnership interests in a bankrupt partnership to avoid being taxed on COD income, it is unlikely that such an abandonment would be respected for federal income tax purposes. In this regard, the Supreme Court recently held that the IRS's timely assessment of employment taxes against a partnership kept the statute of limitations open to collect such taxes from the partners.

Character of Income in Workouts

In a partnership workout, partners may be taxed on two general types of income: 1) COD or capital gain related to reduction or cancellation of partnership debt; or 2) COD or capital gain related to the reduction of a partner's liability for partnership debt (through cancellation or reduction of its obligation with respect to the debt).

There are no specific rules on how a partnership allocates COD income among its partners. If the partnership agreement provides how COD is allocated, such an allocation will be respected as long as it has economic substance (“substantial economic effect” in tax parlance). The legislative history indicates that COD income can be allocated to the partners based on each partner's share of partnership liabilities.

When partnership debt is reduced or cancelled, capital gain or COD income may result, depending on the circumstances. The importance of the distinction as to whether capital gain or COD income arises when partnership debt is reduced or cancelled is that capital gain is always taxable to the partners, whereas the COD income will not be taxable to partners who are bankrupt or insolvent (to the extent of insolvency). While net operating losses (NOLs) may be available to a partner to fully offset any gain, such gain may be subject to the Alternative Minimum Tax (AMT). However, since individual partners may prefer capital gains (taxable at 15%) to COD (taxable at ordinary income rates up to 35%), some structuring opportunities should be considered in order to obtain the desired character of income.

In a partnership workout, the following points should be considered:

• When secured partnership debt is reduced, but the partnership retains the collateral, the partnership has COD to the extent the debt is reduced. When the collateral is transferred to reduce or cancel the secured debt, the partnership has income, which may be COD or capital or both, depending on the nature of the debt;
• A partnership will generally report capital gain when it exchanges collateral for non-recourse debt. Gain also arises when recourse debt is forgiven, but only to the extent that the fair market value of the property exceeds the partnership's tax basis of the collateral transferred to the lender; and
• COD (rather than capital gain) income results when non-recourse debt is reduced or cancelled without a surrender of collateral. COD income also results when recourse debt is extinguished, but only to the extent the tax basis of the debt exceeds the fair market value of the underlying property.

Partnership Debt Restructuring

A common issue in partnership workouts is whether a contribution of partnership debt to the partnership in exchange for a partnership interest creates COD income. One view is that no COD is created because the contribution qualifies as a tax free contribution of property to the partnership under the usual partnership tax rules allowing for tax free contributions of property. However, the better view may be that COD will be generated to the extent the value of the partnership interest received is less than the face amount of the debt contributed. Thus, as is often the case, where the partnership interest received has little or no value, COD may be generated.

Most of the debtors involved in our restructuring work are corporations. On occasion, however, we find ourselves working on a matter involving a bankrupt partnership. Partnerships in bankruptcy raise a host of tax issues that differ from the issues we deal with in our typical corporate debtor work. In this article, we first discuss some basic elements of partnership taxation, and then review some of the tax issues unique to partnerships in bankruptcy.

Partnership Taxation in General

A partnership is not a tax-paying entity. Rather, it reports its income on an informational return, and this income flows through to its partners in accordance with the partnership agreement. The partners are liable for the tax on their allocable share of income from the partnership. Often, partnership agreements provide that cash may be distributed to the partners to enable them to pay the tax liability associated with their allocable share of partnership income.

When losses (rather than income) flow through to the partners, each partner can currently utilize the losses on its tax return, but only to the extent the partner has tax basis in its partnership interest. When losses exceed a partner's tax basis, the losses are suspended until the partner generates additional tax basis, for example, through additional capital contributions or, as discussed below, if additional partnership debt is assumed or the partner's “share” of partnership liabilities increases.

Additional significant tax points regarding partners and partnerships: A partner's tax basis in its partnership interest reflects 1) the tax basis of any assets the partner contributes to capital, 2) income and loss allocated to the partner, and 3) the partner's share of partnership liabilities. A partner's share of partnership liabilities is determined under complicated rules, but, generally, liabilities are allocated to the partner that bears the economic risk associated with the liability (for example, through a guarantee). Where no partner bears a direct economic risk (for example, where the debt is nonrecouse), the liabilities are allocated among the partners in accordance with their interests in the profits of the partnership.

