DRAFT IN PROGRESS - October 23, 2017 - Remains … 4 - Recourse...DRAFT IN PROGRESS - October 23, 2017 - Remains Subject to Ongoing Revision and Review KE 48683530.25 The Uncertain

DRAFT IN PROGRESS - October 23, 2017 - Remains Subject to Ongoing Revision and Review

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The Uncertain (And Sometimes Nonsensical) Distinctions Between Recourse and Nonrecourse Liabilities¥

Anthony V. Sexton∗

¥ This is a working draft of a paper to be presented at the 2017 University of Chicago Tax Conference.

It remains subject to ongoing revision and review in all respects.

∗ Anthony Sexton is a partner in the tax group of Kirkland & Ellis LLP. His practice focuses primarily on the tax considerations relevant to distressed companies and their creditors in out-of-court workouts and bankruptcy reorganizations. The views in this paper are his own and do not reflect the views of Kirkland & Ellis LLP or any client of the firm. [Acknowledgments to come.]

DRAFT IN PROGRESS - October 23, 2017 - Remains Subject to Ongoing Revision and Review

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1. Introduction

To most lawyers, debt can be cleanly divided into two groups: “recourse” or “nonrecourse.” An issuer of recourse debt can generally assert that debt against the borrower itself and seek recovery against anything the borrower owns; the issuer will only go unpaid to the extent the borrower, as a whole, has assets that are less than the amount of the debt. By contrast, issuers of a nonrecourse debt instrument are generally limited to the proceeds of certain specified collateral; if the collateral is worth less than the loan, the issuer has no further recourse against the borrower. This is a relatively straightforward distinction, with straightforward consequences, in the world of corporate law and debt finance: whether debt is recourse or nonrecourse essentially depends on the lender’s state-law rights. That straightforward distinction may be subject to adjustment based on, among other things, credit support provided by third parties (such as letters of credit or surety bonds) or affiliates (such as the common situation of guarantees granted by other members of a borrower’s corporate group or equityholder guarantees); circumstances where entities do not protect other parties from liability (such as general partners of a state law partnership); practical limitations on collection; non-recourse carve-outs (such as so-called “bad boy” guarantees); state law overlays (such as whether a lender that ostensibly has a nonrecourse loan can nevertheless obtain a deficiency judgment, or, on the flipside, whether an ostensibly recourse loan is turned into a nonrecourse loan by operation of state law); and, in the bankruptcy context, certain provisions that operate to create a deficiency recourse claim in certain circumstances. Even when those distinctions are present, though, from a corporate law and debt finance perspective, the consequences of these credit support and secondary obligations are relatively straightforward and rational, and they all boil down to one thing: the lenders’ rights under state law.

For tax lawyers, on the other hand, the distinction between recourse debt and nonrecourse debt can be far more difficult to pin down, and the consequences of that distinction can be extremely significant, highly irrational, and entirely detached from lenders’ state-law rights. The Internal Revenue Code (the “Code”)1 has no set definition of what constitutes “recourse” or “nonrecourse” debt. Indeed, the terms have different meanings depending on the statutory or regulatory provisions at issue, and there are particularly difficult questions regarding the proper treatment of debt borrowed by entities that are disregarded for U.S. federal income tax purposes (“DREs”), where such debt is recourse to the DRE under state law but not guaranteed by the DRE’s regarded owner (“DRE Recourse Debt”). The most recent, and dramatic, development in this area occurred in 2016, when the Internal Revenue Service (the “Service”) issued a Private Letter Ruling (the “2016 PLR”)2 ruling that DRE Recourse Debt is nonrecourse debt for

1 Unless otherwise indicated, references to “Sections” are references to the Code or the Treasury

Regulations thereunder, as appropriate.

2 PLR 201644018 (Oct. 28, 2016).

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purposes of Section 1.1001-23 and Tufts v. Comm’r.4 As discussed in more detail below, the 2016 PLR is at least in tension with prior rulings involving the application of Section 1.1001-3.5 Indeed, the better view is that the 2016 PLR is flatly inconsistent with those earlier rulings, which throws this area of law into a state of even greater uncertainty. In fact, it raises a question of whether debt may be recourse debt under Section 1.1001-3 while being nonrecourse under Section 1.1001-2 (or vice versa), an outcome that is, at a minimum, surprising. This uncertainty adds to a the fact that there are a number of cases where, setting the complexities created by the Code aside, the facts and circumstances involving any particular debt instrument and corporate structure may complicate a tax lawyer’s analysis of whether debt is recourse or nonrecourse.

In the face of this uncertainty, both issuers and creditors may face dramatically different tax consequences depending on whether a particular debt is treated as recourse or nonrecourse debt. These difference include, among other things: the availability of the bankruptcy and insolvency exclusions to cancellation of indebtedness income under Section 108(a) (which may spell the difference between a successful restructuring and administrative insolvency); the character and total amount of gain, income, loss, or deduction recognized in common restructuring transactions (including the allocation of such items in the partnership context); the application of Section 357(d); and the application of the “at-risk” rules.

This paper discusses the potential uncertainties involved with characterizing debt as recourse or nonrecourse, particularly in the context of DREs, and analyzes the sometimes nonsensical tax consequences that distinction can have, particularly in the context of distressed companies. Finally, this paper proposes ways to fix some of the most problematic tax consequences in the current state of law. To be sure, others have traveled this path before, and other articles have explored the theoretical underpinning of the cancellation of indebtedness doctrine in general, as well as the development of the differing treatments between recourse and nonrecourse debt, in greater detail than this article sets out to do.6 However, the 2016 PLR and other recent developments provide a 3 Governing the amount of gain or loss recognized in certain transaction when a transferor transfers

property subject to indebtedness.

4 461 U.S. 300 (1983) (generally standing for the proposition that the amount realized in connection with turning over property subject to nonrecourse indebtedness is equal to the amount of such nonrecourse indebtedness, even if the property is worthless less than the amount of such nonrecourse indebtedness).

5 Governing the determination of whether a debt obligation has undergone a “significant modification” and, therefore, is deemed to be retired and reissued in exchange for a new debt instrument.

6 See, e.g., Cuff, Indebtedness of a Disregarded Entity, 81 Taxes 303 (2003) (discussing, among other things, the distinction between recourse and nonrecourse indebtedness and many of the consequences of such distinction); Cummings, The Disregarded Entity Is and Isn’t (Disregarded), Tax Notes 743 (May 5, 2003) (evaluating the treatment of DRE Recourse Debt in the context of the significant modification rules in light of one of the private letter rulings discussed herein); Bennett, “To Be or Not to Be, That is the Question”: Disregarded Entities and Debt Modification, 81 Taxes 9 (Dec. 2003) (examining the treatment of DRE Recourse Debt in light of certain of the significant modification rulings discussed below); Hoffer, Give Them My Regards: A Proposal for Applying the COD Rules to Disregarded

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reason to take a fresh look at these issues, and they clearly illustrate the need for action to address the problems in this area of law.

2. Distinguishing Between Recourse and Nonrecourse Debt

As noted above, neither the Code nor the Treasury Regulations set forth a comprehensive definition of the meaning of, or distinction between, recourse and nonrecourse debt, despite the distinction being key to the operation of numerous provisions of the Code and Treasury Regulations. The terms are generically referenced in the context of Sections 1.1001-2 and 1.1001-3, and are specifically defined in context of Sections 704 and 752 (in a way that is clearly distinct from their general meaning outside of the partnership context).

(a) Distinction Outside of the Context of Sections 704 and 752: Factual Analysis of Creditors’ Rights.

(i) General Rule: If the Borrower is Personally Liable, the Debt is Recourse; Otherwise, the Debt is Nonrecourse.

Regulations under Section 1001 rely on the distinction between recourse debt and nonrecourse debt to establish the consequences of various transactions.7 Unfortunately,

Entities, Tax Notes 327 (April 18, 2005) (among other issues, discussing the treatment of DRE Recourse Debt in the context of Section 108); Levy and Hofheimer, Bankrupt Partnerships and Disregarded Entities, Tax Notes 1103 (June 7, 2010) (performing an extensive analysis of the legislative history of both the federal income tax code and the bankruptcy code to evaluate the distortive effects that current tax rules, including the treatment of recourse and nonrecourse liabilities, have in certain restructuring contexts); Peaslee, Disregarded Entities and Debt Modifications, Tax Notes 1145 (March 7, 2016) (evaluating the distinction between recourse and nonrecourse debt, particularly with respect to disregarded entities, in the context of the debt modification rules, and proposing specific regulatory changes); Elliott, How Choice of Entity Changes Recourse Debt Classification Answer, 153 Tax Notes 618 (Oct. 31, 2016) (noting recent developments in this area); Lee-Lim and Bozkurt, Significant Modification of Debt Instruments: A Case Study, Tax Notes (April 11, 2017) (evaluating private letter rulings discussed below, and the treatment of DRE Recourse Debt in general, in the context of the significant modification rules through a number of examples); Henderson and Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (2017), §§ 403.1.3, 404 (discussing consequences of recourse vs. nonrecourse distinction and discussing 2016 PLR); Geier, Tufts and the Evolution of Debt-Discharge Theory, 1 Fla. L. Rev. No. 3, 115 (1992) (evaluating history of the different treatment of recourse and nonrecourse debt and suggesting that the inconsistencies should be eliminated); Cunningham, Payment of Debt with Property--the Two-Step Analysis After Commissioner v. Tufts, 38 Tax Lawyer 575 (1985) (exploring history of treatment of dispositions of property in satisfaction of recourse and nonrecourse debt and arguing that distinction is justifiable on put/call option theory); Rosenberg, Better to Burn Out than to Fade Away? Tax Consequences on the Disposition of a Tax Shelter, 71 Cal. L. Rev. 87 (1983) (evaluating caselaw development between Crane and Tufts and proposing and evaluating various different approaches to the issue, including the tax benefit rule and treating certain amounts as cancellation of indebtedness income); Simmons, Nonrecourse Debt and Amount Realized: The Demise of Crane’s Footnote 37, 59 Or. L. Rev. 42 (1980) (discussing caselaw development from Crane to the lower court decisions in Tufts and exploring the theoretical bases for including the full amount of nonrecourse debt in amount realized).

7 As discussed in greater detail below, Section 1.1001-2 relies on the distinction to determine the consequences of disposing of assets that are subject to liabilities, while Section 1.1001-3 relies on the

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neither the Code nor the Treasury Regulations define what constitutes recourse or nonrecourse debt. Many authorities that have considered the question have generally focused on the straightforward dichotomy discussed under corporate and debt finance law: debt is recourse if it can be asserted against the borrower personally, and nonrecourse if it cannot be.8 Additionally, examples under Section 1.1001-2 appear to incorporate that straightforward distinction by reference to the taxpayers at issue being personally liable (or not) on the debt being evaluated.

The Seventh Circuit Court of Appeals drew a direct connection between Section 1.83-3(a)(2), which has language that clearly falls within this straightforward distinction, and the definition of “nonrecourse debt” in Racine v. C.I.R.9 In Racine, a taxpayer incurred indebtedness to enable it to exercise certain stock option awards. Under Section 1.83-3(a)(1), a taxpayer is generally treated as receiving property (and, accordingly, is subject to tax on the receipt of such property) when it obtains a beneficial ownership in such property. That general rule is subject to various exceptions. One such exception is that (a) the transfer of an option to acquire property is not itself a transfer of the underlying property, and (b) vitally in Racine, “if the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option.” The indebtedness incurred by the taxpayer in Racine was recourse to the taxpayer, but the taxpayer asserted that the debt was, in substance, nonrecourse debt because the lender would always execute a margin call long before the acquired stock became worth less than the amount of the indebtedness.10 The Seventh Circuit held that the debt was nevertheless recourse

distinction in evaluating whether a change to a debt instrument constitutes a “significant modification” of a debt instrument. There are other provisions outside of the specific partnership context that

8 See, e.g., Coburn v. C.I.R., T.C. Memo. 2005-283 (Dec. 6, 2005) (ultimately concluding it did not need to decide whether the debt at issue was recourse or nonrecourse to come to a conclusion, but citing Black’s Law Dictionary for basing the distinction on the idea that “[u]nlike collateral securing a nonrecourse liability, the collateral securing a recourse liability does not represent the only source of repayment”); FSA 200135002 (Aug. 31, 2001) (evaluating whether a California “limited recourse” liability was nonrecourse, and noting that “the rights of a creditor with respect to a limited recourse loan are not as great as the rights of a creditor with respect to a recourse loan”); Great Plains Gasification Associates v. C.I.R., T.C. Memo. 2006-276 (Dec. 27, 2006) (“Indebtedness is generally characterized as ‘nonrecourse’ if the creditor’s remedies are limited to particular collateral for the debt and as ‘recourse’ if the creditor’s remedies extend to all the debtor’s assets.”) (citing Raphan v. United States, 759 F.2d 879, 885 (Fed. Cir. 1985) (“Personal liability for a debt (‘recourse indebtedness’) means all the debtor’s assets may be reached by creditors if the debt is not paid. Personal liability is normally contrasted with limited liability (‘nonrecourse indebtedness’), against which a creditor’s remedies are limited to particular collateral for the debt.”).

9 Racine v. C.I.R., 493 F.3d 777 (7th Cir. 2007).

10 The taxpayer also asserted that the “risk of loss” exception of Section 1.83-3(a)(6) applied, which the court also disagreed with. That discussion is beyond the scope of this article.

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indebtedness (and, accordingly, outside the scope of Section 1.83-3(a)(2)) because the taxpayer was personally liable on the full amount of the debt.11

In CCA 201525010,12 the IRS has held that this creditors’ rights-based distinction controls the application of Section 1001 to partnership liabilities, even if a different characterization would apply in the context of Sections 704 and 752 (discussed below). The taxpayer asserted that the debt was recourse for purposes of Section 1001 because of the member guarantees, i.e., that the Section 752 rules should control for purposes of Section 1001. The Service concluded that Section 752 is irrelevant to determinations under Section 1001, pointing out that (a) regulations under Section 704 and 752, along with the relevant preamble, made it clear that Section 1001 and Sections 704 and 752 have different tests. The Service concluded that classification of debt for purposes of Section 1001 is ultimately a fact-intensive analysis of the particular debt documents. Importantly, nothing about the Section 1001 analysis in CCA 201525010 is limited to the partnership context (other than the holding that Sections 704 and 752 do not control).

Finally, the Service has issued many private letter rulings and other authorities indicating that the recourse or nonrecourse nature of a debt obligation is based on an evaluation of creditors’ rights under state law.13 Importantly, however, as discussed in further detail below, these authorities reach disparate conclusions with respect to the characterization of DRE Recourse Debt.

(ii) It is Unclear Whether Equityholder Guarantees and Pledges, Or a “Functional” Analysis of Facially Nonrecourse Debt, Are Relevant.

Although CCA 201525010 purports to clearly distinguish between the application of Sections 704 and 752, on one hand, and Section 1001, on the other hand, certain of the factors identified as potentially relevant to the Section 1001 analysis in the CCA actually generate significant confusion. That is particularly true in light of the CCA’s own comparisons to the circumstances in Great Plains.14 In Great Plains, the Tax Court concluded that the partnership debt at issue was nonrecourse debt for purposes of Section 1001. The debt was not expressly recourse to the partnership, but it was secured 11 Id. at 781 (““’Non-recourse debt’ describes an arrangement in which [] the lender agrees to look

exclusively to the collateral, and never to dun the borrower for a deficiency if a sale of the collateral fetches less than the balance. . . . There is a big legal difference between secured debt and non-recourse debt. A bank that lends $100,000 against a house appraised for $1 million is well secured, but unless the bank had agreed not to collect from the house’s owner the loan is recourse.’”) (emphasis in original).

12 June 19, 2015.

13 See PLR 200315001 (Apr. 11, 2003) (holding that the conversion of a corporation into a DRE did not cause the converted entity’s debt to change from recourse to nonrecourse for purposes of Section 1.1001-3); PLR 200630002 (July 28, 2006) (same); PLR 200709013 (Mar. 2, 2007); PLR 201010015 (Mar. 12, 2010); CCA 20150301F (Jan. 1, 2015); PLR 201644018 ([DATE]) (holding that DRE Recourse Debt was nonrecourse debt for purposes of Section 1001)

14 Great Plains Gasification Associates v. Comm’r, T.C. Memo 2006-276 (Dec. 27, 2006).

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by all of the assets of the partnership (and, it appears from the opinion, that the partnership would have been prohibited from acquiring any assets that would not be subject to that collateral).15 The Tax Court also emphasized that none of the partners were liable on the debt, citing Section 752 (and applicable regulations); it is unclear how relevant that fact was to the Tax Court’s ultimate conclusion.16 The CCA stated that any implication created by Great Plains that Section 752 principles would control the Section 1001 analysis was “erroneous.” Nevertheless, the CCA emphasizes the fact that, unlike in Great Plains, the partnership’s members personally guaranteed the debt in question and pledged the partnership’s interests in support of that debt. Similarly, the CCA emphasizes that the debt in question was “secured by all assets ‘taxpayer’ will ever have, including rents,” but that seemed to be true in Great Plains, as well.17

There may be circumstances where pledges or guarantees by equityholders should be relevant to determinations under Section 1001 (both in and out of the partnership context). Similarly, it should be relatively straightforward to establish a rule with respect to the treatment that is nonrecourse on its face, but functionally recourse because it is secured by every asset a borrower will ever own. Unfortunately, the discussion in CCA 201525010 and Great Plains doesn’t add much certainty because of the lack of clarity in their analyses. These issues are discussed in greater detail below in the context of various hypothetical--and fairly common--situations.

(iii) The Treatment of DRE Recourse Debt is a Difficult-to-Reconcile Quagmire.

The largest area of uncertainty regarding the distinction between recourse debt and nonrecourse debt for purposes of Section 1001 has, since the advent of the “check the box” regulations and the proliferations of limited liability companies, been the proper characterization of DRE Recourse Debt, i.e., debt that is unquestionably recourse to a DRE under state law, but not guaranteed by the DRE’s regarded parent. Commentators have generally focused on two potential views, which this paper will refer to as the “creditors’ rights” view and the “tax formalities” view.18 Under the creditors’ rights view, DRE Recourse Debt should be treated as recourse debt for purposes of Section 1001. Under the tax formalities view, DRE Recourse Debt should be treated as nonrecourse debt for purposes of Section 1001. The general principle guiding the tax formalities view is that creditors only have recourse to a subset of the regarded parent’s assets (i.e., the

15 Id. at 1783.

16 It is worth noting that the taxpayer in Great Plains had filed tax returns consistent with the idea that the debt at issue was nonrecourse debt for purposes of Section 1001.

17 Perhaps the CCA’s distinction here is based on a belief that in Great Plains, the debt would be unable to reach rents from the collateral at issue. In light of the generally-applicable rules regarding “proceeds of collateral,” discussed below, such a distinction would not necessarily be accurate.

18 See, e.g., many of the sources noted in footnote [9]. To be clear, no negative connotations are intended by the “tax formalities” label.

