§ 2.9 USE OF PROPERTY TO CANCEL DEBT

(a) Transfer of Property in Satisfaction of Indebtedness

When a debtor does not pay secured debts because of financial problems or because of a decline in the value of the mortgaged property, that property sometimes is used to satisfy the debt. If property is transferred in satisfaction of debt, the type of debt (recourse or nonrecourse) determines the federal income tax consequences of the transfer. Although the transfer of property to satisfy a debt that is greater than the value of the property would appear to result in DOI income, that is not necessarily the outcome.

(i) Transfer of Property in Satisfaction of Nonrecourse Debt

In simple terms, the debtor is personally liable for recourse debt, but the debtor is not personally liable for nonrecourse debt. The creditor’s remedy for default of a nonrecourse liability is limited to foreclosure on the property used as security. If the value of that property falls below the amount of the outstanding debt, the debtor is free to abandon the property and be relieved of the obligation. Thus, the creditor bears the risk of the property’s loss in value.278

(A) Gain from the Property Transfer

Gains derived from dealings in property are includable in the taxpayer’s gross income under I.R.C. 61(a)(3). If the owner transfers property subject to a nonrecourse mortgage, gain or loss, calculated under I.R.C. section 1001(a), is the difference between the amount realized on the disposition and the debtor’s adjusted basis in the property. The amount realized generally includes the unpaid balance of the nonrecourse mortgage. In Tufts v. Commissioner,279 the Supreme Court held that the amount realized on the sale of an apartment complex includes the balance of the nonrecourse debt, even though the balance exceeded the value of the property. The Court reasoned that if a taxpayer is entitled to include the full amount of the nonrecourse liability in its basis,280 it is not unreasonable to include that amount in the amount realized when the property is sold.

The rule is the same in the debt satisfaction context. Namely, if the owner transfers property subject to a nonrecourse debt to the creditor in satisfaction of the debt, then the amount realized includes the amount of the debt, even if the debt exceeds the fair market value of the transferred property.281 This rule can be illustrated by a simple example, shown in Example 2.3.

In Great Plains Gasification Associates v. Commissioner,282 the Tax Court, in a memorandum decision, addressed the question of whether a partnership debt is recourse or nonrecourse. The subject of the litigation was the timing of recognition of income on a foreclosure sale of the partnership’s assets. The taxpayer argued that a portion of the debt survived the foreclosure. The court disagreed. The court first noted that whether a debt is viewed as recourse or nonrecourse is properly determined at the partnership level. So far, there is nothing very surprising about this. From this initial statement, one would expect that for purposes of I.R.C. section 108, whether a debt of a partnership is viewed as recourse or nonrecourse is determined with respect to whether the debt can be enforced against all of the partnership assets or only certain partnership assets and not whether a partner or partners are personally at risk. This is where the court jumped off into the interesting aspects of the case.

The court next noted that, under regulations applicable at the time of the relevant transaction, a partnership debt was treated as nonrecourse if none of the partners had personal liability on the debt. This is interesting in two respects. First, it seems inconsistent with the court’s finding that the recourse nature of a debt is determined at the partnership level. Second, the court used former I.R.C. section 752 partnership regulations to determine the recourse nature of a debt for purposes of I.R.C. section 108. This seems like quite a leap and is questionable. Under I.R.C. section 108, one would have expected that, if all of the assets of the partnership were subject to the liability, the liability would have been considered recourse at the partnership level.

The court pointed out that the taxpayer had consistently reported the debt as nonrecourse. The court noted that the claims were limited to what was referred to as “project assets” of the partnership. Thus, if the debt were recourse against only certain partnership assets, the pendulum swings to treating the debt as nonrecourse. The court reasoned that because the partnership’s liability on the debt was effectively limited to the project assets that collateralized the debt and the partners’ liabilities were effectively limited to their interests in those project assets, the debt was “in substance nonrecourse against the partnership and the partners.” That would seem to be all fine and clear, except for one aspect. The court also pointed out that the partnership had no significant assets apart from the project assets, and under the terms of the partnership and loan agreement, the partnership was not authorized to acquire nonproject assets. Thus, if the recourse nature of the debt is properly determined at the partnership level and the debt is enforceable against all assets that the partnership owns or is authorized to acquire, it is arguable that the debt could be viewed as recourse, at least for purposes of an I.R.C. section 108 analysis. One would expect to see more of this issue in a world of partnerships and limited liability companies treated as partnerships where the partnership as an entity is liable for its debts.

Although I.R.C. section 108 applies to a cancellation of nonrecourse debt, a disposition of property subject to a nonrecourse debt does not give rise to DOI income.283 As shown in Example 2.3, the Debtor does not realize DOI income. DOI income may be preferable to gain in some situations. Returning to the example, assume that Debtor is insolvent by $20. Debtor might argue that the excess of the unpaid nonrecourse debt over the value of the property of $20 ($100 debt – $80 value) is DOI income that is excluded from income under I.R.C. section 108(a)(1)(B) due to Debtor’s insolvency. The IRS considered and rejected this argument in a Technical Advice Memorandum,284 finding that the transaction was governed by I.R.C. sections 61(a)(3) and 1001.285

The Tax Court reached a similar conclusion in Sands v. Commissioner.286 The court held that the 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). In Sands, the seller of property forgave nonrecourse debt to the purchaser. As part of the agreement, the seller instructed the buyer (which had leased the property to an unrelated party) to transfer all ownership rights in the property to the lessee and to relieve the lessee of all its obligations under the lease. The court determined that the seller’s discharge of debt and the buyer’s release of its ownership in the property occurred as part of a single transaction. Thus, in substance, the transfer of property in satisfaction of nonrecourse indebtedness was a taxable sale or exchange. The court held the buyer had gain equal to the excess of the debt forgiven over its adjusted basis in the property under I.R.C. sections 61(a) and 1001(a). This case involves a tricky situation—an apparent reduction of a nonrecourse debt that usually results in DOI income actually results in capital gain.287

(B) Loss on the Property Transfer

A transfer of property in satisfaction of a nonrecourse debt is treated as a taxable sale or exchange that may also result in a loss.288

(ii) Transfer of Property in Satisfaction of Recourse Debt

The tax consequences are different if the debtor transfers property in satisfaction of a recourse debt. If the debtor transfers property subject to a recourse debt, gain or loss is calculated on the amount realized. In addition, the recourse transaction may involve a DOI income component.289 In other words, the transaction is bifurcated for tax purposes.

(A) Gain on the Property Transfer

The transfer of appreciated property in satisfaction of recourse debt may result in both DOI income under I.R.C. sections 108 and 61(a)(12) and capital gain under I.R.C. sections 1001 and 61(a)(3).290 This is demonstrated in Example 2.4.

The Tax Court has adopted the bifurcation concept.291 In Gehl v. Commissioner,292 the Tax Court held that, where property was transferred in full settlement of the recourse debt, the excess of the fair market value of the property over basis is taxable gain under I.R.C. section 61(a)(3), not income from discharge of indebtedness under I.R.C. section 61(a)(12). The court noted that it is “well settled” that a transfer of property by a debtor to a creditor in satisfaction of a debt is a sale or exchange under I.R.C. section 1001 and that the excess of the fair market value over the basis of the property results in taxable gain. The debt satisfaction also included a discharge of indebtedness component. The taxpayer in Gehl reported (and the IRS conceded) that the excess of the recourse debt over the fair market value of the property transferred was DOI income. The taxpayer was insolvent before and after having made the transfer in an out-of-court settlement, so the DOI income was excluded from gross income under the insolvency exclusion.293

(B) Loss on the Property Transfer

The examples discussed so far involve DOI income and capital gain because the adjusted basis of the property is less than its fair market value. If the adjusted basis of property exceeds the fair market value of the property, the taxpayer may recognize a loss.294 This is illustrated in Example 2.5.

(iii) Character of the Gain or Loss

The character of the gain or loss realized when property is transferred in satisfaction of recourse or nonrecourse debt, whether ordinary or capital, is determined by looking at the underlying transaction. In general, when a taxpayer transfers mortgaged property in settlement of a mortgage obligation, any loss sustained is capital because it is “deemed to have resulted from a sale or exchange on the ground that the taxpayer received consideration in return for transferring property, the consideration being . . . release from liability.”295

The underlying transaction may raise other concerns, including whether the losses are limited by another I.R.C. provision. Under the I.R.C. section 469 passive activity loss rules, losses from passive activities generally cannot be used to offset income from nonpassive activities. Loss from the transfer of property in satisfaction of debt could be a passive loss that is limited by the passive activity loss rules. Similarly, DOI income could be categorized as passive activity income (and offset by a passive activity loss) if the debt was allocated to passive activity expenditures.296

(b) Discharge of Nonrecourse Debt

Clearly, if recourse debt is canceled, then the debtor may have DOI income. Although it is less obvious, the debtor may have DOI income if the debt is nonrecourse. For example, when the value of property securing a nonrecourse debt declines below the amount of the debt, the creditor may reduce the principal amount due and the debtor may realize DOI income. This section discusses transactions that involve a discharge or forgiveness of nonrecourse debt rather than the transfer of the mortgaged property in satisfaction of the nonrecourse debt, as in Tufts v. Commissioner discussed in § 2.9(a)(i)(A) or Michaels v. Commissioner discussed in § 2.3(a)(ii).

The similarity in treatment of recourse and nonrecourse debt is shown in Rev. Rul. 82-202.297 In that ruling, a taxpayer prepaid a home mortgage held by an unrelated lender for less than the principal balance of the mortgage. At the time of the prepayment, the fair market value of the residence was greater than the principal balance of the mortgage. Relying on Kirby Lumber,298 the IRS determined that the taxpayer realized DOI income, regardless of whether the mortgage was recourse or nonrecourse and regardless of whether it was partially or fully prepaid.299 In Rev. Rul. 82-202, the IRS determined that DOI income arose on facts where the value of the mortgaged property was more than the principal amount of the debt and the IRS believes that the result is the same if the value of the property is less than the principal amount of the debt.

Rev. Rul. 91-31300 involves a situation where the nonrecourse debt is partially discharged, but the mortgaged property remains in the hands of the debtor. Individual A borrows $1,000 from C at a fixed market rate payable annually. The debt is secured by an office building valued at $1,000 that A acquires from B with the proceeds of the loan. A is not personally liable for the debt. The next year, after the value of the office building declined to $800 and when the outstanding principal due on the debt is $1,000, C agrees to reduce the principal to $800. The modified debt bears adequate stated interest. The IRS determined that A realizes DOI income of $200.

In Rev. Rul. 91-31, the IRS examined Gershkowitz v. Commissioner,301 in which the Tax Court concluded that the settlement of a nonrecourse debt of $250,000 for a $40,000 cash payment (in lieu of the surrender of the collateral consisting of shares of stock with a fair market value of $2,500) resulted in $210,000 of DOI income. The IRS indicated that it will follow the holding in Gershkowitz, where a taxpayer is discharged from all or a portion of a nonrecourse liability and there is no disposition of the collateral. This is consistent with the determination in Rev. Rul. 91-31 that A realizes $200 of DOI income as a result of the reduction of the principal amount of the nonrecourse note by C, the holder of the debt that was not the seller of the property securing the debt.

To illustrate how the conclusions in Tufts v. Commissioner differ from those in Rev. Rul. 91-31, assume that the $1,000 nonrecourse debt owed to C was settled in full by the transfer of the property to C. Further assume that the basis of the property was $700. In this situation, consistent with Tufts, debtor A would have a gain on transfer of $300 and none of the gain would be considered income from debt discharge. Moreover, even if A had filed a title 11 petition, the gain still would have been income on the transfer and not subject to the exclusions from income of I.R.C. section 108.

However, if the facts and treatment are consistent with Rev. Rul. 91-31, the debt is reduced and there is no transfer of property, then the filing of a title 11 petition is important. In Rev. Rul. 91-31, the income is subject to the provisions of I.R.C. section 108. Thus, if A was in title 11 proceedings, the income would be excluded and A’s tax attributes reduced.

The juxtaposition of the results under the Tufts decision, as adopted in treasury regulations,302 and the results under Rev. Rul. 91-31 suggests that a better approach for insolvent taxpayers (or those in bankruptcy) would be to: (1) Write down a nonrecourse debt to fair market value, creating DOI income and the attendant attribute reduction; then (2) sell the property to an unrelated party and use the proceeds to repay the creditor. Assuming the resulting attribute reduction did not cause a reduction in the basis of the property (but merely a reduction in other attributes), the sale to the unrelated party would result in an I.R.C. section 1001 gain or loss to the extent of the difference between the fair market value in the property (as opposed to the amount of the nonrecourse debt that may exceed the property’s fair market value).303 Taxpayers might be able to achieve the same result by transferring the property directly to the creditor following the writedown. In either scenario, a discharge and subsequent transfer of property made as part of an integrated plan could trigger a recast under the substance over form doctrine.304

From a different perspective, the conclusions of Tufts and Gershkowitz (as followed in Rev. Rul. 91-31) are similar in that the adjustment results in income and not a direct reduction in basis. This is in contrast to a 1934 decision, Fulton Gold Corp. v. Commissioner.305 The continuing value of this decision has been questioned by the courts and the IRS over the years. In Fulton Gold, a taxpayer purchased property subject to a nonrecourse mortgage and subsequently satisfied the debt for less than the face amount. Based on Kirby Lumber, the Board of Tax Appeals held that there was no DOI income because there was no freeing of assets and required the taxpayer to reduced the basis of property by the difference between the face of the mortgage and the amount paid to satisfy the mortgage. Even though the equity in the property was increased as a result of the discharge, the Board found no DOI income because the taxpayer had incurred no personal liability for the debt. The Board did not consider the taxpayer’s equity in the property to be the equivalent of personal liability. In Rev. Rul. 91-31, the IRS concluded that Tufts and Gershkowitz implicitly reject any interpretation of Fulton Gold that a reduction in the amount of a nonrecourse liability by the holder of the debt that was not the seller of the property securing the liability results in a reduction of the basis in the property rather than DOI income for the year of the reduction. In light of conflicting authority on the topic, the continued vitality of Fulton Gold is unclear.306

(c) Foreclosure

When a debtor defaults on an obligation that is secured by property, the creditor may foreclose on the property in satisfaction of the debt. The property may be sold in a foreclosure sale, with the proceeds from the sale applied to the outstanding debt, in full or partial satisfaction. The tax treatment of the debtor in a foreclosure sale is fundamentally the same as the tax treatment of a debtor that voluntarily transfers property to satisfy debt.

A foreclosure sale is a sale or other disposition of property governed by I.R.C. sections 61(a)(3) and 1001. The difference between the amount realized and the debtor’s adjusted basis is a gain or loss, taxed according to the nature of the property.307 For nonrecourse debt, the amount realized in a foreclosure sale is generally the amount of the debt. For recourse debt, the amount realized in a foreclosure sale is generally the fair market value of the property. The gain or loss on foreclosure is reported in the year in which the foreclosure is final.308

In addition to the gain or loss under I.R.C. section 1001, a foreclosure may trigger DOI income if the debt is recourse. If the creditor has a deficiency judgment against the debtor for an amount of recourse debt not satisfied by the sale proceeds and that deficiency judgment is discharged in the foreclosure proceedings, then the debtor may have DOI income. The DOI income will be reported in the tax year the debt is discharged.309

The similarity in treatment for voluntary and involuntary transfers of property to satisfy recourse debt is illustrated in Rev. Rul. 90-16.310 The basic fact pattern involves an insolvent debtor’s transfer of property that is security for a recourse debt to the creditor pursuant to a settlement agreement. This transfer results in both gain under I.R.C. sections 61(a)(3) and 1001 and DOI income under I.R.C. sections 61(a)(12) and 108. Gain is recognized on the transaction to the extent the fair market value of the property exceeds the debtor’s adjusted basis. DOI income is realized to the extent the debt exceeds the fair market value of the property. The basic fact pattern in the revenue ruling involves a voluntary settlement agreement, but the ruling specifically points out that the result would be the same if the property were transferred to the creditor in an involuntary foreclosure proceeding. The transfer in foreclosure, like a voluntary sale, is a disposition within the scope of I.R.C. section 1001.311

In Frazier v. Commissioner,312 the Tax Court considered a foreclosure sale of property that secured a recourse debt. Consistent with Rev. Rul. 90-16, the Tax Court held that it is appropriate to bifurcate the transaction. With regard to the calculation of gain or loss on the transaction (the difference between fair market value and adjusted basis), the Tax Court held that the fair market value is not necessarily the proceeds from the foreclosure sale.313 That is, a debtor may show by clear and convincing evidence that the foreclosure proceeds are not the fair market value of the foreclosed property.

The facts of Frazier are straightforward. The debtor owned real property that was secured by a recourse obligation. The lender foreclosed while the debtor was insolvent. The lender, the only bidder at the foreclosure sale, bid $571,179 for the property even though the appraised fair market value of the property was $375,000. At the time of the foreclosure sale, the outstanding principal balance on the recourse debt was $585,943 and the debtor’s adjusted basis in the property was $495,544. The lender did not attempt to collect the difference between the outstanding debt balance and the bid price for the property. After the foreclosure transaction, the debtor was still insolvent.

The Tax Court found that the foreclosure proceeds were not the fair market value of the property. In its analysis, the Tax Court stated that, absent clear and convincing proof to the contrary, the sales price of property at a foreclosure sale is presumed to be its fair market value. However, the debtor rebutted this presumption to the court’s satisfaction by submitting an appraisal for a fair market value of $375,000, which the IRS did not challenge.

The Tax Court next analyzed the federal tax consequences to the debtor, bifurcating the transaction into two steps: a taxable sale of the property and a taxable discharge of indebtedness. On the first step of the transaction, the debtor realized a capital loss of $120,544 (the difference between the fair market value of the property, $375,000, and the adjusted basis of the property, $495,544). On the second step, the debtor realized $210,943 of income from discharge of indebtedness (the difference between the fair market value of the property, $375,000, and the outstanding balance of the debt, $585,943). Because the debtor was still insolvent after the foreclosure transaction, the debtor’s income from the discharge of indebtedness was excluded from income pursuant to the insolvency exclusion of I.R.C. section 108(a)(1)(B).

