Limited partners generally are not responsible for partnership debts; nonetheless, creditors often demand they guarantee them. When a limited partner who has guaranteed a debt wants to leave the partnership, he must satisfy the guarantee or have it cancelled. How this is accomplished can greatly affect the partnership’s taxation.
MAS One, a limited partnership, had two equal partners—MAS One Generals, the sole general partner, and Midland Mutual Life Insurance Co. (Midland), the sole limited partner. In 1989 MAS One entered into an agreement to construct an office building using a $14.5 million loan from Huntington National Bank. The loan required monthly interest payments, a $2.5 million payment upon completion of construction and repayment of the balance in 1994. Midland guaranteed the monthly interest and the $2.5 million payment. When MAS One failed to make the payments, Midland paid the interest to Huntington and the $2.5 million in 1991 when it was due. In 1994 Midland decided to abandon its partnership interest and notified Huntington, agreeing to pay some money to be released from the mortgage. Also, as a condition of abandoning its interest, Midland paid MAS One $185,000.
MAS One sold the building the next day for $4.1 million, assigning the proceeds to Huntington, and Midland paid the bank $8.3 million, the remaining balance of the loan. On its tax return MAS One treated the $8.3 million payment as a nontaxable contribution to capital by Midland. The IRS reclassified the payment as forgiveness-of-debt income. When the Tax Court ruled for the IRS, MAS One appealed.
Result. For the IRS. When a third party pays another’s debt, the debtor is considered to have taxable income, so MAS One would have reported income when Midland repaid the bank. MAS One argued that this rule applies only when the payor is unrelated to the debtor. The Sixth Circuit Court of Appeals rejected the argument because no authority existed for it, but substantial authority existed for ignoring any relationship when applying the general rule.
MAS One then argued it did not have income because Midland was obligated to pay the debt. If in fact this had been the case, then MAS One would have been correct. However, since Midland was obligated to pay only the interest and the $2.5 million payment, this argument also failed.
MAS One’s final argument was that IRC section 721 shielded it from recognizing income. The Sixth Circuit said section 721 did not apply for two reasons. First, Midland had abandoned its interest before the debt payment, which, therefore, could not be considered a contribution by a taxpayer for an interest in a partnership. MAS One’s attempt to argue substance over form to ignore this fact was rejected. And second, section 721’s primary requirement is that a contribution to capital must be in exchange for an interest in the partnership, but in this case Midland made the payment to sever its relationship with MAS One. In Twenty Mile Joint Venture, 200 F3d 1268, the Tenth Circuit Court of Appeals had ruled that payments to sever an interest were excluded from section 721. The Sixth Circuit concluded that the precedent set in Twenty Mile was directly applicable to MAS One and mandated a rejection of the taxpayer’s arguments.
Taxpayers involved in these transactions will have to consider a recent code change—the 2004 American Jobs Creation Act amended section 108(e)(8) on cancellation of debt in exchange for a partnership interest—in addition to the rules established in MAS One. A partnership now is required to recognize forgiveness-of-debt income to the extent the amount of debt forgiven exceeds the value of the interest transferred to the creditor. Therefore, future partnerships whose debt is cancelled as part of a severance may have to recognize income even if the transaction meets the requirements of section 721. However, neither the 2004 act nor MAS One addresses the possibility the transaction could be a contribution to capital and treated as tax-free under a general rule similar to section 118, which applies to corporations.
MAS One Limited Partnership v. United States, 390 F3d 427 (CA-6).
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.