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assets owned by the DRE), which is analogous to creditors only having recourse to certain assets owned by an entity in a classic situation of nonrecourse debt.

(A) Earlier IRS Authority Provided Consistent Support For Creditors’ Rights View, At Least in the Context of Significant Modifications.

Several private letter rulings were issued in the context of the application of Section 1.1001-3 that arguably gave strong support to the creditors’ rights view. As discussed in greater detail below, under Section 1.1001-3, debt that undergoes a “significant modification” is deemed to be exchanged for a newly-issued debt instrument. Under Section 1.1001-3(e)(5)(A), if a debt changes from recourse debt to nonrecourse debt, such change is a per se significant modification unless one of two exceptions apply. One of these exceptions narrowly applies to defeasance of tax-exempt bonds, while the “original collateral” exception applies where “the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations.”19 Within that context, each of PLR 200315001, PLR 200630002, PLR 200709013, and PLR 201010015 concluded that the conversion of a corporate issuer of debt to a DRE did not cause debt to be subject to a significant modification, although the precise rulings—and whether the rulings specifically addressed the recourse or nonrecourse nature of the debt at issue—shifted over time. Each of these private letter rulings is discussed below.

(1) PLR 200315001: A Firm Adoption of the Creditors’ Rights View.

In PLR 200315001, Parent was a corporation that engaged in Businesses A, B, and C. As part of a reorganization, Parent, which was the issuer of the applicable debt, merged with and into a newly-formed holding corporation, New Parent, with Parent surviving as a wholly-owned subsidiary of New Parent. Parent then converted to a limited liability company that was treated as a DRE. After this conversion, Parent (now referred to as LLC 1 in the private letter ruling), contributed certain assets to a new LLC (LLC 2) treated as a DRE, and distributed LLC 2 to New Parent. The ruling noted that none of the creditors’ state law rights or relationships vis-à-vis Parent/LLC 1 or New Parent would be altered by the restructuring and that no consents were necessary from the debtholders to effectuate the restructuring.20 After citing Acquilino v. United States21 and Morgan v. Comm’r22 for the proposition that “federal tax law looks to State law to determine legal 19 Treas. Reg. § 1.1001-3(e)(5)(B)(2)(i). The original collateral exception is discussed in additional detail

below.

20 This point is perhaps most notable in that it appears that the debt permitted Parent/LLC 1 to distribute assets out from its credit to New Parent. The ruling specifically noted that nothing about the restructuring caused New Parent to be obligated on the debt.

21 363 U.S. 509, 513 (1960).

22 309 U.S. 78, 82 (1940).

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entitlements in property,” and that the “legal rights or obligations referred to in [Section] 1.1001-3 are rights that are determined under State law,” the Service23 concluded that, in light of the fact that none of the creditors’ state-law rights were effected, the restructuring did not “result[] in either a change of obligor or a change in the recourse nature of the Debt for purposes of [Section] 1.1001-3(c)(2)(i).”

This conclusion seems to be a firm endorsement of the creditors’ rights methodology of determining the recourse or nonrecourse nature of debt, at least for purposes of Section 1.1001-3.24 Notably, the Service did not discuss any implications that flowed from the fact that, following the conversion of Parent to a DRE of New Parent, New Parent was the obligor of the debt for U.S. federal income tax purposes. The Service also did not cite the original collateral exception as a basis for its ruling (or even mention the exception).25

(2) PLR 200630002: A Partial Retreat.

In PLR 200630002, Parent issued the applicable debt, which was recourse to Parent. As part of a restructuring, Parent (a) merged with a newly-formed wholly-owned subsidiary of a new holding corporation (the new holding corporation being referred to as New Parent) and (b) immediately after the merger, converted into a DRE. The two steps constituted an “F” reorganization. Parent (now LLC) remained liable on all of the debt that Parent issued, and the assets and liabilities of Parent/LLC after the restructuring was identical to the assets and liabilities of Parent/LLC immediately after the restructuring, other than the payment of certain cash amounts. Making essentially the same observations as in PLR 200315001, the Service concluded that the restructuring did not change the recourse nature of the debt and did not cause a significant modification.

Unlike in PLR 200315001, the Service did not specifically conclude that there was no change in obligor. The Service did cite Section 1.1001-3(e)(4) for the proposition that a change in obligor is a significant modification. The Service did not discuss the exceptions to circumstances where a change in obligor does not constitute a significant modification, including Section 1.1001-3(e)(4)(i)(B) (the “381 Successor Exception”), which provides that the substitution of a Section 381 successor is not a significant 23 Specifically, the Financial Institutions & Products group at the Service. As noted below, this group is a

different group than the group that issued the 2016 PLR.

24 As discussed in greater detail below, it is possible that the Service or tax payers could argue that this reasoning, along with similar reasoning in the other rulings discussed below, is limited to Section 1.1001-3 and does not apply to Section 1.1001-2, despite there being no express basis in the statutory text of Section 1001, the text of the regulations (or the preambles thereto), any caselaw, or the rulings themselves, to draw a distinction between Sections 1.1001-3 and 1.1001-2 for this purpose.

25 As discussed in greater detail below, it is unclear whether the original collateral exception could have applied, for two reasons. First, in light of the distribution by Parent/LLC1 of LLC 2 to New Parent, the debt arguably was not supported by the same assets immediately before and immediately after the conversion of Parent. Second, it is unclear whether the original collateral exception can apply to unsecured debt, which is a question that turns on the importance of the “secured by” language in the provision.

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modification if certain other requirements are met. It is unclear whether the Service’s conclusion was based on the 381 Successor Exception or a conclusion that Parent remained the obligor on the debt for purposes of Section 1.1001-3(e)(4)(i)(B), even though New Parent became the obligor on the debt for tax purposes.

(3) PLR 200709013: A Firm Conclusion With Implicit Reasoning, But Potential Ambiguity.

In PLR 200709013, Company, which was the issuer of the applicable debt, was a wholly-owned subsidiary of Parent. The debt was recourse to the Company (and was unsecured). The debt prohibited the Company from selling “all or substantially all” of its assets unless the purchaser/transferee assumed the debt (and other requirements were satisfied).

In connection with a sale of an interest in Company, prior to such sale, on Date 1, Company converted to an LLC that continued to be taxed as a corporation (“Company LLC”). On Date 4, Company LLC distributed certain assets to Parent, and Parent assumed certain liabilities. On Date 5, Company LLC elected to be treated as DRE in a transaction that qualified as a liquidation under Section 332. After Date 5, but prior to the closing date of the sale transaction: (a) Company LLC distributed additional cash and assets to Parent, and Parent assumed certain liabilities; (b) Parent contributed cash to Company LLC in exchange for preferred units; (c) Parent contributed cash to a new subsidiary of Parent, Preferred Holdco, which contributed such cash to Company LLC in exchange for preferred units. The transaction in clause (c) caused Company LLC to become a partnership among Parent and Preferred Holdco.

After making substantially the same observations regarding creditors’ rights that were made in PLR 200315001 and PLR 200630002, the Service ruled that the transactions did not give rise to a significant modification. Notably, the Service noted that “several steps” of the proposed transactions involved the substitution of a new obligor on the applicable debt, but that each such substitution was of a kind covered by Section 1.1001-3(e)(4)(i)(B) and (C). Thus, it appears that the Service did in fact conclude that the Section 332 liquidation of Company LLC resulted in a change in obligor from Company LLC to Parent. However, the Service did not address, or even mention, the treatment of the debt as recourse or nonrecourse, despite the change in obligor.

The basis for the Service’s conclusion that there was no significant modification is, therefore, somewhat unclear. The Service must have been of the view that Company LLC was a DRE for long enough to not view the debt as simply having converted from recourse debt of a corporation to recourse debt of a partnership, so the explanation doesn’t appear to be that the Service did not account for a period in time where the debt constituted DRE Recourse Debt. Accordingly, the Service was either applying the creditors’ rights view with respect to the characterization of the debt as recourse or

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nonrecourse, or the Service was relying on the Original Collateral Exception (again, without citing it or even mentioning it, which the author views as highly unlikely).26

(4) PLR 201010015: Ambiguity Continues.

In PLR 201010015, Parent wholly owned Subsidiary 1, which, in turn, directly and indirectly owned various entities, including DREs, a partnership,27 and corporations. Subsidiary 1 was the issuer of various debt, including both unsecured debt and debt secured by pledges of the stock of certain of Subsidiary 1’s subsidiaries. Certain of the debt was also guaranteed by certain of Subsidiary 1’s subsidiaries.

In connection with a restructuring, Subsidiary 1 converted into a DRE (LLC 6). Various restructuring steps were undertaken with respect to LLC 6’s direct and indirect subsidiaries, ultimately resulting in a distribution of stock to LLC 6, a further distribution of such stock from LLC 6 to Parent, and an external distribution of such stock from Parent to Parent’s shareholders. All of these steps were undertaken in a “D” reorganization. Pursuant to the transactions, the Service noted that LLC 6’s assets and liabilities immediately before after the transactions were the same as Subsidiary 1’s assets and liabilities immediately before the transactions (and immediately before Subsidiary 1 was converted to LLC 6).28

The Service issued effectively the same ruling that it issued in PLR 200709013, again, without addressing the recourse or nonrecourse nature of the debt.

(B) Other Authorities: Toward the Tax Formalities View of DRE Recourse Debt.

After the release of the four rulings discussed above, tax practitioners could be forgiven for thinking that the better view of the law—and the better assumption regarding 26 As discussed further below, it is unclear whether the Original Collateral Exception would properly apply

given the various distributions of assets on Dates 4 and “after Date 5” but prior to Company LLC’s conversion to a partnership. It is difficult to draw any conclusions, in part, because the timeline of the various dates is unknown.

27 It is somewhat unclear in the ruling why the identified partnership was not treated as a DRE for U.S. federal income tax purposes. Subsidiary 1 wholly owned LLC 1, which in turn wholly owned LLC 2 and LLC 3. Each of LLC 1, LLC 2, and LLC 3 was a DRE--presumably of Subsidiary 1, since LLC 1, a DRE of Subsidiary 1, was the sole owner or LLC 2 and LLC 3. LLC 2 and LLC 3 owned LLC 4, which was also a DRE--again, presumably of Subsidiary 1, since all of LLC 4’s owners were DREs of Subsidiary 1. The ruling goes on to state that LLC 1 and LLC 4--each apparently DREs of Subsidiary 1--owned Partnership 1. Partnership 1 should also be a DRE of Subsidiary 1. In any case, to fill out the structure, Partnership 1 wholly owned Subsidiary 2, a corporation, which in turn wholly owned Subsidiary 3, another corporation. Partnership 1 also wholly owned LLC 5, a DRE. Subsidiary 3 and LLC 5 each owned an interest in Partnership 2 (which is properly treated as a partnership, not a DRE).

28 This conclusion is questionable from an economic perspective. It may be true that LLC 6 continued to own the stock of LLC 1, but certainly LLC 6’s indirect ownership of many other subsidiaries was eliminated. The ruling indicates that the transactions did not result in the addition or deletion of any co-obligors or guarantors on the debt; the facts of the ruling are difficult to follow, in that regard.

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the Service’s position—was that the creditors’ rights view of the treatment of DRE Recourse Debt had carried the day. That would certainly be true for purposes of Section 1.1001-3 and, without any firm reason to distinguish between Section 1.1001-3 and other Section 1001 purposes, probably for purposes of Section 1001 more broadly. However, the Service began chipping away at that view, culminating in the 2016 PLR, when the Service unambiguously set forth its position that DRE Recourse Debt is nonrecourse, at least for purposes of Section 1.1001-2.

(1) AM 2011-003: Conversion from Corporation to Partnership Involves “Change in Obligor” Under Section 1.1001-3.

AM 2011-00329 involved the conversion of a foreign subsidiary of a U.S. corporation from a corporation to a partnership. The Service memorandum addressed multiple issues, including whether the conversion, and the transactions deemed to occur as a result of the conversion pursuant to Sections 301.7701-3(c)(1)(i) and 301.7701-3(g)(1)(ii), resulted in a significant modification of the debt issued by the corporation. The Service held that the conversion (and deemed transactions) did result in a change in obligor. Specifically, even though the obligor on the debt was the same for corporate law purposes before and after the transaction, for tax purposes, the conversion resulted in a distribution of all assets and liabilities to issuer’s owner, followed by a contribution to a new partnership. The Service went on to note that the change in obligor did not result in a significant modification. Although the Service did not discuss whether the debt was nonrecourse debt, the Service noted that this conclusion would be true regardless. If the debt was nonrecourse, a mere change in obligor does not result in a significant modification; if the debt was recourse, at each step, the new obligor (the owner of the issuer, and then the new partnership) owned all of the assets and liabilities of the original issuer.30

The memorandum is notable because it reinforces the fact that the Service had abandoned its analysis from the early Debt Modification Rulings that held that there was no change in obligor because the obligor remained the same under state law. The conclusion is particularly striking because it appears to provide further support for the idea that transitory changes that occur as a result of changes in entity classification are relevant to determinations made under Section 1.1001-3, even if those transitory changes have no economic consequences and no impact on creditors.

29 August 26, 2011.

30 See Treas. Reg. § 1.1001-3(e)(4)(i)(C). The Service went on to note that it was unlikely that the conversion would result in a change in payment expectations and there would be no “significant alteration” of the obligations.

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(2) PLR 201326006: Silence That, In Highsight, Potentially Indicated Shifting Views.

In PLR 201326006,31 Parent was the parent of a consolidated group, and wholly-owned Sub 1, a corporate member of the consolidated group. Sub 1 wholly owned DE, a DRE. Parent directly and indirectly owned various other subsidiaries as well. DE was the issuer of the relevant debt. Sub 1 guaranteed the debt.

Parent incorporated NewCo and contributed Sub 1 to NewCo. After that contribution, Sub 1 converted to an LLC treated as a DRE of NewCo. The Service ruled that these steps constituted an “F” reorganization. Parent then merged with and into NewCo in a transaction that the Service ruled constituted an “A” reorganization.

Most of the rulings in PLR 201326006 related to the elimination of certain excess loss accounts and deferred intercompany gains that existed with respect to the Sub 1 stock prior to the transactions in the ruling. But two points are significant with respect to the evolution of the Service’s view on DRE Recourse Debt.32 First, the Service noted that, in connection with the conversion of Sub 1 to a DRE, the debt that was issued by DE “becam[e] non-recourse to NewCo under applicable state law.” That is a curious observation, in that the debt was always non-recourse with respect to NewCo for state law purposes. The Service may have intended to indicate that the debt became nonrecourse debt of NewCo for federal income tax purposes, because (a) in light of the conversion of Sub 1 to a DRE, the debt became NewCo debt for tax purposes; and (b) there was no recourse to NewCo for state law purposes, because NewCo, unlike Sub 1, did not guarantee the debt. Second, in the normal litany of disclaimers where the Service indicates that it was not ruling on anything not addressed by the ruling, the Service specifically stated that no opinion was expressed with respect to whether the transactions caused the DE’s debt to undergo a significant modification under Section 1.1001-3(e).

(3) CCA 20150301F: Reliance On An Example in the “At-Risk” Regulations To Support A Tax Formalities View.

Although the facts are mostly redacted in CCA 20150301F,33 Company E, which was the issuer of the applicable debt, was apparently a DRE of Company B. The CCA was evaluating, among other things, whether the discharge of Company E’s liabilities in bankruptcy gave rise to sale gain under Section 1001 and Tufts, or cancellation of indebtedness income that could be excluded under Section 108. As discussed below, under current law and Service interpretations thereof, the answer to that question turned

31 June 28, 2013.

32 It is worth noting that this ruling was issued by the Corporate branch of the Service, while the significant modification rulings discussed above were issued by Financial Institutions and Products.

33 September 10, 2014.

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on whether the DRE Recourse Debt issued by Company E, but not guaranteed by Company V, was recourse or nonrecourse for purposes of Section 1.1001-2.34

Without any significant analysis, or citation of the debt modification rulings discussed above, the Service concluded that the tax formalities view of DRE Recourse Debt controlled. In other words, Company E’s debt was nonrecourse debt for purposes of Section 1.1001-2 because (a) the assets and liabilities of Company E were treated as owned by Company B and (b) Company E’s debt was not recourse under state law with respect to Company B. To support this conclusion, the Service cited to Section 1.465-27(b)(6), Ex. 6, which provides that DRE Recourse Debt constitutes “qualified nonrecourse financing secured by real property” with respect to the regarded parent of the DRE for the purposes of applying the “at-risk” rules.

Applying an example of the “at-risk” rules for purposes of determining the characterization of debt as recourse or nonrecourse for purposes of Section 1001 is misguided. The general purpose of the “at-risk” rules is to limit individual taxpayers from claiming losses with respect to activity for which they have no risk of loss. Generally, if an activity is supported by financing that is recourse to a partner, that liability can be factored into the amount with respect to which the partner is “at risk,” and, therefore, can support deductions. Section 465(b)(6)(A) provides a special rule, applicable solely in the context of real estate transactions, pursuant to which a taxpayer may be deemed to be “at risk” with respect to “qualified nonrecourse financing.” Example 6 of Section 1.465-27(b)(6) should be viewed within, and limited to, that very specific framework.35

(4) Section 1.108-9: The Preamble to the Regulations Addressing the Application of the Insolvency Exclusion to DREs Sends Additional Signals.

Explaining the significance of Section 1.108-9 requires a detour into Section 108 (which figures prominently in the discussion below regarding the ramifications of the recourse/nonrecourse distinction) and the application of Section 108(a) with respect to financially distressed DREs.36

In general, Section 108 provides various rules regarding the treatment of cancellation of debt income (“CODI”). Perhaps most importantly, Section 108(a) provides

34 As discussed below, the distinction in treatment also presumes that Company E’s assets are turned

over to creditors in satisfaction of such creditors’ claims. The redacted CCA is unclear whether this is what occurred: one portion of the CCA appears to impute a deemed sale, even though the property itself may have continued to be owned by Company B following the discharge of indebtedness.

35 Peaslee has specifically noted the distinction between the policy driving determinations under Section 465 and Section 1.1001-3. See Peaslee, Disregarded Entities and Debt Modifications, Tax Notes at 1158-59 (Mar. 7, 2016). As discussed below, Peaslee appears to go on to argue that the same basis of distinction applies as between Section 1.1001-2 and 1.1001-3, which is where he and the author part ways on this subject, in large part because of the implications on the application of Section 108.

36 The regulation also applies to grantor trusts.

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for various circumstances where CODI will be excluded from a taxpayer’s taxable income, at the cost of a reduction in various specified tax attributes of the under Section 108(b) (as well as members of the taxpayer’s consolidated group--under certain circumstances, partnerships owned by the taxpayer or the taxpayer’s consolidated group--under associated Treasury Regulations). To greatly simplify things, the most important of these exclusions are the bankruptcy exclusion under Section 108(a)(1)(A), which applies where CODI arises in connection with a “taxpayer’s” bankruptcy, and the insolvency exclusion under Section 108(a)(1)(B), which excludes CODI from income to the extent of the “taxpayer’s” balance sheet insolvency.