In an earlier decision, Lewis v. Commissioner,314 the Tax Court did not bifurcate a foreclosure sale of property that secured a recourse debt. Rather than viewing part of the transaction as a sale under I.R.C. section 1001, the Tax Court appears to treat the entire transaction as triggering DOI income, measured by the difference between the outstanding debt and the proceeds of the foreclosure sale.

This position is suspect for two reasons. First, Treas. Reg. section 1.1001-2(a) and Rev. Rul. 90-16 suggest that the total amount of the income is the difference between the amount of the debt discharged (amount received) and the basis of the property transferred, and not the amount recovered at the foreclosure sale. Second, regarding the nature of the income, Treas. Reg. section 1.1001-2(a) and Rev. Rul. 90-16 suggest that the income consists of two parts: (1) a gain or loss on transfer, calculated as the difference between the fair market value of the property at the time of foreclosure, which may be represented by the purchase price at the foreclosure sale, and the basis of the property, and (2) a gain or loss from debt discharge, calculated as the difference between the amount of the debt and the fair market value of the property. As noted in Tufts, if the debt is nonrecourse, the entire amount of the gain (amount of debt less basis in property) is considered a gain on transfer and no part of the gain is subject to the debt discharge rules of I.R.C. section 108.

(d) Abandonment

In the early 1980s and again in 2008, the value of real property dropped dramatically, often leaving owners with mortgages that exceeded the value of the property. If the property were sold, the resulting loss would be a capital loss. In an attempt to characterize the loss as ordinary, the mortgagors would “abandon” the property and claim an ordinary loss. However, as in a voluntary conveyance or foreclosure, it may be difficult to obtain the ordinary loss. In general, as long as the mortgagor retains title to the property, there can be no abandonment. Furthermore, if the mortgagor transfers the property in satisfaction of either a recourse or nonrecourse liability or subject to a liability, it may be even more difficult to show abandonment.

In Abrams v. Commissioner,315 voluntary abandonment was considered a sale for purposes of determining capital loss. The property was held by the debtor as a capital asset. The debtor made a voluntary reconveyance to the seller and called it an abandonment in order to avoid foreclosure. The IRS argued that there was a capital (not ordinary) loss subject to the limitations of I.R.C. section 1211. The Tax Court agreed.

Similarly, in Middleton v. Commissioner,316 the Tax Court held that the abandonment (not in a bankruptcy case) of property subject to a nonrecourse mortgage was a sale and that the loss sustained on the sale of the property was a capital loss.317 Middleton and other cases suggest that it is extremely difficult to report as an ordinary loss a loss realized on the abandonment of property that is subject to a liability.

The IRS issued final regulations that preclude a taxpayer from taking an ordinary loss on the abandonment of “securities” that are held as capital assets unless the taxpayer satisfies the requirements of I.R.C. section 165(g)(3).318 The regulations apply to any abandonment of stock or other securities after March 12, 2008.

§ 2.10 CONSOLIDATED TAX RETURN TREATMENT

(a) Consolidated Return Issues

I.R.C. section 1501 allows an affiliated group of corporations to file a consolidated federal income tax return. I.R.C. section 1502 provides the Secretary of the Treasury broad authority to issue regulations regarding all aspects of consolidated returns. There are currently over 300 pages of Treasury Regulations and numerous court decisions, revenue rulings, revenue procedures, private letter rulings, technical advice memoranda, and field service advice addressing this area. In addition, several excellent treatises, including The Consolidated Tax Return319 and Federal Income Taxation of Corporations Filing Consolidated Returns,320 countless articles, and outlines are dedicated to this topic. Because federal consolidated return rules are one of the most complex areas in tax law these treatises should be consulted when addressing a consolidated return issue involving debt discharge or the topics noted below. This section discusses several issues that may arise when the debt of a member of a consolidated group is discharged or, as discussed in greater detail next, is deemed to be discharged.

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

A taxpayer that excludes DOI income under I.R.C. section 108(a) must reduce tax attributes under I.R.C. section 108(b). A taxpayer that makes a basis reduction election under I.R.C. section 108(b)(5) first reduces the basis of depreciable property.321 Consolidated group members may elect to reduce the basis of 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. To make this election, the parent and subsidiary must file a consolidated return for the tax year of the discharge. 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. Thus, a holding company in financial difficulty may be able to take advantage of an I.R.C. section 108(b)(5) election to reduce basis in stock of its subsidiaries, even though the holding company has no depreciable property.322

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

(A) Temporary and Final Regulations

When the DOI income of a member of a consolidated group is excluded from gross income, the taxpayer’s tax attributes must be reduced under I.R.C. section 108(b). In the consolidated group context, the operative issue is the identity of the taxpayer. Two alternatives exist: the taxpayer’s attributes could be the attributes of the group (“single entity”) or simply the separate company attributes of the member with excluded DOI income (“separate member”). Although the IRS has issued contrary guidance in this area, its most recent view adopts the single-entity approach.

The temporary regulations, issued in 2003,323 adopt a hybrid approach to address attribute reduction under I.R.C. section 108(b) when a member of the consolidated group realizes DOI income with respect to debt owed to a creditor that is not a member of the same consolidated group.324 Under the temporary regulations, the debtor-member’s tax attributes are reduced to the extent of the excluded DOI income. If the amount of the debtor-member’s excluded DOI income exceeds its tax attributes, the tax attributes of the other members of the group are reduced.

The temporary regulations introduce an ordering rule for purposes of tax attribute reduction under I.R.C. section 108(b) when a member of a consolidated group has excluded DOI income. Under the general rule, first the debtor-member’s tax attributes are reduced to the extent of the excluded DOI income.325 For this purpose, tax attributes attributable to the debtor-member include three components: (1) the debtor-member’s share of the consolidated tax attributes;326 (2) the debtor-member’s tax attributes that arose in separate return limitation years (SRLYs);327 and (3) the basis of property of the debtor-member. In applying the third of these, the debtor-member may reduce, but not below zero, the stock basis of another member of the consolidated group (a “lower-tier member”). If the stock basis of a lower-tier member is reduced, a special “look-through” rule is activated.

Under the look-through rule,328 the temporary regulations treat the lower-tier member as a debtor-member having DOI income in an amount equal to the reduction in the lower-tier member’s stock basis. As a result of this deemed DOI income, the lower-tier member is required to reduce its tax attributes by the amount of the deemed DOI income.

The application of the general rule and the look-through rule is illustrated in Example 2.6.329

Tax attribute reduction may take the form of the reduction of basis in assets. Basis reduction may trigger the recapture rules of I.R.C. section 1245.330 Recapture may result in certain inequities in the consolidated return context, as explained in the preamble to the temporary regulations:

For example, assume a member (a higher-tier member) realizes excluded COD income that is applied to reduce the higher-tier member’s basis in the stock of another member (a lower-tier member) and, as a result, a corresponding reduction to the basis of property of the lower-tier member is made. The following year, the lower-tier member transfers all of its assets to the higher-tier member in a liquidation to which section 332 applies. Under section 1245, recapture on the lower-tier member’s property that is treated as section 1245 property by reason of section 1017(d)(1) is limited to the amount of the gain recognized by the lower-tier member in the liquidation. However, no similar limitation applies to the stock of the lower-tier member that is also treated as section 1245 property. Therefore, the higher-tier member would be required to include as ordinary income the entire recapture amount with respect to the lower-tier member stock. In addition, when the higher-tier member sells the assets of the former lower-tier member the bases of which were reduced, the higher-tier member would be required to include as ordinary income the recapture amount with respect to such assets. In that case, the group may be required to include in consolidated taxable income the amounts representing the same excluded COD income more than once.

The IRS and Treasury Department believe that it is appropriate for the group to include in income as ordinary income amounts reflecting previously excluded COD income only once. Therefore, to prevent a double inclusion of ordinary income amounts representing the same excluded COD income, these regulations provide that a reduction of the basis of subsidiary stock is treated as a deduction allowed for depreciation only to the extent that the amount by which the basis of the subsidiary stock is reduced exceeds the total amount of the attributes attributable to such subsidiary that are reduced pursuant to the subsidiary’s consent under section 1017(b)(3)(D) or as a result of the application of the look-through rule. This rule has the effect of limiting the ordinary income recapture amount to the amount of the stock basis reduction that does not result in a corresponding reduction of the tax attributes attributable to the subsidiary.331

Under the temporary regulations, if the excluded DOI income exceeds the debtor-member’s tax attributes (without regard to the lower-tier member’s tax attributes reduced under the look-through rule), the ordering rule of the temporary regulations then requires the reduction of (1) consolidated tax attributes attributable to other members and (2) tax attributes attributable to other members that arose in a SRLY to the extent that the debtor-member is a member of the same SRLY subgroup.332 For purposes of this rule, a member’s basis in its assets is not considered a consolidated tax attribute subject to reduction under the temporary regulations. If the excluded DOI income exceeds the debtor-member’s attributes and the attributes referred to in this paragraph, there is no reduction in the amount of the excluded DOI income; nor is any further reduction in attributes or other offset required.

The operation of the consolidated attribute reduction rule is illustrated in Example 2.7.333

The temporary regulations were finalized in March 2005.334 The more significant differences between the final regulations and the temporary regulations are described next.

The final regulations clarify that basis of property is subject to reduction pursuant to the rules of I.R.C. sections 108 and 1017 and Treas. Reg. section 1.1502-28 after the determination of tax for the year during which the member realizes excluded DOI income (and any prior years) and coincident with the reduction of other attributes pursuant to I.R.C. section 108 and Treas. Reg. section 1.1502-28. However, only the basis of property held at the beginning of the tax year following the tax year during which the excluded DOI income is realized is available for reduction.

The final regulations provide that the look-through rule applies when there is a reduction in the basis of stock of a corporation that is a member of the group on the last day of the debtor’s tax year during which the excluded DOI income is realized, but is not a member of the group on the first day of the debtor’s following tax year. For example, P1 may own all of the stock of S1 and S1 owns all of the stock of S2, and these corporations file a consolidated return. In Year 1, P1 realizes excluded DOI income. On the last day of Year 1, P1 sells 50 percent of the stock of S1 to P2. P1 reduces its basis in the 50 percent of the S1 stock that it owns on the first day of Year 2 in respect of its excluded DOI income. The final regulations provide that because S1 and S2 were members of the same group on the last day of the debtor’s tax year during which the excluded DOI income was realized, it is appropriate to apply the single-entity principles reflected in the look-through rule. The regulations also apply the look-through rule when there is a reduction in the basis of stock of a corporation that is not a member of the group on the last day of the debtor’s tax year during which the excluded DOI income is realized (by reason of the application of the next day rule of Treas. Reg. section 1.1502-76), but is a member of the group on the first day of the debtor’s following tax year.

The final regulations confirm that if a member realizes the excluded DOI income and either leaves the group (e.g., by reason of a stock acquisition) or its assets are acquired by a corporation that is not a member of the group in a transaction to which I.R.C. section 381(a) applies (generally a section 368 acquisitive asset reorganization) on or prior to the last day of the consolidated return year during which the excluded DOI income is realized, then the tax attributes that remain after the determination of the tax imposed on the group that belong to members of the group are available for reduction.

The final regulations also address attribute reduction when a taxpayer that is a member of a consolidated group realizes excluded DOI income during the same consolidated return year during which it transfers assets in a transaction to which I.R.C. section 381(a) applies to a corporation that is a member of the group immediately after the transaction. The final regulations provide that, if the tax year of a member during which such member realizes excluded DOI income ends prior to the last day of the consolidated return year and, on the first day of the tax year of such member that follows the tax year during which such member realizes excluded DOI income, such member has a successor member, the successor member is treated as if it had realized the excluded DOI income. Accordingly, all attributes of the successor member listed in I.R.C. section 108(b)(2) (including attributes that were attributable to the successor member prior to the date such member became a successor member) are subject to reduction prior to the attributes attributable to other members of the group. For this purpose, a “successor member” means a person to which the member that realizes excluded DOI income transfers its assets in a transaction to which I.R.C. section 381(a) applies if such transferee is a member of the group immediately after the transaction.

Under Treas. Reg. section 1.1502-76, a corporation that leaves a consolidated group during the tax year generally must file a short-period separate return (or join in the consolidated return of another group) for the portion of the year not included in the consolidated return. If a corporation ceases to be a member during a consolidated return year, it ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends at the end of that day. Under the next-day rule, however, any transaction that occurs on the day the member ceases to be affiliated with the group that is properly allocable to the portion of the subsidiary’s day after the event terminating affiliation must be treated as occurring at the beginning of the following day. The final regulations provide that the next-day rule cannot be applied to treat excluded DOI income as realized at the beginning of the day following the day on which it is realized.

(B) Prior to the Temporary Regulations

The temporary regulations governing tax attribute reduction are effective for discharges occurring after August 29, 2003. Prior to the effective date of the temporary regulations, it had been unclear whether attributes would be reduced under the single-entity approach or the separate-member approach discussed in § 2.10(a)(ii)(A), in part because the IRS had issued conflicting guidance. The IRS’s prior determinations with respect to this issue create uncertainty for discharges that occurred prior to the effective date of the temporary regulations.335 Taking the separate-member approach, the IRS ruled privately that each member of a consolidated return group reduces its own tax attributes, without affecting the tax attributes of other members of the group.336 In a 1991 private letter ruling, the IRS found that “Congress used the term ‘tax payer’ in section 108 with the understanding that the attribute reduction rules would not affect other members of a consolidated group absent the making of an explicit election.”337 The IRS specifically noted that I.R.C. section 1017(b)(3)(D)338 is inconsistent with the single-entity approach. The IRS also discussed the investment adjustment and excess loss account provisions of the consolidated return regulations and concluded that these rules render it unnecessary to reduce attributes of members other than the insolvent members. These were the compelling arguments to support the IRS’s conclusion that “the company by company approach requested would be appropriate.”

In a later field service advice,339 however, the IRS departed from its historical analysis and adopted the single-entity approach, ruling that a consolidated return member that excludes DOI income must reduce the group’s consolidated NOL, even if no part of the consolidated NOL is attributable to the member with excluded income.340 In the field service advice, an insolvent member had DOI income attributable to the cancellation of loans that was excluded from gross income because of the insolvency. The insolvent member claimed that it had no tax attributes to reduce under I.R.C. section 108(b). The IRS disagreed and found that the consolidated NOL should be reduced. Finding that the consolidated NOL attributable to one member is available to reduce the tax liability of all members,341 the IRS stated “it is inappropriate” to limit attribute reduction to one particular group member having the DOI income when all members of the group may offset their income with the consolidated NOL carryover. In the field service advice, the IRS stated that the earlier private letter ruling is incorrect to the extent it indicates that, in I.R.C. section 108(b), Congress used the term “taxpayer” to limit the tax attribute reduction to a single member.

To further muddy the waters, the United States Supreme Court adopted the single-entity approach to determine a member’s losses, albeit in a different context. United Dominion Industries, Inc. v. United States342 involved the determination of how much of a consolidated group’s NOL is attributable to product liability losses. That amount may be carried back over a 10-year period.343 The Court held that the amount eligible for the 10-year carryback must be computed on a consolidated basis, as if the group were a single entity, and not under a separate-member approach. Because the amount of a product liability loss is determined by comparing the amount of the taxpayer’s product liability expenses to its NOL and because the consolidated return regulations recognize only the consolidated NOL (and not the separate NOLs of the members), the Court held that the product liability loss is limited only by the consolidated NOL.

In United Dominion, the Court determined that there is no such item as a separate NOL of a group member, only one consolidated NOL.344 The reach of the United Dominion decision with respect to the I.R.C. section 108(b) reduction of NOLs on a single-entity versus separate-entity basis is unclear for discharges that occurred prior to the effective date of the temporary regulations, but, at a minimum, the case put more pressure on looking exclusively to an individual member’s separate company NOL.

The IRS has reconfirmed its more recent view (reflected in the field service advice just discussed) in Internal Legal Memorandum 201033031,345 which concludes that attribute reduction occurs on a group basis and not a single-entity basis prior to the temporary regulations. The IRS discussed the United Dominion case as support for this position.

(iii) DOI/Stock Basis Adjustments/ELAs

The 2003 temporary regulations addressing attribute reduction modify a complex set of rules for adjusting the basis of the stock of the members of a consolidated group.346 In general, the basis in a member’s stock is increased by the member’s taxable and tax-exempt income and decreased by the member’s taxable loss, noncapital, nondeductible expenses, and distributions with respect to the member’s stock.347

The temporary regulations that address attribute reduction amend pre-existing consolidated return regulations to address basis adjustments. The stock basis rules of Treas. Reg. section 1.1502-32 are amended to provide that a subsidiary’s excluded DOI income increases a member’s stock basis in the subsidiary in an amount corresponding to the reduction in tax attributes (including credits) attributable to any member of the group.348 (The preexisting regulation did not provide for a positive adjustment if the common parent’s tax attribute was reduced; nor did the preexisting regulation provide for a positive adjustment if the tax attribute reduced was a credit.) This rule may create stock basis in the debtor-member if the debtor-member has excluded DOI income in excess of its separate company attributes (with the result that other members of the group had attribute reduction). The increase in the debtor-member’s stock basis is illustrated in Example 2.8.349

The temporary regulations discussed in § 2.10(a)(ii)(A) were finalized in March 2005. The final regulations clarified a point on the timing of basis adjustments. The final regulations provide that the basis adjustments just described resulting from excluded DOI income and attribute reduction are effective in cases in which a subsidiary ceases to be a member of the group on or prior to the end of the consolidated return year during which a member realizes excluded DOI income. Therefore, the regulations clarify that, in those cases, basis adjustments resulting from the realization of excluded DOI income and from the reduction of attributes in respect thereof are made immediately after the determination of tax for the group for the consolidated return year during which the excluded DOI income is realized (and any prior years) and are effective immediately before the beginning of the day following the day the member departs from the group.

