COD in insolvent member of affiliated group does not affect tax attributes of other members.

• Author: Price, Richard G.
• Position: Cancellation of debt

An affiliated group is made up of legally separate entities. Each entity will engage in its own transactions, and may even engage in unrelated businesses. As a result of these activities, it is possible for one or more members of the affiliated group to become insolvent even as other members (and even the group as a whole) remain solvent. Although most of the affiliated group rules of the Internal Revenue Code continue to apply, there are complex issues that will require careful consideration.

The central rules governing Federal taxation of cancellation of debt (COD) income are in Sec. 108. COD income is taxable unless the circumstances fall into a specific exception, such as bankruptcy or insolvency. If COD income escapes Federal income taxation through one of these exceptions, the debtor reduces carryforward tax attributes, such as net operating losses (NOLs), credit carryforwards and the adjusted bases of assets owned by the debtor. The theory is that these tax attributes will reduce the taxable income of the debtor corporation in future years, that the cancelled debt was used to "buy" these tax attributes, and that if the debt will not be repaid, the debtor should not get the advantage of the related deductions.

The situation is more complex when the tax laws intertwine the debtor with other entities that may or may not meet the same exceptions. For example, the income of a partnership is taxed to the partners. The bankruptcy and insolvency exceptions are based on the status of each partner rather than the partnership itself. This means that a partnership may be in bankruptcy, but the partners may suffer taxable income from the cancellation of the partnership's debt. Although shareholders of an S corporation are treated similarly to partners in a partnership, the bankruptcy and insolvency exceptions are based on the status of the corporation only. Thus, a bankrupt shareholder may pay tax on COD income passed through from a solvent, nonbankrupt S corporation.

Affiliated groups face similar issues. The tax attributes of one member affect the tax liabilities of the affiliated group. For example, a loss suffered by one member may be used to offset taxable income earned by another. If an insolvent member of an affiliated group has COD income and another member has an NOL carryforward, should the other member's NOL carryforward be reduced? If the affiliated group is considered a single entity for Sec. 108, the answer is yes. If the affiliated...