A partner is deemed to receive a cash distribution from a partnership to the extent the partner is relieved of its share of partnership liabilities. In general, a partner is taxable to the extent cash distributions exceed the partner's tax basis in its partnership interest.

Partnership Workouts

Briefly, in a partnership workout, cancellation of indebtedness (COD) is determined at the partnership level, while the taxability of the COD is determined at the partner level. For example, if a partnership has two partners, one bankrupt and one not, and the partnership recognizes COD, the bankrupt partner will be able to exclude its share of the COD from income, while the non-bankrupt partner will be currently taxable on its share of the COD. A partner may also be required to report capital gain to the extent the partner is relieved of partnership debt in an amount greater than its tax basis in its partnership interest.

Procedurally, when a partnership files for bankruptcy protection, no new taxable entity is created for federal income tax purposes, no new federal taxpayer identification number is required, and the partnership's tax year does not close.

The trustee in bankruptcy is responsible for filing the partnership's informational tax returns for post-petition periods. Any taxable income generated by the partnership is passed through and taxed to the partners in accordance with the partnership agreement, provided that, the allocation has economic substance. Under the Bankruptcy Code, however, the partnership is not permitted to distribute cash or other assets to enable the partners to satisfy their tax liabilities.

Significantly, the state law dissolution of a partnership does not terminate the partnership for tax purposes. Rather, a partnership remains in existence for federal income tax purposes until all of its affairs have been wound up. Thus, if partners attempt to abandon their partnership interests in a bankrupt partnership to avoid being taxed on COD income, it is unlikely that such an abandonment would be respected for federal income tax purposes. In this regard, the Supreme Court recently held that the IRS's timely assessment of employment taxes against a partnership kept the statute of limitations open to collect such taxes from the partners.

Character of Income in Workouts

In a partnership workout, partners may be taxed on two general types of income: 1) COD or capital gain related to reduction or cancellation of partnership debt; or 2) COD or capital gain related to the reduction of a partner's liability for partnership debt (through cancellation or reduction of its obligation with respect to the debt).

There are no specific rules on how a partnership allocates COD income among its partners. If the partnership agreement provides how COD is allocated, such an allocation will be respected as long as it has economic substance (“substantial economic effect” in tax parlance). The legislative history indicates that COD income can be allocated to the partners based on each partner's share of partnership liabilities.

When partnership debt is reduced or cancelled, capital gain or COD income may result, depending on the circumstances. The importance of the distinction as to whether capital gain or COD income arises when partnership debt is reduced or cancelled is that capital gain is always taxable to the partners, whereas the COD income will not be taxable to partners who are bankrupt or insolvent (to the extent of insolvency). While net operating losses (NOLs) may be available to a partner to fully offset any gain, such gain may be subject to the Alternative Minimum Tax (AMT). However, since individual partners may prefer capital gains (taxable at 15%) to COD (taxable at ordinary income rates up to 35%), some structuring opportunities should be considered in order to obtain the desired character of income.

In a partnership workout, the following points should be considered:

• When secured partnership debt is reduced, but the partnership retains the collateral, the partnership has COD to the extent the debt is reduced. When the collateral is transferred to reduce or cancel the secured debt, the partnership has income, which may be COD or capital or both, depending on the nature of the debt;
• A partnership will generally report capital gain when it exchanges collateral for non-recourse debt. Gain also arises when recourse debt is forgiven, but only to the extent that the fair market value of the property exceeds the partnership's tax basis of the collateral transferred to the lender; and
• COD (rather than capital gain) income results when non-recourse debt is reduced or cancelled without a surrender of collateral. COD income also results when recourse debt is extinguished, but only to the extent the tax basis of the debt exceeds the fair market value of the underlying property.

Partnership Debt Restructuring

A common issue in partnership workouts is whether a contribution of partnership debt to the partnership in exchange for a partnership interest creates COD income. One view is that no COD is created because the contribution qualifies as a tax free contribution of property to the partnership under the usual partnership tax rules allowing for tax free contributions of property. However, the better view may be that COD will be generated to the extent the value of the partnership interest received is less than the face amount of the debt contributed. Thus, as is often the case, where the partnership interest received has little or no value, COD may be generated.