Tax effects of cancellation of debt across different entities

Executive summary: Introduction to CODI

Cancellation of Debt Income (“CODI”) can have significant tax implications for various entities, depending on their classification for federal income tax purposes, as well as their solvency and bankruptcy status. Understanding the tax treatment of CODI for partnerships, S corporations, and C corporations is vital for taxpayers to make well-informed decisions and optimize their tax positions. With analysis and illustrative examples, this article provides an introductory guide for navigating CODI in different entity structures.

General cancellation of debt provisions

CODI is a fundamental concept in federal tax law, wherein debtors recognize income when they settle their outstanding debt obligations for an amount less than the adjusted issue price (“AIP”). This principle was formally established in the landmark case Kirby Lumber¹ and later codified in section 61(a)(11)² by including CODI as a part of a taxpayer’s gross income. For instance, if a debtor owes $100 of debt but settles it for $60, the debtor generally recognizes $40 of CODI as taxable income.

Certain exclusions are provided, which allow CODI to be excluded from taxable income to the extent a debtor is insolvent.³ The amount excluded by reason of the insolvency exception cannot exceed the amount by which the taxpayer is insolvent immediately prior to the discharge.⁴

Example:

Debtor Corp. (D) has assets of $100 and liabilities of $150 (thus insolvent to $50). Creditor (C) cancels the indebtedness in exchange for D's stock worth $100. D satisfied $100 of its debt with stock and had $50 forgiven. D has no taxable CODI because the amount forgiven ($50) does not exceed the amount by which D was insolvent ($50).

Another prominent exclusion is the bankruptcy exclusion, in which CODI is excluded if the discharge occurs in a “title 11 case."⁵ The term “title 11 case” means a case under the Bankruptcy Code⁶ [1] if the taxpayer is under the jurisdiction of the court; and the discharge of indebtedness is granted by the court or pursuant to a plan approved by the court.⁷ Where a debt cancellation occurs during the bankruptcy process, but not pursuant to a plan approved/granted by the court, the bankruptcy exclusion does not apply.⁸ If the debt discharge occurs pursuant to a plan approved by the court, the level of insolvency of the debtor is irrelevant to the amount of the exclusion. In other words, the burden of proof is on the taxpayer to establish the amount of insolvency outside of a title 11 bankruptcy case.⁹ One benefit of a title 11 bankruptcy filing is the absence of the requirement for the taxpayer to establish the amount of insolvency.

Generally, where an exclusion (i.e., bankruptcy or insolvency) applies, tax attribute reduction is required under section 108(b), which provides mechanical ordering rules.¹⁰

Additionally, as a way to prevent debtors from avoiding CODI by transferring their indebtedness to related parties, the Code treats the acquisition of outstanding debt by a related person as if the debtor had acquired the debt.¹¹ This means that if a party related to the debtor acquires the debtor's debt at a discount, the debtor is deemed to have realized CODI.

Example:

X borrows $1,000 from a bank. If an entity related to X [as defined in section 108(e)(4)] acquires the debt from the bank for $900, X is treated as the purchaser of the debt and consequently, must recognize $100 of CODI.¹²

Partnerships

When a partnership's debt is forgiven, the consequences are shaped by the interplay of general discharge of indebtedness principles and the rules governing allocation of partnership income and liabilities. For federal income tax purposes, partnerships pass through items of income, gain, deduction, loss, and credit to individual partners. Consequently, when income arises from the discharge of partnership indebtedness, such income is determined at the partnership level, and each partner is responsible for reporting their distributive share of the income on their own income tax returns. Such income is allocated in accordance with the partnership agreement and reflected on Schedules K-1 issued by the partnership to its partners.

The insolvency and bankruptcy exclusions are applied at the partner level and each partner's individual situation determines eligibility to exclude CODI.¹³ As such, even in situations where the partnership itself is insolvent, the insolvency exclusion is unavailable to a partner to the extent that the partner is solvent. Likewise, a partner will generally only qualify for the bankruptcy exclusion if they are a party to the bankruptcy (or join in a bankruptcy filing with the partnership).¹⁴

Example:

A, B, and C are equal partners in XYZ LLP, a partnership for US federal tax purposes. XYZ LLP’s creditors forgave $300,000 of indebtedness creating CODI. A is insolvent by $150,000, B is insolvent by $100,000, and C is insolvent by $50,000. A and B can each exclude their $100,000 allocable amounts from income, while C can only exclude $50,000 and must include the remaining $50,000 in income.

This allocation of CODI impacts each partner's basis in the partnership interest, effectively increasing it by the amount of their share of income.¹⁵ However, this increase in basis is generally, accompanied by an offsetting reduction due to the partnership tax rules treating a decrease in a partner's share of partnership liabilities as a distribution of money.¹⁶ As a result, partners must include in their income their pro rata share of the discharged debt without enjoying a net basis increase that usually accompanies other types of partnership income.