Key to the application of these rules is the identity of the applicable “taxpayer.” Prior to Section 1.108-9, some taxpayers and practitioners took the position that the bankruptcy and insolvency exclusions were tested at the DRE level. In other words, if the DRE issuer of discharged debt was in bankruptcy or was insolvent, the exclusions would apply even if the DRE’s regarded owner was not bankrupt or insolvent.37 Section 1.108-

37 This approach mirrors the approach applied to S-Corporations, where the exclusions are tested at the

S-Corporation level. See Code § 108(d)(7). By contrast, the Code is clear that the exclusions are tested at the partner level in the case of partnerships. See Code § 108(d)(6). Although a full treatment of this is beyond the scope of this paper, the author is unwilling to let this distinction go entirely unaddressed. From the author’s perspective, the right rule to apply to all flow-through and disregarded entities is the rule that applies to S-Corporations, i.e., these exclusions should be tested at the entity from which the CODI arises, and the appropriate consequences should then flow up to the entity’s owners. Two primary counterarguments typically are asserted. First, as Peaslee and others note, the bankruptcy and insolvency exclusions are intended to measure the taxpayer’s ability to pay a tax associated with CODI, and the insolvency of an entity with limited liability does not necessarily inform a taxpayer’s ability to pay the tax liability. Notably, the Service and Treasury relied on this argument in promulgating Section 1.108-9, and the Service has relied on this argument in other interpretations of the insolvency exclusion. Second, the taxpayer-owner of a flow-through entity should not enjoy the benefit of debt-funded deductions (which may offset ordinary income) while being able to later exclude CODI if the taxpayer is not itself bankrupt or insolvent.

In response, as an initial matter, there is no basis to distinguish between S-Corporations and other flow-through or disregarded entities; one set of the rules or the other should be adjusted. The reason the author believes an entity-level determination is more appropriate in all cases because the owner-level methodology, and the arguments supporting it, do not give adequate deference to the real consequences of applying the exclusions at the owner level. Specifically, owner-level testing (a) may serve as inducement for unnecessary bankruptcy filings; (b) may invite aggressive tax planning efforts by the owners of flow-through entities that may be detrimental to creditors; (c) is administratively far more difficult to handle; and (d) most importantly, the tax liability resulting from the CODI may well cause the taxpayer to be subject to severe financial distress. Notably, the application of the insolvency exclusion at the owner level does not include the tax liability that the owner will owe if the insolvency exclusion does not apply: in other words, the tax liability itself can easily cause the owner to become insolvent or go bankrupt, and from that, there is no relief. The last of these considerations can factor prominently into restructuring matters involving oil and gas master limited partnerships, where comparatively unsophisticated investors can end up in a situation where they are allocated a ruinous amount of CODI--including in their retirement accounts, where the CODI will be treated as UBTI.

In short, the author’s view is that the standard counterarguments to entity-level measurement of the bankruptcy and insolvency exclusions should yield to a general principal of financial mercy. Recapture-like rules (in lieu of owner-level black-hole CODI) may be appropriate to address situations involving owners that have managed to offset ordinary income with deductions attributable to the debt being

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9, however, makes it clear that the bankruptcy and insolvency exclusions are tested at the level of the regarded owner. If the DRE is in bankruptcy but the owner is not, or if the DRE is insolvent but the owner is not, the exclusions do not apply, even if the resulting tax liability in fact renders the owner bankrupt or insolvent. The final regulations were generally consistent with the approach in the proposed regulations that were adopted on April 13, 2011.38

The text of the regulation is not determinative with respect to the question of whether DRE Recourse Debt is recourse or nonrecourse for other purposes, although it is generally consistent with a tax formalities worldview. The preamble, on the other hand, arguably provides additional insight.39 In addressing comments, the preamble noted that commentators had recommended clarifications regarding the treatment of DRE-issued debt for purposes of calculating the insolvency exclusion, and that the Service and Treasury are of the view that DRE-issued debt is nonrecourse debt of the borrower for purposes of applying the insolvency exclusion.40

The effect of the Treasury Regulation and the preamble is purportedly to treat DRE-issued debt (whether it is recourse or nonrecourse to the DRE) in a kind of hybrid fashion for purposes of the insolvency exclusion. Relying on the principles of Revenue Ruling 92-5341, the regarded owner is able to include, in determining its insolvency, an amount of the DRE’s debt equal to (a) the fair market value of the DRE’s assets (or, if the DRE debt is, in fact, nonrecourse with respect to the DRE, the value of the liabilities securing the debt), plus (b) the discharged amount of the “excess nonrecourse debt.” Permitting the owner to include the discharged portion of the “excess nonrecourse debt”

cancelled. All of that said, the Service and Treasury have said their piece on this issue. Absent a change in law or in the regulations, the current rules are clear.

38 76 Fed. Reg. 20593.

39 TD 9771 (June 10, 2016).

40 Id. (“[T]he Treasury Department and the IRS are of the view that indebtedness of a grantor trust or a disregarded entity is indebtedness of the owner for purposes of section 108(d)(1); assuming the owner has not guaranteed the indebtedness and is not otherwise liable for the indebtedness under applicable law, such indebtedness should generally be treated as nonrecourse indebtedness for purposes of applying the section 108(a)(1)(B) insolvency exclusion; and accordingly the principles of Revenue Ruling 92-53 apply to determine the extent to which such indebtedness is taken into account in determining the owner’s insolvency under section 108(d)(3).”).

41 Rev, Rul. 92-53 (Jun. 18, 1992) (holding that for purposes of applying the insolvency exclusion, nonrecourse indebtedness is treated as indebtedness of the taxpayer to the extent of (a) the fair market value of the property plus (b) the amount of such excess that is discharged, which is referred to as “excess nonrecourse debt”). As discussed below, Revenue Ruling 2012-14 (May 29, 2012) expanded Revenue Ruling 92-53 to apply to partnership debt, by permitting partners to include the “excess nonrecourse debt” in each partner’s determination of insolvency to the extent CODI with respect to such debt would be allocated to the partner under Section 704(b). Revenue Ruling 2012-14 is discussed in greater detail below.

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effectively treats that portion of the debt as recourse to the owner for purposes of the insolvency exclusion.

Despite the above discussion, in the author’s view, the rational operation of the preamble language arguably supports the view that DRE Recourse Debt be treated as recourse debt for purposes of Section 1.1001-2. As discussed below, if DRE Recourse Debt is treated as nonrecourse debt for purposes of Section 1.1001-2, the insolvency exclusion will simply be inapplicable to the cancellation of the DRE Recourse Debt unless the rules of Gershkowitz, Revenue Ruling 91-31, or Section 108(e)(8) (each discussed below) apply. Instead, the DRE’s property will be treated as having been sold for the amount of the DRE Recourse Debt, giving rise to gain under Section 1001 without regard to the fair market value of the DRE’s property.

(5) PLR 201644018: The Nail in the Creditors’ Rights Coffin?

The 2016 PLR includes a wealth of rulings on a number of topics. It (a) includes a ruling related to the characterization of debt as a “security”; (b) is a comparatively rare ruling addressing a divisive “G” reorganization under Sections 368(a)(1)(G) and 355 that addresses certain issues related to the application of the continuity of interest rules in these kinds of transactions; (c) makes it clear that, in a divisive “D” or “G” reorganization, the newly-formed controlled entity is a member of the distributing entity’s consolidated tax group for a moment in time; and (d) includes rulings that the steps implementing a so-called “busted 351” gain-recognition transaction would be respected, even in the context of a transaction that otherwise constituted a G” reorganization. However, its most significant rulings for broader practice are arguably its rulings regarding the characterization of DRE Recourse Debt (and the consequences that flow from that characterization, which are discussed below).

Distributing was the parent of a consolidated group. Distributing directly and indirectly owned various subsidiaries, including: (a) LLC 1, which wholly owned LLC 2. LLC 2 and its direct and indirect subsidiaries composed the group being spun off. LLC2 was the issuer of a substantial amount of secured and unsecured debt, most of which was guaranteed by LLC1, but not by Distributing. (b) LLC 7 and LLC 8, which owned a greater-than-33% interest in a partnership. (c) Certain other direct and indirect subsidiaries that were not part of the LLC 1 group. LLC 1, LLC 2, LLC 7, and LLC 8 was each disregarded from Distributing.

The transactions addressed by the 2016 PLR essentially had three key components. First, LLC2’s direct and indirect subsidiaries, together with certain of Distributing’s other direct and indirect subsidiaries (but not LLC 7 or LLC 8), and certain related assets and liabilities, were contributed to a newly-formed Controlled, which was initially treated as a disregarded entity, in exchange for (a) Controlled equity; (b) rights to payments from Controlled under an “Agreement,” (c) cash; and (d) Controlled’s agreement to assume certain liabilities (including exit financing but, importantly, excluding any prepetition liabilities other than certain operational liabilities). These assets and certain liabilities were contributed “down the chain” from Controlled through additional disregarded holding companies. Second, certain assets and liabilities that were

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contributed to Controlled were further contributed to a newly-formed “Preferred Stock Entity,” which was initially treated as a disregarded entity, in exchange for a combination of common and non-voting preferred equity in the Preferred Stock Entity. In connection with that transfer, the Preferred Stock Entity converted to a corporation, and the preferred equity was sold to third-party investors. The cash from this stock sale was distributed to LLC 2. These steps, together, constituted a so-called “Busted 351” transaction. Third, following the Busted 351 transaction, Controlled converted to a corporation. In satisfaction of claims against LLC 2, LLC 2 distributed to creditors (a) the equity of Controlled; (b) Controlled’s obligations under the Agreement; (c) cash; and (d) an intercompany claim previously owed by Distributing to LLC 2 (the “Settlement Claim Obligation).42

Several aspects of the 2016 PLR are discussed in more detail below, but the key issue that drove many of the conclusions was the classification of LLC 2’s debt. To the surprise of many in the tax bar, the Service ruled that the LLC2 debt was nonrecourse debt of Distributing for purposes of Tufts.43 The ruling contained no reference to, or distinction of, the debt modification rulings discussed above. Rather, the ruling focused on the issues that underlie the tax formalities view of the treatment of DRE Recourse Debt: under the “check the box” regulations, Distributing was the “tax obligor” of the debt, but Distributing was not personally liable for the debt. As such, the 2016 PLR appears to firmly endorse the tax formalities view.

(C) Reconciling the Debt Modification Rulings to the Later Authorities.

As noted above, absent new regulations, a change in law, a change in heart at the Service, or a taxpayer with nothing to lose that challenges the Service’s position,44 the 2016 PLR appears to put the nail in the coffin with respect to the creditors’ rights view of the proper characterization of DRE Recourse Debt for purposes of Section 1.1001-2. To be sure, the author is of the view that the conclusion reached in the 2016 PLR is the wrong one, and the recommendations discussed below suggest fixing that outcome. For now, however, a key issue practitioners must grapple with is whether the 2016 PLR renders the debt modification rulings a dead letter, such that DRE Recourse Debt will be treated as nonrecourse debt for purposes applying Section 1.1001-3.

In many cases, the original collateral exception (discussed above) may permit a taxpayer to reach the same result that was reached in the debt modification rulings even if the debt modification rulings are now a dead letter. That said, the original collateral

42 LLC 2’s unsecured creditors received cash, while LLC 2’s secured creditors received all of these forms

of consideration.

43 The ruling does not specifically cite Section 1.1001-2.

44 As discussed below, the implications of the rule laid out in the 2016 PLR could be ruinous in many circumstances where taxpayers have no way to avoid those implications, so the Service may well be challenged on this issue.

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exception does not represent a way to reconcile the debt modification rulings to the later authority. While the original collateral exception may have led to the same outcome in some or all of the debt modification rulings, there is no question that the Service did not rely on that rule in PLR 200315001 or PLR 200630002 (because each of those rulings specifically said the debt did not change from recourse to nonrecourse). Moreover, although the basis for, and scope of, the conclusions in PLR 200709013 and PLR 201010015 are more ambiguous, it’s highly unlikely that the Service relied on the original collateral exception without referencing it. Accordingly, if a taxpayer is trying to reconcile the rulings (or determines that it cannot rely on the original collateral exception), a different approach is needed.

That leaves practitioners with an argument that “recourse” and “nonrecourse” have different meanings for purposes of Section 1.1001-2 and 1.1001-3. As an initial matter, there is no basis in the text of Section 1001 for such a distinction, and in the author’s view, applying different meanings for purposes of separate regulations under a single provision of the Code is questionable, at best. That said, the language of Section 1.1001-3, particularly the overall focus on “economic significance” throughout the provisions, arguably provides some textual support for a creditors’ rights view in the context of Section 1.1001-3 that is lacking in the context of Section 1.1001-2. The basis for distinction is arguably reinforced by the fact that caselaw dating back to Crane and its progeny, including Tufts, drove the contours of Section 1.1001-2. That caselaw, rightly or wrongly, does not focus on creditors’ rights in drawing distinctions between the treatment of recourse and nonrecourse debt. Instead, the focus is on ensuring that liabilities included in the owner’s basis (particularly for deduction purposes) are also included in amount realized when the property is disposed of.45 Ultimately, this argument is probably enough for taxpayers to take a position, even at a greater-than-50% level, but it is not a satisfying resolution.

Of course, the third possibility is simply that the Service’s views have changed. In this regard, it is worth re-emphasizing that there was an evolution away from a strict creditors’ rights theory even in the debt modification rulings. Moreover, the significant modification rulings were issued by a different branch of the Service than the branches that issued the later authorities. While tax practitioners commonly rely on private letter

45 Of course, the expansion of Crane in Tufts to cover circumstances where the property is worth less

than the outstanding amount of the debt, without regard to whether the difference is attributable to claimed depreciation or broader declines in value unassociated with depreciation does not follow from the initial is proposition. Moreover, the distinction between the treatment of recourse debt and nonrecourse debt for these purposes is nonsensical: recourse and nonrecourse debt each support basis and deprecation deductions. Finally, in the context of LBO transactions, debt does not even give rise to depreciable basis in many circumstances. It may be the case that Section 1.1001-2(a)(3) could apply to such circumstances to prevent the full amount of the liability from being taken into account, but the scope of that provision is unclear where the property being transferred (e.g., the DRE’s assets) is not the same property as the property that was actually acquired in the LBO (e.g., the stock of the DRE’s parent). Note that the facts of the 2016 PLR appear to indicate that most of the DRE Recourse Debt at issue was issued in connection with (or otherwise traced to) debt issued in connection with a go-private transaction, but the 2016 PLR did not explore the potential application of Section 1.1001-2(a)(3).

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rulings to develop an understanding of the Service’s position on issues, there is a reason that they cannot be relied upon by taxpayers other than the one the ruling is issued to.

In light of the difficulties in reconciling the debt modification authorities with the more recent authority, the Service and Treasury should clarify their position through regulations (or, at a minimum, the Service should issue a Revenue Ruling on the issue). In the absence of such clarification, taxpayers are left in a “no-man’s” land with arguably inconsistent authorities that, as discussed below, could affect a great many ordinary-course transactions along with having profound impacts on financially distressed companies.

(b) A Somewhat Related Issue: Application of Section 357(d).

Section 357(d), and the distinction it makes between recourse and nonrecourse debt, is a close cousin to the distinction between recourse and nonrecourse debt made for purposes of Section 1001. Section 357(c) generally provides an exception to the non-recognition provisions of Sections 351 and 361 (where the reorganization is under Section 368(a)(1)(D) and, probably 368(a)(1)(G)). Specifically, subject to certain exceptions and limitations,46 if the liabilities assumed by the acquiring corporation (i.e., the controlled corporation, in the context of a spinoff) exceed the basis of the assets transferred to the acquiring corporation, the excess is treated as “gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.” In applying Section 357(c), Section 357(d) contains rules for determining the extent to which liabilities are treated as assumed in a transfer. Section 357(d) also applies to various other provisions of the Code that are not specifically addressed by Section 357(c), but also look to the assumption of liabilities in determining tax consequences.47

For recourse liabilities, Section 357(d)(1)(A) provides that a liability, or a portion thereof, is “treated as having been assumed if, as determined on the basis of all facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability (or portion), whether or not the transferor has been relieved of such liability.” This is an analogue to Section 1.1001-2(a)(4)(ii), which provides that “[t]he sale or other disposition 46 The exceptions are (a) Section 357(b)(1) applies, which will treat the assumption of liability as a

distribution of cash in certain situations, and (b) in the context of “G” reorganizations, where “no former shareholder of the transferor corporation receives any consideration for his stock.” Section 357(c)(2). In addition, certain liabilities are excluded from this determination pursuant to Section 357(c)(3).

The fact that this exception applies for “G” reorganizations strongly implies that Section 357(c) in general applies to “G” reorganizations, even though, by its terms, Section 357(c) applies only to transfers under Section 351 and to “D” reorganizations. Although it is beyond the scope of this paper, it should be noted that the scope of Section 357(c)(2)(B) is very unclear. Does a release constitute “consideration for stock”? Shareholder releases are a fundamental aspect of many chapter 11 cases and, often, considerable attention is paid to demonstrating that shareholders are providing sufficient value to justify the release. What about an agreement to pay shareholders’ professional fees as part of a settlement?

47 Specifically, Section 357(d) applies to Sections 357, 358(d), 358(h), 361(b)(3), 362(d), 368(a)(1)(C), and 368(a)(2)(B), unless otherwise provided by regulations.

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of property that secured a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from liability[.]” In other words, for recourse liabilities, a “facts and circumstances” analysis applies, and a liability is treated as assumed only if that reflects economic reality.

For nonrecourse liabilities, Section 357(d)(1)(B) generally provides that “a nonrecourse liability shall be treated as having been assumed by the transferee of any asset subject to such liability.” Section 357(d)(2)(B) then reduces this “deemed” assumption amount to the extent of the lesser of “(A) the amount of such liability which an owner of other assets not transferred to the transferee and also subject to such liability has agreed to, and is expected to, satisfy; or (B) the fair market value of such other assets (determined without regard to section 7701(g)).” As noted above, Section 7701(g) is a corollary to Section 1.1001-2 that provides that, in determining the amount of gain or loss with respect to property, the fair market value of property subject to nonrecourse debt is equal to the nonrecourse debt.

As an example, an issuer owns two assets. Each asset is subject to a single nonrecourse claim totaling $200. Each asset has a tax basis of $50, and each asset has a fair market value of $75. One might assume that if the issuer transfers one of the properties in a transaction to which Section 357(d) applies, the acquiring corporation would be treated as assuming $100 of debt, and the transfer would give rise to $50 of gain under Tufts and Section 1.1001-2. That would be the rational outcome: the acquiring corporation received half of the assets securing the debt, so it should be treated as assuming half of the liabilities. However, under the plain language of Sections 357(d)(1)(B) and 357(d)(2)(B), it would appear that the acquiring corporation is treated as assuming $125 of the liability, because (a) under Section 357(d)(1)(B), the acquiring company would be treated as assuming the full $200 of liability, and (b) under Section 357(d)(2)(B), this is reduced only by the fair market value of the asset that was not transferred (which is $75, not $100).

