by Randy A. Schwartzman, CPA, MST, and Patricia Brandstetter, J.D., LL.M., Melville, N.Y.Editor: Kevin D. Anderson, CPA, J.D.
This item provides an overview of the U.S. income tax implications of cancellation-of-debt (COD) income that results from bankruptcy or insolvency, with a focus on the differences in the tax treatment for C corporations, S corporations, and partnerships. Since the general rule provides that COD income is recognized even though there are no actual cash proceeds, absent certain exclusions to the recognition of COD income that are discussed below, the tax liability on COD income could create liquidity issues for a debtor. Therefore, a thorough understanding of the statutory exclusion and deferral provisions is essential when it comes to tax planning to avoid or ameliorate the tax consequences associated with COD income.
Note: If a debtor has incurred net operating losses (NOLs), there may be certain alternative minimum tax limitations as well as other restrictions on the use of NOLs that may otherwise prevent the full use of those losses to offset COD income. However, that issue is beyond the scope of this item.
Taxable COD Income
Under Sec. 61(a)(12), which codified the landmark case of Kirby Lumber Co., 284 U.S. 1 (1931), gross income includes "income from discharge of indebtedness." This treatment is based on the rationale that since borrowing does not result in taxable income, the borrower realizes an economic benefit when the obligation is reduced or repayment is canceled. Indebtedness in this context is described in Sec. 108(d)(1) as "any indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds property."
COD income can result from a variety of transactions involving the relief of a debt repayment obligation, such as action taken by the creditor (e.g., a formal discharge or repurchase of the debt for less than its principal amount) or by operation of law (e.g., debt discharge in bankruptcy). Interest—as well as principal—may constitute forgiven debt includible in income (see, e.g., Brooks, T.C. Memo. 2012-25; and Black, T.C. Memo. 2014-27). Realization of COD income generally occurs when it is clear that debt is undisputed, uncollectible, and nonrevivable (see, e.g.,Zarin, 916 F.2d 110 (3d Cir. 1990)).
In the absence of actual payment or repurchase of the debt, the timing for realizing COD income is harder to pinpoint. While the courts have taken a fact-specific approach, the timing of COD income is generally tied to an identifiable event making it clear that the debt will never be paid (see, e.g., Cozzi, 88 T.C. 435 (1987)).
There is also a rebuttable presumption that an identifiable event occurred in a calendar year if the creditor has received no payments at any time during a testing period (generally 36 months) ending at the close of the year (Regs. Sec. 1.6050P-1(b)(2)(iv); see, e.g., Kleber, T.C. Memo. 2011-233). However, proposed regulations have been issued that, when finalized, will eliminate this rule.
Exceptions From COD Income Recognition
Bankruptcy exclusion: Under Sec. 108(a)(1)(A), COD income is excluded from gross income where the discharge of indebtedness is granted in a Title 11 case, which includes Chapter 11 reorganizations, Chapter 7 liquidations, and Chapter 13 bankruptcy proceedings under Title 11 of the U.S. Code. This exclusion applies only if the discharge of indebtedness is granted by a court order or in a court-approved plan (Sec. 108(d)(2)).
When debt is discharged in bankruptcy, the bankruptcy exclusion rules govern, even if one of the other exceptions would have applied (Sec. 108(a)(2)(A)); this treatment is important since the required reduction of tax attributes differs depending on which COD income exclusion applies.
Sec. 382 limitation and bankruptcy exceptions: In Title 11 and similar cases, debtors frequently pay off creditors by issuing new equity. This stock-for-debt exchange could trigger an "ownership change" as defined in Sec. 382 to the extent that "old" equity is replaced.
In general, an ownership change under Sec. 382 occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by one or more 5% shareholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period, which is generally a three-year lookback period. The measure of the change is based on stock value rather than the absolute number of shares held, which is an important distinction when there is more than one class of stock.
In effect, this means that the corporation's value must be known at each testing date to determine each 5% shareholder's share of the total value. A testing date is any date on which (1) an insolvent company experiences a shift in owners/equity structure, or (2) an issuance or transfer of an option is treated as exercised for Sec. 382 purposes.
