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Editor’s Note
CMTQ couldn’t help notice in mid-April when the stock market
was “shocked, shocked” at a news report that President
Joe Biden would propose increasing individual federal income tax
rates on long-term capital gains to equal ordinary income rates
(39.6% under Biden’s proposal).1 If only folks had
read CMTQ last quarter, they would have realized this proposal was
lurking in the wings.2 We checked and the last time tax
rates on long-term capital gains were higher was immediately before
the 1978 Revenue Act during the Carter Administration when the
effective long-term capital gain rate was 49%.3 And
individual long-term capital gain and ordinary income tax rates
have not been equal since the George H.W. Bush Administration,
albeit at a much lower 28% rate. This recent capital gains
“news” was good for several days of media reports,
analysis and talking head air time and, some would say, increased
volatility in the stock market–exactly what we need. Unfortunately
for tax advisors as of this writing there is no legislative
language for any of the President’s tax proposals (which BTW
are discussed below); for example the effective date of any change
in individual long-term capital gain (and ordinary income) rates is
currently unknown.4 So, dear reader, stay tuned. As
always, CMTQ will continue to cover the ups and downs of the
legislative process as it unfolds in 2021.
In the meantime, this CMTQ also covers a private letter ruling
approving the settlement of debt without CODI in a bankruptcy, some
highlights from recent tax proposals from President Biden’s
Administration, and more.
PLR 202050014: Another Ruling Supporting Debt Settlement
Without CODI
In PLR 202050014 (the “Ruling”), the IRS blessed a
tax-efficient bankruptcy reorganization, again blessing tax
planning technology that is at least as old as 2016. The Ruling
bolsters authority for the use of bankruptcy transactions as a
means of settling debt without triggering cancellation of
indebtedness income (“CODI”).
First, the facts of the Ruling: A parent corporation
(“Parent”) owned all of the equity interests of two
disregarded entities, LLC1 and LLC2. The substantial majority of
the value of Parent was owned by LLC1 and its subsidiaries. Parent,
LLC1 and LLC1’s subsidiaries subsequently filed for bankruptcy,
with LLC1 being the direct borrower of a significant portion of the
group’s debt. Significantly, the Parent was not a guarantor of
LLC1’s debt. Under the Ruling, Parent proposed to contribute
its assets (including the equity and assets of LLC1 and LLC2) to a
newly formed corporation (“NewCo”). Then, pursuant to the
same plan, Parent distributed the equity of NewCo to creditors in
satisfaction of a portion of LLC1’s debt. The Ruling concludes
that the LLC1 debt is treated as nonrecourse indebtedness, and the
transaction as a whole satisfied the requirements to be treated as
a “G reorganization.”
Generally, debt of a disregarded entity is treated as owed by
the disregarded entity’s owner. However, there is uncertainty
regarding whether indebtedness that is nominally recourse to the
disregarded entity borrower is better treated as recourse
indebtedness or nonrecourse indebtedness. On the one hand, because
the debt is recourse indebtedness under local law, it is possible
to view the indebtedness as recourse indebtedness of the owner. On
the other hand, because creditors may only look to the assets of
the disregarded entity in order to satisfy any claims, and not to
the assets of the owner generally, the tax law may alternatively
view the indebtedness as nonrecourse indebtedness of the owner. The
difference in treatment is significant. Satisfaction of recourse
indebtedness for an amount less than the principal amount of the
indebtedness generally results in CODI. If certain requirements are
met, CODI may be excluded from the owner’s income if the owner
is bankrupt or insolvent, although the price of such exclusion is a
reduction of the debtor’s tax attributes. Alternatively,
satisfaction of nonrecourse indebtedness for an amount less than
the principal amount of the indebtedness may in certain
circumstances be treated as a sale of the collateral, resulting in
gain rather than CODI.5 Although gain cannot be excluded
under Section 108, gain may qualify for nonrecognition treatment
where a transaction qualifies as a tax-free reorganization.
The Ruling illustrates the use of this principle. Although the
Ruling does not indicate the dollar amounts at issue, the
principles of the Ruling can be used to satisfy indebtedness to
creditors without incurring CODI. Gain may be realized on the
transaction to the debtors, but if the requirements are met to
treat the transaction as a tax-free reorganization, the gain is not
recognized. The end result is that no tax is owed by the creditors
for settling their indebtedness for less than the face amount.
Furthermore, because CODI is not applicable, tax attributes of the
debtor are not reduced.
The issues addressed in the Ruling are similar to the
transactions undertaken as part of a major bankruptcy for which a
ruling was sought in 2016, part of which sought the same advice as
that requested in the Ruling.6
Refresher in Info Letter 2020-0033: Short Sales Not UBTI
THE SHORT OF IT
On December 31, 2020, the IRS published Info Letter
2020-00337 , confirming that, under certain
circumstances, income of retirement plans that is attributable to a
short sale of publicly traded stock through a broker is not subject
to the unrelated business income tax under section 511 of the
Code.8
Following, we summarize the applicable provisions of the Code
relating to the taxation of unrelated business taxable income
(“UBTI”) and we briefly analyze the rulings that the IRS
cited in Info Letter 2020-0033 in order to understand which income
attributable to a short sale of publicly traded stock is excluded
from UBTI.
UBTI – GENERAL BACKGROUND
Code section 511(a) imposes a tax on the UBTI of certain
taxpayers that are otherwise exempt from federal income taxation
under Code section 501(a).
Code section 512(a)(1) of the Code defines UBTI as gross income
derived by any organization from any unrelated trade or business
regularly carried on by it, less certain deductions which are
directly connected with the carrying on of such trade or business,
both computed with the modifications provided in Code section
512(b). Section 512(b)(4) provides, in part, that UBTI includes
certain income from “debt-financed property” as defined
in Code section 514(b).
Footnotes
1 Including the 3.8% Medicare tax on investment income,
the maximum federal income tax rate on long-term capital gains
would be 43.4%. The maximum long-term capital gain rate would apply
to individual taxpayers with incomes over $1 million.
2 See Vol. 03, Issue 1 and Vol. 3, Issue 2.
3 See Report to Congress on the Capital Gains Tax
Reductions of 1978, US Treasury, Government Printing Office,
Washington DC (1985). The report notes that the 49% maximum rate
resulted from the combined effect of several Internal Revenue Code
provisions.
4 For some interesting reading on legislative action and
effective dates, see United States v. Carlton, 512 U.S. 26, at
30-31 (1994); Welch v Henry, 305 U.S. 134, at 146-147
(1931).
5 See Commissioner v. Tufts, 461 U.S. 300
(1983). Treas. Reg. section 1.1001-2(c), Ex. 7.
6 PLR 201644018.
7 INFO 2020-0033 (December 31, 2020).
8 All section references herein are to the Internal
Revenue Code of 1986, as amended (the “Code”)
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