CHAPTER TWO

Discharge of Indebtedness

§ 2.1 Introduction

§ 2.2 Discharge of Indebtedness Income

§ 2.3 Determination of Discharge of Indebtedness Income

(a) What Is Discharge of Indebtedness Income?

(i) In General

(ii) Discharge of Recourse and Nonrecourse Debt

(iii) Transfer or Repurchase of Debt

(iv) Income Other than Discharge of Indebtedness

(v) No Income

(vi) Contested Liability Doctrine and Unenforceable Debt

(b) Is the Obligation Indebtedness?

(c) Who Is the Debtor?

(d) When Does Discharge of Indebtedness Income Occur?

§ 2.4 Section 108(e) Additions to Discharge of Indebtedness Income

(a) Debt Acquired by Related Party: Section 108(e)(4)

(i) Related Party

(ii) Acquisition by a Related Party

(A) Direct Acquisition

(B) Indirect Acquisition

(iii) DOI Income for a Related Party Acquisition

(b) Indebtedness Contributed to Capital: Section 108(e)(6)

(i) Allocation between Principal and Interest

(ii) Withholding Requirement

(iii) Accounting Method Differences

(c) Stock for Debt: Section 108(e)(8)

(i) Background

(ii) Overlap with Capital-Contribution Rule

(A) Meaningless Gesture Doctrine

(B) Bifurcation

(C) Advantages and Disadvantages

(d) Debt for Debt: Section 108(e)(10)

(i) Background

(ii) Publicly Traded Debt versus Non–Publicly Traded Debt

(iii) Significant Modification of a Debt Instrument

(A) Modification

(B) Significant Modification

(C) Multiple Modifications

(D) Disregarded Entities

§ 2.5 Section 108(e) Subtractions from Discharge of Indebtedness Income

(a) Otherwise Deductible Debts: Section 108(e)(2)

(b) Purchase Price Reduction: Section 108(e)(5)

(i) Creditor That Is Not Seller

(ii) Solvent Debtor

(c) Summary

§ 2.6 Discharge of Indebtedness Income Exclusions

(a) Title 11 Exclusion

(b) Insolvency Exclusion

(i) Liabilities

(ii) Assets

(iii) Timing

(c) Qualified Farm Indebtedness Exclusion

(d) Qualified Real Property Business Indebtedness Exclusion

(e) Tax Benefit Rule

§ 2.7 Consequences of Qualifying for Section 108(a) Exclusions

(a) Attribute Reduction

(b) Net Operating Loss Reduction

(i) Net Operating Loss Reduction and Carrybacks

(ii) Net Operating Loss Carryover Calculation

(iii) Interaction with Section 382(l)(5)

(c) Credit Carryover Issues

(d) Basis Reduction

(i) Basis Reduction Election

(A) Election Procedures

(B) Basis Adjustment of Individual’s Estate

(ii) Basis Reduction Rules

(A) Title 11 and Insolvency

(B) Basis Reduction Election

(C) Qualified Farm Indebtedness

(D) Qualified Real Property Business Indebtedness

(E) Depreciable Property Held by Partnership

(F) Depreciable Property Held by Corporation

(G) Multiple Debt Discharges

(H) Recapture Provisions

(iii) Tax-Free Asset Transfers

(iv) Comparison of Attribute Reduction and Basis Reduction Elections 94>

(e) Alternative Minimum Taxable Income

§ 2.8 Section 108(i) Deferral and Ratable Inclusion of DOI from Business Indebtedness Discharged by the Reacquisition of a Debt Instrument

(a) Overview

(b) Statutory Provisions

(i) Defined Terms

(ii) Effect on OID

(iii) Making the Election

(iv) Acceleration of Deferral

(v) Interplay with Other Section 108 Exclusions

(c) Revenue Procedure 2009-37

(i) Applicable Debt Instrument

(ii) Reacquisition and Acquisition

(iii) Partial Elections

(iv) Consolidated Groups and Foreign Entities

(v) Earnings and Profits

(vi) Protective Election

(vii) Annual Statement and 12-Month Extension

(d) Treasury Decision 9497 (Temporary Regulation)

(i) Mandatory Acceleration Events for Deferred DOI Income

(A) Net Value Acceleration Rule

(B) Changes in Tax Status

(C) Cessation of Existence

(D) Bankruptcy

(ii) Earnings and Profits

(iii) Intercompany Obligations

(iv) Deemed Debt-for-Debt Exchanges

(v) Deferred OID Deductions

(vi) Effective/Applicability Dates

(e) Treasury Decision 9498 (Temporary Regulation)

(f) Planning Points

§ 2.9 Use of Property to Cancel Debt

(a) Transfer of Property in Satisfaction of Indebtedness

(i) Transfer of Property in Satisfaction of Nonrecourse Debt

(A) Gain from the Property Transfer

(B) Loss on the Property Transfer

(ii) Transfer of Property in Satisfaction of Recourse Debt

(A) Gain on the Property Transfer

(B) Loss on the Property Transfer

(iii) Character of the Gain or Loss

(b) Discharge of Nonrecourse Debt

(c) Foreclosure

(d) Abandonment

2.10 Consolidated Tax Return Treatment

(a) Consolidated Return Issues

(i) Election to Treat Stock of a Member as Depreciable Property

(ii) Single-Entity versus Separate-Member Approach for Attribute Reduction

(A) Temporary and Final Regulations

(B) Prior to the Temporary Regulations

(iii) DOI/Stock Basis Adjustments/ELAs

(iv) Intercompany Obligation Rules

(A) Intercompany Obligation Regulations: General Rules and Application to Intragroup and Outbound Transactions

(B) Intercompany Obligation Regulations: Application to Inbound Transactions

§ 2.11 Discharge of Indebtedness Reporting Requirements

(a) Information Reporting Requirements for Creditors

(i) Applicable Entity

(ii) Amount Reported

(iii) Identifiable Event

(iv) Exceptions

(v) Multiple Debtors

(vi) Multiple Creditors

(vii) October 2008 Final and Temporary Regulations

(b) Filing Requirements for Debtors

§ 2.1 INTRODUCTION

One major source of income in most insolvency and bankruptcy proceedings is debt cancellation. Section 61 of the Internal Revenue Code (I.R.C.) lists discharge of indebtedness as one item subject to tax, and the Treasury Regulations (Treas. Reg.), at section 1.61-12(a), provide that the discharge of indebtedness, in whole or in part, may result in the realization of income. Prior to the codification of the general principle that debt cancellation is income, debt cancellation was deemed to produce income under the Supreme Court’s decision in United States v. Kirby Lumber Co.1 The Supreme Court held that the debtor realized income under two interrelated theories. First, the debtor realized an accession to income due to the transaction. Second, under a freeing-of-the-assets theory, assets previously offset by liabilities were “freed” by the transaction.

Several exceptions to this basic policy have evolved since the Kirby Lumber decision. For example, a cancellation of indebtedness may be more appropriately characterized as a contribution to capital, distribution, gift, or purchase price adjustment. The Bankruptcy Tax Act of 1980 codified some of these exceptions, rejected or conditioned the availability of others, and introduced additional provisions addressing whether and to what extent particular transactions give rise to discharge of indebtedness income. Before discussing the current discharge of indebtedness provisions, the manner in which debt cancellation was handled in prior law will be summarized.

§ 2.2 DISCHARGE OF INDEBTEDNESS INCOME

The treatment of income from the discharge of indebtedness was of particular interest to the drafters of the Bankruptcy Tax Act of 1980. Their chief concern was that taxation of such income would reduce the amount available to satisfy the claims of creditors who, in most cases, were already receiving less than 100 percent of their claims.

The Bankruptcy Tax Act amended I.R.C. section 108 to apply to bankruptcy proceedings as well as to out-of-court settlements. Prior to this amendment, I.R.C. section 108 applied only to discharge of indebtedness out of court. I.R.C. section 108(a), as amended by the Tax Reform Act of 19862 and subsequent statutory amendments, provides that income from discharge of debt can be excluded from gross income under any one of the following conditions:3

• The discharge occurs in a title 11 case.4
• The discharge occurs when the taxpayer is insolvent.5
• The indebtedness discharged is qualified farm indebtedness.6
• The indebtedness discharged is qualified real property business indebtedness.7

Exclusion of income under these provisions must be accompanied by a reduction of tax attributes. Attribute reduction and other consequences of qualifying for income exclusion under I.R.C. section 108(a) are discussed in detail later in this chapter (§ 2.7(a)–(d)).

Before income can be excluded under I.R.C. section 108(a), it must be properly characterized as income from the discharge of indebtedness under I.R.C. section 61(a)(12) (DOI income8), and not operating income or gain on an exchange. Numerous cases and rulings have addressed this issue. The Bankruptcy Tax Act of 1980 codified (and/or altered) some judicial approaches to whether particular transactions give rise to DOI income. Although this codification should logically have been added to I.R.C. section 61(a), it was instead added to I.R.C. section 108(e).

The remainder of this chapter discusses whether particular income is DOI income, focusing first on representative cases and rulings under I.R.C. section 61(a)(12) and then on the provisions of I.R.C. section 108(e) that explicitly expand and contract the scope of DOI income. Having determined which income is DOI income, the chapter then turns to whether that income is excluded from gross income under one of four exclusions: title 11 cases, insolvency, qualified farm indebtedness, and qualified real property business indebtedness. The discussion then addresses the consequences of coming within the purview of I.R.C. section 108(a). The chapter considers the unique issues raised by the use of mortgaged property to cancel debts and addresses specific rules that are provided in the consolidated return regulations. If the consolidated return regulations apply, the tax consequences of a debt cancellation may be different from the tax consequences initially discussed in the sections to follow. Finally, the chapter addresses specific filing requirements.

§ 2.3 DETERMINATION OF DISCHARGE OF INDEBTEDNESS INCOME

(a) What Is Discharge of Indebtedness Income?

I.R.C. section 61(a)(12) includes in gross income “income from the discharge of indebtedness.” The basic concept of DOI income may be illustrated by example. A debtor borrows $100 from a creditor who later accepts $60 from the debtor in complete satisfaction of the $100 debt. In this simple example, the debtor has $40 of DOI income. Before discussing the ramifications of DOI income, the threshold issue is whether DOI income exists in a particular transaction. As demonstrated by cases and rulings, one of three characterizations generally prevails: DOI income, income other than DOI income, or no income.

(i) In General

DOI income arises when a creditor releases a debtor from an obligation that was incurred at the outset of the debtor-creditor relationship. In United States v. Centennial Savings Bank FSB,9 the Supreme Court held that the imposition of an early withdrawal penalty on certificates of deposit (CDs) was not the discharge of an obligation to repay. When customers deposited money and the bank issued CDs, debtor-creditor relationships were created between the bank and the depositors. Like most CDs, the terms and conditions of the instruments included an interest rate, maturity date, and early withdrawal penalty.

Focusing on the meaning of “discharge,” the Supreme Court found that “discharge of indebtedness” conveys the forgiveness of, or the release from, an obligation to repay. A depositor who cashed in a CD before the maturity date and paid the early withdrawal penalty did not forgive or release any obligation of the bank. By paying principal and interest, less the penalty, the bank paid exactly what it was obligated to pay under the terms of the CD agreement. Although the bank has income equal to the amount of the penalty, the income is not from the release of an obligation incurred by the bank at the outset of its debtor-creditor relationship with the depositor. The Supreme Court held that to determine whether the debtor has realized DOI income, “it is necessary to look at both the end result of the transaction and the repayment terms agreed to by the parties at the outset of the debtor-creditor relationship.”10

The standard used in Centennial Savings Bank was applied to a different transaction, but had the same result, in Philip Morris Inc. v. Commissioner.11 Philip Morris borrowed an amount of foreign currency from a bank. Before Philip Morris repaid the loan, the value of the dollar increased relative to the borrowed foreign currency. When Philip Morris paid back the amount of foreign currency it had borrowed, it used a stronger dollar (i.e., it converted fewer dollars into the foreign currency) to satisfy its obligations.

Philip Morris did realize a “foreign exchange gain” on the repayment of the foreign currency loan, but the gain was not DOI income. The Tax Court noted that “the teaching of Centennial Savings is clear, namely that the discharge of an indebtedness may be an occasion for the realization of income but, unless there is a cancellation or forgiveness of a portion of the indebtedness not reflected in the terms of the indebtedness, such income is not discharge of indebtedness income.”12 Because Philip Morris’s foreign exchange gain resulted from favorable conditions in the currency market, rather than a forgiveness or release of its obligations under the foreign currency loan, DOI income did not exist.13

Philip Morris is representative of the far-reaching impact of Centennial Savings. Before Centennial Savings, the courts had generally held that foreign exchange gain was DOI income. One example of this was Kentucky & Indiana Terminal Railroad Co. v. United States.14 The Philip Morris decision specifically notes that Centennial Savings undermines the continued viability of Kentucky & Indiana Terminal Railroad Co.15

(ii) Discharge of Recourse and Nonrecourse Debt

The cancellation of either recourse or nonrecourse debt may trigger DOI income.16 In basic terms, debt is recourse if the debtor is personally liable for the amount due; debt is nonrecourse if the debtor is not personally liable for the debt (i.e., the creditor can look only to the property securing the debt if the debtor defaults).

The next cases involve the satisfaction and assumption of mortgages on real property. In re Collum17 is another example of what is not DOI income based on Centennial Savings. Collum involves the sale of real property that is subject to a recourse mortgage (i.e., the mortgagor is personally liable for the debt). The Collums sold the property to a corporation that assumed the mortgage; however, the couple was not released from liability. The court held that gain, not DOI income, was realized on the sale of the property.18

The extant cases discussed so far demonstrate what is not DOI income. The next decision is an example of what is DOI income—a discount received on the prepayment of a recourse mortgage. Generally, satisfaction of a mortgage on a taxpayer’s residence for less than the amount due creates DOI income.19 Michaels v. Commissioner20 involves the Michaels’ sale of their primary residence. In connection with the sale of the house, the mortgage balance was discounted by 25 percent. The Michaels included the discount as part of the capital gain on the sale, which was deferred under I.R.C. section 1034 when the couple purchased a more expensive residence. The Michaels argued unsuccessfully that, because the mortgage payment was an integral part of the sale of the residence and because the buyer’s funds were used to prepay the mortgage, the discount should be taken into account in calculating the gain realized, but not recognized due to I.R.C. section 1034. The Tax Court held that the discount was income from the discharge of indebtedness separate from the sale of the property.

The Supreme Court issued Centennial Savings after the Tax Court issued Michaels, so it is possible that the subsequent decision undermines the precedential value of Michaels, as in Kentucky & Indiana Terminal Railroad discussed in § 2.3(a)(i). This is not likely, however, because the facts of Michaels do not indicate that the discount was part of the terms of the mortgage.

(iii) Transfer or Repurchase of Debt

DOI income may be realized when the debtor repurchases outstanding debt at a bargain price. This occurred in the 1931 landmark United States v. Kirby Lumber Co.21 decision. The Supreme Court held that the debtor realized DOI income under two interrelated theories. First, the debtor realized an accession to income due to the transaction. Second, under a freeing-of-the-assets theory, assets previously offset by liabilities were “freed” by the transaction.

The calculation of income on the repurchase of debt is currently addressed in Treas. Reg. section 1.61-12(c)(2)(ii), which provides that “[a]n issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of Treas. Reg. section 1.1275-1(b)). The amount of discharge of indebtedness income is equal to the excess of the adjusted issue price over the repurchase price.”22

The reference to the original issue discount provisions (Treas. Reg. section 1.1275-1(b)) for the determination of adjusted issue price was added to the regulations in 1998.23 Interestingly, this amendment was a stealth regulatory reversal of United States Steel Corp. v. United States24 and Fashion Park, Inc. v. Commissioner.25 Both cases involved fact patterns that are similar to the following scenario: Assume that a corporation issued preferred stock for $100, and the value of the preferred stock increases to $165. The corporation redeems the preferred stock with $165 in debt. The corporation later repurchases the debt for $120.

In Fashion Park, a 1954 decision, the Tax Court relied on Kirby Lumber and Rail Joint Co. v. Commissioner26 to hold that the corporation did not have any income when it repurchased debt for less than its face value because there was no increase in the corporation’s assets.

A 1988 case, United States Steel, involved a fact pattern and result similar to Fashion Park—no DOI income based on the freeing-of-assets theory. When United States Steel was decided, the then-current regulations generally provided that DOI income from the repurchase of debt was equal to the excess of the issue price (without reference to the original issue discount rules) over the repurchase price.27 The Internal Revenue Service (IRS) argued that the issue price of the debt was the market value of the preferred stock when the debt was issued ($165 in the example), resulting in DOI income equal to the issue price less the repurchase price ($165 – $120 = $45). The Federal Circuit was not persuaded by this argument and held that the issue price of the debt was the amount the corporation received when it originally issued the preferred stock for $100, noting that it was not necessary to determine issue price by reference to the original issue discount rules. Consequently, the Federal Circuit found no DOI income on the debt repurchase.

United States Steel would not have the same outcome under the current regulations; rather, the position the IRS had taken in that case would prevail and the debtor would have DOI income. Under Treas. Reg. section 1.61-12(c)(2)(ii), the calculation of the issue price is determined under the original issue discount rules, which results in $45 DOI income ($165 issue price less $120 repurchase price). This 1998 change was made as part of a larger regulatory package without mention of the United States Steel decision in the accompanying preamble.

It appears that the amendment made to Treas. Reg. section 1.16-12(c)(2)(ii) was made by Treasury to overturn the United States Steel decision. The exact breadth of the amendment is unclear. One could argue that the change could apply to result in DOI in fact patterns such as those in cases like Centennial Savings (discussed in § 2.3(a)(i)) and Rail Joint.28 The better view, however, is that regulatory amendments should not have the effect of overturning precedents such as Centennial Savings and Rail Joint that are cornerstone cases in the DOI area.

The Tax Court’s analysis in a more recent DOI case is worthy of discussion but should be viewed circumspectly in light of its reliance on a regulatory regime that applied to the year at issue but that was, as discussed, subsequently amended. Although Hahn v. Commissioner29 represents a perfectly fine decision with respect to its particular facts, one should be careful in applying certain statements in the decision to other fact patterns.30

The facts of the Hahn decision are simple. Gilbert Hahn borrowed money from a bank in exchange for his promissory note. When he subsequently satisfied the debt at a discount, the Federal Deposit Insurance Corporation (FDIC), which had taken over the receivable from the bank, issued him a Form 1099-C reflecting DOI income for 1995. DOI income arises when a creditor releases a debtor from an obligation that was incurred at the outset of the debtor-creditor relationship. For Gilbert Hahn, the DOI amount was computed based on the original principal amount of the debt as well as other nonprincipal items, such as unpaid interest, penalties, and attorney’s fees (the “Related Items”). The Related Items were the focus of the Hahn decision.

Gilbert Hahn argued that the Related Items should not enter into the computation of DOI. Why? Because he never borrowed or received the Related Items. Therefore, he did not have an accession to income due to a “freeing of assets” as required for DOI income under the seminal case of United States v. Kirby Lumber31 and its progeny.32 Under the Kirby Lumber freeing-of-the-assets theory, assets previously offset by liabilities are “freed” by the transaction and DOI income results. Gilbert Hahn argued that he was never enriched because he never borrowed the amount of money constituting the Related Items.

The Tax Court refused Gilbert Hahn’s argument, at least under the facts of the case, noting that other cases have upheld DOI income resulting from the discharge of obligations—such as interest, taxes, attorney’s fees, trustee’s fees, and cash advance fees.33 The court noted that the right to use money represents a valuable property right. Therefore, the forgiveness of the Related Items resulting from the use of the funds constituting the principal borrowed beyond the time specified by the note resulted in DOI income, consistent with the Kirby Lumber freeing-of-the-assets standard. It was a straightforward decision, but certain statements made by the Tax Court merit further examination.

In support of his view that the Related Items should not be included when computing DOI, Gilbert Hahn cited Rail Joint Co. v. Commissioner34 and Fashion Park v. Commissioner.35 Of particular interest is the following statement in Hahn:

The holdings in Rail Joint Co. and Fashion Park, Inc. are consistent with section 1.61-12(c)(3) Income Tax Regs., which provides: “If bonds are issued by a corporation and are subsequently repurchased by the corporation at a price which is exceeded by the issue price * * *, the amount of such excess is income for the taxable year.”36

The Tax Court properly quoted the version of the regulation that applied during the year of Gilbert Hahn’s transactions. However, that regulation was changed, effective in 1998. To understand the confusion that the Tax Court’s statement could cause, a review of the two decisions cited in the statement is in order.

