Cancellation of indebtedness income

Section 61 generally defines gross income as "all income from whatever source derived". Section 61(a)(12) specifically provides that gross income includes income from the discharge of indebtedness. Gitlitz v. Commissioner [2001-1 USTC ¶50,147] 531 U.S. 206, 213 (2001); United States v. Kirby Lumber Co. [2 USTC ¶814] 284 U.S. 1 (1931).

With all of the "short sale" mortagages, there will be lots of "cancellation of indebtedness income" for 2008 and beyond.





Code Sec. 108(i) allows businesses to elect to defer cancellation of indebtedness (COI) income until 2014 and then to recognize the income ratably over five years, Bakke explained. The provision applies to repurchases of debt occurring in 2009 or 2010 by the issuer of the debt or a related party. Ordinarily, the business would have to recognize income on the COI, unless an exception applied under Code Sec. 108(a).





The Treasury Department's Donald Bakke indicated on March 11 that Treasury is considering guidance under Code Sec. 108(i), a provision enacted in the American Recovery and Reinvestment Act of 2009 (P.L. 111-5).





The repurchase can be for cash or for other debt, Bakke said. The provision applies separately to each debt instrument. There is no consistency requirement --a debtor can defer income for one class of debt instrument and recognize income on the repurchase of other debt. The provision can also apply to an insolvent debtor who ordinarily could exclude the income but would have to reduce tax attributes. He emphasized that the exclusion was elective.



Bakke noted that if the debtor issues the instrument with original issue discount (OID), the debtor ordinarily would have to recognize the OID each year. However, under Code Sec. 108(i), the OID is deferred to the extent that COI income is deferred, Bakke suggested. A questioner suggested there could be additional OID that did not track the COI income and would not be exempt from taxation. Bakke agreed that a distinction could be drawn. Another practitioner asked about the consequences if the debt was repurchased with other property. Bakke requested comments on this issue.



Another questioner asked whether a protective election would be allowed if it was unclear whether a change in the terms of the debt instrument gave rise to a new debt instrument. Bakke said that the Treasury was discussing protective elections and that there would be guidance on making the election to defer income.



A big question for the guidance to address is how earnings and profits (E&P) is affected if a debtor elects to defer income, Bakke indicated. Ordinarily, if the COI income is taxable, the debtor must increase E&P. However, if the debtor excludes the income and reduces attributes, E&P is not affected. Economically, deferral is like a transaction that increases E&P. Todd Reinstein of Pepper Hamilton LLP noted that a private letter ruling linked the E&P to the recognition of income. Bakke said he would not prejudge the Treasury's answer and again asked for comments.



Another issue for guidance is whether to accelerate the recognition of deferred income if the debtor disposes of assets in a tax-free transaction like a liquidation or merger, Bakke said. Arguably, the successor could step in the shoes of the debtor and, thus, the income would not be accelerated.

Summary:
At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of corporate or business debt instrument is includible in gross income ratably over a five-tax-year period.

Background:
Discharge of indebtedness income. When a loan is settled for less than the amount owed, discharge of indebtedness (DOI) income is realized by the debtor and usually must be included in the debtor's gross income (Code Sec. 61(a)(12)). The amount of DOI income is generally equal to the amount of loan forgiveness. DOI income also occurs when a debtor repurchases his own debt at a discount (meaning a price lower than the adjusted issue price of the debt instrument). In debt repurchase transactions, the amount of DOI income is generally equal to the difference between the adjusted issue price and the price paid for the debt instrument (Reg. §1.61-12(c)(2)(ii)).

Comment:
DOI income is particularly burdensome because transactions that cause such income do not normally provide cash to pay the tax. Worse yet, when the economy is in recession a taxpayer who was counting on other assets and investments to pay taxes may find that severe declines in asset values or illiquid markets make it impossible to raise sufficient funds.