Unfortunately, Section 357(d)(1)(B) is unclear about its application where the property subject to the nonrecourse liability is being transferred free and clear of such liability. In other words, if part of the transaction is that the asset in question is no longer subject to the nonrecourse debt, is the asset “subject to such liability”? This is not problematic in the context of recourse debt, because there, the “facts and circumstances” analysis would clearly show that there is no intention that the acquiring corporation will be liable to repay the debt. Fortunately, the 2016 PLR appears to reach the correct resolution of that question, at least when the weight of a bankruptcy court plan of reorganization is behind the fact that the asset is being transferred free and clear of liabilities. What if the issue is less clear? For instance, what if property is transferred, but a collateral agent is unwilling to formally acknowledge the release of liens until some period of time later until certain conditions are satisfied? In the recourse debt context, the facts and circumstances could show that no one expects the acquiring corporation to pay such debt, even though liens continue to encumber some assets that were transferred, but in the nonrecourse context, this delay in the release of collateral could result in gain under Section 357(c).

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(c) Distinction In The Partnership Context: Different Rules for Different Reasons.

In the partnership context, the characterization of debt as recourse or nonrecourse may be different depending on the specific issue being addressed. Section 752 (and the regulations thereunder) addresses the allocation of partnership liabilities to partners for purposes of determining the partners’ outside basis in the partnership interest. In that context, debt can be “recourse” to a partner (and, therefore, allocated to that partner) for purposes of Section 752 even if the partner has no legal liability on the debt to the extent the partner is determined to have the “economic risk of loss” with respect to such debt (“Section 752 Recourse Liabilities”).48 Liabilities that are nonrecourse for purposes of Section 752 (“Section 752 Nonrecourse Liabilities”) are allocated to the partners based on a tiered approach that takes account of (a) partnership minimum gain (a concept that is discussed in more detail below), (b) allocations under Section 704(c), and (c) any remaining amounts, according to partnership profits. A full discussion of these rules is outside of the scope of this paper. The key point is that Section 752 Recourse Liabilities may be nonrecourse to the partnership for purposes of Section 1001, and Section 752 Nonrecourse Liabilities may be recourse to a partnership for purposes of Section 1001.49

This distinction is fairly understandable and fully justifiable. The rules under Sections 704 and 752, on one hand, and Section 1001, on the other hand, are generally addressing distinct issues. As discussed in more detail below, however, the allocation of partnership items to partners can vary dramatically as a result of the characterization of partnership debt under Section 1001, and it is unclear whether such variations are justifiable. Moreover, the “partnership minimum gain” rules under Section 704(b) stand at the intersection between recourse/nonrecourse determinations made for purposes of Section 752, on one hand, and Section 1001, on the other hand, and significant uncertainty exists at this crossroad. These issues are discussed in greater detail below.

(d) Examples of Characterization Determinations.

As discussed at the beginning of the paper, making recourse or nonrecourse determinations is relatively straightforward in many circumstances. The following examples walk through various circumstances and build to illustrate numerous fact patterns in which the characterization of debt as recourse or nonrecourse is unclear. Following the discussion of the consequences of the recourse/nonrecourse determination, several of these examples will be built upon to illustrate the fact that these characterization issues lead to surprising consequences.

48 Treas. Reg. § 1.752-1(a)(1) (providing that partnership debt is recourse based on economic risk of loss

concept); Treas. Reg. § 1.752-2(a) (providing that recourse debt is allocated to partner with economic risk of loss).

49 See CCA 201525010. The same DRE Recourse Debt issues can present themselves in the partnership context as in the corporate context: a partnership may have a DRE that has issued DRE Recourse Debt, and a taxpayer must consider (a) whether such debt constitutes recourse or nonrecourse debt of the partnership for purposes of Section 1001 and (b) the proper characterization under Section 752.

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(i) Debt of a Regarded Corporation.

As discussed above, determinations with respect to corporation-issued debt are straightforward. If a creditor can assert the claim against the corporate issuer itself, without being limited to a subset of assets for recovery, the debt is recourse. Otherwise, the debt is nonrecourse.

(ii) Debt of a Regarded Partnership.

As discussed above, for purposes of Sections 1.1001-2 and 1.1001-3, determinations with respect to debt issued by a partnership are made pursuant to the same rules that apply to corporations. The “economic risk of loss” concept guides determinations for purposes of Section 752 and, generally, the nonrecourse debt allocation regulations under Section 704(b) (subject to the uncertainty discussed above regarding the proper calculation of partnership minimum gain).

(iii) Debt of a DRE.

As discussed above, while the state of law is arguably in significant flux, it appears to be the case that the tax formalities view controls determinations for purposes of Section 1.1001-2, while the creditors’ rights analysis (which is identical to the analysis applied to regarded entities) controls determinations for purposes of Section 1.1001-3.

Of course, a key question is whether every “F” reorganization that is not accompanied by a guarantee by the new corporation causes the character of the debt to change for purposes of either (or both) Treasury Regulations 1.1001-2 (the answer appears to be “yes” in light of the 2016 PLR) and 1.1001-3 (the answer appeared to be “no” in light of the debt modification rulings, but is now quite unclear). If so, as discussed below, myriad consequences (and potential planning opportunities) flow from that conclusion.

(iv) DRE Recourse Debt of a DRE Guaranteed by Regarded Parent.

The Service appears to be of the view that if DRE Recourse Debt is guaranteed by the DRE’s regarded parent, the debt will be treated as recourse debt of the parent for purposes of both Section 1.1001-2 and 1.1001-3.

Does it make a difference whether the regarded parent is a shell entity? There is no practical difference between this situation and example (iii): in either case, all of the assets of the DRE support the debt. Perhaps a distinction should be drawn between a shell entity that is not permitted to acquire other assets and a shell entity that is not expected to, but may, acquire additional assets?

Notably, as discussed above, the Service has been unclear on the extent to which partner guarantees matter to determinations made pursuant to Section 1001-2 in the case of partnerships.

(v) Stock Pledges.

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The Service has also been unclear on the extent to which stock pledges matter to determinations made for purposes of Section 1.1001-2 in the case of partnerships. The theory that a stock pledge matters might be based on a theory that a 100% stock pledge effectively makes the debt recourse to the entity by permitting the creditor to take ownership of the entity and, subject to any claims against the entity itself, control all of the entity’s assets in the same way a fully recourse creditor can do so. This theory would appear to only have even potential application if a 100% stock pledge exists--if there are any minority owners that have not pledged their stock, this theory should hold no sway.

Does the relevance of a stock pledge turn on whether the stock can permissibly be transferred free and clear of any guarantee? Would a transfer of a portion of the stock of the issuer cause the debt to change from recourse to nonrecourse debt for purposes of either Sections 1.1001-2 or 1.1001-3?

(vi) Highly Subordinated Debt.

Presume an issuer has issued three tranches of debt: senior secured, junior secured, and unsecured. Presume further than the junior and senior secured debt is secured by all of the issuer’s assets. When the unsecured debt was issued, although not free from doubt, it was properly treated as debt under general tax principles (rather than being treated as equity). Since that issuance, the issuer has declined in value: no event has occurred that would require a retest of debt/equity, but the unsecured debt is mostly out of the money.

From an economic perspective, the unsecured debt does not have a source of recovery. But few would argue that such debt is nonrecourse debt under Sections 1.1001-2 or 1.1001-3.

What about structurally subordinated debt? Take a case where shell Parent owns DRE. DRE has issued debt that is treated as nonrecourse (whether under the 2016 PLR or because the debt is in fact nonrecourse debt). The Parent has also issued its own debt which, as a practical matter, has recourse to nothing other than the equity of the DRE. As a practical matter, this kind of structurally senior debt is identical to a situation involving a Parent’s guarantee of a DRE’s debt, except that the creditors’ claims against the DRE are far more attenuated. Yet, again, few would argue that such debt is nonrecourse debt under Sections 1.1001-2 or 1.1001-3.

(vii) “Bad Boy” Guarantees and Nonrecourse Carveouts.

Many nonrecourse debt instruments have provisions that cause the loan to become recourse to a party related to the borrower of the debt if certain “bad acts” are committed. The question is whether such provisions mean that the debt is recourse in the first instance (with the recourse being conditional), is “substantially all nonrecourse” in all cases, or whether the triggering of the “bad boy” guarantee or carveout changes the character of the debt from recourse to nonrecourse (which would cause a testing event under Section 1.1001-3). The answer to this question is not entirely clear, but the author agrees with the view that such debt should be treated as nonrecourse in the first instance.

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What if the “bad boy” guarantee is by a third party, such that the debt continues to be nonrecourse to the issuer but can be asserted on a recourse basis against the “bad boy” guarantor? Creditors’ legal rights vis-à-vis the issuer of the debt have not changed, so arguably the debt remains nonrecourse. A possible exception to this could be a situation where debt could be treated as debt of the guarantor under generally applicable tax principles. Such a circumstance would be comparatively rare, particularly where the guarantee is not effective until some time after the debt is incurred, but could arise if, for example, the borrower is under such financial distress that it is reasonably certain that the guarantor will need to pay such debt and the guarantor’s subrogation claim against the borrower is effectively worthless. But what if the debt is issued by a DRE, and the “bad boy” guarantor is the DRE’s regarded owner? That would appear to change the debt from nonrecourse to recourse, under the view expressed in the 2016 PLR.

What if the “bad boy” trigger is the filing of a bankruptcy petition or an insolvency event, and the provision is deemed to be an impermissible “ipso facto” provision such that the contractual right is not respected for bankruptcy purposes? One might assume that the provision would then be ignored for purposes of Section 1.1001-2 and 1.1001-3, but the answer is not necessarily clear.50

(viii) Bankruptcy Issues: Bankruptcy Code Section 1111(b)(1)(A) and “Adequate Protection” Liens.

Bankruptcy cases raise unique, and difficult, questions in this area.

Under Section 1111(b)(1)(A) of the Bankruptcy Code, a secured claim is deemed to be treated as if the claim was recourse to the debtor itself, regardless of state law rights under the applicable debt instrument. There are two exceptions: (a) where an election is made to forego this so-called “deficiency” claim; and (b) where the property that is subject to the secured debt is sold pursuant to a so-called “section 363” sale, which section has other provisions designed to address “lien stripping.”

Does this mean that every nonrecourse debt claim is transformed into recourse debt for purposes of Sections 1.1001-2 and 1.1001-3 whenever an issuer files for bankruptcy (or, if not, any time it becomes clear that the exceptions to this rule--elections and section 363 sales--will not apply in a given case)? That certainly is not the view taken by practitioners, but the answer is far from cut and dry.51 If one adopts a “tax formalities”

50 For additional discussion of the issues that arise under Sections 1.1001-2 and 1.1001-3 involving “bad

boy” provisions, see Keator & Wootton, ‘Bad Boy’ Carve-Outs and their Effect on Nonrecourse Debt, 39 Real Est. Tax’n 4 (2011).

51 One might be inclined to argue that these kinds of issues that flow from law that is external to the debt agreements should be ignored, at least for purposes of determinations under Section 1.1001-3. However, Section 1.1001-3(c)(1) provides that a “modification” is “any alteration . . . of a legal right . . . whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.” (emphasis added). Moreover, a change in the nature of a debt from recourse constitutes a modification even if the modification occurs by operation of the terms of a debt instrument--the only question is whether such modification is “significant.” As noted below, a change from nonrecourse to

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view of the world, it would seem odd not to respect the statutory mandates of other provisions of law, and under a “creditors’ rights” view, this provision unquestionably changes creditors’ state-law rights. It is worth noting that the Service and Treasury have acknowledged the impact of provisions of the Bankruptcy Code that bifurcate claims into secured and unsecured portions in the context of Section 1.368-1(e)(6)(iii), which applies the reorganization “continuity of interest” rules to creditors’ claims that are bifurcated according to “an order in a title 11 or similar case . . . or pursuant to an agreement between the creditor and the debtor.” A potential argument against this treatment is that the impact of Section 1111(b)(1)(A) cannot necessarily be known until a plan of reorganization is confirmed and consummated, because the exceptions to this deficiency claim treatment may be invoked until that time. It is similarly unclear what effect the common practice of “waiving” the deficiency claim (which secured creditors often do as a way to garner support from junior creditors) has on these issues.

Also in the bankruptcy context, secured claims are entitled to “adequate protection” against the potential diminution in the value of the collateral supporting such claims during the pendency of the case.52 Adequate protection issues are commonly resolved by (a) agreeing to effectively pay interest on a current basis postpetition; (b) granting “adequate protection liens” on previously-unencumbered property; and (c) giving superpriority administrative “adequate protection claims”--which are recourse--to support this adequate protection obligation. If the debt at issue was previously nonrecourse, does the grant of these recourse “adequate protection claims” cause the debt to become recourse? These adequate protection claims are limited to the amount by which an issuer can prove collateral diminished in value during the case--it is not a claim that supports the entire amount of the debt--so there is a good argument that such claims do not cause the debt to become recourse. That said, the answer is not entirely clear, especially if debt is fully secured at the beginning of the case: hypothetically, if the value of the collateral then declined to zero, the adequate protection claim would equal the full amount of the debt.

3. Consequences of the Recourse/Nonrecourse Distinction.

The foregoing discussion addresses some of the issues associated with classifying debt as recourse or nonrecourse. The following discussion addresses the question, “so what?” The characterization can have dramatic--and sometimes disastrous--impacts, but it can also result in a windfall to certain taxpayers.

(a) Section 1.1001-2: CODI vs. Sale Gain.

As discussed in greater detail below, the distinction between recourse and nonrecourse debt will, under many circumstances, determine whether a debt restructuring gives rise to a combination of gain under Section 1001 and CODI, or if the restructuring

recourse is a per se significant modification under Section 1.1001-3(e)(5)(ii)(A); unlike a change from recourse to nonrecourse, there are no exceptions.

52 If “adequate protection” cannot be provided/proven, then the debtor may be preventing from utilizing the collateral, and this is potential cause to lift the automatic stay to permit foreclosure.

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only gives rise to gain under Section 1001. To further complicate matters, certain restructuring outcomes avoid gain under Section 1001 entirely (without regard to whether the debt is recourse or nonrecourse), and certain restructuring transactions are subject to recharacterization such that a transaction that the parties may have thought would have gain under Section 1001 ends up having gain after all. The 2016 PLR further muddied these waters. Each of these issues is discussed below.

(i) Tufts and the Distinction in Treatment Between Recourse and Nonrecourse Debt Under The Regulation.

Section 1.1001-2 draws a fundamental distinction between the treatment of recourse debt, on one hand, and nonrecourse debt, on the other hand. Regardless of whether debt is recourse or nonrecourse, if assets are transferred subject to debt, such debt is included in the amount realized with respect to the transfer of the assets.53 However, in the case of recourse indebtedness only, the amount realized “does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12).”

Thus, in the case of a transfer of property subject to recourse debt, there is a two-step analysis: (a) gain under Section 1001 with respect to the difference between the taxpayer’s basis in the transferred property and the fair market value of such property, and (b) CODI with respect to the difference between the fair market value of such property and the applicable liabilities.54 By contrast, the full amount of nonrecourse debt is realized without regard to fair market value.

Section 1.1001-2 was promulgated while Tufts was pending before the Supreme Court, but Tufts, and the cases leading to it, supplies the fundamental anchor for the distinction in Section 1.1001-2. In Tufts, the Supreme Court concluded that, where property secured by nonrecourse debt was transferred to the creditor in satisfaction of the creditor’s claims, the taxpayer had an amount realized equal to the debt. In so doing, the Supreme Court resolved longstanding ambiguity that was created by a footnote in Crane, the case that serves as the foundation for the principle that nonrecourse debt is included in the amount realized, rather than treating a taxpayer as realizing an amount only with respect to the taxpayer’s equity value in the company. The Supreme Court left open in Crane the question of whether the same rule would apply where the amount of debt exceeded the fair market value of the assets in question. The issue was litigated in lower courts for a number of years, and ultimately resolved in Tufts.

Put simply, the Court in Tufts, and the distinction between the discharge of recourse and nonrecourse debt in Section 1.1001-2, get this issue wrong. The two-step analysis applied by Section 1.1001-2(a)(2) should apply to both recourse and

53 Treas. Reg. § 1.1001-2(a)(1),

54 This interpretation of Section 1.1001-2 was confirmed by the Service in Revenue Ruling 90-16, 1990-1 C.B. 12.

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nonrecourse debt. As other commentators have explored in greater detail,55 there are various potential theories underlying Crane and its progeny, but each theory generally revolves around ensuring that taxpayers are unable to receive a benefit related to the incurrence of indebtedness without suffering a detriment if the taxpayer does not ultimately repay the debt. Perhaps the most common-expressed concern is that parties should not be able to get “basis credit” for nonrecourse financing, claim depreciation deductions with respect to such financing, and then not include such financing in the amount ultimately realized upon the disposition of the asset. However, as other commentators have noted, there’s no particularly good reason to distinguish between recourse and nonrecourse debt on the depreciation theory. In either case, the taxpayer receives debt-funded depreciation deductions. Indeed, Section 1.1001-2 does not distinguish between recourse debt and nonrecourse debt--in either case, the debt must be included in the amount realized--unless the debt is distressed.

Notably, the concurrence in Tufts appeared to favor a bifurcated approach premised on treating the sale transaction separately from the treatment of the financing. Unfortunately, Justice O’Connor thought herself bound by principles of administrative law: the Service relied on previous caselaw and its own long-standing view regarding the treatment of nonrecourse debt to promulgate Section 1.1001-2, and Justice O’Connor believed that the Service’s regulation was not such a departure from the statute that it could be invalidated.

The courts and the Service have not expressed a specific reason for the distinction in treatment between distressed recourse and nonrecourse debt. Any theory based on “recapturing” depreciation deductions is flawed: deductions can (and are) equally “funded” by recourse and nonrecourse debt. What’s more, depreciation-based justifications simply do not address situations in which the nonrecourse debt at issue does not support depreciation deductions. Section 1.1001-2(a)(3) provides limited relief from the general rule of Section 1.1001-2(a)(3) in the case of liabilities that are “incurred by reason of the acquisition of the property” where “such liability was not taken into account in determining the transferor’s basis for such property.” There is a dearth of any authority applying the provision, and its application is unclear. For instance, the provision may well apply only to situations where a purchaser is treated as assuming a liability that encumbered an asset that is acquired by such purchaser. Does the provision apply where an LBO is structured as a stock acquisition and the acquired entities incur financing to support distributions to the prior owners? The provision certainly would not apply to debt financing incurred after the acquisition of an asset (such as common leveraged recapitalization transactions).

