CHAPTER THREE

Partnerships and S Corporations

Tax Impact of Workouts and Bankruptcies

§ 3.1 Introduction

§ 3.2 Partnerships

(a) General Provisions

(b) Responsibility for Filing Tax Returns

(i) Partnership Entity

(ii) Partnership Disposition

(iii) Administrative Expenses

(c) Types of Debt Restructurings

(i) Modification of Terms

(ii) Purchase Price Reduction

(iii) Reduction of Principal

(A) Cancellation of Real Property Business Indebtedness 150

(iv) Exchange of Debt for Partnership Interest

(d) Partnership Impact

(e) Partner-Level Impact

(i) Reporting by Partners

(ii) Allocation to Individual Partners

(iii) Discharge of Partnership Debt

(f) Tax Attribute Reduction

(g) Character of Debt

(i) Allocation to Passive Activities

(h) Reduction of Partnership Interest

(i) Senate Committee Report

(j) Exchange of Partnership Interest for Debt

(k) Abandonment of Partnership Interest

(l) Impact of Partner Bankruptcies

§ 3.3 S Corporations

(a) General Provisions

(b) Responsibility for Filing Corporate Returns

(c) Tax Attribute Reduction

(d) Exceptions

(e) Impact on Shareholder

(f) Impact of Termination

(g) Debt Modifications and Restructurings

(h) Reorganization under Section 368

(i) Liquidations

(j) Bankruptcy Estate

(k) Shareholder Bankruptcy

(l) Shareholder Guarantee

§ 3.1 INTRODUCTION

As the number of real estate failures and workouts has increased, the tax consequences of debt modifications and discharge of partnership debt, exchange of partnership interest for debt, and termination of partnership interest have received more attention from tax practitioners and the IRS. Tax law changes during the 1980s resulted in an increase in the number of corporations electing the S status. These corporations have incurred financial problems, as have many C corporations.

Although the tax consequences for workout and bankruptcy purposes of a partnership are significantly different from those of an S corporation, both entities are discussed in this chapter because the profits and losses from each type of entity are generally passed through to the partners or the shareholders.

This chapter describes the major tax issues that arise when a troubled partnership or S corporation files a bankruptcy petition or attempts to solve its financial problems in an out-of-court workout.

§ 3.2 PARTNERSHIPS

(a) General Provisions

Considerable confusion existed in prior law as to the proper way to handle discharge of partnership debt. The confusion centered around a controversial decision in the Fifth Circuit. In Stackhouse v. United States,1 discharge of a partnership debt was not treated as income to the partnership but was deemed to be a distribution to the individual partners under Internal Revenue Code (I.R.C.) section 752(b). As a result, partners would recognize income only to the extent that their shares of the debt discharge exceeded their bases in the partnership interest, in accordance with I.R.C. section 731(a). Under prior practice, the gain from debt discharge was first reviewed at the partnership level. If nonrecognition was permitted, then, under Treasury Regulations (Treas. Reg.) section 1.61-12(b), the nonrecognition was considered at the partner level. For example, the IRS claimed that partners received a constructive cash distribution under I.R.C. section 752(b), which reduced the basis of the partners’ interests under I.R.C. sections 705(a) and 733.2 Taxability was determined under I.R.C. section 731(a) after applying the insolvency exception in Treas. Reg. section 1.61-12(b). The degree of interplay between I.R.C. sections 752(b) and 61(a)12 was, however, very unclear.3

The Tax Court ruled on two cases involving this issue in 1987. In Gershkowitz v. Commissioner,4 the first case outside the Fifth and Eleventh Circuits (note that the Fifth Circuit’s decision in Stackhouse predates the creation of the Eleventh Circuit), the court held that the taxpayer (partner) had to recognize ordinary income at the time the debts were discharged under I.R.C. section 702 (a)(8). This income provided each partner with an increase in basis under I.R.C. section 705(a)(1)(A). At the same time, each partner received a distribution from the partnership equal to his or her share of the debt canceled under I.R.C. section 752(b). Thus, there would be no net change in the partner’s basis—an increase under I.R.C. section 705 and a distribution and decrease in basis under I.R.C. sections 752 and 733. In a decision arising in the Eleventh Circuit (Moore v. Commissioner),5 the Tax Court determined that it was bound by the Fifth Circuit’s decision in Stackhouse and would therefore reach a result contrary to the decision in Gershkowitz. In Moore, the court held that income from discharge of a partnership debt was capital gain and not ordinary income, based on the reasoning in the Stackhouse case as discussed above. Both Gershkowitz and Moore were based on the code prior to its amendment by the Bankruptcy Tax Act of 1980.

I.R.C. section 108(d)(6), which was added by the Bankruptcy Tax Act of 1980, overturned the Stackhouse decision by providing that income from debt cancellation would not be excludable at the partnership level, but would instead be allocated to the individual partners under I.R.C. section 702. Thus, the debt discharge is applied at the partner level rather than at the partnership level. In addition, the earlier disallowance of nonrecognition if the discharge results in the solvency of the partner no longer applies in a title 11 case.

If a partner receives money from the partnership under an obligation to repay the money, this is a loan and not a distribution of property. If the partnership subsequently cancels the partner’s debt, Treas. Reg. section 1.731-1(c)(2) requires the partner to realize income from debt discharge. In a liquidation of a partnership, the taxpayer must be able to present evidence that part of the amount received related to debt canceled, in order to claim that the income on liquidation was from debt discharge.6

The IRS, in Revenue Proceeding (Rev. Proc.) 92-35,7 announced that if, under local law and the partnership agreement, the bankruptcy or removal of a general partner of a limited partnership causes the dissolution of the partnership, unless the remaining general partners or at least a majority in interest of all remaining partners agree to continue the partnership, then the IRS will not take the position that the limited partnership has the corporate characteristic of continuity of life. Rev. Proc. 92-35 applies to all limited partnerships whose partnership agreements contain, specifically or by operation of local law, this provision.

(b) Responsibility for Filing Tax Returns

I.R.C. section 1399 provides that no new entity is created when a case is filed by a partnership under the provisions of the Bankruptcy Code. Likewise, no new entity is created for a corporate bankruptcy. The bankruptcy trustee would be required to file a partnership information return (Form 1065) under I.R.C. section 6031 for the period(s) during which the trustee was operating the business. The committee reports indicate that it is the responsibility of the trustee to file the partnership return, although this is not specifically required by the statute.8 In a private letter ruling,9 the IRS held that a trustee of a partnership is responsible for filing Form 1065 only for the year during which the trustee was appointed and subsequent years. No obligation exists to file Form 1065 for earlier partnership years. The trustee must, however, cooperate with the IRS by providing any and all relevant tax information it may have concerning prior years. In another private letter ruling,10 the IRS indicated that in preparing a partnership return for which prior years were not filed, the trustee should base the return for the first year in which it has the responsibility for filing on all the information that is available. If additional information becomes available, an amendment can be made to the return.

In In re Samoset Associates,11 the bankruptcy court held that there is no specific requirement for the filing of federal income tax returns by the trustee in bankruptcy of a partnership in ordinary bankruptcy proceedings. The court discovered no authority for the proposition put forth by the government that I.R.C. section 6012 imposes a duty on the trustee in bankruptcy of a bankrupt partnership to file income tax returns. I.R.C. section 6012 imposes responsibility for the filing of federal income tax returns on individuals, fiduciaries and receivers, and corporations.

Samoset involved a liquidation under the Bankruptcy Act after an effort to reorganize under Chapter XII had failed. The court justified the decision not to require a return because the partnership was in the process of liquidating the assets of the partnership.12

In several situations, a question has arisen as to who will cover the cost of preparing the return if no free assets are available. The bankruptcy court addressed one aspect of this issue in In re Cotswold Village.13

The trustee for Cotswold Village Investors, Inc. (and a number of other related companies that filed under chapter 11) was unable to hire accountants to prepare the debtor’s tax returns because the assets of the debtor were frozen. The trustee filed a motion seeking an order indicating that he had no responsibility for filing partnership tax returns for the debtors. The government claimed that a trustee has a statutory duty to file these returns.

The court noted that a chapter 11 trustee is charged by the statute with many responsibilities, but could find no instance requiring the trustee to finance the expense out of his or her own personal resources. The bankruptcy court, however, ruled that the trustee may apply to the court for an order to assess the cost of the preparation of the returns against the partners of the debtors. The court also noted that the filing would be to the benefit of the partners of the debtor.

The National Office of the IRS issued a “policy statement” change indicating that it would issue prompt determination letters only on returns for which there is a tax liability. The IRS no longer issues determination letters for partnerships. However, it is still advisable for the debtor to request such a letter and properly document the request. For example, in In re First Securities Group of California, Inc.,14 the bankruptcy court considered the request valid over the objection of the IRS. See § 10.3(a) for a discussion of this case.

(i) Partnership Entity

The filing of a partnership petition creates a separate estate15 for bankruptcy purposes but, as noted earlier, no new estate (entity) is created for tax purposes. The partnership may file a chapter 7, 11, or 12 petition. Thus, the partnership return is filed in its normal manner as though no bankruptcy petition was filed.

