United States

Understand available elections after a CODI event to claim tax savings

Consider the order of attribute reduction following a CODI event

INSIGHT ARTICLE  | 

In general cancellation of indebtedness income (CODI) is excludable if incurred in a bankruptcy or to the extent of a taxpayer’s insolvency. However, when excluded, the taxpayer must generally reduce their tax attributes (net operating losses (NOLs), general business credits, capital loss carryovers, etc.) or the tax basis in its assets by a corresponding amount. As a result, CODI is often a deferral as opposed to a true exclusion.

Excludable CODI and attribute reduction

To the extent CODI is excluded due to bankruptcy or insolvency you must determine the amount of attribute reduction necessary. However, before the taxpayer reduces its attributes, it should consider the following before proceeding forward with a reduction:

  1. Expiration dates of NOLs, capital loss and credit carryovers
  2. Limitations on the use of NOLs, capital loss and credit carryovers (keep in mind that Sec. 382 limitations do not affect the ability to reduce an attribute but may limit the ability to utilize the attributes against future income)
  3. Useful life of depreciable property (i.e. 39 years vs. 5 or 7 years)
  4. Possible application of the “liability stop rule”, a taxpayer is not required to reduce basis by more than the excess of the aggregate basis of all of its property and the amount of money held immediately after the discharge over the aggregate of the taxpayer’s liabilities immediately after the discharge (keep in mind that the liability stop rule does not apply to reductions made under the election to first reduce the basis of its depreciable property, discussed below)
  5. If CODI exceeds the attributes, the CODI is tax-exempt (Black hole CODI)

NOTE: This is not an all-inclusive list and is meant to only highlight the main areas of focus surrounding excludable CODI and attribute reduction.

Order of attribute reduction

As previously stated, if a taxpayer incurs excludable CODI in a bankruptcy or insolvency, the taxpayer must reduce its tax attributes in accordance with Sec. 108(b)(2) as follows: 

Normal attribute reduction rules

1. NOLs and NOL carryovers
2. General business credits
3. Minimum tax credits
4. Net capital losses and capital loss carryovers
5. Basis of property
6. Passive activity loss and credit carryovers
7. Foreign tax credit carryovers
Note: Credits and credit carryover reductions will be limited to 33⅓ cents for each dollar of CODI excluded and basis and losses should be reduced by one dollar for each dollar of excludable CODI. 

 

However, taxpayers have an option to change the order of attribute reduction and elect to reduce the basis in depreciable property first before any NOLs, in which case reduction occurs as follows:  

Election to reduce basis

1. Basis of depreciable property 
2. NOLs and NOL carryovers
3. General business credits
4. Minimum tax credits
5. Net capital losses and capital loss carryovers
6. Basis of property
7. Passive activity loss and credit carryovers
8. Foreign tax credit carryovers
Note: Credits and credit carryover reductions will be limited to 33⅓ cents for each dollar of CODI excluded and basis and losses should be reduced by one dollar for each dollar of excludable CODI. 

 

Why should a taxpayer make the election to reduce basis?

Pursuant to Sec. 1017(b)(3)(B) “depreciable property” is defined as any property eligible for depreciation or amortization but only if a basis reduction would reduce the amount of depreciation otherwise allowable for the period immediately following such reduction. It should also be noted that the reduction cannot exceed the aggregated adjusted bases of the depreciable property as of the beginning of the tax year following the tax year of the discharge under Sec. 108(b)(5)(B). If any excludable CODI remains after the reduction to the basis of the depreciable property, then the normal attribute reduction rules apply.

This election is advantageous if, for example, the taxpayer has available NOLs to offset post-bankruptcy income faster than the depreciation or amortization (e.g. 15 year amortizable property or 39-year real property). As noted above, it is critical that a taxpayer understands any limitations that may exist on the utilization of the NOLs (e.g. Sec. 382) before making this election.

Example

Corporation X, as a result of bankruptcy, has excludable CODI of $500,000, a depreciable asset with an adjusted tax basis of $400,000, an NOL carryover of $250,000 and no credit or capital loss carryovers. The depreciable asset has a 15 year life with 10 years of depreciation remaining. It will carryforward liabilities of $100,000. Corporation X is projecting taxable income of $20,000 (tax depreciation deduction not included) each year, for the first 5 years after bankruptcy. Assuming the bankruptcy does not result in an ownership change (e.g. an ownership change during bankruptcy for which Sec. 382(l)(5) applies), should Corporation X elect to reduce basis in its depreciable property first or should it follow the normal attribute reduction rules?

Scenario 1 – Attribute reduction under normal rules

In applying the normal attribute reduction rules Corporation X would first reduce NOLs to zero leaving $250,000 of remaining attribute reduction. Corporation X would then reduce its basis in its depreciable asset by $250,000 leaving it with an adjusted tax basis of $150,000 (the “Liability Stop Rule” does not come into effect in this scenario as the asset basis of $150,000 exceeds the corporation’s liabilities of $100,000). At the end of the 5 years, Corporation X will have recognized $25,000 of taxable income ($100,000 of taxable income minus $75,000 of tax depreciation) and assuming a 35 percent rate, will have paid $8,750 in taxes. X will have $75,000 in future depreciation deductions in future years.

Scenario 2 – Election to reduce basis first

In electing to reduce the basis of its depreciable property first, Corporation X would reduce its depreciable asset down to zero (the “Liability Stop Rule” does not apply when making an election under Sec. 108(b)(5) and thus the corporation can reduce the entire basis of its depreciable property (but not below zero) without regard to the amount of remaining liabilities) with remaining attribute reduction of $100,000. Corporation X would then reduce the amount of NOLs by $100,000 leaving an NOL carryover of $150,000. At the end of the 5 years, Corporation X will have recognized $100,000 of taxable income before NOL ($20,000 annually with no depreciation) and $0 taxable income after NOL utilization. X will have an NOL carryforward of $50,000 to use in future years.

Conclusion

In applying the limited facts and background in this example, it is clear that the election to reduce basis is more advantageous for Corporation X than not making the election and simply applying the normal attribute reduction rules. The company will not pay any taxes and will be able to take advantage of its NOL carryovers if it chooses scenario 2.

Final thoughts

A similar analysis should be completed for any taxpayer that has excludable CODI and will need to reduce its tax attributes. As illustrated above, the election to reduce basis can provide immense value to a taxpayer when it is properly applied in the correct situation.

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