The primary theoretical basis to distinguish the treatment of recourse and nonrecourse debt is that the incurrence of nonrecourse debt essentially represents a transaction pursuant to which the borrower has an option to sell the subject property back

55 See, e.g., the sources cited in footnote [8].

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to the lender for an amount equal to the loan.56 However, such an approach is seemingly at odds with the general ability (and requirement) that a taxpayer treat nonrecourse debt as real debt,57 permitting the taxpayer to claim depreciation deductions with respect to the full purchase price of property, and not otherwise impairing a taxpayer’s ownership of property for tax purposes. In other words, if the general theory is that the nonrecourse loan is nevertheless a loan, why should the treatment of that loan be distinguished from the treatment of a recourse loan? It is also difficult to square such a theory with the fact that a taxpayer can (and often will) avoid Section 1001 by, rather than transferring the collateral securing the nonrecourse loan, transfer some combination of equity and/or cash raised by new debt financing in an amount equal to the fair market value of the subject property. Moreover, the “option” theory arguably applies with just as much force to a company that has issued debt that is recourse to the company (but not its shareholders): the company can satisfy the recourse debt by turning over all of its assets to the creditor because, simply put, one cannot draw blood from a stone. In other words, the “option” theory of nonrecourse debt is particularly difficult to square with modern-day “floating lien” lending practices, and even more difficult to square with DRE Recourse Debt.

(ii) Gershkowitz, Revenue Rulings 82-202 and 91-31, Briarpark, and the 2016 PLR: Two Exceptions to the Distinction Between Recourse and Nonrecourse Debt, A Step Transaction-Based Exception to that Exception, and a PLR that Stands Alone.

A key aspect of Section 1.1001-2 and Tufts is that, by their terms, they apply only when property subject to indebtedness is transferred subject to (or in satisfaction of) the indebtedness at issue. A separate line of authority stands for the proposition that if the property is not transferred and creditors receive recovery from another source, no gain under Section 1001 arises at all.

(A) Gershkowitz and the Discharge of Debt through the Transfer of Property that Does Not Secure the Debt.

Gershkowitz v. Comm’r58 involved a series of partnerships that incurred a variety of debt that was subject to discharge. Each of the applicable loans constituted nonrecourse debt. The collateral packages were overlapping among the loans, with certain rights in place regarding “pecking order” of the different loans with respect to particular types of collateral. The loans were ultimately in an amount in excess of the 56 See, e.g., Cunningham, Payment of Debt with Property. Tax Lawyer, Vol. 38, No. 3, at 593-97, 623

(discussing the appropriateness of the put option theory in the context of devalued property); New Ghosts for Old--Crane Footnote 37 is Dead (Or Is It?), 2 Am. J. Tax Policy 89 (1983) (vigorously arguing that the distinction between recourse and nonrecourse debt is appropriate on the basis that a borrower on nonrecourse debt is not personally obligated on the debt and essentially has a put option).

57 C.f. Tufts, 461 U.S. at 307 (“Crane ultimately does not rest on its limited theory of economic benefit; instead, we read Crane to have approved the Commissioner’s decision to treat a nonrecourse mortgage in this context as a true loan.”).

58 88 T.C. 984 (April 21, 1987).

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value of the applicable collateral. Certain of the loans (the “Prentice-Hall Loans”) were settled for a discounted cash payment. A separate set of loans were settled by transferring certain collateral to the applicable lenders.59 The cash settlement of the Prentice-Hall Loans occurred a few months before the turnover of collateral with respect to the remaining loans.60 In the same year in which these settlements occurred, the partnerships ceased operations.61

The Tax Court concluded that the resolution of the Prentice-Hall Loans gave rise to CODI, while the resolution of the other loans gave rise to gain under Section 1001. With respect to the Prentice-Hall Loans, the Tax Court held that the discharge of the Prentice-Hall Loans gave rise to CODI, without considering whether gain under Section 1001 was the proper result. The Tax Court reached this conclusion after refusing to limit the amount of CODI to the fair market value of the property that supported the indebtedness in question.62 By contrast, the Tax Court concluded--again, without much analysis--that the turnover of collateral to the lenders of the other loans was “governed by the rules of section 1001 and not by the discharge of indebtedness doctrine.”63

Gershkowitz is often thought to stand for the proposition that the discharge of a nonrecourse loan will give rise to CODI, rather than Section 1001 gain, so long as the collateral securing the underlying nonrecourse loan is not transferred in satisfaction of

59 Id. at 999-1002.

60 It is not entirely clear whether there was a single comprehensive plan to execute each of the debt cancellations, although the facts in the case indicate that there was such a plan.

61 Id.at 1003. In connection with these transactions, amendments were made to the partnership agreements to specially allocate gains and losses arising in the applicable year (1977) to attempt to drive all capital accounts to zero, prior to resuming ordinary-course allocations of gains and losses. The Tax Court concluded that these amendments did not satisfy the substantial economic effect test and were therefore invalid, which is a notable result because it likely caused certain partners to have negative capital accounts and, potentially, deficit restoration obligations with respect to such negative capital accounts.

62 The partnerships argued that under the Kirby Lumber “freeing of assets” theory, any income or gain should have been limited to the value of the collateral that was released from liens. The Tax Court disagreed with that analysis in a discussion that largely discounted the continuing vitality of the “freeing of assets” theory. Id. at 1010-13. The Tax Court further noted that the taxpayer was apparently attempting to avoid the result that would have occurred if the partnerships had turned the applicable collateral over to the Prentice-Hall Loan lenders (although, somewhat confusingly, the Tax Court indicated that such a turnover would have given rise to ordinary income, rather than capital gain). It is worth noting that the Tax Court’s analysis appeared to be driven, at least in part, by the fact that the transactions at issue were potentially abusive and some of the parties involved had actively engaged in tax shelter activity that was under scrutiny in other contexts.

63 Id. at 1016.

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such debt.64 In the author’s view, however, the scope of Gershkowitz is somewhat unclear, as illustrated by the following fact patterns:

• Variation #1. An issuer has two assets, Asset A and Asset B. Asset A is pledged in support of Debt A, and Asset B is pledged in support of Debt B. Presume Asset A and Asset B are of equal value. If Asset A is transferred to the holders of Debt B in satisfaction of Debt B, and Asset B is transferred to the holders of Debt A in satisfaction of Debt A, does Gershkowitz apply to support the idea that the transfers give rise to a combination of CODI and sale gain? Collateral other than the collateral securing the respective claims was transferred in satisfaction of the respective nonrecourse claims. But all of the applicable collateral was, in fact, transferred. One could imagine that the Service would recharacterize this transaction to provide that (a) Asset A is transferred in satisfaction of Debt A (giving rise to gain or loss under Section 1001), (b) Asset B is transferred in satisfaction of Debt B, and (c) the holders of Debt A and Debt B exchange the assets they received in an “across-the-top” transaction. Of course, such an attempted recharacterization would add a step, in violation of fundamental recharacterization principles.65

• Variation #2. Issuer has two assets, Asset A and Asset B. Each of Asset A and Asset B has a tax basis of $25 and a FMV of $50. Debt A is a $100 nonrecourse liability secured by Asset A, and Debt B is a $100 nonrecourse liability secured by Asset B. Asset A is transferred in satisfaction of Debt B, while 100% of the stock of the issuer (which continues to own Asset B) is transferred in satisfaction of Debt A. As discussed in greater detail below, Section 108(e)(8) specifically provides that the satisfaction of Debt A with the stock of issuer gives rise to CODI, and under Gershkowitz (a) Debt A was satisfied using something (issuer stock) other than the collateral securing such debt (Asset A), and (b) the collateral securing Debt B (Asset B) is never transferred, so the discharge of of Debt A again should give rise to CODI. However, one could again imagine that the Service could attempt to recharacterixe this transaction to provide that (a) Asset A is transferred in satisfaction of Debt A; (b) Asset B is transferred in satisfaction of Debt B; (c) the creditors “swap” the respective assets “across the top,” and (d) the Debt A creditors contribute the asset to a new company. As with variation #1, however, such a recast adds steps to the transaction and is an even more attenuated recharacterization.

• Variation #3. Issuer has $100 of nonrecourse debt secured by Asset A, which has a FMV of $50 and a tax basis of $30. Issuer and creditor agree to discharge the debt for Asset A and a cash payment of $10.66 Is the issuer treated as discharging (x) $10

64 The rule is further reinforced by Revenue Ruling 82-202, 1982-2 C.B. 35 (holding that the release of a

nonrecourse mortgage in exchange for a discounted cash payment gave rise to CODI).

65 See, e.g., Esmark, Inc., 90 T.C. 171, 196-97 (1998), aff’d 886 F.2d 1318 (7th Cir. 1989) (generally providing that the Service cannot add or invent additional steps to a transaction in an effort to recharacterize a transaction or apply step transaction principles); ,

66 One might ask why the issuer would agree to make a cash payment in addition to turning over the collateral securing the nonrecourse debt. This is not as uncommon as one might think. One relatively

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of the liability for $10 of cash and (y) $90 of the liability with Asset A, which would give rise to $60 of gain ($90 of liability less $30 of tax basis)? Or is a proportionate approach applied? Under a proportionate rule, (a) the creditor receives $60 of recovery, ~83% of which is Asset A ($50 of FMV out of $60 of total of recovery), (Asset A’s FMV of $50 and $10 of cash) and ~17% is cash; (b) ~$83 of the liability (83% of the $100 liability) is treated as being discharged by Asset A, which gives rise to $53 of gain ($83 of liability less $30 of tax basis); and (c) ~$17 of the liability (17% of the $100 liability) is treated as being discharged by the $10 of cash, giving rise to $7 of CODI. In the author’s view, the proportionate rule is the better approach, but the answer is not clear.

To what extent should “proceeds of collateral” be treated as collateral for the purpose of determining whether a creditor has received something other than the collateral securing the nonrecourse debt in satisfaction of that debt? As a general rule, under Article 9 of the UCC, a security interest in collateral extends to “proceeds” of that collateral. The “proceeds” concept is quite broad, and includes “proceeds of proceeds,” although this chain of proceeds may be cut off to the extent proceeds can no longer be traced.67 The Tax Court in Gershkowitz did not explore whether the cash that was paid

common reason is to avoid potential lawsuits by the applicable nonrecourse creditors. In such a circumstance, one might reasonably ask if the cash payment should be entirely separated from the treatment of the debt discharge and separately evaluated as a litigation settlement payment. However, as a practical matter, these payments will sometimes be made without litigation being brought. Moreover, under Arrowsmith and under relation-back principles, it is unclear why a creditors’ litigation recovery should be treated any differently than any other recovery on account of a debt instrument. Another reason for such a payment could be that in the context of a bankruptcy proceeding, the creditor would receive a recovery on account of its deficiency claim, as discussed above, and the recovery on account of such deficiency claim could exceed the negotiated out-of-court additional payment. Finally, as discussed in greater detail below, it is not uncommon for a first-step reduction in debt to be accompanied by a payment of cash, followed by a later restructuring in which collateral is turned over. Under step transaction principles, such a “two-step” transaction might be collapsed into a single transaction.

67 See U.C.C. § 9-102(a)(64) (with certain exceptions, proceeds means “(A) whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral; (B) whatever is collected on, or distributed on account of, collateral; (C) rights arising out of collateral; (D) to the extent of the value of collateral, claims arising out of the loss, nonconformity, or interference with the use of, defects or infringement of right in, or damage to, the collateral; or (E) to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.”). There are some uncertainties in the scope of these rules. For instance, there is authority that stands for the proposition that proceeds from the mere use of collateral in a business (as opposed to rentals or sales of such collateral) does not constitute “proceeds of collateral” so, for example, a secured lender with a security interest in factory equipment does not necessarily have a security interest in the goods produced by that equipment (unless the lender also has a security interest in the produced goods themselves). See, e.g., 1st Source Bank v. Wilson Bank & Trust, 735 F.3d 500, 504-505 (6th Cir. 2013) (Tennessee law) (quoting both the Commentary to Article 9 and a leading interpretative treatise for the proposition). Nevertheless, the author understands that, as a matter of commercial practice, it is common for lenders to at least threaten to assert that cash flows from the operation of collateral constitute proceeds--a particularly important issue in the bankruptcy context, where the petition date cuts off a secured lender’s interest in any after-acquired property that does not constitute “proceeds of collateral.” See 11 U.S.C. § 522(a) and (b) (although there is arguably a distinction between the language in Bankruptcy Code

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to discharge the Prentice-Hall Loans constituted proceeds of collateral. This distinction is relevant only if the “proceeds” are not themselves collateral.68

In general, because “proceeds of collateral” generally constitute “collateral,” the better view (to the extent one subscribes to the distinction between recourse and nonrecourse debt in this area) is that a turnover of “proceeds of collateral” should be treated the same as the turnover of the underlying collateral. In other words, a turnover of “proceeds of collateral” should be subject to gain or loss under Section 1001, rather than giving rise to CODI.

(B) Revenue Ruling 91-31: CODI if Nonrecourse Debt is Written Down Without A Transfer of Collateral.

Revenue Ruling 91-3169 expands on the Gershkowitz rule. In this revenue ruling, an individual borrowed funds on a nonrecourse basis, secured by an office building that was purchased using the proceeds of the financing. Later, the creditor agreed to write the debt down to the fair market value of the property, which had declined in value. The Service, relying on the treatment of the Prentice-Hall Loan in Gershkowitz, ruled that there is CODI, rather than sale gain, “where a taxpayer is discharged from all or a portion of a nonrecourse liability when there is no disposition of the collateral.”

The main issue regarding the application of Revenue Ruling 91-31 is the extent to which step transaction principles might prevent it from applying if a first-step debt writedown occurs at a time when a subsequent restructuring is anticipated. For example, Variation 3 in the discussion of Gershkowitz, above, could apply equally to a situation where there is a first-step reduction of debt in exchange for a partial cash payment, followed by a later disposition of collateral, where those steps are collapsed under step transaction principles.

Section 522(b), which speaks to “proceeds, products, offspring, or profits” of property, and the language of Article 9; though Bankruptcy Code Section 522(b) defers to state law, it is plausible to read the language as applying to things that would not constitute “proceeds of collateral” under Article 9, such as funds generated from the use of underlying collateral).

68 The distinction between the scope of Bankruptcy Code Section 522(b) and “proceeds of collateral” under Article 9 could be of particular relevance here. Assume a secured lender has a lien in equipment as well as goods and accounts receivable generated from the operation of that equipment. Under 1st Source Bank, the goods and accounts receivable do not constitute “proceeds of collateral,” though they do constitute security for the underlying loan. Under Bankruptcy Code Section 522(b), however, the prepetition liens cannot attach to goods and accounts receivable generated after the filing date unless such goods and accounts receivable constitute “proceeds, products, offspring, or profits” of such property. Common bankruptcy practice is to interpret the scope of Bankruptcy Code Section 522(b) quite broadly, although at least some cases have found limitations. See, e.g., In re Timothy Dean Restaurant & Bar, 342 B.R. 1 (Bankr. D.C. 2006) (room service charges were not covered as proceeds of sale of encumbered food and beverage inventory).

69 1991-1 CB 19.

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(C) Section 108(e)(8) and its Interaction with Gershkowitz.

Section 108(e)(8) provides that, regardless of whether debt is recourse or nonrecourse, and in the context of both partnerships and corporations, if debt is satisfied by the issuance of equity, then “such corporation of partnership shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock or interest.”70 This “deemed” cash-for-debt treatment does not necessarily apply for all purposes of the Code. For example, Section 1.721-1(d) provides that a debt-for-equity exchange in the partnership context is treated as a Section 721 contribution from the creditors’ perspective. The provision works together with Section 1032, which provides that a corporation does not recognize gain or loss “on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation.”

Notably, Section 108(e)(8) does not, by its terms, apply to a situation in which parent stock is issued in satisfaction of subsidiary debt, or subsidiary stock is issued in satisfaction of parent debt. By contrast, Section 1.1032-3 makes it clear that the non-recognition rule of Section 1032 applies in most situations where parent stock is utilized to discharge debt.

Take a situation in which Parent owns Subsidiary, each a corporation, and Parent and Subsidiary file a consolidated tax return. Subsidiary has issued debt of $1,000, secured by substantially all of Subsidiary’s assets but not recourse to Subsidiary itself. Subsidiary’s assets are worth $500 and have a tax basis of $200. Presume the Parent consolidated group has $300 of NOL carryforwards. Subsidiary files for bankruptcy. Pursuant to Subsidiary’s bankruptcy plan, Parent, Subsidiary, and Subsidiary’s creditors agree that, in full and final satisfaction Subsidiary’s debts, Subsidiary’s creditors will receive 80% of the stock of Parent, with Parent’s current shareholders retaining the other 20% of the Parent stock.71

If Section 108(e)(8) did apply to this transaction, one would expect $500 of CODI (the difference between the $500 value of the Parent stock and the amount of Subsidiary’s debt: under Section 1.721-1(d), no gain is recognized with respect to the transfer of the Parent stock). That CODI would be subject to the bankruptcy exclusion of Section 108(a): as a result, the $500 of CODI would be excluded from income; however, under Section

70 The purpose of this provision was to effect the repeal of the historic “stock-for-debt” exception to the

recognition of CODI. Note, however, that this deemed cash treatment does not apply for all purposes of the Code. For example, Section 1.721-1(d) provides that a debt-for-equity exchange is treated as a Section 721 contribution, other than with respect to satisfaction of certain ordinary income items.

71 This recovery split implies that Parent has assets other than Subsidiary and Subsidiary’s assets with a value of approximately $125, such that the total enterprise value of Parent and all of its subsidiaries is $625. Alternatively, this recovery split may imply that Parent’s shareholders have hold-up value and they are being provided an equity “kicker.”

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108(b) and Section 1.1502-28, the basis in Subsidiary’s assets would be reduced to zero, and all of the NOLs of the Parent consolidated tax group would be eliminated.72

However, it is not clear that Section 108(e)(8) applies: Parent is not the issuer of the debt at issue. Accordingly, one might expect that, under Section 1.1002-2, Subsidiary would recognize $800 of gain under Section 1001 (the difference between the $200 of tax basis in Subsidiary’s assets and the $1,000 of Subsidiary’s debt). Such a tax liability could well make any restructuring impossible. Nevertheless, Subsidiary’s creditors received property other than the property securing their nonrecourse debt (Parent stock) in satisfaction of their claims. It would appear that, under Gershkowitz, the transaction would give rise to CODI. That is, in fact, the position that (at least in the author’s experience) is most common. As discussed below, however, the scope of Gershkowitz may have been called into question by the 2016 PLR.

(D) Briarpark and Step Transaction Limitations on Gershkowitz and Revenue Ruling 91-31.