When an ownership change occurs, Sec. 382 limits a corporation's ability to use tax attributes from before the change in ownership, including NOL carryovers and certain built-in losses, to offset post-change taxable income. However, the Sec. 382 rules do not reduce the amount of the corporation's prechange losses; rather, an annual limitation is placed on how much of the corporation's prechange losses may be used to offset income in a post-change year. To the extent that prechange NOLs exceed that year's limitation, the remaining prechange NOLs can be carried forward to the next year to offset income of year 2 (also subject to the Sec. 382 limitation).
Unless a special carryback or carryforward period applies, an NOL for a tax year may be carried back two years and then carried forward 20 years. The annual limitation under Sec. 382 is a formula-driven amount based on the corporation's value immediately before the ownership change, multiplied by the current federal long-term tax-exempt rate under Sec. 1274(d). Sec. 383 provides similar limitation rules for prechange tax attributes not covered under Sec. 382, such as capital loss carryovers, general business credits, any unused minimum tax credits, or foreign tax credits.
Secs. 382(l)(5) and 382(l)(6): Mutually exclusive rules contained in Secs. 382(l)(5) and 382(l)(6) allow an insolvent company to preserve its NOLs. This alternate set of taxpayer-favorable limitations applies in lieu of the general Sec. 382 limitation.
A company that qualifies under Sec. 382(l)(5) can use its prechange NOLs in full, unrestricted by the Sec. 382 limitation. To qualify, the corporation:
- Must be under the jurisdiction of a bankruptcy court immediately before the ownership change; and
- The corporation's shareholders and "qualified creditors" (determined immediately before the ownership change) must own at least 50% (both in vote and in value) of the corporation's stock immediately after the ownership change (Secs. 382(l)(5)(A)(i) and (ii); Regs. Sec. 1.382-9).
A creditor is a qualified creditor under Regs. Sec. 1.382-9(d)(1) to the extent that the creditor is the beneficial owner of qualified indebtedness immediately before the ownership change. Qualified indebtedness is defined as the debt exchanged by the creditor if it was:
- Held by the creditor for at least 18 months before the filing date of the Title 11 or similar case, or
- A claim that arose in the ordinary course of the trade or business of the company before the ownership change and is held by a person who at all times held the beneficial interest in that indebtedness (Sec. 382(l)(5)(E); Regs. Sec. 1.382-9(d)(2)).
For Sec. 382(l)(5) purposes, a qualified creditor owns stock as a result of being a qualified creditor only to the extent that the creditor receives stock in full or partial satisfaction of qualified indebtedness under a transaction or plan that is approved by a court order in a Title 11 or similar proceeding. There are two important caveatsin applying Sec. 382(l)(5):
- Under Sec. 382(l)(5)(B), while the use of NOLs is generally unrestricted, the company must reduce its NOLs in the year of the ownership change, as well as the preceding three years, for any interest relating to debt that was converted into stock (also known as a statutory haircut).
- If the company undergoes a second ownership change within two years of the first Sec. 382(l)(5) ownership change, the second ownership change would subject the NOLs to a "zero" limitation, which would effectively eliminate NOL carryovers permanently that arose before the first ownership change. It is important to note, however, that despite the zero limitation on use of the NOLs to offset future taxable income, the NOLs incurred before the first ownership change would still be available for attribute reduction under Sec. 108(b) if a future COD exclusion event should occur under Sec. 108(a)(1)(A) or 108(a)(1)(B) (Sec. 382(l)(5)(D)).
Under Sec. 382(l)(5)(H), a taxpayer may elect not to have the rules under Sec. 382(l)(5) apply. A decision to elect out of the exception requires a projection of the corporation's taxable income for the next few years following the ownership change. The present value of the tax benefits available from electing out and applying the full prechange NOL against the projected income (subject to the annual Sec. 382 limitation) would then need to be compared to the present value of the tax benefits available from using a reduced NOL after the statutory haircut without a Sec. 382 limitation.
