Selected debt cancellation issues.

• Author: Friedel, David B.

Sec. 61(a)(12) provides that gross income includes income from discharge of indebtedness (DOI). Generally, Sec. 108 provides special rules as to when such DOI income should not be includible in the debtor's gross income. Two fairly common situations involve a parent's contribution of accrued interest liability to the capital of its debtor-subsidiary and determining which property is eligible for basis reduction under Sec. 108(e)(5).

Example 1: A, a foreign entity, owns 100% of domestic corporation B. Several years ago, A loaned $100 to B in exchange for a note with adequate stated interest of 8%. B accrued interest of $8 on the loan each year, but did not claim a deduction (due to the deferral mechanism of Regs. Sec. 1.267(a)-3). Currently, A wants to contribute the $100 to B's capital, as well as all the accrued but unpaid interest. (B will not issue actual stock certificates to A in exchange.) The issue is whether B must report any DOI income under Sec. 61(a)(12) as to either the principal or interest.

With respect to A's contribution of the $100 principal amount to capital, no DOI income should result to B under Sec. 108(e)(6) and/or Regs. Sec. 1.61-12(a). This assumes that A's basis in the debt equals the face value of the note, which is the most likely scenario. (Sec. 108(e)(8) does not apply, because no physical shares were issued.)

The cancellation of the interest component is more complicated; it depends on the interplay between a nonrecognition provision and the tax benefit rule. Ordinarily, an accrual-method taxpayer that had previously claimed an interest deduction would be required to report DOI income when the obligation to pay that amount is discharged. However, the Tax Court has held that the specific nonrecognition policy of Sec. 108 should override that general tax benefit rule when the interest obligation is forgiven by the debtor's shareholders (Putoma Corporation, 66 TC 652 (1976)).

The IRS disagreed with this result and promptly issued Rev. Rul. 76-316, which held that the debtor would have to report DOI income under these facts. In 1980, Congress enacted Sec. 108(e)(6), overruling Putoma and explaining that the debtor-subsidiary is only permitted to avoid DOI consequences to the extent of the creditor/shareholder's basis in the debt. Since the creditor would have no basis in the receivable corresponding to the unpaid interest, there would be DOI income for the discharged interest under this rule.

Thus, in Example 1, B...