Application of the consolidated tax return rules to insolvent members.

• Author: Feinstein, Bruce

The tax treatment of an insolvent debtor realizing discharge of indebtedness income under the U.S. consolidated income tax return rules can vary considerably depending on the particular circumstances. As discussed below, the consolidated tax rules governing transactions involving intercompany debt obligations between members of the same consolidated group differ greatly from the rules that govern debt obligations owed by an insolvent debtor/member to a nonmember creditor. The application of these rules presents numerous tricks and traps for the unwary.

This item highlights the U.S. consolidated tax return rules that govern the treatment of cancellation of indebtedness (COD) income (see generally Regs. Secs. 1.1502-13(g) and -28). A comprehensive discussion of these rules is beyond the scope of this item. Accordingly, if a member of a consolidated group realizes COD income, taxpayers and practitioners are urged to thoroughly familiarize themselves with these rules to ensure that all relevant issues are identified and properly addressed.

Sec. 108 Gross Income Exclusion and Attribute Reduction Rules

COD is an item of gross income that is subject to current taxation under Sec. 61(a)(12), unless it is otherwise excluded. For example, COD income is excluded from current taxation if the COD event occurs in a Title 11 bankruptcy case, i.e., where the debtor/taxpayer is under the jurisdiction of the bankruptcy court. COD income is also excluded from current taxation if the taxpayer is insolvent. Sec. 108(d)(3) provides that a taxpayer is considered insolvent if its liabilities exceed the fair market value (FMV) of its assets immediately before the COD event occurs.

If COD income is excluded under the insolvency exception rules, the debtor/ member is required to reduce certain specified tax attributes and asset bases in accordance with the ordering rules set forth in Secs. 108(b) and 1017. As is further discussed below, the application of these rules can have anomalous consequences.

Sec. 108 also contains a number of other rules that can either eliminate or reduce the amount of realized COD income. Of particular relevance here are the contribution-to-capital and stock-for-debt rules.

The following discussion assumes that the insolvent member does not elect under Sec. 108(b)(5) to apply attribute reduction first against depreciable property and does not elect to treat the stock of lowertier members as depreciable property pursuant to Sec. 1017(b)(3)(D).

Shareholder Capital Contribution of Debt

Under the Sec. 108(0(6) contribution-to-capital rule, if a corporation acquires its debt from a shareholder, the transferee corporation is treated as satisfying the debt with an amount of money equal to the shareholder's basis in the debt. Two examples illustrate the application of this rule.

Example 1: A Co., an accrual-method debtor/corporation, accrues an unpaid expense owed to B, a cash-method creditor/shareholder. B has not recognized income yet and therefore has no basis in the obligation. If B later contributes her zero-basis liability to A Co., the corporation recognizes COD income to the extent of the face amount of the liability.

Example 2: On the other hand, if B loans money to A Co. and B's basis in the debt is equal to...