On the filing of a chapter 7 petition, the estate is turned over to the trustee. The functions of the trustee are to protect the assets of the partnership, to liquidate the partnership in an orderly manner, and to distribute the proceeds according to the priority order provided by the Bankruptcy Code. Although the partnership is liquidated, the debts are not discharged; only an individual can obtain a discharge in a chapter 7 proceeding.16

If the estate is unable to pay all creditors’ claims, then each general partner is liable to the trustee for the full amount of the deficiency.17 If any of the general partners wants a discharge, such partner must file a separate bankruptcy petition. Furthermore, section 723(b) of the Bankruptcy Code provides that the trustee, to the extent practicable, must seek recovery from general partners that are not debtors in a title 11 case.

(ii) Partnership Disposition

A transfer of the partnership interest of an individual in bankruptcy to the estate does not result in a disposition for any Internal Revenue Code purpose.18 Section 364(g)(1)(A) of the Bankruptcy Code provides that no gains or losses will be recognized for state and local tax purposes.19

A transfer of 50 percent or more of the interest in a partnership by an individual to the bankruptcy estate will not terminate the partnership under I.R.C. section 708.20 A partnership that files a petition continues in existence, even though an estate is created for bankruptcy purposes.21 Thus, there has not been a termination of the partnership.

(iii) Administrative Expenses

The Bankruptcy Code provides that administrative expenses are deductible for state and local tax purposes.22 Also, administrative expenses are deductible by an individual.23 This provision (I.R.C. section 1398(h)(1)) refers to section 503 of the Bankruptcy Code, which allows for an administrative expense deduction for all estates: individuals, partnerships, and corporations. It would appear that the partnership would incur the same type of administrative expenses as an estate of an individual and should be entitled to the deduction from income earned at the partnership level. An alternative interpretation of these expenses would be that they are deductible at the partner’s level, but not by the partnership. However, unlike the provision for debt discharge,24 no special provision was made for this treatment. Thus, it might be presumed that a partnership can deduct the administrative expenses.

(c) Types of Debt Restructurings

During the last half of the 1980s and in the early 1990s, large numbers of real estate investors and developers were unable to make the payments required by their loan agreements. As a result, properties were sold at losses or the debt was restructured. Many owners allowed the properties to be sold, transferred to the lenders through foreclosure proceedings, or deeded to the mortgage holders in lieu of foreclosure. Businesses and individuals faced the same problem following the beginning of the recession toward the end of 2007.

Debt of partnerships can be restructured in many different ways; however, the methods can be classified into four basic types:

(i) Modification of Terms

Many lenders have agreed to modify the terms of their debt instruments rather than foreclose on a property or seek other types of action against debtors. In these cases, the debtors need to consider the tax impact. Generally, a modification of the debt does not have any tax impact, but an exchange (or a “material” modification) of one debt instrument for another may have adverse tax consequences. Modification typically involves altering the maturity date and/or the interest rate. In some partnerships, the modification may involve the conversion of recourse debt to nonrecourse.

The extent to which a modification can be made without being construed as an exchange or a “material” modification became controversial because of (1) the repeal of I.R.C. section 1275(a)(4) by the Revenue Reconciliation Act of 1990, and (2) the decision of the Supreme Court in Cottage Savings Association v. Commissioner.25 The Court held that an exchange of mortgage pools was taxable because each pool represented a legally distinct entitlement. The Court rejected the IRS’s argument that there was a material modification due to an economic analysis and instead held that a material modification existed because the holder of the properties enjoyed legal entitlements that were materially different in kind and extent. Cottage Savings involved the exchange of mortgage portfolios by two savings and loan associations.

As a result of Cottage Savings, the IRS issued regulations26 intended to help determine when a modification of a debt instrument is sufficient to warrant the recognition of a gain or loss.27 Where the modification is material and an exchange is found to occur, income from debt discharge will be determined by comparing the excess of the adjusted price of the old debt over the issue price of the new debt. For a discussion of what type of modification is considered an exchange and how the gain is determined, see § 2.4(d)(iii)(B).

An issue in many real estate workouts is whether the conversion of debt from nonrecourse to recourse or vice versa is a material modification. As noted, a change in the collateral, according to Rev. Rul. 73-160, was not considered a material modification. If the conversion is from recourse to nonrecourse, it might be argued that income from debt discharge should be realized to the extent that the debt exceeds the fair market value of the collateral. To claim this difference as income, it would appear that the IRS would have to show that the parties to the adjustment did not expect repayment. There was some concern that the IRS might use an anti-abuse argument to claim that if the new or modified debt instrument is nonrecourse, then issue price of the new instrument should not exceed the fair market value of the debt instrument that was eliminated. Income from debt discharge would result if the value of the original debt instrument was less than the balance. The final regulations adopt the rule of the proposed regulations that a change in the recourse nature of an instrument is a significant modification, but limit this specific rule to changes from substantially all recourse to substantially all nonrecourse, or vice versa. If an instrument is not substantially all recourse or not substantially all nonrecourse either before or after a modification, the significance of the modification is determined under the general significance rule. Importantly, the final regulations provide that a modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. See § 2.4(d)(iii)(B) for a detailed discussion of the rules related to debt modification.

Although a recourse-nonrecourse modification of a debt instrument may not result in income from debt discharge for a debtor partnership and eventually for the partner, the modification may result in a recognized gain for the individual partner. For example, if the modification alters the allocation of the debt between partners under I.R.C. section 752, gain may be recognized.

(ii) Purchase Price Reduction

I.R.C. section 108(e)(5) provides that no income from debt discharge is created when a purchase money debt containing a mortgage on specific property of a solvent nonbankrupt debtor is reduced. I.R.C. section 108(e)(5) does not apply to insolvent debtors or to title 11 debtors. However, the IRS, in Rev. Proc. 92-92,28 provides that, for a partnership that is either bankrupt or insolvent for purposes of I.R.C. section 108, the IRS will not challenge the partnership’s treatment of a reduction (in whole or in part) of an indebtedness owned by the partnership as a purchase price adjustment, provided the transaction would qualify as a purchase price adjustment for purposes of I.R.C. section 108(e)(5) were it not for the bankruptcy or insolvency of the taxpayer.

The IRS noted that the favorable tax treatment will not apply to a partnership if any partner adopts an income tax reporting position regarding the debt discharge that is not consistent with the partnership’s income tax treatment of that discharge.

In Hirsch v. Commissioner,29 the Seventh Circuit held that a discharge of debt qualifying as an adjustment of purchase price allows adjustments of specific asset basis in lieu of general attribute reduction. I.R.C. section 108(e)(5) applies only to adjustments that are made between the original buyer and the original seller. However, several commentators regard I.R.C. section 108(e)(5) as a safe harbor rule and not one that disallows the reduction of purchase price when the debt is held by a third party.30 The IRS held, in Rev. Rul. 91-31,31 that the reduction of the principal amount of an undersecured nonrecourse debt by the holder of the debt, who was not the seller of the property securing the debt, results in the realization of income from debt discharge. See § 2.8(b) for a discussion of Rev. Rul. 91-31.

(iii) Reduction of Principal

In cases where the value of the collateral is much less than the amount of a nonrecourse note, the lender may agree to reduce the debt. As noted, a reduction in principal is considered a material modification of the debt. Under these conditions, the debtor will have income from debt discharge regardless of the nature of the debt, recourse or nonrecourse. See § 2.4(d) for a complete discussion of debt-for-debt exchanges.

(A) Cancellation of Real Property Business Indebtedness

The Omnibus Budget Reconciliation Act of 1993 allows individuals, partnerships, S corporations, and fiduciaries to exclude from gross income gain due to the discharge of qualified real property business indebtedness. Qualified real property business indebtedness is indebtedness that (1) is incurred or assumed in connection with real property used in a trade or business and (2) is secured by the real property. Qualified real property business indebtedness does not include qualified farm indebtedness. However, special rules under I.R.C. section 108(g) allow solvent farmers to make the election to reduce tax attributes. Debt incurred or assumed by the taxpayer after December 31, 1992, will qualify only if it was incurred or assumed in connection with the acquisition, construction, reconstruction, or substantial improvement of real property, or to finance the amount of any qualified real property business indebtedness.

The amount that is excluded cannot exceed the excess of the outstanding principal of the debt just prior to discharge over the fair market value of the business property that is the security for the debt. For the purposes of determining the fair market value of the property, the fair market value of the property is reduced by the outstanding principal amount of any other debt secured by the property.

Reduction in the basis of depreciable property may not exceed the adjusted basis of the depreciable real estate held by the taxpayer immediately before the discharge, determined after any reductions that might be required under I.R.C. sections 108(b) and (g). The basis is determined as of the first day of the next taxable year—or earlier, if the property is disposed of after the discharge occurs and before the end of the taxable year. Thus, basis in property other than the property that secures the debt that was discharged may be reduced under this provision. To some extent, this legislation codifies the ruling in Fulton Gold Corp. v. Commissioner.32 Fulton Gold held that the reduction of a nonrecourse debt was not income from debt discharge but should rather be reflected in basis reduction.