Exceptions for inclusion of DOI income. There are several exceptions, under Code Sec. 108(a)(1), to the general rule that DOI income must be included in the debtor's gross income, which are:

(1) if the debt is discharged under a Chapter 11 bankruptcy;

(2) if the debt is discharged when the taxpayer was insolvent;

(3) if the debt discharged is qualified farm indebtedness;

(4) if the debt discharged is qualified real property business indebtedness (except if the debtor is a C corporation); and

(5) if the debt discharged is qualified principal residence indebtedness, discharged before January 1, 2013 (Code Sec. 108(a)(1)).

In cases of debt discharged under a Chapter 11 bankruptcy, debt discharged due to insolvency or qualified farm indebtedness, tax attributes must be reduced by the amount of excluded DOI income in a specific order (Code Sec. 108(b)(1)). In cases of discharged qualified real property business indebtedness or qualified principal residence indebtedness, the bases of properties must be reduced by the amount of excluded DOI income (Code Secs. 1017(b)(3) and 108(h)(1)).

Acquisition of indebtedness by a related person. If outstanding debt is acquired from a third party by a person related to the debtor through certain family, business or fiduciary connections, the transaction is generally treated as if the debtor repurchased the debt himself (Code Sec. 108(e)(4)). Therefore, any DOI income which results from the transaction must generally be recognized as gross income by the debtor - and not by the person who acquired the debt. There are certain exceptions and limitations including if the debtor was in Chapter 11 bankruptcy or was insolvent (Reg. §1.108-2(a)). In addition, the regulations provide further rules and limitations regarding disclosure, timing of acquisitions and subsequent transactions (Reg. §1.108-2). A person is generally considered to be a related person, for purposes of acquisitions of debt under Code Sec. 108(e)(4), under the same rules that are applied for disallowance of losses from transactions between related parties under Code Sec. 267(b) and controlled partnerships under Code Sec. 707(b)(1). Losses from transactions between related persons are not deductible, but a previously disallowed loss can later be used (to the extent of gain) by the original transferee if he sells the property to a non-related third party. (Code Sec. 267(a); Reg. §1.267(d)-1).

Comment:
There is great potential for tax fraud in transactions among related persons, so these transactions are heavily regulated under the Code. Creating false losses and undervaluing assets are among the more common tax avoidance schemes. For example, losses generated by a purchase and sale of property between related persons can produce paper losses which in fact have no economic substance, because of the relationship between the buyer and the seller. Such losses are disallowed under Code Sec. 267(a) and related provisions for good reason.

NEW LAW EXPLAINED

Limited deferral for discharge of indebtedness income from reacquisition of debt instruments. --At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument is includible in gross income ratably over the five-tax-year period beginning with:

 The fifth tax year following the tax year in which the reacquisition occurs for a reacquisition occurring in 2009; and

 The fourth tax year following the tax year in which the reacquisition occurs for a reacquisition occurring in 2010 (Code Sec. 108(i)(1), as added by the American Recovery and Reinvestment Tax Act of 2009 (P.L. 111-5)).

Deferral of deduction for OID in debt-for-debt exchanges. If a debt instrument is issued for the applicable debt instrument being reacquired (or is treated as issued under Code Sec. 108(e)(4), which concerns acquisition of indebtedness by a person related to the debtor), and there is any original issue discount (OID) with respect to the debt instrument:

 no deduction otherwise allowable shall be allowed to the issuer with respect to the portion of such OID which (a) accrues before the first tax year in the five-tax-year period in which income from the discharge of indebtedness attributable to the reacquisition of the debt instrument is includible in gross income, and (b) does not exceed the income from the discharge of indebtedness with respect to the debt instrument being reacquired; and

 the aggregate amount of deductions disallowed shall be allowed as a deduction ratably over the five-tax-year period.