2925 Briarpark Ltd.73 represents a potentially significant step transaction-based limitation on Gershkowitz and Revenue Ruling 91-31. In that case, property secured by a nonrecourse liability of approximately $24.6 million was sold to a third party for a gross amount of approximately $11.6 million (subject to certain sales-related adjustments). The applicable creditor agreed that the transfer would be free and clear of liens, provided that the gross sales proceeds were assigned to the lender (and certain other partnership cash was transferred to the lender). The excess of the liability was discharged.74

The issuer argued that the debt cancellation, on one hand, and sale of the property, on the other hand, should be viewed as two separate transactions, with the sale giving rise to Section 1001 treatment, and the debt cancellation giving rise to CODI. The Service, by contrast, argued that the transaction was, in essence, a turnover of the collateral to the lender, which gave rise to Section 1001 treatment. The Tax Court and the

72 The mechanical rules of Section 1.1502-28 provides that, in the context of CODI in a consolidated

group, a three-step approach is applied. First, CODI is applied to reduce the tax attributes (including tax basis, unless there are liabilities that invoke the so-called “liability floor”) of the member of the group that actually generated the CODI. Second, to the extent the first step involves a reduction in the tax basis of any stock of a subsidiary of that member that is also a member of the consolidated group, the CODI “tiers down” into that subsidiary (in an amount equal to the basis reduction in that subsidiary’s stock) and reduces that subsidiary’s tax attributes. Third, any remaining CODI “fans out” to reduce tax attributes (but not tax basis) at other members of the consolidated group on a pro rata basis. An in-depth discussion of these rules is beyond the scope of this paper, but suffice to say, their application to this simple fact pattern is that the basis of Subsidiary’s assets would be reduced to zero, and regardless of whether the Parent group’s NOLs were generated by Subsidiary, Parent, or another of Parent’s direct or indirect subsidiaries, all such NOLs would be eliminated.

73 T.C. Memo 1997-298, aff’d, 163 F.3d 313, 318 (5th Cir. 1999).

74 There was also a payment by one of the partners in the debtor-partnership to satisfy the partner’s guarantee of the nonrecourse debt. The loan had been recourse when it was initially incurred, but was later converted to a nonrecourse obligation.

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Fifth Circuit both concluded that, in light of the integration between the sale and the discharge of debt, Section 1001 treatment was appropriate. In so holding, the Fifth Circuit distinguished “[Section] 61(a)(12) cases, where debt forgiveness occurs as a single transaction and the realization of the property income occurs in a later and separate transaction.” The Fifth Circuit specifically distinguished Gershkowitz on the basis that there was a delay between the cash payment to certain creditors and the disposition of collateral to others.

The conclusion in Briarpark is not necessarily surprising. Economically, the effect of the transaction was exactly the same as it would have been had the property been foreclosed on by the lender and immediately sold to the third party, or sold at a foreclosure sale. It is notable that the Fifth Circuit appeared to indicate that a delay of three months is insufficient to destroy this analysis, although it is unclear to what extent a Briarpark analysis could be applied where a first-step debt reduction is done at a time when a restructuring is nearly certain, even if the form of the restructuring is not known and it is more than three months out. In the author’s view, Briarpark should be read narrowly to apply only to a fully-integrated transaction: certainly, applying it to a first-step debt reduction where the form of a later restructuring is unknown would be inappropriate.

Is there a different outcome if secured lenders do not expressly agree to the release of liens? For example, if a debtor sells assets “free and clear” pursuant to a plan of reorganization or pursuant to Section 363 of the Bankruptcy Code, and the proceeds are applied pursuant to a “waterfall” that results in the proceeds being turned over to nonrecourse creditors, does Briarpark apply? The answer is unclear, although parts of the 2016 PLR, discussed below, could be read to limit the scope of Briarpark.

(E) The 2016 PLR Resets the Landscape.

As discussed above, the “headline” of the 2016 PLR was the Service’s adoption of the tax formalities approach to treating debt as recourse or nonrecourse. As discussed below, however, the 2016 PLR is actually far broader in its implications.

(1) Interaction Between Section 1.1001-2, Section 361, and Section 108(a).

As discussed above, in the 2016 PLR, the Service held that debt issued by a DRE (LLC2), which was not guaranteed by the DRE’s parent (Distributing) was nonrecourse debt for purposes Tufts (and, implicitly, for purposes of Section 1.1001-2). Accordingly, the distribution by LLC2 to LLC2’s creditors in satisfaction of their claims gave rise to gain to be determined by reference to the total amount of LLC2’s debt, and that Section 108(a) did not apply to such gain.75 However, the Service went on to rule that, so long as the transaction otherwise qualified as a “G” reorganization, the non-recognition provision of Section 361(c) applied to any gain realized as a result of the distribution, specifically

75 See 2016 PLR, Ruling #11. The facts in the PLR do not specify the amount of potential gain.

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“including any gain or loss attributable to the amount realized under section 1001 with respect to such property, as provided in the preceding ruling[.]”76

That combination of rulings converted potential catastrophe for the debtor into a potential “home-run” result. As at least one commentator has recognized,77 because Section 108(a) was inapplicable, Distributing will not have any attribute reduction pursuant to Section 108(b). The ruling makes it clear that Distributing remained in chapter 11 following the distribution with substantial assets; while tax attributes, if any, are not disclosed, the ruling appears to leave the door open to a way to avoid both attribute reduction and the recognition of gain.78 As discussed below, that result gives rise to potentially significant tax planning opportunities.

(2) Limitation on Gershkowitz and Section 108(e)(8).

The 2016 PLR discussed two key creditor groups: junior creditors (the LLC2 Junior Debt) and senior creditors (the LLC2 First Lien Debt). LLC2 Junior Debt received cash, while LLC2 First Lien Debt received a combination of Controlled stock, Controlled obligations, the Settlement Claim Obligation,79 and cash. Under Gershkowitz, the Controlled stock and Controlled obligations arguably represented property other than the collateral for such debt, such that CODI treatment should have applied. The 2016 PLR did not discuss that issue, but it is possible that the Service was applying a “proceeds of collateral” theory to this situation. In other words, the property that was contributed to Controlled was, for the most part, the same property that was collateral for the LLC2 debt. Accordingly, the stock and obligations of Controlled effectively represented “proceeds of collateral.” That explanation does not fully account for the fact that Distributing did contribute certain property to Controlled other than property that originally supported the LLC2 debt. However, the ruling indicates that such property was a minor part of the overall consideration.

Rather than a “proceeds of collateral” theory, was the Service essentially applying a Briarpark-style analysis? At the end of the day, the debt at issue was discharged and 76 See id., Ruling #12.

77 See Henderson and Goldring, Tax Planning for Troubled Corporations, at § 403.1.3 (“It is therefore noteworthy to observe that it was seemingly against the IRS’s own interest to treat the debt as nonrecourse under the circumstances, since by doing so Distributing not only avoids taxable gain, it also avoids the attribute reduction that generally is the quid pro quo for excluding COD income under the bankruptcy or insolvency exceptions to COD income.”).

78 What’s more, the result avoids the generation of any earnings and profits as a result of the debt cancellation. By contrast, CODI generally gives rise to earnings and profits except to the extent it reduces tax basis in assets. See Section 312(l)(1) (providing that CODI does not increase earnings and profits if the CODI reduces asset tax basis under Section 1017).

79 By way of reminder, the Settlement Claim Obligation was initially an intercompany claim owed from Distributing to LLC2. That claim was distributed by LLC2 to the LLC First Lien Debt. Accordingly, after giving effect to the transaction, the Settlement Claim Obligation essentially represented a third-party debt claim held by LLC2’s former creditors against Distributing.

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title was no longer owned to the assets. If LLC2 had sold the applicable assets for cash to a newly-formed corporation and given the cash proceeds to the LLC2 creditors, which in turn used such cash to acquire 100% of the stock of the newly-formed corporation, the “picture” would have looked the same. Such an analysis could help to explain why the Service did not draw a distinction between the treatment of the junior LLC2 debt, which received nothing but cash, and the senior LLC2 debt. However, it is unlikely this was the Service’s approach. First, such a recast would involve the creation of additional steps (including deemed cash transactions that never actually occurred), in violation of well-established limitations on the Service’s ability to re-order steps. Second, such a recast would have constituted a taxable disposition of assets to which Section 361 would not have applied, so it would be inconsistent with the overall theory of the ruling.

Does the 2016 PLR have any implication with respect to the application of Section 108(e)(8)? As discussed above, Section 108(e)(8) only applies by its terms to a situation involving an issuer debt-for-equity exchange. Since the LLC2 debt was Distributing debt for tax purposes, and no Distributing stock was issued in the transaction, Section 108(e)(8) would not apply by its terms.

(3) Clarification/Limitation of Section 357(d).

As discussed above, Section 357(d) generally provides that nonrecourse debt is treated as having been assumed (for purposes of Section 357(c)) by an acquiring company where property is transferred to the acquiring company subject to such debt. Ruling #5 provided that Controlled was not treated as assuming any portion of the LLC2 debt in connection with the contribution of assets to Controlled (or Controlled’s conversion to a corporation). The ruling includes representations to the effect that Controlled would not “be liable for, or be expected to satisfy, any of the [LLC2 debt]” and that the assets contributed to Controlled would not be subject to the LLC2 debt.80 Thus, the Service appears to have adopted an interpretation of Section 357(d) that respects factual circumstances that demonstrate that an asset is no longer “subject to” a particular debt.81

(b) Section 1.1001-3.

As briefly noted above, the question of whether debt is recourse or nonrecourse significantly impacts the analysis of whether debt undergoes a “significant modification” under Section 1.1001-3.

(i) Effect of Debt Characterization on Whether a Significant Modification Occurs.

First, pursuant to Section 1.1001-3(e)(4)(i)(A), a change in obligor on a recourse debt instrument is a significant modification, unless (a) the substitution occurs in

80 See Representation f.

81 The Service similarly ruled that, in connection with the “Busted 351” transaction, the LLC2 debt was not treated as an amount realized in connection with the transfer.

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connection with a Section 381(a) transaction (as long as there is no “change in payment expectations”82 and no “significant alteration”;83 or (b) the substitution occurs pursuant to a transaction in which the new obligor acquires substantially all of the assets of the original obligor (and, again, there is no change in payment expectations or significant alteration). The exceptions to the general rule are significant and, in the context of “check the box” elections and “F” reorganizations, will oftentimes result in there being no significant modification as a result of a change in obligor on a recourse debt instrument. That said, there are, of course, exceptions. By contrast, the substitution of an obligor on a nonrecourse debt instrument is never a significant modification under Section 1.1001-3(e)(4)(ii).

Second, under Section 1.1001-3(e)(4)(iv)(A), modifications that change security or credit enhancements (including the addition of guarantees) are only a significant modification if they result in a change in payment expectations. By contrast, under Section 1.1001-3(e)(4)(iv)(B), for a nonrecourse debt instrument, such changes generally constitute a significant modification, subject to an exception for the substitution of collateral that is “fungible or otherwise of a type where the particular units pledged are unimportant.” The regulation also clarified that neither the substitution of a “similar commercially available credit enhancement contract” (e.g., a surety) nor improvements to property securing nonrecourse debt (e.g., office building renovations) constitute significant modifications.

The application of this second provision is potentially broad in the context of DRE Recourse Debt, if the 2016 PLR stands for the proposition that DRE Recourse Debt is nonrecourse debt for purposes of both Section 1.1001-2 and 1.1001-3. Take a situation where the applicable credit documents are amended to turn debt that is unsecured (from a state law perspective) to secured. This is a credit enhancement. If the debt was treated as recourse debt, the “change in payment expectations” test would apply. However, if the debt is treated as nonrecourse debt under the tax formalities view, this change from unsecured debt to secured debt appears to be a per se significant modification. That could be true even if a collateral package is merely expanded. Similarly, a guarantee provided by another entity (perhaps another DRE) would also appear to result in a significant modification.

Third, and likely most fraught, are the provisions dealing with changes in the nature of the debt instrument, e.g., changes from recourse to nonrecourse (and vice versa). Under Section 1.1001-3(e)(5)(ii)(A), if a debt instrument changes from nonrecourse to recourse, such change is a per se significant modification, with no exceptions. Thus, under the tax formalities view of the world, if a DRE borrower is converted to a corporation (or a partnership), or if a DRE’s regarded owner provides a 82 This is a high standard, requiring a shift from the debt being “primarily speculative” prior to the

modification and “adequate” afterward (or vice versa). See Treas. Reg. § 1.1001-3(e)(vi).

83 Generally, a modification that would be a significant modification except for the fact that it is not otherwise treated as a modification at all because it happens pursuant to the terms of the debt instrument. See Treas. Reg. § 1.1001-3(e)(4)(i)(E).

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guarantee of the DRE’s debt, that debt undergoes a significant modification. Under that same provision, a change in debt from recourse to nonrecourse also constitutes a significant modification, subject to two exceptions: one narrow one relating to tax-exempt bonds, and the broader “original collateral” exception.

Section 1.1001-3(e)(5)(ii)(B)(2) provides that a change from recourse to nonrecourse is not a significant modification if (a) “the instrument continues to be secured only by the original collateral” (emphasis added) and (b) there is no “change in payment expectations.” As is the case with changes in credit support and collateral, certain changes in fungible collateral are disregarded.84 In general, the conversion of a regarded entity to a DRE will not result in a “change in payment expectations” because creditors’ rights are unaffected.85 So, the real question is whether the conversion of a corporation to a DRE satisfies the original collateral exception.

No authority of which the author is aware has interpreted the original collateral exception,86 and there are two key ambiguities. As an initial matter, the exception relies on the concept that the debt be “secured by” “collateral.” In the world of debt finance, these terms refer to secured debt, not unsecured debt, so there is a question of whether the original collateral exception can apply at all with respect to DRE Recourse debt that is a general unsecured obligation of the DRE. There are other places in the Code and Treasury Regulations where there is some ambiguity in whether the operation of a provision turns on the meaning (and potential differences in meaning) between terms like “secured by” (which invokes secured debt principles) and “subject to” (which less clearly invokes secured debt principles). A full discussion of those issues is outside the scope of this paper, but the better view seems to be that the provision should be interpreted broadly. The tax formalities view of DRE Recourse Debt should be accompanied by a broader view of the meaning of “secured by.” 87 This is further reinforced by the fact that Section 1.1001-3(e)(iv)(A) specifically applies the concept of “collateral” to recourse debt.

84 Id. (“[I]f the original collateral is fungible or otherwise of a type where the particular units pledged are

unimportant (for example, government securities or financial instruments of a particular type and credit quality), replacement of some or all units of the original collateral with other units of the same or similar type ad aggregate value is not considered a change in the original collateral.”).

85 A potential exception to this could be a related disposition of assets that supported the debt. However, such a disposition would implicate the original collateral prong of the test, as well, and so it is not addressed further.

86 The applicability date of the original collateral exception in the current regulations is misleading. The original version of the final regulations did include the original collateral exception. See TD 8975 (June 25, 1996) (noting that the final regulations provide two exceptions to the general per se rule: the original collateral exception and the tax-exempt bond exception). The originally proposed regulations did not contain this original collateral exception. See 57 FR 57038 (Dec. 2, 1992). Unfortunately, TD 8975 contained no meaningful analysis of these exceptions. The application date language in the current regulations appears to be a referenced to certain technical changes that were made with respect to Dodd-Frank.

87 Indeed, CCA 20150301F, which relied on Example 6 of Section 1.465-27(b)(6) for the proposition that debt of a DRE constituted qualified nonrecourse financing, implicitly adopts the broader view. Section

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A more difficult question is raised in determining what the “testing moment” is for whether the “original collateral” test is satisfied. In any situation involving a “floating” set of collateral (which includes DRE Recourse Debt), the assets that secure such debt are highly likely to shift significantly over the course of time. This is because the assets owned by the DRE will shift as the needs and operations of the business change. If the question is whether the property that supports the debt immediately before the debt modification is the same as the property that supports the debt immediately after the debt modification, then the original collateral exception will apply to many conversions of corporations to DREs.88 By contrast, if “original collateral” means the property the DRE owned when the debt was incurred, more often than not, the test will not be able to be satisfied.

It is tempting to conclude that “original collateral” must mean the collateral in place immediately before the debt modification. That is certainly the more rational view. However, several provisions in Section 1.1001-3 make that conclusion far from certain. If that is the test, the “fungible collateral” language in the exception seems to apply only in a very narrow set of circumstances where the conversion transaction is accompanied by changes in the fungible collateral. Because Section 1.1001-3 was promulgated before the rise of DREs, the Service and Treasury were almost certainly focused less on “floating lien” scenarios and more on more typical situations involving nonrecourse debt secured by identifiable collateral, so it is unclear whether the language should be read to apply only to that narrow situation.

Additionally, as noted above, Section 1.1001-3(e)(iv)(B) provides that property improvements and substitutions of fungible collateral do not result in a significant modification in the context of testing whether a modification that “releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument” is a significant modification. The improvements language, in particular, could be read to imply that, in the absence of that language, an improvement could in fact constitute an “addition” or “alteration” of the collateral supporting a nonrecourse debt instrument. That, in turn, could be viewed as supporting a conclusion that the original collateral exception would take account of any changes in a collateral package since the incurrence of a debt instrument. original collateral.

Yet another question in the application of the original collateral exception is the extent to which related dispositions (or acquisitions) of property will be taken into account. Certain of the debt modification rulings discussed above involved circumstances where the issuer distributed certain property to the issuer’s shareholders. The rulings did not address the original collateral exception, because they relied on the creditors’ rights view of Section 1.1001-2, and there is no authority on point. What if the issuer acquires

1.465-27(b)(2) provides that the rule applies where the financing is “secured only be real property,” and the example itself notes that the debt, which is recourse to the DRE, will be treated as financing “secured by” real property.

88 A key issue in these circumstances will be the extent to which related dispositions of property, such as in certain of the debt modification rulings, must be factored into the analysis.

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additional property in connection with its conversion shortly after its conversion, but in the ordinary course of business? Or, what if a property disposition is planned at the time of the conversion, but does not occur until later and is subject to significant contingencies (such that general step transaction principles would ordinarily not apply)? The better view is likely that this is generally addressed by a step transaction inquiry: dispositions or acquisitions that form a part of the transaction pursuant to which the conversion occurs will be included, while other dispositions and acquisitions will be ignored.

(ii) Implications of a Significant Modification.

A full discussion of the implications, to both creditors and issuers, of debt undergoing a significant modification is beyond the scope of this paper. However, two issues are particularly relevant to the scope of this paper’s discussion.89

First, from an issuer’s perspective, the deemed debt-for-debt exchange that results from a significant modification is a taxable event. Although most tax practitioners think of these kinds of deemed exchanges as giving rise to CODI equal to the difference between the adjusted issue price of the “old” debt and the issue price of the “new” debt, might there be circumstances under which a deemed debt exchange gives rise to gain under Section 1001? Section 108(e)(10), like Section 108(e)(8), generally provides that “[f]or purposes of determining income of a debtor from discharge of indebtedness, if a debtor issues a debt instrument in satisfaction of indebtedness, such debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument.” This would generally seem to imply that even exchanges (including deemed exchanges) of nonrecourse debt instruments give rise to CODI, rather than gain.

