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On October 31, 2008, the Treasury published Prop. Regs. §§1.108-8 and 1.721-1(d) addressing the tax consequences of a contribution of partnership debt to the capital of a partnership in exchange for a partnership interest. The proposed regulations provide that, as a general rule: (i) the partnership must recognize cancellation of indebtedness (“CoI”) income to the extent the face amount of the debt exceeds the amount the creditor would receive if the partnership sold all of its assets for their fair market values and liquidated; (ii) the creditor does not recognize gain or loss on the contribution of the debt in exchange for a partnership interest; and (iii) the creditor's basis in the debt becomes basis in his partnership interest.

As the example below illustrates, the proposed regulations' failure to provide a special rule for partner nonrecourse liabilities means that a contribution (or deemed contribution) of a partner's nonrecourse loan (with a liquidating value which is less than face) to capital will require the partner to recapture partner nonrecourse deductions as current ordinary income in exchange for a deferred capital loss. Although the tax problem could, and in the writer's view should, be eliminated by providing that the debt's liquidating value would be deemed to be at least equal to the contributing partner's partner nonrecourse deductions, the absence of such a proviso requires a partner who is considering advancing funds to a partnership as a loan (rather than as preferred capital) to weigh the potential economic advantage of participating parri passu with other unsecured creditors against the potential tax disadvantage of converting ordinary deductions into deferred capital losses.

Example: A & B form a 50-50 LLC (M) with each of them contributing initial capital of $ 10,000. A advances an additional $75,000 which is to be repaid prior to any repayments of the initial capital. M purchases two buildings for $500,000 each and each building secures a third party mortgage loan of $462,500 with each mortgage lender's sole recourse being against the building securing its loan. M has ordinary losses of $20,000 in year one and $50,000 in year two; as of the end of year two the buildings are worth $400,000 each. In year three, the mortgage lenders acquire the buildings through deeds in lieu of foreclosure.

As the schedule below illustrates, the nature and timing of losses allocated to A from inception through the transfers to the mortgage lenders are identical whether A's advances have been classified as loans or as priority capital. However, if the advances were loans, A is holding a loan receivable with a $75,000 tax basis and has a negative capital account of $75,000.

Absent unusual circumstances, a loan to a partnership from a noncorporate partner is a non-business bad debt. Accordingly, claiming a bad debt deduction would result in A recognizing a $75,000 short term capital loss and M recognizing $75,000 of CoI (i.e., ordinary) income all of which would be allocable to A. If A were deemed to have contributed the loan to M's capital, under the proposed regulation M would have $75,000 ($75,000 face value over a zero liquidating value) of CoI income (all allocable to A) and A would have a $75,000 long term capital loss on the liquidation of his partnership interest. (A's 0 basis in his partnership interest is: increased by his $75,000 basis in the loan (per §722); decreased by $75,000 (per §752(b)); and increased by the $75,000 of CoI income.)

It is believed that in such circumstances most taxpayers did not report additional gain or loss on the partnership's liquidation, perhaps justifying their position on the ground that it should be treated as though the creditor partner had assumed the debt from the partnership (i.e., should be treated as having made a capital contribution equal to the debt's face amount). The lack of administrative or judicial authorities addressing the issue suggests that IRS agents either accepted or overlooked such treatment.

For more information, in the Tax Management Portfolios, see McCoy, 538 T.M., Bad Debts, and in Tax Practice Series, see ¶1040, Discharge of Indebtedness.