Consider this example involving an S corporation that owns a building with a fair market value of $600,000 and a basis of $500,000. The building is pledged as security for a first mortgage for $530,000 and a second mortgage for $150,000. The corporation settles the second mortgage for a payment of $50,000 and has $100,000 of cancellation of debt income. If the debtor so elects, it may exclude from income $80,000—the amount by which the second mortgage exceeds the value of the property less the outstanding principal of any other debt securing the property [$150,000 – ($600,000 – $530,000)]. The basis of the property will be reduced by the amount of income from debt discharge that is excluded from current income, or $420,000 ($500,000 – $80,000).

The corporation will be required to report as income $20,000 of the $100,000 of gain realized from debt discharge.

(iv) Exchange of Debt for Partnership Interest

In cases where a partnership is not able to make its debt payments, rather than foreclosing on the property, the lender may agree to accept an interest in the partnership in exchange for cancellation of all or part of the debt of the partnership. For a discussion of the tax impact of the exchange of debt for an equity position in the partnership, see § 3.2(j).

(d) Partnership Impact

The handling of a cancellation of a partnership debt may be summarized in this way:

(e) Partner-Level Impact

The tax treatment of an individual partner as a result of debt discharge will depend on the financial status of each individual partner. A solvent partner that has not filed a bankruptcy petition would consider the debt cancellation to be income unless the discharge occurred prior to January 1, 1987, and the partner elected to reduce the basis under the qualified business indebtedness provision. An insolvent partner or partner in bankruptcy would be subject to rules that apply to the debt discharge of income for taxpayers under those conditions. The taxpayer would either reduce certain tax attributes or first elect to reduce the basis of depreciable property.

(i) Reporting by Partners

The income from debt discharge is treated as a separately stated line item to each partner under I.R.C. section 702 (a).

As noted in § 3.2(d), the partner’s basis is reduced by a constructive distribution of cash caused by the reduction in partnership liabilities under I.R.C. section 731. Under I.R.C. section 731(a) (1), the partner may be required to recognize income to the extent that the constructive distribution exceeds the partner’s basis. For example, a gain would be recognized in a situation where the partner’s allocated share of the income from debt discharge is less than the constructive cash distribution and the partner does not have enough basis to absorb the excess of basis reduction under I.R.C. sections 752 and 731 over the increase in basis under I.R.C. section 704(b).

However, the partner may have a larger basis in the partnership if the partner’s share of the income from debt discharge exceeds the constructive distribution of cash under I.R.C. section 731.

In Babin v. Commissioner,33 the Sixth Circuit held, in a pre-1980 Bankruptcy Tax Act law case, that an insolvent partner is not entitled to an increase in basis because the partner did not report income as the partner was insolvent. In Babin, the bankrupt partnership reached an agreement with a bank, discharging over $2.4 million of secured debt. Under the partnership agreement, the taxpayer was allocated 51 percent of the income from debt discharge (approximately $1.2 million) as a general partner. The taxpayer increased his basis by the amount of debt discharged under I.R.C. section 705. Section 705 provides that each partner’s basis in the partnership is increased by its distributive share of the partnership income resulting from the debt discharge. Under I.R.C. section 752, there is a deemed distribution and resulting decrease in each partner’s basis to the extent that each partner is liable for the debt. While these are independent adjustments, they generally would cancel each other out prior to Babin. However, if the partner’s allocable share of partnership debt is greater than its share of partnership income (as was the case of the partner in Babin), the deemed distribution will be greater than the basis increase. This could result in the recognition of gain by the partner if the partner’s basis was otherwise insufficient to support the deemed distribution. In Babin, the taxpayer was liable for 75 percent of the partnership debt under the partnership agreement, resulting in a deemed distribution of over $3.9 million from the debt settlement. When the taxpayer considered the increase in basis of $1.2 million, the deemed distribution of approximately $3.9 million resulted in a taxable gain. However, when the basis increase was disallowed, the taxpayer recognized almost $1.3 million of taxable gain on the deemed distribution.

The Sixth Circuit concluded that the taxpayer’s $1.2 million share of the partnership’s income from debt discharge did not pass through to the taxpayer because it was not taxable due to the insolvency exception. The court held that the basis adjustment provided under I.R.C. section 705(a) (1)(A) applies only to income from debt discharge that is taxed to the individual partner or passes through to that partner. Thus, if the partner is in bankruptcy or falls under the insolvency exception, the Sixth Circuit ruled that the income is not taxable and thus no basis increased would be allowed under I.R.C. section 705.

As noted earlier, this decision was based on the Internal Revenue Code in effect prior to the amendments by the Bankruptcy Tax Act of 1980. Thus, it would appear that this ruling should not apply to cases based on the I.R.C. after amended by the Bankruptcy Tax Act of 1980. In spite of a clear legislative intent to reverse resulting in cases like Babin, Sheryl Stratton, reporting on a meeting of the ABA Tax Section on Real Estate, notes that some agents are evidently still citing Babin as good law.34 Although the IRS has made no formal announcement regarding the applicability of Babin to post-I.R.C. filings, it has indicated informally that it assumes that Babin applies only to pre-I.R.C. cases.

The Tax Court has held that a Texas woman’s community interest in a loss passed through from her husband’s partnership had to be reduced by the excluded discharge of indebtedness (DOI) income that was also passed through.35

The taxpayers argued that the DOI income was not community property because it was generated by the husband’s release from his guaranty of the promissory note. The Tax Court found that the DOI income was generated by the bank’s discharge of the sovereign’s indebtedness. Because the taxpayers stipulated that the partnership interest was community property under Texas law, the Tax Court held that any income and deductions attributable to that partnership interest were also community property.

(ii) Allocation to Individual Partners

Under Rev. Rul. 92-97,36 if a partner is allocated a share of the partnership’s cancellation of debt (COD) income that differs from the partner’s share of the canceled debt under I.R.C. section 752(b), the allocation of income from debt discharge must have substantial economic effect under I.R.C. section 704(b). The IRS concluded that the allocation difference has substantial economic effect under I.R.C. section 704(b) if:

• The deficit restoration obligations covering any negative capital account balances resulting from the DOI income allocations can be invoked to satisfy other partners’ positive capital account balances; and
• The requirements of the economic effect test are otherwise met.
• Substantiality is independently established.

These rules disallow any allocation of income from debt discharge that is different from the partner’s share of the debt, even though such an allocation is provided in the partnership agreement and the allocation complies with an alternative test for economic effect.

Rev. Rul. 92-97 contains two examples that illustrate the allocation procedure.

(iii) Discharge of Partnership Debt

In a technical advice, the IRS ruled that when a bankruptcy court discharges a partner from his share of a partnership recourse debt, the partner’s tax consequences are determined under I.R.C. sections 731 and 752, not under I.R.C. sections 61(a)(12) and 108(a).37 The IRS further ruled that the partner’s tax consequences from his acceptance of cash in cancellation of a liability owed him by the partnership are, depending on the facts, determined under I.R.C. sections 731, 752, and 166.

In June 1986, the partner sold rental property to the partnership in exchange for a note payable of $49,621. He reported the sale under the I.R.C. section 453 installment method. The partnership made monthly payments on the note through June 1991. It made no payments after that, leaving both principal and accrued interest due. As of December 31, 1992, the partner maintained that he was owed $49,166 on the note. In addition, the partnership had also incurred $279,000 in third-party secured debt.

When the partner filed a chapter 7 voluntary bankruptcy petition, he listed his share of the partnership’s secured debt as a liability. He did not list his portion of the note payable as a debt on his bankruptcy petition, but he did list it as an asset. At that time, the partner had a negative capital account of $91,000 and a basis in his partnership interest of $18,000.

Under the subsequent bankruptcy order, the partner was released from all dischargeable debts, including his $93,000 share of the secured debt. Before the end of 1992, the court closed the partner’s bankruptcy estate, and the partnership interest reverted to him.

The IRS pointed out that under Treas. Reg. section 1.752-2, a partner’s share of partnership recourse debt equals the portion of economic risk of loss borne by the partner. Excluding the note payable, the partnership owed $279,000 of recourse debt when the partner filed his bankruptcy petition. The partner had a one-third interest in the partnership, so his share of the debt was $93,000. When that debt was discharged, a deemed distribution was created under I.R.C. section 752(b). Based on Rev. Rul. 94-4,38 the IRS ruled that a deemed distribution of money under section 752(b) resulting from a decrease in a partner’s share of partnership liabilities is treated as an advance or drawing of money under Treas. Reg. section 1.731-1(a)(1)(ii). This distribution is taken into account at the end of the partnership tax year.

Thus, the deemed distribution took place on December 31, 1992, the last day of the partnership’s 1992 tax year. At that time, the partner’s bankruptcy estate was closed and the partnership interest, with a tax basis of $18,000, had already reverted to him. Consequently, the partner recognized a gain of $75,000 ($93,000 – $18,000) under I.R.C. section 1001. Depending on the application of I.R.C. section 751(a), the IRS said, the gain may be capital or ordinary. The IRS noted that this result is consistent with the Tax Court’s decision in Moore v. Commissioner.39 It distinguished its ruling from Marcaccio v. Commissioner, where the gain was reported as income for debt discharge. 40

(f) Tax Attribute Reduction

Applying the procedure in I.R.C. section 108(b)(4) for reducing tax attributes to the partners would require that:

• All reductions of partners’ tax attributes are to be made after the determination of the partners’ tax for the year of discharge.
• Reductions for partners’ net operating loss (NOL) and capital loss carryovers are to be made first in the loss for the taxable year of the discharge and then in the carryovers to such taxable years in the order of the taxable years from which each carryover arose.

