IRS rules on cancellation of debt of a disregarded entity.

• Author: Stringfield, Jack

On Dec. 11, 2020, the IRS released Letter Ruling 202050014, in which it ruled that a series of proposed transactions pursuant to a bankruptcy plan would not result in gain or loss to a corporation and that Sec. 61(a)(12) (before its redesignation as Sec. 61(a)(11) by Section 11051 of the law known as the Tax Cuts and Jobs Act, P.L. 115-97) and Sec. 108(a) did not apply to the cancellation of debt owed by its disregarded entity (DRE).

Facts of Letter Ruling 202050014

In Letter Ruling 202050014, a corporation, Distributing, was the common parent of a group that included corporations and DREs (the Distributing Group). Distributing directly owned 100% of LLC1, which was a DRE. LLC1 had outstanding debt consisting of first lien debt, second lien debt, and unsecured debt (the LLC1 debt). The LLC1 debt was not, and never had been, guaranteed by Distributing.

Pursuant to a proposed plan of restructuring, the Distributing Group contributed all the assets that it directly owned to LLC1, then LLC1 formed a new corporation (Newco) and contributed all of its assets to Newco in exchange for Newco stock, cash, and newly issued Newco debt. LLC1 then planned to distribute all of the property that it held to LLC1's creditors in satisfaction of the LLC1 debt. Finally, LLC1 planned to liquidate, and any equity held by Distributing was canceled for no consideration.

Background of cancellation of nonrecourse debt: Tufts

Generally, when a lender cancels recourse debt in exchange for property that has fair market value (FMV) less than the amount of the debt canceled, the consequences are bifurcated. First, the debtor will recognize Sec. 1001 gain (or loss) to the extent that the FMV of the property received exceeds (or is less than) the basis of the property. Second, the debtor will recognize cancellation-of-debt (COD) income under Sec. 61(a)(11) in an amount equal to the excess of the adjusted issue price of the debt (within the meaning of Regs. Sec. 1.1275-1(b)) and the FMV of the property.

The consequences for the same transaction can be different if the debt is nonrecourse (i.e., debt where the lender is only permitted to seize the collateral specified in the loan agreement). Generally, if nonrecourse debt is canceled in exchange for the property that is subject to the debt, then the debtor will instead treat the amount of the debt as the amount realized in exchange for the property for purposes of Sec. 1001, even if the amount of the debt exceeds the value of the property exchanged. Thus, the debtor will have gain under Sec. 1001 to the extent the amount of the debt exceeds the basis of the property (Tufts gain), unless another provision of the Code (e.g., Sec. 361) provides for tax-free treatment (see Tufts, 461 U.S. 300 (1983)).

Therefore, Sec. 61(a)(11) (regarding COD income) and Sec. 108(a) (regarding exclusion of COD income) may not apply when there is a cancellation of nonrecourse debt in exchange for the...