The election is irrevocable and must be made by the due date of the company's tax return (including any extensions of time to file) for the tax year that includes the change date, by attaching a statement to the return under Regs. Sec. 1.382-9(i). If the Sec. 382(l)(5) requirements are met and no election was made to prevent Sec. 382(l)(5) from applying, these rules apply by default. When a company elects out of Sec. 382(l)(5) or does not meet the statutory requirements for the bankruptcy exception under Sec. 382(l)(5), the availability of its NOLs will automatically be governed by a second safe-harbor provision contained in Sec. 382(l)(6).
For purposes of determining the Sec. 382 limitation, Sec. 382(l)(6) allows a corporation to value its stock after the Sec. 382 ownership change by multiplying the long-term tax-exempt rate by the lesser of:
- The prechange gross asset value, or
- The post-change stock value.
Sec. 382(l)(6) permits valuing the equity of a corporation for purposes of the Sec. 382 limitation by using the value immediately after the ownership change rather than immediately before the ownership change (Regs. Sec. 1.382-9(j)). This allows for an increase in the value of the stock attributable to the conversion of debt into stock (but not the increase in value from any fresh infusion of capital). Since the amount of the post-ownership change NOL is a function of the value of the loss corporation, the higher the value of the stock, the higher the annual Sec. 382 limitation under this rule. Sec. 382(l)(6) may thus result in annual Sec. 382 limitations that are large enough to shelter post-change taxable income for several years. This reduces the stress of having a company attempt to avoid a second ownership change in the immediately succeeding two years, especially when the ability to raise capital could be crucial to the post-emergence corporation's long-term success.
Insolvency exclusion: This exception under Sec. 108(a)(1)(B) applies when the taxpayer is insolvent (outside of bankruptcy). Insolvency for this purpose is defined in Sec. 108(d)(3) as the excess of liabilities over the fair market value (FMV) of assets, as determined immediately before the debt discharge and including the debt to be discharged (Miller, T.C. Memo. 2006-125). The amount excluded from income by reason of a debtor's insolvency cannot exceed the amount of the debtor's insolvency (Sec. 108(a)(3)). The taxpayer has the burden of proof in meeting the definition of insolvency (see Hill, T.C. Memo. 2009-101). In the calculation of a taxpayer's insolvency, nonrecourse debt is treated as a liability to the extent of the FMV of the property securing the debt. Nonrecourse debt in excess of the property's FMV is treated as a liability only to the extent it is discharged (Rev. Rul. 92-53, as modified by Rev. Rul. 2012-14).
The authors have seen a proliferation in the use of disregarded entities that are owned by corporations and other types of taxpayers. The IRS has issued proposed regulations concerning the application of Secs. 108(a)(1)(A) and (B) to disregarded entities (REG-154159-09). According to these regulations, the owner of the disregarded entity, not the disregarded entity itself, will be considered the taxpayer for purposes of determining insolvency. As a result, if the disregarded entity is in a Title 11 bankruptcy case but the owner is not, Sec. 108(a)(1)(A) will not apply. If indebtedness of a disregarded entity is otherwise discharged (i.e., outside of Title 11), Sec. 108(a)(1)(B) will apply only to the extent the owner of the disregarded entity is insolvent. If the disregarded entity is insolvent but the owner is not, Sec. 108(a)(1)(B) will not apply to the discharge of indebtedness income (Prop. Regs. Sec. 1.108-9). While this regulation applies to COD income occurring on or after the date the final regulations are published, it indicates how the IRS views COD income in these circumstances.
"Toll Charge" for Excluded COD Income
Sec. 108 lists certain exceptions to the general rule of including COD income in the taxpayer's gross income under Sec. 61(a)(12). However, a toll charge must be paid for income exclusion, in the form of a corresponding reduction of certain favorable tax attributes, including NOLs and the adjusted tax basis of property, according to the complex attribute reduction rules in Secs. 108(b) and 1017.
Generally, tax attributes are reduced in the following order: NOLs, unused general business credits, minimum tax credits, net capital losses, basis, passive activity losses and credits, and foreign tax credits (Regs. Sec. 1.108-7(a)(1)). The taxpayer is allowed to take into account for the year of discharge the tax attributes that are carryovers to that year, before the attributes are reduced in the immediately succeeding year (Regs. Sec. 1.108-7(b)). A provision in Sec. 108(b)(5) allows a taxpayer to elect to first reduce the basis of its depreciable property as an alternative to the general ordering rule for attribute reduction. Where the excluded COD income exceeds the sum of the taxpayer's tax attributes, the excess is permanently excluded from the taxpayer's gross income.
