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disparate treatment between recourse
debt and nonrecourse debt makes it crit-
ical for taxpayers to determine whether
debt is nonrecourse or recourse under
these circumstances.
In Letter Ruling 202050014, LLC1
was a DRE of Distributing, and Distrib-
uting was not personally liable for any of
the LLC1 debt. Then, in the proposed
transactions, the LLC1 lenders canceled
all of the LLC1 debt in exchange for
all of the assets of LLC1. In the let-
redesignation as Sec. 61(a)(11) by Sec- than the amount of the debt canceled, ter ruling, the IRS first ruled that the
tion 11051 of the law known as the Tax the consequences are bifurcated. First, LLC1 debt was treated as a nonrecourse
Cuts and Jobs Act, P.L. 115-97) and Sec. the debtor will recognize Sec. 1001 gain liability of Distributing for purposes
108(a) did not apply to the cancellation (or loss) to the extent that the FMV of of Regs. Sec. 1.1001-2. Therefore, the
of debt owed by its disregarded entity the property received exceeds (or is less cancellation of the LLC1 debt fell under
(DRE). than) the basis of the property. Second, Tufts, resulting in an amount realized
the debtor will recognize cancellation- equal to the amount of the outstanding
Facts of Letter Ruling 202050014 of-debt (COD) income under Sec. debt, and former Sec. 61(a)(12) and Sec.
In Letter Ruling 202050014, a corpora- 61(a)(11) in an amount equal to the 108(a) did not apply to the cancellation
tion, Distributing, was the common excess of the adjusted issue price of of the LLC1 debt. Second, the IRS ruled
parent of a group that included corpo- the debt (within the meaning of Regs. that the potential Tufts gain would not
rations and DREs (the Distributing Sec. 1.1275-1(b)) and the FMV of be recognized by Distributing, provided
Group). Distributing directly owned the property. that the proposed transaction qualified
100% of LLC1, which was a DRE. The consequences for the same as a tax-free reorganization under Sec.
LLC1 had outstanding debt consisting transaction can be different if the debt is 368(a)(1)(G).
of first lien debt, second lien debt, and nonrecourse (i.e., debt where the lender Letter Ruling 202050014 is not
unsecured debt (the LLC1 debt). The is only permitted to seize the collateral the first letter ruling in which the
LLC1 debt was not, and never had been, specified in the loan agreement). Gen- IRS has ruled the debt of a DRE was
guaranteed by Distributing. erally, if nonrecourse debt is canceled nonrecourse debt of a regarded entity.
Pursuant to a proposed plan of in exchange for the property that is Under similar facts, the taxpayer in
restructuring, the Distributing Group subject to the debt, then the debtor will Letter Ruling 201644018 sought to
contributed all the assets that it directly instead treat the amount of the debt as engage in a proposed transaction pursu-
owned to LLC1, then LLC1 formed the amount realized in exchange for the ant to a bankruptcy. In Letter Ruling
a new corporation (Newco) and con- property for purposes of Sec. 1001, even 201644018, the IRS also held that debt
tributed all of its assets to Newco in if the amount of the debt exceeds the of a DRE, where the regarded owner
exchange for Newco stock, cash, and value of the property exchanged. Thus, was not personally liable, was treated as a
newly issued Newco debt. LLC1 then the debtor will have gain under Sec. nonrecourse debt of the regarded owner.
planned to distribute all of the property 1001 to the extent the amount of the The IRS also ruled that the cancellation
that it held to LLC1’s creditors in satis- debt exceeds the basis of the property of the DRE debt resulted in an amount
faction of the LLC1 debt. Finally, LLC1 (Tufts gain), unless another provision of realized under Sec. 1001 in the amount
planned to liquidate, and any equity the Code (e.g., Sec. 361) provides for of the debt, that former Sec. 61(a)(12)
IMAGE BY ANTON MELNYK/ISTOCK Background of cancellation of COD income) and Sec. 108(a) (regard- recognition treatment under Sec. 361(c).
and Sec. 108(a) did not apply, and any
tax-free treatment (see Tufts, 461 U.S.
held by Distributing was canceled for
potential Tufts gain was eligible for non-
300 (1983)).
no consideration.
Therefore, Sec. 61(a)(11) (regarding
nonrecourse debt: Tufts
Planning considerations
ing exclusion of COD income) may
Generally, when a lender cancels re-
not apply when there is a cancellation
Based on Letter Ruling 201644018 and
Letter Ruling 202050014, taxpayers may
of nonrecourse debt in exchange for
course debt in exchange for property
that has fair market value (FMV) less
February 2022 17
www.thetaxadviser.com the property subject to that debt. This be able to support the position that debt