Example:

A and B are equal partners in a partnership. $100,000 of the partnership's outstanding debt is forgiven by their creditor without consideration in return. A and B separately report $50,000 as their distributive share of the CODI on their returns. Each partner adjusts their basis in the partnership interest by increasing it by $50,000 (i.e. the decrease in partners’ share of partnership liabilities). However, the reduction in each partner's share of the liabilities is treated as a distribution of money. Consequently, both A and B must reduce their basis in the partnership by $50,000, resulting in no net basis increase despite the inclusion of the CODI in their taxable income.

As mentioned above, to the extent there is CODI excluded there are attribute reduction ordering rules that apply. In the case of partnerships, attribute reduction applies at the partner level based on the amount of excluded CODI and based on the partner’s tax attributes.

S corporations

While S corporations are similar to partnerships in their flow-through nature, for purposes of CODI, the insolvency and bankruptcy exclusions are applied at the corporate level as opposed to the shareholder level. ¹⁷ Just as a partner in a partnership is entitled to deduct their share of the partnership’s losses, so too is the shareholder of an S corporation entitled to deduct their share of the corporate losses.¹⁸ In the S corporation context, losses are taken into account by the shareholder, but are generally limited to the shareholder's basis in the stock or debt of the corporation. As such, a shareholder may have losses allocated in excess of basis which are suspended.¹⁹

Shareholders must carry forward their suspended losses, and since there is no carryover at the S corporation level, a special rule treats these suspended losses of the shareholder as deemed NOLs of the corporation for that tax year.²⁰ As a result, the suspended losses are subject to reduction when CODI is excluded from income under the insolvency or bankruptcy exclusions.²¹

CODI that is taxable to the S corporation, increases the shareholders tax basis ²², and also increases the S corporation's accumulated adjustments account (“AAA”)²³. However, to the extent that CODI is excluded from the S corporation's income because of its bankruptcy status or insolvency, the shareholders do not increase their basis for the excluded CODI.²⁴

Example:

XYZ, an S corporation, has two shareholders, A and B, who each own 50%. XYZ incurred CODI of $600,000 and was fully solvent at the time of discharge but had no other income in the year of discharge. Both A and B have $100,000 of suspended losses from the prior tax year. Each A and B are allocated $300,000 of the CODI which increases their basis in the XYZ stock, thereby freeing up each of their $100,000 suspended losses. As such, after taking into account their suspended losses, A and B each have CODI of $200,000 includable in their gross income ($300,000 of CODI less $100,000 of suspended losses).

C corporations

C corporations recognize CODI at the corporate level, and is included in gross income, subject to specific exceptions. As mentioned above, Section 108(a) outlines circumstances under which CODI is excluded from a C corporation's gross income and generally include discharge in a Title 11 bankruptcy and discharge when the corporation is insolvent.²⁵ Again, while Section 108 allows for the exclusion of CODI, it generally comes at a cost by way of tax attribute reduction.²⁶

The ordering rules generally provide reduction in the following order:

A.     Net Operating Losses (“NOL”)

B.     General Business Credits

C.    Minimum Tax Credits

D.    Capital Loss Carryovers

E.     Basis Reduction

F.     Passive Activity Loss and Credit Carryovers

G.    Foreign Tax Credit Carryovers

To the extent that any CODI remains after the attribute reduction is applied, it is essentially erased, something that practitioners have come to refer as “Black-hole Cancellation of Debt (COD) ”. By reducing tax attributes, to the extent they exist, the debtor is provided with a fresh start, but also facilitates an equitable tax deferral, rather than a permanent tax difference.

Example:

Debtor Corp. is insolvent by $75 and realizes $100 of CODI. $25 is taxable income and the remaining $75 is excluded from income according to section 108(a)(1)(B). If Debtor Corp. has $25 of NOL carryforwards into the year of discharge, and $25 tax basis in its assets and has no other attributes, it will reduce both the NOLs and tax basis to $0 and the remaining $25 is Black-hole COD.

Additionally, the attribute reduction, described above, occurs after determination of the debtor's tax liability for the year of the debt discharge.²⁷ This ordering rule can significantly impact a debtor corporation’s tax liability, particularly in instances of liquidating bankruptcies. When it is clear that a corporation will not become profitable even after its outstanding debt is reduced, the purpose of the bankruptcy process is then to ensure the orderly liquidation and distribution of the debtor's assets to its creditors.²⁸ A liquidating bankruptcy process often involve taxable sales of debtor assets under section 363 of the Bankruptcy Code, and also potential CODI.

Example:

Debtor Corp. is undergoing a liquidation in bankruptcy. At the time of liquidation, Debtor Corp. had assets, with a total fair market value of $10x and tax basis of $0x. Debtor Corp. also had $10x of NOL carryforwards from prior years. Debtor Corp. sells its assets to a Buyer in year 2 and distributes the proceeds to Creditor in partial repayment of its $100x loan. Debtor Corp. had no other items of income or loss. Debtor Corp. then legally liquidates.

