Tax consequences of canceling S debt can be deceptive.

• Author: Price, Richard G.

The Tax Reform Act of 1986 (TRA) dramatically increased the Federal tax advantages of S corporations over C corporations. It also changed the consequences to S corporations and their shareholders on cancellation of debt (COD).

The tax consequences of COD were first addressed by Congress when it enacted Sec. 61(a)(12). The Bankruptcy Tax Act of 1980 reaffirmed the taxability of COD income with an exception for bankrupt and insolvent individuals and C corporations. In 1982, the tax treatment of COD for S corporations was first added by Congress, providing for the bankruptcy and insolvency exception at the shareholder level. The TRA shifted the focus of the exception to the corporate level (Sec. 108(d)(7)(a)). Practitioners need to be aware of these consequences when reorganizing an S corporation's debt.

Exclusion from income

As a general rule, COD is taxable income to the debtor (Sec. 61(a)(12)). If a debtor is bankrupt or insolvent, however, COD may be excluded from income under Sec. 108(a). The general rule is that taxable transactions in the S corporation are taxable to the shareholders, leaving the question of whose status controls the tax consequences of COD. Ultimately, Congress concluded that the S corporation's status was more important than the shareholders' (perhaps reflecting that the S corporation's liabilities could not be imposed on the shareholders without personal guarantees). Once COD qualifies for the exclusion under Sec. 108, it is not reported on the shareholder's Schedule K-1 as a separately distributable item. The result is strikingly different for partnerships (Sec. 108(d)(6)). In a partnership, the partners' status controls, perhaps reflecting the partners' potential liability for partnership debts. COD is allocated to each partner, and each partner then qualifies or fails to qualify for the exclusions. Sec. 108 does not distinguish between general and limited partners, although it would seem that limited partners are more similar to S shareholders than general partners.

Reduction of attributes

Sec. 108(b)(2) requires a taxpayer to reduce certain tax attributes (including net operating losses (NOLs), tax credit carryforwards and the basis of certain assets) by the amount of COD excluded. Just as the exclusions are applied at the corporate level, the attribute reductions occur at the corporate level (Sec. 108(d)(7)(a)).

Because S corporations do not pay Federal income taxes at the corporate level, they do not have NOLs...