A PARTNERSHIP had no cancellation of debt income, but it took the IRS a year and a half to come to that conclusion.

Normally when a borrower is excused from having to repay a debt, he or she must report the principal amount excused as income. Tax lawyers refer to this as “COD,” meaning cancellation of debt, income.

A partnership was formed to develop a project. Two partners withdrew before the project was built. Under the terms of the partnership agreement, the partnership had to repay the partners their capital, but not until it
could do so comfortably out of operating earnings. Interest accrued on the obligation to repay the capital in the meantime.

The project was never built.

A company that owned 50% of the partnership eventually bought the “debts” for a nominal amount from the two former partners (so that if anything was ever paid on them, it would receive the payments). Nothing was expected to be paid. 

When a borrower or a related party buys back his own note from a lender at a deep discount, this has the same effect as canceling most of the debt.

However, the IRS said there was no real “debt” in this case. The partnership merely had a contingent  obligation to the withdrawing partners to give them a share of any operating cash flow. The ruling is Private Letter Ruling 200523007. The IRS made it public in late June. The IRS agonized about the conclusion: it was a year and a half before the partnership got its ruling.