Generic Legal Advice Memorandum AM 2011-003 (August 18, 2011)
GLAM 2011-003 is one of the most talked about internal IRS opinions in recent years. It addresses the check-the-box liquidation of an insolvent foreign corporation and its reformation as an insolvent partnership owing a liability to its principal partner. The GLAM builds on Rev. Rul. 2003-125, 2003-2 C. B. 1243, which addressed the check-the-box liquidation of a domestic corporation’s insolvent foreign subsidiary that continued to operate its business as a disregarded entity; the insolvency similarly was caused by a liability to the parent. The GLAM’s facts differ from the revenue ruling only in that a foreign affiliate of the parent owns a minority interest in the subsidiary, and so the entity continued as a partnership under the check-the-box fiction. Whereas the revenue ruling ruled that the parent could deduct its loss on the stock of the worthless security (probably as an ordinary loss under Section 165(g)) and indicated the parent could deduct an ordinary loss for a bad debt under Section 166(a), the GLAM denies the bad debt loss solely because the business continues as a partnership that owes the liability.
Situation 1 of the GLAM
Situation 1: X (domestic) owns all of Y (foreign) and 80 percent (basis of $100) of Z (foreign). Y owns the other 20 percent of Z (basis of $30). Z owns property worth $100 (basis of $120); Z owes $110 to X (the GLAM does not state that the debt is secured by the Z assets, or whether it is recourse or nonrecourse); Z is insolvent. Z checks the box and thereby is deemed to liquidate as a corporation, to be recreated as a partnership owned by X and Y. Z continues to operate its business unchanged; indeed, it continues as a corporation for foreign local law purposes. The IRS wants to know how much, when and what character of deduction for losses on stock and debt X and Y can claim as a result of Z’s deemed liquidation (X hopes for a $110 ordinary loss, and Y hopes for a $30 capital loss). Also, because Z reforms under the checkthe- box fiction as a partnership owned by X and Y, the parties are interested in basis: What is the basis of the partners in the new partnership interests and what is the partnership’s basis in its assets?
The GLAM is based primarily on Reg. § 301.7701-3(g)(1)(ii):
If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this section to be classified as a partnership, the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.
The GLAM opines that:
- The shareholders of Z can deduct their basis in the stock of Z as losses under Section 165(g), meaning deductions of $100 (which may be ordinary loss under Section 165(g)(3)) and $30; this is consistent with prior guidance.
- The shareholders are deemed to buy the corporate property in exchange for their proportionate assumptions of the corporate recourse liabilities and receipt of property subject to nonrecourse liabilities (meaning X assumes or takes subject to 80 percent of the liabilities to itself).
- The shareholders obtain a combined basis of $110 in property worth $100. The GLAM only partly explains this conclusion. To the extent the liability is recourse, the assumption of personal liability that the GLAM interprets the regulation to require clearly creates a basis in the property equal to the debt. However, to the extent the liability is nonrecourse, normally the Estate of Franklin/ Pleasant Summit analysis would not allow the basis to exceed the value of the property securing the liability.
- The new partnership obtains a basis in its property of $110.
- The new partners obtain basis in their partnership interests of $108 and $2, respectively, determined under Sections 722 and 752 as follows: $110 combined asset basis ($88 and $22), reduced by $100 upon the deemed distribution caused by the liability assumption by Z, to $10 ($8 and $2), increased by $100 due to partner X’s deemed liability assumption, totaling $110 ($108 and $2). Note that the GLAM does not bifurcate the creation of the partnership into a “sale” of the property for a liability assumption and the distribution of a valueless partnership interest; it treats the entire transaction as subject to Subchapter K, even though the partnership created is instantly under water.
- X remains a creditor of the new partnership, presumably with its original $110 basis in a receivable (although the GLAM does not specifically state this basis) from the partnership worth $100, which is the same receivable X started with.
There is a better alternate construct for taxpayers, which allows the bad debt loss. Upon an extinguishment, X would recognize a $10 bad debt loss along with the $100 loss on its stock (and Y’s $30 loss on its stock). Then Z must be formed as a partnership. This is accomplished by X selling 20 percent of the property to Y for a $20 note, and then Y contributes its property to Z in exchange for assumption of the obligation to X; X then sells its 80 percent of the property to Z in exchange for a purchase money note for $80. At the end of these steps, Z owns the property with a basis of $100, its Section 1012 cost; X holds the $100 obligation of Z with a basis of $100. X then must be deemed to receive as a distribution an additional obligation from Z for $10, which is worthless, with a basis of zero.
The results of this alternate construct are as follows:
- Section 707(a)(2)(B) will apply to the exchanges of X’s and Y’s property (basis of $100) for Z’s $100 combined obligation, resulting in X and Y recognizing no gain or loss.
- Z also distributes to X its obligation for $10, value of zero, basis of zero to Z, which X takes with a zero basis and does not suffer a reduction in X’s partnership interest basis (Sections 731, 732, 733(2)).
- Thus X takes a basis of $100 in the combined obligation of Z for $110.
- Z takes a basis of $100 in the property.
- Y’s basis in the partnership interest is zero and X’s basis is $100 because X and Y give no value for the partnership interests and X is allocated $100 of the $110 liability of Z, thereby obtaining a Section 752 basis increase. X will not be allocated the extra $10 of Z liability because that is a Section 1.752-7 liability (because it did not create basis in Z’s assets).
If Z sells the property to an unrelated buyer for $100 free of the liability, pays the $100 to X and the debt is discharged and Z dissolves, the results are as follows:
- Z does not recognize any gain or loss on the sale, or on the discharge of $10 of indebtedness, because it is not made solvent.
- X’s basis interest reduces by $100 to zero because all of the Z debt is eliminated.
- X recognizes no bad debt loss because X’s basis was $100 and X received $100.