Cancellation of Indebtedness Income and the New Regulations
Imagine taking out a loan and making regular and timely payments on the loan until an unforeseen circumstance occurs such as a job loss or personal illness. You notify your lender and explain your circumstances. Fortunately, the lender agrees to forgive a portion of your loan. However, you discover when you file your yearly income tax return that the amount of the loan that is forgiven is considered income and taxable. This is called cancellation of indebtedness (“COD”) income, an unsuspecting result that we should all be aware of especially in the current economic climate.
Under section 108 of the Internal Revenue Code and subject to a limited number of exceptions, amounts resulting from the discharge of indebtedness (that is amounts resulting from loan forgiveness) are included as part of a taxpayer’s gross income. The exceptions to this rule include indebtedness discharged (1) according to a bankruptcy proceeding, (2) when the taxpayer is insolvent, (3) by non-corporate taxpayers if the debt was incurred or assumed by the taxpayer in connection with real property used in a trade or business and the debt was secured by the real property, or (4) that is qualified principal residence indebtedness which is discharged before January 1, 2013.
New COD Income Deferral Rules
On August 11, 2010, the Treasury Department and IRS released two sets of temporary regulations concerning the rules under Internal Revenue Code section 108(i) regarding COD income incurred by C corporations (see T.D. 9497 and REG-142800-09) and S corporations or partnerships (see T.D. 9498 and REG-144762-09) with respect to reacquisitions of applicable debt instruments made in 2009 or 2010.
Provisions in the American Recovery and Reinvestment Act of 2009 (as codified in Internal Revenue Code section 108(i)) allow certain taxpayers that reacquire certain debt instruments in 2009 and 2010 to elect to include certain COD income ratably over 5 years beginning in 2014. The taxpayer may reacquire its own debt or have a related party acquire the debt. The debt can be acquired for cash, exchanged for new debt or equity, contributed to capital, or forgiven.
An applicable debt instrument is a debt instrument issued by a C corporation or any other person in connection with the conduct of a trade or business by such person.
If an entity that made the election were to liquidate, sell substantially all of its assets, or otherwise cease all business operations, the COD would be recognized at that time. Similar acceleration rules would apply to a partner or S corporation shareholder that transferred an interest in a partnership or S corporation that had elected deferral. Additional rules would apply to partnerships.
On August 17, 2009, the IRS issued Revenue Procedure 2009-37 to provide rules and procedures for making an election under the new code section 108(i). The IRS added that additional guidance may be released including treasury regulations addressing issues in the revenue procedure, and the regulations may be retroactive. The revenue procedure provides:
– Taxpayers making the election are to provide additional information on returns beginning with the year following the year in which the election is made.
– Partnerships the flexibility to make the election on a partner-by-partner and debt-by-debt basis.
– An automatic 12-month extension from the due date of the election for making the election under Treasury Regulations section 301.9100-2(a)
– Procedures by which a taxpayer may make a protective election under Internal Revenue Code section 108(i).
The Temporary Regulations
The temporary regulations relating to C corporations generally reflect a narrower interpretation of the statutory acceleration events and rather focus on events that impair the ability to pay the tax liability associated with deferred income. These temporary regulations do not require acceleration in every instance but apply rules in three situations when corporations have impaired their ability to pay their tax liability. These three instances are:
– When the electing corporation changes its tax status.
– When it ceases its corporate existence in a transaction to which the rules relating to the carryover of attributes in certain corporate acquisitions of Internal Revenue Code section 381(a) do not apply.
– When it engages in a transaction that impairs its ability to pay the tax liability associated with its COD income.
Partnerships and S Corporations
A second set of temporary regulations were issued regarding to the application of Internal Revenue Code section 108(i) to partnerships and S corporations that have made this election. The acceleration rules that apply to partnerships and S corporations differ from those that apply to C corporations, and include the following:
– Rules determining if a sale by an electing partnership or S corporation of some, but not all, of its assets constitutes a sale, exchange, transfer, or gift of substantially all of its assets.
– Rules for sale of assets in tiered partnership arrangements.
– Rules for sales, gifts, or other dispositions of part of an interest in an electing partnership or S corporation.
– Rules for transfers by an electing partnership of all of its assets to another partnership in a transfer involving the contribution of assets to the partnership in exchange for an interest in the partnership.
– Rules for transfers by an electing partnership or S corporation of assets in a like-kind exchange.
The temporary regulations also provide the following with respect to electing partnerships and electing S corporations:
– Five safe harbors under which a debt instrument issued by a partnership or S corporations is deemed to be issued in connection with the partnership’s or S corporation’s trade or business for purposes of Internal Revenue Code section 108(i).
– Rules for allocation of COD income to partners and S corporations shareholders.
– Rules for when a partner or S corporation shareholder adjusts their basis in their partner share or S corporation stock to account for their share of deferred COD income.
– Rules addressing how a partner’s capital accounts should be adjusted to account for a partner’s share of partnership deferred COD income.
– Rules to prevent an 108(i) election from triggering recapture of losses under Internal Revenue Code section 465(e).
These new COD income deferral rules will provide a benefit to many taxpayers. However, a careful review of a taxpayer’s current and future projected income is necessary to determine if making a section 108(i) election is valuable. Some taxpayers may not need to take the election as they may be able to shelter COD income through insolvency or bankruptcy. Due to the administrative burden of preparing the return and the information reporting requirements in subsequent years, it could significantly increase the burden of recordkeeping and compliance associated with filing a return. Regardless, this election may still allow for significant deferral opportunities and should be considered.