If the amount of OID accruing before the first tax year in which the OID income is to be recognized exceeds the income from the discharge of indebtedness with respect to the applicable debt instrument being reacquired, the deductions are to be disallowed in the order in which the OID is accrued (Code Sec. 108(i)(2)(A), as added by the 2009 Recovery Act).
Deemed debt-for-debt exchanges. If any debt instrument is issued by an issuer and the proceeds are used directly or indirectly by the issuer to reacquire an applicable debt instrument of the issuer, the newly issued debt instrument is treated as issued for the debt instrument being reacquired. If only a portion of the proceeds from a debt instrument are used for this purpose, the deferral rules apply to the portion of any OID on the newly issued debt instrument which is equal to the portion of the proceeds from such instrument used to reacquire the outstanding instrument (Code Sec. 108(i)(2)(B), as added by the 2009 Recovery Act). Thus, if a taxpayer makes the deferral election for a debt-for-debt exchange in which the newly issued debt instrument issued (or deemed issued, including by operation of Reg. §1.108-2(g)) in satisfaction of an outstanding debt instrument of the debtor has OID, then any otherwise allowable deduction for OID with respect to such newly issued debt instrument that (a) accrues before the first year of the five-tax-year period in which the related, deferred discharge of indebtedness income is included in the gross income of the taxpayer, and (b) does not exceed such related, deferred discharge of indebtedness income, is deferred and allowed as a deduction ratably over the same five-tax-year period in which the deferred discharge of indebtedness income is included in gross income (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

This rule can apply in certain cases when a debtor reacquires its debt for cash. If the taxpayer issues a debt instrument and the proceeds of such issuance are used to reacquire a debt instrument of the taxpayer, the newly issued debt instrument is treated as if it were issued in satisfaction of the retired debt instrument. If the newly issued debt instrument has OID, this rule applies. Thus, all or a portion of the interest deductions with respect to OID on the newly issued debt instrument are deferred into the five-tax-year period in which the discharge of indebtedness income is recognized. Where only a portion of the proceeds of a new issuance are used to satisfy outstanding debt, the deferral rule applies to the portion of the OID on the newly issued debt instrument that is equal to the portion of the proceeds of such newly issued instrument used to retire outstanding debt of the taxpayer (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Applicable debt instrument. An applicable debt instrument is any debt instrument issued by: (i) a C corporation, or (ii) any other person in connection with the conduct of a trade or business by such person (Code Sec. 108(i)(3)(A) as added by the 2009 Recovery Act). A debt instrument for these purposes is broadly defined to include bonds, debentures, notes, certificates, or any other instrument or contractual arrangement constituting indebtedness within the meaning of Code Sec. 1275(a)(1) (which excludes certain annuity contracts) (Code Sec. 108(i)(3)(B), as added by the 2009 Recovery Act).

Reacquisition. Reacquisition for these purposes includes any acquisition of an applicable debt instrument by (i) the debtor which issued (or is otherwise the obligor under) the debt instrument, or (ii) a related person to such debtor (Code Sec. 108(i)(4)(A), as added by the 2009 Recovery Act). The determination of whether a person is related to another person is made in the same manner as Code Sec. 108(e)(4) concerning acquisition of indebtedness by a person related to the debtor (Code Sec. 108(i)(5)(A), as added by the 2009 Recovery Act).

Acquisition. Acquisition for these purposes includes an acquisition of an applicable debt instrument for cash, the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument), the exchange of the debt instrument for corporate stock or a partnership interest, the contribution of the debt instrument to capital, and the complete forgiveness of the indebtedness by the holder of the debt instrument (Code Sec. 108(i)(4)(B), as added by the 2009 Recovery Act).