Any taxpayer that excludes discharged debt from gross income must report the exclusion and related adjustments to tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to be filed with the income tax return for the tax year of the discharge.
COD Income in Consolidated Returns
For consolidated returns, each subsidiary generally stands on its own in applying the COD rules discussed above. The amount of COD income excluded from gross income when the debtor is insolvent is determined based on the assets and liabilities of only the member that has COD income (Regs. Sec. 1.1502-28(a)(1)).
The regulations use a consolidated approach that reduces all tax attributes available to the debtor (Regs. Sec. 1.1502-28(a)(2)). Thus, the rules provide for a reduction of the consolidated NOLs as well as all other consolidated tax attributes (including those attributable to members other than the debtor-member). Items attributable to the debtor-member include the debtor-member's (1) consolidated attributes, (2) attributes that arose in separate return limitation years (SRLYs), and (3) basis of property.
The consolidated attribute for the debtor-member is determined under Regs. Sec. 1.1502-21(b)(2)(iv). If the excluded COD income exceeds the attributes of the debtor-member, the reduction of consolidated attributes of other members and attributes of members other than the debtor-member that arose (or are treated as arising) in a SRLY is required to the extent that the debtor-member is a member of the SRLY subgroup for the attribute.
Tax attributes subject to reduction include tax attributes of other members that arise in a SRLY and that are not subject to a SRLY limitation (Regs. Sec. 1.1502-28(a)(4)). Those include, for example, attributes from SRLYs that are not subject to the SRLY limitations as a result of the overlap rule of Regs. Sec. 1.1502-15(g) or Regs. Sec. 1.1502-21(g).
Unlike consolidated attributes, the basis of assets held by members other than the debtor-member is not an attribute that is directly available to offset income of the debtor-member. The basis of assets held by members other than the debtor-member may never give rise to an attribute that could be directly available to offset income of a member of the group for a consolidated return year. Therefore, a reduction of the basis of assets of members other than the debtor-member is allowed only in limited circumstances.
A lookthrough rule applies if the attribute of the debtor-member to be reduced is the basis of stock of another member of the group (Regs. Sec. 1.1502-28(a)(3)). In these cases, corresponding adjustments must be made to the attributes of the lower-tier member. To make these adjustments, the lower-tier member is treated as a debtor-member that has COD income excluded from gross income in the amount of the stock basis reduction for purposes of the rules relating to the reduction of the attributes of a debtor-member. The consolidated attributes of the lower-tier member (determined by Regs. Sec. 1.1502-21(b)) and the lower-tier member's separate attributes (including attributes that arose in SRLYs and asset basis) are available for reduction.
While the above rules apply to outside creditor relationships, special rules apply to intercompany obligations. Regs. Sec. 1.1502-13(g)(4)(i)(C) provides that Sec. 108(a) does not apply to income from an intercompany obligation. Therefore, COD income of a member must be included in the gross income of the member realizing the income, with a corresponding bad debt expense deduction to the other member. While the income and bad debt expense offset each other at the federal consolidated return level, there could be taxable COD income for those stand-alone companies that do not file a combined or consolidated return and that do not have specific adjustments to eliminate the COD income at the state level.
Considerations for S Corporations
The application of the COD income rules to S corporations and their shareholders has several unique features. COD income exclusion and attribute reduction provisions are applied at the S corporation level. Therefore, insolvency or bankruptcy is determined at the S corporation level rather than at the shareholder level. COD amounts that are excluded from the S corporation's income may reduce the losses that are suspended for a particular shareholder, but only in the immediately succeeding year.
Since an S corporation is generally a nontaxpaying conduit, taxable COD income does not create a tax liability at the S corporation level; the income passes through to the shareholders, who increase their basis for stock or debt by an equal amount under Sec. 1367. If any shareholders have suspended losses, the basis increase could free up suspended losses to offset the taxable COD income in the year of the discharge. Taxable COD income not only increases tax basis, but it also increases the S corporation's accumulated adjustments account (AAA), which may allow for a nondividend distribution if the corporation has accumulated earnings and profits. Since the cancellation of debt does not provide the S corporation with any cash to distribute, the corporation may simply have a net increase in the AAA.
