IRS disagrees with partner exclusion of partnership's debt cancellation income

Federal, State, Local and International Taxes – In an Action on Decision (AOD), IRS has announced its nonacquiesence with four Tax Court cases each of which held that a partner, who guaranteed the debt of a partnership and was not in bankruptcy in his individual capacity, may exclude from gross income under Code Sec. 108(a), partnership debt cancelled in a title 11 case of the partnership.

Background. Code Sec. 61(a)(12) provides that gross income includes cancellation of debt income (COD income). But Code Sec. 108(a)(1)(A) excludes from gross income any amount derived from “the discharge (in whole or in part) of indebtedness of the taxpayer” if the discharge occurs in a title 11 case. Code Sec. 108(d)(2) defines a “title 11 case” as “a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.” Code Sec. 108(d)(6) provides that, in the case of a partnership, Code Sec. 108(a) and certain other parts of Code Sec. 108 must be applied at the partner level.

Under the Bankruptcy Code, the term “debtor” means a person concerning which a case under title 11 has been commenced. (11 USC 101(13))

Facts. Each of the four taxpayers was a general partner in a partnership and personally guaranteed some of the partnership's debts. The partnership initiated a case under title 11. The partners reached a settlement agreement with the trustee of the bankruptcy estate, under which they would make payments to the partnership's bankruptcy estate in exchange for the release of claims or potential claims of creditors against them relating to the partnership. The bankruptcy court approved the agreement and discharged and released the partners from all liability related to the partnership, their status as general partners, and their personal guarantees of partnership debts. The same order provided that each partner “is subject to the jurisdiction of the Bankruptcy Court.”

None of the partners included the COD income allocated to him by the partnership on his tax return for the year of the discharge. In the notice of deficiency, IRS rejected the partner's claim to an exclusion of the partnership COD income.

Tax Court decisions. The Tax Court held that each partner may exclude his share of the partnership COD income from gross income under Code Sec. 108(a)(1)(A) because the partnership debt was discharged “in a title 11 case” within the meaning of Code Sec. 108(d)(2). The Tax Court noted that the bankruptcy court's order discharged and released the partners from liability in a title 11 case and explicitly asserted jurisdiction over them. (Gracia, TC Memo 2004-147; Mirarchi, TC Memo 2004-148; Price, TC Memo 2004-149; Estate of Martinez, TC Memo 2004-150)

IRS disagrees with Tax Court. In nonacquiescing with the Tax Court holdings, IRS noted the following:

In Yamamoto, TC Memo 1990-549, aff'd without published opinion, (CA 9 1992) 958 F.2d 380, the Tax Court observed that “the entire structure of Code Sec. 108, as well as the . . . legislative history [of Code Sec. 108(a)(1)(A)] (see, e.g., S. Rept. 96-1035, pp. 8-14 (1980)), makes it plain that the provision [Code Sec. 108(a)(1)(A)] operates to provide tax relief to the debtor in bankruptcy,” and not a non-debtor party in a bankruptcy proceeding.

In discussing Code Sec. 108(d)(6), Congress explained that discharge of a partnership debt is an item of income allocated separately to each partner pursuant to Code Sec. 702(a). Congress indicated its intent to limit the scope of Code Sec. 108(a)(1)(A) to bankrupt or insolvent partners, and not to all partners of a bankrupt partnership. “The tax treatment of the amount of discharged partnership debt which is allocated as an income item to a particular partner depends on whether that partner is in a bankruptcy case, is insolvent (but not in a bankruptcy case), or is solvent (and not in a bankruptcy case). . . . [I]f the particular partner is bankrupt, the debt discharge amount is excluded from gross income pursuant to amended Code Sec. 108. . . ” (S. Rep. No. 96-1035, p. 21)

The legislative history further explains that the income tax treatment of debt discharge in bankruptcy is intended to preserve the debtor's “fresh start” after bankruptcy by excluding COD income from the debtor's income so that “the debtor coming out of bankruptcy . . . is not burdened with an immediate tax liability.” (S. Rep. No. 96-1035, p. 10)

The Tax Court's rulings were inconsistent with the structure of Code Sec. 108 and underlying Congressional intent. The partners were not under the jurisdiction of the bankruptcy court in a title 11 case as debtors. The partnership, not the partners, filed the petition in the bankruptcy court. None of the partners met 11 USC 101(13)'s definition of a debtor, i.e., a person concerning which a case under title 11 has been commenced. Code Sec. 108(a) applies at the partner level. The exclusion in Code Sec. 108(a)(1)(A) applies only to partners who are debtors in bankruptcy in their individual capacities and need a “fresh start.” None of the partners was in bankruptcy in his individual capacity and, therefore, did not need a “fresh start.”

Therefore, none of the partners was not entitled to exclude his share of the partnership COD income under Code Sec. 108(a)(1)(A).

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