Election. The election to defer OID income is to be made on an instrument by instrument basis. Once made, the election is irrevocable. A taxpayer makes an election with respect to a debt instrument by including with its return for the tax year in which the reacquisition of the debt instrument occurs a statement that: (a) clearly identifies the debt instrument, and (b) includes the amount of deferred income under this provision, plus any other information that may be prescribed by the IRS. The IRS is authorized to require reporting of the election (and other information with respect to the reacquisition) for years subsequent to the year of the reacquisition. In the case of a pass-through entity, such as a partnership or S corporation, the election is made at the entity level (Code Sec. 108(i)(5)(B), as added by the 2009 Recovery Act; Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Coordination with other exclusions. If a taxpayer elects to defer discharge of indebtedness income, the exclusions for discharge under a Chapter 11 bankruptcy, when the taxpayer is insolvent, qualified farm indebtedness, and qualified real property business indebtedness (Code Sec. 108(a)(1)(A), (B), (C) and (D)) do not apply to the income from the discharge of indebtedness for the tax year of the election or any subsequent tax year (Code Sec. 108(i)(5)(C), as added by the 2009 Recovery Act). Thus, for example, an insolvent taxpayer may elect to defer income from the discharge of indebtedness rather than excluding the income and reducing tax attributes by a corresponding amount (Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Acceleration of deferred items. In the case of the death of the taxpayer, the liquidation or sale of substantially all the assets of the taxpayer (including in a title 11 bankruptcy or similar case), the cessation of business by the taxpayer, or similar circumstances, any item of income or deduction which is deferred (and has not previously been taken into account) must be taken into account in the tax year in which such event occurs (or in the case of a title 11 bankruptcy or similar case, the day before the petition is filed). This rule applies in the case of the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by a partner, shareholder, or other person holding an ownership interest in such entity (Code Sec. 108(i)(5)(D), as added by the 2009 Recovery Act).

Practical Analysis:
Paul C. Lau and Sandy Soltis, Tax Partners at Blackman Kallick in Chicago, point out that under Reg. §1.61-12(a), a debtor has cancellation of debt (COD) income equal to the amount of debt reduction. Under Code Sec. 108, the debtor can exclude COD income to the extent it is insolvent or to the extent the debt is discharged in a Title 11 (bankruptcy) proceeding. Some debtors may also exclude the COD income if the debt is "qualified farm indebtedness" or "qualified real property indebtedness." The COD income exclusion is not a free lunch. The debtor is required to reduce certain tax attributes such as net operating losses, general business credits, basis of property (both depreciable and nondepreciable) and unused foreign tax credits. In certain reductions of property tax basis, Code Sec. 1017(b)(2) provides that any basis reduction cannot be more than the excess of the total adjusted basis of property over the total liabilities of the debtor immediately after the debt discharge.

These COD income recognition and exclusion rules apply when a debt is forgiven, "significantly modified," exchanged for a new debt, or repurchased by the debtor. A significant modification of a debt is treated as an exchange of the old debt for a new debt. Significant modifications, subject to certain safe harbors, include a change in interest rate and/or a deferral of principal and interest payments. In addition, a debt that is repurchased by a related party of the debtor (as described in Code Sec. 108(e)(4)) is treated as repurchased by the debtor.

New Law. The new law, Code Sec. 108(i), is intended to provide a debtor the ability to elect to recognize COD income on a deferred basis ratably over a five-tax year period. The election is made on a debt by debt basis and, once made, is irrevocable. If this election is made, both the COD income exclusion and tax attribute reduction rules are no longer applicable.

The application of the COD income deferral election is far from clear, especially in a partnership context. Code Sec. 108(d)(6) currently provides that the general COD income exclusion and tax attribute reduction rules are applied at the partner level. The new COD income deferral election rule, however, is made and applied at the partnership level. Guidance is needed to coordinate the application and interaction of these rules.

The election to recognize COD income on a deferred basis can be beneficial in most cases where the debtor is not a C corporation and does not qualify for any COD income exclusion (e.g., insolvency exclusion). In cases where a debtor qualifies for COD income exclusion, the debtor should compare the tax benefits and costs between the election and the COD income exclusion to make an informed decision.

In the case of a C corporation, which does not qualify for the COD income exclusion under Code Sec. 108(a), it should analyze the interaction of the COD income deferral rules with the net operating loss (NOL) limitation rules under Code Sec. 382. If a debt discharge occurs in conjunction with a change in ownership subject to Code Sec. 382, the use of the NOL in subsequent years is limited by the "Code Sec. 382 limitation" described in Code Secs. 382(b) and (h). COD income recognized at the time of or within the five-year period beginning on an ownership change may be fully offset by the NOL or may increase the Code Sec. 382 limitation and the use of the NOL against taxable income during the five-year period. Under Code Sec. 382(h)(6) and (7), COD income recognized after the five year period generally cannot increase the Code Sec. 382 limitation. Without further guidance, it appears that COD income recognized after the fifth year following the ownership change year may not be offset by any NOL carryover. If the deferral election were not made, the COD income could have been offset by the NOL. Following are more detailed discussion and analysis of the new provisions.

