Character of debt impacts taxation of cancellation of debt income
INSIGHT ARTICLE |
The discharge of debt (whether through voluntary surrender or foreclosure) can give rise to taxable gains, cancellation of debt income (CODI), or both. Determining the nature of this income is important as gains are generally not afforded the exclusions from taxation that may apply to CODI.
Entity level characterization
The existence of CODI is a partnership level determination that is, in part, based upon the classification of the discharged debt as either "recourse" or "nonrecourse." The determination of the ultimate taxability of CODI is determined at the partner level and is impacted by debt characterization as recourse or nonrecourse to the partner, but in doing so relies on a significantly different application of those terms.1
Debt that is secured by specific property is generally nonrecourse to a partnership (e.g., a mortgage on a piece of real estate). The exchange of or foreclosure on secured property in satisfaction of a nonrecourse debt is treated as a sale or exchange for an amount equal to the debt discharged without regard to the fair market value of the property, as opposed to CODI.2
Debt that is not secured by specific property but is secured by all assets of the business represents recourse debt of a partnership (e.g., senior debt taken to finance operations). Discharge of this debt generates CODI to the extent the value of cash or property transferred upon the discharge is less than the debt owed.3 To the extent CODI occurs for an insolvent taxpayer, the CODI is excludable from income to the extent of the taxpayer's insolvency. As stated above, the determination for insolvency is made at the level of each partner. Insolvent partners have the ability to exclude their allocable share of partnership CODI to the extent of their individual insolvency. Insolvency is defined as having liabilities equal to or in excess of asset value.4
Partner level characterization
Partners determine their individual insolvency level by looking to their individual assets (including partnership interests) and liabilities along with their allocable share of partnership liabilities that are in excess of the value of their share of the underlying partnership assets. It is in the determination of "excess" partnership liabilities that a different definition of the terms recourse and nonrecourse is employed.
At the partner level, a debt is recourse if the partner bears personal liability. A partner may include all recourse debts in their insolvency calculation. However, with the increasing use of limited liability companies and limited liability partnerships, barring a personal guarantee, it is increasingly common to see no debt classified as recourse to a partner or member.
If the partner does not bear personal responsibility for the debt, it is considered nonrecourse to the partner, and in the event of a CODI event, any excess nonrecourse debt is included in the partner's insolvency calculation.5
A has personal assets of $5, his allocable share of partnership X's assets is $75 and his allocable share of nonrecourse debt is $100. A's share of partnership X's excess nonrecourse debt is $25.
A is solvent with $5 of assets. ($5 + $0 value of partnership X + $0 of includable excess nonrecourse debt). If A received CODI income from sources other than X, he would not be eligible for the insolvency exclusion.
However, were partnership X to generate CODI allocable to A as a result of a discharge of $25 of the nonrecourse debt, A would include the excess nonrecourse debt in its insolvency calculation. As a result or A's inclusion of the debt in the insolvency calculation results in A being insolvent in the amount of $20, and A could exclude $20 of the $25 in CODI under the insolvency exception.6
The ability to exclude CODI can provide significant tax benefits, but taxpayers must first ensure that the debt discharge transaction has created income eligible for exclusion. Although this determination is often made at the entity level, where the entity is taxed as a partnership the ability to exclude the income is determined by each partner. Partners and partnerships contemplating such transactions should consult their tax advisors to ensure that all tax implications are fully understood.
1 Section 108(d)(6)
2 Reg. section 1.1001-2(a)(1)
3 Reg. section 1.1001-2(a)(2)
4 Section 108(d)(3)
5 Rev. Rul. 2012-14, 2012-24 I.R.B. 1012
6 Section 108(a)(3)