Negative investment adjustments that exceed the basis in a member’s stock result in a negative basis in the member’s stock. This negative stock basis is referred to as an excess loss account (ELA).351 Certain events, such as the transfer of the stock with an ELA outside of the consolidated group or the deconsolidation of a member with an ELA, will trigger the ELA into income of the owner of the member’s stock.352 The gain resulting from triggering ELA is treated as a gain from the disposition of the shares so it usually is a capital gain. One important exception to this rule is that gain resulting from the triggering of an ELA is treated as ordinary income to the extent that the member is insolvent.353

One event that triggers an ELA is when stock is deemed to be worthless.354 This generally occurs in two situations:

Temporary regulations issued in 2004 provide that if the inclusion of an ELA is required in connection with the realization of excluded DOI income, then the ELA is included on the return for the tax year that included the date on which the excluded DOI income was realized.356

The 2003 temporary regulations also amend the pre-existing consolidated return regulations relating to the ELA rules.357 Previously, these rules provided that the entire ELA would be recognized as income if a debtor-member had excluded DOI income without a corresponding amount of attribute reduction. It appeared that this rule could cause a $100 million ELA to be recognized as a result of $1 of excluded DOI income in excess of attribute reduction. In addition, it also appeared that under prior rules, the reduction of a credit could result in the triggering of an ELA in full. As a result of the temporary regulations, an ELA is taken into account only to the extent that the excluded DOI income exceeds the amount by which group members’ tax attributes (including credits) are reduced.358

Finally, the temporary regulations amend the rules for loss absorption under Treas. Reg. section 1.1502-21. Generally, these amendments conform the rules governing the apportionment of a consolidated NOL to a member for purposes of carrying that loss to a separate return year with the temporary regulations governing tax attribute reduction.359

As noted, the temporary regulations governing tax attribute reduction are effective only for discharges of indebtedness occurring after August 29, 2003. The amendments to the stock basis rules of Treas. Reg. section 1.1502-32 and the loss apportionment rules of Treas. Reg. section 1.1502-21 are effective for tax years having an unextended return due date after August 29, 2003. The amendment to Treas. Reg. section 1.1502-19 is effective for ELAs taken into account after August 29, 2003.

The amendment to Treas. Reg. section 1.1502-19, however, may be applied retroactively. Taxpayers that recognized an ELA into income as a result of excluded DOI income in excess of the amount of tax attributes reduced should consider applying the amendment to Treas. Reg. sections 1.1502-19 retroactively. In particular, the retroactive application of the amendment would limit the amount of the ELA taken into account to the amount by which the excluded DOI income exceeded the amount of tax attributes reduced.

The amendment to Treas. Reg. section 1.1502-32 may also be applied retroactively. Taxpayers that reduced the tax attributes of the common parent as a result of a subsidiary having excluded DOI income should consider applying the amendment to Treas. Reg. section 1.1502-32 retroactively. In particular, the retroactive application of the amendment would provide a positive basis adjustment to the stock of the subsidiary if a group member’s tax attributes, including those of the common parent, were reduced to offset the subsidiary’s excluded DOI income. The final regulations provide additional effective dates.

(iv) Intercompany Obligation Rules

Members of a consolidated group often lend money to each other. Treas. Reg. section 1.1502-13(g) provides rules for the treatment of intercompany obligations. A new set of regulations under Treas. Reg. section 1.1502-13(g) is generally effective for transactions occurring in consolidated return years beginning on or after December 24, 2008. The regulations effective prior to the new set of regulations are referred to as the “former regulations.”360 Before summarizing the intercompany obligation rules, an overview of the meaning of certain terminology is appropriate.

• A “member” of a consolidated group is a corporation (including the common parent) that is included in the consolidated group.361
• An “obligation of a member” is generally a debt of a member for federal income tax purposes, but it also includes certain securities.362
• An “intercompany obligation” is an obligation between two members of a consolidated group, but only for the period in which both parties are members.363

The intercompany obligation regulations apply generally to three broad categories of transactions: (1) transactions in which all or a part of the rights or obligations under an intercompany obligation is assigned or extinguished within the consolidated group (“intragroup transactions”), (2) transactions in which an intercompany obligation becomes a non-intercompany obligation (“outbound transactions”), and (3) transactions in which an obligation becomes an intercompany obligation (“inbound transactions”). Like the former regulations, the current intercompany obligation regulations provide two main sets of rules: one set for intragroup transactions and outbound transactions and a second set for inbound transactions. The most significant changes in the current intercompany obligation regulations from the former regulations are with respect to the intragroup and outbound transactions, as will be noted.

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

The intercompany obligation regulations include a regime of deemed satisfaction and deemed reissuance that applies to “triggering transactions.” If there is a triggering transaction, then immediately before the triggering transaction, the intercompany obligation is treated for all federal income tax purposes as satisfied by the debtor for cash in an amount generally equal to the obligation’s fair market value.364 The intercompany obligation is then treated as reissued as a new obligation (with a new holding period but otherwise identical terms) for the same amount of cash.365 The deemed satisfaction and reissuance are treated as transactions separate and apart from the triggering transaction.366 In other words, if a triggering transaction occurs, the consequences from the deemed satisfaction and reissuance must be determined first; the parties are then treated as engaging in the actual transaction but with the new obligation.367

There are two categories of triggering transactions: assignment and extinguishment transactions (i.e., intragroup transactions) and outbound transactions. The first category comprises transactions in which a member of a consolidated group realizes an amount, directly or indirectly, from the assignment or extinguishment of all or part of its rights or obligations relating to an intercompany obligation.368 In addition, comparable transactions (such as a mark-to-market of an obligation or a bad debt deduction) in which a member realizes any such amount are triggering transactions in the first category. The second category of triggering transactions is any transaction in which an intercompany obligation becomes an obligation that is not an intercompany obligation.369

In one of the main (and taxpayer-friendly) departures from the former regulations, the current intercompany obligation regulations provide exceptions to the deemed satisfaction and reissuance rules for several transactions that otherwise qualify as triggering transactions.370 Before some of these exceptions are discussed, an important observation should be made. If an exception applies, the tax consequences of a transaction involving intercompany debt are taken into account under normal federal income tax principles subject to the exception that certain other rules in the intercompany obligation regulations continue to apply. For example, if the deemed satisfaction and reissuance rules do not apply due to an exception, the debtor member may continue to realize DOI income and the creditor member may continue to incur a loss. However, the regulations may continue to apply to make the I.R.C. section 108(a) exclusions of DOI income from income inapplicable and to treat what would otherwise be a capital loss to a creditor from the extinguishment of a debt as an ordinary loss under the consolidated return regulations’ “matching rule.”371

Now back to the exceptions to the deemed satisfaction and reissuance rules. There are a total of eight exceptions listed in the regulations: four for intercompany assignments, two for extinguishments of intercompany obligations, and two for outbound transactions. It is beyond the scope of this work to explore the details of each exception, but a summary of some of the more common exceptions for each transaction type is provided.372

The main exception for intercompany assignments is for intercompany exchanges to which I.R.C. section 361(a), I.R.C. sections 332 and 337(a), or I.R.C. section 351 applies in which no amount of income, gain, deduction, or loss is recognized by the creditor or debtor member.373 Another exception is for a transaction in which all the debtor’s obligations under an intercompany obligation are assumed in connection with the debtor’s sale or other disposition of property (other than solely money) in an intercompany transaction in which gain or loss is recognized under I.R.C. section 1001.374 With respect to extinguishment transactions, there is an exception for a transaction in which (i) all or part of the rights and obligations under an intercompany obligation are extinguished in an intercompany transaction, (ii) the adjusted issue price of the obligation is equal to the creditor’s basis in the obligation, and (iii) the debtor’s corresponding item and the creditor’s intercompany item with respect to the obligation offset in amount.375 There is also a “routine modification” exception if the extinguishment occurs in an exchange (or deemed exchange) for a newly issued intercompany obligation and the issue price of the new obligation equals both the adjusted issue price and the creditor’s basis with respect to the extinguished obligation.376

In the outbound category, there is an exception when there is an “intercompany obligation subgroup” (generally, two or more members that include the creditor and debtor and in which the creditor and debtor bear the relationship described in I.R.C. section 1504(a)(1) to each other through a subgroup parent) and all of the members of the subgroup cease to be members of the consolidated group and become members of a new consolidated group.377 In this case, if neither creditor nor debtor recognizes an amount with respect to the intercompany obligation, the transaction is not treated as a triggering transaction.

It is important to note that the general I.R.C. section 108(a) (i.e., for bankruptcy and insolvency) income exclusions do not apply to an existing intercompany obligation.378 This prevents a mismatch in which a creditor member of the group takes a bad debt deduction and the debtor member excludes DOI income. The DOI income and bad debt deduction usually wash, but this needs to be closely analyzed because the regulations are complex and do not always work perfectly.

Although a discussion of every detail in the intercompany obligation regulations and every type of transaction implicating the deemed satisfaction and reissuance regime is beyond the scope of this work, the operation and complexity of these provisions are best conveyed by a few examples, which are based on the examples in the regulations.

(B) Intercompany Obligation Regulations: Application to Inbound Transactions

A separate set of rules governs a non-intercompany obligation that becomes an intercompany obligation.393 Said another way, these rules will apply if a debtor and the holder of the obligation are not members of the same consolidated group and something occurs that causes the debtor and the holder to become members of the same consolidated group. The debtor and holder could become members of the same consolidated group in several ways, such as: (1) the debtor is a member of a consolidated group and another member of the group purchases the obligation from a nonmember; (2) the debtor is a member of a consolidated group and another member of the group purchases the stock of the nonmember/holder of the obligation, causing the holder to become a member of the consolidated group; (3) the holder of the obligation is a member of a consolidated group and a member of the group purchases the stock of the debtor, causing the debtor to become a member of the consolidated group; and (4) the debtor and the holder of the obligation are members of an affiliated group that does not file a consolidated return, and the group makes an election to file a consolidated return.

The following federal income tax consequences will occur if a debt becomes an intercompany debt (and an exception is not applicable):394

• The debt is treated for all federal income tax purposes, immediately after it becomes an intercompany obligation, as satisfied by the debtor for cash in an amount determined under the principles of Treas. Reg. section 1.108-2(f). The debt is then treated as reissued as a new obligation (with a new holding period but otherwise identical terms) for the same amount of cash.395
• The deemed satisfaction and deemed reissuance are treated as transactions separate and apart from the actual transaction (in which the debt becomes an intercompany obligation). Thus, the tax consequences of the actual transaction are determined before the deemed satisfaction and reissuance occurs.396
• DOI income may be excluded from gross income under I.R.C. section 108(a) (i.e., for bankruptcy and insolvency).
• I.R.C. section 108(e)(4) (related-party acquisitions of debt) will not apply.397
• The attributes of all items resulting from the deemed satisfaction are taken into account on a separate-entity basis rather than treating the debtor and holder of the obligation as divisions of the same corporation (the general consolidated return rule). Thus, it may be possible for the debtor to recognize ordinary income from the discharge of indebtedness and the creditor to recognize capital loss or even no loss on the deemed satisfaction of the obligation.398
• Any intercompany gain or loss realized by the creditor is not subject to I.R.C. sections 354 (nonrecognition for shareholder or security holder in a corporation reorganization) or 1091 (wash-sale rules).399

Example 2.18 is the same example as provided in Treas. Reg. section 1.1502-13(g)(7), Example 10.400 The example, however, leaves some questions unanswered (as it did in the former regulations). For instance, how was the $70 deemed satisfaction for fair market value determined? As noted, when a non-intercompany obligation becomes an intercompany obligation, the obligation is deemed to be satisfied in an amount determined under the principles of Treas. Reg. section 1.108-2(f). Thus, as is described in detail next, if an obligation becomes an intercompany obligation because the holder of the obligation becomes a member of the same consolidated group with the debtor, there are two possible amounts for determining the amount of the deemed satisfaction and reissuance. The two alternative amounts are generally the holder’s basis in the obligation or the fair market value of the obligation; the determination of which amount to use is based on how long the obligation was held prior to becoming an intercompany obligation and how it was acquired.

The deemed satisfaction and reissuance amount is most often determined under this rule:

Holder did not acquire the indebtedness by purchase on or less than six months before the acquisition date. Except as otherwise provided in this paragraph (f), the amount of discharge of indebtedness income realized . . . is measured by reference to the fair market value of the indebtedness on the acquisition date if the holder (or the transferor to the holder in a transferred basis transaction) did not acquire the indebtedness by purchase on or less than six months before the acquisition date.401

These were the salient facts in the example immediately above (i.e., the holder (NM) of the debt had owned it for more than six months prior to joining the debtor’s consolidated group), and thus the deemed satisfaction and reissuance amount was determined based on the fair market value of the obligation.

In another scenario, the regulations would provide for the deemed satisfaction and reissuance amount as follows:

Holder acquired the indebtedness by purchase on or less than six months before the acquisition date. Except as otherwise provided in this paragraph (f), the amount of discharge of indebtedness income realized . . . is measured by reference to the adjusted basis of the related holder (or of the holder that becomes related to the debtor) in the indebtedness on the acquisition date if the holder acquired the indebtedness by purchase on or less than six months before the acquisition date. For purposes of this paragraph (f), indebtedness is acquired “by purchase” if the indebtedness in the hands of the holder is not substituted basis property within the meaning of section 7701(a)(42). However, indebtedness is also considered acquired by purchase within six months before the acquisition date if the holder acquired the indebtedness as transferred basis property (within the meaning of section 7701(a)(43)) from a person who acquired the indebtedness by purchase on or less than six months before the acquisition date.402

In this example, if the holder (NM) had purchased the debt within six months of joining the consolidated group, NM’s basis in the debt would have been used as the deemed satisfaction and reissuance amount.

In other circumstances, the debt of a member of a consolidated group that is owned by a nonmember may be purchased by another member of the consolidated group. In this instance, it appears that the Treas. Reg. section 1.108-2(f)(1) would result in a deemed satisfaction and reissuance for an amount equal to the acquiring member’s basis in the acquired debt (an amount that also happens to equal the acquiring member’s purchase price, which presumably would equal the debt’s fair market value).403

§ 2.11 DISCHARGE OF INDEBTEDNESS REPORTING REQUIREMENTS

(a) Information Reporting Requirements for Creditors

The Revenue Reconciliation Act of 1993 added I.R.C. section 6050P to the Code, requiring certain entities to report discharges of indebtedness of $600 or more. The treasury regulations set forth the time, form, and manner of reporting under I.R.C. section 6050P.404

(i) Applicable Entity

In general, an “applicable entity” that discharges $600 or more of the debt of any person must file an information return on a Form 1099-C (Cancellation of Debt).405

An applicable entity includes an executive, judicial, or legislative agency, or an “applicable financial entity,” such as a bank, savings and loan association, or credit union.406 The reporting requirement was later extended to “any organization a significant trade or business of which is the lending of money.”407

(ii) Amount Reported

The applicable entity must report the entire amount of discharged indebtedness income, even though the debtor is not taxed (e.g., one of the I.R.C. section 108(a)(1) exclusions apply).408 Reporting the discharge of interest is not required.409 Multiple discharges are not aggregated for reporting purposes, unless the separate discharges are pursuant to a plan to avoid reporting.410

(iii) Identifiable Event

Information reporting is required only if an identifiable event has occurred.411 The regulations list eight identifiable events:

(iv) Exceptions

There are some exceptions to the reporting requirements. The discharge of nonprincipal amounts (e.g., penalties) in a “lending transaction”420 does not need to be reported. Reporting is not required for the discharge of debt of foreign debtors to foreign branches of U.S. financial institutions.421 An applicable entity is not required to report discharge that is deemed under I.R.C. section 108(e)(4), the related-party acquisition rule.422 Reporting the release of a co-obligor on the debt is not required, if the other debtors remain liable for the entire unpaid amount.423 Similarly, no information reporting is required for guarantors.424

(v) Multiple Debtors

The reporting requirements for a discharged debt with multiple debtors depend on when the debtors incurred the debt and the amount of the debt. In general, if the debt discharged is less $10,000 or if the debt was incurred before January 1, 1995 (regardless of the amount), then reporting is only required for the primary, or first-named, debtor. But if the discharged debt is $10,000 or more and the debt was incurred after December 31, 1994, then the reporting requirements apply to each debtor. Nevertheless, only one information return is required for multiple debtors that are husband and wife.425 Unless clear and convincing proof shows that multiple debtors are not jointly and severally liable for the debt, then the entire amount of the discharge is reported for each debtor.426

(vi) Multiple Creditors

If discharged indebtedness is owned (or treated as owed for federal income tax purposes) by more than one creditor, then each creditor that is an applicable entity must comply with the reporting requirements. A lead bank, or other designee, may file the information return on behalf of the other creditors.427

(vii) October 2008 Final and Temporary Regulations

As discussed, the regulations require certain entities to report a discharge of indebtedness if an identifiable event has occurred. One identifiable event is the expiration of a 36-month nonpayment testing period during which no payment was made. There is a rebuttable presumption that an identifiable event occurred if no payment is received for 36 months. This presumption may be rebutted by a creditor who has engaged in significant, bona fide collection activities.

The 36-month rule was drafted at a time when I.R.C. section 6050P applied only to financial institutions, credit unions, and certain federal agencies (such as the FDIC) and did not extend to executive, judicial, or legislative agencies, or to entities engaged in a significant trade or business of lending money. Commentators were concerned that application of the 36-month rule to entities engaged in a significant lending business would prematurely trigger a reporting requirement when such an entity had not legally or practically discharged a debt. In October 2008, the regulations were modified so as not to apply the nonpayment testing period as an identifiable event to an organization that is an applicable entity because it is (i) in the trade of business of lending money or (ii) an executive, judicial, or legislative agency.

(b) Filing Requirements for Debtors

Debtors are required to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), upon either the exclusion of income or the reduction of tax attributes under I.R.C. section 108.

The instructions to Form 982 provide that the form should be filed with a timely filed (including extensions) tax return for the tax year that the discharge of indebtedness is excluded from gross income under section 108(a). Form 982 with instructions is reprinted in § 2.7(b) as Exhibit 2.1.

Recall that an identifiable event triggers reporting under I.R.C. section 6050P. The debtor could report DOI income, even though the debt remains legally enforceable. The creditor’s subsequent collection actions could cause the debtor to repay the obligation, either voluntarily or involuntarily. In this situation, the debtor should file an amended tax return for the year DOI income was reported.428

1 284 U.S. 1 (1931).

