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Cancelation of Debt- Beware the Tax Cost

Great News- your obligations are canceled...
Bad News- the Internal Revenue Code taxes that as income, and you’re getting a tax bill.

The cancelation of debt (COD), or discharge of indebtedness, gives rise to taxable income unless an exception applies. The imposition of tax on this phantom income takes many taxpayers by surprise, and as you can guess they are not at all happy.

Once the current crisis clears, there will be a need for relief by businesses and individuals who will look to modify, alter or flat-out eliminate their debt burdens. These same businesses and individuals need to consider the tax impact of any changes that are made. The discussion below applies to Federal taxes only, as some states take a different view, so you should consult a tax advisor to evaluate your specific circumstances. Also, there are some exceptions to the rules (there always are), some of which are covered below. The issues around COD income are complicated, so as the saying goes, “don’t try this at home.” Seek out a knowledgeable professional to assist you.

Why on earth does the IRS consider debt forgiveness taxable?

The theory is that you were not taxed when the money was borrowed, because you had an obligation to repay the debt, but after the debt forgiveness, you no longer have the obligation to repay the debt. Thus, you received money that you will not have to repay, and in the eyes of the IRS, you have an “accession to wealth.”

In the most basic of situations, an obligation is forgiven, in whole or part, the amount of the debt relief is easily quantified and the inclusion in taxable income, while painful, is not difficult to address. COD income, however, arises in less conspicuous ways, including the following:

  • Repurchase of corporate bonds by the issuer at a discount
  • Discharges in bankruptcy proceedings
  • Certain transfers of property in satisfaction of a debt, where the FMV of the property is less than the debt
  • Settlement of an obligation for less than full payment in litigation
  • Disposition of real property for less than the amount of the debt where the transferor has guaranteed the liability, for example in a foreclosure.
  • Forgiven employee debt obligations owed to an employer
  • Forgiven shareholder/partner debt owed to, or owed from, the respective business</li
  • Reduction in indebtedness used to acquire real property
  • Certain exchanges of new debt for old debt
  • Acquisition of debt by a related party at a discount

A number of these instances are nuanced, and have specific criteria that must be present in order to qualify as COD income. In other situations the type of income may not be COD at all; rather, it could be compensation or dividend income, for example. Each instance where an obligation is altered or the debtor/creditor relationship is changed needs to be evaluated.

Cash basis taxpayers need to look to the timing of the payment of the debt in question. Instances where the forgiveness of debt relate to an item that would be deductible if paid, will not give rise to COD income. There is no COD for invoices from a vendor, as an example, if it’s never paid (deducted) and the vendor cancels (forgives) the invoice.

For questions or more information on the cancellation of debt, please contact a member of Withum’s Forensic and Valuation Services Group.

What are the exceptions and what do I need to be thinking about to take advantage of them?

There are currently several exceptions that are available to minimize or eliminate the inclusion of the income.

  • The Title 11 exception– this relates to debt forgiven in a bankruptcy situation.
  • The insolvency exception– similar to the above; however, the bankruptcy court is not involved. Insolvency is when the liabilities of the taxpayer are greater than its assets. An exception is available to the extent a taxpayer is insolvent. This requires a detailed evaluation of what constitutes “assets” and “liabilities” immediately before the forgiveness.
  • There is an exclusion for qualified farm indebtedness if the farmer meets certain criteria.
  • There is an exclusion for qualified real property indebtedness, which is available for real property trades or businesses if the debt was incurred before January 1993.
  • Certain student loans

Then as long as I meet an exception I do not have taxable income and we’re done, right?

This is the Internal Revenue Code, and what it gives with one hand it takes away with the other – there is no free lunch. A taxpayer that gets to exclude income under an exception must pay a price, and the price is that it must reduce its tax attributes in an amount equal to the discharged debt. The effect in most cases is to defer the recognition of the income, not eliminate it.

What’s a tax attribute?

Tax attributes are carryovers or credits available to the taxpayer for use in future years. These will need to be reduced in the following order:

  • Net operating loses
  • General business credits
  • Minimum tax credits
  • Capital loss carryover
  • Basis of property
  • Passive activity loss and credit carryover
  • Foreign tax credit carryover

What if I run through all of them and still have unapplied COD?

Then you get that free lunch and the COD income is eliminated rather than deferred.

What if this is all going on in my S corporation or partnership, how will I be affected?

In an S corporation, the COD income will not pass through to the shareholders. S corporations do not have tax attributes; however, the ability of a shareholder to claim passthrough losses is limited to the shareholder’s outside basis in the stock of the S corporation. Losses in excess of basis are suspended. The shareholder will need to reduce its suspended losses to the extent of the excluded COD income.

Partnerships, LLC’s and LLP’s, on the other hand, have a particularly nasty surprise for the partners. The COD income passes through to the partners. Each partner must then assesses its individual situation to see if it satisfies one of the exceptions, irrespective of the financial condition of the partnership. This creates different classes of partners, some who must pick up the income and others who do not.

There are other considerations that need to be addressed such as the timing of income recognition, when the attributes get offset, and reporting requirements. This seeming simple area of tax law has significant traps for the unwary. Speak with your tax professional and our Distressed Team here at Withum.

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