In the 1932 Rail Joint decision, a corporation distributed bonds to its shareholders as a dividend and therefore received no proceeds in return. Several years later, Rail Joint reacquired several of the bonds from its shareholders for less than face value. The Second Circuit Court of Appeals recognized that Rail Joint did not hold any additional assets after the acquisition that it had not held prior to the acquisition. Therefore, the Second Circuit ruled that Rail Joint did not recognize DOI income within the Kirby Lumber freeing-of-the-assets theory.

Fashion Park, decided in 1954, involved a more complex set of facts that may be simplified in this way. The corporation issued preferred stock with a par and stated value of $50 per share. The corporation, however, received only $5 per share on the preferred stock when it was issued. The corporation later redeemed the preferred stock for a $50 note. Subsequently, the note was satisfied for an amount greater than $5 but less than $50 (the note’s face amount). Following Kirby Lumber and Rail Joint, the Tax Court in Fashion Park held that the corporation did not have DOI income when it repurchased the note for less than its face amount, because there was no net increase in the corporation’s assets.

The Tax Court in Hahn could have harmonized the decisions in Rail Joint and Fashion Park that there was no DOI income with its decision in Hahn that there was DOI income by specifically distinguishing the source of the debt discharged. As the Tax Court noted, the Related Items arose from a borrowing of money, and it is the right to use money that represents a valuable property interest. As such, any discharge of the obligation to pay the Related Items should be included in the computation of DOI income. On the contrary, in Rail Joint, no money was borrowed. Similarly, in Fashion Park, the corporation satisfied its indebtedness for an amount in excess of the original inflow of funds from the overall transaction. Additional amounts of indebtedness that accrued on the original borrowing were not at issue.

The Tax Court instead took another approach—it distinguished Gilbert Hahn’s situation by pointing out that he did not issue bonds or other debt instruments at a discount. The court noted that, for purposes of determining the amount of DOI, it had consistently held, à la Rail Joint and Fashion Park, that the issue price of a debt, and not its face amount, should be used to determine DOI income.37 This is an interesting statement because it appears to be inconsistent with the Treasury regulation that is in effect for today’s transactions.

Before examining the change in the regulation itself, it is interesting to consider why Treasury and the IRS made the change. United States Steel Co. v. United States38 is a case that was not discussed in Hahn but merits consideration nonetheless because of its effect on the 1998 regulatory change.

The facts in United States Steel are similar to those in Fashion Park. To restate, the pertinent facts are these: In 1901, U.S. Steel issued preferred stock for $100. In 1966, as part of a merger transaction, U.S. Steel redeemed the preferred stock with a $165 note. In 1972, U.S. Steel satisfied its outstanding $165 note for $120. When United States Steel was decided, the then-current regulations generally provided that DOI income from the repurchase of debt was equal to the excess of the issue price over the repurchase price.39 The regulations, however, did not provide a definition for “issue price.” The IRS argued that the issue price of the debt was the market value of the preferred stock when the debt was issued, resulting in $45 of DOI income (the issue price of $165 less the repurchase price of $120). The Federal Circuit was not persuaded by this argument and held that the issue price of the debt was the amount the corporation received when it originally issued the preferred stock for $100, noting that it was not necessary to determine issue price for DOI purposes by reference to cases dealing with the tax treatment of bond discount.40 Consequently, the Federal Circuit found no DOI income on the debt repurchase.

The Federal Circuit United States Steel decision is consistent with the Tax Court’s Fashion Park decision. Furthermore, the regulation at issue in United States Steel is the same regulation the Hahn Tax Court found to be consistent with Rail Joint and Fashion Park. If the story ended at this point, one would not expect a corporate debtor to realize DOI income under a Rail Joint, Fashion Park, or United States Steel scenario.

It seems that the Treasury and/or the IRS was not pleased with the loss in United States Steel. In what could be viewed as a stealth regulatory reversal of United States Steel and Fashion Park, the Treasury amended the regulations to define the amount of the debt used to compute DOI income by reference to the original issue discount (OID) rules, as part of a large regulatory package addressing the OID provisions.41

The regulation cited by the Hahn court provided that the calculation of DOI income on the repurchase of corporate debt is the excess of the issue price over the repurchase price. The calculation of DOI income on the repurchase of debt is currently addressed in section 1.61-12(c)(2)(ii) of the Treasury regulations, which provides that “[a]n issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of Treas. Reg. section 1.1275-1(b)).” The “issue price” of the old regulations is now the “adjusted issue price” as defined in the OID regulations.

Consequently, if the adjusted issue price of the discharged indebtedness in United States Steel and Fashion Park had been determined based on the debt’s fair market value, face amount, or some type of yield-to-maturity method (as would generally be the case under the current OID regulations), the satisfaction of the debt for less than this amount would appear to result in DOI income. Perhaps the current regulation also has implications for the fact pattern in Rail Joint—that is, a fact pattern in which debt distributed by a corporation as a dividend that has an adjusted issue price (within the meaning of the OID rules) when issued and is later satisfied for a lesser amount.42

Depending on the facts, the version of the regulations cited by the Hahn court and the current version of the regulations could yield different results. So what is the moral of the story? Be careful when citing statements made by a court because, although such statements may be perfectly correct within the parameters of the case, they may not be correct or may trigger other issues on a going-forward basis.

(iv) Income Other than Discharge of Indebtedness

Cancellation of debt may be the medium through which other types of income arise, if the relationship of the parties is more than debtor-creditor—such as employer and employee, shareholder and corporation, or buyer and seller of property. The characterization and tax consequences of the transaction depend on the relationship of the parties and the context in which the discharge occurs. In Spartan Petroleum Co. v. United States,43 for example, a reduction of a debt was viewed simply as the means used to pay for property.

Debtors may set off obligations, as illustrated by this example: Mr. X owes Mr. Y $100 and Mr. Y also owes Mr. X $100. Rather than paying each other $100, the two debts are set off against each other. Neither has DOI income. The Bankruptcy Code generally preserves a creditor’s right to offset mutual obligations between the creditor and a bankrupt debtor. In an analogous vein, in OKC Corp. v. Commissioner,44 the Tax Court held that a cancellation of debt was merely a means of settling a claim. The IRS reached a similar conclusion in Revenue Ruling (Rev. Rul.) 84-176,45 finding that cancellation of debt in exchange for a release of a contract counterclaim does not result in DOI income.

If a corporation makes a bona fide loan to a shareholder, or a corporation acquires a shareholder’s debt from a third party, and the corporation subsequently cancels the shareholder’s obligation, the cancellation may be a distribution.46 The amount of the distribution may not be equivalent to the amount of the debt canceled, however. Assume that on January 1, 2000, a corporation loaned its sole shareholder $100 with a 10-year term to maturity. The debt bore a 5 percent rate of interest, payable annually, which reflected a market rate of interest. On January 1, 2004, the corporation canceled the $100 principal obligation. At this time, interest rates in the market had risen to 9 percent. Assume that the value of the debt (a $100 receivable in the hands of the corporation) dropped to $85 as a result of the rise in interest rates. I.R.C. section 301(b) provides that the amount of any distribution is the fair market value of the money received by the shareholder, plus the fair market value of the other property received. One approach suggested by revenue rulings is to bifurcate the transaction. That is, the debt cancellation results in a distribution to the extent of the fair market value of the debt ($85) and DOI income with respect to the remainder ($15).47 This bifurcation concept may also apply to loans between employers and employees. Another approach ignores the difference between the amount of the debt and its fair market value and treats the face amount of the debt as the amount of the distribution.48

The cancellation of an obligation between an employer and an employee may be a payment for services.49 If an employer makes a bona fide loan to an employee and in a later year cancels the debt in exchange for overtime services, the cancellation should be treated as compensation from both the employee-debtor’s and the employer-creditor’s perspectives. Treating the discharge as payment for services rather than DOI income results in significant differences with respect to (1) the employee’s ability to take advantage of the section 108 income exclusions discussed in §§ 2.6(a)–(d), (2) the timing of the income (if the advance of money is a prepayment for services rather than a bona fide loan), and (3) the corporation’s ability to deduct the amount as compensation expense as opposed to a bad debt. If the debt has depreciated in value at the time it is forgiven as compensation, it may be more appropriate to bifurcate the cancellation as compensation up to the value of the debt (which should equal the value of the services performed) and DOI income with respect to any remaining amount.

Due to the variety of financial arrangements in employment relationships, there are many ways in which something that facially resembles debt discharge is actually a payment for services. For example, employers often pay the moving expenses of an employee who generally agrees to repay those expenses if the employee quits within a certain time frame. If the employee does quit, the employer may cancel the reimbursement obligation. In a private letter ruling,50 the IRS determined that the canceled obligation must be reported as income on a W-2 (i.e., as wages) because the indebtedness arose as a result of an employment relationship.

Another example of compensation resulting from debt discharge arises when an employer transfers property to an employee in exchange for a note, which is later reduced or canceled. Generally, the amount of compensation the employee includes in gross income is the excess of the fair market value of the property over the amount (if any) paid for the property. Debt may be treated as an amount paid for the property, thereby lowering the amount the employee includes in gross income. The forgiveness or cancellation of that debt, in whole or part, will be included in the gross income of the employee as compensation rather than DOI income.51

(v) No Income

I.R.C. section 108(f) provides a special rule for the cancellation of student debt. The gross income of an individual does not include DOI income attributable to the forgiveness of certain student loans. I.R.C. section 108(f) excludes something from gross income that would otherwise be DOI income; there are several other situations where a discharge of debt does not result in income from the start.

A cancellation of debt may result in no income if the discharge is a gift.52 This is fairly easy to envision among family members or individuals with personal relationships. The issue that has created more confusion is whether a cancellation of debt may be treated as a gift in a commercial context. The Supreme Court originally held that a commercial discharge was a gift in Helvering v. American Dental Co.,53 but later in Commissioner v. Jacobson,54 the Supreme Court held that a commercial discharge was not a gift and resulted in DOI income. Uncertainty remained because the Jacobson decision did not overrule American Dental. Congress resolved this issue in the legislative history to the Bankruptcy Tax Act of 1980, which provides that gifts do not occur in a commercial context.55

A guarantor does not realize income when the primary debtor makes a payment or satisfies the debt. In Landreth v. Commissioner,56 the Tax Court held that a guarantor does not realize DOI income when the principal debtor discharges the debt. In reaching this conclusion, the Tax Court contrasted the impact of a cancellation of debt on a primary debtor with the impact on a guarantor. If the obligation of a debtor is relieved, the debtor’s net worth increases and the debtor may have DOI income under Kirby Lumber.57 However, when a guarantor is relieved of the contingent liability, either because of payment by the debtor or a release given by the creditor, there is no accretion of assets.58 The payment by the debtor did not result in an increase in the guarantor’s net worth, it merely prevented a decrease in the guarantor’s worth. The Tax Court concluded that the “guarantor no more realizes income from the transaction than he would have if a tornado, bearing down on his home and threatening a loss, changes course and leaves the house intact.”59

(vi) Contested Liability Doctrine and Unenforceable Debt

Under the contested liability doctrine, a taxpayer who disputes the original amount of a debt and later settles with the creditor on a lesser figure can use the lower amount when computing DOI income. That is, the excess of the original debt over the amount later determined to be correct may be disregarded in calculating gross income.60 Situations that invoke the contested liability doctrine often involve debt that may not be enforceable, which invokes another rule: If there is no legal obligation to pay the debt, there is no income when that “debt” is discharged.

The Third Circuit considered the contested liability doctrine and unenforceable debt in Zarin v. Commissioner.61 This case involves a $3.4 million gambling debt that arose when Mr. Zarin borrowed gambling chips from a casino. He immediately lost the chips and eventually settled the matter with the casino for $500,000. The Tax Court held that Mr. Zarin realized DOI income in an amount equal to the difference between the amount borrowed and the amount paid. The Third Circuit reversed on two grounds. The first and more compelling reason was that Mr. Zarin did not have a legal liability to the casino. Applicable law prohibited the casino from providing a marker to Mr. Zarin in the amount that it did, so he was not legally obligated to satisfy the debt. The gambling debt did not meet the definition of indebtedness in I.R.C. section 108(d)(1), so its discharge was not income under I.R.C. section 61(a)(12).62 The second reason was application of the contested liability doctrine. The casino and Mr. Zarin settled the unenforceable debt for $500,000, which Mr. Zarin paid. Because Mr. Zarin owed and paid the same amount, there was no DOI income. The authors do not find much comfort in or basis for this rationale given the facts at issue in Zarin.

The Third Circuit’s holding in Zarin has been questioned by other courts. In Preslar v. Commissioner,63 the Tenth Circuit found that the Third Circuit improperly applied the contested liability doctrine to unenforceable debt, confusing liquidated debt with unliquidated debt. According to the Tenth Circuit, the contested liability doctrine only applies to unliquidated debt, that is, the theory applies when the exact amount of consideration that initially exchanged hands is unclear.64 A total denial of liability or a challenge to the enforceability of the underlying debt does not go to the amount of the underlying debt. The Tenth Circuit found that in such a situation, the infirmity exception to the purchase price adjustment rule (which is discussed in § 2.5(b)) would apply, but the contested liability doctrine would not.

At least one court sidestepped the contested liability doctrine by resorting to the tax benefit rule. In Schlifke v. Commissioner,65 the Tax Court avoided the necessity of cutting its “way through the thicket of subissues . . . such as the presence of a liquidated, as distinguished from an unliquidated indebtedness, and the enforceability of the underlying obligation, i.e., whether it is void or voidable and the impact of the element of rescission”66 by applying the tax benefit rule. To simplify the facts of the case, Republic Home Loan (Republic) loaned $100 to the Schlifkes, who paid $20 in interest on the loan and deducted $20 as interest expense. The Schlifkes rescinded the loan three years later because it violated the Truth in Lending Act. As part of the rescission, the previously paid $20 in interest was applied against the $100 principal of the loan, reducing the Schlifkes’ debt to $80.

The Tax Court adroitly avoided DOI income issues by applying the tax benefit rule. Under the tax benefit rule, if an amount deducted from gross income in one tax year is recovered in a subsequent tax year, the recovery is included in gross income in the year of receipt, to the extent the prior deduction resulted in a tax benefit.67 The Tax Court held that under the tax benefit rule, the Schlifkes had taxable income of $20. The court cited and quoted Hillsboro National Bank v. Commissioner for the proposition that the tax benefit rule triggers income where a “subsequent recovery . . . would be fundamentally inconsistent with the provision granting the deduction.”68

The Tax Court’s ultimate holding in Schlifke may be correct, namely that the taxpayers should include income. The outcome is consistent with the Supreme Court’s later decision in Centennial Savings. The Tax Court in Schlifke, however, could have concluded that there was no discharge of indebtedness under Zarin, because the taxpayer fulfilled its legal liability under the terms of the note and applicable law. We will never know. The Tax Court’s short-shrift approach, completely discarding the characterization of the income as discharge of indebtedness, is not a recommended analysis. Although the characterization of the income may not have made a difference under the facts of the case, it could easily have significant implications if the debtor were in bankruptcy or insolvent.

The IRS addressed another situation in which the characterization of income as includible under the tax benefit rule or excludible as DOI under I.R.C. section 108 was at issue. This is discussed in greater detail in § 2.6(e) below.

(b) Is the Obligation Indebtedness?

Another threshold issue is whether the obligation is “indebtedness” for federal income tax purposes. If the instrument is not “indebtedness,” then the I.R.C. section 108 rules do not apply. For closely held corporations, the nature of an instrument as debt or equity may be questioned. In general, debt qualifies as indebtedness for federal income tax purposes in part if the amount of the obligation does not exceed the amount that a reasonable unrelated lender would lend to the debtor under commercially reasonable terms.69

(c) Who Is the Debtor?

If there are multiple debtors liable for a debt that is canceled, any DOI income must somehow be allocated among the debtors. Stated another way, who is the debtor for federal income tax purposes? In a private letter ruling,70 a partnership owned an insolvent corporation, and both were jointly and severally liable on bank debt. As part of a settlement with the bank, the partnership satisfied the debt for less than the amount due. The IRS found that the corporation (not the partnership) recognized DOI income, which was excluded to the extent of its insolvency.

Another case involving the identity of the debtor is Plantation Patterns, Inc. v. Commissioner.71 A corporation issued debentures that were personally guaranteed by its sole shareholder.72 Even though the corporation made all payments due on the debentures, the Fifth Circuit considered the circumstances that existed when the debentures were issued and held that the debentures were not indebtedness of the corporation. Thus, the corporation was not a debtor and not entitled to deduct the payments made on the debentures as an interest expense. Rather, the Fifth Circuit treated the debentures as a contribution of capital by the shareholder and treated the corporation’s payments as distributions to the shareholder.73

The authors have often seen practitioners express undue concern regarding a Plantation Patterns issue. Not every shareholder guarantee of a corporation’s debt results in this treatment. Even if a lending institution would lend money to a corporation on a stand-alone basis, those institutions commonly require a shareholder guarantee when the corporation is closely held. Under these circumstances, the corporation’s obligation should be treated as indebtedness and not recast under Plantation Patterns.

(d) When Does Discharge of Indebtedness Income Occur?

Sometimes the issue is not whether DOI income exists but when it occurs. Debt is discharged when it becomes clear that the debt will never have to be paid, based on a practical assessment of the facts and circumstances.74 The courts require only that the time of discharge be fixed by an identifiable event. Repayment of the loan need not become absolutely impossible before a debt is considered discharged. A slim possibility of repayment does not prevent a debt from being treated as discharged. Whether a debt has been discharged depends on the substance of the transaction. The courts look beyond formalisms, such as the surrender of a note or the failure to do so.75

Corduan v. Commissioner76 not only provides another example of what is income from debt cancellation but also sheds some light on when that income is realized. The taxpayer owned a piece of equipment subject to recourse debt of $18,581. The creditor repossessed the equipment, which had a fair market value of $12,575. The taxpayer and the creditor later agreed that the taxpayer would pay the creditor $1,000 and the creditor would release the taxpayer from the remaining debt. Debt is considered discharged “the moment it is clear that it will not be repaid.” Using this standard, the Tax Court held that the taxpayer had DOI income of $5,006 ($18,581 less $12,575 less $1,000) when the creditor released the taxpayer from further obligations under the debt, not when the creditor repossessed the equipment.

In Milenbach v. Commissioner,77 the Ninth Circuit considered the timing of DOI income. The taxpayer owned the Los Angeles Raiders and the case arose from the nomadic nature of the team. In 1987, the Raiders tried to move from Los Angeles to Irwindale, California. In connection with the move, the Raiders executed a memorandum of agreement (MOA) with the city of Irwindale for a $115 million loan to finance a football stadium. Irwindale advanced the Raiders $10 million of the $115 million. The MOA provided that, if Irwindale failed to perform its obligations, the Raiders’ obligations would be extinguished, including the obligation to repay the advance. The Raiders would be allowed to keep the advanced funds “as consideration for the execution” of the MOA. The MOA stated that Irwindale proposed to finance the stadium by issuing general obligation bonds. In 1988, the California legislature passed a statute that precluded the use of general obligation bonds to build a stadium. Despite this legislation, the Raiders continued to negotiate with the city through 1990 to construct a stadium in Irwindale. All alternative financing schemes were rejected, however. The Raiders never repaid the $10 million advance.

The classification of the $10 million as DOI income was not in dispute in Milenbach.78 The timing of the DOI income was the issue. The Tax Court held that the Irwindale debt was discharged in 1988, primarily because the 1988 legislation made financing the stadium with general obligation bonds impossible. The Ninth Circuit disagreed, finding that although the parties assumed that Irwindale would fund the loan with these general obligation bonds, that funding was not required by the MOA. Forfeiture would occur only if Irwindale was unable to provide the funds, from whatever source. The passage of the 1988 legislation was simply an obstacle that the Raiders and Irwindale attempted to overcome. The Ninth Circuit remanded the matter to the Tax Court to determine when the Irwindale debt was discharged, directing the Tax Court to perform a “practical assessment of the facts and circumstances relating to the likelihood of payment” to determine when, as a practical matter, it became clear that Irwindale would not be able to fund the entire loan and that the stadium would not be built.

A recent chief counsel advice memorandum addressed the timing of DOI.79 The debt at issue became the subject of complex litigation. Ultimately, the debtor and creditor negotiated a settlement agreement regarding amounts owed. The settlement agreement specified a creditor effective date when the taxpayer was discharged from all indebtedness and the notes were canceled. In furtherance of the settlement agreement, the parties filed a motion to dismiss with prejudice the various lawsuits, and the court granted the motion. The creditor effective date was many months after the court order date.