2 Prior to the Tax Reform Act of 1986, an exception was also provided for “qualified business indebtedness.” I.R.C. § 108(d)(4) (1982).

3 See § 2.10 for a discussion of consolidated return regulations providing that the I.R.C. § 108(a) exclusions are not available for certain intercompany obligations.

4 I.R.C. § 108(a)(1)(A).

5 I.R.C. § 108(a)(1)(B).

6 I.R.C. § 108(a)(1)(C).

7 I.R.C. §§ 108(a)(1)(D), 108(c).

8 Also referred to by some authors as cancellation of debt (COD) income.

9 499 U.S. 573 (1991).

10 Id. at 581 (emphasis added). But see Technical Advice Memorandum 200606037 (Feb. 10, 2006) (discussing the exchange of debt for stock pursuant to a conversion right; further discussion at infra note 119).

11 71 F.3d 1040, aff’g 104 T.C. 61 (1995).

12 104 T.C. 61, 73 (1995) (emphasis added).

13 Foreign exchange gain is generally income under a provision of section 988 that did not exist when Philip Morris incurred the gain.

14 330 F.2d 520 (6th Cir. 1964).

15 Philip Morris, 71 F.3d at 1043; 104 T.C. at 72–73.

16 “Indebtedness” for purposes of I.R.C. section 108 includes debts for which the taxpayer is liable (recourse debt) or debts on property owned by the taxpayer, such as a nonrecourse mortgage on real property. I.R.C. § 108(d). Given this definition, both recourse and nonrecourse debts should be subject to the provisions of I.R.C. § 108. For more details, see § 2.9.

17 131 B.R. 793 (Tex. N.D. 1991), aff’d, 84 F.3d 433 (5th Cir. 1996).

18 In Coburn v. Commissioner, 90 T.C.M. (CCH) 563 (2005), the Tax Court held that an individual who defaulted on a loan did not realize DOI income when he abandoned the collateral for the loan. According to the note’s terms, the individual was not discharged from the obligation when he abandoned the collateral. The court did not decide whether the debt was recourse or nonrecourse because that determination would not affect the court’s conclusion that there was not DOI income. If the debt were nonrecourse, gain (not DOI income) could have been realized at the time the collateral was abandoned. See infra, discussion at note 317. If the debt were recourse, there would be no DOI income realized because abandonment of the collateral would not discharge the obligor from the debt obligation. The court pointed out that “[u]nlike collateral securing a nonrecourse liability, the collateral securing a recourse liability does not represent the only source of repayment.”

19 See, e.g., DiLaura v. Commissioner, 53 T.C.M. (CCH) 1077 (1987); Juister v. Commissioner, 53 T.C.M. (CCH) 1079 (1987), aff’d, 875 F.2d 864 (6th Cir. 1989).

20 87 T.C. 1412 (1986).

21 284 U.S. 1 (1931).

22 Although calculation of the adjusted issue price is the more controversial part of this equation, sometimes the valuation of the repurchase price is at issue. For example, in Yamamoto v. Commissioner, the taxpayer owed $1.6 million to one corporation and was owed $1.7 million by another corporation. The taxpayer owed both the creditor corporation and the debtor corporation. To satisfy his $1.6 million obligation, the taxpayer assigned the $1.7 million note from the debtor corporation to the creditor corporation. The court found that the fair market value of the $1.7 million note was zero (i.e., no one would purchase the note due to the poor financial condition of the debtor corporation). Because the taxpayer used a worthless note to satisfy his $1.6 million obligation to the creditor corporation, he had DOI income of $1.6 million when the worthless note was assigned. Yamamoto v. Commissioner, 60 T.C.M. (CCH) 1050 (1990), aff’d, 958 F.2d 380 (9th Cir. 1992).

23 T.D. 8746, 62 Fed. Reg. 68173 (Dec. 31, 1997).

24 848 F.2d 1232 (Fed. Cir. 1988), rev’g 11 Ct. Cl. 375 (1986).

25 21 T.C. 600 (1954), nonacq. 1955-2 C.B. 10.

26 22 B.T.A. 1277 (1931), nonacq. 1931-2 C.B. 99, aff’d, 61 F.2d 751 (2d Cir. 1932). Rail Joint is an important early decision that applied the accession-to-wealth theory, discussed by the courts in both Fashion Park and United States Steel. However, Rail Joint involved a different factual situation, a corporation’s repurchase of bonds originally issued to its shareholders as dividends. The corporation did not realize DOI income because there was no freeing of assets. The analysis in Rail Joint could be different under a later-enacted I.R.C. § 108(e)(6). See § 2.4(b).

27 Treas. Reg. § 1.61-12(c)(3) (1972).

28 See supra note 26.

29 93 T.C.M. (CCH) 1055 (2007).

30 The discussion that follows is based on Liquerman, Beware of Analysis in Recent COD Case, 2007 TNT 132-22.

31 284 U.S. 1, 3 (1931).

32 See, e.g., Hahn citing Jelle v. Commissioner, 116 T.C. 63, 67 (2001).

33 See Hahn citing Harris v. Commissioner, 34 T.C.M. (CCH) 597 (1975), aff’d without published opinion, 554 F.2d 1068 (9th Circuit 1977); Jelle, supra note 32; Earnshaw v. Commissioner, 84 T.C.M. (CCH) 146 (2002); Seay v. Commissioner, 33 T.C.M. (CCH) 1406 (1974).

34 61 F.2d 751 (2d Cir. 1932), aff’g 22 B.T.A. 1277 (1931).

35 21 T.C. 600 (1954).

36 93 T.C.M. 1055 (omission in original).

37 Although the Tax Court does not make the point, it is implicit in the earlier decisions that the court will look to the inflow of assets to a debtor from the overall transaction when determining issue price. That is, cash was not received by the corporation in Rail Joint because the debt was distributed as a dividend and the cash received in Fashion Park on stock that was subsequently redeemed with a note was less than the amount ultimately paid to satisfy the note.

38 848 F.2d 1232 (Fed. Cir. 1988).

39 Treas. Reg. § 1.61-12(c)(3) (1972). This is the same regulation quoted by the Tax Court in Hahn.

40 The IRS obviously believed that if the issue price of the obligation in United States Steel was determined by reference to the bond discount rules, the issue price of the debt would have been $165, thereby resulting in DOI when such obligation was satisfied with $120. An in-depth analysis of the bond discount rules, however, is beyond our scope here.

41 This issue was not discussed in the preamble to the regulation in proposed (61 Fed. Reg. 33396 (June 27, 1996)) or final form (T.D. 8746, 62 Fed. Reg. 68173 (Dec. 31, 1997)). We will not delve into whether the change to the regulation to define issue price by reference to the OID rules for DOI purposes would be upheld as valid if challenged.

42 As noted, a detailed discussion of the OID rules is beyond our scope. However, see I.R.C. § 1275(a)(4), which provides that “[a]ny debt obligation of a corporation issued by such corporation with respect to its stock shall be treated as if it had been issued by such corporation for property.”

43 437 F. Supp. 733 (D.S.C. 1977).

44 82 T.C. 638 (1984).

45 1984-2 C.B. 34.

46 Treas. Reg. § 1.301-1(m). The distribution is treated as a dividend to the extent of the corporation’s earnings and profits, then as a return of the shareholder’s basis in the stock, and finally as a capital gain. I.R.C. § 301(c). See § 2.10 regarding debt cancellation between members of a consolidated group.

47 See Rev. Rul. 2004-79, 2004-2 C.B. 106. Rev. Rul. 2004-79 suggests another approach, which determines fair market value by reference to the debt’s adjusted issue price under I.R.C. §§ 1273 and 1274. For an analogous discussion, see § 2.9, Example 2.11.

48 See Combrink v. Commissioner, 117 T.C. 82 (2001).

49 Nemark v. Commissioner, 311 F.2d 913, 915 (2d Cir. 1962); Denny v. Commissioner, 33 B.T.A. 738 (1935); Lehew v. Commissioner, 54 T.C.M. (CCH) 81 (1987); Treas. Reg. § 1.61-12(a).

50 P.L.R. 8315021 (Jan. 7, 1983).

51 Treas. Reg. §§ 1.83-1(a)(1), 4(c) In Rev. Rul. 2004-37, 2004-1 C.B. 583, an employee issued a recourse note to his employer in satisfaction of the exercise price of a stock option, and the employee and employer later reduced the principal amount of the note. The IRS determined that the employee recognizes compensation income. Thus, compensation treatment trumps purchase price adjustment treatment. See § 2.5(b).

52 The issue of valuation and the bifurcated treatment discussed in § 2.3(a)(iv) could similarly arise in the gift context. For instance, assume a debt from a son to his mother in the amount of $100 has depreciated in value to $85 due to interest rate fluctuations. If the mother discharges the indebtedness, one approach would be to treat $85 as a gift and $15 as DOI income. See I.R.C. § 102.

53 318 U.S. 322 (1943).

54 336 U.S. 28 (1949).

55 S. Rep. No. 1035, 96th Cong. 2d Sess. 19 n. 22 (1980). See also Plotinsky v. Commissioner, 96 T.C.M. (CCH) 292 (2008).

56 50 T.C. 803 (1968), acq., 1969-2 xxiv.

57 284 U.S. 1 (1931).

58 50 T.C. at 813, citing Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir. 1932) and Fashion Park, Inc. v. Commissioner, 21 T.C. 600 (1954).

59 50 T.C. at 813. Case law addresses this concept in other situations. See Bradford v. Commissioner, 233 F.2d 935 (6th Cir. 1956); Eagle Asbestos & Packing Co. v. United States, 348 F.2d 528 (Ct. Cl. 1965); Yale Avenue Corp. v. Commissioner, 58 T.C. 1062 (1972). See also P.L.R. 201027035 (July 9, 2010) (no DOI upon the prepayment of a contingent liability; the liability in question was the liability to make payment under a tax-sharing agreement and was contingent on certain unknown factors, such as future tax rates and future earnings).

60 Preslar v. Commissioner, 167 F.3d 1323, 1327 (10th Cir. 1999). See, e.g., P.L.R. 200243034 (July 26, 2002) (no DOI income from the discharge of unliquidated tort and environmental claims).

61 916 F.2d 110 (3d Cir. 1990), rev’g 92 T.C. 1084 (1989).

62 See also Vanguard Recording Society v. Commissioner, 418 F.2d 829 (2d Cir. 1969) (taxpayer debited accounts payable and credited an earned surplus account to dispose of an ancient, unexplained control account; this did not result in DOI income because there was no evidence of an underlying debt).

63 167 F.3d 1323, 1327-29 (10th Cir. 1999).

64 See Earnshaw v. Commissioner, 84 T.C.M. (CCH) 146 (2002) (applying Preslar holding that the contested liability doctrine does not apply to liquidated debt and finding that credit card finance charges and late payment fees do not create a liquidated debt).

65 61 T.C.M. (CCH) 1697 (1991).

66 Id. at 1698.

67 See § 2.6(e) for a discussion of the tax benefit rule.

68 Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370, 384 (1983).

69 The criteria used to judge the nature of an instrument are complex and involve the interaction of numerous factors that have been applied differently by different circuit courts. In one cornerstone decision, the Third Circuit looked to the following factors: (1) intent of the parties; (2) identity between creditors and shareholders; (3) extent of participation in management by the holder of the instrument; (4) ability of the corporation to obtain funds from outside sources; (5) “thinness” of the capital structure in relation to debt; (6) risk; (7) formalities; (8) relative position of the obligees as to other creditors; (9) voting power of the holder; (10) fixed rate of interest; (11) contingency on the repayment obligation; (12) source of interest payments; (13) fixed maturity date; (14) provision for redemption by the corporation; (15) provision for redemption at the option of the holder; and (16) timing of the advance with reference to the organization of the corporation. Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968).

70 P.L.R. 9317020 (Jan. 27, 1993). See also P.L.R. 9105042 (Feb. 27, 1990).

71 462 F.2d 712 (5th Cir. 1972), aff’g 29 T.C.M. (CCH) 817 (1970).

72 This is a simplification of the facts. The Plantation Patterns fact pattern is more complicated—the wife was the sole shareholder of the corporation and her husband guaranteed the debentures. The court found that the husband completely controlled the wife’s stock and held that the husband was the constructive owner of the stock. Plantation Patterns, 462 F.2d at 722.

73 The cancellation of a debt may be a corporate distribution. See § 2.3(a)(iv).

74 For other cases addressing the timing of DOI income, see United States v. Ingalls, 399 F.2d 143 (5th Cir. 1968); Estate of Broadhead v. Commissioner, 391 F.2d 841 (5th Cir. 1968); Estate of Shapiro v. Commissioner, 53 T.C.M. (CCH) 317 (1987). See also Significant Service Center Advice 200235030 (June 3, 2002).

75 Cozzi v. Commissioner, 88 T.C. 435, 445 (1987) (holding that partners had DOI income from discharge of the partnership’s debt in the year that the source of the debt payment (a film production agreement) became worthless and not in the later year of a debt settlement agreement; the identifiable act was the failure to make scheduled final payment under the film production agreement, which was clear evidence of abandonment). The Cozzi court cited United States v. S.S. White Dental Manufacturing Co., 274 U.S. 398 (1927) (noting that any identifiable event that fixes the loss with certainty may be taken into consideration). Accord Great Plains Gasification v. Commissioner, 92 T.C.M. (CCH) 534 (2006). See also Fidelity-Philadelphia Trust Co. v. Commissioner, 23 T.C. 527 (1954) (finding that when the taxpayer, a bank, transferred unclaimed, dormant, and inactive deposit accounts to its surplus account, thus closing out the unclaimed deposit accounts, the bank’s book entry was the identifiable event; holding this created DOI income because the bank was not likely to have to honor obligations to the depositors in question after the book entry (and after the depositors’ accounts were closed)); Ellis v. Commissioner, T.C. Summ. Op. (Dec. 1, 2005) (finding taxpayer realized DOI income absent creditor’s formal release from debt; according to the court, “our practical assessment of the facts and circumstances is that the debt will never have to be paid and has been discharged.”) But see Michael Friedman v. C.I.R., 216 F.3d 537 (2d Cir. 2000) (applying the identifiable event test, but holding that S corporation shareholders did not have DOI income, even though it appeared clear that the S corporation debt would not be repaid, because there was no identifiable event to fix a discharge of indebtedness where the bankruptcy trustee was actively administering the bankruptcy estate, collecting accounts receivable, seeking buyers for salable assets, and filing reports with the bankruptcy court and where claims with highly uncertain values continued to be negotiated throughout the course of the bankruptcy).

76 T.C. Summary Opinion 2001-74 (2001).

77 318 F.3d 924 (9th Cir. 2003), rev’g in part, aff’g in part, and remanding, 106 T.C. 184 (1996).

78 Applying the Centennial Savings principles (see § 2.3(a)(i)) to the $10 million advance seems to show that the Ninth Circuit missed the mark because the Raiders did not have DOI income. Irwindale did not forgive an obligation that the Raiders incurred at the outset of the debtor-creditor relationship. Because repayment of the $10 million advance was not required under the terms of the MOA, there was no release of an obligation to repay. The Raiders did have income as a result of the advance, but that income does not appear to be DOI income.

79 Chief Counsel Advice 200844015 (Feb. 26, 2008).

80 See supra note 75, discussion of Michael Friedman.

81 Treas. Reg. § 1.61-12(c)(2)(ii).

82 For special ordering rules for acquisitions of debt by a related party that is a member of the same consolidated group, see § 2.10(a)(iv)(B) of this text.

83 See, e.g., Technical Advice Memorandum 9541006 (July 5, 1995) (two S corporations, S1 and S2, are owned, respectively, by husband and wife; debt of S1 acquired at a discount from bank by S2; pursuant to I.R.C. § 108(e)(4), S1 has DOI income).

84 T.D. 8460, 57 Fed. Reg. 61805 (Dec. 29, 1992) (preamble).

85 I.R.C. § 108(e)(4) provides that “regulations shall provide for such adjustments in the treatment of any subsequent transactions involving the indebtedness.” Although I.R.C. § 108(e)(4) is generally applicable to transactions after December 31, 1980, and the rules of Treas. Reg. § 1.108-2 are applicable over 10 years later, to transactions after March 21, 1991, the statutory language could be interpreted as creating self-executing regulations. That is, the treatment is available whether the government issues regulations or not. Additionally, before the regulations were issued, a successful step transaction doctrine argument could apply the related party rule to some indirect acquisitions of debt and stock (e.g., that took place on the same day or pursuant to the same commitment); but the result would have been unclear for other indirect acquisitions (e.g., if the two steps were stretched out over a significant period of time). See, e.g., Rev. Rul. 91-47, 1991-2 C.B. 16 (applying step transaction doctrine to recast transaction where there was no business purpose and the primary purpose for the transaction was the avoidance of DOI income). See also Lipton, Stephens, and Free- man, Regs. Increase Gain Potential if Related Party Acquires Debt, 74 J. Tax’n 354 (1991).

86 The holder group consists of the holder and all persons who are both related to the holder before the holder becomes related to the debtor and are related to the debtor after the holder becomes related to the debtor. Treas. Reg. § 1.108-2(c)(5).

87 56 Fed. Reg. 12135 (March 22, 1991) (preamble).

88 Notice 91-15, 1991-1 C.B. 319.

89 The form of the attachment is identified in Treas. Reg. section 1.108-2(c)(4)(iv).

90 Treas. Reg. § 1.108-2(c)(4)(ii).

91 Treas. Reg. § 1.108-2(c)(4)(iii).

92 Treas. Reg. § 1.108-2(c)(4)(i).

93 Treas. Reg. § 1.108-2(c)(4)(v).

94 Treas. Reg. § 1.108-2(f).

95 See Rev. Rul. 2004-79, 2004-2 C.B. 106 (analyzing a direct related party acquisition under I.R.C. § 108(e)(4)).

96 See Treas. Reg. § 1.108-2(e).

97 For a discussion of the consolidated tax return regulations, see § 2.10.

98 See § 2.10, Examples 2.12 and 2.13 regarding the cancellation of a subsidiary’s debt by its parent corporation in the consolidated group context.

