In Action on Decision 2015-01 the IRS announced that it will not follow the Tax Court’s decision in four cases that were decided on the same day in 2004 that involved the interaction of the bankruptcy code and taxation of partners on cancellation of debt income.
The cases in question were:
- Estate of Martinez v. Commissioner, T.C. Memo. 2004-150
- Gracia v. Commissioner, T.C. Memo. 2004-147
- Mirarchi v. Commissioner, T.C. Memo. 2004-148; and
- Price v. Commissioner, T.C. Memo. 2004-149
The issue involved is the quirk in the provisions of IRC §108 that provide for an exclusion from gross income the amount of cancellation of debt income in certain circumstances.
Under IRC §108(a)(1)(A) “[g] ross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if…the discharge occurs in a title 11 case...” “Title 11” refers to the US Bankruptcy Code.
Specifically, IRC §108(d)(2) provides “[f]or purposes of this section, the term ‘title 11 case’ means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.”
Further down in §108 we find §108(d)(6) which provides “[i]n the case of a partnership, subsections (a), … shall be applied at the partner level.”
The IRS has interpreted those two provisions to mean that the individual partner can only claim the bankruptcy exclusion if the partner him/herself is a party to a bankruptcy proceeding.
However in the four cases cited above the Tax Court did not require the partners to themselves have been in bankruptcy in their individual capacities to take benefit of the exclusion under IRC §108(a)(1)(A).
The IRS described the facts in the cases as follows:
The taxpayer was a general partner in a partnership and personally guaranteed some of the partnership’s debts. The partnership initiated a case under title 11 of the United States Code (relating to bankruptcy). The partners in the partnership, including the taxpayer, reached a settlement agreement with the trustee of the bankruptcy estate, under which they would make payments to the partnership’s bankruptcy estate in exchange for the release of claims or potential claims of creditors against them relating to the partnership. The bankruptcy court approved the agreement, and discharged and released the partners from all liability related to the partnership, their status as general partners, and their personal guarantees of partnership debts. The same order provided that each partner “is subject to the jurisdiction of the Bankruptcy Court.”
The taxpayer did not include the cancellation of debt income (COD income) allocated to him by the partnership on his tax return for the year of the discharge. In the notice of deficiency, the Service rejected the taxpayer’s claim to an exclusion of the partnership COD income.
The Tax Court concluded that since the bankruptcy court took it upon itself to discharge any liability on the part of the partners, the Court claimed jurisdiction over the taxpayers in this regard and the discharge was granted pursuant to a plan approved by the Court.
The IRS disagreed with the Court’s view. First, the IRS claims that the Tax Court holding is at odds with Congressional intent in enacting the “test at the partner level” rule found in §108(d)(6) described above. As the AOD notes:
In discussing the addition of section 108(d)(6), Congress explained that discharge of a partnership debt is an item of income allocated separately to each partner pursuant to section 702(a). Congress indicated its intent to limit the scope of section 108(a)(1) to bankrupt or insolvent partners, and not to all partners of a bankrupt partnership. “The tax treatment of the amount of discharged partnership debt which is allocated as an income item to a particular partner depends on whether that partner is in a bankruptcy case, is insolvent (but not in a bankruptcy case), or is solvent (and not in a bankruptcy case). . . . [I]f the particular partner is bankrupt, the debt discharge amount is excluded from gross income pursuant to amended section 108. . . .” S. Rep. No. 961035, at 21, 19802 C.B. 620, 631.
The legislative history further explains that the income tax treatment of debt discharge in bankruptcy is intended to preserve the debtor’s “fresh start” after bankruptcy by excluding COD income from the debtor’s income so that “the debtor coming out of bankruptcy . . . is not burdened with an immediate tax liability.” S. Rep. No. 961035, supra, at 10, 19802 C.B. at 624.
Thus, the AOD concludes:
The Tax Court’s ruling is inconsistent with the structure of section 108 and underlying Congressional intent. The taxpayer was not under the jurisdiction of the bankruptcy court in a title 11 case as a debtor. The partnership, not the taxpayer, filed the petition in the bankruptcy court. The taxpayer was not a “person . . . concerning [whom] a case under this title [title 11] has been commenced.” 11 U.S.C. 101(13). Section 108(a) applies at the partner level. The exclusion in section 108(a)(1)(A) applies only to partners who are debtors in bankruptcy in their individual capacities and need a “fresh start.” The taxpayer was not in bankruptcy in his individual capacity and, therefore, did not need a “fresh start.” The taxpayer was not entitled to exclude his shares of the partnership COD income under section 108(a)(1)(A).
Based on that analysis, the AOD announces nonacquiesence with the decision.
Of course the fact that the IRS doesn’t agree with the Court doesn’t change the fact that the Court’s decision is what matters. However it does mean the IRS is likely to refuse to budge on this issue at exam and would consider accepting a negative ruling at the trial court level to enable the IRS to appeal a similar case to the applicable Circuit Court of Appeals to obtain a reversal if the Tax Court itself will not reconsider its logic.
As well, it’s important to note when reading the decisions in question that the Tax Court very specifically based its ruling on the bankruptcy court claiming jurisdiction over the obligations of partners who were themselves filing for bankruptcy. The Court would almost certainly not reach the same result if the bankruptcy court did not specifically address its jurisdiction over the liabilities of individual partners.
Presumably the IRS has decided to bring forth this nonacquiescence at this time because cases are now beginning to come up from partnerships that failed due to the real estate crisis in the middle of the last decade. Advisers with clients who were involved in such partnerships should consider reviewing both the AOD and the underlying cases in determining reporting positions for individual partners.