The author of the chief counsel advice memorandum concluded that the discharge of the taxpayer’s indebtedness did not occur as of the court order date and instead occurred, under the terms of the settlement agreement, as of the creditor effective date. As of the court order date, the creditor still had rights with respect to the notes that could be judicially enforced: “. . . in the event a payment was not received by Creditor pursuant to the Settlement Agreement, Creditor could seek subsequent judicial assistance in enforcing the Settlement Agreement.”80

§ 2.4 SECTION 108(e) ADDITIONS TO DISCHARGE OF INDEBTEDNESS INCOME

(a) Debt Acquired by Related Party: Section 108(e)(4)

As discussed in § 2.3(a)(iii), a debtor may have DOI income when it repurchases its own debt for less than the adjusted issue price.81 A debtor cannot avoid the DOI income by inducing a related party to purchase the debt at a discount because I.R.C. section 108(e)(4) recharacterizes the purchase by the related party as a purchase by the debtor.

(i) Related Party

I.R.C. section 108(e)(4) identifies a “related party” by cross-reference to the relationships in I.R.C. sections 267(b) and 707(b)(1), which include family members, shareholders and controlled corporations, fiduciaries and beneficiaries of a trust, and many others. For example, a person is considered related to the debtor if that person is any of the following:

• A member of a controlled group (for purposes of I.R.C. section 414(b)) of which the debtor is also a member82
• Under common control with the debtor as defined in I.R.C. section 414(b) or (c)
• A partner in a partnership that the debtor controls (owns more than 50 percent of the capital interest or profit interest)
• A partner in a partnership that is under common control as defined in I.R.C. section 707(b)(1)

The Bankruptcy Tax Act does provide for some exceptions to the related party rules. As one example, brothers and sisters of the debtor are not related parties. Other family members—the debtor’s spouse, children, grandchildren, parents, and any spouse of the debtor’s children or grandchildren are related parties.83

(ii) Acquisition by a Related Party

Under I.R.C. section 108(e)(4), the acquisition of the debt of a related party from a person who is not a related party can result in DOI income to the debtor (a “direct acquisition”). Thus, if a parent corporation (P) purchases the debt of its subsidiary (S) on the open market for an amount less than the adjusted issue price, there is DOI income to S. The tax consequences may be the same if the steps are reversed; that is, S acquires the debt of P in the open market at a time when S and P are unrelated, but, at a future date, P purchases the stock of S (an “indirect acquisition”).

(A) Direct Acquisition

The current regulations, Treas. Reg. section 1.108-2, cover both direct and indirect acquisitions. A “direct acquisition” is defined as an acquisition of outstanding debt if a person related to the debtor (or a person who becomes related to the debtor on the date the debt is acquired) acquires the debt from a person who is not related to the debtor. Thus, if P owns all the stock of S, P’s acquisition of S’s debt, or vice versa, is a direct acquisition. Likewise, if on the same day P acquires all the stock of S from unrelated X and P acquires all the S debt from unrelated Y, there is a direct acquisition within the meaning of I.R.C. section 108(e)(4), and S has DOI income.

The IRS is studying transactions in which P acquires the S stock and the S debt from the same person in the same transaction, to see whether these transactions should be excluded from the definition of a direct acquisition.84

(B) Indirect Acquisition

Indirect acquisitions, which fall outside the literal language of I.R.C. section 108(e)(4), achieve the same result as direct acquisitions. In response to these indirect acquisitions and to prevent abuses under I.R.C. section 108(e)(4), the government issued regulations, at Treas. Reg. section 1.108-2.85 Under the current regulations, an indirect acquisition is a transaction in which a holder of the debt becomes related to the debtor, if the holder acquired the debt in anticipation of becoming related to the debtor. Assume P and S are unrelated to each other. P has outstanding debt in the hands of unrelated parties. S buys the P debt in anticipation of P’s acquisition of the stock of S. Shortly thereafter, P buys all the stock of S. The discharge of indebtedness rules and I.R.C. section 108(e)(4) apply. Similarly, if S had outstanding debt held by unrelated parties, the acquisition by P of the S debt in anticipation of P’s buying the S stock is also an indirect acquisition.

The contentious phrase in the definition of an indirect acquisition is “in anticipation of becoming related.” A holder of the debt is treated as having acquired that debt in anticipation of becoming related if the relationship is established within 6 months after the debt is acquired. This appears to be a conclusive presumption. If the relationship is not established within six months, “all facts and circumstances will be considered . . . including the intent of the parties.” Specifically, the nature of the contacts between the parties, the time period during which the holder held the debt, and the significance of the debt in proportion to the total assets of the holder (or holder group)86 are considered. Curiously, the absence of discussions between the debtor and the holder does not, by itself, establish that the holder did not acquire the indebtedness in anticipation of becoming related to the debtor.

(1) Nonrecognition Transactions and DOI Income

The Treasury Department may issue regulations aimed at preventing taxpayers from using nonrecognition transactions to avoid DOI income under I.R.C. section 108(e)(4). In the preamble to the proposed Treas. Reg. section 1.108-2 regulations, the Treasury Department stated that it intended to prevent elimination of DOI income in certain nonrecognition transactions described in I.R.C. sections 332, 351, 368, 721, and 731. The preamble also provides:

In general, if assets are transferred in a tax-free transaction and the transferee receives the assets with a carryover (or, in certain cases, a substituted) basis, any built-in income or gain is taxed when the transferee disposes of the asset. If, however, the debtor acquires its own indebtedness, the indebtedness is extinguished. In that case, the indebtedness in all cases should be treated as if it is acquired by the transferee and then satisfied. Similar treatment should apply if a creditor assumes a debtor’s obligation to the creditor.

In both cases, the debt is effectively extinguished, and current recognition of income from discharge of indebtedness is appropriate. Thus, the regulations to be issued will provide for recognition of income from discharge of indebtedness in these cases.87

Although nonrecognition transaction regulations have not been issued, the regulations, when issued, would apply retroactively to March 21, 1991.88 Nonrecognition transactions involving the discharge of indebtedness should be evaluated to determine the possible retroactive application of these yet-to-be-issued regulations.

(2) Disclosure of Indirect Acquisition

In an indirect acquisition transaction, the debtor is required to disclose, by attaching a statement89 to its tax return for the year in which the debtor became related to the holder, whether either of two tests is met: (1) the 25 percent test or (2) the 6- to 24-month test.

The 25 percent test is satisfied if, on the date the debtor becomes related to the holder, the debt in the hands of the holder represents more than 25 percent of the fair market value of the assets of the holder (or holder group).90 For this computation, cash, marketable stock and securities, short-term debt, options, futures contracts, and an ownership interest of a member of the group are excluded.

The 6- to 24-month test is satisfied if the holder acquired the indebtedness less than 24 months, but at least 6 months, before the date the holder becomes related to the debtor.91

The only exception to the disclosure requirement is where the holder actually treats the transaction as a related-party acquisition under I.R.C. section 108(e)(4).92 If the debtor fails to disclose, there is a rebuttable presumption that the holder acquired the debt in anticipation of becoming related to the debtor.93

(iii) DOI Income for a Related Party Acquisition

Two things happen if either a direct or indirect acquisition occurs. First, on the acquisition date, the debtor has DOI income measured by the difference between the adjusted issue price of the debt and the related party’s basis in the debt acquired (cost). The measure is fair market value, not cost, if the holder did not acquire the debt by purchase on or less than six months before the acquisition (i.e., becoming related).94 Second, the debtor is deemed to issue a new debt to the holder in an amount equal to the amount used to compute discharge of indebtedness (cost or value).95

As an example, holder H acquires debtor D’s $1,000 face debt in the open market for $700. Five months later, H and D become related. D has DOI income of $300. D is deemed to issue a new debt to H (face $1,000 and issue price $700). Thus, D has original-issue discount deductions and H has original-issue income of $300 over the life of the old (deemed new) debt.

I.R.C. Section 108(e)(4) does not apply to all related party acquisitions of debt. For example, DOI income is not triggered if (1) the debt that is acquired in a direct or indirect acquisition has a stated maturity date within one year of the acquisition date and the debt is in fact retired on or before such date, or if (2) the acquisition of indebtedness is by certain securities dealers in the ordinary course of business.96

As a practical matter, many related party issues are covered by the consolidated tax return regulations. The application of section 108(e)(4) may be trumped by the application of the consolidated return regulations when a member of a consolidated group has its debt canceled or is deemed to have its debt discharged.97

(b) Indebtedness Contributed to Capital: Section 108(e)(6)

Even if the cancellation of a debt is structured as an otherwise tax-free contribution to capital, DOI income may be realized under I.R.C. section 108(e)(6). The tax effect of the cancellation of a loan from a corporation to its debtor-shareholder was discussed in § 2.3(a)(iv). The opposite scenario is addressed here: the shareholder’s cancellation or satisfaction of a corporation’s obligation. This situation often occurs in the consolidated group setting, where different rules, which are discussed in § 2.10, apply.98 Unlike the stock-for-debt exception under I.R.C. section 108(e)(8) discussed in § 2.4(c), the capital-contribution situation generally involves a creditor that is an existing shareholder of the debtor corporation. Nevertheless, the capital-contribution exception and the stock-for-debt exception are similar enough to overlap in many situations, as discussed in § 2.4(c)(ii).

I.R.C. section 108(e)(6) provides that if a debtor corporation acquires its debt from a shareholder as a contribution to capital, I.R.C. section 118 (which excludes contributions to capital from the corporation’s gross income) does not apply, and the corporation will be deemed to have satisfied the debt with an amount of money equal to the shareholder’s adjusted basis in the debt.

The satisfaction of a debt in exchange for stock of the debtor corporation is not considered a contribution to capital, however, if the shareholder is also a creditor and acts as a creditor to maximize the satisfaction of a claim.99 This exception might apply to situations where stock and bonds are publicly held and the creditor also happens to be a shareholder.

Shareholders that forgive corporate debt would prefer a bad debt deduction to capital contribution treatment. The shareholder was allowed a bad debt deduction rather than capital contribution treatment in Mayo v. Commissioner.100 The shareholder in Mayo forgave debt of an insolvent corporation, but the corporation was still “hopelessly insolvent, even after the cancellation.” Thus, the Tax Court held that the cancellation of debt of the insolvent corporation did not enhance the corporation’s value and, therefore, did not constitute a contribution to capital.101

Lidgerwood Mfg. Co. v. Commissioner,102 unlike Mayo, found that the shareholder made a capital contribution in the form of debt forgiveness. The Second Circuit assumed that the debtor corporation was insolvent both before and after the cancellation; however, there was no finding that the corporate debtor was “hopelessly insolvent.” The Second Circuit noted that:

[W]iping out the debts was a valuable contribution to the financial structure of the subsidiaries. It enabled them to obtain bank loans, to continue in business and subsequently to prosper. This was the avowed purpose of the cancellations. Where a parent corporation voluntarily cancels a debt owed by its subsidiary in order to improve the latter’s financial position so that it may continue in business, we entertain no doubt that the cancellation should be held a capital contribution and preclude the parent from claiming it as a bad debt deduction.103

In addition to Lidgerwood, the bulk of case law favors characterizing a shareholder’s cancellation of debt of an insolvent corporation as a contribution to capital, rather than allowing the shareholder a bad debt deduction.104

A 1998 field service advice105 cites to Mayo and Lidgerwood, while considering the tax treatment when a parent corporation (P) forgives debt of a wholly owned, and insolvent, subsidiary (S). To illustrate the determination in the field service advice, assume S is insolvent to the extent of $10 and P forgives a note with a face amount of $20, in which S has a basis of $20.

Turning first to whether P (the shareholder) made a capital contribution, the IRS applied this standard: “A shareholder generally makes a capital contribution to a debtor corporation to the extent that the shareholder’s cancellation of the corporation’s debt enhances the value of the shareholder’s stock.” The value of the stock of S, the debtor corporation, increased by the amount by which it became solvent as a result of the debt cancellation. Applying this standard to the previous numbers, the value of S stock increased from zero to $10. Under I.R.C. section 108(e)(6), S is deemed to have satisfied $10 of the outstanding debt with an amount equal to P’s $10 basis in that portion of the debt. Under the assumed facts, S would not have DOI income on the portion that qualified as a capital contribution, but if P had a lower basis in the debt, then S could have DOI income.

Recall that only $10 of the $20 of debt cancellation is treated as a capital contribution. The IRS found that S realized DOI income equal to the canceled debt that is not a capital contribution.106 Special rules that apply when an insolvent taxpayer has DOI income are discussed in § 2.6(b). Under those rules, S has all the DOI income excluded from income under the I.R.C. section 108(a)(1)(B) insolvency exclusion (i.e., to the extent of its insolvency of $10) and applied to reduce tax attributes pursuant to I.R.C. section 108(b)(1).

(i) Allocation between Principal and Interest

Allocation between principal and interest is another matter to be considered with regard to the deemed satisfaction of an outstanding debt under section 108(e)(6). If a corporation is deemed to satisfy outstanding debt (attributable to principal or loaned funds and to accrued but unpaid interest), the payment must be allocated between principal and interest. Prior law allowed the parties to decide how to allocate the payment.107 Under current law, the payment is generally first allocated to the interest component.108

(ii) Withholding Requirement

The IRS took the fiction of the deemed allocation one step further in a series of field service advices by requiring withholding for a foreign creditor that had a deemed payment of interest under I.R.C. section 108(e)(6).109 This conclusion is questionable in light of the introductory language of I.R.C. section 108(e)(6), which provides that it is “for purposes of determining income of the debtor from discharge of indebtedness.” The IRS’s position in the field service advice applies the deemed payment treatment to other purposes of the I.R.C. Extending this logic one more step, the deemed interest payment could result in an interest deduction and interest income for cash-method debtors and creditors.110

(iii) Accounting Method Differences

The effect of I.R.C. section 108(e)(6) may rectify complications caused by different accounting methods of the corporation and the shareholder, as illustrated by the next example. Assume that a cash-method shareholder lends $1,000 to an accrual-method corporation and that interest in the amount of $200 accrues on the loan, but is not paid by the corporation.111 This results in a $200 interest expense deduction to the accrual-method corporation (assuming the deduction is not deferred under section 267) but no interest income to the cash-method shareholder. If the shareholder cancels the debt as a contribution to capital, the corporation is no longer obligated to pay $1,200. Under section 108(e)(6), the corporation is deemed to satisfy the $1,200 obligation with an amount equal to the shareholder’s basis in the debt of $1,000. This means that the corporation would have DOI income of $200.112 If one follows the interest payment ordering rules, the deemed $1,000 payment would be split as follows: $200 of the deemed payment would be allocated first to the $200 accrued interest and the remaining $800 of the deemed payment would be allocated to the $1,000 of principal.113 If the accrued but unpaid interest has not yet been deducted and would be deductible on payment (for instance, in a situation in which I.R.C. section 267 might apply), some interesting and potentially inconsistent consequences could ensue.

If one follows the interest payment ordering rules, the first $200 of deemed payment could be applied to the accrued but unpaid interest, potentially resulting in $200 of interest deduction with the remaining $800 of deemed payment allocated to the $1000 of principal, resulting in $200 of DOI. Such an outcome does not appear to be the best resolution of this issue for several reasons. First, the statutory language of 108(e)(6) that creates a deemed satisfaction for purposes of determining DOI does not indicate that it applies for other purposes such as creating a deemed payment for purposes of generating an interest deduction. Second, certain preexisting case law that could be interpreted as resulting in a deemed payment beyond the scope of computing DOI is better viewed as eroded and inconsistent with section 108(e)(6) as enacted in the Bankruptcy Tax Act of 1980.114 The legislative history to the Bankruptcy Tax Act of 1980 indicates that if the I.R.C. section 108(e)(6) capital contribution rule would not be applied to prevent DOI, I.R.C. section 108(e)(2) nevertheless remains available. Thus, it is possible that under I.R.C. section 108(e)(2), accrued interest (the payment of which would result in a deduction) would not be included as DOI. The result would be that the entire payment could be allocated to the $1,000 of principal under I.R.C. section 108(e)(6), resulting in no DOI with respect to the principal under I.R.C. section 108(e)(6). The question is, which rule should trump—I.R.C. section 108(e)(2), which was enacted to address items that are deductible upon payment (even if the section 108(e)(6) capital contribution rule does not provide shelter), or the more recently enacted and generally applicable interest payment ordering rules. In this specific situation the better rule would appear to be section 108(e)(2).115

(c) Stock for Debt: Section 108(e)(8)

A debtor corporation may have DOI income if its debt is transferred to the corporation from a shareholder. Similarly, if the debt is transferred to the corporation in exchange for the corporation’s stock (making the creditor a shareholder), the debtor corporation has DOI income under I.R.C. section 108(e)(8) to the extent, if any, that the amount of the debt discharged exceeds the fair market value of the stock issued.

(i) Background

For many years, a corporation that satisfied debt with stock could take advantage of a favorable nonrecognition rule. That rule, however, eventually evolved into a recognition rule. The courts initially held that the exchange of stock for debt does not require the recognition of income. This nonrecognition rule was known as the stock-for-debt exception. The stock-for-debt exception, as originally codified, applied to solvent corporations as well as insolvent corporations and those in bankruptcy proceedings.116 The Tax Reform Act of 1984 changed this by providing for a general recognition rule for stock-for-debt exchanges and an exception to that general recognition rule for insolvent debtors and debtors in title 11 cases.117 The Omnibus Budget Reconciliation Act of 1993 abolished that regime by eliminating the exception for insolvent and title 11 debtors, leaving only the general recognition rule in place. Income recognized under this provision will continue to be excludable under section 108(a) for insolvent and title 11 debtors, but only at the price of attribute reduction.118

(ii) Overlap with Capital-Contribution Rule

Depending on the facts, the difference between an I.R.C. section 108(e)(6) capital contribution and an I.R.C. section 108(e)(8) stock-for-debt exchange may merely be a matter of form or may have economic significance. A corporation may also have DOI income if the holders of convertible debt convert the debt into common stock pursuant to a conversion right in the instrument.119

In this situation, which rule should govern? There are three possibilities: (1) Form governs, (2) the stock-for-debt rule trumps, or (3) the capital-contribution rule trumps. The answer may have significant tax implications.

Suppose a corporation has two 50 percent shareholders (A and B) and the corporation also has an outstanding debt to A. The satisfaction of the debt by means of a stock-for-debt exchange would change the relative ownership percentages in the corporation, an economically significant event. If shareholder A receives additional stock in satisfaction of the debt, A’s percentage of the ownership increases and B’s decreases. However, if A merely discharges the corporation’s debt by means of a capital contribution, the relative stock ownership percentages would be unchanged. The application of the stock-for-debt rule or the capital-contribution rule is straightforward in this example, depending on whether or not A receives additional stock. Substance and form are uniform.

The distinction between the stock-for-debt and capital-contribution rules blurs if a pro rata discharge of the debt among all shareholders of a debtor corporation is considered. If the discharge is pro rata, the actual issuance of additional stock in satisfaction of the debt is a mere formality without economic significance. This concept is easily illustrated in the sole-shareholder context. Assume that A owns 100 percent of the stock in corporation X, which has a bona fide debt to A. If A discharges X’s obligation, the receipt of additional shares would be economically meaningless. Whether or not additional stock is issued, the debt is discharged and A owns 100 percent of the outstanding stock of X, both before and after the discharge.

Assume Corporation Y issued a $1,000 obligation bearing a market rate of interest. The value of the obligation declines due to market fluctuations in interest, and Drew, a person unrelated to Y, purchases the obligation on the market for $950. Two years later, in an unrelated transaction, Mary acquires 100 percent of the stock of Y.120 The fair market value of the debt instrument further declines to $920. If Y satisfies the $1,000 obligation with $920 worth of its own stock, Y would realize $80 of DOI income pursuant to the stock-for-debt rule. However, pursuant to the capital-contribution rule, if Drew forgives the debt as a capital contribution, Y would realize $50 of DOI income, determined by subtracting Drew’s basis in the debt ($950) from the adjusted issue price of the debt ($1,000).

The IRS considered the overlap in two private letter rulings. In a 1989 ruling,121 form governed and the stock-for-debt rule applied. In that ruling, P, a corporation, owns all the stock and a debt instrument of subsidiary S. P surrenders the debt to S in exchange for newly issued S stock equal in value to the fair market value of the debt. Even though P is the sole shareholder of S both before and after, the IRS allowed the form to control and applied the stock-for-debt rules and not the capital-contribution rules. As a result, income to S is measured by the excess of the principal amount of the debt over the value of the stock issued, and not by the principal amount of the debt over P’s basis in the debt. Assuming the adjusted issue price of the debt and the value of the S stock are equal, S would not have DOI income.

