Sec. 108(e) (2) and debt that would give rise to basis.

• Author: Unell, Bela

Forgiveness of liabilities generally gives rise to taxable income under Sec. 61(a) (12) (cancellation of indebtedness (COD) income), but Sec. 108 contains several exceptions to that rule. One such exception is for liabilities whose payment would give rise to a deduction (Sec. 108(e)(2)). A taxpayer is not required to recognize taxable income for the discharge of a liability when payment of the liability would have given rise to a tax deduction.

This sometimes is called a "tax benefit" rule, reflecting the idea that COD income excludes deductible expenses from which no tax benefit has resulted. However, even with corporate taxpayers, the tax benefit that results from indebtedness is not always a deduction. Some liabilities, particularly acquisition liabilities, are capitalized into the basis of stock or of various assets.

And sometimes those liabilities are not reflected in basis immediately. For example, when a taxpayer acquires property subject to contingent debt, that debt is not taken into account in basis unless and until it is paid. But what if the debt is forgiven before it is paid? A line of cases excludes the discharge of contested debt from COD income, and commentators sometimes cite those cases as establishing that there is no COD income from the discharge of contingent debt generally (see Zarin, 916 F.2d 110 (3d Cir. 1990); Whitmer, T.C. Memo. 1996-83; and Estate of Smith, 198 F.3d 515 (5th Cir. 1999)). Whether those cases go that far is questionable, but they are clearly inapplicable when the subject debt is fixed and determinable at the time of discharge--even if it was originally too contingent to give rise to basis.

It does not seem right that liabilities that were too contingent to have given rise to basis should give rise to COD income when canceled, yet there is apparently no explicit exclusion from COD income for them. Acquisition debt that did not give rise to basis is explicitly excluded from creating gain on a taxable sale or exchange of the property subject to the debt under Regs. Sec. 1.1001-2(a)(3), but that provision does not apply to COD income.

Martin Cowan suggests that Sec. 108(e)(2) should be read to exclude from COD income a cancellation of debt that would otherwise give rise to basis because the debt would have been covered by Section 346(j)(2) of the old Bankruptcy Code (11 U.S.C. [section]346(j)(2), before amendment by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8), which...