99 S. Rep. No. 1035 96th Cong., 2d Sess. 19, n. 22 (1980).

100 16 T.C.M. (CCH) 49 (1957) (treating the bad debt deduction as a nonbusiness bad debt deduction).

101 Cf. Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955) (holding that, under similar facts, cancellation of a debt to a corporation that was insolvent both before and after the cancellation was not a contribution to capital).

102 229 F.2d 241 (2d Cir. 1956), aff’g 22 T.C. 1152 (1954). Lidgerwood and Mayo were both decided before I.R.C. § 108(e)(6) was enacted.

103 Lidgerwood at 243. The Second Circuit cited Bratton v. Commissioner, 217 F.2d 486 (6th Cir. 1954) to support its holding, but distinguished and disagreed with Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955) (discussed supra note 101).

104 See, e.g., Plante v. Commissioner, 168 F.3d 1279 (11th Cir. 1999); Bratton v. Commissioner, 217 F.2d 486 (6th Cir. 1954). See also Carroll-McCreary v. Commissioner, 124 F.2d 303 (2d Cir. 1941) (holding that debt discharge, which made an insolvent corporation solvent, was a capital contribution, not DOI income); Hartland Assoc. v. Commissioner, 54 T.C. 1580 (1970), nonacq., 1976-2 C.B. 3 (holding that taxpayer was not entitled to a bad debt deduction; rather discharge was a capital contribution to a corporation in a poor financial position that continued to worsen (unclear whether the corporation was insolvent)).

105 Field Service Advice 199915005 (Dec. 17, 1998).

106 But see Carroll-McCreary, 124 F.2d 303, which comes to the opposite conclusion and treats the full amount of the discharge as a capital contribution when the discharge caused the corporation to become solvent.

107 See, e.g., Huntington-Redondo Co. v. Commissioner, 36 B.T.A. 116 (1937); Rev. Rul. 63-57, 1963-1 C.B. 103.

108 Treas. Reg. § 1.446-2.

109 Field Service Advices 199922034 (March 3, 1999), 199926018 (March 30, 1999), and 200006003 (June 11, 1999).

110 See Liquerman and Yeadon, Section 108(e)(6): Can It Do More Than Determine COD Income, forthcoming in Tax Notes, analyzing this issue in greater detail and concluding that the better result is that the capital contribution of debt should generally not result in a deemed/constructive payment of interest for withholding purposes or any purposes beyond the scope of determining DOI absent the application of certain I.R.C. sections in certain limited circumstances. See, e.g., I.R.C. §§ 482 and 7872.

111 For purposes of simplicity, it is assumed that the original issue discount provisions of the I.R.C. do not cover the debt instrument. If those provisions apply, a cash-method taxpayer may be required to include in income the original issue discount as it accrues, which would be reflected in the creditor’s basis in the debt. See generally I.R.C. §§ 1271–1274 and accompanying regulations.

112 I.R.C. § 108(e)(6) overruled Putoma Corp. v. Commissioner, 601 F.2d 734 (5th Cir. 1979), which would have treated the entire $1,200 as a tax-free contribution of capital. The discharge would also not be excluded under I.R.C. § 108(e)(2), which is discussed in § 2.5(a), because the payment of the interest by an accrual-method corporation would not result in a deduction to such corporation.

113 See supra note 108 and infra note 155 discussing interest payment ordering rules.

114 See, e.g., Fender Sales v. Commissioner, T.C. Memo 1963-119. This view is not necessarily consistent with the most recent IRS positions taken on this issue in the withholding area. See § 2.4(b)(ii).

115 However, as noted above in § 2.4(b)(ii) of this text, in certain circumstances specific I.R.C. sections such as 482 and 7872 could result in deemed payment.

116 Commissioner v. Motor Mart Trust, 156 F.2d 122 (1st Cir. 1946); Commissioner v. Capento Securities Corp., 140 F.2d 382 (1st Cir. 1944).

117 For authorities and commentary under the stock-for-debt exception, see former I.R.C. § 108(e)(10), Treas. Reg. §1.108-1, Alcazar Hotel, Inc. v. Commissioner, 1 T.C. 872 (1943); Rev. Rul. 92-52, 1992-2 C.B. 34; Rev. Rul. 69-135, 1969-1 C.B. 198; Rev. Rul. 59-222, 1959-1 C.B. 80; P.L.R. 8852039 (Oct. 4, 1988); Lipton, Debt-Equity Swap for Parent-Subsidiary: A Current Analysis of a Useful Technique, 59 J. Tax’n 406 (1983).

118 See § 2.7(a). The repeal of the stock-for-debt exception applies to stock transferred after December 31, 1994. Later transfers will continue to be subject to the stock-for-debt exception only if they were made pursuant to title 11 or similar cases filed on or before December 31, 1993.

119 In Technical Advice Memorandum 200606037 (Feb. 10, 2006), the IRS found that the conversion of certain convertible preferred securities (by the holders of such securities) into common stock gives rise to DOI income. The IRS concluded that the conversion of the convertible preferred securities into the corporation’s common stock, when the fair market value of the common stock was less than the adjusted issue price of the convertible preferred securities, resulted in DOI income for purposes of I.R.C. §§ 61(a)(12) and 108 and Treas. Reg. § 1.61-12(c)(2)(ii). In the facts underlying the Technical Advice Memorandum, the Taxpayer established a grantor trust (Trust) to issue convertible preferred securities (CPSs). The CPSs issued by Trust were convertible into shares of Taxpayer’s no-par-value common stock. Each CPS was convertible at any time, at the option of the holder, into shares of Taxpayer’s common stock. Trust used the proceeds from the issuance of its common securities and the CPSs to purchase Taxpayer’s convertible junior subordinated debentures. Taxpayer’s convertible junior subordinated debentures were the sole assets of Trust. In general, the CPSs were guaranteed by Taxpayer with respect to distributions and amounts payable upon liquidation or redemption. On Date 2 (a date in Tax Year 1), Taxpayer’s board of directors established a committee to evaluate the possibility of issuing shares of Taxpayer’s common stock in exchange for the retirement of either Taxpayer’s publicly traded debt or the CPSs. The committee was authorized to approach debt holders with the offer of the exchange of Taxpayer’s common stock for outstanding debt. On Date 3 (a date in Tax Year 1), Taxpayer petitioned for chapter 11 bankruptcy and stopped all payments to Trust. In Tax Year 1, some holders of the CPSs converted their CPSs into shares of Taxpayer’s common stock in accordance with their conversion right (under the original terms of the CPSs) at a time when the fair market value of Taxpayer’s common stock was less than the adjusted issue price of the CPSs. No offer was made in connection with conversion of the CPSs on any terms other than the original terms of the CPSs. In the Technical Advice Memorandum, the IRS found that under Treas. Reg. § 1.61-12(c)(2)(ii), an 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. § 1.1275-1(b)). The amount of DOI income is equal to the excess of the adjusted issue price over the repurchase price. I.R.C. § 1.61-12(c)(2)(ii) refers to I.R.C. § 108 and the regulations thereunder for additional rules relating to income from discharge of indebtedness. Pursuant to I.R.C. § 108(e)(8), for purposes of determining income of a debtor from DOI, if a debtor corporation transfers stock to a creditor in satisfaction of its indebtedness, such corporation shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock. The legislative history to the predecessor to I.R.C. § 108(e)(8) provides:

The House bill provides that a debtor corporation realizes income from discharge of indebtedness when it satisfies its debt with stock having a fair market value less than the principal of the debt. This rule applies where the principal amount of a corporate debt is discharged, including by reason of the exercise of a conversion right by the holder of the debt . . . [I.R.C. § 1032] does not prevent the recognition of this income from the discharge of indebtedness.

H.R. Rep. No. 98-861 (Conf. Rep.), 98th Cong., 2d Sess. 829 (1984), 1984-3 C.B. (Vol. 2) 1, 83. Based on Centennial, discussed supra in § 2.3(a)(i), Taxpayer argued that there can be no DOI income when debt is converted into common stock in accordance with the terms of the original debt instrument. Accordingly, because the conversion of the CPSs into Taxpayer’s stock in this case was pursuant to the original terms of the CPSs, Taxpayer argued there is no DOI income. The IRS did not believe Centennial controlled because the case did not address I.R.C. § 108(e)(8). Thus, the operation of I.R.C. §§ 61(a)(12) and 108 and Treas. Reg. § 1.61-12(c)(2)(ii) resulted in DOI income on the conversion of the CPSs into Taxpayer’s common stock at a time when the fair market value of Taxpayer’s common stock was less than the adjusted issue price of the CPSs.

120 For purposes of simplicity, this example does not take into consideration the tax effects of market discount rules of I.R.C. §1276.

121 P.L.R. 9018005 (Nov. 15, 1989) (reviewed by the Treasury).

122 P.L.R. 9830002 (Mar. 20, 1998).

123 P.L.R. 200537026 (June 17, 2005).

124 April 23, 2010.

125 See also P.L.R. 9010077 (Dec. 14, 1990) (issuance of preference stock to a 90.28 percent shareholder as consideration for subordinated debt is treated as stock-for-debt exchange).

126 In general, I.R.C. § 351 requires a transfer of property to a controlled corporation solely in exchange for the controlled corporation’s stock. The transferee corporation must be controlled immediately after the property transfer by the transferors. “Control” for this purpose means ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each class of nonvoting stock. I.R.C. § 368(c); Rev. Rul. 59-259, 1959-2 C.B. 115.

127 Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989); Rev. Rul. 64-155, 1964-1 C.B. 38; P.L.R. 9623028 (Mar. 7, 1996); P.L.R. 9335024 (June 3, 1993); P.L.R. 9215043 (Jan. 14, 1992).

128 P.L.R. 9050031 (Sept. 17, 1990) (capital-contribution rule governs the cancellation of lower-tier subsidiary’s debt to common parent corporation preceding spin-off of debtor); P.L.R. 8927051 (Apr. 12, 1989) (contribution of debt by two individual shareholders treated as capital contribution; the adjusted basis of each shareholder’s stock interest increased by their basis in the debt); P.L.R. 8844032 (Aug. 8, 1988) (the capital-contribution rule applies to the contribution of debt owed to a shareholder with a 50.01 percent direct interest and a 24.99 percent indirect interest in the debtor corporation; DOI income is the excess of the principal amount of the debt over the shareholder’s adjusted basis in the debt); P.L.R. 8813041 (Dec. 31, 1987) (capital-contribution rule controlled where debt of a wholly owned subsidiary is canceled by parent corporation). See also P.L.R. 9114020 (Jan. 4, 1991) (I.R.C. § 108(e)(6) applied in the case of brother-sister corporations where (1) S1 was indebted to S2, (2) S2 merged with S3, (3) parent contributed the stock of S1 to S3, and (4) S3 canceled the S1 note). The IRS has also punted on the issue because neither rule triggered DOI income. See Technical Advice Memorandum 9822005 (Jan. 16, 1998); P.L.R. 9830002 (Mar. 20, 1998) (U.S. subsidiary issues stock in cancellation of debt to its foreign parent, foreign grandparent, and foreign great-grandparent corporations. The IRS notes there is an issue as to whether the issuance of stock is a meaningless act and thus whether I.R.C. § 108(e)(6) capital contribution rules or I.R.C. § 108(e)(8) stock-for-debt rules apply to determine DOI income. Because the parent, grandparent, and great-grandparent are separate corporations, the issuance of stock was not meaningless and would be respected, and thus the I.R.C. § 108(e)(8) stock-for-debt rule applies).

129 See Potter and Harris, Unintended Tax Consequences from Intercompany Debt Cancellations, Corporate Taxation, 3 (September/October 2010).

130 See G.M. Trading Corp. v. Commissioner, 121 F.3d 977 (5th Cir. 1997), rev’g 103 T.C. 59 (1994). This authority is controversial, in part because the IRS has continued to follow the Tax Court decision reversed by the Fifth Circuit. See Field Service Advice 200123008 (Feb. 27, 2001). But see Kohler v. United States, 468 F.3d 1032 (7th Cir. 2006). The Kohler court stated that it is “dubious” of the G.M. Trading Corp. approach. However, it does not appear that the Kohler decision (or dicta in Kohler) criticized the bifurcation of a transaction into an exchange and a capital contribution, but rather it appears to endorse such treatment. First, the Seventh Circuit held that the transaction would not be bifurcated because the overpayment was more akin to a payment for services, as opposed to a capital contribution. Second, the court noted that under appropriate circumstances the difference between a rate paid and a bottom rate could be considered a contribution to capital, thus implicitly endorsing a bifurcation view.

131 Under the stock-for-debt rule, the $100 debt would be satisfied with $100, resulting in no DOI income. Under the capital-contribution rule, the $100 debt would be deemed satisfied by the corporation in an amount equal to the shareholder’s basis in the debt ($100 in the facts), also resulting in no DOI income.

132 A shareholder’s basis in the debt may be less than fair market value for many reasons, including: (1) The stock and a debt security were received upon the creation of the debtor corporation on or before October 2, 1989 (the effective date of the 1989 Tax Act that treated securities received in an I.R.C. § 351 transfer as boot), and the basis of the assets transferred was apportioned to the stock and debt based on relative fair market of the stock and debt received; (2) if (a) an accrual-basis corporation, owes a cash-basis shareholder, $1,000, (b) a consolidated return is not filed that includes the corporation and the shareholder, and (c) the debtor corporation accrues and deducts (but does not pay) $300 of interest, then the shareholder’s basis in the debt will be $1,000 and the face will be $1,300; or (3) the shareholder may have acquired the corporation’s debt from an unrelated party at a discount prior to the shareholder’s acquisition of the stock of S. If I.R.C. § 108(e)(4) (acquisition by related member treated as an acquisition by the member itself) does not apply, P’s basis in the debt will be less than face.

133 I.R.C. § 368(a)(1)(E).

134 I.R.C. § 351(d)(2).

135 109 B.R. 51 (Bankr. S.D.N.Y. 1990), aff’d in part, rev’d in part, 961 F.2d 378 (2d Cir. 1992).

136 Pub. L. No. 103-66, § 13226(a)(1)(A)-(B).

137 I.R.C. § 1273(b)(3).

138 An instrument is traded on an established securities market if, at any time during the 60-day period ending 30 days after the issue date: (i) the security is listed on a registered national securities exchange (e.g., the New York Stock Exchange, the American Stock Exchange); an inter-dealer quotation system sponsored by a national securities association, or certain foreign exchanges; (ii) the security trades on a contract market board of trade; (iii) the security appears on a system of general circulation (a quotation medium); or (iv) dealers and brokers have readily available price quotations with respect to the security. Treas. Reg. § 1.1273-2(f).

139 H.R. Rep. No. 881, 101st Cong., 2d Sess. 355 (1990).

140 For debt instruments subject to interest on deferred payments under I.R.C. § 483 (rather than I.R.C. § 1274), the issue price, determined under I.R.C. § 1273(b)(4), is reduced to exclude unstated interest for purposes of determining DOI income.

141 Consider authorities that existed prior to the 1001 regulations. E.g., Rev. Rul. 73-160, 1973-1 C.B. 365 (extension of maturity date and subordination is not an exchange); Rev. Rul. 82-188, 1982-2 C.B. 90 (increase in principal amount and elimination of conversion feature of a convertible installment note is an exchange). A 1991 United States Supreme Court case contributed to the uncertainty. Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991) (involving an exchange of mortgage portfolios by two savings and loan associations that constituted a material modification). Prior to Cottage Savings, a variety of rulings and determinations addressed whether a modification of the terms of a debt instrument triggered an exchange. See, e.g., Rev. Rul. 89-122, 1989-2 C.B. 200 (principal amount); Rev. Rul. 87-19, 1987-1 C.B. 249 (rate of interest); General Counsel Memorandum 39225 (Apr. 27, 1984) (principal obligor).

142 See Treas. Reg. § 1.1001-3(c).

143 See also Technical Advice Memorandum 200606037 (Feb. 10, 2006) (discussing the exchange of debt for stock pursuant to a conversion right; discussed further at supra note 119).

144 Generally, the exercise of an option is a modification unless the option is unilateral. In addition, an option exercised by the creditor (as opposed to the debtor) is a modification, unless the exercise does not defer or reduce scheduled payments of interest or principal. See Treas. Reg. § 1.1001-3(c)(2)(iii). For example, the option by a bank (the creditor) to reduce interest rates to keep a customer if rates decline is a modification, but the bank’s exercise of an option to increase the rates due to the decline in the financial condition of the issuer is not a modification. Treas. Reg. § 1.1001-3(d), Examples 7, 9.

145 Treas. Reg. § 1.1001-3(e)(3)(ii).

146 In P.L.R. 200742016 (June 21, 2007), holders of debt were extended a tender offer to exchange their debt for new debt and cash. In the ruling, a guarantor (D2) on an existing debt became the primary obligor on the new debt and the primary obligor (D1) on the existing debt was released from liability on the debt. D1 paid D2 an amount equal to the fair market value of the tendered debt. Another related party that also guaranteed the existing debt continued to guarantee the new debt. The IRS ruled the new debt exchanged for the outstanding tendered debt was an indirect modification under Treas. Reg. § 1.1001-3(a). Furthermore, as a result of the change of primary obligor, the exchange was treated as a significant modification under Treas. Reg. § 1.1001-3(e)(4)(i).

147 A change in payment expectations occurs when there is (1) a substantial enhancement to the borrower’s ability to make payment, the ability was speculative before, and is adequate after the transaction; or (2) a substantial impairment in the borrower’s ability to make payment, the ability was adequate prior, and is speculative after. In addition, if there is another significant modification, such as a change in yield in connection with an I.R.C. § 381(a) transaction, there will be an exchange of debt instruments. This exchange may remain tax-free from the creditor’s perspective if it qualifies as an exchange of securities. See Rev. Rul. 2004-78, 2004-31 I.R.B. 108.

148 This issue arises in the context of an I.R.C. § 338 election because the target is treated as a new corporation after the election is effective. In addition, a significant alteration is a change that would otherwise be a significant modification, but for the fact that the change results from the terms of the instrument.

