Shareholder's forgiveness of insolvent corporation's debt.

• Author: Borghino, Jeff

A debt cancellation or forgiveness by a corporation's shareholder is a common transaction. Despite the prevalence of these transactions, some critical tax consequences are uncertain, including the determination of any income from the cancellation of debt (COD income) under certain circumstances. Recently, the IRS concluded in Letter Ruling 202112003 (March 26, 2021) that an insolvent corporation should determine whether it had any COD income by applying Sec. 108(e)(6), which addresses the effect of a shareholder's forgiveness of a corporation's indebtedness. In the letter ruling's analysis, it made no difference in determining the effect of the shareholder's debt forgiveness whether the corporation was insolvent. This was a noteworthy ruling because the IRS had reached a different conclusion in the past on similar facts involving a shareholder's cancellation of an insolvent corporation's indebtedness. This item first summarizes the relevant Code provisions, then looks at past IRS guidance on this issue, and finally discusses Letter Ruling 202112003.

Background

Sec. 61(a)(11) provides the general rule that gross income includes income from cancellation of debt except as provided by law. If a debtor repurchases a debt instrument for an amount less than its adjusted issue price (within the meaning of Regs. Sec. 1.1275-1(b), the debtor realizes COD income (Regs. Secs. 1.61-12(c)(2)(ii)).

Under Sec. 108(a), a taxpayer's gross income does not include COD income in certain circumstances. One example is when the discharge occurs and the taxpayer is insolvent (the insolvency exception). The amount excluded under the insolvency exception must be applied to reduce the taxpayer's tax attributes as specified under Sec. 108(b).

In general, if a shareholder gratuitously forgives debt owed by a corporation, the transaction constitutes a contribution to the capital of the corporation to the extent of the principal of the debt (Regs. Sec. 1.61-12(a)). Sec. 108(e)(6), the key provision in the present discussion, further provides that if a debtor corporation acquires its debt from a shareholder as a contribution to capital: (1) Sec. 118, which concerns contributions to the capital of a corporation, does not apply; and (2) such debtor corporation is treated as having satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the debt. The legislative history indicates that to fall within the scope of Sec. 108(e)(6), the...