Debt discharge under Sec. 108: partnerships vs. S corps.

• Author: Boos, Robert, Jr.

As tax liability for cancellation of debt (COD) income gives many taxpayers an unpleasant surprise in today's economy, its tax treatment continues to be a focal point for tax professionals in tax planning and preparation.

The primary difference regarding debt discharge between businesses that are organized as partnerships and those organized as S corporations is the application of Sec. 108 and its effect on the passthrough character of the debt discharge.

In a partnership, the partner recognizes a pro rata share of COD income in full and applies Sec. 108 at the partner level (Sec, 108(d)(6)). In contrast, COD income in an S corporation is recognized at the corporate level, where the taxable portion after the application of Sec. 108 is realized and passed through to the shareholders (Sec. 108(d)(7)(A)).

Sec. 108(a)(1) allows for exclusion of COD income from gross income where the debt discharge:

1. Occurs in a Title 11 case (bankruptcy);

2. Occurs when the taxpayer is insolvent;

3. Is qualified farm indebtedness;

4. Is qualified real property business indebtedness (other than for a C corporation); or

5. Is qualified principal residence indebtedness discharged prior to Jan. 1, 2013 (currently proposed legislation would extend this date by one year).

In addition, the ordering rules in Sec. 108(b)(2) for reducing tax attributes by the amount of excluded COD income applies differently to partnerships and S corporations. This item compares the tax results of debt discharge for partnerships and S corporations and the effect on the stakeholder in each entity.

Sec., 108(a) (1) (A): Bankruptcy

Because the Sec. 108 exclusion from gross income is determined at the partner level, partners qualify for the bankruptcy exclusion only if they are individually in bankruptcy. Partners that exclude COD income from gross income must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with their tax return and reduce their tax attributes per the ordering rules of Sec. 108(b), as discussed later in this item.

For an S corporation, the bankruptcy exclusion applies if the S corporation is under the jurisdiction of a court in a bankruptcy case and the debt discharge is granted by the court or as part of a court-approved plan. Any taxable income after the application of Sec. 108 is passed on to the shareholders as taxable income, without any stock basis adjustment for the excluded income. The S corporation...