Credit carryovers (including foreign tax credits) of partners are to be made in the order in which the carryovers are listed in I.R.C. section 108(b)(2) for the taxable year of the discharge.

These provisions allow a partner to exclude gains due to debt discharge from income and, before reducing partnership basis, to use NOLs, certain credit carryovers, and capital loss carryovers to absorb all or part of the gain due to debt discharge. Thompson and Tenney suggest that these provisions make effective planning possible by allowing the partner to immediately use certain credit carryovers that otherwise would be taxed over a much longer time period.41

A partner with a $240,000 short-term capital loss carryover would, without any capital gains, be able to use only $3,000 per year. If this partner has an interest in a partnership having financial problems and if the other partners agree, a voluntary petition could be filed so that the partner’s allowable share of the debt discharge could be used to reduce the capital loss carryover.42 Otherwise, it would take 80 years to use up the capital loss carryover.

(g) Character of Debt

In order for a solvent, noncorporate partner that has not filed a petition under title 11 to reduce basis of depreciable property, the debt discharge must occur prior to January 1, 1987, and be in connection with property used in the partner’s trade or business. It would appear that the character of the debt at the partnership level would be used to make this determination.43 If this interpretation is in error, most limited, solvent partners in real estate and other investment partnerships would most likely be required to report the gain in income. At the partner level, the debt will probably not be considered a trade or business debt.

(i) Allocation to Passive Activities

According to Rev. Rul. 92-92,44 income from discharge of indebtedness is generally characterized as income from a passive activity for purposes of I.R.C. section 469 to the extent that, at the time the indebtedness is discharged, the debt is allocated to passive activity expenditures and as income from a nonpassive activity to the extent that, at the time indebtedness is discharged, the debt is not allocated to passive activity expenditures.

Temporary Treas. Reg. section 1.163-8T provides that interest expense is generally allocated in the same manner as the debt to which the interest expense relates, for purposes of the passive loss limitation of I.R.C. section 469. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.

The IRS has concluded that it is generally appropriate to allocate the income from debt discharge in the manner in which Temporary Treas. Reg. section 1.163-8T allocates the debt at the time of the discharge and to treat the income allocated to an expenditure as income from the activity to which the expenditure relates.

The IRS also indicates that traditional substance-over-form and step-transaction principles will apply to prevent taxpayers from attempting to manipulate the character of the income from debt discharge.

In Rev. Rul. 92-92, the IRS provided Example 3.1.

The Bankruptcy Tax Act amended I.R.C. section 703 to provide a fifth exception to the requirement that the election affecting the computation of taxable income derived from a partnership is to be made by the partnership. The exception added provides that an election to reduce first depreciable property in a bankruptcy or insolvency case, or to reduce depreciable property in an out-of-court solvency situation involving qualified business indebtedness discharged prior to January 1, 1987, is allowed at the partner level.45 This exception was added because of the requirement to apply the provision of I.R.C. section 108 at the partner level.46

(h) Reduction of Partnership Interest

I.R.C. section 1017(b)(3)(C) provides that a partner’s interest in a partnership is to be treated as depreciable property to the extent of such partner’s proportionate interest in depreciable property owned by the partnership. Thus, for a partner that elects to reduce basis in partnership interest, the partnership will be required to make a reduction in the basis of the partnership’s assets with respect to that individual partner. This reduction would be made in a manner similar to that which would be required in a transfer of partnership interest when, under I.R.C. section 754, the partner made an election to reduce basis. Because this reduction is treated as a depreciation deduction, subsequent sale of the partnership might result in ordinary income under I.R.C. section 1245.47 It appears that if the partnership will not make the basis reduction, the partner cannot adjust Form K-1 to allow for this reduction and would have to report the gain as income or reduce the basis of other property.

The determination of a partner’s proportionate share will not be difficult in simple partnership arrangements where the shares are consistent from year to year and are identical with respect to the different types and levels of profits and losses. There are, however, situations where complex profit and loss sharing arrangements exist, creating problems that will probably have to be resolved by regulation. Rabinowitz and Greenbaum make these comments regarding the more complicated partnership arrangements:

One such arrangement involves a shift of sharing ratios upon the occurrence of a certain event, e.g., the recovery by the limited partners of their investment. Another type of arrangement involves different ratios for sharing profit tiers among the partners. For example, a partnership agreement may provide that cash flow is to be distributed in the following order of priority: first to the limited partners an 8 percent preferred return on their investment, then to the general partner a 2 percent subordinated return on the investment of the limited partners, and the balance 80 percent to the limited partners and 20 percent to the general partner. How is one to determine any partner’s share in the “depreciable property” held by such partnerships? Perhaps, the test should be based upon the extent to which a partner would share in the proceeds of a sale of depreciable property at the time the determination is made. This in turn may involve a valuation of that property. The task of those charged with drafting these regulations will not be an easy one.48

The election to treat a partnership interest as depreciable property is permitted only when a partner has an interest in a partnership having depreciable property. It appears that it would not be necessary for the canceled debt to have been related to either the partnership or the partnership’s interest, the basis of which is reduced.49

(i) Senate Committee Report

The following excerpt from the Senate committee report illustrates many of the points just discussed regarding the discharge of indebtedness of a partnership:

[A]ssume that a partnership is the debtor in a bankruptcy case which begins March 1, 1981,50 and that in the bankruptcy case a partnership liability in the amount of $30,000 is discharged. The partnership has three partners. The three partners have equal distributive shares of partnership income and loss items under section 702(a) of the Code. Partner A is the debtor in a bankruptcy case; partner B is insolvent (by more than $10,000), but is not a debtor in a bankruptcy case; and partner C is solvent, and is not a debtor in a bankruptcy case.

Under section 705 of the Code, each partner’s basis in the partnership is increased by $10,000, i.e., his distributive share of the income of the partnership. (The $30,000 debt discharge amount constitutes income of the partnership for this purpose, inasmuch as the income exclusion rules of amended section 108 do not apply at the partnership level.) However, also by virtue of present law, each partner’s basis in the partnership is decreased by the same amount (Code secs. 752 and 733). Thus, there is not [sic] net change in each partner’s basis in the partnership resulting from discharge of the partnership indebtedness except by operation at the partner level of the rules of sections 108 and 1017 of the Code (as amended by the bill).

In the case of bankrupt partner A, the $10,000 debt discharge amount must be applied to reduce net operating losses and other tax attributes as specified in the bill, unless A elects first to reduce the basis of depreciable assets. The same tax treatment applies in the case of insolvent partner B. In the case of solvent partner C, such partner can elect to reduce basis in depreciable assets in lieu of recognizing $10,000 of income from discharge of indebtedness (providing the discharge occurred prior to January 1, 1987).

If A, B, or C elects to reduce basis in depreciable assets, such partner may be permitted, under the Treasury regulations, to reduce his basis in his partnership interest (to the extent of his share of partnership depreciable property), because the bill treats that interest as depreciable property. However, a partner may reduce basis in his interest in the partnership only if the partnership makes a corresponding reduction in the basis of the partnership property with respect to such partner (in a manner similar to that which would be required if the partnership had made an election under section 754 to adjust basis in the case of a transfer of a partnership interest).51

(j) Exchange of Partnership Interest for Debt

I.R.C. section 108(e)(7)(F) provides that the Treasury will propose regulations dealing with the exchange of an interest in the partnership for partnership indebtedness. These proposed regulations are to be designed to provide for treatment similar to the issue of stock for debt. This section also provides that the regulations will deal with the subsequent sale of such interest in the partnership and how it will result in I.R.C. section 1245 income to the partner who was, at one time, a creditor.

Under existing law, the exchange of a partnership interest for debt will, however, have some tax consequences. Under I.R.C. section 752, the reduction in partnership liabilities as a result of the exchange of equity for debt will be treated as a distribution to the partners (other than the partner converting the debt). As a result of the distribution, each partner’s basis in the partnership will be reduced. Because the financing is now by a related party, the application of the at-risk rules to the debt must be determined.

The American Jobs Creation Act of 2004 contains an amendment to section 108(e)(8) providing that COD income will be recognized on the transfer of partnership interest for debt just as it applies for the transfer of stock of a corporation for debt. COD income will be recognized on the transfer to the extent that it would have been recognized if the debt was satisfied with cash equal to the fair value of the partnership interest. Any COD income on the transfer will be allocated to the partners that held debt prior to the transfer. This provision is in effect for transfers made after October 22, 2004.

(k) Abandonment of Partnership Interest

At times, a partner would like to abandon a partnership interest in order to obtain an ordinary loss rather than a capital loss. A partner that abandons property and is not relieved of any debt should recognize an ordinary loss for the amount of its adjusted basis in the partnership. In In re Kreidle,52 a partner that was also a debtor in bankruptcy recognized an ordinary loss for worthless partnership interest where the partner remained liable for the debt and received no distributions from the failed partnership. Earlier courts have held that an abandonment is treated as a sale or transfer. (See § 2.8(d) for a discussion of these cases.) Abandonment may be difficult in cases where the partner is personally liable for the debts of the partnership.