149 Treas. Reg. § 1.1001-3(f)(7), which is effective as of January 7, 2011. See T.D. 9513 (Dec. 21, 2010). Treas. Reg. § 1.1001-3(f)(7) provides that deterioration in the financial condition of the obligor between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the obligor’s ability to repay the debt instrument) is not taken into account in making a determination as to whether an instrument resulting from a modification of a debt instrument will be recharacterized as property that is not debt, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. Treas. Reg. § 1.1001-3(f)(7)(ii)(A),(B). In addition, conversion of the debt into equity of the issuer pursuant to the holder’s option is not a modification.

150 Examples of entities that are subject to disregarded entity treatment include certain domestic and foreign single-member entities (e.g., limited liability companies) to which the check-the-box regulations apply, qualified real estate investment trust subsidiaries, and qualified subchapter S subsidiaries. Treas. Reg. § 301.7701-3.

151 P.L.R. 200315001 (Sept. 19, 2002) (newly formed company acquires target and then target converts to a limited liability company by making a check-the-box election).

152 See also P.L.R. 200630002 (April 24, 2006); P.L.R. 200709013 (Nov. 22, 2006). Note, however, that in the latter two private letter rulings, the IRS concluded that there was no significant modification (as opposed to no modification) under the facts of the rulings, thus implying that an insignificant modification had occurred. This is a narrower rationale than the first private letter ruling, which appeared to base its finding that a modification of a debt does not occur when a check-the-box election is made because the same legal debtor exists. The latter two rulings could be interpreted as treating the deemed liquidation occurring as a result of the check-the-box fiction as an actual liquidation (subject to recast under substance over form principles) for purposes of determining whether there has been a change in obligor (and therefore a modification).

153 P.L.R. 201010015 (Nov. 5, 2009). The answer to this quagmire seems to be in the regulations, which provide that there is a modification if there is “any alteration . . . of a legal right or obligation of the issuer or holder of a debt instrument. Thus, because the check-the-box election does not change any legal right of the holder or issuer, it is not a modification.”

154 See, e.g., P.L.R. 200243034 (July 26, 2002) (I.R.C. § 108(e)(2) exception applies because payment of discharged liquidated tort and environmental claims would have been deductible under I.R.C. § 162(a)).

155 Treas. Reg. § 1.446-2. Under prior law, the taxpayer could choose to allocate the payment to interest or principal. For instance, if a cash-method debtor chose to allocate the payment to principal first, the debtor would realize $20 of DOI income attributable to principal reduction ($100 principal less $80 payment) and no DOI income as a result of the $10 of discharged interest under I.R.C. § 108(e)(2). See § 2.4(b)(i) for a discussion of allocation between principal and interest.

156 See supra section 2.4(b)(iii), discussing interaction of sections 108(e)(6) and 108(e)(2) and the interest payment ordering rules.

157 See Helvering v. Killian Co., 128 F.2d 433 (8th Cir. 1942); Bankruptcy Tax Act of 1980, Pub. L. 96-589, 94 Stat. 3389.

158 See Allen v. Courts, 127 F.2d 127 (5th Cir. 1942); Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940).

159 H.R. Rep. No. 833, 96th Cong., 2d Sess. 13 (1980). See also Bressi v. Commissioner, 62 T.C.M. (CCH) 1668 (1991), aff’d without opinion, 1993 U.S. App. LEXIS 5320 (3d Cir. 1993) (I.R.C. section 108(e)(5) does not apply where taxpayer did not demonstrate that purchaser’s debt was owed to seller).

160 H.R. Rep. No. 833, 96th Cong., 2d Sess. 13 (1980).

161 See also P.L.R. 9037033 (June 18, 1990) (involving a purchase of stock by buyer for purchase money indebtedness followed by a transfer of the purchased stock to a corporation, which assumed the purchase money indebtedness; finding the corporation was the imputed purchaser of the stock for purposes of purchase price adjustment).

162 Technical Advice Memorandum 9338049 (June 15, 1993).

163 That is, as part of the same plan or arrangement, a corporation may be both created and dissolved. These types of corporations are transitory—born to die. Under the transitory entity doctrine, the IRS ignored the existence of a corporation that was transitory.

164 1992-2 C.B. 35.

165 167 F.3d 1323 (10th Cir. 1999), rev’g 72 T.C.M. (CCH) 1496 (1996).

166 See § 2.3(a)(vi) for a discussion of this case and the contested liability doctrine.

167 73 T.C.M. (CCH) 2398 (1997), aff’d, 164 F.3d 618.

168 See P.L.R. 9037033 (June 18, 1990).

169 See § 2 6(b).

170 I.R.C. § 108(d)(2). Application of the title 11 exclusion is somewhat unclear in a liquidating bankruptcy under chapter 7 or 11 because a corporate debtor is not granted a discharge. This rule applies to debtors that, like corporations, are not individuals. Bankruptcy Code §§ 727(a)(1), 1141(d)(3). There are three possible outcomes for a liquidating bankruptcy. First, there is no DOI income because no discharge occurred. See Friedman v. Commissioner, 216 F.3d 537, 548 n.7 (6th Cir. 2000). Second, either actual or de facto DOI income occurs as the result of the liquidation, but the DOI income is not excluded from gross income under the title 11 exclusion because the bankruptcy court did not grant or approve the discharge. Third, there is DOI as a result of a court-approved liquidation (either actual or constructive under federal income tax principles), and the title 11 exclusion applies to exclude the DOI income from gross income because the discharge occurs pursuant to a plan approved by the court

171 See supra note 150.

172 Prop. Treas. Reg. § 1.108-9 (proposed April 13, 2011).

173 S. Rep. No. 1035, 96th Cong. 2d Sess. at 8 (1980); Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95 (5th Cir. 1934) (superseded by I.R.C. § 108(b)(1)(B)).

174 I.R.C. § 108(a)(3).

175 See Newton, Bankruptcy and Insolvency Accounting: Practice and Procedure, Ch. 11 (updated annually).

176 78 T.C. 742 (1982), acq., 1984-1 C.B. 1.

177 See also Philip Morris Inc. v. Commissioner, 96 T.C. 606 (1991), aff’d, 970 F.2d 897 (2d Cir. 1992) (using capitalization or excess-earnings method to value corporation in I.R.C. § 332 case); T.D. 8530, 59 Fed. Reg. 12840 (Mar. 18, 1994) (preamble) (going-concern valuation may be used to value assets under I.R.C. § 382(l)(6)).

178 Prop. Treas. Reg. § 1.108-9 (proposed April 13, 2011).

179 The Eighth Circuit reversed the Tax Court’s demand for explicit proof that judgments against the taxpayer remained unsatisfied as “wholly unreasonable” and held that the taxpayer was insolvent. Toberman v. Commissioner, 294 F.3d 985 (8th Cir. 2002), rev’g 80 T.C.M. (CCH) 81 (2000).

180 1992-2 C.B. 48.

181 109 T.C. 463 (1997), aff’d, 192 F.3d 844 (9th Cir. 1999).

182 See, e.g., United States v. Kirby Lumber, 284 U.S. 1 (1931).

183 Fifth Avenue-Fourteenth Street Corp. v. Commissioner, 147 F.2d 453 (2d Cir. 1944); Davis v. Commissioner, 69 T.C. 814 (1978); Hunt v. Commissioner, 57 T.C.M. (CCH) 919 (1989).

184 116 T.C 87 (2001). See Quartemont v. Commissioner, T.C. Summ. Op. 2007-19 (Feb. 6, 2007) (following Carlson); P.L.R. 9932013 (May 4, 1999) (revoking P.L.R. 9125010 (Mar. 19, 1991)); Field Service Advice 9932019 (May 10, 1999). In Quartemont v. Commissioner, T.C. Summ. Op. 2007-19 (Feb. 6, 2007), the taxpayer argued that Carlson was wrongly decided, as it caused a disparity in determining DOI income between taxpayers that filed for bankruptcy and taxpayers that did not. Notwithstanding this argument, the Tax Court followed Carlson.

185 See also Gitlitz v. Commissioner, 531 U.S. 206, 215 (2001).

186 The same issue arises with respect to the proper treatment of benefits from pension funds. See, e.g., Patterson v. Shumate, 504 U.S. 753 (1992) (although debtor’s retirement funds cannot be attached in bankruptcy, these funds are assets for purposes of determining whether the debtor is insolvent).

187 Scranton, Corporate Transactions Under the Bankruptcy Tax Act of 1980, 35 Tax Law. 49, 78 (1981).

188 Id. But see Rev. Rul. 92-52 (the sequence of a debt-for-debt exchange and a stock-for-debt exchange do not matter because the exchanges are related).

189 For an example of qualified farm indebtedness, see Campbell v. Commissioner, 81 T.C.M. (CCH) 1241 (2001), aff’d, 2002-1 U.S. Tax Cas. (CCH) ¶ 50242 (8th Cir. 2002).

190 I.R.C. § 108(g)(2).

191 Lawinger v. Commissioner, 103 T.C. 428 (1994).

192 I.R.C. § 108(g)(2).

193 A “related person” is defined by cross-reference to I.R.C. § 465(b)(3)(C).

194 I.R.C. § 108(g)(3). The tax attributes generally include net operating losses (NOLs), general business and minimum tax credits, and capital loss, passive activity, credit, and foreign tax credits. Tax attributes that are credits are adjusted by multiplying by 3.

195 Id.

196 1987-2 C.B. 41.

197 I.R.C. § 108(a)(2)(B).

198 I.R.C. §§ 108(a)(2)(A); (c)(3)(C).

199 I.R.C. § 108(c)(2)(A), Treas. Reg. § 1.108-6(a).

200 I.R.C. § 108(c)(2)(B), Treas. Reg. § 1.108-6(b). In determining the aggregate adjusted basis of depreciable real property for this purpose, aggregate basis is first reduced under I.R.C. § 108(b) and (g). Also, the basis of depreciable real property acquired in contemplation of the discharge is not taken into account. I.R.C. § 108(c)(2)(B).

201 Treas. Reg. § 1.1017-1(c).

202 Treas. Reg. § 1.108-5(b). See P.L.R. 200021014 (Feb. 17, 2000) (granting an extension of time to file an election to reduce basis in depreciable property because the taxpayer’s CPA mistakenly believed that the election had to be made at the shareholder level rather than at the S corporation level); P.L.R. 200818006 (Jan. 28, 2008) (granting extension of time to make I.R.C. § 108(c) election when extent of taxpayer’s insolvency was unclear and thus application of I.R.C. § 108(c) exclusion was unclear and also listing a number of requirements necessary to obtain relief to make a late election).

203 Treas. Reg. § 1.108-5(c).

204 See § 2.3(a)(vi) for a discussion of Schlifke v. Commissioner and the tax benefit rule from the perspective of income inclusion. See note 428, infra, discussing a Significant Service Center Advice position that the claim of right doctrine does not apply when debt that was treated as discharged is subsequently satisfied.

205 I.R.C. § 111 provides that gross income does not include income attributable to the recovery during the tax year of any amount deducted in any prior year to the extent such amount did not reduce tax imposed under Chapter 1 of the I.R.C. A detailed discussion of what may be excluded from gross income is beyond the scope of this treatise.

206 See Rev. Rul. 67-200, 1967-1 C.B. 15, clarified by Rev. Rul. 70-406, 1970-2 C.B. 16 (applying tax benefit rule to exclude income prior to the I.R.C. § 108 exclusions). In a nondocketed service advice review issued in 2000, the IRS said that Rev. Rul. 67-200 was rendered obsolete when the Tax Reform Act of 1986 removed the elective exception to DOI inclusion. See 2000 Non-Docketed Service Advice Review (NSAR) 10773 (Jan. 2, 2000). However, Rev. Rev. 67-200 has not officially been declared obsolete. Moreover, although the changes to I.R.C. § 108 affecting which taxpayers are eligible for DOI exclusion may have made the ruling’s conclusion irrelevant, there appears to be no reason why the rationale does not continue to apply regarding the treatment of forgiveness of an obligation to pay accrued interest.

207 As noted previously, the Tax Court has applied the tax benefit rule to require an income inclusion in a debt cancellation context in Schlifke v. Commissioner. See supra § 2.3(a)(vi) and note 65. However, it was not clear under the facts of Schlifke that the inclusion of income under either the tax benefit rule or as DOI made a difference. The court appeared to merely take a less complex road to reach its decision.

208 Chief Counsel Advice 200801039 (Sept. 24, 2007).

209270 B.R. 393 (E.D. Mich. 2001). Dow Corning provided only for the deductibility of post-petition interest that accrued according to contractual terms and not for other obligations.

210 See supra note 206.

211 The taxpayer is usually the debtor for purposes of attribute reduction, and those terms are used interchangeably in this treatise. However, the estate may be the taxpayer if the debtor is an individual in a title 11 case. I.R.C. § 108(d)(8). Attribute reduction for a debtor that is a member of a consolidated group is discussed in § 2.10.

212 This order of attribute reduction applies only for income excluded under I.R.C. § 108(a)(1)(A) (title 11), (B) (insolvency), and (C) (qualified farm indebtedness). Income excluded by taxpayer election under I.R.C. § 108(a)(1)(D) (qualified real property business indebtedness) is treated as a reduction in the basis to the taxpayer’s depreciable property pursuant to I.R.C. § 1017, which is discussed at § 2.7(d)(ii)(D).

213 I.R.C. § 1017(b)(2).

214 I.R.C. § 172(b)(1)(A), (H).

215 Treas. Reg. § 1.108-7T(b), (e); Treas. Reg. § 1.108-7(b), (f).

216 But see § 5.8(b) providing in I.R.C. § 381(a) transaction the basis of property includes reduction.

217 531 U.S. 206, 218 (2001).

218 Id. at 218 (emphasis added by Supreme Court, as indicated).

219 United States v. Farley, 202 F.3d 198 (3d Cir. 2000); Hogue v. United States, 2000-1 U.S. Tax Cas. (CCH) ¶ 50149 (D. Ore. 2000). See also Witzel v. Commissioner, 200 F.3d 496 (7th Cir. 2000), vacated and remanded, 2001-1 U.S. Tax Cas. (CCH) ¶ 50339.

220 Gitlitz v. Commissioner, 182 F.3d 1143 (10th Cir. 1999), rev’d, 531 U.S. 206 (2001); Guadiano v. Commissioner, 216 F.3d 524 (6th Cir. 2000), overruled in part, Gitlitz v. Commissioner, 531 U.S. 206 (2001); Nelson v. Commissioner, 110 T.C. 114 (1998), aff’d, 182 F.3d 1152 (1999), overruled in part, Gitlitz v. Commissioner, 531 U.S. 206 (2001).

221 See Treas. Reg. § 1.1502-28(b)(3) (requiring basis reduction coincident with the reduction of other attributes pursuant to I.R.C. § 108). See also Example 4 of Treas. Reg. § 1.1502-32(b)(5), which involves an insolvent subsidiary whose NOL is reduced under I.R.C. § 108(b) at the close of the tax year of the discharge.

222 Treas. Reg. §1.108-7(b), (f); former Temp. Treas. Reg. § 1.108-7T(b), (e).

223 P.L.R. 9504032 (Oct. 31, 1994).

224 I.R.C. § 382(g).

225 For tax-attributed reductions before January 1, 1987, credit carryovers were reduced at the rate of 50 cents for each dollar of debt discharged.

226 I.R.C. § 108(b)(3)(A).

227 I.R.C. § 108(b)(4).

228 S. Rep. No. 1035, 96th Cong., 2d Sess. 13 (1980). Prior to the Tax Reform Act of 1984, I.R.C. § 108(b)(2)(B) provided a different list of credit carryovers subject to reduction that became obsolete due to the combination of certain credits into a general business credit.

229 Treas. Reg. § 1.1017-1 is effective on or after October 22, 1998. Treas. Reg. § 1.1017-1(i). For previous rules regarding basis reduction, see former Treas. Reg. §§ 1.1016-7 and 1.1017-2 that were promulgated in 1957 and 1956, respectively.

230 Implicit in this rule is that debtor can make an I.R.C. § 108(b)(5) election to the extent the debtor chooses. It is not mandatory to make this election to the extent of the full discharge of indebtedness or to the entire amount of the debtor’s basis in depreciable property. See Treas. Reg. § 1.1017-1(c)(2).

231 I.R.C. § 1017(b)(3)(B). The basis reduction is not limited to the amount of depreciation or amortization for the subsequent period, however.

232 I.R.C. § 1017(b)(3)(E).

233 See §§ 2.7(d)(ii)(E), (F), 2.10.

234 See, e.g., P.L.R. 9406015 (Nov. 12, 1993); P.L.R. 9150033 (Sept. 13, 1991) (taxpayer demonstrated good cause for not filing elections to reduce basis due to uncertainty of pending request for private letter ruling).

235 Treas. Reg. § 1.108-4(b).

236 P.L.R. 200210044 (Dec. 6, 2001); P.L.R. 200208016 (Nov. 21, 2001).

237 531 U.S. 206 (2001), rev’g, 183 F.3d 1143 (10th Cir. 1999). For a discussion of the Gitlitz decision, see §§ 2.7(b)(i)(A) and 3.3(e).

238 S. Rep. No. 1035, 96th Cong., 2d Sess. 14 (1980).

239 Treas. Reg. § 1.1017-1(d).

240 I.R.C. §§ 1017(b)(3)(E), (4)(C); Treas. Reg. § 1.1017-1(f). Neither the I.R.C. § 108(b)(5) basis reduction election nor the I.R.C. § 1017(b)(3)(E) depreciable property election is available for the qualified real property business indebtedness exclusion.

