Sec. 108(a) (1) excluded COD income: are "windfall" basis adjustments allowed?

• Author: Pollack, Sheldon D.
• Position: Cancellation of indebtedness

Last year, the Sixth Circuit held in Babin[1] that a partner is not entitled to an increase in the basis of his partnership interest for partnership cancellation of debt (COD) income, when the income is excluded from tax under the Sec. 108(a)(1)(b) insolvency exception. Subsequently, in Letter Ruling (TAM) 9423003,[2] the IRS took a comparable position with respect to COD income of an insolvent S corporation; the S shareholders were not entitled to an increase in the basis of their S stock for their pro rata shares of excluded income.

With respect to both partnerships and S corporations, the Service's position is that income excluded from tax under Sec. 108(a)(1) is not tax-exempt income for which a basis adjustment is allowed under subchapters K and S. Arguably, this position can be justified from a policy perspective: under certain facts, such a basis adjustment can produce a windfall to the partners or shareholders of the debtor, a passthrough entity for tax purposes whose debt has been discharged. However, the basis adjustment is warranted under the language of the Code. For this reason, the Service's litigation position is problematic; legislative amendment by Congress, not equitable decisionmaking by the Federal courts, is the appropriate remedy.[3] This article examines the pro and con arguments surrounding this basis adjustment.

Background

According to the Supreme Court in Kirby Lumber Co.,[4] when a debtor acquires its own debt instrument for less than its face amount, income is recognized equal to the difference between the purchase price and the debt's outstanding balance. Likewise, a lender's COD results in COD income to the debtor. Whether a debt discharge results in COD income is still determined under this judicial doctrine, rather than by the Code. Once it is determined that COD income has been recognized (and that no relevant judicial exception applies), it is includible in gross income under Sec. 61 (a)(12), unless otherwise excluded.

A number of the original cases involving debt discharge were decided during the Depression, when the value of real estate significantly declined; many of the recent cases and rulings have facts reminiscent of these leading decisions and involve debt workouts in the context of distressed real estate projects.[5] These cases and rulings often involve the use of tax entities that either did not exist or were less commonly used in the 1930s (e.g., partnerships and S corporations). Further, Congress added Sec. 108 to the Code via the Bankruptcy Tax Act of 1980 (BTA '80), which codified several of the judicial exceptions to the general rule that COD results in COD income.

These developments in tax law have forced the courts, the IRS and taxpayers to grapple with the intricacies of subchapters K and S, as well as the many peculiarities that can arise when COD income is realized in the context of a debtor partnership or S corporation. Technical glitches arise because tax rules enacted at different times under different Code provisions are not well integrated with one another.

Exceptions to Income Recognition

Historically, the courts have recognized a number of exceptions to Kirby Lumber; after that Supreme Court decision, many of those exceptions continued to be respected by the lower courts. Among the many judicial exceptions enunciated by the courts over the years (some of which may no longer be good law), the most significant have held that income is not recognized (1) when the "overall transaction" is a loss,[6] (2) when the cancellation is of nonrecourse debt,[7] (3) when a debt discharge is in economic substance a "purchase price reduction"[8] and (4) to the extent that debt discharge occurs while the debtor is insolvent.[9]

A number of these judicial exceptions were codified in the enactment of Sec. 108. Under Sec. 108(a)(1)(b), when a taxpayer realizes COD income, the income is not recognized to the extent that the debtor is insolvent. Sec. 108(d)(3) defines "insolvency" for this purpose as the excess of liabilities over the fair market value (FMV) of assets, as of immediately before the discharge. Under Sec. 108(a)(1)(A), COD income is not recognized to the extent that the debt discharge occurs in a bankruptcy proceeding. The following examples illustrate how these two statutory exceptions are applied to an S corporation debtor.

Example 1: An S corporation ("Debtor") is owned by two equal shareholders, X and Y, who each contributed $500,000 in exchange for stock. On Jan. 1, 1996, Debtor purchases a commercial office building on leased land for $11,000,000, using the $1,000,000 in capital contributions and a $10,000,000 bank loan. The loan, which is interest only for 10 years and a balloon payment at maturity, is secured by a first mortgage on the building. The shareholders do not guarantee the loan and are not personally liable for the debt.

For the first five years of operation, Debtor's operating expenses exactly equal its revenues; hence, there is no net cash flow. Annual tax losses of $282,040 (0.02564 x $11,000,000) attributable to...