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TAX CLINIC

owed by a DRE is nonrecourse debt of recognizing any of the Sec. 1001 gain with one of the exceptions being that a
the regarded owner for purposes of Sec. (similar to the taxpayers in Letter Rul- change in obligor occurs in connection
1001 and Regs. Sec. 1.1001-2. Due to ings 202050014 and 201644018) and with a Sec. 381(a) transaction (see Regs.
the potential different tax treatment, would not have to reduce any of its at- Sec. 1.1001-3(e)(4)(i)(B)). For nonre-
taxpayers should give consideration tributes under Sec. 108. course debt, a change in obligor does not
as to which consequences apply to Whether Scenario 1 or Scenario 2 generally result in a significant modifica-
them based on their specific borrow- applies to a taxpayer will depend on the tion. Therefore, determining whether
ing arrangements. specific facts, including which entity debt is recourse or nonrecourse, and who
The following basic example illus- (i.e., a regarded entity or a DRE) is is the obligor of the debt, is important
trates the different potential results: the primary borrower on the relevant in determining whether a significant
borrowing arrangement. In addi- modification has occurred under Regs.
Base example: Taxpayer, a corpora- tion, whether Scenario 1 or 2 is most Sec. 1.1001-3.
tion, is the borrower of debt for U.S. beneficial will vary depending on a In the four letter rulings mentioned
federal income tax purposes that has taxpayer’s circumstances. Furthermore, above, the IRS has addressed the treat-
a face amount of $100, and its assets the determination of whether a debt of a ment of debt under Regs. Sec. 1.1001-3
have an FMV of $75 and a basis of DRE is nonrecourse debt of a regarded when the named borrower of the debt
$60. Taxpayer is insolvent under Sec. entity may depend on whether the re- changes its entity status from a regarded
108(d)(3) because its liabilities, $100, garded entity’s assets consist solely of the entity to a DRE, most recently in Letter
exceed the FMV of its assets, $75. In DRE borrower. Ruling 201010015. In Letter Ruling
a debt workout, Taxpayer transfers all 201010015, the taxpayer held 100% of
its assets to its creditors in satisfac- Other considerations related to the stock of a subsidiary (Subsidiary 1),
tion of the debt. Regs. Sec. 1.1001-3 which was treated as a corporation for
A separate but related issue that arises federal income tax purposes prior to a
Scenario 1: Taxpayer is the legal bor- is whether recourse debt of a DRE is set of proposed transactions. Subsidiary
rower, and the debt is considered considered nonrecourse debt of the re- 1 held third-party debt, and the taxpayer
recourse debt. Taxpayer would rec- garded entity for purposes of Regs. Sec. was not a guarantor on the debt. In Let-
ognize $15 of gain under Sec. 1001 1.1001-3. ter Ruling 201010015 the taxpayer pro-
related to its assets (the difference be- The IRS has also issued rulings posed to engage in a set of transactions
tween the basis and the FMV of the related to this issue, and it should be that would be treated as a reorganization
assets transferred) and $25 of COD considered anytime a taxpayer consid- under Sec. 368(a)(1)(D) in which Sub-
income (the difference between the ers structuring into a borrowing that sidiary 1 converted to a single-member
FMV of the assets transferred and uses a DRE as the legal borrower (see limited liability company that would
the amount of the debt). Letter Rulings 201010015, 200709013, be treated as a DRE for federal income
200630002, and 200315001). tax purposes. In the ruling, the IRS
Scenario 2: The legal borrower is Generally, the regulations under concluded that the proposed transac-
a DRE owned by Taxpayer, and Regs. Sec. 1.1001-3 provide rules for tion resulted in a change in obligor for
Taxpayer did not guarantee the debt; determining when an alteration to a purposes of Regs. Sec. 1.1001-3 but that
thus, the entire $40 of gain would be debt obligation should be considered a the change in obligor did not result in
capital gain under Tufts (i.e., Tufts realization event for the holders. Regs. a significant modification under Regs.
gain). Sec. 1.1001-3 generally treats a change Sec. 1.1001-3 because the transaction
in the terms of a debt instrument as trig- qualified for the exception under Regs.
In Scenario 1, the $25 of COD gering a deemed exchange if the change Sec. 1.1001-3(e)(4)(i)(B) for Sec. 381(a)
income is potentially eligible for exclu- in the terms is a “modification” of the transactions. Importantly, and seemingly
sion from income under Sec. 108, but debt instrument and that modification is counterintuitive with the other parts of
it may also result in attribute reduc- a “significant modification.” Under Regs. the holding, the IRS described the new
tion under Sec. 108(b). In Scenario 2, Sec. 1.1001-3, a change in an obligor of DRE, instead of the DRE’s regarded
even though the gain is not eligible for recourse debt is considered a significant owner, as the obligor of the debt.
Sec. 108 exclusion, if the taxpayer is modification (and therefore creates a The other three letter rulings under
able to structure the debt workout as a deemed exchange of debt) unless any Regs. Sec. 1.1001-3 also ended up at the
tax-free reorganization under Sec. 368, of several enumerated exceptions under same conclusion that the IRS reached
then the taxpayer may be able to avoid Regs. Secs. 1.1001-3(e)(4)(i) apply, in Letter Ruling 201010015, however,

18 February 2022 The Tax Adviser