In a 1998 private letter ruling,122 the IRS once again found that form controls and the stock-for-debt rule, and not the capital-contribution rule, applies when creditors cancel debt of a debtor corporation in exchange for debtor corporation stock. The IRS concluded that I.R.C. section 108(e)(6) did not apply because the phrase “contribution to capital” does not encompass an exchange. As a matter of form, because the debtor corporation issued stock in return for three creditors’ cancellation of indebtedness, there was not a capital contribution. The IRS further concluded that the issuance of the stock could not be disregarded because the legal relationship of the creditors to the corporation changed—before the transaction, one creditor directly owned all the stock of the debtor corporation, but as a result of the transaction, the two other creditors also became shareholders of the corporation. Thus, because the debt cancellations were not capital contributions, I.R.C. section 108(e)(6) could not apply, and therefore, the stock-for-debt rule of I.R.C. section 108(e)(8) applied.

In 2005, the IRS went the extra mile in an overlap situation and treated one discharge of corporate debt as an I.R.C. section 108(e)(6) capital contribution and treated a discharge of another debt of the same corporation as an I.R.C. section 108(e)(8) stock-for-debt exchange.123

In certain circumstances, a taxpayer may discover after the completion of a debt cancellation that one form of cancellation was more advantageous than another. In such situations, a rescission may be necessary (if it is available). In Private Letter Ruling 201016048,124 the IRS allowed a corporate taxpayer to rescind the cancellation of its debt owed to its parent in exchange for its stock. The debt cancellation would have qualified under section 108(e)(8). After the rescission, the IRS allowed the taxpayers to substitute a contribution of the debt to the capital of the subsidiary that qualified under section 108(e)(6).

Do these private letter rulings mean that form always governs in an overlap? Although tax practitioners generally regard this as the better view,125 a careful practitioner should consider the substance of the transaction and the meaningless gesture doctrine.

(A) Meaningless Gesture Doctrine

The meaningless gesture doctrine has been applied in I.R.C. section 351 exchange transactions. I.R.C. section 351 allows a taxpayer to transfer property to a controlled corporation in a tax-free exchange.126 Both the courts and the IRS have acknowledged that when a 100 percent shareholder transfers property to the corporation in a section 351 exchange, the issuance of additional shares of stock would be a meaningless gesture127 and the transfer of the property is tax-free regardless of whether additional shares are actually issued. If the meaningless gesture doctrine is applied in a pro rata debt discharge in which additional shares were not issued, the transaction could be evaluated as if the shares were constructively issued. This approach would require the stock-for-debt rules to apply in an overlap situation. This is in contrast to the approach of the IRS in several private letter rulings that blessed capital-contribution-rule treatment where no stock was issued.128

(B) Bifurcation

Another issue that arises in the overlap situation is whether both rules may apply to the same transaction.129 Although there is little authority on this question, it appears that a discharge could be bifurcated into a capital-contribution portion and a stock-for-debt portion. Consider this scenario: Foreign Parent corporation owns 100 percent of the outstanding stock of U.S. Subsidiary. U.S. Subsidiary owes a $100 debt to Foreign Parent and Foreign Parent’s basis in the debt and the fair market value of the debt are $100. Under foreign law, Foreign Parent cannot cancel the debt as a capital contribution without some consideration from U.S. Subsidiary. To comply with the foreign law requirements, the U.S. Subsidiary issues $70 of its own stock to Foreign Parent in satisfaction of the $100 debt. If the stock-for-debt rule applies, U.S. Subsidiary has $30 in DOI income, the difference between the outstanding debt ($100) and the fair market value of the stock issued in satisfaction of the debt ($70). This result, however, does not appear to be appropriate because the exchange is not an arm’s-length transaction.

Arguably a better result—no DOI income—may be reached under two alternative theories. The route you take may depend on which camp you fell into after reading and considering the prior discussion of the stock-for-debt/capital-contribution rule overlap. If you believe the meaningless gesture doctrine applies and there should be a constructive issuance of stock, the $100 debt would be discharged in exchange for an actual stock issuance of $70 plus a constructive stock issuance of $30 resulting in no DOI income (i.e., the stock is issued in an amount equal to the fair market value of the debt). However, if you believe that form controls, there is authority (albeit outside the debt-discharge area) that a transaction may be bifurcated into a capital contribution and another type of exchange.130 Namely, the transaction could be treated as a stock-for-debt exchange to the extent of $70 and a capital contribution of $30. This would also result in no DOI income.131

This issue could be avoided completely if the transaction is modified. If U.S. Subsidiary issued $100 worth of its stock (equal to the value of the debt) or issued no stock at all (in a capital contribution or deemed stock issuance scenario), then there would be no DOI income under either the stock-for-debt rule or the capital-contribution rule. Changing the transaction to avoid the issue is preferable to issuing $70 of stock. At times, however, the form cannot be altered due to legal, accounting, or other business considerations.

(C) Advantages and Disadvantages

Whether stock-for-debt or capital contribution treatment is more advantageous is not always clear. From the debtor corporation’s perspective, the amount of DOI income may differ depending on whether it is determined under the I.R.C. section 108(e)(6) capital-contribution rules or the I.R.C. section 108(e)(8) stock-for-debt rules. In general, the capital-contribution rules are more advantageous if the shareholder’s basis in the debt exceeds the fair market value of the debt.132 However, the stock-for-debt rules are generally preferable if the fair market value of the debt is greater than the shareholder’s basis.

Even if the stock-for-debt treatment is advantageous for the debtor, the shareholder may be exposed to adverse tax consequences. The debtor corporation might avoid DOI income, but the shareholder has a gain to the extent, if any, the value of the stock used to satisfy the debt exceeds the shareholder’s basis in the debt. There is an exception to this rule where the debt is a “security” (generally, an instrument with a maturity longer than five years). In that case, the transaction could qualify as a recapitalization133 or a tax-free exchange.134

(d) Debt for Debt: Section 108(e)(10)

DOI income may be realized if one debt is issued in satisfaction of another debt. I.R.C. section 108(e)(10) generally involves the satisfaction of a debt instrument (the “old debt”) by the debtor’s issuance of another debt instrument (the “new debt”). For purposes of determining DOI income, the debtor is treated as having satisfied the old debt with an amount of money equal to the issue price of the new debt.

(i) Background

Prior to the passage of the Revenue Reconciliation Act of 1990, I.R.C. section 1275(a)(4) provided that, if any debt instrument was issued in a reorganization in exchange for any other debt instrument, and the issue price of the new debt was less than the adjusted issue price of the old debt, then the issue price of the new debt would be treated as equal to the adjusted issue price of the old debt. The result was that no gain was realized in the exchange.

The IRS sought the repeal of this rule and redoubled its efforts following the bankruptcy court’s decision in In re Chateaugay Corp.135 The 1990 Act repealed I.R.C. section 1275(a)(4) and revised I.R.C. section 108(e)(11) to provide that taxpayers would realize DOI income to the extent of the excess of the adjusted issue price of the old debt over the issue price of the new debt. The issue price of the new debt was (and is) determined under I.R.C. sections 1273 and 1274. I.R.C. section 108(e)(11) was subsequently redesignated as I.R.C. section 108(e)(10) in the Omnibus Revenue Reconciliation Act of 1993.136

(ii) Publicly Traded Debt versus Non–Publicly Traded Debt

Under current law, the issue price of the new debt is a key factor when determining DOI income because the debtor is treated as if it paid that amount for the new debt. If either the old debt or the new debt is publicly traded, the issue price of the new debt is determined by the public trading price.137 An instrument is generally “publicly traded” if it is part of an issue that is traded (in whole or in part) on an established securities market or issued for securities that are traded on an established securities market.138

A report by the House Committee on Ways and Means139 contains this illustration of an exchange of publicly traded debt:

A corporation issued for $1,000 a bond that provided for annual coupon payments based on a market rate of interest. The bond is publicly traded. Some time later, when the old bond is worth $600, the corporation exchanges the old bond for a new bond that has a stated redemption price at maturity of $750. The exchange is treated as a realization event under section 1001. Under the bill, the new bond will have an issue price of $600 (the fair market value of the old bond) and deductible OID of $150 ($750 stated redemption price at maturity less $600 issue price) and the corporation will have COD of $400 ($1,000 adjusted issue price of the old bond less $600 issue price of the new bond). Such results will occur whether or not the exchange qualifies as a reorganization.

If neither the old debt nor the new debt is publicly traded, the issue price of the new debt is determined under I.R.C. section 1274.140 That section states that:

• Where the instrument has “adequate stated interest” (i.e., generally the instrument bears a rate of interest equal to or in excess of the applicable federal rate and the interest is unconditionally payable at least annually), the issue price equals the stated principal amount
• In other cases, the issue price is the “imputed principal amount,” which generally equals the net present value of all payments due under the new debt determined using a discount rate equal to the applicable federal rate, compounded semiannually.

Aside from the general rules, I.R.C. sections 1273 and 1274 and the regulations provide guidance for specialized situations. Treas. Reg. section 1.1274-2(g) contains a special rule for contingent-payment non–publicly traded debt. Application of that rule to a debt-for-debt situation may produce an inequitable result. For example, assume there is a “significant modification” of a debt (discussed next in § 2.4(d)(iii)) that triggers I.R.C. section 108(e)(10). The old debt has a $100 adjusted issue price and a fixed rate of interest. Neither the new debt nor the old debt is publicly traded. The new debt provides only for payments that are contingent on future events (such as future profitability). Because the new debt is not publicly traded and includes contingent payments, the adjusted issue price of the new debt could be determined under Treas. Reg. section 1.1274-2(g) to be zero. An issue price of zero means that the debtor has $100 of DOI income. Given this seemingly inappropriate result, it is arguable that the special rule should not apply in the discharge of indebtedness context.

(iii) Significant Modification of a Debt Instrument

I.R.C. section 108(e)(10) applies not only to situations in which an old debt instrument is exchanged by the holder for a new debt instrument; it also applies to situations in which a significant change in the terms of the old instrument rises to the level of an exchange that is a realization event for federal income tax purposes. A change to a debt instrument does not necessarily have any tax impact; but an exchange will be subject to the provisions of I.R.C. section 108(e)(10) and may therefore give rise to DOI income.

The distinction between a mere modification and an exchange is not always clear.141 In 1996, the government issued regulations under I.R.C. section 1001 that address this matter and provide some bright-line rules. These rules turn on whether a modification occurred and, if so, whether the modification is significant. A significant modification is an exchange subject to the I.R.C. section 108(e)(10) debt-for-debt rule.

(A) Modification

Treas. Reg. section 1.1001-3 provides that almost all changes in the terms of a debt instrument are considered a modification of the indebtedness. However, changes that are the result of the terms of the instrument (e.g., a change in the interest rate as provided for in a variable rate loan) are generally not considered modifications.142 Other examples of adjustments allowed by the terms of the debt instrument that are not modifications under the regulations include:

• The resetting of the interest rate every two months143
• The substitution of collateral when the original collateral depreciates
• The drop in interest rate as a bond is registered
• The conversion of an adjustable mortgage to a fixed mortgage

The allowance of debt-instrument-provided adjustments is severely limited, however. Each of the following items is considered a modification, even if it occurs under the terms of the debt instrument:

• Change that converts the debt to something that is not debt for federal income tax purposes (unless the holder exercises an option to convert the debt to equity of the issuer)
• Change in the debtor, the addition or deletion of a co-obligor on the debt
• Change from recourse to nonrecourse debt, or vice versa
• Change that results from the exercise of certain options.144

(B) Significant Modification

If the modification is “significant,” as defined in the regulations, the modification is a realization event. The significant modification of a debt instrument is treated as an exchange of the old debt instrument for a new debt instrument, so the I.R.C. section 108(e)(10) debt-for-debt rules could apply to trigger DOI income for the debtor.

Under the “general significance rule” in Treas. Reg. section 1.1001-3(e)(1), a modification is significant if, based on all the facts and circumstances, the legal rights or obligations being changed and the degree to which they are being changed are economically significant.

The general significance rule is broad and applies to a modification that is effective upon the occurrence of a substantial contingency. Moreover, the general significance rule applies to modifications that are effective on a substantially deferred basis. When testing a modification under the general significance rule, all modifications made to the instrument (other than those for which specific bright-line rules are provided) are considered collectively. Thus, a series of related modifications, each of which independently is not significant under the general significance rule, may together constitute a significant modification.

The regulations provide a number of bright-line tests to determine significance for these areas: change in yield, change in timing of payments, change in obligor or security, change in the nature of the instrument.

(1) Change in Yield

A change in yield is significant if the modified yield varies from the old debt interest rate by more than the greater of (1) 25 basis points or (2) 5 percent of the annual yield. This rule gives the same weight to changes in the principal amount as to changes in the interest payments.

(2) Change in Timing of Payments

A change in timing is a significant modification if it results in a material deferral in scheduled payments. A deferral could occur through either an extension of the final maturity date or a deferral of payments due prior to maturity. The materiality of the deferral is a facts-and-circumstances test that takes into account the length of deferral, the original terms of the instrument, the amount of payments that are deferred, and other material factors. The regulations provide a safe harbor for a period of time equal to the lesser of five years or 50 percent of the original term of the debt instrument.145 The period begins on the due date of the first scheduled payment (i.e., principal or interest) that is deferred. This period does not take into account an option to extend the original maturity and deferrals of de minimis payments. Because an extension of maturity or reduction of principal may affect yield, the changed instrument must also be tested under the change-in-yield test just described.

(3) Change in Obligor or Security

The consequence of a change in obligor depends on various factors, including whether the obligation is recourse or nonrecourse. The substitution of a new obligor on a recourse debt instrument is a significant modification146 unless (1) the change is a result of an I.R.C. section 381(a) transaction, there is no change in payment expectations, and the transaction (other than an F reorganization) does not result in a significant alteration;147 (2) the new obligor acquires substantially all the assets of the original obligor and there is no change in payment expectations; (3) it is a result of an I.R.C. section 338 election;148 or (4) it is a result of a bankruptcy filing. The regulations also recognize that if a debt is assumed by a purchaser in connection with the sale of property, the debt is not retested to determine whether it has adequate stated interest, and implicitly the transaction does not result in DOI. The substitution of a new obligor on a nonrecourse debt is not a significant modification. The addition or deletion of a co-obligor will only be treated as a significant modification if there is a change in payment expectations.

The recourse or nonrecourse nature of a debt instrument is also important with respect to the significance of a change. The release, substitution, addition, or alteration of collateral, guarantee, or credit enhancement for recourse indebtedness is a significant modification if there has been a change in payment expectations. In the case of a nonrecourse debt, the changes in security, guarantee, or credit enhancement will generally result in a significant modification.

(4) Change in the Nature of the Instrument

A significant modification may also arise as a result of a change in the nature of a debt instrument. For example, a modification of a debt instrument that transforms it into something that is not debt is a significant modification. The determination of whether a modification results in an instrument or property right that is not debt generally takes into account all of the debt equity factors relevant to that determination, with one significant exception.149 A change in the nature of debt from recourse to nonrecourse or vice versa is a significant modification. The regulations specifically provide that a legal defeasance of a debt instrument releasing the debtor from all liability upon the creation of a trust to fund future payments is a significant modification. Exceptions to these rules exist for a change from recourse to nonrecourse if the instrument remains secured by the same collateral (or fungible collateral) and there is no change in payment expectations. Changes to customary accounting or financial covenants are not significant modifications.

(C) Multiple Modifications

Generally, multiple modifications of a debt instrument over a period of time, such as several changes to the yield, are analyzed on a cumulative basis (unless the changes are more than five years apart). However, modifications that fall under the bright-line tests (change in yield, payment expectation, nature, or accounting/financial covenants) are not tested on a cumulative basis. Thus, a change in yield and a change in collateral that are not significant separately could not be added together to result in a significant modification. Changes that are not covered under the bright-line tests are, however, tested on a cumulative basis.

To recap, if a significant modification occurs, gain or loss may be realized. The debtor’s recognition of DOI income under I.R.C. section 108(e)(10) depends on whether the adjusted issue price of the old debt, determined under I.R.C. section 1273 or 1274, is less than or greater than the issue price of the new debt. The creditor’s realization of gain or loss generally depends on a comparison of the issue price of the new debt with the creditor’s basis in the old debt.

(D) Disregarded Entities

The treatment of entities that are disregarded for federal income tax purposes sometimes further complicates determining whether there is a significant modification of a debt held by a corporation that elects to be a disregarded entity.150 Assume that a parent corporation owns a subsidiary corporation with debt outstanding to an unrelated creditor. The subsidiary makes a check-the-box election to become a disregarded entity. The tax fiction disregards the subsidiary, but it exists for state law purposes. Has there been a change in the identity of the debtor that is a significant modification under the I.R.C. section 1001 regulations? One private letter ruling151 looks to state law to determine legal entitlements, finding that the subsidiary would remain the debtor because the debtor is the legal entity for legal purposes of the debt. In that ruling, there was no modification of the debt, and thus no deemed satisfaction of the debt.

Other private letter rulings appear to rely on the fact that the section 381(a) exception to the significant modification rules would apply.152 The most recent in the series of rulings seems to comingle both, in that it discusses in detail that the check-the-box election does not result in a change in legal obligor, but seems to rely on the section 381(a) exception.153

If the check-the-box fiction resulted in a deemed change in obligor and thus a modification, the next question is whether such a modification is significant. That question raises issues beyond the section 381(a) exception, such as whether the debt is viewed as changing from recourse to nonrecourse for tax purposes.

§ 2.5 SECTION 108(e) SUBTRACTIONS FROM DISCHARGE OF INDEBTEDNESS INCOME

To this point, the discussion in this chapter has focused on what is included in DOI income. This section focuses on what is excluded from DOI income.

(a) Otherwise Deductible Debts: Section 108(e)(2)

I.R.C. section 108(e)(2) provides that no income will be realized from the discharge of indebtedness to the extent that payment of the indebtedness would have given rise to a deduction.154 This means that no income will be realized if creditors forgive the expenses of a cash-basis taxpayer that were not actually paid.

The purpose of this provision is to place cash-method taxpayers on an equal footing with accrual-method taxpayers. To illustrate, assume that an accrual-method taxpayer has a $100 debt outstanding. In Year 1, $10 of interest accrues and is deducted by the debtor. On January 1, Year 2, the creditor cancels the debt. The debtor would have DOI income of $110 ($100 as a result of principal and $10 as a result of accrued but unpaid interest). I.R.C. section 108(e)(2) would not provide relief for the debtor because the payment of the interest would not result in a deduction. The interest was already deducted by the accrual-method debtor. Over the course of the obligation, the debtor deducted $10 of interest in Year 1 and included $110 of DOI income in Year 2 for a net (multiyear) income inclusion of $100.

If, however, the debtor were a cash method taxpayer, there would be no deduction in Year 1 because the interest was not paid. (This assumes that the interest obligation would not be deductible under the original issue discount rules.) If I.R.C. section 108(e)(2) did not exist, the cash-method debtor would include DOI income in the amount of $110 in Year 2 with no offsetting interest deduction in the Year 1. This would penalize the debtor for using the cash method. I.R.C. section 108(e)(2) comes to the rescue, permitting the cash-method debtor to exclude $10 of accrued and unpaid interest because the payment of the interest would result in a deduction. The cash-method debtor would include $100 of DOI income in Year 2 for a total of $100 of net income over the course of the loan, thus placing the accrual-method and cash-method debtors in general parity.

Anomalies may result if a debt is partially satisfied. Reconsider the basic facts in the previous paragraph. A debtor has $110 of debt outstanding ($100 of principal and $10 due to interest that accrued in Year 1, but remains unpaid). This time, on January 1 of Year 2 the debtor reaches an agreement with the debtor to retire the $110 of debt for a payment of $80. Under current law, the payment generally would be first allocated to interest and then to principal.155 Thus, $10 would be allocated to the interest component, resulting in a $10 deduction. The remaining $70 of consideration would be allocated to the outstanding principal, resulting in DOI income of $30 ($100 principal less $70 remaining consideration). Although this appears to wash (DOI income of $20 versus DOI income of $30 with an offsetting interest deduction of $10), subtle, yet important differences may exist. For instance, if the debtor were bankrupt or insolvent and able to exclude the DOI income, as discussed in §§ 2.6(a)–(b), it may be more advantageous to generate a deduction in the year of discharge to offset other income.156

(b) Purchase Price Reduction: Section 108(e)(5)

When a debt arises out of the purchase of property, the cancellation or reduction of the amount due may be treated as a reduction of the purchase price rather than as income. If the discharge is treated as a purchase price reduction, the debtor generally reduces basis in the purchased property and does not recognize DOI income. This rule of law was initially developed by the courts and later codified in I.R.C. section 108(e)(5).157 That section provides seven basic factors that must be satisfied:

Although this statutory exception appears to codify the principles of case law, it is in some ways much broader.158 Unlike the judicial exception, the statutory exception is not limited by property values, and it is not necessary for the parties to have renegotiated the original purchase price.

