November 12, 2008 | By Keith Martin in Washington, DC

PARTNERSHIPS should take the tax consequences into account before asking a lender or other creditor to convert debt into equity. The Internal Revenue Service addressed the tax issues in proposed rules in late October. Such conversions are likely to become more common until the economy recovers.

In general, the partnership should determine the “liquidation value” of the partnership interest that the lender or other creditor will receive. The liquidation value is the share of cash the creditor would receive as a partner if the partnership liquidated and sold all of its assets at market value and then distributed the sales proceeds to the partners, including the creditor in its new role as a partner. 

If the liquidation value is less than the principal amount that the creditor was owed on the debt, then the partnership must report the difference as income. Anyone excused from a debt has income. The income in this case is reported by the persons who were partners immediately before the creditor became a partner.

Economically, the creditor has a loss. However, it cannot claim the loss immediately on its tax return. Rather, it takes a tax basis in its new partnership interest equal to the full principal amount of the debt that was converted. If the creditor later sells the partnership interest for less than its basis, then it will have a loss at that time.

This approach of using the liquidation value to determine how much of the debt a creditor recovered by converting the debt into equity in the partnership only works if the partnership
maintains proper “capital accounts” for the partners. Each partner usually has a capital account that tracks what the partner put in and took out of the partnership.The balance a partner has at any given time is his claim on the assets if the partnership liquidates.The IRS has detailed rules for how capital accounts are supposed to be calculated. If the partnership does not keep proper capital accounts, then the IRS said the parties will have to fall back on other measures — what it calls a “facts and circumstances”
approach — to determine what value the creditor received.

Most conversions of debt into equity in a partnership should be tax free for the creditor. However, the creditor will have income to the extent the debt being converted is money the
partnership owes the creditor — and that the creditor has not reported yet as income — for rent, royalties, past services or unpaid interest, including “original issue discount,” on a loan. The new rules are in proposed regulations interpreting section 108(e)(8) of the US tax code. They were published in the Federal Register on October 31.