Here Debtor Corp. will recognize a $10x gain on the sale of the assets, and likely recognizes $90x of CODI. The CODI would likely be excluded under section 108(a) and will reduce the $10x NOLs after the determination of the tax for the year of the discharge.²⁹ As such the ordering rule will allow Debtor Corp. to use its NOLs to offset the gain on the sale, prior to the attribute reduction. Thus, when the attribute reduction is made, there are no attributes left to reduce and the entire $90x of CODI is Black-hole COD.

Consolidated Group Setting³⁰

If a debtor corporation, that is a member of a consolidated group, recognizes CODI and excludes it from income under section 108(a), there are special rules regarding attribute reduction.³¹ The consolidated group's tax attributes are generally subject to reduction, after reduction of the debtor's own tax attributes, following a mechanical ordering rule. Additionally, in the consolidated context, there is a “tier-down” attribute reduction mechanism that applies to reduce the tax attributes of a lower-tier member in certain circumstances.³²

For U.S. federal tax purposes, the exclusion of CODI under section 108(a) (i.e., bankruptcy, insolvency, etc.) does not apply to cancellation transactions between members of a consolidated group involving intercompany debt.³³

The ultimate impact of debt workouts for a consolidated group are complex, and often can have odd results depending upon which a consolidated group member is the true debtor. Careful consultation and modeling from knowledgeable tax advisors is always recommended in these contexts.

Conclusion

The tax consequences of CODI are highly dependent on the entity's classification, solvency, and bankruptcy status. Successfully navigating the complexities of CODI requires a thorough understanding of the tax implications specific to each entity type and the equity owners. Consulting with experienced tax advisors and legal professionals is critical in handling CODI and related tax matters effectively.

_{^{[1] Kirby Lumber v. United States, 284 U.S. 1 (1931).}}

_{^{[2] All section references are to the Internal Revenue Code of 1986 (the “Code”), as amended, or to underlying regulations.}}

_{^{[3] Section 108(a)(1)(B).}}

_{^{[4] Section 108(a)(3).}}

_{^{[5] Section 108(a)(1)(A).}}

_{^{[6] Title 11 U.S.C.}}

_{^{[7] Section 108(d)(2).}}

_{^{[8] For example, if during the bankruptcy proceedings, the debtor and creditor independently agree to a modification of the debt, or the debtor buys back its debt for stock at a discount, all without the court’s approval.}}

_{^{[9] Note that a Chapter 7 (liquidating) or Chapter 11 (reorganizing bankruptcy) are two examples of title 11 bankruptcies.}}

_{^{[10] The mechanics of the attribute reduction resulting from excluded CODI is beyond the scope of this article.}}

_{^{[11] Section 108(e)(4);. Reg. section 1.108-2.}}

_{^{[12] Timing of the acquisition of the debt when compared to the timing of becoming related is also relevant, for example:  Reg. section 1.108-2(c)(3) “a holder of indebtedness is treated as having acquired the indebtedness in anticipation of becoming related to the debtor if the holder acquired the indebtedness less than 6 months before the date the holder becomes related to the debtor.”}}

_{^{[13] Section 108(d)(6).}}

_{^{[14] Reg. section. 1.108-9(b); Note: There are Tax Court cases wherein a partner was permitted to exclude CODI, where the partnership was in bankruptcy, but the partner was not in their individual capacity, however the IRS has come out against these decisions in nonacquiescence in A.O.D. 2015-001. See e.g., Estate of Martinez v. Commissioner, T.C. Memo. 2004-150; Gracia v. Commissioner, T.C. Memo. 2004-147; Mirarchi v. Commissioner, T.C. Memo. 2004-148; and Price v. Commissioner, T.C. Memo. 2004-149 (essentially identical opinions for three partners in the partnership).}}

_{^{[15] Section 705.}}

_{^{[16] See Sections 752(b) and 733. Note however, that depending on the nature of the debt discharged, the basis decrease may differ from the increase pursuant to Section 705.}}

_{^{[17] Section 108(d)(7)(A).}}

_{^{[18] Section 1366(a)(1).}}

_{^{[19] Section 1366(d)(1); (d)(2).}}

_{^{[20] Section 108(d)(7)(B).}}

_{^{[21] Reg. section 1.108-7(d).}}

_{^{[22] Section 1367(a)(1)(A).}}

_{^{[23] Section 1368(e).}}

_{^{[24] Section 108(d)(7)(A).}}

_{^{[25] Note: also includes discharge of qualified farm indebtedness}}

_{^{[26] Section 108(b).}}

_{^{[27] Section 108(b)(4)(A).}}

_{^{[28] This process has various tax consequences, but for purposes of this article the discussion is limited to CODI.}}

_{^{[29] Section 108(b)(4)(A).}}

_{^{[30] A detailed discussion of the consolidated return rules regarding CODI is beyond the scope of this limited discussion.}}

_{^{[31] Reg. section. 1.1502-28.}}

_{^{[32] Reg. section. 1.1502-28(b).}}

_{^{[33] Reg. section. 1.1502-13(g)(4)(i)(C).}}