Tax considerations for cancellation-of-debt income.

• Author: Schwartzman, Randy A.

This item provides an overview of the U.S. income tax implications of cancellation-of-debt (COD) income that results from bankruptcy or insolvency, with a focus on the differences in the tax treatment for C corporations, S corporations, and partnerships. Since the general rule provides that COD income is recognized even though there are no actual cash proceeds, absent certain exclusions to the recognition of COD income that are discussed below, the tax liability on COD income could create liquidity issues for a debtor. Therefore, a thorough understanding of the statutory exclusion and deferral provisions is essential when it comes to tax planning to avoid or ameliorate the tax consequences associated with COD income.

Note: If a debtor has incurred net operating losses (NOLs), there may be certain alternative minimum tax limitations as well as other restrictions on the use of NOLs that may otherwise prevent the full use of those losses to offset COD income. However, that issue is beyond the scope of this item.

Taxable COD Income

Under Sec. 61(a)(12), which codified the landmark case of Kirby Lumber Co., 284 U.S. 1 (1931), gross income includes "income from discharge of indebtedness." This treatment is based on the rationale that since borrowing does not result in taxable income, the borrower realizes an economic benefit when the obligation is reduced or repayment is canceled. Indebtedness in this context is described in Sec. 108(d)(1) as "any indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds property."

COD income can result from a variety of transactions involving the relief of a debt repayment obligation, such as action taken by the creditor (e.g., a formal discharge or repurchase of the debt for less than its principal amount) or by operation of law (e.g., debt discharge in bankruptcy). Interest--as well as principal--may constitute forgiven debt includible in income (see, e.g., Brooks, T.C. Memo. 2012-25; and Black, T.C. Memo. 2014-27). Realization of COD income generally occurs when it is clear that debt is undisputed, uncollectible, and nonrevivable (see, e.g., Zarin, 916 F.2d 110 (3d Cir. 1990)).

In the absence of actual payment or repurchase of the debt, the timing for realizing COD income is harder to pinpoint. While the courts have taken a fact-specific approach, the timing of COD income is generally tied to an identifiable event making it clear that the debt will never be paid (see, e.g., Cozzi, 88 T.C. 435 (1987)).

There is also a rebuttable presumption that an identifiable event occurred in a calendar year if the creditor has received no payments at any time during a testing period (generally 36 months) ending at the close of the year (Regs. Sec. 1.6050P-1(b)(2)(iv); see, e.g., Kleber, T.C. Memo. 2011-233). However, proposed regulations have been issued that, when finalized, will eliminate this rule.

Exceptions From COD Income Recognition

Bankruptcy exclusion: Under Sec. 108(a)(1)(A), COD income is excluded from gross income where the discharge of indebtedness is granted in a Title 11 case, which includes Chapter 11 reorganizations, Chapter 7 liquidations, and Chapter 13 bankruptcy proceedings under Title 11 of the U.S. Code. This exclusion applies only if the discharge of indebtedness is granted by a court order or in a court-approved plan (Sec. 108(d)(2)).

When debt is discharged in bankruptcy, the bankruptcy exclusion rules govern, even if one of the other exceptions would have applied (Sec. 108(a)(2) (A)); this treatment is important since the required reduction of tax attributes differs depending on which COD income exclusion applies.

Sec. 382 limitation and bankruptcy exceptions: In Title 11 and similar cases, debtors frequently pay off creditors by issuing new equity. This stock-for-debt exchange could trigger an "ownership change" as defined in Sec. 382 to the extent that "old" equity is replaced.

In general, an ownership change under Sec. 382 occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by one or more 5% shareholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period, which is generally a three-year lookback period. The measure of the change is based on stock value rather than the absolute number of shares held, which is an important distinction when there is more than one class of stock.

In effect, this means that the corporation's value must be known at each testing date to determine each 5% shareholder's share of the total value. A testing date is any date on which (1) an insolvent company experiences a shift in owners/equity structure, or (2) an issuance or transfer of an option is treated as exercised for Sec. 382 purposes.

When an ownership change occurs, Sec. 382 limits a corporation's ability to use tax attributes from before the change in ownership, including NOL carryovers and certain built-in losses, to offset post-change taxable income. However, the Sec. 382 rules do not reduce the amount of the corporation's prechange losses; rather, an annual limitation is...