Treas. Reg. section 1.165-1(b) provides that a loss is allowable only if evidenced by a closed and completed transaction, fixed by identifiable events, and sustained during the taxable year. In Echols v. Commissioner,53 the Fifth Circuit determined that a refusal by a general partner to make additional payments on partnership nonrecourse debt was adequate enough to constitute an abandonment of the partnership interest. The court also determined that the facts supported an alternative worthlessness deduction under I.R.C. section 165(a).

Under I.R.C. sections 731, 741, and 752, a partner that is relieved of debt as a result of the abandonment will recognize a capital loss only to the extent of the adjusted basis in excess of the amount of the liabilities that are canceled.

A partner in bankruptcy may find that an interest in a partnership has been abandoned without any action by the partner. For example, in In re Nevin,54 the bankruptcy court ordered the trustee to abandon to the debtors their respective partnership interests in the limited partnerships. The order came after the IRS filed a motion for abandonment. The limited partnership filed a chapter 7 petition and ceased operating its restaurant. The bankruptcy court approved the sale of the restaurant, which resulted in a federal tax liability of approximately $100,000 to the partners.

The partners are in chapter 7 in a “no asset” case, and there are no funds in the estates of the individuals to pay the tax liability, but there are funds in the partnership to pay the taxes.

The impact of an abandonment on I.R.C. section 469 is unclear. It could be argued that an abandonment is an event that would trigger the use of suspended losses under I.R.C. section 469. Courts have held that forgiveness may occur when the creditor has abandoned the debt collection efforts in a case where the debt was not discharged.55

(l) Impact of Partner Bankruptcies

A transfer of a partnership interest of an individual in bankruptcy to the bankruptcy estate does not result in a disposition for federal tax purposes under I.R.C. section 1398(f) and for state and local tax purposes under I.R.C. section 346(g)(1)(A). Likewise, a transfer of 50 percent or more of the interest in a partnership by an individual to its bankruptcy estate will not terminate the partnership interest under I.R.C. section 708.56

There is some uncertainty as to the impact that nontermination of the partnership interest for tax purposes will have on allocations (gains, losses, etc.) in the year of the discharge.

Based on I.R.C. section 1398(f), the IRS, in a private letter ruling,57 held that all items of gain, loss, deduction, or credit for the entire year in which the petition is filed are allocable to the bankruptcy estate.

The partnership issued two K-1s; the first was issued to the individual debtor, reflecting the income from the income and expenses incurred prior to the bankruptcy filing, and the second K-1 was issued to the trustee for income and expenses subsequent to the filing. The bankruptcy court held that only one K-1 should have been issued for 1999, and it should have been issued to the trustee.58 The bankruptcy court noted that I.R.C. section 708(b)(1)(B), provides that only a sale or an exchange of a partner’s entire interest in a partnership closes the partnership’s taxable year with respect to the partner.

Other commentators have suggested that the estate’s gains, losses, and so on, should be allocated both to the individual and to the estate. For example, it can be argued that to not consider the tax on income earned as a prepetition tax is in opposition to the legislative history for I.R.C. section 1398(d)(2).59 The fact that the transfer of the property to the estate is not a disposition does not automatically lead to the conclusion that the debtor and the estate cannot both have an interest in the pass-through items for the year in which the petition is filed. Regarding a partnership pass-through entity, Malek notes that “although it is admitted that the non-disposition status of the transfer probably would put it beyond the reach of I.R.C. section 706(c)(2), it should not put it beyond the reach of I.R.C. section 706(d), which is triggered when there is a mere ‘change’ in a partner’s interest.”60

§ 3.3 S CORPORATIONS

The number of S corporations that filed chapter 11 petitions or attempted an out-of-court workout increased significantly during the late 1980s and early 1990s.

(a) General Provisions

Under I.R.C. section 61(a)(12), the S corporation has income from the cancellation of its debts unless excluded from income under the provisions of I.R.C. section 108. Any income that does not qualify for a section 108 exclusion loses its character as income from debt discharge in the case of an S corporation. This income is combined with other profits and losses and passes through to the shareholders. If the income from debt discharge arose from passive activities, that income would pass through to the shareholders as a part of the profit or loss from passive activities. If the debt arose for activity in a trade or business, then the income would be part of the S corporation’s trade or business profit or loss, which is passed through to the shareholders. Shareholders that receive the income will in turn increase their basis in their stock under I.R.C. section 1367(a)(1). Because the income from debt discharge cannot be distributed, it will increase the S corporation’s accumulated adjustment account (AAA) under I.R.C. section 1368(e)(1)(A).

The Tax Court held that when an individual who owned two S corporations filed for bankruptcy before the close of the S corporations’ year, the NOLs sustained during the year are reported by the bankruptcy estate. The NOLs then must be reduced by the discharge of the indebtedness income, limiting the amount of NOLs available to the individual.61 The bankruptcy court held that an individual debtor was entitled to pass-through losses from an S corporation, regardless of whether the debtor transferred its stock to a trust.62 The bankruptcy court rejected the IRS’s position that the taxpayer ceased to be a shareholder when it transferred shares to the trust. According to the bankruptcy court, the trust agreement supported Forte’s assertion that the trust may be a shareholder under I.R.C. section 1361. The court determined that because the taxpayer was taxed on the trust’s income under section 671, the corporation did not lose its status as an S corporation.

The court did, however, agree with the IRS that the adjusted basis had to be reduced.

(b) Responsibility for Filing Corporate Returns

The debtor in possession or trustee, if one is appointed, is responsible for filing the corporate tax return. Under I.R.C. section 1399, a separate estate is not created for federal income tax purposes when a corporation files a bankruptcy petition.

Even though income is not taxed at the corporate level in the case of an S corporation, there is no indication that the responsibilities for filing an S corporation return are different from those for filing a return of a C corporation. (For a discussion of the responsibility for filing corporate returns, see § 7.26.) However, it could be argued that the responsibility for filing an S corporation return is similar to that of a partnership. Both entities pass through income and losses to the owners—either partners or shareholders. (For a discussion of the responsibility for filing a partnership return, see § 3.2(b).)

The National Office of the IRS issued a “policy statement” change indicating that it would issue prompt determination letters only on returns for which there is a tax liability. The IRS no longer issues determination letters for S corporations. However, it is still advisable for the debtor to request such a letter and properly document the request. For example, in In re First Securities Group of California, Inc.,63 the bankruptcy court considered the request valid over the objection of the IRS. See § 10.3(a) for a discussion of this case.

(c) Tax Attribute Reduction

I.R.C. section 108(d)(7), as amended by the Tax Reform Act of 1984, provides that attributes are to be reduced and the income from debt discharge is to be handled at the corporate level under these conditions:

• The S corporation files a title 11 petition.
• The S corporation is insolvent (or to the extent that insolvency exists).
• In an out-of-court workout under I.R.C. section 108(g), the S corporation qualifies for attribute reduction due to “qualified farm indebtedness.”

In 2009, final regulations64 were issued providing guidance on the manner in which an S corporation reduces its tax attributes under I.R.C. section 108(b) for taxable years in which the S corporation has discharge of indebtedness income that is excluded from gross income under section 108(a). In particular, the regulations address situations in which the aggregate amount of the shareholders’ disallowed section 1366(d) losses and deductions that are treated as an NOL tax attribute of the S corporation exceeds the amount of the S corporation’s excluded discharge of indebtedness income. The regulations affect S corporations and their shareholders.

When an amount of COD income is excluded from taxable income under one of the relief provisions of I.R.C. section 108, certain favorable tax attributes of the taxpayer have to be reduced. Because an S corporation is a “pass-through entity,” the situation is complicated as the tax attributes to be reduced are at the individual shareholder level. Under the final regulations, certain amounts are calculated at the S corporation level and certain amounts are calculated at the shareholder level.

The novel feature of the regulation is the “deemed corporate level NOL” system that applies to cases where one shareholder has less favorable tax attributes than the amount of COD income excluded and another shareholder has more favorable tax attributes than the COD income excluded. The excess COD becomes a “deemed NOL,” which reduces the favorable tax attributes of the second shareholder.

In an S corporation, expenses and losses can be deducted only up to the amount of the shareholder’s tax basis in the S corporation, which includes shareholder loans to the corporation. When an S corporation shareholder has a loss in excess of basis, the excess becomes a “suspended loss.” It is fairly common for S corporation shareholders to have these suspended losses, which are carried forward indefinitely until the shareholder invests additional capital thereby obtaining additional tax basis in the S corporation (I.R.C. section 1366(d)). Under the S corporation regulations, each type of deduction retains its character when suspended for lack of basis. However, the regulation refers to all of the suspended deductions as “deemed net operating loss” or “deemed NOL.”

When an S corporation has cancellation of debt income that is not taxed because of the exclusions under Section 108(a), this is usually because the corporation is in bankruptcy or insolvent. Then the first step is to see if the shareholders have suspended deduction carryforwards, the “deemed NOL.” In a year when an S corporation receives nontaxable COD income and there is a deemed NOL, the COD income is allocated to the shareholders, generally based on shareholder percentages, to reduce their deemed NOL. (As with C corporations, the reduction of tax attributes takes place after the computation of tax for the year in question.) However, if a shareholder does not have any deemed NOL, no COD amount will be allocated to it.

