United States

New IRS rules on debt discharge and disregarded entities

Bankruptcy and insolvency exceptions apply to the ultimate tax owner

TAX ALERT  | 

For debt discharges occurring on or after June 10, 2016, new IRS regulations clarify how the special rules for bankrupt or insolvent taxpayers apply to sole proprietors or partners who hold their businesses, or their partnership interests, through a disregarded entity, such as a single-member limited liability company or a grantor trust.

The regulations clarify that the disregarded entity will be disregarded. Thus, in determining whether a sole proprietor or a partner is eligible for an exception from debt discharge income because of his insolvency or bankruptcy, only the insolvency or bankruptcy of the individual sole proprietor or partner is considered. The status of any disregarded entity is ignored.

The bankruptcy and insolvency exclusions and partnerships

Generally, section 108(a)(1)(A) allows a taxpayer to exclude income from the cancellation or discharge of debt (COD) if the taxpayer is insolvent or in bankruptcy. By statute, these rules apply at the partner level where a partnership is involved. Thus, even if a partnership were insolvent or in bankruptcy, these exclusions would not apply to partners who were not insolvent or also in bankruptcy.

Case law had raised questions about how these rules should apply if a disregarded entity were insolvent or in bankruptcy, or if a partner claimed to be subject to the jurisdiction of a bankruptcy proceeding. These new regulations provide that disregarded entities are disregarded. In particular, the regulations provide that bankruptcy exclusion applies only if “the owner of the grantor trust or the owner of the disregarded entity [is] under the jurisdiction of the court in a title 11 case as the title 11 debtor.” Similarly the owner of such an entity, not the entity itself, must be insolvent for the insolvency exception to apply. This new rule could apply to a partner holding a partnership interest through a disregarded entity or to a sole proprietor holding his entire business through a disregarded entity.

Although the preamble to the regulations suggests that the IRS was also concerned with the technicalities of how these exceptions apply to other cases where a partner, not holding through a disregarded entity, claims to be subject to the jurisdiction of the bankruptcy, the regulations, by their terms, do not address that case. For example, the regulations do not provide that a partner, not holding through a disregarded entity, must be ‘the title 11 debtor’ to qualify for the bankruptcy exclusion, although that is likely to be the IRS position.

Further comments requested

In connection with the new regulations, the IRS also requested comments about several situations that were outside the scope of the regulations as finalized. One area for comment was how liabilities should be allocated among the owners of multiple-owner grantor trusts for purposes of determining if the owner is insolvent. Comments were also requested regarding principles under which debt of a disregarded entity or grantor trust would be treated as recourse or nonrecourse debt for purposes of applying the insolvency exception.

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