Presume, however, that following such a deemed exchange, the property underlying the debt is distributed to creditors in satisfaction of such debt. If the disposition of property was fully planned at the time of the initial deemed debt exchange, would Briarpark principles essentially step together the subsequent property distribution with the first-step debt modification? To bring the facts even closer to Briarpark, what if the debt was modified to release liens (a change in credit support); the property at issue was subsequently sold to a third party for cash; and the cash proceeds were distributed to creditors in satisfaction of their claims? Such a transaction would appear to be particularly subject to recharacterization under Briarpark.

Second, applying a tax formalities view, significant modifications of DRE Recourse Debt could result in distressed debt being recharacterized as equity. Section 1.1001-3(f)(7)(ii) generally provides that the financial condition of an obligor is ignored in determining whether a deemed newly-issued debt instrument should be recharacterized as equity. Vitally, however, this rule does not apply where there is a substitution of a new obligor. Of course, many situations involving a deemed change from recourse to 89 Other issues include re-testing the debt instrument (and interest deductibility) under the AHYDO rules

and the many potential impacts on creditors (despite, in the case of an entity conversion, creditors not having taken any actions and there having been no impact whatsoever on creditors’ rights!).

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nonrecourse debt (or vice versa) resulting from changes in entity classification will also result in a change in obligor. Indeed, the later debt modification rules acknowledged that, even while concluding that there was no significant modification.

The tax consequences of recharacterizing DRE Recourse Debt as equity are, of course, potentially even more significant than in many other recharacterization issues. Few practitioners would expect that, by converting a corporate issuer to a DRE, they have actually created a partnership between the issuer’s parent and the issuer’s creditors!

(c) Partnership Considerations.

As discussed above, a distinct set of rules applies for the purpose of determining whether liabilities are recourse or nonrecourse for purposes of Sections 704 and 752 (and the regulations thereunder). However, as discussed below, the interaction among Sections 704 and 752, on one hand, and Section 1001, on the other hand, can result in surprising outcomes in determining the allocation of partnership items in restructuring contexts. Moreover, the application of the “partnership minimum gain” rules is rendered uncertain by confusing (and, probably, erroneous) drafting of those comparatively arcane provisions.

(i) Allocation of CODI vs. Allocation of Section 1001 Gain.

As discussed in detail above, depending upon the characterization of debt as recourse or nonrecourse under Section 1001-2, the discharge of such debt may give rise to CODI or gain under Section 1001. CODI will generally constitute ordinary income, while gain under Section 1001 will generally constitute a mix of ordinary income and capital gain.90

In the absence of a contrary provision in the partnership agreement, CODI is allocated to partners in accordance with such partners’ interest in partnership profits. Any alternative allocation is tested for “substantial economic effect” under Section 704 and the regulations thereunder.91 Sale gain under Section 1001 is subject to much different rules. As an initial matter, the partnership may allocate such items in a different way (subject to the rules generally governing partnership allocations). More importantly, however, to the extent any property with built-in gain was contributed by a partner to the partnership, Section 704(c) may require that any gain attributable to such assets be allocated to the contributing partner (and similar rules apply with respect to certain revaluations of

90 The specific rules governing the character of Section 1001 gain in the partnership context are outside

the scope of this paper.

91 See, e.g., Rev. Rul. 92-97, 1992-2 CB 124 (evaluating whether certain special allocations of CODI has substantial economic effect by reference to whether certain parties to whom deductions were specially allocated had a deficit restoration obligation); Rev. Rul. 99-43, 1999-2 C.B. 506 (holding that special allocations intended to offset CODI allocated to partners lacked substantial economic effect). A portion of the Gershkowitz opinion also evaluated changes to the applicable partnerships agreements that essentially represented special allocations of items intended to “zero out” partner capital accounts and, therefore, minimize tax liabilities associated with the allocation of CODI.

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partnership property). This distinction between the allocation of CODI, on one hand, and Section 1001 gain, on the other hand, can lead to substantially different results in economically similar partnership restructurings, as illustrated in more detail below.

In addition to these differences, the difference in character between CODI and Section 1001 gain is vital, and partners’ preferences will vary significantly depending upon their individual circumstances. CODI, again, will be ordinary income. Although the allocation of CODI to a partner will increase such partner’s outside basis in its partnership interest, because such partner’s loss in the partnership interest will generally be capital, rather than ordinary, the ability to claim such loss may be of little comfort. The cancellation of the partner’s interest in the partnership may well unlock losses that the partner was previously unable to use, which may take the “sting” out of the allocation of CODI. However, if the partner is a recent purchaser of the partnership interest, such partner may not have been allocated sufficient losses to offset such CODI. By contrast, a significant portion of any Section 1001 gain may be capital in nature and, accordingly, the capital loss that can be claimed with respect to the partnership interest would be available to offset such amounts.

Exacerbating this “character mismatch” issue is the way the bankruptcy and insolvency exclusions under Section 108 are applied in the partnership context. As noted above, each test is applied at the partner level, rather than the partnership level. Thus, if a partner is not itself insolvent or in bankruptcy, the exclusions are unavailable (even if the tax liability attributable to the debt restructuring renders the partner insolvent or bankrupt). If a partner is able to avail itself of one of these exceptions, it may well prefer an allocation of CODI, but otherwise, Section 1001 gain will be preferable in many circumstances.

The treatment of CODI in the partnership context is a particularly troubling issue in the context of public MLP restructurings. Public MLPs may have widely-traded units held by “mom and pop” investors that do not appreciate the peril they find themselves in. Indeed, such “mom and pop” holders might hold MLP units in retirement accounts, and the allocation of CODI to units held in retirements accounts may lead to allocations of UBTI to such accounts, putting the tax treatment of such accounts at risk.

[Illustration to be Added.]

(ii) Partnership Minimum Gain.

Specific regulations apply to allocations attributable to “nonrecourse liabilities,” which is defined, for these purposes, as a Section 752 Nonrecourse Liability (as opposed to being determined pursuant to Section 1001).92 Notably, this regulation expressly recognizes the distinction between determinations made under Section 752, on one hand, and Section 1001, on the other hand, in that it provides for specific rules for “partner

92 See Treas. Reg. § 1.704-2 (definition of “nonrecourse liability” contained in Section 1.704-2(b)(3)).

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nonrecourse debt” (or a “partner nonrecourse liability”), which is defined as Section 752 Recourse Liability that is nonrecourse for purposes of Section 1.1001-2.

The premise of these regulations is that allocations of items attributable to Section 752 Nonrecourse Liabilities cannot have “substantial economic effect” (generally a key to allocations being respected). Accordingly, such allocations must be allocated in accordance with partners’ “overall economic interests” in the partnership (which is often quite different from the economic deal parties reach for purposes of these allocations) unless the “minimum gain chargeback” rules are satisfied.93

The key problem with Section 1.704-2 is that it fails to address so-called “exculpatory” liabilities, i.e., situations where the debt is recourse to the partnership under Section 1.1001-2, but the debt constitutes Section 752 Nonrecourse Liabilities. Section 1.704-2(b)(2) states that “[t]o the extent a nonrecourse liability exceeds the adjusted tax basis of the partnership property it encumbers, a disposition of that property will generate gain that at least equals that excess (‘partnership minimum gain’).” As discussed below, however, that is true only if the liability is nonrecourse for purposes of Section 1.1001-2; if the liability is recourse for purposes of Section 1.1001-2, the amount of gain may be limited to the fair market value of the encumbered assets.

This issue throws into question the entire functioning of Section 1.704-2(b)(2) and, in turn, also poses problems for the application of Section 752 (where, as noted above, the allocation of Section 752 Nonrecourse Liabilities depends, in part, on each partner’s allocation of partnership minimum gain). The amount of “partnership minimum gain” is calculated by calculating the amount of gain that would arise if property subject to Section 752 Nonrecourse Liabilities was disposed of for no consideration other than full satisfaction of the liability--which, again, in the case of exculpatory liabilities, would be limited to an amount equal to the difference between tax basis and fair market value.94 In the event of a “book/tax” disparity, this amount is adjusted further--rather than being calculated based on the tax basis of the given assets, it is based on the book basis of the assets.95 From there, the amount of “nonrecourse deductions” that are subject to the rules of Section 1.704-2(b)(2) are, for any particular year, limited to the net increase in partnership minimum gain, as reduced for “aggregate distributions made during the year of proceeds of a nonrecourse liability that are allocable to an increase in partnership

93 As a technical matter, if the minimum gain chargeback rules are satisfied, allocations attributable to

Section 752 Nonrecourse Liabilities are “deemed” to accord with the partners’ interests.

94 Treas. Reg. § 1.704-2(d). Where property is subject to more than one liability, the liability must be allocated among the properties.

95 See Treas. Reg. § 1.704-2(d)(3). The simplest example of this situation is a circumstance where a partner contributes built-in gain property to a partnership. Under these circumstances, the book value of the property will equal fair market value, while there will be carryover tax basis. The rules under Section 704(c) control allocations with respect to such contributions. It should be noted that there theoretically should never be partnership minimum gain with respect to newly-contributed property: because book basis should equal fair value, no “book gain” should arise if such property is disposed of for no consideration other than satisfaction of the applicable debt.

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minimum gain.”96 Subject to certain exceptions, if there is a net decrease in partnership minimum gain for a particular year, “each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain.”97 Finally, partnership minimum gain is allocated among the partners in accordance with (a) nonrecourse deductions that have been allocated to them and the proceeds of distributions from Section 752 Nonrecourse Liabilities allocable to an increase in partnership minimum gain, minus (b) the partner’s share of the net decreases in partnership minimum gain (plus decreases attributable to certain revaluations), plus (c) certain amounts determined in connection with situations where “a recourse or partner nonrecourse liability becomes partially or wholly nonrecourse” (with such definitions, again, apparently determined by reference to Section 752 determinations, rather than determinations made under Section 1.1001-2).

In general, the discharge of a Section 752 Nonrecourse Liability that is also nonrecourse for purposes of Section 1.1001-2 will result in a decrease in the amount of partnership minimum gain. The amount of the decrease will track the full amount of the liability. The question is whether the rules work correctly in connection with the discharge of an exculpatory liability, where the amount of partnership minimum gain attributable to such liability is arguably limited to the fair market value of the applicable property, rather than the full amount of the debt. Section 1.704-2(e)(2) does specifically provide that cancellation of indebtedness income attributable to “partnership nonrecourse liabilities” is an item that should be allocated as a minimum gain chargeback. That would seem to support the idea that exculpatory liabilities should be treated as giving rise to partnership minimum gain in an amount determined as if they were nonrecourse for purposes of Section 1.1001-2. However, unless that position is adopted, in a situation where an exculpatory liability is discharged, it may not have any associated partnership minimum again, so any associated CODI may not be subject to the minimum gain chargeback requirement.

Unless Section 1.704-2 is interpreted to perform calculations on the basis that all Section 752 Nonrecourse Liabilities are also nonrecourse under Section 1.1001-2, partners may be able to enjoy the benefits of deductions attributable to exculpatory liabilities without the minimum gain chargeback rules applying to all such allocations.98 Moreover, the preamble to the regulations seems to contemplate that result,99 and its 96 Treas. Reg. § 1.704-2(c).

97 Treas. Reg. § 1.704-2(f)(1).

98 See, e.g., Burke, Exculpatory Liabilities and Partnership Nonrecourse Allocations, 57 Tax Law 33, 43-48 (2003) (evaluating minimum gain rules and concluding that they must essentially treat the full amount of an exculpatory liability as an amount realized).

99 See T.D. 8385 (Dec. 27, 1991) (“A partnership may have a liability that is not secured by any specific property and that is recourse to the partnership as an entity, but explicitly not recourse to any partner (exculpatory liability). Section 1.704-2(b)(3) of the final regulations defines nonrecourse liability by referring to the definition of nonrecourse liability in the regulations under section 752. Under that definition, an exculpatory is a nonrecourse liability. The application of the nonrecourse debt rules of §1.704-2-more specifically, the calculation of minimum gain-may be difficult in the case of an

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admonition that taxpayers should address exculpatory liabilities “in a manner that reasonably reflects the principles of section 704(b)” is arguably enough to require that approach. However, even the language in the preamble fails to appreciate that the amount of gain realized in connection with a disposition of property in satisfaction of recourse indebtedness under Section 1.1001-2 is limited to the fair market value of the property. Accordingly, the author does not believe a taxpayer would be unjustified in holding the Service to the definitions it has chosen to utilize. After all, the regulation expressly recognizes the distinction between determinations made under Section 752 and Section 1001 and specifically defines “nonrecourse liability” by reference to determinations made under Section 752, not Section 1001.

[Illustration to Be Added.]

4. Going Down the Rabbit Hole

The foregoing discussion highlights that (a) distinguishing between recourse and nonrecourse debt for tax purposes is not as easy as it may appear to be; and (b) the distinction can have dramatic, and difficult-to-defend, consequences. The following examples (which are, of course, not remotely exhaustive), illustrate some surprising outcomes (and potential tax planning opportunities) that result from the combination of these rules, especially in light of the uncertainty created by the 2016 PLR.

(a) Hypothetical #1 - Acquisitive “D” or “G” Reorganization.

Parent owns 100% of Issuer, a DRE. Issuer has assets with a FMV of $200 and a tax basis of $150, and has issued $300 of debt that is recourse to the issuer under state law. Parent has $100 of NOL as a result of Issuer’s operations, but is otherwise a shell company with no assets, and it has not guaranteed the Issuer debt. To restructure Issuer’s debt, (a) Issuer contributes all or substantially all of its assets to NewCo in exchange for 100% of the stock of NewCo, and (b) immediately thereafter, Issuer distributes the NewCo stock to Issuer’s creditors in full and final satisfaction of the Issuer debt. NewCo never assumes the Issuer debt under state law and Issuer’s creditors agree that the transfer of Issuer’s assets to NewCo is free and clear of liens.

Assuming other applicable requirements are satisfied, this transaction is either a “D” or a “G” reorganization100 of Parent under Sections 368 and 354 (as opposed to the 2016 PLR, which was a “G” reorganization under Sections 368 and 355). Under Section 381(a)(2), NewCo is a 381 successor of Parent since the requirements of subparagraphs

exculpatory liability, however, because the liability is not secured by specific property and the bases of partnership properties that can be reached by the lender in the case of an exculpatory liability may fluctuate greatly. Section 1.704-2 does not prescribe precise rules addressing the allocation of income and loss attributable to exculpatory liabilities. Taxpayers, therefore, are left to treat allocations attributable to these liabilities in a manner that reasonably reflects the principles of section 704(b).”).

100 The transaction would constitute a “G” reorganization if Parent is in chapter 11; otherwise, it would constitute a “D” reorganization.

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(A) and (B) of Section 354(b)(1) are satisfied.101 As a result, NewCo succeeds to Parent’s $100 NOL if the NOL is not otherwise reduced as a result of this transaction.

Before the 2016 PLR, the author believes that the consensus view of the tax bar was that this transaction gave rise to $100 of CODI (Debt of $300 less FMV of $200). After the 2016 PLR, however, the answer is far less clear. The primary distinction between this transaction and the 2016 PLR transaction is that this is an “acquisitive” “D” or “G” reorganization, as opposed to a “divisive” “G” reorganization. But nothing about the 2016 PLR limits its implications to divisive reorganizations. Accordingly, the 2016 PLR would imply that (a) Issuer’s debt is nonrecourse debt for purposes of Section 1.1001-2; (b) this transaction gives rise to $150 of gain under Section 1001 ($300 of debt less $150 of tax basis); (c) Section 108(a) is inapplicable (because Section 108(a) does not apply to Section 1001 gain; (d) the $150 of Section 1001 gain is excluded from income under Section 361(c); and (e) NewCo is not treated as having assumed Issuer debt in excess of the tax basis contributed to NewCo under Section 357(d). As a result, the 2016 PLR would imply that, following the distribution of the NewCo stock to Issuer’s creditors, NewCo has $100 of NOLs and assets with a basis of $150.

This probably is not the proper result. This transaction is difficult to economically distinguish from a transaction pursuant to which Issuer’s creditors receive Parent stock, and that transaction would clearly result in CODI (and a resulting elimination of NOLs) under Section 108(e)(8) (and Gershkowitz). It may be possible to distinguish the 2016 PLR on the basis that, because NewCo is a Section 381 successor of Parent, Issuer’s creditors should be treated as having received Parent stock for purposes of determining whether this transaction gives rise to Section 1001 gain or CODI: such a theory would have the effect of limiting the particularly good result achieved in the 2016 PLR to “divisive” reorganizations. That would have the effect of encouraging taxpayers to “find” divisive reorganizations where they otherwise do not make sense, but that could be policed by the various requirements of Section 355, including the business purpose doctrine.

Alternatively, under a creditors’ rights view of the characterization of debt as recourse or nonrecourse under Section 1001, the Issuer debt would be viewed as recourse debt, which leads to the transaction generating CODI, but that conclusion is, of course, irreconcilable with the 2016 PLR. Moreover, that reasoning would not address a situation in which the Issuer debt is, in fact, nonrecourse debt under state law--a fact that points to potential tax planning opportunities.

What if, in advance of a restructuring, Issuer and Issuer’s creditors agreed to modify the Issuer debt to change it to being nonrecourse debt—but secured by all of the Issuer’s assets—under state law? Whether such a modification would be treated as a significant modification under Section 1.1001-3 would depend, in large part, on whether the 2016 PLR stands for the proposition that the tax formalities view of DRE debt controls

101 By contrast, because the 2016 PLR involved a “divisive” reorganization, Controlled was not a Section

381 successor of Distributing in that transaction.

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for purposes of Section 1.1001-3 as well as 1.1001-2. If the tax formalities view does control for purposes of Section 1.1001-3, then such a modification would arguably be a “nothing” for tax purposes: the Issuer debt would be treated as nonrecourse debt of Parent both before and after the modification, and upon the subsequent restructuring, the same analysis above would apply, without any questions about whether the creditors’ rights or tax formalities approach controls with respect to determining whether the above transaction gives rise to gain or CODI.

Importantly, though, even if different rules apply for purposes of Section 1.1001-2 and 1.1001-3, i.e., even if the creditors’ rights view continues to control for Section 1.1001-3, the original collateral exception would arguably apply to the conversion of the Issuer debt from recourse to nonrecourse. As discussed above, this analysis would depend on when the “original collateral” is tested--and whether step transaction principles would collapse the subsequent restructuring together with earlier modification of the Issuer debt.

(b) Hypothetical #2 - “F” Reorganization of Issuer Followed By Acquisitive “D” or “G” Reorganization.

Issuer is a corporation that has assets with a FMV of $200 and a tax basis of $150, and has issued $300 of debt that is recourse to Issuer under state law. Issuer has $100 of NOL.

On Date 1, the owner of Issuer forms NewCo and contributes 100% of the stock of Issuer to NewCo. Issuer converts to an LLC treated as a DRE. NewCo does not assume or guarantee the Issuer debt.