To the extent that the COD income is excluded from the S corporation's income because the corporation is in bankruptcy or is insolvent, the shareholders do not increase their bases for the excluded COD income (Sec. 108(d)(7)(A)). This rule was changed in response to a taxpayer-favorable Supreme Court decision, Gitlitz, 531 U.S. 206 (2001). In Gitlitz, the shareholders of an S corporation asserted that COD income that was excluded from gross income passed through to the shareholders to increase the basis of their stock in the same manner as other types of tax-exempt income. This allowed the shareholders to claim suspended losses that had been previously disallowed because of insufficient basis in their stock. The shareholders observed that, as a technical matter, attribute reduction attributable to nontaxable COD income did not occur until the subsequent tax year. The government argued that COD income that was excluded as taxable income did not increase stock basis. The Supreme Court agreed with the taxpayers. As a consequence of the Gitlitz decision, the Code was amended for debt discharges after Oct. 11, 2001, to provide that if COD income is excluded from the S corporation's income because the corporation is in bankruptcy or is insolvent, the shareholders are expressly denied a stock basis increase for the excluded COD income (Job Creation and Worker Assistance Act of 2002, P.L. 107-147, §402).
Unlike C corporations, S corporations generally do not have NOLs, unless an NOL carryover arose in a prior year in which the S corporation was taxed as a C corporation. A reduction of tax attributes at the S corporation level thus generally affects each shareholder's distributive share of losses and deductions that have been excluded for the tax year of the debt discharge. Consequently, each shareholder's losses suspended due to basis limitations that carry forward into the years following the year of debt discharge need to be recalculated (Sec. 1366(d)). If an S corporation has an NOL carryover from a prior year, arguably, this loss could be reduced under the reduction of tax attributes rules of Sec. 108(b)(2)(A). However, Sec. 1371(b)(1) appears to prevent the application of Sec. 108(b)(2)(A), as the tax attributes of an S corporation that are required to be reduced under Sec. 108(b) do not statutorily include any carryover of tax attributes from a C corporation year.
Considerations for Partnerships
COD income recognized at the partnership level must be allocated among the partners based on their respective ownership percentages under the general rules of Secs. 702(a) and 704(b); the receipt of COD income increases the partner's basis in his or her partnership interest under Sec. 705. Under Sec. 108(d)(6), the COD income exclusion and attribute reduction rules are applied exclusively at the partner level. Therefore, insolvent partners may exclude their allocable share of COD income in whole or in part, while solvent partners would be taxed on their allocable share of COD income despite the underlying level of insolvency of the partnership, unless another exclusion under Sec. 108 applies.
A partnership could convert to a corporation under Sec. 351 in a number of ways, including by contributing the partnership assets into a newly formed corporation, followed by a liquidation of the partnership, then having the partners contribute their interests into a newly formed corporation, or by making a check-the-box election for the partnership before the COD event (see Rev. Ruls. 84-111 and 2004-59) to take advantage of the insolvency or bankruptcy exceptions. But this incorporation technique could be a trap for the unwary because an incorporation transaction under Sec. 351 could result in gain recognition under Sec. 357(c) for liabilities in excess of tax basis. If the incorporation precedes the COD event, the liabilities that are ultimately forgiven are counted for purposes of measuring the amount of Sec. 357(c) gain. Similarly, gain recognition could result if partners contribute their interests to corporations to avoid the passthrough of COD income.
A strong understanding of the rules surrounding bankruptcy and insolvency, along with careful tax planning for C corporations, S corporations, and partnerships, is critical for any taxpayers contemplating either bankruptcy or a debt restructuring with their lenders. With proper tax planning, taxpayers may be able to exclude COD income from taxable income as well as preserve valuable tax attributes. Since tax liabilities are generally not dischargeable in bankruptcy, careful tax planning is essential for those taxpayers truly in need of a "fresh start," to ensure the best possible chances of post-restructuring success.