The provision is mandatory if the debtor is solvent. Thus, a debtor preferring to report the debt discharge as income (e.g., to reduce an expiring net operating loss carryover) will not be able to do so.

The legislative history of I.R.C. section 108(e)(5) describes a number of transactions that are not covered; for example, the section does not apply if the creditor who agreed to the reduction is not the original seller or if the debtor does not own the property at the time of the reduction.159 Moreover, the purchase price reduction rule does not apply if the debt is reduced for reasons not involving direct agreements between the buyer and the seller, such as expiration of the statute of limitations on enforcement of the obligation.160 These exceptions are contained in legislative history and do not have the force of a statute.

Determining whether the factors of I.R.C. section 108(e)(5) are satisfied is difficult.161 The intricacies of many transactions do not make the task any easier. For example, in a technical advice memorandum,162 the steps taken by the parties did not satisfy the I.R.C. section 108(e)(5) factors. However, the IRS recast the form of a transaction by disregarding a transitory entity.163 As recast, the form of the transaction looked like a purchase in exchange for debt, and as such, I.R.C. section 108(e)(5) applied.

(i) Creditor That Is Not Seller

The purchase price reduction treatment of section 108(e)(5) is generally not available if the creditor that discharged a debt that was incurred for the purchase of property was not the seller of the property. There is an “infirmity exception” to this general rule if the reduction is based on an infirmity that clearly relates back to the original sale, such as the seller’s fraud or material misrepresentation.

In Rev. Rul. 92-99,164 the IRS concluded that the cancellation of “non-seller-financed” acquisition debt generally results in DOI income when the principal amount of the debt is reduced to the fair market value of the underlying security. In the ruling, A purchased property from B for $1 million, financed with a $1 million nonrecourse loan from unrelated lender C. Subsequently, when the fair market value of the property was $800,000 and the debt principal was still $1 million, C reduced the amount due to $800,000. (The ruling does not indicate what A’s basis was at the time of the debt reduction.) The IRS ruled that A had DOI income. Because the debt reduction by the unrelated lender C was not based “on an infirmity that clearly relates back to the original sale,” there was no purchase price adjustment. Although the IRS generally will not follow other judicially created exceptions to income recognition for discharge of acquisition debt, the IRS will treat a debt reduction in unrelated lender cases as a purchase price adjustment to the extent allowed by the infirmity exception.

In Preslar v. Commissioner,165 the Tenth Circuit Court of Appeals reached a conclusion similar to Rev. Rul. 92-99—DOI income rather than a purchase price reduction. In Preslar, the taxpayers purchased a ranch from a financially troubled seller. Moncor Bank, one of several banks that held the seller’s mortgage on the ranch, financed the purchase. The taxpayers received title to the ranch free and clear of all prior mortgages. The taxpayers developed the ranch into a sportsman’s resort by subdividing the property into lots for cabins. Moncor Bank permitted the taxpayers to repay the loan by assigning the installment sale contracts from purchasers of the cabin lots to the bank at a 5 percent discount. This repayment arrangement was not memorialized in the loan documents. Moncor Bank was also financially troubled, declared insolvent, and placed in receivership with the FDIC. The FDIC refused to accept further assignments of sale contracts as repayment. The taxpayers sued the FDIC for refusing to accept additional assignments and the FDIC settled the lawsuit by discharging more than 50 percent of the remaining loan balance.

Relying on the I.R.C. section 108(e)(5) purchase price reduction, the taxpayers reduced their basis in the ranch by the amount of debt discharged rather than reporting DOI income. The Tenth Circuit held that the taxpayers realized DOI income because title to the ranch never passed to Moncor Bank; as a result, the purchase-price-reduction rule was not available to the taxpayers. The Tenth Circuit also held that the dispute with the FDIC did not relate back to the original sale; thus, the infirmity exception was inapplicable. Preslar is consistent with Rev. Rul. 92-99, which limits a purchase price adjustment to cases in which the direct seller discharges the debt, unless the infirmity exception applies. As shown in Preslar, sometimes the purchase price reduction rule and the contested liability doctrine are invoked in the same transaction.166

For a discussion of the purchase price reduction in a partnership context, see I.R.C. section 2.9(a)(1)(A) and Sands v. Commissioner,167 in which the Tax Court held that a partnership’s transfer of property in satisfaction of nonrecourse indebtedness did not result in DOI income and, therefore, could not qualify as a purchase price reduction under I.R.C. section 108(e)(5).

(ii) Solvent Debtor

Only a solvent taxpayer can take advantage of the I.R.C. section 108(e)(5) purchase price reduction. But if an insolvent debtor is pushed into solvency by a purchase price reduction, the IRS has taken the position that the transaction should be bifurcated with I.R.C. section 108(e)(5) applying only to the extent the taxpayer is solvent.168

To illustrate this point, assume a corporation has $180 of assets ($100 of cash and a machine with a fair market value of $80) and $200 in liabilities, consisting of a $90 debt to an unrelated creditor and a recourse $110 debt to the seller of the machine. The $110 debt is reduced by $30 to $80. The IRS bifurcates the transaction. To the extent of the taxpayer’s insolvency ($20), the discharge of indebtedness is not covered by I.R.C. section 108(e)(5) and the corporation has $20 in DOI income. (As discussed in §§ 2.6(b), 2.7(d)(i), this amount is excluded from income under the I.R.C. section 108(a)(1)(B) insolvency exception with attendant attribute reduction of $20 pursuant to section 108(b).) The balance of the discharge ($10) is treated as an I.R.C. section 108(b)(5) purchase price adjustment, which reduces the basis in the machine by $10.

(c) Summary

Taxpayers wishing to avail themselves of the I.R.C. section 108(a) exclusions must first determine whether and to what extent their income is DOI income. Such income includes income deemed by rulings and case law to be I.R.C. section 61(a)(12) income, increased by income meeting the requirements of I.R.C. section 108(e)(4), (e)(6), (e)(8), and (e)(10) (and the modification regulations), and decreased by income meeting the requirements of I.R.C. section 108(e)(2) and (e)(5). Once it is determined that a taxpayer’s income is DOI income, that income may be excluded from gross income if the taxpayer demonstrates that the discharge qualifies as a:

• Title 11 case exclusion
• Insolvency exclusion
• Discharge of qualified farm indebtedness exclusion
• Discharge of qualified real property business indebtedness exclusion

Even if a taxpayer excludes DOI income under one of the four exclusions, the taxpayer generally must offset the amount discharged by the reduction of certain tax attributes under I.R.C. section 108(b).

§ 2.6 DISCHARGE OF INDEBTEDNESS INCOME EXCLUSIONS

The financial and legal status of the debtor determines which of the I.R.C. section 108(a) exclusions (if any) applies to DOI income. The tax treatment of the debtor is further affected by whether the debtor is insolvent, solvent, or in a title 11 case. Favorable tax treatment is also allowed for qualified farm debt and qualified real property business indebtedness.

(a) Title 11 Exclusion

The title 11 exclusion of I.R.C. section 108(a)(1)(A) provides that a debtor in a title 11 case excludes DOI income from gross income. Different treatment is provided for a debtor who is insolvent but not under the jurisdiction of the bankruptcy court in a title 11 case.169 The term “title 11 case” means a case under title 11 of the Bankruptcy Code, but only if the taxpayer is under the jurisdiction of the court and the discharge of indebtedness is granted by the court or is pursuant to a court-approved plan.170

If one of the other three exclusions also applies to a discharge, then the title 11 exclusion trumps. The title 11 exclusion may be preferable for some debtors because, unlike the insolvency exclusion, income can be excluded under the title 11 exclusion even if the discharge renders the debtor solvent.

An issue of recent interest is whether an entity that is disregarded for federal income tax purposes171 that is in a title 11 case can apply the bankruptcy exclusion when its owner is not in bankruptcy. One could argue that because the disregarded entity is subject to the jurisdiction of the bankruptcy court, the assets and liabilities of the owners of the disregarded entity (for federal income tax purposes) are subject to the court’s jurisdiction. Thus the owner should be viewed as being subject to the bankruptcy court’s jurisdiction for purposes of the bankruptcy exclusion. Treasury and the IRS recently issued a proposed regulation disagreeing with that analysis. The proposed regulation provides instead that the status of the disregarded entity is irrelevant and that the owner of the disregarded entity must be subject to the bankruptcy court’s jurisdiction.172 Although the regulation is still in proposed form and would not be effective until it is published in final form, the IRS’s view on this subject is already quite clear.

(b) Insolvency Exclusion

The insolvency exclusion of I.R.C. section 108(b)(1)(B) excludes DOI income from gross income if the discharge occurs when the taxpayer is insolvent. The insolvency exclusion is a judicially developed doctrine that was added to the I.R.C. as part of the Bankruptcy Tax Act of 1980.173 For debt discharged outside a title 11 case, the determination of the extent to which the debtor is insolvent is critical because, absent the applicability of another exclusion, the insolvency exclusion is limited to the extent of the debtor’s insolvency.174

I.R.C. section 108(d)(3) defines the term “insolvent” as the amount by which liabilities exceed the fair market value of assets. Thus, in an out-of-court settlement where the debt outstanding is $10 million, the fair market value of the assets is $7 million, and $4 million of debt is canceled, $3 million would fall under the insolvency exclusion and $1 million would be included in income.

Determination of fair market value can be difficult. The courts have used different methodologies to determine value. In cases under the Bankruptcy Act, the courts have used the going-concern concept for valuation of assets and liabilities.175 Applying that concept, goodwill, going-concern value, and any off-balance-sheet intangibles should be included in the value. For many years, the going-concern value for bankruptcy purposes was determined by estimating the earnings and multiplying this value by a capitalization multiple. The Tax Court in Concord Control, Inc. v. Commissioner176 used the capitalization approach to determine how the purchase price was to be allocated between tangible and intangible assets. Concord did not involve the valuation of a company in bankruptcy, but it indicates that the capitalization method may be appropriate for tax purposes.177 Another aspect of calculating insolvency is identifying and valuing both liabilities and assets.

The proposed regulations addressing the DOI exclusions for disregarded entities (discussed in § 2.6(a)) take a similar course with respect to the insolvency exception. The regulations provide that the determination of insolvency is made with respect to the owner of the disregarded entity and not with respect to the assets and liabilities solely at the disregarded entity level.178

(i) Liabilities

Proving insolvency is fundamentally an evidentiary matter.179 The valuation of the debtor’s liabilities can be difficult, especially if the debt is contingent or nonrecourse. If a debt is nonrecourse (i.e., secured by a piece of property and no personal liability), and the amount of debt exceeds the value of the property, one must determine how much of the nonrecourse debt should be included in determining solvency or insolvency. Counting the nonrecourse liability in excess of the fair market value of the property securing the debt in the insolvency calculation would increase the amount of the debtor’s insolvency and consequent ability to exclude DOI income. This may not reflect economic reality because the debtor is not liable for the excess. Recognizing this, the IRS allows a taxpayer to include nonrecourse debt up to the value of the property securing the debt plus the excess nonrecourse debt (nonrecourse debt in excess of the fair market value of the security) as a liability when calculating insolvency, but limited to the amount of the excess debt actually discharged.

The IRS took this position in Rev. Rul. 92-53,180 determining that the amount by which nonrecourse debt exceeds the fair market value of property securing the debt (excess nonrecourse debt) should be treated as a liability in determining insolvency under I.R.C. section 108(a)(1)(B), but only to the extent that the excess nonrecourse debt is discharged in the same transaction. The revenue ruling included the following example. M owns property 1 (fair market value of $800,000 subject to nonrecourse debt of $1,000,000) and property 2 (fair market value of $100,000). M is also personally liable for debts of $50,000. If M’s creditor reduces the $1,000,000 nonrecourse debt to $825,000, M has excess nonrecourse debt discharged of $175,000. As a result, M will have total liabilities of $1,025,000 ($50,000 personal liability + $800,000 fair market value of property secured by nonrecourse debt + $175,000 excess nonrecourse debt discharged). The excess of these total liabilities ($1,025,000) over the fair market value of total assets ($900,000) is M’s insolvency ($125,000). The insolvency exclusion applies to the extent of M’s insolvency, $125,000. Only the excess of the DOI income ($175,000) over the extent of insolvency ($125,000), or $50,000, will be included in income. Similarly, if M’s $50,000 debt is satisfied for property worth $40,000 (basis is also $40,000), there is $10,000 of DOI income. M is solvent because the excess nonrecourse debt is not counted; it is not discharged.

Contingent liabilities may be disregarded when determining whether the debtor is insolvent pursuant to I.R.C. section 108(d)(3). To prove insolvency, the debtor may count only the liabilities the debtor will likely be called upon to pay. This issue was addressed in Merkel v. Commissioner.181 The taxpayers in Merkel owned a corporation that borrowed more than $3 million from a bank. The shareholders were required to guarantee the debt. When the corporation defaulted on the debt, the shareholders’ guarantee became a fixed and unconditional obligation. After the default, the corporation and the shareholders entered into an agreement with the bank. The bank agreed to cancel the remaining balance for $1.1 million and to release the shareholders’ liability if the corporation and the shareholders did not file for bankruptcy within 400 days from the date on which the corporation would make the reduced payment (settlement date). Thus, as a result of the agreement, the shareholders’ fixed obligation was replaced with a contingent obligation.

The shareholders realized DOI income from another source that was realized at a time when the shareholders’ obligation to the bank was contingent (i.e., after the settlement date but before the completion of the 400-day period). The shareholders excluded DOI income under the insolvency exclusion. To calculate insolvency, the shareholders included their contingent obligations due to the bank debt. The Tax Court and the Ninth Circuit disagreed with this treatment.

In concluding that contingent obligations should not be counted for purposes of determining insolvency, both the Tax Court and the Ninth Circuit examined the freeing-of-assets theory, which underlies the insolvency exclusion.182 Under this theory, a debtor should realize DOI income due to the cancellation of a debt only if the debtor’s postdischarge liabilities do not exceed the value of the debtor’s postdischarge assets. Fundamental to the freeing-of-the-assets theory is a level of certainty that the debtor’s obligations truly offset its assets, because the obligations are ones that the taxpayer will be called on to pay. The courts found that, because Congress indicated that the purpose of the insolvency exclusion was to avoid burdening insolvent taxpayers with an immediate tax liability, the ability to pay an immediate tax was a controlling factor with respect to whether a tax should be imposed. In general, to convince the courts that a taxpayer will be called on to pay an obligation, the proponent must satisfy a “preponderance of the evidence” standard. This requires the proponent to prove a fact to be more likely than not. To claim the benefits of the insolvency exclusion, the debtor must prove that it is more probable than not that the debtor will be called upon to pay each obligation in the amount claimed and that the total liabilities so proved exceed the fair market value of debtor’s assets. Applying this approach, the courts did not allow contingent liabilities arising from taxpayers’ guarantees to be included for purposes of determining whether the taxpayers were insolvent.

(ii) Assets

Determining which assets of a debtor are included for purposes of the insolvency exclusion has also raised issues. For example, to determine whether the debtor is solvent or insolvent, should assets that are exempt from creditor’s claims under state law be considered? Under current law, exempt assets are considered when determining whether a debtor is insolvent under I.R.C. section 108(d)(3), but this was not always the case.

Under the judicially created insolvency exclusion for DOI income, exempt assets were not considered in determining the solvency or insolvency of the debtor for out-of-court workouts.183 The IRS traditionally followed this rule, but in recent years, the IRS had reversed its position, setting the stage for resolution by the Tax Court in Carlson v. Commissioner.184 In Carlson, the Tax Court held that assets that are exempt from the claims of creditors under state law are counted when measuring insolvency. The Tax Court rejected any interpretation of the court-created insolvency exclusion that had not been codified. I.R.C. section 108(e)(1) specifically states that, except as provided in I.R.C. section 108, “there shall be no insolvency exception from the general rule that gross income includes income from discharge of indebtedness.” The Tax Court in Carlson concluded that this directive precludes the courts from relying on any judicial understanding of the insolvency exclusion that was not later codified.185

As in Merkel, the Tax Court distinguished between the definition of “insolvent” in the Bankruptcy Act and in I.R.C. section 108(d)(3). The Tax Court found that Congress intended to exclude exempt assets for purposes of determining solvency in bankruptcy proceedings and intended to include exempt assets for purposes of determining entitlement to the insolvency exclusion. The Tax Court focused the inquiry on the ability of the debtor to pay an immediate tax on income from the discharge of indebtedness. In Carlson, the taxpayer’s assets (including exempt assets) exceeded the taxpayer’s liabilities; thus, the taxpayer had the ability to pay the tax.186

(iii) Timing

Notice that insolvency is determined when DOI income occurs, so any increase in the taxpayer’s solvency due to the discharge is not considered when determining what is excludable. I.R.C. section 108(d)(3) states “whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.” The term “immediately before the discharge” is not defined in the I.R.C. or in legislative history. For simple cases involving only debt forgiveness, the application of this provision is clear. But consider a situation where debt discharge is included in a settlement that involves issuance of stock for debt, contribution of new capital, and other reorganization techniques. The taxpayer may be able to plan to be solvent or insolvent based on the ordering of each of the transactions.187 In most situations, it would be best to have the debt discharged first and to have the taxpayer insolvent by the largest possible amount just before the discharge. There might, however, be situations where the taxpayer would like to have income realized from debt discharge. Thus, until the meaning of this provision is clarified through either technical amendments or case law, the timing of the reorganization transaction should be carefully considered to obtain the maximum tax benefit.188

(c) Qualified Farm Indebtedness Exclusion

The Tax Reform Act of 1986 contained a special provision for handling debt discharge by farmers. I.R.C. section 108(g) initially had provided that income from debt discharge by solvent farmers was handled as if the farmers were insolvent. Thus, tax attributes, including the basis of property, were reduced. Special rules applied for basis reduction. The Technical and Miscellaneous Revenue Act (TAMRA) of 1988 significantly changed the debt discharge rules for farm debt.

I.R.C. section 108(a)(1)(C) provides that income from debt discharge will not be included in gross income if the debt discharged is qualified farm indebtedness.189 “Qualified farm indebtedness” is indebtedness incurred directly in connection with the operation by the taxpayer of the trade or business of farming, where 50 percent or more of the aggregate gross receipts of the taxpayer for the three tax years immediately prior to the year the discharge occurred is attributable to the trade or business of farming.190 For determining the 50-percent-or-greater threshold, the proceeds from the sale of farm machinery are considered gross receipts, but income from the rental of farmland is not.191

To take advantage of the qualified farm indebtedness exclusion, the debt discharge must be by a “qualified person.” Federal, state, and local governments and agencies are automatically considered qualified persons.192 For all other creditors, a qualified person is defined in I.R.C. section 108(g)(1) by cross-reference to I.R.C. section 49(a)(1)(D)(iv) as a person who is “actively and regularly engaged in the business of lending money,” but not any of the following: (1) related to the taxpayer,193 (2) a person from whom the taxpayer acquired the property, or (3) a person who receives a fee with respect to the taxpayer’s investment in the property.

The qualified farm indebtedness exclusion will apply only if the exclusions for title 11 cases and insolvency cases do not apply. In other words, the qualified farm indebtedness exclusion applies only to out-of-court settlements where the farmer is solvent at the time debt is discharged or to the extent the farmer becomes solvent as a result of debt being discharged.

The amount of income excluded as qualified farm indebtedness cannot exceed the sum of adjusted tax attributes plus the aggregate adjusted basis of qualified property held by the taxpayer as of the beginning of the tax year following the year in which the discharge occurred.194 “Qualified property” is defined as any property used or held for use in a trade or business or for the production of income.195 Thus, to determine how much income the farmer could exclude, the basis of personal use property would not count, including the basis of the farmer’s home.

The amount of DOI income from qualified farm indebtedness that can be excluded from gross income may result in a reduction of tax attributes, including basis. Special rules for basis reduction for income excluded as qualified farm indebtedness are set forth in I.R.C. section 1017(b)(4).