241 See §§ 2.7(d)(ii)(E)-(F); 2.10.

242 Treas. Reg. § 1.1017-1(c)(3).

243 I.R.C. § 1017(b)(4).

244 For a discussion of the qualified farm indebtedness exclusion, see § 2.6(d).

245 I.R.C. §§ 1017(b)(3)(E), (4)(C); Treas. Reg. § 1.1017-1(f).

246 I.R.C. §§ 1017(b)(4)(C); see §§ 2.7(d)(ii)(E)–(G); 2.10.

247 Because basis is the only tax attribute affected in this situation, the basis reduction election does not apply.

248 For a discussion of the qualified real property business indebtedness exclusion, see § 2.6(d).

249 Treas. Reg. § 1.1017-1(c)(1).

250 I.R.C. § 1017(b)(3)(F)(ii); Treas. Reg. § 1.1017-1(f).

251 I.R.C. § 1017(b)(3)(F)(i); Treas. Reg. § 1.1017-1(g).

252 I.R.C. § 1017(b)(3)(C); Treas. Reg. § 1.1017-1(g)(2)(i).

253 Treas. Reg. § 1.1017-1(g)(2)(ii).

254 Treas. Reg. § 1.1017-1(b)(2).

255 I.R.C. § 1017(c)(2). Under prior law, if the basis of property on which investment tax credit was claimed was reduced because of debt cancellation, the credit was recaptured as if part of the property were disposed. Rev. Rul. 74-184, 1974-1 C.B. 8, superseded by Rev. Rul. 81-206, 1981-2 C.B. 9. The IRS announced in Rev. Rul. 84-134,1984-2 C.B. 6, that it would no longer require a recapture of investment tax credit when taxpayers reduce the basis of property for discharge of indebtedness that occurred before January 1, 1981.

256See § 2.10 for a discussion of some special I.R.C. § 1245 recapture rules in the consolidated return context.

257 As discussed in § 2.7, there is a debate regarding the timing of attribute reduction in certain situations.

258 Field Service Advice 200145009 (July 31, 2001). The Field Service Advice involved a target corporation that had DOI income from a title 11 case. Debt was discharged and the target corporation participated in a G reorganization in the same tax year. I.R.C. § 108(b) would normally require the target corporation to reduce basis in the year following the discharge. The IRS nevertheless found that there would not be any basis reduction because the target corporation no longer existed and did not have any property in the year after the discharge.

259 Treas. Reg. § 1.108-7T; T.D. 9080 (July 17, 2003).

260 H.R. Rep. No. 833, 96th Cong., 2d Sess. at 34 (1980). See § 2.7(d)(i) for a discussion of the basis reduction election of I.R.C. § 108(b)(5). This example was not included in the Senate Report or Conference Report for an unrelated reason. The later versions of the Bankruptcy Tax Act expanded the application of the former stock-for-debt exception; hence, in the context of the House Report example, there would be no need to reduce any attributes. See S. Rep. No. 1035, 96th Cong., 2d Sess. (1980).

261 Treas. Reg. § 1.108-7. T.D. 9127, 69 Fed. Reg. 26038 (May 11, 2004).

262 For simplicity, this example ignores any depreciation that may have been taken in the discharge year.

263 For a discussion of quasi-reorganizations, see Newton, supra note 175 at Chapter 14.

264 But see Technical Advice Memorandum 9402003 (Sept. 9, 1993) providing that former I.R.C. section 56(f)(2)(I) did not apply where a parent corporation issued stock to a subsidiary in exchange for the extinguishment of the parent’s debt.

265 See Treas. Reg. § 1.56(g)-1(a)(5).

266 This section is drawn from Robert Liquerman and Lauren Rogers, Section 108(i) Election to Defer Cancellation of Indebtedness Income, What’s News in Tax (KPMG LLP publication), March 14, 2011.

267 I.R.C. § 108(i)(1).

268 I.R.C. § 108(i)(3)(A).

269 I.R.C. § 108(i)(3)(B).

270 I.R.C. § 108(i)(4).

271 I.R.C. § 108(i)(2).

272 I.R.C. § 108(i)(5)(B); H.R. Conf. Rep. No. 111-16 (2009).

273 Rev. Proc. 2009-37.

274 I.R.C. § 108(i)(5)(D).

275 Rev. Proc. 2009-37, 2009-36 I.R.B. 309; T.D. 9497.

276 I.R.C. § 108(i)(5)(D).

277 Treasury Decision 9497 implemented rules regarding earnings and profits, as discussed in § 2.8(d).

278 Commissioner v. Tufts, 461 U.S. 300, 311-12 (1983).

279 Id. at 308–310.

280 Crane v. Commissioner, 331 U.S. 1 (1947).

281 See Treas. Reg. § 1.1001-2(c), example 7. This assumes that the reduction of the nonrecourse debt would not qualify as a purchase price adjustment. This principle applies in a redemption transaction when stock is redeemed from a shareholder in satisfaction of nonrecourse debt. See P.L.R.s 200745001 (Aug. 3, 2007), 200745002 (Aug. 3, 2007), 200745003 (Aug. 3, 2007), and 200745004 (Aug. 3, 2007) (the IRS ruled in all five rulings that the transfers of stock in satisfaction of nonrecourse debt are treated as a redemption under I.R.C. § 302 and the shareholders recognize gain or loss in the exchange).

282 92 T.C.M. (CCH) 534 (2006). As discussed § 2.3(a)(ii) , the classification of debt as recourse or nonrecourse can result in different tax consequences when the debt is satisfied with collateral.

283 The discharge of nonrecourse debt when the collateral is retained is discussed in § 2.9(b).

284 Technical Advice Memorandum 9302001 (Aug. 31, 1992) (applying Tufts and Treas. Reg. 1.1001-2(c), Example 7).

285 The taxpayers had relied on Rev. Rul. 91-31, 1991-1 C.B. 19 (discussed in infra note 300 and accompanying text)), which treated the difference between the nonrecourse liability and the value of the property as DOI income. The IRS factually distinguished Rev. Rul. 91-31 because that ruling did not involve a disposition of the property by the debtor, the creditor merely wrote down the face of the debt to equal the value of the underlying security.

286 73 T.C.M. (CCH) 2398 (1997).

287 See also 2925 Briarpark, Ltd. v. Commissioner 163 F.3d 313 (5th Cir. 1999); Field Service Advice 200135002 (Apr. 10, 2001).

288 See, e.g., Freeland v. Commissioner, 74 T.C. 970 (1980).

289 Treas. Reg. § 1.1001-2(a) (“the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.”). See Field Service Advice 200135002 (Apr. 10, 2001) (discussing the tax consequences of debtor’s sale of property securing debt as nonrecourse and, alternatively, as recourse).

290 Treas. Reg. § 1.1001-2(c) Example 8.

291 As discussed in § 2.9(c), the IRS also applies this treatment in Rev. Rul. 90-16, 1990-1 C.B. 12 (capital gain and DOI income that is excluded from gross income due to insolvency). See also P.L.R. 8928012 (Apr. 7, 1989).

292 102 T.C. 784, aff’d 50 F.3d 12 (8th Cir. 1995).

293 I.R.C. § 108(a)(1)(B); § 2.6(b).

294 See § 2.9(c) for a discussion of Frazier v. Commissioner, 111 T.C. 243 (1998) (transaction bifurcated into a taxable sale of the property resulting in a loss and DOI income). Cf. P.L.R. 9245023 (Aug. 7, 1992) (transfer resulting in a loss but not DOI income where the transferor not relieved of liability).

295 Freeland v. Commissioner, 74 T.C. 970, 975-76 (1980) (holding that taxpayers’ voluntary reconveyance of real property to mortgagee on nonrecourse debt resulted in capital, not ordinary, loss). See also Middleton v. Commissioner, 693 F.2d 124 (11th Cir. 1982) (addressing abandonment); Yarbro v. Commissioner, 737 F.2d 479 (5th Cir. 1984) (addressing abandonment). See § 2.8(c) for same result under foreclosure.

296 Rev. Rul. 92-92, 1992-2 C.B. 103 (doctrines, such as substance over form and step transaction, may also apply to prevent taxpayers from manipulating the character of DOI income).

297 1982-2 C.B. 35.

298 284 U.S. 1 (1931). See § 2.3(a)(iii).

299 The IRS amplified Rev. Rul. 82-202 in Rev. Rul. 91-31 to also apply if the value of the property is less than the principal amount of the mortgage at the time of the refinancing. See also P.L.R. 8314021 (Dec. 29, 1982) (satisfaction of an obligation by paying an amount that is less than the amount of the nonrecourse debt creates income from discharge).

300 1991-1 C.B. 19.

301 88 T.C. 984 (1987).

302 See Treas. Reg. § 1.1001-2(c), Example 7.

303 In many instances, the taxpayer may be indifferent between I.R.C. § 108(b) attribute reduction and capital gain. For example, NOLs that would have been reduced under I.R.C. § 108(b) if the debt is discharged may be available to offset Tufts gain recognized on the transfer of property subject to nonrecourse indebtedness. Each situation will need to be considered to determine if this potential planning technique is beneficial, particularly in light of the possible limitation on NOL utilization for AMT purposes. See § 2.7(e).

304 See Sands v. Commissioner, 73 T.C.M. (CCH) 2398 (1997) discussed in § 2.8(a)(i)(A).

305 31 B.T.A. 519 (1934).

306 The Supreme Court, in footnote 11 of Tufts, noted that according to one view Fulton Gold stands for the concept that, when nonrecourse debt is forgiven, the debtor’s basis in the securing property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. The footnote highlights theoretical issues with such a conclusion.

307 If the property is a capital asset or I.R.C. § 1231 property, the gain will be a capital gain, subject to the depreciation recapture requirements.

308 See Great Plains Gasification v. Commissioner, 92 T.C.M. (CCH) 534 (2006), in which gain or loss was triggered on a foreclosure sale disposition of the collateral at the conclusion of foreclosure litigation regardless of fact that the debt was not formally discharged. For a noncorporation to deduct a loss, the property transferred must have been held as business property or held in connection with a transaction entered into for profit.

309 See Lewis v. Commissioner, 56 T.C.M. (CCH) 1328 (1989), aff’d, 928 F.2d 404 (6th Cir. 1991) (ruling that a contract between the debtor and creditor regarding the settlement of a delinquency did not result in income; rather, a subsequent foreclosure sale that relieved the debtor of the balance due resulted in DOI income).

310 1990-1 C.B. 12.

311 Rev. Rul. 90-16 cited Helvering v. Hammel, 311 U.S. 504 (1941), Electro-Chemical Engraving Co. v. Commissioner, 311 U.S. 513 (1941), and Daneberg v. Commissioner, T.C. 370 (1979), acq. 1980-2 C.B. 1. See also Freeland v. Commissioner, 74 T.C. 970 (1980) (addressing a voluntary conveyance but noting same result in context of foreclosure under Hammel).

312 111 T.C. 243 (1998).

313 See also Aizawa v. Commissioner, 99 T.C. 197 (1992) (proceeds from foreclosure sale are the amount realized for I.R.C. § 1001(a), but the court had no reason to conclude that the sale proceeds were not the fair market value of the property).

314 Lewis v. Commissioner, 928 F.2d 404 (6th Cir. 1991); reported in full, 1991 U.S. App. LEXIS 4623; aff’g 56 T.C.M. (CCH) 1328 (1989).

315 42 T.C.M. (CCH) 355 (1981). See also Freeland v. Commissioner, 74 T.C. 970 (1980); Arkin v. Commissioner, 76 T.C. 1048 (1981); Commissioner v. Green, 126 F.2d 70 (3d Cir. 1942).

316 277 T.C. 310 (1981) aff’d per curiam, 693 F.2d 124 (11th Cir. 1982). See also Yarbro v. Commissioner, 737 F.2d 479 (5th Cir. 1984).

317 See Coburn v. Commissioner, 90 T.C.M. (CCH) 563 (2005) (in dicta, agreeing that abandonment of property subject to a nonrecourse debt is a sale) (discussed supra, note 18). See also Lockwood v. Commissioner, 94 T.C. 252 (1990) (applying exchange treatment to taxpayer’s abandonment of depreciable property subject to a nonrecourse mortgage, even though the property was destroyed and consequently provided no benefit to the creditor). But see Hoffman v. Commissioner, 40 B.T.A. 459 (1939), aff’d, 117 F.2d 987 (2d Cir. 1941) (taxpayers were entitled to deduct a loss after the abandonment of property subject to a nonrecourse mortgage) (decided before the Supreme Court’s 1947 decision in Crane v. Comnmissioner, 331 U.S. 1 (1947)).

318 See T.D. 9386, 73 Fed. Reg. 13124 (Mar. 12, 2006), Treas. Reg. § 1.165-5(i).

319 Hennessey, Yates, Banks, and Pellervo, The Consolidated Tax Return (6th ed. 2002).

320 Dubroff, Blanchard, Broadbent, and Duvall, Federal Income Taxation of Corporations Filing Consolidated Returns (2nd ed. 2002).

321 See § 2.7(d), Basis Reduction.

322 See P.L.R. 9650019 (Sept. 11, 1996) (when the taxpayer makes an I.R.C. § 1017(b)(3)(D) election, the reduction of basis of depreciable property held by a subsidiary may exceed the taxpayer’s basis in the subsidiary stock). Any reduction in excess of stock basis, however, would result in the shareholder member having an excess loss account in the subsidiary stock. Pursuant to prior Temp. Treas. Reg. § 1.1502-28T and current Treas. Reg. § 1.1502-28, basis in stock of a subsidiary may no longer be reduced below zero. This includes basis reductions when subsidiary stock is treated as depreciable property under a § 1017(b)(3) election. An excess loss account in the stock of the subsidiary may be created if the subsidiary’s attributes are reduced under the “fan out” rules, as described below.

323 These regulations were issued in final form in March 2005. T.D. 9192, 70 Fed. Reg. 14395-01 (Mar. 22, 2005). The final regulations generally adopt the approach of the temporary regulations described herein. The citations in this section to the temporary regulations generally correspond to the final regulations. The more significant modifications made to the temporary regulations in the final regulations are described at the end of this section.

324 T.D. 9089, 68 Fed. Reg. 52487 (Sept. 4, 2003), amended by 68 Fed. Reg. 69024 (Dec. 11, 2003). These regulations were published as Temp. Treas. Reg. § 1.1502-28T. T.D. 9089 also amends Treas. Reg. §§ 1.1502-19, 21, and 32. These regulations are generally effective for DOI income realized after August 29, 2003, investment adjustments for consolidated years in which the original return is due (without extensions) after August 29, 2003, and excess loss account triggers after August 29, 2003. The temporary regulations were issued in final form in March 2005. T.D. 9192, 70 Fed. Reg. 14395-01 (Mar. 22, 2005). The final regulations apply to discharges of indebtedness that occurred after March 21, 2005. Groups are permitted to apply the final regulations in whole, but not in part, to discharges of indebtedness that occurred before March 22, 2005, and after August 29, 2003. If a group does not apply the final regulations for discharges of indebtedness occurring before March 22, 2005, and after August 29, 2003, the temporary regulations apply. Furthermore, groups may apply the “fan-out rules” of the final regulations to discharges of indebtedness that occur before August 30, 2003, in cases when I.R.C. § 1017(b)(3)(D) was applied.

325 Temp. Treas. Reg. § 1.1502-28T(a)(2).

326 In general, a consolidated tax attribute is an attribute that arose in a year for which the group filed a consolidated return. It is also interesting to note that unlike the normal pro rata use of losses of a group to offset consolidated income, § 108(b) attribute reduction is first applied to reduce attributes of a separate member before they are applied to reduce attributes attributable to other members of a consolidated group.

327 In general, under Treas. Reg. § 1.1502-1(f), a pre- or post-affiliation year of a member. Under Temp. Treas. Reg. § 1.1502-28T, however, only pre-affiliation losses would be reduced. The Treasury amended the temporary regulations and readdressed the attributes available for reduction when a debtor-member of a consolidated group realizes DOI income subject to I.R.C. § 108(a). Under the amendment, the nondebtor-member’s attributes that are available for reduction include attributes that arose in a separate return year or a SRLY, to the extent a SRLY is not imposed on those attributes. The amendment applies to DOI income after August 29, 2003, in a tax year with an original due date (without extensions) after December 10, 2003. 69 Fed. Reg. 69024 (Dec. 11, 2003).

328 Temp. Treas. Reg. § 1.1502-28T(a)(3).

329 See, e.g., Temp. Treas. Reg. § 1.1502-28T(c), Example 2.

330 See § 2.7(d)(ii)(G).

331 T.D. 9117, 69 Fed. Reg. 12069 (Mar. 15, 2004) (preamble).

332 Temp. Treas. Reg. § 1.1502-28T(a)(4). Treas. Reg. § 1.1502-21(c)(2) for the definition of a SRLY subgroup.

333 See, e.g., Temp. Treas. Reg. § 1.1502-28T(c), Example 4.

334 T.D. 9192, 70 Fed. Reg. 14395-01 (Mar. 22, 2005).

335 In addition, prior to the temporary regulations, legislative efforts adopt and expand the single-entity approach. On June 25, 2003, a bill was introduced in the Senate that would apply § 108(b) attribute reduction to all consolidated NOLs and other consolidated attributes of the group, regardless of whether the source of the attributes is the debtor member. This bill was not limited to the consolidated NOL, but requires the netting and reduction of all tax attributes of the consolidated group on a single-entity basis. S. 1331, 108th Cong. (2003).

336 P.L.R. 9650019 (Sept. 11, 1996); P.L.R. 9121017 (Feb. 21, 1991).

337 P.L.R. 9121017 (Feb. 21, 1991).

338 See § 2.9(a)(i).

339 Field Service Advice 9912007 (Dec. 14, 1998).

340 The IRS also embraced the single-entity approach in Chief Counsel Advice 200149008 (Aug. 10, 2001) and asserted a similar argument in Peoplefeeders, Inc. v. Commissioner, T.C. Memo 1999-36. In that case, the Tax Court did not reach the issue; rather it held that another issue was determinative. See also Chief Counsel

341Advice 200714017 (Dec. 1, 2006) (IRS ruled that for periods prior to the adoption of Treas. Reg. § 1.1502-28T, members of a consolidated group must reduce NOLs and alternative minimum tax credits on a single-entity basis but reduce asset basis on a separate-entity basis and cited United Dominion Indus., Inc. v. United States, 532 U.S. 822 (2001).

See Treas. Reg. § 1.1502-6. Moreover, the IRS argued that Treas. Reg. §§ 1.1502-11 and 1.1502-21 only permit the group to have an NOL carryover, so the subsidiary could not have its own NOL absent an apportionment event (e.g., disposition of the subsidiary).