Because section 108(b) contains ordering rules, the deemed NOL actually has to be tracked by its components and ordinary deductions are reduced first, then section 1231 losses, finally capital losses.

To facilitate the complicated corporation-shareholder interplay when there is untaxed COD income, the regulation calls for shareholders to inform the corporation of the amount of their deemed NOL. Because of possible basis differences due to different stock purchase prices and shareholder loans, there can be a wide difference in deemed NOL between two shareholders owning the same percentage of corporate stock.

Treas. Reg. 1.108-7 contains the following example:

Example 5. (i) Facts. During the entire calendar year 2008, A, B, and C each own equal shares of stock in X, a calendar year S corporation. As of December 31, 2008, A, B, and C each have a zero stock basis and X does not have any indebtedness to A, B, or C. For the 2008 taxable year, X excludes from gross income $30,000 of COD income under section 108(a)(1)(A). The COD income (had it not been excluded) would have been allocated $10,000 to A, $10,000 to B, and $10,000 to C under section 1366(a). For the 2008 taxable year, X has $30,000 of losses and deductions that X passes through pro-rata to A, B, and C in the amount of $10,000 each. The losses and deductions that pass through to A, B, and C are disallowed under section 1366(d)(1). In addition, B has $10,000 of section 1366(d) losses from prior years and C has $20,000 from prior years. A’s ($10,000), B’s ($20,000) and C’s ($30,000) combined $60,000 of disallowed losses and deductions for the taxable year of the discharge are treated as a current year net operating loss tax attribute for X under section 108(d)(7)(B) (deemed NOL) for purposes of the section 108(b) reduction of tax attributes.

(ii) Allocation. Under section 108(b)(2)(A), X’s $30,000 of excluded COD income reduces this $60,000 deemed NOL to $30,000. Therefore, X has a $30,000 excess net operating loss (excess deemed NOL) to allocate to the shareholders. Under paragraph (d)(2)(ii)(C) of this section, none of the $30,000 excess deemed NOL is allocated to A because A’s section 1366(d) losses and deductions immediately prior to the section 108(b)(2)(A) reduction ($10,000) do not exceed A’s share of the excluded COD income for 2008 ($10,000). Thus, A has no shareholder’s excess amount. Each of B’s and C’s respective section 1366(d) losses and deductions immediately prior to the section 108(b)(2)(A) reduction exceed each of B’s and C’s respective shares of the excluded COD income for 2008. B’s excess amount is $10,000 ($20,000 – $10,000) and C’s excess amount is $20,000 ($30,000 – $10,000). Therefore, the total of all shareholders’ excess amounts is $30,000. Under paragraph (d)(2) of this section, X will allocate $10,000 of the $30,000 excess deemed NOL to B ($30,000 × $10,000 / $30,000) and $20,000 of the $30,000 excess deemed NOL to C ($30,000 × $20,000 / $30,000). These amounts are treated as losses and deductions disallowed under section 1366(d)(1) for the taxable year of the discharge. Accordingly, at the beginning of 2009, A has no section 1366(d)(2) carryovers, B has $10,000 of carryovers, and C has $20,000 of carryovers.

(d) Exceptions

There are several exceptions and modifications to the basic income from debt discharge rules. They include the following:

• I.R.C. section 108(e)(6) provides that, if a corporation acquires its indebtedness from a shareholder as a contribution to capital, the corporation will be treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the debt. However, for S corporations, I.R.C. section 108(d)(7) provides that a shareholder’s adjusted basis in the indebtedness of an S corporation is to be determined without regard to any adjustments that have been made under I.R.C. section 1367(b)(2). For example, assume a shareholder of an S corporation has a claim for $10 and the basis for the debt is $3 less, because of a prior loss pass-through. If the shareholder agrees to cancel the entire claim as a contribution to capital, the S corporation will not have any income from debt discharge.
• Under I.R.C. section 108(e)(5), a reduction of a purchase money debt owned by an S corporation that is solvent and has not filed a bankruptcy petition is considered basis reduction and not income from debt discharge, provided the adjustment is between the original buyer and seller of the property. Note that this applies only to modifications made between the original buyer and seller.
• Under I.R.C. section 108, income from debt discharge will not be recognized to the extent that payment of the liability would have given rise to a deduction. Thus, the settlement of a liability by an S corporation on the cash basis, or the cancellation of contested or contingent liability, does not generally give rise to income from debt discharge.
• Eustice65 indicates that, if debt is acquired by a related party as defined under I.R.C. sections 267(b) and 707(b), then I.R.C. section 108(e)(4) treats the debt as immediately discharged “to the extent provided in regulations,” and Proposed Treas. Reg. section 1.108-2(a) treats the transaction acquiring the debt as an immediate deemed discharge of the old debt at its fair market value. Proposed Treas. Reg. section 1.108-2(e)(1) provides for a deemed new issue of that debt at its then-value. Thus, an original issue discount (OID) is created by both the S corporation and the related holder.

(e) Impact on Shareholder

I.R.C. section 1366(d) provides that a shareholder may not deduct losses and deductions in excess of its basis in stock plus the amount owed by the S corporation to the shareholder. The tax treatment of the S corporation is the same whether a bankruptcy petition was filed or not. The filing of a chapter 11 petition does not terminate the S corporation status as a small business.66

I.R.C. section 1366(a)(1)(A) provides that the shareholder’s basis in stock must be adjusted by the shareholder’s share of the corporation’s items of income (including tax-exempt income), loss deduction, and so on. I.R.C. section 108(b)(4) provides that the reduction of tax attributes must be made after the determination of the tax for the taxable year of the discharge. The reduction of tax attributes is made first for the loss for the taxable year of the discharge and then for the losses carried forward. Thus, it would appear that (1) the increase in stock basis resulting for the income from debt discharge and (2) the utilization of suspended losses occur before any attribute reduction under I.R.C. section 108. Any reduction in the basis of property is made as of the first day of the taxable year after the discharge occurs.

As noted, income from debt discharge will not be included in gross income; instead, tax attributes will be reduced at the S corporation level. There are two basic theories as to the impact of the income from debt discharge on the shareholder’s basis in the stock. The position probably followed most in practice suggests that the shareholder has a stepped-up basis. The second position suggests that the basis is not stepped up.

The Supreme Court in Gitlitz v. Commissioner67 reversed a decision of the Tenth Circuit and held that income from the discharge of debt is an item of income that passes through to shareholders, increasing their stock basis. The Court also held that the increase occurs before they are required to reduce the tax attributes in the S corporation. The original interpretation by most of the leading commentators is consistent with the ruling by the Supreme Court. However, the IRS, in an effort to close what it considered a tax loophole, attempted in vain to get the Supreme Court to look at the equity of the issues rather than focusing on the wording of the statute.

However, the right of shareholders of S corporations to increase their basis due to income from debt discharge lasted for only a short time period. On March 9, 2002, President Bush signed the Job Creation and Worker Assistance Act of 2002, providing that income from debt discharge by an S corporation was excluded from the tax-exempted items, overruling the decision of the Supreme Court in Gitlitz. The amendment applies to discharges of indebtedness after October 11, 2001, in taxable years ending after such date. The amendment made by this section did not apply to any discharge of indebtedness before March 1, 2002, pursuant to a plan of reorganization filed with a bankruptcy court on or before October 11, 2001.

The IRS, in an effort to reverse the trend developing to allow the stepped-up basis, issued regulations concluding that tax-exempt income does not include income from discharge of indebtedness excluded from income under section 108 because such income is not permanently excludable from income in all circumstances in which section 108 applies.68

Earlier, in attempts to limit the increase in basis at the shareholder level, the IRS issued a private letter ruling,69 ruling that the discharge of indebtedness income that is excluded from gross income under I.R.C. section 108(a) does not pass through to S corporation shareholders as a separately stated item of tax-exempt income under I.R.C. section 1366(a)(1) and as a result does not increase shareholders’ stock basis under section 1367.

(f) Impact of Termination

An S corporation may be terminated as a result of the bankruptcy proceeding for several reasons. Among them are:

• Another class of stock is issued, such as preferred stock.
• Stock is issued to an impermissible new shareholder.
• Shareholders’ holdings are in excess of the maximum shares allowed.
• The S corporation is liquidated.

The termination occurs as of the date of the terminating event. If a plan that calls for stock to be issued to creditors would create more than 35 stockholders, the terminating event would be the confirmation of the plan by the court. The American Jobs Creation Act of 2004 increased the number of shareholders that is allowed in an S corporation to 100. This provision is effective for tax years beginning after 2004.

The IRS has granted a former S corporation’s request for a waiver of the five-year waiting period for reelecting S status.70 The company lost its S election because, in a shareholder’s bankruptcy, the shares of stock were transferred to a trust that was a nonqualified shareholder. After the transfer, the company filed income tax returns as a C corporation. The company subsequently purchased the shares from the trust and then filed a request for relief with the IRS.