Different rules apply to farmers that receive generic commodity certificates (often called PIK or payment-in-kind certificates) under a government deficiency and diversion program; they must include the face amount of the certificate in income in the year they are received. If a farmer pledges a commodity to the Commodity Credit Corporation (CCC) as security for a loan, the farmer may, under I.R.C. section 77(a), elect to include the face amount of the loan in income. If such an election is made, there is no gain or loss when the loan is repaid. I.R.C. section 1016(a)(8) provides that the basis of property will be adjusted to the extent of income reported. Treas. Reg. section 1.1016-5(e) states that, in a case where property is pledged to the CCC and the face amount of the loan is reported in income, the basis of the property shall be increased by the amount received as a loan and reduced by the amount of any deficiency on such loan to the extent that the taxpayer has been relieved from any liability. To explain these transactions, the IRS issued Rev. Rul. 87-103.196

(d) Qualified Real Property Business Indebtedness Exclusion

The Revenue Reconciliation Act of 1993 added new I.R.C. sections 108(a)(1)(D) and 108(c), the qualified real property business indebtedness exclusion. These provisions permit taxpayers other than corporations that own business real estate to defer the tax that would otherwise be payable upon discharge of their indebtedness until they dispose of the related property. More precisely, for a discharge of indebtedness occurring after December 31, 1992, taxpayers (other than C corporations) can elect to exclude from gross income the income from a discharge of qualified real property business indebtedness. Debt is “qualified real property indebtedness” if (1) it was incurred or assumed by the taxpayer in connection with real property used in a trade or business and it is secured by that real property; (2) it was either incurred or assumed before January 1, 1993, or was qualified acquisition indebtedness (generally indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business and secured by that property); and (3) the taxpayer makes the appropriate election to invoke the provision.

The qualified real property business indebtedness exclusion does not apply to the extent the taxpayer is insolvent.197 Nor is it available for discharge of indebtedness that arises from a title 11 case or a discharge that qualifies for the qualified farm indebtedness exclusion.198

The amount excluded as qualified real property business indebtedness under I.R.C. section 108(a)(1)(D) is limited in two ways. First, the exclusion is limited to the amount by which the principal exceeds the fair market value of the property that secures the debt, less the outstanding principal of any other qualified real property business indebtedness secured by the same collateral (a sort of mini-insolvency test).199 Second, the exclusion may not exceed the aggregate adjusted basis of depreciable real property held by the taxpayer immediately before the discharge.200

The amount excluded reduces the basis of the taxpayer’s depreciable real property pursuant to I.R.C. section 1017 and thus may affect the basis of both the property securing the debt and other depreciable real property.201

The qualified real property business indebtedness exclusion is the only exclusion that is elective. An election to reduce basis of qualified real property must be made on Form 982 (see Exhibit 2.1) with a timely filed (including extensions) federal income tax return for the tax year in which a taxpayer has discharge of indebtedness that is excludible from gross income under section 108(a).202 This election is revocable with the consent of the Commissioner.203

(e) Tax Benefit Rule

The tax benefit rule may interact with the I.R.C. section 108(a) exclusions. The annual accounting period principle requires a determination of income at the close of each tax year without regard to subsequent events. That is, each tax year is a separate unit for tax accounting purposes. The tax benefit rule is designed to deal with certain subsequent events. Generally, gross income includes the recovery or refund of amounts deducted in an earlier year, unless the taxpayer can demonstrate that there was no tax benefit.204 The tax benefit rule allows for an exclusion from gross income. Stated another way, the taxpayer excludes from gross income any recovery or refund of an amount that the taxpayer deducted in an earlier year, to the extent the previous deduction did not produce a tax benefit.205 Due to recent IRS advice, it is unclear whether taxpayers may continue to exclude DOI income by application of the tax benefit rule before applying exclusions from gross income that are provided for under I.R.C. section 108.206

The interaction of the I.R.C. section 108 exclusions and the tax benefit rule exclusion may be illustrated by example. An accrual-method taxpayer borrows $100 from an unrelated creditor, deducts $10 in interest expense, but never pays interest or principal on the debt. The $10 interest expense deduction generates a net operating loss (NOL) for the taxpayer, but the NOL expires before the taxpayer can use it to offset other taxable income. That is, the deduction of the interest did not create a tax benefit for the taxpayer. Later, the creditor forgives the debt. The tax benefit rule applies first, and the taxpayer can exclude from gross income the recovery of the interest, equal to the amount that the taxpayer deducted in an earlier year ($10) because it did not produce a tax benefit. The tax benefit rule does not apply to the $100 of principal forgiven because it was not deducted in an earlier year. The discharge of indebtedness rules apply to the $100, and it may be excluded to the extent permitted under I.R.C. section 108, subject to attribute reduction as discussed in § 2.7(a).

The IRS recently determined that the tax benefit rule required an income inclusion and thus implicitly trumped the I.R.C. section 108 bankruptcy exclusion for DOI.207 Some background information is necessary to set the stage for the issue.

In a chief counsel advice,208 the IRS concluded that a corporation may treat a contractual liability for interest expense that arises after the filing of a bankruptcy petition as incurred and deductible until the resolution of the bankruptcy. The deductibility of postpetition interest has been a hotly debated issue. Much of this issue stems from Bankruptcy Code section 502(b)(2) that subjects a claim for “unmatured interest” in bankruptcy to disallowance (subject to some exceptions that are not relevant here). The IRS’s conclusion that the postpetition interest remains deductible despite this statutory provision is consistent with the bankruptcy court’s In re Dow Corning Corp. decision.209 However, as pointed out in Dow Corning, there are other authorities that one could cite for the opposite conclusion. Thus, the deductibility point is not without arguments on both sides of the fence.

Having set the stage, proceed with the assumption that postpetition interest is deductible and is deducted by the bankrupt taxpayer during the postpetition period in tax years prior to confirmation. The bankruptcy plan or reorganization is finalized. As expected, there will be no actual payments for interest that accrues in the postpetition period and that liability is discharged. In the chief counsel advisory, the IRS stated its view that the nonpayment of the interest resulted in an income inclusion:

Under the tax benefit rule, a taxpayer using an accrual method of accounting must recognize income if the taxpayer accrues and deducts an expense in a taxable year before it becomes payable and eventually does not have to pay the liability. Hillsborough National Bank v. Commissioner, 460 U.S. 370, 381-2 (1983). To the extent Taxpayer . . . received the benefit of a deduction for interest expense for the [prior] taxable year . . . and because that tax benefit is fundamentally inconsistent with a later event (the confirmation and acceptance of the plan of reorganization that does not provide for the payment of interest on . . . contractual borrowings), Taxpayer must include an offsetting amount in income for the taxable year [of the confirmation].

Although the IRS’s description of the tax benefit rule is succinct and accurate, its application seems to miss one key point: The event that gave rise to the purported application was the discharge of a debt, and DOI is subject to the rules and exclusions of I.R.C. section 108. Furthermore, the application of the tax benefit rule without regard to the I.R.C. section 108 exclusions appears contrary to the IRS’s own published positions, which provide that income may be excluded first under I.R.C. section 111 (Recovery of Tax Benefit Items) and then under I.R.C. section 108.210 The better view is that the tax benefit rule should not be applied to trump the I.R.C. section 108 exclusions and force DOI that is excluded from gross income under I.R.C. section 108 into taxable income under another theory.

§ 2.7 CONSEQUENCES OF QUALIFYING FOR SECTION 108(a) EXCLUSIONS

(a) Attribute Reduction

Although certain DOI income may be excluded from income, I.R.C. section 108(b)(2) provides that the price for such exclusion is tax attribute reduction. For DOI income excluded under the title 11 exclusion, the insolvency exclusion, or the qualified farm indebtedness exclusion (but not the qualified real property business exclusion), these tax attributes of the taxpayer211 must be reduced, in the order listed:

• NOLs. Any NOL for the tax year of discharge and any NOL carryover to the tax year of discharge.
• General business credit. Any carryover to or from the tax year of discharge of a credit under I.R.C. section 38.
• Minimum tax credit. Any minimum tax credit available under I.R.C. section 53(b) at the beginning of the tax year immediately after discharge.
• Capital loss carryovers. Any capital loss for the tax year of the discharge and any capital loss carryover to the tax year of discharge under I.R.C. section 1212.
• Basis reduction. The basis of the debtor’s property reduced according to the provisions of I.R.C. section 1017.
• Passive activity loss and credit carryovers. Any passive activity loss or credit carryover of the taxpayer under I.R.C. section 469(b) from the tax year of the discharge.
• Foreign tax credit carryovers. Any carryover to or from the tax year of discharge of the credit allowed under I.R.C. section 33.212

Each tax attribute category, except for basis reduction, must be reduced to zero before any reductions in the next category are made. For insolvency or title 11 situations, the reduction to basis is required only to the extent that the basis of the taxpayer’s assets exceeds the amount of liabilities immediately after discharge.213 After the NOL has been reduced to zero, any balance remaining is first applied against the business credit carryover, and so forth. If all attributes are reduced to zero (and basis is reduced to an amount equal to postdischarge liabilities), any amount of DOI income that remains is completely discharged. It is not included in income, and future tax attributes are not reduced. In most cases, however, the reduction of tax attributes defers rather than eliminates the tax on income from debt discharge.

As an alternative to this order for attribute reduction, the debtor can elect to reduce the basis of depreciable property before the other tax attributes. The basis reduction election is discussed in detail in § 2.7(d)(i).

I.R.C. section 108(b)(4)(A) provides that the reduction in attributes is made after income is computed for the year in which the discharge occurs. Recall that in an out-of-court case, the gain from debt discharge where the debtor is solvent, or to the extent that the debtor becomes solvent, is DOI income. Thus, the income from debt discharge (which is not excluded from income under section 108(a)) as well as other income arising from other activities that occur in the year a debt is discharged are offset by the debtor’s NOL carryovers and other attributes prior to reducing those attributes due to excluded DOI income under I.R.C. section 108(b). In addition, any remaining income can be reduced by an NOL carryover to that year. I.R.C. section 108(b)(4)(B) also provides that reductions to NOLs or capital losses are first made to losses arising in the tax year of the discharge and then to carryovers to such year in the order of the tax years from which each carryover arose.

Next, consider an example that shows how attribute reduction is computed. X Corporation has assets with a value of $1,000 and liabilities of $1,200. The only tax attributes of X are an NOL carryover of $400 and an asset basis of $100. In a workout outside of bankruptcy, all the creditors receive long-term debt with a face amount and issue price of $700. The reduction of debt ($500) is excluded to the extent of the prior insolvency ($200), and the balance ($300) is DOI income includable in gross income. That income (along with any operating income for the year) can be offset by the NOL carryover (reducing the carryover to $100). The debt reduction that was excluded from income due to the insolvency exclusion ($200) is then applied against the tax attributes, thereby eliminating the $100 loss carryover. The basis of assets is then reduced by $100. If the discharge occurred pursuant to bankruptcy proceedings, then the exclusion of DOI income would not be limited to the extent of X’s insolvency. Nevertheless, tax attributes, including the loss carryover and basis, would be reduced to the extent of the $500 excluded DOI income.

In a workout outside of bankruptcy, the timing of the debt discharge is important. In the next example, the debt is reduced in the same amount as the previous example, but in different tax years and with different tax consequences. Assume the same facts as in the last example, except that $400 of debt was canceled in Year 1 and the balance of $100 was canceled in Year 2. Under these conditions, in Year 1, X Corporation would have DOI income excluded to the extent of prior insolvency of $200. The balance of $200 of DOI income can be offset by the $400 NOL carryover. X Corporation will reduce tax attributes by the $200 of excluded DOI income, using up all the NOL carryover. In Year 2, the $100 of income from the discharge of indebtedness will be taxed because there is no NOL left to reduce. X Corporation could have elected to reduce the basis of depreciable property first and left the NOL for use in Year 2. If X Corporation was in bankruptcy, this problem would not exist.

(b) Net Operating Loss Reduction

Before an NOL or NOL carryover can be reduced under I.R.C. section 108(b), a debtor must consider the impact, if any, of other I.R.C. provisions on the amount or availability of that NOL.

(i) Net Operating Loss Reduction and Carrybacks

Ordering and timing issues abound when tax attributes are reduced as the price for excluding DOI income from gross income. One ordering conflict is between I.R.C. section 108(b) reduction of tax attributes and the carryback of those tax attributes to prior tax years. NOLs may be carried back, that is, applied to previous tax years. The use of an NOL for any tax year (the loss year) to offset taxable income of other tax years is limited to a period of tax years before the loss year (the carryback period) and a period of tax years after the loss year (the carryover period). The carryback and carryover periods determine the maximum number of tax years in which a taxpayer may offset taxable income with any particular NOL. The current general rule for corporations provides a two-year carryback period and a 20-year carryover period; provided, however, that a five-year carryback period applies for NOLs for tax years ending during 2001 or 2002.214

The ordering rule of I.R.C. section 108(b)(4)(A) states that tax attribute reduction is made after tax liability is determined for the year in which the DOI income occurred. The I.R.C. does not address how the carryback of tax attributes fits into this sequence. One question is ordering, whether an NOL (or other tax attribute subject to carryback) that occurs in the same tax year as the discharge is first reduced under I.R.C. section 108(b) or is first carried back to another tax year. Regulations issued in 2003 resolved this question for discharges of indebtedness occurring after July 17, 2003; the uncertainty remains, however, for prior discharges. For post-July 17, 2003 discharges, tax attributes that are carryovers to the discharge year or that may be carried back to the predischarge years are taken into account by the taxpayer before attributes are reduced under I.R.C. section 108(b).215 Another open issue is the timing of attribute reductions, that is, whether the reductions are made in the tax year of the discharge or in the next tax year.

With regard to the timing issue, the I.R.C. does not specifically address when tax attributes are reduced (with the exception of basis reduction). Does the reduction occur as the last event in the year of the discharge or as the first event in the year following the discharge? Unlike the other tax attributes subject to reduction, the timing of basis reduction at first blush appears clear. I.R.C. section 1017(a) provides that basis reduction occurs at the beginning of the year following the year of the discharge.216 There is no companion rule provided for other tax attributes, including NOL. If the NOL reduction occurred at the same time as basis reduction, then the NOL would be available in the year of discharge to be carried back to another year.

Prior to the issuance of the treasury regulations, the Supreme Court considered the order of tax attribute reduction under section 108 and the taxation of shareholders in an S corporation in Gitlitz v. Commissioner.217 The case supports ordering tax attribute reduction after the carryback of attributes in line with the regulations but may not shed much light on the timing issue. As discussed in greater detail in § 3.3(e), the Supreme Court held that although DOI income of an insolvent taxpayer is not included in gross income, it is nevertheless an item of income that passes through to the S corporation shareholders. Having determined that the DOI income passes through to the shareholders, the Supreme Court held that the pass-through occurs before the tax attribute reduction. The Supreme Court found that the “[t]he sequencing question is expressly addressed in the statute. Section 108(b)(4)(A) directs that the attribute reductions ‘shall be made after the determination of tax imposed by this chapter for the tax year of the discharge.’ (Emphases added.) See also Section 1017(a) (applying the same sequencing rules when Section 108 attribute reduction affects basis of corporate property).”218 Broadly read, this language could equate the general attribute reduction with the next-year basis reduction rule. However, the Supreme Court seems to address the ordering of attribute reduction as opposed to the timing of attribute reduction. That is, it does not appear that the Supreme Court’s ultimate decision was based on whether a suspended loss is reduced as the last event in the tax year of the discharge or as the first event in the following tax year.

Cases that preceded the Supreme Court’s decision in Gitlitz did address the timing issue, but those cases reached conflicting results. The Third Circuit held that all tax attributes were reduced on the first day of the year following the year of discharge.219 Conversely, the Tenth Circuit, the Sixth Circuit, and the Tax Court held that tax attributes (except basis) were reduced at the end of the year of discharge.220 Although the Supreme Court’s decision in Gitlitz could be read to support this position, the Tenth and Sixth Circuit cases were overruled by Gitlitz on other issues. The differing views of the circuit courts on the timing issue, coupled with the lack of clear guidance by the Supreme Court, have left this issue in flux.

It is implicit in a consolidated return regulation example of discharge of indebtedness that the reduction in NOL occurs in the year of discharge, rather than on the first day of the following tax year.221 Caution should be used in relying on this regulation outside the consolidated return context to argue that the attribute reduction occurs on the last day of the discharge year, especially in light of the contradictory judicial authority. The case law, statutes, and administrative guidance on the timing issue are far from examples of judicial, legislative, or administrative clarity.

Regulations clarify the ordering issue for discharges occurring after July 17, 2003, that the carrybacks to predischarge years occur before I.R.C. section 108(b) attribute reduction.222 For discharges that occurred before the effective date of the temporary regulations, it is also arguable that the carrybacks occur before the attribute reduction (other than basis) on the premise that carrybacks may affect tax liability for the year. That is, attribute reduction occurs after the determination of tax for the tax year of the discharge and there are circumstances in which the carryback could affect the computation of tax liability for the year of discharge. For instance, note the items of ordinary income, ordinary loss, capital gain, and capital loss for corporation X in years 1 through 5.

Assume that in Year 3 there is also $100 of excluded discharge of indebtedness income that may reduce the $100 capital loss. Further assume that the $100 ordinary loss generated in Year 1 has been carried over to offset the capital gain in Year 2.

The $100 capital loss generated in Year 3 cannot be used to offset the Year 3 $100 of ordinary income. If the Year 3 $100 capital loss is carried back to offset the $100 of capital gain in Year 2, the Year 1 $100 ordinary loss would be freed up and carried over to offset $100 ordinary income in Year 3. Therefore, the carryback of the capital loss impacts the computation of tax imposed in the year of the discharge and should be permitted prior to attribute reduction. This begs the question: Does a taxpayer need to be in a situation in which the carryback actually impacts the computation of tax in the year of discharge? Given this example and no indication in the legislative history to the Bankruptcy Tax Act of 1980 to the contrary, it is reasonable to conclude that a carryback of an NOL or other enumerated item should be permitted prior to attribute reduction regardless of whether the carryback actually impacts that year’s tax liability.

Even this argument is not conclusive, however. Returning to the example, the Year 5 $100 ordinary loss may be carried back to offset the Year 4 $100 capital gain. If the Year 3 $100 capital loss is carried forward to offset the Year 4 $100 capital gain, then the Year 5 $100 ordinary loss may be carried back to offset the Year 3 $100 of ordinary income. Therefore, the carryover of the Year 3 capital loss affects the computation of tax liability for Year 3. It would be difficult to argue that a loss may be carried over prior to being reduced, even if it impacts current year tax liability.

As shown by this exercise, the absence of clear guidance renders this issue susceptible to varying interpretations for time periods not covered by the temporary regulations.

(ii) Net Operating Loss Carryover Calculation

How NOL carryover is calculated is beyond the scope of this section. It is interesting to note, however, that a taxpayer may correct its earlier mistakes to recalculate net operating carryover to a current year. This is an option, even if the mistake occurred in a closed tax year (i.e., a year for which the statute of limitations has expired). Once the statute of limitations has run for a year, the taxpayer cannot redetermine its NOL for that year. Nevertheless, the IRS has taken the position that a taxpayer may correct a mistake in a closed tax year to recalculate the NOL carryover to an open tax year.

That position was taken in a private letter ruling.223 In that ruling, the debtor’s plan of reorganization in a title 11 case was confirmed in Year 1. The debtor’s income tax return for that year showed DOI income that was completely offset by the debtor’s NOLs under I.R.C. section 108(b). After the statute of limitations for filing an amended return for Year 1 expired, the debtor claimed that it had made a mistake in Year 1 that affected its net operating loss carryover for a later (open) tax year. The debtor claimed that it did not have a cancellation of debt in Year 1, hence no DOI income, and that it should not have reduced its net operating losses in Year 1. The IRS allowed the debtor to recalculate the net operating loss carryover to correct the mistake in the closed year because the tax year that was affected by the net operating loss carryover was still open.

(iii) Interaction with Section 382(l)(5)

I.R.C. section 382, which is discussed in detail in Chapter 6, limits the usefulness of a corporation’s NOLs following certain ownership changes. In general, that section determines how certain tax attributes, including NOL carryovers, are used following an ownership change of a loss corporation. An ownership change occurs when the percentage of stock held by one or more 5 percent shareholders of a loss corporation on a testing date has increased by more than 50 percentage points over the lowest stock ownership held by such shareholders during a testing period (usually a three-year period).224 The terminology of I.R.C. section 382, such as “ownership change,” “5 percent shareholder,” and “loss corporation” are discussed in Chapter 6.

Generally, when an ownership change occurs, I.R.C. section 382(a) limits the amount of post–ownership-change taxable income that can be offset by pre– ownership-change losses. I.R.C. section 382(a) limits the usefulness of NOLs and NOL carryovers, but does not reduce the dollar amount of those items. NOLs and NOL carryovers may be reduced under I.R.C. section 108(b), even if their use is limited by I.R.C. section 382(a).

