LLC taxed as a partnership and loan forgiveness

Technical topics regarding tax preparation.
#1
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3 individual members of an LLC taxed as a partnership took loans from the partnership. Those partners don’t want to pay back the loans. Partnership is willing to forgive but the partners don’t want to realize COD. 3 other members of the LLC are trusts. The beneficiary of trust 1 is individual partner 1. The beneficiary of trust 2 is partner 2 etc. There are a couple more trusts as members. If the LLC distributes the respective note to each trustee of each applicable trust then the trustee cancels the note, does that result in COD to the individual partner as the beneficiary? Partnership would make distributions of cash to the other members to keep things economically balanced. Does this work? Thanks in advance.
 

#2
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As a follow up, under Rev. Rul. 93-7 when indebtedness of a partner is distributed to that partner, the debt is extinguished. Since there is no mechanism for preserving gain or loss, current recognition of any gain is appropriate. Treas. Reg. 1.731-1(c)(2) says that it addresses the tax consequences of a direct loan from a partnership to a partner followed by cancellation is governed by 707. Does that mean the related party rules would apply and the distribution to the trust would be treated as a distribution to the individual resulting in gain recognition or COD?
 

#3
lckent  
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If you want to keep it simple, distribute cash to all members in regular ratios and then have the members with loans repay the loans.
CPA, Retired
 

#4
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The problem with that approach is that the members receiving the loans own a very small percentage of the entity so the distributions to the other members are not feasible.
 

#5
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Partnership would make distributions of cash to the other members to keep things economically balanced.

Clarify yourself, CLE. If a note-holder member, who owns 30% of the partnership (let’s say), holds a note (as borrower) with a face of $30k and that note is distributed to him, what will a 10% non-note-holder member get…$10k in cash?

Or, are you saying that the note is worth $3, such that a 10% owner will get $1 in cash?
 

#6
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Yes, that is generally right. Individuals have small percentage interests (.33% each), other trust 25%, other trusts aggregate of about 15%, and 3 trusts each for the benefit of the individuals receiving the loans (approx 20% each). The idea would be to distribute a note to each of the respective trusts fbo of the loan recipients (this would be the note owed by the respective beneficiary). The remaining members would receive an equivalent amount of cash to the notes being distributed. Each trust would then go ahead and forgive the note owed by the respective beneficiary.
 

#7
Anderly  
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Be cautious about advising a client to have a trustee forgive the note owed by the respective beneficiary. This is a fiduciary/legal issue, not a tax issue. The forgiveness could be a breach of the trustee's fiduciary obligation to all of the beneficiaries of the trust depending on the terms of the trust.
 

#8
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Thanks. Each loan recipient partner is the sole beneficiary of the respective trust.
 

#9
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Partnership is willing to forgive but the partners don’t want to realize COD.

Reg 1.731-1(c)(2)
To the extent that such an obligation is canceled, the obligor partner will be considered to have received a distribution of money or property at the time of cancellation.

Would cancelling the debt simply be a distribution to those partners?
 

#10
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Thanks. Yes, if the note were distributed to the loan recipient
or cancelled by the LLC then yes that would be treated as a distribution of cash to the LLC member. So at least there is the benefit of capital gains treatment. Here the note would be distributed to the trust, then cancelled by the trustee. What isn’t clear is if the distribution of the note to the trust would fall under that reg under the related party rules under 707.
 


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