The Ninth Circuit Bankruptcy Appellate Panel held that the revocation of a corporation’s subchapter S election prior to the filing of a chapter 7 petition is a transfer that the trustee may avoid under section 548 as a fraudulent transfer.71

Craig Saunders and his wife owned all the stock of Bakersfield Westar Inc., which provided air and ground ambulance services to the residents of Kern County, California. They filed an S corporation election at the beginning of 1992, and on February 1, 1994, that election was revoked by the taxpayers. Fourteen days later the taxpayers filed a chapter 7 petition. The chapter 7 trustee filed a voluntary chapter 7 petition for Bakersfield. The trustee for Bakersfield filed action against the Saunderses and their trustee and the IRS to avoid the revocation of the S corporation status as a fraudulent transfer under section 548 of the Bankruptcy Code. The bankruptcy court ruled that the revocation was not a transfer by the corporation of property or a property interest. The chapter 7 trustee for Bakersfield appealed.

On appeal, the IRS argued that the right to revoke a subchapter S election under section 548 of the Bankruptcy Code is not an interest of the debtor in property because the right has no present value. The Ninth Circuit Bankruptcy Appeals Panel (BAP) rejected the argument of the IRS, noting that the IRS’s argument unduly limits the definition of property and held that the right has value to a debtor’s estate and is therefore properly characterized as property. The court cited Begier v. IRS,72 holding that section 541 includes all the debtor’s legal or equitable interests in the definition of property of the debtor, and In re Trans-Lines West Inc.,73 holding that a corporation’s right to use and dispose of its subchapter S status is property because it is a right guaranteed by I.R.C. section 1362(c).

The court concluded that the ability not to pay taxes has value, because of the subchapter S revocation, Bakersfield will be taxable on approximately $400,000 in capital gains that without the revocation would have been taxable to its shareholders. This action reduced the funds available for distribution to Bakersfield’s creditors.

Once the Ninth Circuit BAP concluded that the right to revoke the election is property, the court then held that the revocation is an avoidable transfer under section 548(a) of the Bankruptcy Code. This conclusion by the Ninth Circuit BAP follows In re Russell,74 which held that an irrevocable transfer under the I.R.C. constitutes a transfer for purposes of the Bankruptcy Code. The Ninth Circuit noted that the election, an issue in In re Russell, was an election to carry over an NOL under section 172. However, the bankruptcy court in In re Trans-Lines followed In re Russell, even though the issue involved a subchapter S election. The Ninth Circuit BAP found no significant difference between the two elections for avoidance purposes. The court was unpersuaded by the IRS’s claim that allowing trustees to avoid otherwise irrevocable elections would create administrative havoc.

(g) Debt Modifications and Restructurings

An S corporation in financial difficulty may attempt to resolve its financial problems by reducing the interest rate, stretching out the terms, issuing equity interest for the debt, or some combination of those methods. The tax issues that are raised when the debt is restructured are similar to those raised by a C corporation (see Chapter 2). For example, if the face amount of the new debt is at least equal to that of the old debt and the stated interest rate is adequate, there will be no income from debt discharge to the corporation unless the debt is publicly held, which is unlikely in the case of an S corporation.75

However, a few issues are unique to an S corporation. The issuance of stock may result in the termination of the S corporation for several reasons, including the issuance of stock to too many shareholders and the issuance of a debt security that might be reclassified as equity under I.R.C. section 385, thus creating a second class of stock. To avoid the termination of the S corporation status by the issuance of shares to creditors, thereby creating too many shareholders, the issuance of debt for stock is often restricted to selected large debt holders or creditors that are also shareholders. An S corporation, by not issuing stock for at least some of its debt, may see the basis of its assets reduced materially, which will impact future deductions. If stock had been issued that was not de minimis under I.R.C. section 108(e)(8) or disqualified stock under I.R.C. section 108(3)(10), tax attributes—including the basis in property of the debtor—would not have been reduced.

The requirements of I.R.C. section 385 might especially be a problem if the debt was held by a shareholder. Thus, in issuing stock for debt held by a shareholder, the transaction needs to be carefully constructed. For example, the issuance of the equity might be evidence that the debt held by the shareholders was in fact disguised equity, meaning that the S corporation status has already been terminated.

The S corporation would need to be careful in the issuance of stock purchase options or warrants for debt. The IRS has traditionally taken the position that warrants are not stock for purposes of subchapter C but are boot for purposes of I.R.C. sections 351, 354, and 355.76 However, Treas. Reg. section 1.1361-1(1)(4)(iii) considers deep-in-the-money options as stock; thus, two classes of stock may exist, terminating the S corporation status.

(h) Reorganization under Section 368

Any reorganization under I.R.C. section 368(a)(1), such as a G reorganization that involves a mandatory liquidation of the old corporation, will result in the termination of the S corporation status. The general provisions of a tax-free reorganization that apply to a C corporation will apply to the S corporation. For example, assume a reorganization qualifies as tax-free under I.R.C. section 368(a)(1). Under I.R.C. section 361, no gain or loss will be recognized on the assets transferred and, generally, no gain or loss will be recognized on the liquidating distributions made by the acquirer.

Shareholders that do not receive any interest in the new corporation, or other forms of consideration, will most likely have a worthless stock deduction—a capital loss, unless the stock is considered section 1244 stock. According to I.R.C. section 1367(b)(3), any basis adjustment under this section and any pass-through items under I.R.C. section 1366 are to be applied before losses are recognized under I.R.C. sections 165(g) and 166(d). Upon the elimination of the shareholders’ interest, any suspended loss carryovers would terminate.

Shareholders that receive stock in the acquiring corporation would qualify for the nonrecognition treatment under I.R.C. section 354. The old shareholders’ AAA shares and any I.R.C. section 1371(e) rights would not carry over into the stock of the acquiring C corporation.

Most likely, these attributes would carry over if the acquiring corporation was an S corporation. It would appear that the suspended shareholder losses and the benefits of I.R.C. section 1366(d)(3) (carryover of disallowed losses and deductions to a posttermination transition period) would not carry over to the acquiring S or C corporation because both provisions apply to the stock of the original loss-generating S corporation.

The impact of a reorganization on the creditors of an S corporation will not differ from the impact on those of a C corporation.

The IRS ruled that the restructuring of an S corporation in a bankruptcy will qualify as a tax-free reorganization under section 368(a)(1)(G).77 The S corporation was in default on two of its issues of subordinated notes. In order to restructure the corporation and rehabilitate its business, it planned to file a plan of reorganization under chapter 11, where the S corporation would form a C corporation, Newco, that would merge into it. In exchange for all of their notes, interest, and claims, the noteholders of the S corporation would receive 95 percent of the Newco stock. The S corporation shareholders were to receive 5 percent of Newco stock in exchange for their shares.

The IRS ruled that the merger would qualify as a G reorganization and, as a result, there would be no gain or loss recognized by the S corporation or Newco as a result of the transfer of assets and distribution of Newco stock. The IRS ruled that to the extent that the adjusted issue price of the S notes exceeds the fair market value of the Newco stock received by the noteholders, the S corporation would realize cancellation of indebtedness income based on Treas. Reg. section 1.61- 12(c)(3). However, since the S corporation was in bankruptcy, the COD income realized would be excludable from gross income under section 108(a)(1)(A) in the corporation’s final S corporation year. Newco would reduce its attributes under section 108(b)(2) in an amount equal to the discharged and excluded COD income. The IRS ruled that any loss or deduction disallowed under section 1366(d)(1) will be treated as an NOL for the tax year of discharge under section 108(d)(7)(B) but that the COD income neither passes through nor increases the shareholders’ bases in their S corporation stock under section 1367(a).

(i) Liquidations

An S corporation that liquidates incurs no unusually negative tax consequences. In a case of debt discharge, liquidation may have an advantage to shareholders, as discussed previously.

Any gain or loss on the sale of the assets will be passed through to the shareholders. If there are any I.R.C. section 1374 built-in gains that may have adverse tax consequences, they are handled at the corporate level. Thus, they become a liability of the corporation and will, in case of a bankruptcy proceeding, receive payment before unsecured creditors. However, when there are no free assets, as is often the case, the tax liability will remain unpaid.

The shareholders will most likely not receive any proceeds from the liquidation, but they may have taxable income from the gains that pass through and deductible losses on the pass-through losses incurred, provided there is sufficient basis to absorb the losses.

Any income from debt discharge is reflected at the corporate level and not taxed to individual shareholders, but the shareholders may have the opportunity to increase their basis as a result of the debt discharge, as discussed previously.

(j) Bankruptcy Estate

When the S corporation files its bankruptcy petition, a new estate is created for bankruptcy purposes; however, a new entity is not created for tax purposes. The S corporation will continue to file its tax return in the same manner as before. However, the requirements for an S corporation continue, and if any of the provisions for the termination of the S corporation are not satisfied, the S corporation status will be terminated.

(k) Shareholder Bankruptcy

I.R.C. section 1361(c)(3) provides that the estate of an individual that is in bankruptcy is a qualified shareholder for an S corporation.