Under new Code Sec. 108(i), a taxpayer can elect to recognize and report COD income from a "reacquisition" of an "applicable debt instrument" that occurs after December 31, 2008, and before January 1, 2011, ratably over a five-tax year period. For a reacquisition occurring in 2009, the COD income is reportable as income starting in the fifth tax year following the tax year in which the debt is repurchased. For example, if a debtor repurchased a debt in 2009 and elected the new provision, it would recognize the COD income ratably from 2014 to 2018. For a reacquisition occurring in 2010, the COD income is reportable ratably over five tax years starting in the fourth tax year following the reacquisition year (i.e., 2014-2018).

An "applicable debt instrument" is defined as a debt instrument issued by a C corporation or by any other person in connection with the conduct of its trade or business. In essence, the debt must be issued or incurred in connection with a trade or business for a person other than a C corporation. Personal debt or debt incurred for investment purposes does not qualify for the election. It is unclear if a debt incurred by a partner or a shareholder (active or passive) to invest in a partnership or S corporation which conducts an active trade or business would qualify for the election.

A "reacquisition" is defined as an acquisition of the debt instrument by the debtor (or a related party) that issued (or is the obligor of) the debt. An acquisition is broadly defined to include: (1) a cash purchase of the debt, (2) an exchange of new debt for old debt (including an exchange due to significant modifications), (3) an exchange of debt for corporate stock or a partnership interest, (4) contribution of the debt to capital and (5) a complete debt forgiveness by the debt holder. A related party is any person described under the current law (i.e., Code Sec. 108(e)(4)).

If a taxpayer made the election to apply the COD income deferral recognition, the COD income exclusions (such as bankruptcy or insolvency exclusion) and tax attribute reduction rules will not apply to the debt discharge. A taxpayer makes the election by attaching a statement to the income tax return for the tax year in which the debt is reacquired. The statement must identify the debt instrument, the amount of COD income to be deferred, and any other information required by the IRS. The election, once made, is irrevocable. The IRS may issue regulations requiring information of the election on tax returns for subsequent tax years. For partnerships, S corporations, or other pass through entities, the election is made by the applicable entity.

If a debt with original issue discount (OID) is issued in exchange for the old debt as part of the repurchase of the old debt by the debtor, the debtor must defer the deduction of the amount of accrued OID equal to the amount of COD income attributable to the debt repurchase until the first tax year in which the COD income (first COD income year) is includible in income. The deferred OID is deductible ratably over five tax years beginning with the first COD income year. If the amount of accrued OID for the period before the first COD income year exceeds the amount of COD income, the OID amount accrued in the earliest years is subject to deferral until the accrued OID amount equal to the COD income amount.

A debt is treated as issued for the repurchased debt if the proceeds are used directly or indirectly to acquire the repurchased debt. If only a portion of the proceeds are used to acquire the repurchased debt, the amount of accrued OID subject to deferral is the amount of OID on the new debt in proportion to the amount of new debt proceeds used to repurchase the old debt. The OID deferral rules are applicable to the repurchase of debt by a debtor or a related party of the debtor.

The amount of COD income that has not been includible in income becomes taxable income immediately upon: (1) the debtor's death; (2) the liquidation or sale of substantially all of the debtor's assets (including Title 11 or similar proceeding); (3) the closing of business; or (4) other similar events. Any accrued OID that has not been deducted also becomes deductible. These income and deduction acceleration rules also apply in the case of a sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by a partner, shareholder, or owner. The IRS can issue regulations to expand the acceleration rules to other circumstances.

In the partnership context, presumably only a partner's distributive shares of COD income and OID deduction are accelerated and allocated to the partner whose interest is sold or redeemed. It is unclear what amounts should be accelerated when there is a constructive termination of the partnership under Code Sec. 708(b)(1)(B).

