Conversion of LLC member debt to equity without triggering COD

Great question Paul...

The details of a debt-equity exchange are complex. Multiple classes of debt and equity may be involved. As with any major corporate transaction, the tax consequences have to be considered.

If the amount of debt that is cancelled exceeds the fair value of the equity issued in exchange for the debt, the company will recognize cancellation of debt (COD) income in the amount of the excess. I.R.C. § 61(a)(12), § 108(e)(8). The Code provides several exceptions to recognition of COD income. Pay close attention to Secton 721.

Generally, when property is transferred as payment on indebtedness(or in satisfaction thereof), gain or loss on the property is recognized. The IRS and the Treasury Department, however, believe that in the case of a debt-for-equity exchange, the nonrecognition rule of section 721 generally should apply to the creditor's contribution of partnership indebtedness (other than unpaid interest or accrued original issue discount) to the partnership in exchange for the partnership interest. Such a rule is consistent with the policies underlying section 721 to defer the recognition of gain or loss where persons join together to conduct joint business (including investment). Accordingly, the proposed regulations provide that with certain exceptions, section 721 applies to debt-for-equity exchanges.

Regards,
Pete