Partnership Debt-for-Equity Exchanges: IRS Issues Final Regulations on Cancellation of Indebtedness Income

Sullivan & Cromwell LLP - November 18, 2011

The Internal Revenue Service (the “IRS”) recently released final regulations (the “Final Regulations”) relating the federal income tax consequences of the transfer of a partnership interest by a partnership to a creditor in satisfaction of the partnership’s indebtedness. The Final Regulations modify and expand upon the proposed regulations that the IRS issued on this topic in October 2008 (the “Proposed Regulations”). Similar to the Proposed Regulations, the Final Regulations permit a debtor partnership and its creditor to use the liquidation value of the transferred partnership interest as its fair market value for purposes of calculating the partnership’s cancellation of indebtedness income, but the Final Regulations modify the requirements for this treatment as compared to the Proposed Regulations. The Final Regulations, similar to the Proposed Regulations, generally do not permit or require a creditor to recognize gain or loss on the transfer, but instead require the creditor to carryover its basis and holding period in the indebtedness to its partnership interest. The Final Regulations apply to debt-for-equity exchanges occurring on or after November 17, 2011.