Tax consequences of liquidating a partnership

Accordingly, when the lender discharged the loan and foreclosed upon the collateral property, the partnership taxpayer reported cancellation of debt (or COD) income.

The partners, in turn, applied the insolvency exception and did not pay tax on this income, to the extent of their respective insolvencies. 300 (1983) (holding that a taxpayer’s amount realized in the disposition of property includes the amount by which a nonrecourse debt exceeds the property’s FMV).

In its memorandum, the IRS concluded that the IRC Section 752 definition of a partnership recourse loan is limited to the determination of a partner’s basis, because Treasury Regulation 1.752-1(a) specifically states that these definitions of recourse and nonrecourse liabilities apply to only that section.

The Section 752 allocation tests and the general partner basis principles address the issue of whether a debt is recourse or nonrecourse to the partners – and not to the partnership. It is possible for a debt to be recourse to an individual partner, for Section 752 purposes and, yet, be nonrecourse to the partnership borrower.

This article presents a primer on the applicable law and examines the IRS’ position in this recent memorandum. IRC Section 752 defines a partnership loan as one in which a partner or related person bears the economic risk of that liability.

A partner or related person bears the economic risk of that liability if that individual would be obligated to repay the loan, if the partnership were to constructively liquidate.

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However, when the lender discharges the loan and forecloses upon the property, the partnership has acquired an economic benefit.

The relevant partnership loan documents did not specify whether the loan was recourse or nonrecourse.

In addition, these same loan documents did not specify that the partnership taxpayer was unconditionally and personally liable for the repayment of the loan if the collateral property was insufficient to fully repay the loan.

The IRC Section 704b regulations present this possibility but the Code section does not define this classification of liability.

Case law, however, defines nonrecourse debt as debt in which the creditor’s right of recovery is limited to the collateral, or the particular asset securing the liability.

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