United States: Final Regulations On Partnership Debt-For-Equity Exchanges

Last Updated: November 28 2011
Article by Kevin J. Feeley and Patrick J. McCurry

The U.S. Department of the Treasury recently issued final regulations providing helpful clarifications on the partnership and partner level tax consequences of debt-for-equity exchanges.

On November 15, 2011, the U.S. Department of the Treasury (DOT) issued final regulations governing the federal income tax treatment of a transaction in which a partnership issues a partnership interest to a creditor in satisfaction of the partnership's indebtedness.  These regulations largely follow the approach taken in the proposed regulations issued in 2008, but with some helpful clarifications added.


In 2004, Congress amended Section 108(e)(8) of the Code to provide that, when a debtor partnership issues a capital or profits interest to a creditor in satisfaction of a recourse or nonrecourse debt of the partnership, the partnership is treated as having satisfied the debt for an amount of money equal to the fair market value of the partnership interest being issued to the creditor.  To the extent that the principal amount of the debt exceeds the fair market value of the equity being issued, the partnership recognizes cancellation of debt (COD) income.  Such COD income generally must be included in the distributive shares of the partners immediately prior to the discharge (subject to any applicable exclusions at the partner level).  This required recognition of COD income generally comports with the treatment of a corporation that undertakes a debt-for-equity exchange.

Key Provisions of Proposed Regulations

In 2008, the DOT issued proposed regulations that addressed a number of issues that arise when a partnership issues equity in exchange for the discharge of a debt of the partnership.  The proposed regulations provided that, for purposes of determining the amount of COD income recognized by the partnership, the partnership and the creditor may treat the equity being issued to the creditor as having a fair market value equal to its liquidation value, assuming four conditions are satisfied.  The four conditions for this liquidation value "safe harbor" are (i) a requirement to maintain capital accounts consistent with the capital accounting rules under Section 704(b) of the Code; (ii) a consistency requirement that both the partnership and partner will treat the debt-for-equity interest as having a fair market value equal to its liquidation value; (iii) an arm's length requirement; and (iv) an anti-abuse rule prohibiting a planned retirement or sale of the debt-for-equity interest designed to avoid COD income.

At the partner level, the proposed regulations applied Section 721 of the Code to the debt-for-equity exchange.  As a result, the creditor generally does not recognize gain or loss on exchange of the debt for a capital or profits interest in the debtor partnership.  Also, a bad debt deduction may not be claimed in the debt-for-equity exchange.  Instead, under Section 722 of the Code, the creditor's basis in the debt-for-equity interest will equal the creditor's tax basis in the debt.  However, an exception to Section 721 treatment applies for transfers of partnership equity in satisfaction of debt for unpaid rent, royalties or accrued interest.  This exception was designed to prevent the conversion of what would otherwise be ordinary income into capital gain.

Final Regulations

The final regulations do not deviate materially from the approach taken in the proposed regulations, but do provide some helpful clarifications and instructive explanations.

  • At the request of commentators, the final regulations provide that the capital account maintenance requirement for the liquidation value safe harbor does not require the partnership to liquidate in accordance with positive capital account balances.
  • The final regulations retain the exception to Section 721 treatment for the satisfaction of ordinary income items (unpaid rent, royalties and accrued interest).  The regulations also clarify that when a partnership issues equity in satisfaction of these types of debt, the partnership will not be treated as having transferred a fractional interest in each asset to the creditor.  There was a concern among practitioners that if Section 721 did not apply, the exchange could be treated as a deemed sale of assets under an aggregate theory of partnership taxation.  Instead, the final regulations take a circular cash flow approach, treating the creditor as having received cash and then as having contributed the cash to the partnership for equity in a tax-free Section 721 transaction.
  • In a debt-for-equity exchange, the final regulations also state that the portion of the equity treated as exchanged for any accrued interest or accrued original issue discount (OID) is determined under Treasury Regulations Sections 1.446-2 and 1.1275-2, respectively.  Because these regulations generally apply payments first to interest, it is not likely that a creditor in a debt-for-equity will be in a position to claim a bad debt deduction for accrued but unpaid interest.
  • Despite the request of commentators, the final regulations reject a bifurcation approach that would have allowed a creditor to take a bad debt deduction or loss on the portion of the debt that exceeded the fair market value of the equity and treat the balance of the debt as having been contributed to the partnership in a Section 721 exchange.  However, the preamble to the final regulations indicates that a creditor may claim a bad deduction under Section 166 of the Code prior to (and independent of) the debt-for-equity exchange.  Of course, under Section 166(d)(3), a taxpayer other than a corporation may not deduct a partially worthless nonbusiness debt.


While the final regulations generally track the proposed regulations, they contain a few helpful clarifications which should provide greater certainty to parties that are planning to undertake a partnership debt-for-equity exchange.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions