Partners Beware: How Bankrupt Partnerships May Pass on Liabilities to Individual Partners

The world remains embroiled in economic upheaval caused by Covid-19. For nearly six months, state and local governments have grappled with shutting down businesses, protecting vulnerable population segments and navigating a reopening that balances economic and health concerns. Meanwhile, federal aid programs have sought to protect struggling businesses in light of those shutdowns. For some, that relief was too little, too late. For others, only the future will tell if they can survive the ongoing crisis.

As businesses shutter and others attempt to restructure their operations to fend off complete liquidations, bankruptcies will become more and more prevalent. The benefits of bankruptcy are obvious—a reorganization can salvage a business facing insurmountable costs due to short-term, but drastic, fluctuations in cash flows. For partners in pass-through entities, bankruptcies and other forms of debt relief may have unintended consequences. Congress requires taxpayers, including partnerships, to recognize gross income when creditors forgive debt through tax code Section 61(a)(11) but applies the debt relief exclusion rules of Section 108 at the partner level.

General Application of Section 61(a)(11)

In United States v. Kirby Lumber Co., the U.S. Supreme Court held that a corporation recognized economic gain—and taxable income—when it purchased its own bonds on the open market for less than their principal amount. The Supreme Court reasoned that the corporation freed up assets that would have otherwise been needed to satisfy the debt. As such, the corporation had taxable income equal to the difference between the principal amount of the debt and the purchase price of the bonds.

Congress later codified that debt relief equals income principle. Section 61(a)(11) provides that gross income includes amounts of indebtedness discharged. Cancellation of debt (COD) income results where a lender discharges, in whole or in part, debts owed by the debtor/taxpayer. Flowing from the freeing of assets theory under Kirby Lumber, the tax code seeks to tax the economic gain resulting from the relief from that debt.

Congress provided important exceptions to the general income inclusion principles found in Section 61(a)(11). In Section 108(a)(1), Congress excludes from gross income debt discharged as a result of a bankruptcy under Title 11, insolvency, and other relief from certain business debts (including farm debts). Outside of certain tax attribute reductions required by Section 108(b), Section 108 provides important benefits to otherwise struggling taxpayers. For partners in certain pass-through entities, the benefits of Section 108 may prove illusory.

Application of Section 108 to Partnerships

Section 108(d)(6) provides that “in the case of a partnership, subsections (a), (b), (c), and (g) shall be applied at the partner level.” Importantly, Section 61(a)(11) does not provide a corresponding partner-level rule. This means that debt relief/taxable income determination found in Section 61(a)(11) occurs at the partnership level while the debt relief exclusion found in Section 108 occurs at the partner level.

The tax code’s diverse partnership/partner level application of the debt relief provisions may adversely impact unsuspecting partners. For starters, Section 702(a) treats COD income as an item that must be separately allocated to each partner. While the insolvent partnership may have seen its income excluded under Section 108(a)(1)(B), the individual partners may not qualify. As a result, they may be forced to recognize income that could have been excluded if the insolvency test applied at the partnership-level.

For example, Partners A, B, and C each own equal shares of partnership ABC. The partnership’s debts greatly exceed its assets. If a creditor forgives $900,000 of debt, Sections 61(a)(11) requires the partnership to recognize $900,000 of COD income while Section 702(a) requires the taxation of that income to be determined at the individual partner level. Due to their equal ownership of ABC, each partner will be allocated $300,000 of COD income. If A and B are also insolvent, then Section 108(a)(1)(B) excludes the COD income from their individual gross income. If Partner C has a positive net worth, Section 108(a)(1)(B)’s insolvency exception would not apply. Partner C must include the $300,000 in taxable income.

Bankruptcy may similarly result in disparate treatment depending on whether the individual partner files for bankruptcy. Under Section 108(d)(2), the bankruptcy discharge exclusion of Section 108(a)(1)(A) only applies if the taxpayer falls under the jurisdiction of the bankruptcy court. In Gracia v. Commissioner, , the U.S. Tax Court analyzed whether Section 108 could apply when the partnership, not the partners, filed for bankruptcy. There, the bankruptcy court expressly released the individual partner from the debts and confirmed that they fell under the court’s jurisdiction. Because of this, the Tax Court held that Section 108 applied and the partnership’s COD income should be excluded from the partner’s gross income.

The IRS refused to acquiesce to the decision in Gracia, as well as three other nearly identical cases: Mirarchi v. Commissioner; Price v. Commissioner; and Estate of Martinez v. Commissioner. See IRS Action on Decisions (AOD) 2015-1. The IRS cited the Senate Report S.Rep. No. 96-1035 at 21 as the reason for its disagreement. The Senate Reports provides the example of a bankrupt partnership with three partners: A, B, and C. Partner C is solvent and not the debtor under jurisdiction of the bankruptcy court. The Senate indicated that because Partner C is not the debtor, it can either elect to reduce its basis in depreciable assets or recognize its share of the partnership COD income. Under the Senate and IRS’s reasoning, Section 108(a)(1)(A) only applies to the debtor in a bankruptcy proceeding. Because the partner is not the debtor, it does not qualify.

With a slew of bankruptcies likely on the horizon, partners should consult tax advisors as to the potential tax consequences to them individually as a result of partnership-level debt relief.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

John Hackney is a shareholder in Chamberlain Hrdlicka’s Atlanta offices in the Tax Controversy and Litigation group. He can be reached at John.Hackney@chamberlainlaw.com.

Jasen D. Hanson is an associate in Chamberlain Hrdlicka’s Atlanta office in the Tax Controversy and Litigation Group. He can be reached at Jasen.Hanson@chamberlainlaw.com.