Under I.R.C. section 382(l)(5)(B), prechange losses and credits that may be carried to a postchange year are computed as if no deduction was allowable for amounts paid or accrued for interest that was converted into stock pursuant to Title 11 or a similar case during the three-year period prior to the year in which the ownership change occurs and the prechange portion of the year in which the ownership change occurs. To prevent a double detriment, DOI determined under I.R.C. section 108(e)(8) (stock for debt exchange) is not taken into account for any interest indebtedness satisfied with stock, as described.

(c) Credit Carryover Issues

When tax attributes are reduced, the amount of the reduction varies according to which attribute is affected. The general business credit, the minimum tax credit, the passive activity credit, and the foreign tax credit carryovers are reduced by 33 cents for each dollar of DOI income excluded.225 All other reductions are dollar for dollar.226 This makes sense because a tax credit differs from a deduction. The deduction lowers the amount of income subject to taxation; the credit lowers the amount of tax due. Thus, the overall economic effect of lowering a deduction by $100 may be the same as a $33 reduction in a tax credit.

As discussed, the reductions are made after the determination of tax for the year of discharge. Thus, the debtor is given one more opportunity to absorb any NOL, capital loss, or credit carryovers, if income was earned in the year the debt is discharged. For net operating and capital losses, the reductions must be made first from the losses for the tax year and then from the loss carryovers in the order of the tax years for which the losses arose. The reduction of tax credits is to be made in the order the carryovers are taken into account for the tax year of the discharge.227 In determining the amount of the reduction under I.R.C. section 108(b)(1), any limitation on the use of credits based on the income of the debtor is disregarded.228

(d) Basis Reduction

The exclusion of DOI income for bankruptcy or insolvency results in a reduction to the basis of property in one of two ways: as the fifth tax attribute reduced under the I.R.C. section 108(b)(2)(E) general ordering rules or as the first tax attribute reduced pursuant to the I.R.C. section 108(b)(5) basis reduction election. If NOLs, general business credits, minimum tax credits, and capital loss carryovers do not fully absorb the reductions required to offset the DOI income excluded from gross income under I.R.C. section 108(a), then the debtor must reduce the basis of assets. Rather than following the standard attribute reduction order, the debtor can elect to reduce basis in depreciable property first. I.R.C. section 1017 and the regulations generally govern basis reduction, specifying the manner and timing of reductions to asset basis.229

(i) Basis Reduction Election

The order of tax attribute reduction is altered if the debtor makes a basis reduction election under I.R.C. section 108(b)(5). The basis reduction election allows a debtor first to apply any portion of the attribute reduction required due to debt discharge to reduce the basis of depreciable property.230 “Depreciable property” is defined as any property of a character subject to the allowance for depreciation, but only if the basis reduction will reduce the amount of depreciation or amortization that otherwise would be allowed for the period immediately following the reduction.231 It would appear that property subject to depletion is included in this definition. A debtor may elect to treat any real property held primarily for sale to customers in the ordinary course of business as depreciable property.232 A debtor may elect to treat stock of another member of a consolidated group or partnership interest as depreciable property under certain circumstances, generally if the corporation or partnership owns depreciable property and consents to the election.233

The basis reduction election is an option if the DOI income is excluded due to a title 11 case, insolvency, or qualified farm indebtedness. The election is not available for qualified real property business indebtedness.

If no basis reduction election is made in a title 11 or insolvency situation, I.R.C. section 1017(b)(2) provides that the reduction to basis is required only to the extent that the basis of assets exceeds the amount of the liabilities immediately after discharge. Although this rule does not apply if the debtor makes the basis reduction election, another rule applies: The amount to which the election applies cannot exceed the aggregate adjusted basis of depreciable property held by the debtor as of the beginning of the first tax year subsequent to the tax year of discharge.

(A) Election Procedures

To make an election under I.R.C. section 108(b)(5), a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), must be completed and attached to a timely filed (including extensions) federal income tax return for the tax year in which DOI income is excluded from income. If the taxpayer establishes to the satisfaction of the Commissioner reasonable cause for failure to file the election with the taxpayer’s original return, the taxpayer may file the election with an amended return or a claim for credit or refund.234

The election may be revoked only with the consent of the Commissioner.235 In private letter rulings,236 the IRS allowed S corporations to revoke I.R.C. section 108(b)(5) elections that were made shortly before the Supreme Court issued Gitlitz v. Commissioner,237 reversing decisions of the Tax Court and the Tenth Circuit Court of Appeals. The S corporations requested revocation of the elections within two months after the Gitlitz decision was issued, because the basis reduction elections would not have been made if the law, as decided in Gitlitz, had been clear at the time the elections were made. The IRS allowed the S corporations to revoke the basis reduction elections because each taxpayer “acted reasonably and in good faith” such that granting relief would not prejudice the interests of the government.

(B) Basis Adjustment of Individual’s Estate

I.R.C. section 108(d)(8) provides that the basis adjustments, along with other attribute reductions due to debt discharge, are to be made by the estate as the taxpayer and not the individual. Thus, the election to reduce depreciable property and not tax attributes will be made by the trustee or debtor in possession. Basis adjustment is to be made as of the first day of the tax year following the discharge. For example, assume an estate files its final return for a period ending on September 15, 20X6, and basis adjustment is required. Should the individual reduce property as of September 16, 20X6—the beginning of a new tax year of the estate if it was required to file a return—or January 1, 20X7, the first day of the individual’s tax year? A Senate Report238 indicated that if basis reduction is required due to debt discharge in the final year of the bankruptcy estate, the reduction is to be made in the basis of assets acquired by the debtor from the estate and at the time acquired. Thus, in the example, it would appear that the basis should be reduced as of September 16, 20X6, and cannot include reduction of other property held by the debtor on September 16, 20X6. I.R.C. section 1017(c)(1) specifically states that basis of exempt property cannot be reduced. See Chapter 4 for additional information related to the tax impact of an individual’s estate.

(ii) Basis Reduction Rules

(A) Title 11 and Insolvency

If the basis reduction election is not made, recall that for insolvency and title 11 case exclusions, under the I.R.C. section 1017(b)(2) rule, basis reduction is limited to the excess of the aggregate basis of property and money held by the taxpayer over the liabilities of the taxpayer immediately after the discharge. For basis reduction that results from income excluded under the insolvency or title 11 exclusions (and no basis reduction election is made), Treas. Reg. section 1.1017-1(a) provides that the reduction of basis of specified assets must be made in the following order (in proportion to adjusted basis):

• Real property used in a trade or business or held for investment (other than real property included as inventory or held primarily for sale to customers in the ordinary course of business) that secured the discharged debt immediately before the discharge
• Personal property used in a trade or business or held for investment (other than inventory, accounts receivable, and notes receivable) that secured the discharged debt immediately before the discharge
• Other property used in a trade or business or held from investment (other than inventory, accounts receivable, notes receivable, and real property included as inventory or held primarily for sale to customers in the ordinary course of business)
• Inventory, accounts receivable, notes receivable, and real property included as inventory or held primarily for sale to customers in the ordinary course of business
• Property neither used in a trade or business nor held for investment

The regulations include an anti-abuse rule that disregards changes to property securing debt made within the year preceding the discharge if a principal purpose of the change is to affect basis reduction.239

(B) Basis Reduction Election

As discussed in § 2.7(d)(i), if a basis reduction election is made, the basis of depreciable property is reduced before any other tax attribute. A taxpayer who makes a basis reduction election under I.R.C. section 108(b)(5) may make a second election to treat any real property held primarily for sale to customers in the ordinary course of business as depreciable property.240 The taxpayer may also make other elections to treat corporate stock or partnership interest as depreciable property under certain circumstances.241

Treas. Reg. section 1.1017-1(c) modifies the order of attribute reduction described in § 2.7(d)(ii) for a debtor that makes a basis reduction election. The debtor may reduce the basis of depreciable property in the next order:

• Real property used in a trade or business or held for investment (other than real property included as inventory or held primarily for sale to customers in the ordinary course of business) that secured the discharged debt immediately before the discharge.
• Personal property used in a trade or business or held for investment (other than inventory, accounts receivable, and notes receivable) that secured the discharged debt immediately before the discharge.
• Other property used in a trade or business or held from investment (other than inventory, accounts receivable, notes receivable, and real property included as inventory or held primarily for sale to customers in the ordinary course of business).
• If the debtor makes a second election to treat real property included as inventory or held primarily for sale to customers in the ordinary course of business as depreciable property, then the basis of that property is reduced next.

Excluded DOI income in excess of the basis reductions to depreciable property must be applied to reduce the other tax attributes according to the general ordering rules of I.R.C. section 108(b)(2) starting with NOLs, if any. The tax attributes reduced may include the basis in property that is not depreciable. In this situation, the rule that limits basis reductions to postdischarge liabilities for title 11 and insolvency situations is modified. That is, if the basis of a debtor’s assets is reduced by $100 pursuant to a basis reduction election, the aggregate asset basis of the debtor, for purposes of I.R.C. section 1017(b)(2), would be reduced by $100.242

(C) Qualified Farm Indebtedness

Special rules apply for qualified farm indebtedness.243 If DOI income is excluded as qualified farm debt (and a basis reduction election is not made), then the debtor must reduce tax attributes according to the general ordering rule of I.R.C. section 108(b)(2).244 Only the basis of “qualified property” (property used or held for use in a trade or business or for the production of income) is reduced. Qualified property is reduced in this order: depreciable property, land used for farming, then other qualified property.

The first type of qualified property eligible for basis reduction to offset income attributable to the discharge of qualified farm indebtedness is depreciable property. Like a debtor that makes a basis reduction election, a debtor that must reduce tax attributes as a result of qualified farm indebtedness may elect to treat real property that is inventory or is held primarily for sale to customers in the ordinary course of business as depreciable property.245 Under the right circumstances, the debtor may be able to elect to treat corporate stock or partnership interest as depreciable property.246 The basis reduction election of I.R.C. 108(b)(5) is also an option for the debtor.

(D) Qualified Real Property Business Indebtedness

The general ordering rules for attribute reduction under I.R.C. section 108(b) are not applicable to the qualified real property business indebtedness exclusion.247 This is the only elective exclusion and if the debtor opts to exclude DOI income under the qualified real property business indebtedness exclusion, then the debtor must reduce the basis of depreciable real property.248 The basis reduction order described in § 2.7(d)(ii)(A) is modified in this situation.249 The basis of “qualifying real property” is reduced before the basis of other depreciable real property is reduced. Qualifying real property is generally the real property underlying the qualified real property business indebtedness.

An election under I.R.C. section 1017(b)(3)(E) to treat any real property held primarily for sale to customers in the ordinary course of business as depreciable property is not available for basis reductions due to qualified real property business indebtedness.250 Under the right circumstances, however, the taxpayer may elect to treat depreciable real property of a partnership as depreciable real property subject to basis reduction.251

(E) Depreciable Property Held by Partnership

The debtor that excludes DOI income may own an interest in a partnership that holds depreciable property. The partnership interest may be treated as depreciable property to the extent of the debtor-partner’s proportionate interest in the depreciable property held by the partnership. This treatment is available only for basis reduction of depreciable property after a basis reduction election or in a qualified real property business indebtedness setting.252

This special rule may be applied only if there is a corresponding reduction in the basis of the partnership’s depreciable property (“inside basis”). The regulations generally allow the partner to choose whether to ask the partnership to reduce the partner’s share of depreciable partnership property and also generally allow the partnership the right to grant or deny the request in its sole discretion. A partnership must consent to make appropriate reductions in a partner’s share of inside basis, however, if requested by (i) partners owning, directly or indirectly, a greater-than-80-percent capital and profits interest of the partnership or (ii) five or fewer partners owning, directly or indirectly, more than 50 percent of the capital and profits interests of the partnership. The regulations require a “consenting” partnership to provide the partners with a “Partnership Consent Statement” on or before the partnership files its Form 1065, and require the partner to attach a copy of the statement to its federal income tax return for the tax year in which the taxpayer has DOI income that is excluded from gross income under I.R.C. section 108(a).253

(F) Depreciable Property Held by Corporation

As discussed in § 2.10, consolidated group members may elect flow-through treatment for depreciable property owned by a lower-tier member of the group. I.R.C. section 1017(b)(3)(D) provides that a parent corporation’s investment in the stock of its subsidiary shall be treated as depreciable property to the extent that the subsidiary agrees to reduce the basis of its depreciable property. This election is not limited to a single tier; it may be used by a chain of corporations, provided the lowest-tier subsidiary reduces the basis in its depreciable property.

(G) Multiple Debt Discharges

The debtor often has more than one debt discharged. The regulations provide that, if the DOI income is attributable to the cancellation of more than one debt, the basis reductions will be applied in proportion to the DOI income attributable to each discharged debt.254 For example, assume a debtor excludes $100 of DOI income from gross income ($20 from a secured debt and $80 from an unsecured debt). Of that DOI income, $40 (i.e., 40 percent) results in the reduction of NOLs, general business credits, minimum tax credits, and capital loss carryovers, and the other 60 percent is used to reduce basis. The debtor must apply the basis reduction rules, allocating $12 to secured debt (60 percent of the $20 secured debt) and $48 to unsecured debt (60 percent of the $80 unsecured debt).

(H) Recapture Provisions

Basis reduction under I.R.C. section 1017 should not trigger any recapture provisions.255 Two current recapture provisions are I.R.C. sections 1245 and 1250. These recapture provisions generally apply to any transfer of depreciable property. I.R.C. sections 1245 and 1250 were enacted to close the loophole that resulted from allowing depreciation deductions on assets to offset ordinary income while taxing gain from the sale of these depreciated assets as capital gains. The recapture provisions close the loophole by recharacterizing part or all of the gain on transfers of depreciable assets as ordinary income.

Even though basis reduction itself should not trigger any recapture, the loophole remains closed by I.R.C. section 1017(d), which establishes a recapture rule providing for eventual ordinary income treatment. If basis is reduced in any property that is neither I.R.C. section 1245 property nor I.R.C. section 1250 property, then that property is treated as I.R.C. section 1245 property, resulting in the recapture of the gain on disposal of the property as ordinary income to the extent of the basis reduction. The amount of reduction is treated as depreciation for the purpose of these sections, and the straight-line depreciation calculation under I.R.C. section 1250 is made as if there had been no reduction in basis resulting from debt forgiveness. This recapture rule may trap the unwary. For example, assume that the basis in the stock of a subsidiary is reduced pursuant to I.R.C. section 108(b). If that subsidiary subsequently liquidates in an otherwise tax-free liquidation under I.R.C. section 332, then the I.R.C. section 1245 recapture may be triggered.256

(iii) Tax-Free Asset Transfers

Basis reduction generally occurs on the first day of the tax year following the year the discharge took place.257 Thus, the basis of property acquired after the discharge but prior to the end of the tax year following the discharge year is subject to reduction; similarly, the basis of property sold or otherwise disposed of after the discharge but prior to the beginning of the next tax year is generally not reduced. A taxpayer who faces attribute reduction should carefully consider using the purchase or sale of property as a planning technique.

A tax-free asset transfer or reorganization seems to be a likely candidate for controlling how the basis reduction affects the debtor’s tax liability. One potential planning vehicle is a tax-free asset reorganization under I.R.C. section 368(a)(1)(G) (a G reorganization), which is discussed in greater detail in Chapter 5. In general, a G asset reorganization involves a transfer of assets by a bankrupt corporation (the “target corporation”) to another corporation (the “acquiring corporation”) in exchange for stock of the acquiring corporation. The bankrupt target corporation distributes the acquiring corporation stock to its creditors and/or shareholders and completely liquidates. Following the G reorganization, the target corporation no longer exists.

Although the IRS issued a taxpayer-favorable field service advice258 that allowed a taxpayer to avoid basis reduction following a tax-free reorganization because the target corporation ceased to exist, subsequent regulations issued in 2003259 and the legislative history to the Bankruptcy Tax Act of 1980 will not allow the taxpayer to avoid basis reduction. The House Report includes an example of a G reorganization in which the bankrupt target corporation has DOI income that may be excluded from its gross income. The example states that for attribute reduction, the target corporation “may elect to reduce the basis of its depreciable assets transferred to [the acquiring corporation] by all or part of the . . . debt discharge amount; to the extent the election is not made, the debt discharge amount reduces [the target corporation’s] net operating loss carryover by the remainder of the debt discharge amount.”260 Thus, the target corporation was required to reduce its tax attributes, including basis, in the context of a G reorganization.

Treasury put this issue to bed in final regulations261 that follow the legislative history guidance. The regulations clarify that, in the case of I.R.C. section 381(a) transactions (e.g., a G reorganization or a tax-free I.R.C. section 332 liquidation), any tax attributes of the target corporation to which the acquiring corporation succeeds and the basis of property acquired by the acquiring corporation in the transaction must reflect the reductions required by sections 108(b) and 1017. This rule applies to excluded DOI income realized either during or after the tax year in which the taxpayer is the transferor or distributor of assets.

(iv) Comparison of Attribute Reduction and Basis Reduction Elections

The debtor should consider carefully whether to first reduce the tax attributes listed in I.R.C. section 108(b)(2) or to first reduce the basis of depreciable property under I.R.C. section 108(b)(5). Several factors affect this decision.

• If NOL carryovers or credit carryovers are expected to expire unused, the debtor should not make the election.
• If the I.R.C. section 108(b)(5) election will result in the reduction of basis in property with a fairly long life for depreciation purposes, the debtor can, in effect, accelerate the depreciation by electing to reduce depreciable property first.
• If the amount of debt that is to be discharged is greater than the tax attributes that will be reduced, the debtor should not make the election. Basis in assets will not be reduced below the amount of postdischarge liabilities; however, this limitation does not apply if the election is made.
• The impact of each alternative on state and local taxes.

The example that follows illustrates the operation of the attribution reduction rules and also illustrates some of the factors that impact a decision to make the basis reduction election. XYZ is negotiating an out of court agreement. These facts apply:

	Basis	Fair Market Value
Assets (nondepreciable)	$150	$100
Assets (depreciable)	300	140
Liabilities	800	800
NOL carryover (after tax in the year of discharge has been determined)	275
General business tax credit carryover	25

Under the settlement, one of XYZ’s creditors has agreed to accept $100 in full payment of a $500 debt.

Assume that XYZ’s depreciable property has a 23-year straight-line depreciation period that commenced two years ago. Although it currently is insolvent, there is a strong likelihood that XYZ will return to profitability and that XYZ will be able to utilize its NOL carryovers and general business tax credit carryovers in the near term. XYZ does not plan to sell its depreciable property.

However, the fact that XYZ’s depreciable property has a high tax basis and a long depreciation period weigh in favor of making an election to reduce the basis of depreciable property first. The fact that XYZ anticipates the utilization of its NOL carryovers and general business tax credit carryovers in the near term also contributes to the value of making the election. However, if XYZ makes the election, there is no limitation to the amount of tax basis that will be reduced. (If the election is not made, the amount of tax basis that will be reduced is limited to $150, which is the excess of tax basis ($450) over liabilities ($300) immediately after the discharge.)

Because XYZ anticipates being able to use its NOL carryovers and general business tax credit carryovers in the near term, and because XYZ’s depreciable property has a long depreciation period (and there is no plan to sell this property), XYZ opts to make the election to reduce the basis of depreciable property first.

XYZ is insolvent to the extent of $560, which is the excess of liabilities over the fair market value of its assets immediately before the discharge. Although the exclusion of DOI income from gross income is limited to the taxpayer’s insolvency immediately before the discharge (I.R.C. sections 108(a) and 108(d)(3)), XYZ’s discharge of $400 of debt does not exceed this limitation. Therefore, the entire $400 of DOI income is excluded from gross income under I.R.C. section 108(b). As a result of the election, XYZ will reduce the basis of its depreciable property from $300 to zero262 on the first day of the tax year following the year of discharge; XYZ will reduce its NOL carryovers by $100.

If XYZ did not make the election to reduce the basis of depreciable property first, the $400 of excluded DOI income would first reduce XYZ’s NOL carryovers from $275 to zero; next, $75 would apply to reduce the general business tax credit carryover from $25 to zero (i.e., the general business tax credit carryover is reduced by 331/3 cents for each dollar of DOI income excluded); finally, XYZ would reduce the basis of its property by $100 in the order provided for under Treas. Reg. section 1.1017-1(a). (Here the limitation on basis reduction of the excess of tax basis ($450) over liabilities following the discharge ($300) is irrelevant, because tax basis only will be reduced by $100.)