342 532 U.S. 822 (2001).

343 Under I.R.C. § 172, an NOL generally may be carried back two tax years and used as a deduction to produce an overpayment—and generate a refund—in the earlier year. There is an exception for the portion of an NOL relating to product liability deductions or certain other types of expenses. I.R.C. § 172(f) permits the portion of an NOL relating to these types of deductions to be carried back 10 years. The statute and the consolidated return regulations, however, do not specifically address how the special 10-year carryback rules under I.R.C. § 172(f) apply in the context of a consolidated return.

344 The provision now contained in Treas. Reg. § 1.1502-21(b)(2)(iv) that defines the amount of the consolidated NOL attributable to a departing member does not apply to “unbake the cake.” 532 U.S. at 833. That is, although the consolidated return regulations provide a mechanism to apportion NOLs to a departing member, the Court did not view this as equivalent to a separate member’s NOL.

345 August 23, 2010.

346 Treas. Reg. § 1.1502-32. The investment adjustment rules do not apply to the common parent. The current consolidated return investment adjustment regulations are generally effective with respect to consolidated return years beginning on or after January 1, 1995. See Treas. Reg. § 1.1502-32(h).

347 Treas. Reg. § 1.1502-32(b).

348 Temp. Treas. Reg. § 1.1502-32T(b)(3)(ii)(C)(1). The cite remains the same in the final regulations.

349 See, e.g., Temp. Treas. Reg. § 1.1502-32T(b)(5)(ii), Example 4. The cite remains the same in the final regulations.

350 P’s basis in the S stock is also reduced to reflect S’s $10 distribution.

351 Treas. Reg. §§ 1.1502-19, 1.1502-32(a)(3)(iii). The current consolidated return ELA regulations are generally effective with respect to consolidated return years beginning on or after January 1, 1995. See Treas. Reg. § 1.1502-19(h).

352 See Treas. Reg. § 1.1502-19(c) for all events resulting in a disposition of stock thereby triggering an ELA.

353 Treas. Reg. § 1.1502-19(b)(4). For this purpose, “insolvent” is defined to have the same meaning as I.R.C. § 108(d)(3) plus (1) any amount to which the preferred stock would be entitled if the member were liquidated immediately before the trigger and (2) any former liabilities that were discharged to the extent the discharge is treated as tax-exempt income under Treas. Reg. § 1.1502-32(b)(3)(ii)(C) (i.e., the DOI results in the reduction of tax attributes).

354 See also Field Service Advice 9908005 (Mar. 1, 1999) (IRS concludes that the debtor member of a consolidated group has income in the year the debt becomes worthless. Although the creditor member is entitled to a bad-debt deduction, the debtor member has an offsetting amount of corresponding income that is not excludable from gross income under the I.R.C. § 108(a)(3) insolvency exception); Yates, Banks, and Rainey, Deducting Your Loss on Winding Up a Purchased Subsidiary: A Lost Cause?, Vol. 50, No. 1, The Tax Executive 19 (Jan.-Feb. 1998).

355 A third trigger applies if a member takes into account the deduction or loss for the uncollectibility of an indebtedness and the deduction or loss is not matched in the same tax year by the debtor taking into account a corresponding amount of income or gain from the indebtedness in determining consolidated taxable income. Due to other changes in the consolidated return regulations, this third trigger is unlikely to continue to occur.

356 T.D. 9117, 69 Fed. Reg. 12069 (Mar. 15, 2004).

357 Under Treas. Reg. § 1.1502-19, an ELA is negative tax basis. Generally, an ELA is created when the subsidiary has made a debt-financed distribution to its shareholder, or the group has used a debt-financed loss of the subsidiary.

358 Temp. Treas. Reg. § 1.1502-19T(b)(1)(ii). The cite remains the same in the final regulations.

359 Temp. Treas. Reg. § 1.1502-21T(b)(2)(iv). The cite remains the same in the final regulations.

360 The former regulations are generally applicable to transactions occurring in consolidated return years beginning on or after July 12, 1995, and before December 24, 2008.

361 Treas. Reg. § 1.1502-1(b).

362 Treas. Reg. § 1.1502-13(g)(2)(i).

363 Treas. Reg. § 1.1502-13(g)(2)(ii).

364 Treas. Reg. § 1.1502-13(g)(3)(ii)(A). The former regulations also use a deemed satisfaction and reissuance regime, but the current regulations are intended to simplify and clarify aspects of (and add exceptions to) that model. The use of fair market value as the deemed satisfaction and reissuance amount is one of the clarifications. Under the former regulations, this amount could be unclear (i.e., if an intercompany obligation was sold for cash, the amount of cash was the deemed satisfaction and reissuance amount but in other situations, the deemed satisfaction and reissuance amount could be based on the debt’s issue price as determined under the original issue discount (OID) principles under I.R.C. §§ 1273 and 1274).

365 Id.

366 Treas. Reg. § 1.1502-13(g)(3)(ii)(B).

367 The separation of the deemed transactions from the actual transaction is a simplification of the deemed satisfaction and reissuance model in the current intercompany obligations regulations (when compared with the former regulations). See T.D. 9442 (Dec. 24, 2008).

368 Treas. Reg. § 1.1502-13(g)(3)(i)(A)(1).

369 Treas. Reg. § 1.1502-13(g)(3)(i)(A)(2).

370 The preamble to the current intercompany obligation regulations states that the exceptions are provided “either because it is not necessary to apply the deemed satisfaction-reissuance model to carry out the purposes of section 1.1502-13(g) or because the burdens associated with valuing the obligation or applying the mechanics of the deemed satisfaction-reissuance model outweigh the benefits achieved by its application.” See T.D. 9442 (Dec. 24, 2008).

371 The matching rule generally operates to redetermine the separate entity attributes (i.e., character and source) of the items generated in an intercompany transaction to produce the same effect on consolidated taxable income as if the parties to the intercompany transactions were divisions of a single corporation. Treas. Reg. § 1.1502-13(c).

372 The intercompany obligation regulations include two anti-abuse rules—the “material tax benefit rule” and the “off-market issuance rule”—that may apply to transactions otherwise excepted from the deemed satisfaction and reissuance regime. These are beyond the scope of this work but are generally intended to ensure that the exceptions cannot be used to distort consolidated taxable income through intragroup transactions. See Treas. Reg. §§ 1.1502-13(g)(3)(i)(C), (g)(4)(iii). All of the examples in this section assume that neither of these rules applies.

373 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(1). Notwithstanding this exception, transactions under § 351 may still be triggering transactions if the transaction is described in one of six exceptions to the exception (these include a situation in which the transferor or transferee member has a loss subject to a limitation (such as a SRLY loss) to which the other member is not subject; the transferee member has a nonmember shareholder; the transferee member issues preferred stock to the transferor in exchange for the intercompany obligation; and, subject to certain exceptions, the stock of the transferee member is disposed of within 12 months from the assignment of the intercompany obligation).

374 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(2).

375 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(5).

376 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(6).

377 Treas. Reg. § 1.1502-13(g)(3)(i)(B)(8).

378 In addition, income, gain, deduction or loss from an intercompany obligation is not subject to I.R.C. § 354 (nonrecognition for shareholder or security holder in a corporate reorganization), I.R.C. § 355(a)(1) (nonrecognition for shareholders on a corporation distribution of the stock of a controlled corporation), I.R.C. § 1091 (wash sale rules), and, in the case of an extinguishment in transaction in which the creditor transfers the intercompany obligation to the debtor in exchange for stock of the debtor, I.R.C. § 351(a). Treas. Reg. § 1.1502-13(g)(4)(i)(C).

379 If the note in this example were instead sold for $120 (reflecting a decline in prevailing market interest rates), the general application of the intercompany obligation regulations would be the same but B would have $20 of repurchase premium under Treas. Reg. § 1.163-7(c) as a result of the deemed satisfaction and S would have $20 of gain (redetermined to be treated as ordinary income). After the actual sale, the new note held by M would have a $120 issue price, a $100 stated redemption price at maturity, and a $120 basis. The treatment of B’s $20 of bond issuance premium under the new note would be determined under Treas. Reg. § 1.163-13.

380 Under the former regulations, B would be treated as reissuing the new note directly to M (instead of S). This would not change the result in this example.

381 If the note in this example were instead sold to NM (a nonmember of the P consolidated group), the transaction would still be a triggering transaction (albeit for a different reason—because it is an outbound transaction). The consequences to S and B from the deemed satisfaction and reissuance would be the same although the new note held by NM (with $80 issue price and a $100 stated redemption price at maturity with $20 of OID) would be a non-intercompany obligation.

382 Under the former regulations, the deemed reissuance in this example would be treated as occurring immediately after S becomes a nonmember. This difference would not have a significant tax implication under these facts.

383 Under the former regulations, there would have been a deemed satisfaction and reissuance of the note because the note would be treated as becoming a non-intercompany obligation (i.e., an outbound transaction) even though the note would ultimately be an intercompany obligation with respect to the NM group.

384 For a discussion of I.R.C. § 351, see supra note 126.

385 This conclusion assumes that certain exceptions to the nonrecognition exception that may apply to § 351 transactions do not apply. Treas. Reg. § 1.1502-13(g)(3)(B)(1). For example, if S received property from N in addition to N stock and this caused S to recognize gain under I.R.C. § 351(b), the transaction would no longer fall within the nonrecognition exception and the note would be treated as satisfied and reissued.

386 Under the former regulations, the note would be deemed satisfied and reissued because although no gain or loss is recognized on the exchange of the note, S would realize a loss on the exchange. This outcome lends itself to a potential recast, (as described in Example 2.13), leaving certain unresolved issues. The current regulations have resolved some of these issues by both excluding certain nonrecognition transactions from the deemed satisfaction and reissuance rules and providing a more definite treatment of the recast for how a deemed satisfaction and reissuance occurs when such rules apply.

387 I.R.C. § 108(e)(8).

388 Under the former regulations, the transfer of the note would result in an amount realized, and thus the deemed satisfaction rules would apply (although the note would not be deemed reissued because it does not remain outstanding). If the note were contributed for no consideration (instead of for additional stock of S), there are no examples in the current regulations (or former regulations) addressing this situation. When such a transaction occurs, it appears that, under general tax principles, the more accepted view is that I.R.C. § 108(e)(6) (capital contribution rules) and not I.R.C. § 108(e)(8) (stock for debt rules resulting from a deemed satisfaction) should apply. Under the capital contribution rules, it would appear that if the holder’s basis in the debt equals the adjusted issue price of the debt, then the debtor would not be treated as incurring DOI income pursuant to I.R.C. § 108(e)(6), and the creditor would not have a loss on the capital contribution of the debt. Lidgerwood v. Commissioner, 229 F.2d 241 (2d Cir. 1956). If this analysis is correct, the extinguishment exception would apply. If, however, the holder’s basis in the debt is less than the adjusted issue price of the debt, one would expect under general tax principles that there may be DOI income to the debtor and no loss or deduction recognized to the creditor that contributed the debt to capital (and thus, the extinguishment exception would not apply). See generally § 2.4(b) and (c).

389 Under Treas. Reg. § 1.1502-13(f)(2)(iii), the principles of I.R.C. § 311(b) apply to distributions of loss property (as well as gain property) within a consolidated group.

390 Treas. Reg. § 1.1502-13(f)(2)(ii).

391 In Rev. Rul. 2004-79, 2004-2 C.B. 106, a subsidiary distributes parent debt to the parent in forgiveness of the debt (in a nonconsolidated context). The ruling concludes, in relevant part, that “because the

distribution of the P indebtedness to P extinguishes the indebtedness, it is repurchased within the meaning of Treas. Reg. § 1.61-12(c)(2), and P is treated as having repurchased its indebtedness for an amount equal to the fair market value of the indebtedness.”

392 There is no example in the regulations addressing this fact pattern, but this example demonstrates the most likely analysis.

393 Treas. Reg. § 1.1502-13(g)(5).

394 The results described in this section generally also occur under the former regulations. One significant addition, however, is an “inbound subgroup exception” that is not present in the former regulations. Similar to the subgroup exception noted in the outbound context, there is no deemed satisfaction and reissuance when members of an intercompany obligation subgroup cease to be members of a consolidated group, neither the creditor nor the debtor recognizes any amount with respect to the obligation, and such members constitute an intercompany obligation subgroup of another consolidated group immediately after the transaction. Treas. Reg. § 1.1502-13(g)(5)(i)(B)(2). The current regulations also retain an exception found in the former regulations for an acquisition by a securities dealer, but do not retain another exception found in the former regulations for an acquisition of debt due and retired within one year of the acquisition. Treas. Reg. § 1.1502- 13(g)(5)(i)(B)(1).

395 Treas. Reg. § 1.1502-13(g)(5)(ii)(A).

396 Treas. Reg. § 1.1502-13(g)(5)(ii)(B).

397 Treas. Reg. § 1.1502-13(g)(6)(i)(A).

398 Treas. Reg. § 1.1502-13(g)(6)(i)(B).

399 Treas. Reg. § 1.1502-13(g)(6)(i)(C).

400 This is also identical to Example 4 in Treas. Reg. section 1.1502-13(g)(5) of the former regulations.

401 Treas. Reg. § 1.108-2(f)(2).

402 Treas. Reg. § 1.108-2(f)(1).

403 It should be noted that these regulations include defined terms such as “purchase” and also include anti-abuse rules and should be applied carefully.

404 The IRS issued temporary and proposed regulations in 1993. Temporary regulations § 1.6050P-1T was effective January 1, 1994, for discharges of indebtedness after December 31, 1993. Final regulations § 1.6050P-1 generally became effective for discharges of indebtedness occurring after December 2, 1996, with an election to apply them to a discharge occurring after January 1, 1996. The provision has since been amended by T.D. 9160 (Oct. 22, 2004), T.D. 9430 (Nov. 7, 2008), and T.D. 9461 (Sept. 16, 2009). Proposed Treas. Reg. § 1.6050P-2, which addresses money lenders, was published on June 13, 2002, adopted in final form in T.D. 9160, and is effective for DOI on or after January 1, 2005.

405 I.R.C. § 6050P; Treas. Reg. § 301.6050P-1(a)(1).

406 I.R.C. § 6050P(c). More specifically, applicable financial entities include: (1) any financial institution described in I.R.C. § 581 or 591(a) (generally, banks, mutual savings banks, cooperative banks and domestic building and loan associations, and other savings institutions) and any credit union; (2) the FDIC, Resolution Trust Corporation, National Credit Union Administration, and any other federal executive agency, and any other successor or subunit of such; (3) any other corporation that is a direct or indirect subsidiary of an entity referred to in (1) above, but only if, by virtue of being affiliated with the entity, the corporation is subject to the supervision and examination by a federal or state agency that regulates such other entities; and (4) organizations significantly engaged in the trade or business of lending money.

407 I.R.C. § 6050P(c)(2)(d), added by Pub. L. No. 106-170 § 553(a) (1999); see also Treas. Reg. § 301.6050P-2 (addressing what is a significant money lending trade or business, including safe harbors).

408 Treas. Reg. § 1.6050P-1(a)(3).

409 Treas. Reg. § 1.6050P-1(d)(2).

410 Treas. Reg. § 1.6050P-1(a)(2).

411 Treas. Reg. § 1.6050P-1(b).

412 Treas. Reg. § 1.6050P-1(b)(2)(i)(A), 1(d)(1). Indebtedness is considered incurred for business purposes if it is incurred in connection with the conduct of any trade or business (except performing services as an employee). Indebtedness is incurred for investment purposes if it is incurred to purchase property held for investment as defined in I.R.C. § 163(d)(5).

413 Treas. Reg. § 1.6050P-1(b)(2)(i)(B).

414 Treas. Reg. § 1.6050P-1(b)(2)(i)(C), 1(b)(2)(ii).

415 Treas. Reg. § 1.6050P-1(b)(2)(i)(D).

416 Treas. Reg. § 1.6050P-1(b)(2)(i)(E).

417 Treas. Reg. § 1.6050P-1(b)(2)(i)(F). See P.L.R. 200212004 (Dec. 20, 2001) (finding Treas. Reg. § 301.6050P-1(b)(2)(i)(F) not applicable).

418 Treas. Reg. § 1.6050P-1(b)(2)(i)(G), -1(b)(2)(iii). See P.L.R. 200212004 (Dec. 20, 2001) (finding Treas. Reg. § 301.6050P-1(b)(2)(i)(G) not applicable).

419 Treas. Reg. § 1.6050P-1(b)(2)(i)(H), 1(b)(2)(iv). The testing period is 36 months, increased by the number of months the creditor was stayed from collection. This creates a rebuttable presumption that an “identifiable event” has occurred. This presumption may be rebutted if the creditor has engaged in significant collection activity (during the last 12 months of the 36-month period). Significant collection activity does not include merely nominal or ministerial collection activity, such as automated mailing.

420 Any transaction in which a lender loans money to, or makes advances on behalf of, a borrower (including revolving credits and lines of credit). Treas. Reg. § 1.6050P-1(d)(3).

421 Treas. Reg. § 1.6050P-1(d)(4).

422 Treas. Reg. § 1.6050P-1(d)(5). See § 2.4(a) for a discussion of I.R.C. § 108(e)(4).

423 Treas. Reg. § 1.6050P-1(d)(6).

424 Treas. Reg. § 1.6050P-1(d)(7).

425 Treas. Reg. § 1.6050P-1(e)(1)(i).

426 Treas. Reg. § 1.6050P-1(e)(1)(ii).

427 Treas. Reg. § 1.6050P-1(e)(2).

428 This assumes that the tax year remains open. See Significant Service Center Advice 200235030 (June 3, 2002). The IRS also concluded that under the applicable facts the taxpayer would not be entitled to a deduction under an alternate “Claim of Right” theory under § 1341 because (1) the discharge did not occur under a claim of right and (2) the payment of a personal loan is not deductible. See two articles addressing this Advice: Raby and Raby, Tax Traps IN Form 1099-C Discharge of Indebtedness, 2002 TNT 225-46 (Nov. 19, 2002); Raby and Raby, Taxpayer Repayments and the Tax Benefit Rule, 2002 TNT 228-26 (Nov. 25, 2002).