It is also unclear how the acceleration rules should apply in an S corporation context. If a shareholder's stock is sold or redeemed, presumably only the amounts of COD income and OID deduction in proportion to the percentage of stock sold or redeemed will be accelerated and allocated to all shareholders.

For purposes of allocating COD income and OID deductions to partners, the COD income and OID deductions will only be allocated to those who were partners at the time immediately before the debt repurchase. The allocable shares to the partners are the amounts that would have been allocated to these partners if the income and deductions were not deferred. Any decrease in a partner's share of partnership liabilities as a result of the debt repurchase is not taken into account under Code Sec. 752 to the extent that a deemed cash distribution (due to a reduction of partnership debt) would cause the partner to recognize gain under Code Sec. 731. Instead, the decrease in partnership liabilities that was deferred is taken into account by the partner at the same time, and to same extent, as the COD income is includible in income.

In essence, any gain that would have been recognized from a deemed cash distribution that is attributable to a debt reacquisition is also deferred. Again, clarification is needed on how the deemed cash distribution should interact with the deferred COD income rules in determining the amount of gain to be recognized under Code Sec. 731. COD income, if not deferred as taxable income, increases the tax basis of the partnership interest in the hands of the partners, which should, in turn, reduce the amount of gain recognized from the deemed cash distribution for purposes of Code Sec. 731. Therefore, the deferred COD income, when recognized, should increase a partner's tax basis for determining the amount of gain from the deemed cash distribution. Presumably, the deferred partnership liabilities will also be taken into account ratably over the five-year period as the COD income.

Special rule for partnerships. In the case of a partnership, any income deferred under this provision is to be allocated to the partners in the partnership immediately before the discharge in the manner such amounts would have been included in the distributive shares of the partners under Code Sec. 704 if the income were recognized at such time. Any decrease in a partner's share of partnership liabilities as a result of such discharge is not be taken into account for purposes of Code Sec. 752 (concerning the treatment of certain liabilities) at the time of the discharge to the extent it would cause the partner to recognize gain under Code Sec. 731. Thus, the deemed distribution under Code Sec. 752 is deferred with respect to a partner to the extent it exceeds such partner's basis. Amounts so deferred are taken into account at the same time, and to the extent remaining in the same amount, as income deferred under the provision is recognized by the partner (Code Sec. 108(i)(6), as added by the 2009 Recovery Act; Conference Committee Report for American Recovery and Reinvestment Act of 2009).

Practical Analysis:
Kip Dellinger, CPA, Senior Tax Partner at Kallman And Co. LLP in Los Angeles, notes that the decision whether or not to utilize the cancellation of indebtedness provisions will be very troublesome for partnerships. Because the election is made at the partnership level, and because it prohibits other beneficial option in Code Sec. 108 for bankruptcy, insolvency and qualified real property indebtedness, potentially conflicting desires of respective partners will likely come into play. In addition, partners may have decidedly different views of the benefit of deferral on the tax ramifications on their particular tax situations in the years of ratable inclusion of the income. This may create situations that place the tax matters partner between a rock and a hard place when contemplating the election.

Also, the provision the deemed distribution that occurs by virtue of any decrease in a partner's share of partnership liabilities as a result of the discharge; however, the decrease is only to the extent it will cause a partner to recognize gain under Code Sec. 731 at the time of distribution. Accordingly, the deemed distribution for a partner only to the extent it exceeds the partner's basis; the effect is that a partner's basis for her partnership interest may be reduced as consequence of the reacquisition.

The Secretary of the Treasury may prescribe rules and regulations regarding the application of this provision, including: (a) extending the application of the rules regarding the acceleration of deferred items to other circumstances where appropriate, (b) requiring reporting of the election (and such other information as the Secretary may require) on returns of tax for subsequent tax years, and (c) rules for the application of the provision to partnerships, S corporations, and other pass-through entities including for the allocation of deferred deductions (Code Sec. 108(i)(7), as added by the 2009 Recovery Act).

Effective date. The provision applies to discharges in tax years ending after December 31, 2008 (Act Sec. 1231(b) of the American Recovery and Reinvestment Tax Act of 2009 (P.L. 111-5)).