(e) Alternative Minimum Taxable Income

For tax years beginning in 1987 through 1989, the alternative minimum taxable income (AMTI) of a corporation was computed by adjusting its taxable income for certain items, including one that was based on its financial statement income. Although income from debt discharge is not income for regular tax purposes if the debtor corporation is in title 11 or is insolvent, it is generally reported as financial statement income. As a result, debts discharged in tax years beginning in 1987 through 1989 could give rise to increases in AMTI. To avoid such increases, corporations structured debt discharges as quasi-reorganizations for financial statement purposes, reporting gain directly to their capital accounts in order to avoid a discrepancy between taxable income and financial statement income.263

TAMRA eliminated the need for quasi-reorganization treatment to the extent stock was exchanged for debt. TAMRA added I.R.C. section 56(f)(2)(I) effective for all tax years beginning after 1986, which provided that the transfer of a corporation’s own stock in exchange for the corporation’s debt in a bankruptcy case or to the extent the corporation is insolvent does not give rise to financial statement income for alternative minimum tax purposes.264 I.R.C. section 56(f)(2)(I) was effective for all tax years beginning after 1986 but was repealed as part of the Omnibus Budget Reconciliation Act (OBRA) of 1990.

The OBRA of 1990 replaced the financial statement income adjustment with an adjustment based upon the corporation’s adjusted current earnings (ACE). Under a provision added to I.R.C. section 56(g)(4)(B)(i) pursuant to the Revenue Reconciliation Act of 1989, however, income excluded under I.R.C. section 108 is not taken into account in determining a corporation’s ACE adjustment. This is consistent with the Treasury’s general view that all I.R.C. provisions that apply in determining regular taxable income also apply in determining ACE.265 As a result, for tax years after 1989, income excluded under I.R.C. section 108 should not cause a difference between regular taxable income and AMTI.

§ 2.8 SECTION 108(i) DEFERRAL AND RATABLE INCLUSION OF DOI FROM BUSINESS INDEBTEDNESS DISCHARGED BY THE REACQUISITION OF A DEBT INSTRUMENT

(a) Overview

The American Recovery and Reinvestment Act of 2009 (signed into law by President Obama on February 17, 2009) allows taxpayers to make an election to defer recognition of certain cancellations of debt income pursuant to new I.R.C. section 108(i).

In the discussion that follows, we concentrate, for the most part, on the application of section 108(i) to corporate taxpayers. The description is divided into an overview of the statutory provision followed by a summary of a revenue procedure and treasury regulations issued to provide more detailed rules and clarify how certain aspects of the rules operate.266

(b) Statutory Provisions

I.R.C. section 108(i) provides that a taxpayer can elect to defer DOI income from the “reacquisition” of an “applicable debt instrument” during the calendar years 2009 and 2010. If a taxpayer makes this election, the DOI income is included ratably over the five-tax-year period beginning with:

• The fifth taxable year following the tax year in which the reacquisition occurs for a reacquisition occurring in calendar 2009 (i.e., generally, 2014 for calendar-year taxpayers without intervening short years);
• The fourth taxable year following the tax year in which the reacquisition occurs for a reacquisition occurring in calendar 2010 (i.e., generally, 2014 for calendar-year taxpayers without intervening short years).267

(i) Defined Terms

An “applicable debt instrument” is a debt instrument issued by (i) a C corporation or (ii) any other person in connection with the conduct of its trade or business.268

“Debt instrument” means a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness (within the meaning of I.R.C. section 1275(a)(1)).269

“Reacquisition” is an acquisition of the debt instrument by the debtor that issued the debt or a related person within the meaning of I.R.C. section 108(e)(4). Acquisition for this purpose includes cash purchase of the debt, exchange of new debt for old debt (including deemed exchange resulting from a modification of a debt instrument), exchange of debt for corporate stock (or a partnership interest), capital contribution, or a complete debt forgiveness by the debt holder.270 A reacquisition by a related party generally allows for the making of an I.R.C. section 108(i) election for section 108(e)(4) transactions.

(ii) Effect on OID

If the reacquisition occurs by issuance (actual or deemed) of a new debt instrument that is subject to OID rules, the taxpayer must defer its OID deductions that accrue during the DOI deferral period to the extent of the deferred DOI. The deferred OID deductions are deducted ratably over the same five-taxable-year period.271

(iii) Making the Election

The taxpayer makes the election by attaching a statement to the income tax return for the tax year in which the debt is reacquired. The election is irrevocable and made by on an instrument-by-instrument basis.272

For pass-through entities, the election is made at the entity level. This may cause some friction among investors in the entity. For example, a debtor partnership has two partners, one of which is an insolvent corporation (the amount of insolvency is at least equal to its allocable portion of the partnership’s DOI income) and the other of which is an individual. The insolvent corporate partner would prefer to take advantage of the I.R.C. section 108(a)(1(B) insolvency exception while the individual would like to defer the recognition of the DOI income. As discussed next, this quagmire was handled by the Internal Revenue Service in Revenue Procedure (Rev. Proc.) 2009-37.273

(iv) Acceleration of Deferral

The deferral is terminated and the remainder of the previously deferred DOI income has to be included in taxable income (i) on the death of a taxpayer; (ii) when the taxpayer liquidates, sells substantially all the assets (including in a Title 11 or similar case), ceases business, or any similar circumstances; or (iii) when there is a sale or exchange or redemption of an interest in a pass-through entity.274

The previously deferred OID deductions (if any) similarly get triggered upon the acceleration event. The Treasury and IRS provided a somewhat different approach to many of these triggering events, as described in much more detail in sections to come.275

(v) Interplay with Other Section 108 Exclusions

If an I.R.C. section 108(i) election is made for an applicable debt instrument, the taxpayer cannot take advantage of other section 108 exclusions with respect to the DOI income from this instrument (e.g., insolvency or bankruptcy exceptions in I.R.C. section 108(a)).276

(c) Revenue Procedure 2009-37

Revenue Procedure 2009-37, published September 8, 2009, provides guidance and clarification on the exclusive procedures and operative rules for taxpayers making an I.R.C. section 108(i) election. Specifically, it provides clarification on “applicable debt instruments” in the consolidated return context, reacquisitions, bifurcation, partial elections, and earnings and profits calculations in the context of a section 108(i) election.

(i) Applicable Debt Instrument

The background section of Rev. Proc. 2009-37 clarifies how the section 108(i) rules operate within a consolidated group. Intercompany obligations are only considered “applicable debt instruments” if DOI income is realized on the deemed satisfaction of the instrument, pursuant to Treas. Reg. section 1.1502-13(g)(5). Thus, in the context of consolidated groups, an I.R.C. section 108(i) election is generally available only if an obligation that was not an intercompany obligation becomes an intercompany obligation. As such, DOI income arising from deemed or actual satisfaction of an intercompany obligation under other circumstances is ineligible for an I.R.C. section 108(i) election.

(ii) Reacquisition and Acquisition

The revenue procedure also gave additional guidelines for the terms “acquisition” and “reacquisition.” Reacquisition can occur if the issuer uses property other than cash or other forms of consideration that were specifically addressed in the statute. In addition, an acquisition can include an indirect acquisition under Treas. Reg. section 1.108-2(c) if a direct acquisition would qualify for an I.R.C. section 108(i) deferral. A direct acquisition occurs if the person related to the debtor (or becomes related to the debtor on the date of the indebtedness is acquired) acquires the indebtedness from a person that is not related to the debtor. An indirect acquisition occurs if the holder acquires the indebtedness in anticipation of becoming related to the debtor, as determined by the facts and circumstances and applicable regulations.

(iii) Partial Elections

The revenue procedure allows bifurcation of DOI income. A taxpayer may make a section 108(i) election for any portion of DOI income realized on the reacquisition of any applicable debt instrument and may exclude from income the portion of DOI income that the taxpayer does not elect to defer under section 108(i). Additionally, a taxpayer may make an election for different portions of DOI income arising from different debt instruments, even if not part of the same issue. This authorizes significant flexibility with respect to the recognition of DOI income.

Partnerships that elect to defer less than all of the DOI income realized from the reacquisition of an applicable debt instrument are permitted to allocate deferred and undeferred DOI income to its partners disproportionately. The revenue procedure states that the partnership may determine “in any manner, the portion, if any, of a partner’s DOI income amount that is the partner’s deferred amount and the portion, in any, of a partner’s DOI income amount that is the partner’s included amount.” A partner’s DOI income for which an election has not been made may be excluded under I.R.C. section 108(a)(1)(A), (B), (C), or (D), if applicable. The election statement must include the deferred DOI income amount and the list of partners that have a deferred DOI income. More specific reporting requirements and other information on pass-through entities are included in the text of the revenue procedure.

(iv) Consolidated Groups and Foreign Entities

The revenue procedure states that the common parent of a consolidated group makes the I.R.C. section 108(i) election on behalf of all members of the group. It provides further guidance regarding foreign entities as well. A controlling domestic shareholder of a controlled foreign corporation, or a noncontrolled 902 corporation that is not required to file a tax return, may make an I.R.C. section 108(i) election on behalf a foreign corporation. In the partnership context, a foreign partnership that is not otherwise required to file a partnership return in the United States must attach the election statement to a partnership return that satisfies certain requirements for foreign partnerships.

(v) Earnings and Profits

The revenue procedure indicated that the IRS and Treasury Department intend to issue regulations regarding the computation of earnings and profits with respect to DOI income and OID deductions deferred under I.R.C. section 108(i).277 Preliminarily, the revenue procedure stated that earnings and profits are increased in the taxable year(s) that deferred DOI income is realized, not in the taxable year(s) that the deferred DOI income is includible in gross income. Deferred OID deductions will decrease earnings and profit in the taxable year(s) in which the deduction would be allowed, without regard to an I.R.C. section 108(i) election.

However, in the context of regulated investment companies (RICs) or real estate investment trusts (REITs), deferred DOI income will increase earnings and profits in the tax year(s) that the amount is included in gross income, not the year realized. Likewise, deferred OID deductions will decrease earnings and profits in the tax year(s) the amount is deductible.

(vi) Protective Election

The revenue procedure allows a taxpayer to make a protective election if, for example, the taxpayer determined that it did not have reportable DOI income but later determines such position to be incorrect. If DOI income has not been reported or is understated due to a mistake by the taxpayer, a protective election is admissible to retain the taxpayer’s ability to defer the recognition of the DOI income. If the amount of DOI income subsequently recognized is greater than the DOI income initially reported, then the taxpayer may defer the additional DOI income, if the protective election was made. However, if the protective election is made and DOI income is subsequently recognized, it is treated as an irrevocable I.R.C. section 108(i) election, and even if the statute of limitations has expired for the year in which the DOI income was realized, the taxpayer may be required to report the deferred DOI income.

(vii) Annual Statement and 12-Month Extension

The IRS grants an automatic extension of 12 months for the making of a section 108(i) election. A taxpayer that makes an I.R.C. section 108(i) election must attach a statement to its federal income tax return every year beginning with the first year after the election was made and ending with the first taxable year that all deferred items have been recognized.

(d) Treasury Decision 9497 (Temporary Regulation)

Treasury Decision (Temporary Regulation) 9497, promulgated August 13, 2010, provides guidance to corporations that make an I.R.C. section 108(i) election regarding mandatory acceleration events, deferred DOI income, deferred OID deductions, and the calculation of earnings and profits.

(i) Mandatory Acceleration Events for Deferred DOI Income

The preamble to the temporary regulations provide that the purpose of the deferral rules of I.R.C. section 108(i) are to facilitate debt workouts and alleviate taxpayer liquidity concerns by deferring the tax liability associated with DOI income. However, the acceleration rules under I.R.C. section 108(i)(5)(D) reduce the tax favorable deferral rules in situations where the government’s ability to collect the tax on the deferred DOI income may be impaired because the taxpayer or its business has ceased to exist. The mandatory acceleration events in the statute (described earlier) that give rise to such treatment are: death of the taxpayer, liquidation or sale of substantially all assets of the taxpayer (including bankruptcy), or the cessation of the taxpayer’s business. Given the nature of the corporate entity, some corporate transactions would require acceleration despite that they may not pose concerns with collectability (i.e., certain corporate nonrecognition transactions or distribution of corporate assets to shareholders). The temporary regulations address this issue by narrowing the mandatory acceleration requirements for corporations to circumstances in which the corporation has impaired its ability to pay its tax liability. Specifically, an electing corporation will accelerate its deferred DOI income only if it: (1) engages in a transaction that impairs its ability to pay the tax liability (the net value acceleration rule); (2) changes its tax status; (3) ceases its corporate existence, except, generally, in a transaction to which I.R.C. section 381(a) applies; or (4) liquidates, ceases to exist, or sells substantially all of its assets in a title 11 bankruptcy or similar proceeding.

(A) Net Value Acceleration Rule

Under the net value acceleration rule, an electing corporation must accelerate its DOI income if it engages in an impairment transaction and, immediately after the transaction, the value of its assets falls below a minimum threshold (the net value floor) and the value is not restored by the due date of its tax return. Impairment transactions generally include transactions that impair the corporation’s ability to pay its tax liability on the deferred DOI income and reduce the corporation’s asset base. Examples of impairment transactions include distributions (including I.R.C. section 381(a) transactions), redemptions, below-market sales, donations, and the incurrence of additional indebtedness without a corresponding increase in asset value. Value-for-value sales, exchanges such as I.R.C. section 351 transactions, or a mere decline in fair market value of assets are not impairment transactions.

The net value floor is the minimum threshold that the gross value of the corporation’s assets value cannot fall below immediately after the impairment transaction. The net value floor is less than 110 percent of the sum of its total liabilities and the tax on the net amount of its deferred items. The tax on net income for this purpose is determined by applying the highest rate of tax specified in I.R.C. section 11(b) for the taxable year. The IRS and Treasury Department believe that this rule is an appropriate interpretation of I.R.C. section 108(i) because an electing corporation may realign business operations through strategic acquisitions and dispositions to avoid falling below the objective standard of the net value floor. The net value floor can be better understood with Example 2.1.

(B) Changes in Tax Status

If an electing corporation changes its tax status, it must take into account its remaining deferred DOI income immediately before such change. For example, a C corporation that elects to be treated as an S corporation, or converts to a RIC or REIT, must accelerate its remaining deferred DOI income immediately before the election is made. These rules may apply more stringently to accelerate gain than, for example, the treatment of built-in gains for a C corporation that elects to become an S corporation. The IRS and Treasury Department indicated that a permanent exclusion of a corporate tax liability under I.R.C. section 108(i) is inconsistent with the congressional intent to provide for deferral of corporate DOI income tax liability.

(C) Cessation of Existence

Generally, if an electing corporation ceases to exist, it must accelerate its remaining deferred DOI income in the taxable year that it ceased to exist. However, if the corporation ceases to exist in a reorganization or liquidation to which I.R.C. section 381(a) applies, deferral typically will continue. In such case, the acquiring company succeeds to the electing corporation’s remaining DOI income and becomes subject to the section 108(i) requirements. The temporary regulations points out that the policies behind nonrecognition also support continued deferral of DOI income.

However, some I.R.C. section 381(a) transactions may still constitute an impairment transaction, and the corporation must accelerate its remaining deferred DOI income in those circumstances. For instance, the impairment tests are applied to the acquiring corporation immediately following the I.R.C. section 381(a) transaction. In addition, acceleration may be required if the assets of a domestic electing corporation are acquired by a foreign corporation or if the assets of a foreign electing corporation are acquired by a domestic corporation. Further, some I.R.C. section 381(a) transactions that involve acquisitions of assets by a RIC, REIT, or S corporation may also require the corporation to accelerate its deferred DOI income immediately before such transaction.

(D) Bankruptcy

The Temporary Regulations do not provide special rules for title 11 transactions and apply the acceleration rules discussed above.

(ii) Earnings and Profits

Consistent with Rev. Proc. 2009-37, the temporary regulations provide guidance on how an I.R.C. section 108(i) election will affect earnings and profits. In general, deferred DOI income increases earnings and profits in the taxable year it is realized. Deferred OID deductions decrease earnings and profits in the taxable year(s) in which deductions would be allowed without regard to the deferral rules of I.R.C. section 108(i). The preamble to the temporary regulations state that earnings and profits should be increased or decreased pursuant to the above rule without regard to method of accounting or an installment sale.

The temporary regulations corroborate Rev. Proc. 2009-37 regarding treatment of earnings and profit for RICs or REITs as well. In such cases, deferred DOI income increases earnings and profits in the taxable year(s) in which the deferred DOI income is includible in gross income and not in the year realized. Deferred OID deductions decrease earnings and profits in the taxable year(s) that deferred OID deductions are deductible. The preamble to the temporary regulations explain that the purpose of the exception is to ensure that RICs and REITs have enough earnings and profits to claim dividend deductions in the year that deferred DOI income is included in taxable income.

(iii) Intercompany Obligations

Supported by Rev. Proc. 2009-37, the preamble to the temporary regulations states that due to the intercompany obligation rules of Treas. Reg. section 1.1502-13, the elective deferral rules of I.R.C. section 108(i) may be beneficial for intercompany obligations in a consolidated return context only if a non-intercompany obligation becomes an intercompany obligation, as described in Treas. Reg. section 1.1502-13(g)(5). Accordingly, in the case of intercompany obligations, the temporary regulations limit the application of I.R.C. section 108(i) in the consolidated return context by defining an “applicable debt instrument” to include only a “debt instrument for which DOI income is realized upon the debt instrument’s deemed satisfaction under Treas. Reg. section 1.1502-13(g)(5).”

(iv) Deemed Debt-for-Debt Exchanges

The temporary regulations also provide guidance on debt-for-debt exchanges in an effort to prevent related parties from avoiding rules for deferred OID deductions. Thus, if the proceeds of any debt instrument are used directly or indirectly by the issuer or person related to the issuer to reacquire an applicable debt instrument, the debt instrument shall be treated as issued for the applicable debt instrument being reacquired. The determination as to whether a debt instrument will be treated as having been used directly or indirectly to reacquire the debt instrument will be a facts-and-circumstances inquiry.

(v) Deferred OID Deductions

If a portion of the proceeds of a debt instrument with OID are used directly or indirectly to reacquire a debt instrument, then the issuer will defer only a portion of the OID deductions. The temporary regulations provide the specific rules on the percentage requirements. However, if the total amount of OID that accrues before the inclusion period is greater than the total amount of deferred DOI income, then the OID deductions are disallowed in the order in which OID is accrued, subject to the total amount of deferred DOI income.

Acceleration of deferred OID deductions may be required if the issuer is a C corporation. The temporary regulations provide that the acceleration of deferred OID deductions is appropriate when the corresponding deferred DOI income is taken into account. In addition, a C corporation issuer’s remaining deferred OID deductions may be accelerated when the deferred DOI income continues to be deferred in certain limited situations.

(vi) Effective/Applicability Dates

The rules regarding deferred DOI income, calculation of earnings and profits, and deferred OID deductions generally apply to debt instruments in taxable years after December 31, 2008. The rules with respect to acceleration of deferred DOI income and deferred OID deductions apply to acceleration events occurring on or after August 11, 2010, but electing corporations and C corporation issuers may elect to apply these rules to all acceleration events occurring prior to August 11, 2010. In a consolidated group, this option is available if the acceleration rules are applied to all acceleration events for all members of the group. If an electing corporation or C corporation issuer does not apply the acceleration rules to acceleration events occurring prior to August 11, 2010, then all deferred items are subject to I.R.C. section 108(i)(5)(D)(i).

(e) Treasury Decision 9498 (Temporary Regulation)

Treasury Decision (T.D.) 9498 serves as the corresponding temporary regulation to T.D. 9497 for partnerships and S corporations. It provides guidance on the operative rules for partnerships and other pass-through entities in the context of an I.R.C. section 108(i) election. Specifically, the temporary regulations provide rules regarding “applicable debt instruments” in the partnership context, allocation of DOI income to partners, basis adjustment, I.R.C. section 752 deferral amounts, capital accounts, I.R.C. section 465(e) recaptures, deferral of OID, and acceleration events for partnerships.

(f) Planning Points

At a first look, from a cash-flow perspective, it would be beneficial to defer recognition of income. However, each taxpayer’s tax attributes and taxable income projections must be taken into account in determining whether the election should be made. For example, it may be preferable to take advantage of the insolvency or bankruptcy exceptions in I.R.C. section 108(a), if the taxpayer does not have any valuable tax attributes subject to I.R.C. section 108(b) attribute reduction. If there are valuable tax attributes, one should consider whether and the extent to which the utilization of such attributes would be limited (e.g., by I.R.C. section 382) before electing out of I.R.C. section 108(a) treatment that would in turn reduce such attributes. Further, if the taxpayer is expecting an acceleration event, the benefit of the election can be significant.