I.R.C. section 1377(a)(1) provides that income and losses from an S corporation are to be allocated among the shareholders based on the number of days that each held an interest in the S corporation, unless the shareholders elect to terminate the taxable year. No specific reference is made to the method of allocation when an interest is transferred to the bankruptcy estate. It is often assumed that the income and profits should be prorated based on the time (number of days) each held an interest in the S corporation.

Under I.R.C. section 1377(a)(2), in order to terminate the taxable year as of the date when the chapter 7 or chapter 11 petition is filed, all persons who are shareholders during the taxable year must agree to the election to terminate the taxable year. If a trustee has been appointed where a shareholder has filed a chapter 7 or chapter 11 petition, the trustee would most likely not agree to the termination if it would be disadvantageous to the estate. Furthermore, in a chapter 11 case where the debtor remains in possession, the court might be reluctant to accept or might even overturn such an election if one was made.78

Based on I.R.C. section 1377(a)(2), it appears that the election must be made only if there has been a termination of the shareholders’ interest. There is some question as to whether the transfer of the stock to a bankruptcy estate, especially in a chapter 11 case, would constitute a termination of shareholder interest.

(l) Shareholder Guarantee

In Lamar and Norma K. Hunt v. Commissioner,79 the Tax Court held that income from debt discharge is included in the income of the debtor and not that of the guarantee. This ruling is consistent with I.R.C. section 108(e)(2). As noted, income is not realized if payment of the liability would have given rise to a deduction. If the guarantee had been required to make the debt payment, a deduction for bad debt would most likely have been reported.

Mathias80 notes that there is little authority on who reports income from cancellation of a joint and several liability. The income might be reported by the party that receives the original proceeds from the loan, or it could also be argued that the income from debt discharge should follow the taxpayer that will ultimately bear the economic burden. In Bressi v. Commissioner,81 the Tax Court held that, in a case where a shareholder borrowed money for the development of personally owned property, the shareholder must report the income from debt discharge even though a wholly owned subsidiary was jointly and severally liable for the debt.

1 441 F.2d 465 (5th Cir. 1971). See Rev. Rul. 71-301, 1971-2 C.B. 257.

2 Rev. Rul. 71-301, 1971-2 C.B. 257. (The ruling is now obsolete due to changes to § 108 by the Bankruptcy Tax Act of 1980.)

3 Thompson and Tenney, Partnership Bankruptcy—The New Entity and Individual Tax Consequences, 35 Tax Law. 89, 103–104 (1981).

4 88 T.C. 984 (1987).

5 54 T.C.M. (CCH) 749 (1987).

6See Zager v. Commissioner, 53 T.C.M. (CCH) 230 (1982), aff’d without opinion, 842 F.2d 332 (9th Cir. 1988).

7 1992-1 C.B. 790.

8 S. Rep. No. 1035, 96th Cong., 2d Sess. 26 (1980).

9 P.L.R. 8509038 (Nov. 30, 1984).

10 P.L.R. 8535015 (May 31, 1985).

11 14 B. R. 408 (Bankr. D. Maine 1981).

12 As a result of Holywell Corp. v. Smith, 112 S. Ct. 1021 (1992), it may be difficult for a chapter 7 trustee to use this reason to avoid filing a partnership return. The Samoset court noted that a partnership is not a separate entity for tax purposes, as was suggested in Rev. Rul. 68-48, 1968-1 C. B. 301, and, as a result, it is not required to file a tax return.

13 No. 87-00846-SWC; LEXIS 88 TNT 235-23 (Bkrtcy. N. D. Ga. 1988).

14 SIPA No. LA 92-01156 KM (Bankr. CD. Cal. Oct. 7, 1997).

15 11 U.S.C. § 541.

16Id. § 727(a)(1).

17Id. § 723(a).

18 I.R.C. § 1398(f). Section 346(g)(1)(A) of the Bankruptcy Code provides that no gain or loss will be recognized.

19 Thompson and Tenney suggested that this provision may not be adequate to prevent recapture of investment tax credit under a state or local provision that is equivalent to I.R.C. § 47, supra note 3, at 92.

20Id. at 93; see also Rev. Rul. 68-48, 1968-1 C.B. 301, and I.R.C. § 1398(f).

21 I.R.C. § 1399.

22 11 U.S.C. § 346(e).

23 I.R.C. § 1398(h)(1).

24 I.R.C. § 108(d)(6).

25 11 S. Ct. 1503 (1991).

26 Treas. Reg. § 1.1001.-3.

27See § 2.4(d)(iii)(B) of the text for a discussion of the regulations.

28 1992-2 C.B. 505.

29 115 F.2d 656 (7th Cir. 1940).

30See Malek, Tax Issues Relevant to Partnership Workouts, Proc. 9th Ann. Reorg. & Bankr. Conf. 5 (1993); Shenfield and Maynes, Selected Issues in Partnership Debt Restructuring, 68 Taxes 861, 880 (Dec. 1990), especially cases cited at note 98.

31 1991-1 C.B. 19.

32 31 B.T.A. 519 (1934).

33 23 F.3d 1032 (6th Cir. 1994).

34 71 Tax Notes 1013 (May 20, 1996).

35Brickman v. Commissioner, T.C. Memo. 1998-340, 76 T.C.M. (CCH) 506.

36 1992-2 C.B. 124.

37 P.L.R. 9619002 (May 20, 1996).

38 1994-1 C.B. 195.

39 T.C. Memo. 1994-446.

40 T.C. Memo. 1995-174.

41Supra note 3, at 108.

42Id.

43See Treas. Reg. § 1.58-2(b)(2) dealing with the investment interest limitations.

44 1992-45 I.R.B. 21. See P.L.R. 9522008 (Feb. 22, 1995).

45 I.R.C. § 703(b)(2).

46 I.R.C. § 108(d)(6).

47 I.R.C. § 1017(d).

48 Rabinowitz and Greenbaum, The Bankruptcy Tax Act of 1980: Partnership Considerations, 39 Inst. on Fed. Tax’n (NYU) 41-19 (1981).

49 Berenson and Blank, The Bankruptcy Tax Act of 1980 (Part 1), 12 Tax Adviser 68, 77 (1981).

50 The committee report was published prior to a change in the effective date of the various sections of this Act. Therefore, the March 1, 1981, date should be assumed to be a date subsequent to the effective date for the provisions of the Bankruptcy Tax Act of 1980.

51S. Rep. supra note 8, at 22.

52 91-2 USTC (CCH) 50,371 (Bankr. D. Col. 1991).

53 935 F.2d 703 (5th Cir. 1991).

54 135 B.R. 652 (Bankr. D. Hawaii 1991).

55See Cozzi v. Commissioner, 88 T.C. 435 (1988); Carlins v. Commissioner, 55 T.C.M. (CCH) 228 (1988).

56See Rev. Rul. 68-48, 1968-1 C. B. 301 and I.R.C. § 1398(f).

57 P.L.R. 9304008 (Oct. 27, 1992).

58In re Tomlin, No. 99-35175-HCA-7 (Bankr. N.D. Texas, 2002).

59 H. R. Rep. No. 833, 96th Cong., 2d Sess. 21 (1980).

60 Malek, Comments on Proposed Regulations under Section 1398 (Communication to IRS from Association of Insolvency Accountants, Jan. 11, 1993), p. 3.

61Williams v. Commissioner, 123 T.C. 144, 123 T.C. Memo. No. 8 (2004).

62In re Michael Forte, 234 B.R. 607; 99-1 U.S. Tax Cas. (CCH) P50, 568 (Bankr. E.D.N.Y. 1999).

63 SIPA No. LA 92-01156 KM (Bankr. CD. Cal. Oct. 7, 1997).

64 T.D. 9469 (10/29/2009); Treas. Reg. 1.108-7.

65 Eustice, Financially Distressed S Corporations, 53 Tax Notes 97, 99 (Oct. 7, 1991).

66Mourad v. Commissioner, 121 T.C. No. 1, No. 7873-01 (2003).

67 121 S. Ct. 701 (2001).

68 Treas. Reg. § 1.1366-1(a)(2)(viii), 64 Fed. Reg. 71641, 71643 (Dec. 22, 1999).

69 P.L.R. 9423003 (Feb. 28, 1994). See P.L.R. 9541006 (July 5, 1995) for a similar ruling.

70 P.L.R. 9537006 (June 14, 1995).

71In re Bakersfield Westar Inc., 226 B.R. 227 (BAP 9th Cir. 1998).

72 496 U.S. 53 (1990).

73 203 B.R. 653 (Bankr. E.D. Tenn. 1996).

74 927 F.2d 413 (8th Cir. 1991).

75 I.R.C. §§ 1273 and 1274.

76 Supra note 65, at 103.

77 P.L.R. 9629016 (July 19, 1996).

78See In re Russell, 927 F.2d 413 (8th Cir. 1991), where the trustee’s avoidance powers under the Bankruptcy Code were allowed to avoid an irrevocable election under I.R.C. § 172(b)(3)(C) to carry forward a taxpayer’s net operating losses.

79 59 T.C.M. (CCH) 635 (1990).

80Tax’n for Law. 234, 238 (Jan./Feb. 1993).

81 62 T.C.M. (CCH) 1668 (1991), aff’d without opinion, 1993 U.S. App. LEXIS 5320 (3d Cir. 1993).