The obvious first question here is whether this run-mill “F” reorganization results in a significant modification of the Issuer debt, and that depends on one’s view of whether the debt modification rulings issued before the 2016 PLR continue to have any vitality. If they do, although the Issuer’s conversion to a DRE is a change in obligor (at least under the later rulings), that does not result in a significant modification because exceptions apply. Moreover, there is no change of the debt from recourse to nonrecourse because creditors’ rights are unaffected. However, if, in light of the 2016 PLR, one concludes that the tax formalities view applies, then the Issuer debt has been converted from recourse debt to nonrecourse debt. However, as discussed in connection with Hypothetical #1, the original collateral exception may apply (depending on the applicable timing rule).

If the original collateral exception does not apply, there is a significant modification of the debt at this step. Under Section 108(e)(10), as well as Revenue Ruling 91-31, one would expect that this significant modification may give rise to CODI (to the extent the issue price of the “new” debt is less than the adjusted issue price of the “old” debt).

If the original collateral exception does apply, is there another theory pursuant to which there may be a significant modification? Importantly, because there is a change in obligor even under the more recent debt modification rulings, any decline in the financial condition is relevant to retesting for debt/equity. But, the financial condition of whom? NewCo, not Issuer, is the new obligor for tax purposes. NewCo has not guaranteed the

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debt. To be sure, NewCo is worth nothing—its only asset is its stock of Issuer, and Issuer’s liabilities exceed its FMV, so the stock of Issuer is worthless—but it is unclear whether that fact would lead the Issuer debt to be recharacterized as stock of Issuer (which would have the effect of causing Issuer to be converted into a partnership), and because the debt is not recourse to NewCo, it is difficult to see how the debt in fact could be recharacterized as stock of NewCo.

On Date 2, Issuer and NewCo file for bankruptcy, and consummate a “G” reorganization transaction as outlined in Hypothetical #1.

The subsequent restructuring raises essentially the same issues as discussed in Hypothetical #1. Importantly, however, in Hypothetical #2, the taxpayer has converted a certain CODI situation into a situation that may, under the 2016 PLR, completely shield NOLs from any reduction. That fact may lead the Service or the courts to be even more aggressive in attempting to utilize step transaction principles to essentially ignore the first-step “F” reorganization and to say that the stock of the newly-formed acquiring company was distributed in satisfaction of recourse debt, thereby giving rise to CODI (resulting in the elimination of tax attributes), rather than Section 1001 gain.

A taxpayer might counter any effort to ignore the first-step “F” reorganization, even if it was done as part of a plan that contemplated the later restructuring, by arguing that “F” reorganizations generally are not subject to being eliminated under step transaction theories. Specifically, Section 1.368-2(m)(3)(ii), “[r]elated events that precede or follow the potential F reorganization will not cause that potential D reorganization to fail to qualify as a reorganization under section 368(a)(1)(F).” In other words, the fact that there was a subsequent restructuring cannot wipe away the “F” reorganization. However, the same provision goes on to provide that “[q]ualification of a potential F reorganization as a reorganization under section 368(a)(1)(F) will not alter the character of other transactions for federal income tax purposes, and step transaction principles may be applied to other transactions without regard to whether certain steps qualify as a reorganization or part of a reorganization under section 368(a)(1)(F).” Accordingly, the Service would likely have the better argument that it could treat the subsequent “G” reorganization as a satisfaction of recourse debt, rather than nonrecourse debt (as long as the Service could otherwise demonstrate that step transaction principles apply), but the issue is not clear from doubt.

(c) Hypothetical #4 - DRE Issuer, Subsequent Guarantee By Parent, Followed By Turnover of Assets.

Issuer is a DRE owned by Parent that has issued debt that is nonrecourse to Issuer under state law. Parent owns no assets other than the stock of Issuer.

On Date 1, Parent guarantees the Issuer debt on a recourse basis.

What is the effect of the Parent’s guarantee? Under a tax formalities view of DRE debt, this guarantee arguably causes the debt to change from being nonrecourse debt of Parent to recourse debt of Parent. A change in the character of debt from nonrecourse to recourse is a per se significant modification under Section 1.1001-3. That would be

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the case even though Parent is a shell, and even if the Issuer debt was already secured by a blanket lien on all of Issuer’s assets, such that the Parent guarantee has no economic impact on the likelihood that Issuer’s creditors will be repaid.

The answer to this question is more fact-specific if the creditors’ rights view of DRE debt continues to apply. The debt was nonrecourse debt prior to the guarantee. That said, under the later debt modification rulings, the obligor on such debt would seem to be Parent, rather than Issuer; in that case, the guarantee would presumably still cause the debt to change from being nonrecourse debt to recourse debt, again, potentially despite any economic change. One might alternatively argue that the Parent guarantee should not be viewed as causing the debt to become recourse and, rather, the guarantee should be treated as a change in credit support. Such a change in credit support would not give rise to a significant modification unless the guarantee resulted in a change in payment expectations. Because Parent is a shell, the guarantee would only result in such a change if Issuer had significant assets that were not pledged in support of the Issuer debt (because, in such case, the guarantee reflects a residual equity interest in those unpledged assets).

In the event the guarantee does give rise to a significant modification, as discussed in the context of Hypothetical #1, even though the debt is initially nonrecourse, under Section 108(e)(10) and Gershkowitz, in the absence of the application of step transaction principles to a later transaction, there should be CODI rather than gain under Section 1001.

On Date 2, Issuer’s creditors foreclose on the Issuer collateral. What effect?

Under the debt modification rulings, again, the answer is unclear. If the debt continues to be viewed as nonrecourse debt, then the turnover of collateral should result in Section 1001 gain. However, because the debt may now be viewed as recourse debt even under the debt modification rulings, the transfer may give rise to CODI. Moreover, if Issuer owned assets other than the collateral, when Parent turns over the stock in Issuer on account of Parent’s guarantee, the deemed transfer of Issuer’s remaining assets presumably should give rise to CODI since such assets did not constitute collateral.

By contrast, as noted above, under the 2016 PLR, the Parent guarantee arguably rendered the debt recourse and, presumably, the turnover of assets would give rise to CODI, rather than sale gain.

Again, to the extent the Parent guarantee was executed in contemplation of the restructuring (e.g., to transform the debt into recourse debt to enable the use of the bankruptcy or insolvency exclusions for any CODI), the Service may attempt to apply step transaction principles to cause the assets to have been turned over in satisfaction of nonrecourse debt. Notably, it is difficult to see how such recast could apply if Issuer had any assets other than the assets that constituted collateral for the debt prior to the guarantee, so the Service would seemingly be limited to arguing that Section 1001 gain arises with respect to a portion of the debt discharge.

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(d) Hypothetical #4 - Change in Nature of Debt Accompanied By Asset Disposition.

Issuer is corporation that is wholly owned by Parent. Issuer’s debt is initially recourse to Issuer under state law.

Pursuant to a single set of transactions, (a) Issuer’s debt is converted into nonrecourse debt for purposes of Section 1.1001-2 (either by an actual modification to the terms of the debt, or by a conversion of Issuer into a DRE); and (b) Issuer sells certain of its assets to a third party buyer for cash. Is there a significant modification of the debt? It would seem so: the debt has been converted from recourse to nonrecourse debt, and the assets securing such debt immediately after the modification are different than the assets that secured the debt immediately before the modification. This would appear to be the case even though the cash constitutes “proceeds of collateral” under Article 9 of the UCC, and even though the transaction was (presumably) permitted under the debt documents.

Is that the right result? In the author’s view, the original collateral exception in general is both overly broad in some circumstances and overly narrow in others. Immediately after the above series of transactions occurs, Issuer’s creditors are in exactly the same position as they were prior to the modification of the debt. Indeed, they have a lien on the cash generated from the sale of their original collateral, either as an initial matter under the debt documents or under Article 9’s “proceeds of collateral” provisions. Moreover, so long as the cash can be traced, anything that the Issuer buys with the cash (e.g., new assets) will also constitute “proceeds of collateral,” and creditors’ liens will attach to such assets. In that way, the exception is too narrow.

By contrast, presume the asset sale referenced above had not occurred. If the modification is actually a modification to the terms of the debt instrument (as opposed to a conversion of Issuer into a DRE), Issuer is now potentially free to raise financing from other sources and acquire assets that Issuer’s original creditors do not have a claim to, whereas before, those creditors would at least have a recourse claim against such newly-acquired assets. Perhaps Issuer will now comparatively neglect the assets that constitute collateral for the modified debt. Perhaps, over time, accounts receivable and cash received from the operation of the assets (which arguably do not constitute “proceeds of collateral” and would, therefore, potentially be free of liens from the original debt) will become a disproportionate percentage of Issuer’s assets. In any of these circumstances, the original creditors’ rights will have been significantly changed by the modification of the debt.

As discussed below, this issue of being both overbroad and overnarrow is indicative of a fundamentally flawed provision that fails to focus on the question that should underlie any analysis under Section 1.1001-3: whether a debt modification is economically significant.

(e) Hypothetical #5 - Sale of DRE Subject to Liabilities.

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Parent wholly owns Issuer, a DRE of Parent. Issuer has issued debt that is fully recourse to Issuer under state law. Buyer purchases Issuer, with Issuer remaining subject to all of its liabilities. Is there a significant modification of the Issuer debt?

Under the 2016 PLR, the answer to this is reasonably clear: no. The debt is initially nonrecourse debt of Parent and, as a result of the sale, the debt becomes nonrecourse debt of Buyer. A change in obligor on nonrecourse debt does not constitute a significant modification.

Under the debt modification rulings, the answer is unclear, again, because of those rulings’ disparate treatment of obligors, on one hand, and the nature of debt as recourse or nonrecourse, on the other hand. Under the later debt modification rulings, the Issuer debt is, initially, recourse debt of Parent. As a result of the purchase, the debt becomes recourse debt of Buyer. Whether this change in obligor constitutes a significant modification will, therefore, turn on whether Parent had any significant assets other than Issuer, because the change in obligor will be a significant modification unless Buyer is viewed as acquiring all of Parent’s assets. That is a bizarre result: the debt modification rulings purport to be focused on creditors’ rights, and there is no doubt that creditors’ rights have not changed as a result of this purchase. The outcome is more straightforward under the earlier debt modification rulings, pursuant to which the debt is recourse debt of Issuer both before and after the transaction at issue.

The analysis becomes even more muddled if Parent originally guaranteed the Issuer debt. First, assume Buyer does not assume that guarantee. Under the 2016 PLR, the debt has changed from being recourse debt of Parent to nonrecourse debt of Buyer. However, the original collateral exception may apply to prevent that change from being a significant modification, so long as the loss of the Parent guarantee does not result in the loss of collateral for the loan (i.e., so long as Parent did not have other assets). Under the later debt modification rulings, the debt would apparently be treated as initially recourse debt of Parent, and then recourse debt of Buyer, resulting in substantially the same analysis as above. An additional question would arise with respect to whether the loss of the Parent guarantee results in a change in payment expectations, but that could be the case only if Parent had assets other than Issuer, in which case the change in obligor would result in a significant modification. Finally, under the earlier debt modification rulings, the debt would be recourse debt of Issuer before and after the transaction, and the only relevant question would be whether the loss of the Parent guarantee results in a change in payment expectations.

Finally, what if Parent guaranteed the debt, and Buyer assumed such guarantee? In such a circumstance, somewhat oddly, the same analysis would appear to apply regardless of whether one is utilizing the framework of the 2016 PLR or the significant modification rulings. Under the 2016 PLR, the debt is initially recourse debt of Parent and becomes recourse debt of Buyer, and the relevant question is whether Buyer has acquired all of Parent’s assets. Under the later debt modification rulings, the same analysis apparently applies. And, under the earlier debt modification rulings, the question is whether the substitution of the Parent guarantee for the Buyer guarantee constitutes a change a change in payment expectations. The most relevant question, there, is whether

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Buyer is a materially stronger (or weaker) credit support party, which fundamentally turns on (a) whether Parent had any assets other than Issuer and (b) whether Buyer has any assets other than Issuer. Only the relevance of Buyer’s assets other than Issuer represents a “tweak” to the analysis compared to the analysis that would apply under the 2016 PLR or the later debt modification rulings.

5. So, How Do We Fix This Mess?

The foregoing discussion, along with years of inconsistent cases, searching articles, numerous conference presentations, and inconsistent Service guidance, illustrate that this area has a significant amount of inconsistency and uncertainty. How should those issues be fixed?

First of all, for many of these issues, one should go to the source. The distinction between the treatment of recourse and nonrecourse debt enshrined in Tufts and Section 1.1001-2 is not rational. Instead, the “bifurcation” approach should be applied equally to discharges of both recourse and nonrecourse debt. Such a fix arguably could be accomplished through changes to Section 1.1001-2, with the one potential “hiccup” being Section 7701(g), which arguably provides a statutory hook for treating any disposition of an asset in satisfaction of nonrecourse debt as being for an amount equal to such debt. However, in the author’s view, the Service would be within its authority to issue a regulation interpreting Section 7701(g) in a narrow way to make it apply only where an asset subject to nonrecourse debt is disposed of to a third party in a way where the nonrecourse debt remains outstanding. Indeed, such an interpretation would be consistent with the way Section 357(d) was interpreted in the 2016 PLR.

If that is seen as a “bridge too far,” to address the most damaging impact of the distinction between Section 1001 gain and CODI, the Service could implement a regulation altering the interpretation of Section 108(a). Specifically, such a regulation would provide that Section 1001 gain that arises in connection with the discharge of a liability is subject to exclusion under Section 108(a) to the extent such gain reflects the difference between FMV and debt. This would implement the bifurcation approach to avoid unjustifiably rendering restructuring taxpayers administratively insolvent because of the distinction between recourse and nonrecourse debt.

These changes would eliminate potential motivations to “elect” between recourse and nonrecourse debt by engaging in first-step transactions intended to change the nature of debt. Moreover, these approaches would disable the possibility of relying on the 2016 PLR to generate situations in which debtors are able to avoid attribute reduction in connection with the discharge of liabilities. Finally, these changes would minimize the risk that the distinction between recourse and nonrecourse debt drives issuers into administrative insolvency resulting from inappropriately high amounts of gain under Section 1001.

Failing any of those broader changes, at the very least, for all purposes of Section 1001 (i.e., both 1.1001-2 and 1.1001-3), the “creditors’ rights” view of DRE-issued debt should be adopted. Specifically, the views of the earlier debt modification rulings, which

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looked to creditors’ rights to determine both the nature of the debt and the obligor on such debt, should be adopted for all purposes of Section 1001. The current “mix and match” approach is unsupportable, and the earlier (and stronger) version of the creditors’ rights view best reflects the economic reality of DRE-issued debt.

Further to the goal of eliminating unnecessary distinctions between the treatment of recourse and nonrecourse debt, many of those distinctions should be eliminated from Section 1.1001-3. The guiding principle of the “bright line” tests in Section 1.1001-3 should consistently look to whether a particular modification is economically significant. Thus, in the author’s view:

• Any change from recourse to nonrecourse or nonrecourse to recourse should be a per se significant modification, because of the dramatic going-forward implications of such a change. The one exception to this general rule should take the form of an anti-avoidance rule, pursuant to which such a change does not constitute a significant modification if a purported change in the nature of a debt instrument does not actually constitute a real change. For example, take a special purpose entity that is not permitted to obtain any assets other than assets that constitute collateral for a debt instrument. In such a circumstance, the debt instrument is functionally recourse to the entity, even if the debt instrument does not actually have a claim against such entity. Taxpayers should not be able to “engineer” a significant modification by changing the nature of the debt instrument in this circumstance.

• Changes in security or credit enhancements should be evaluated based on whether they result in a change in payment expectations, regardless of whether the debt is recourse or nonrecourse.

• Changes in the obligor of a nonrecourse debt instrument should not constitute a significant modification. Although this rule does not function properly in the case of DRE debt under the Service’s guidance (as illustrated above), the fundamental premise of this rule is based on the fundamental premise that the obligor of a nonrecourse debt instrument is unimportant because a change in obligor does not impact the economic expectations of creditors. With that acceptable as the fundamental premise, the author believes that a general rule, applicable to both nonrecourse and recourse debt, could be adopted, pursuant to which a change in obligor is a significant modification only if the change results in a change in payment expectations. This simplifies the analysis in the case of recourse debt and eliminates an arguably unnecessary “first step” barrier in such cases.

In the context of the partnership minimum gain rules, as discussed above, the purpose of those rules is intended to prevent partners from being specially allocated noneconomic nonrecourse deductions, unless such partner is exposed to having such deduction “clawed back” in certain realization events. To accomplish that goal, notwithstanding this paper’s proposed elimination of the concept of Tufts gain, the minimum gain rules should operate as if the assets that are supporting the applicable nonrecourse deductions are disposed of for an amount equal to the applicable nonrecourse debt. This does not represent an inconsistency in this paper’s proposals.

55 KE 48683530.25

Rather, it acknowledges the different policy goals and purposes of the Subchapter K allocation rules, on one hand, and the rules that determine the nature of and amount of income, gain, loss, or deduction under Section 1001, on the other hand.

One final potential place for exploration is whether changes should be made to eliminate the distinction between scenarios where assets are turned over in satisfaction of debt, on one hand, and “equitization” scenarios, on the other hand. In general, under Gershkowitz and Revenue Ruling 91-31, if there is no turnover of assets of any kind, none of the built-in gain in a debtor’s assets will be recognized in connection with a restructuring; rather, the only item of income that will accrue is CODI equal to the difference between the FMV of the property received by creditors and the amount of outstanding debt. In other words, in “equitization” scenarios, not only does the character of gain or loss change, but the total amount of gain or loss also changes. This distinction has a distortive effect on restructuring transactions: if assets have economic “built-in gain” (not just Tufts gain) and an issuer lacks sufficient tax attributes to offset such gain, to avoid generating administrative tax liabilities, creditors may have to accept equity, rather than foreclosing on their collateral.

In the author’s view, this distinction is justified. When assets are turned over to creditors, those creditors will obtain FMV tax basis in such assets. By contrast, when creditors are equitized, assets retain the built-in gain that they had before the restructuring was consummated (and, such gain may be increased as a result of reduction in tax basis under Section 108(b)). The distinction is fundamentally the same as the distinction that arises in any ordinary-way M&A transaction when parties are evaluating whether to purchase the stock of a corporation or, instead, to buy the corporation’s assets: taxing the built-in gain in such assets is not justifiable if the new owners have carryover basis in such assets.

The proposals in this paper would overturn decades of authority and distinctions between the treatment of recourse and nonrecourse debt. That is no small ask. However, the uncertainty—and renewed focus on these issues—spawned by the 2016 PLR provides as good an opportunity as any to make changes that simplify and rationalize this area of law and relieve taxpayers of the burdens (and potential planning opportunities) presented by fundamentally irreconcilable authorities and irrational outcomes.

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DRAFT IN PROGRESS - October 23, 2017 - Remains … 4 - Recourse...DRAFT IN PROGRESS - October 23, 2017 - Remains Subject to Ongoing Revision and Review KE 48683530.25 The Uncertain