Important FAQs: Cancellation of Debt

By:
Robert M. Finkel
Published Date:
Aug 1, 2020

In the current economic climate, many of our clients have or will reach agreements with creditors to reduce agreed 1 debt. The reduction of certain types of debt can give rise to taxable income to the debtor, so-called cancellation of debt (COD) income under IRC section 61(a)(12).

The idea is that the forgiveness of a debtor’s obligation results in a taxable economic inurement. There are several statutory (IRC section 108) exclusions that can or will  reduce some or all of the income, but some of them come with a cost: the reduction of the debtor’s tax attributes. This, in effect, changes the exclusion to a mere deferral. [Note that the application of the bankruptcy and insolvency exclusion is not elective. COD income excluded under the bankruptcy and insolvency exclusions under IRC sections 108(a)(1)(A) and (B), respectively.]

This article is intended to provide brief answers to some frequently asked questions.

What Is COD Income?

IRC section 61(a)(12), which is a codification of the Supreme Court’s decision in U.S. v. Kirby Lumber,284 U.S. 1 (1930),  provides that income includes discharge of indebtedness (or cancellation of debt)2.  If a debt is forgiven, the amount of COD income is generally the amount of the unpaid balance of the debt 3.  

When debt is modified, the debtor has COD income equal to the difference between the amount of the old debt (the adjusted issue price) and the amount (the issue price) of the new modified debt 4.

EXAMPLE: in Year 1, D gives C a five-year Interest-only note for $50,000 in exchange for cash in the same amount. During Year 4, when the principal balance on the note is $10,000, C accepts, in full satisfaction of the note, property worth $2,000. D has COD income of $8,000.

Acquisition of a debtor’s debt by a person related to the debtor can also give rise to COD income [IRC section 108(e)(4)]. The regulations set forth the general rule that an acquisition of indebtedness by a person related to the debtor from a person not related to the debtor results in the realization of COD income by the debtor.

The amount of COD income is measured with reference to the adjusted basis in the related party's hands if the debt was acquired by purchase within six months of the “acquisition date,” provided that the principal purpose of the acquisition was not federal income tax avoidance. Otherwise, the amount of COD income is generally measured by reference to the fair market value of the indebtedness acquired by the related party [Treasury Regulations section 1.108-2(d) and (f)].

What Is Debt for This Purpose?

Not all obligations are debt for the purposes of IRC section 108. There must be a debtor-creditor relationship and valid obligation to pay. If a person has no obligation to repay funds advanced to him, as in the case of a gift, no cancellation of debt can arise.

And not all debts are debt for COD purposes. No COD income arises upon the cancellation of a debt that would have given rise to a deduction by the debtor if paid [IRC section 108(a)(1)(E)]. The cancellation or settlement of debts that are contested in good faith may not give rise to COD income when a settlement of the dispute results in a lower amount due. That lower amount is treated as the amount of debt for tax purposes (Zarin  v. Commissioner, 916 F2d 110,113 (3d Cir. 1990).

Guarantors don‘t realize COD income when debt that they have guaranteed is discharged or forgiven.  Even forgiveness of a guaranty that had ripened into a primary debt obligation may not give rise to COD income where the forgiveness does not itself enrich the guarantor (Mylander v. Commissioner, T.C. Memo. 2014-191). 

What Is Cancellation of Debt?

As discussed earlier, cancellation of debt for the purposes of determining COD income includes a wide range of circumstances where a debtor is relieved from the obligation to pay, such as when a creditor reduces a debt obligation or treats as satisfied a debt obligation for less than the full amount due. 

The surrender by a debtor of collateral with a fair market value lower than the outstanding balance of outstanding principal due on recourse debt by a debtor in full satisfaction of the debt will generate COD income to the extent of the excess of the cancelled debt over the value of the collateral. The debtor will realize gain (not COD income) to the extent, if any, that the fair value of the collateral exceeds the debtor’s adjusted basis in the collateral (Revenue Ruling 1990-16, 1990-1 C.B. 12). A debtor realizes cancellation of debt income if a debt becomes unenforceable by the creditor through operation of law (Estate of Bankhead v. Commissioner, 60 T.C. 535 (1973)).

What If the Debt Is Nonrecourse?

In the case of nonrecourse debt, the analysis is a bit more complicated. According to the IRS, whether or not there’s COD income will depend on whether the debt forgiveness occurs in the context of a disposition of underlying collateral. A debtor who is discharged from all or a portion of a nonrecourse debt when there’s no disposition of the collateral will realize COD income (Revenue Ruling 82-202, 1982-2 C.B. 36).

EXAMPLE: The settlement by D of a $250,000 nonrecourse debt for a cash payment of $40,000, without surrender of collateral worth $2,500 produces $210,000 of COD income (Herbert Gershkowitz v. Commissioner, 88 T.C. 984 (DATE) ).

Where nonrecourse debt is cancelled in exchange for a transfer of underlying collateral, however, the transfer is treated as a sale or exchange of the collateral (Treasury Regulations section 1001-1-2(b), 2(c), Ex. 7; Commissioner v. Tufts, 461 U.S. 300, 310; 103 S. Ct. 1826 (1983) . The amount realized by the debtor is the amount of the debt, even if the amount of the debt is more than the property's fair market value. 

So, when equipment secured by nonrecourse debt is repossessed, the debtor realizes gain, not COD income equal to the difference between the property's basis and the amount of the debt.

EXAMPLE: D purchased equipment for $20,000, paid for entirely with a nonrecourse note. A year later—when the principal balance on the note was $19,000, D’s basis in the equipment is $16,000, and the value of the equipment is $15,000—D transfers the equipment back to the seller in cancellation of the nonrecourse recourse debt. D has gain, not COD income on the transfer of the equipment of $3,000 ($19,000–$16,000).

Importantly, because gain and not COD income is realized, the COD exclusion under IRC section 108 does not apply.  

What Exceptions Are There to COD Income?

Prior to the Bankruptcy Tax Act of 1980 (Pub. L. No. 96-589, 94 Stat. 3389 (1980), which added section 108 to the IRC, there were judicial exceptions to the recognition of COD Income. IRC section 108 codified many of the judicial exceptions to COD income, including discharges:

  • issued in connection with the debtor’s bankruptcy case under Title 11
  • where the debtor is insolvent
  • of qualified farm indebtedness
  • related to qualified real property indebtedness
  • related to certain reductions of purchase price
  • of certain student loans
  • in connection with the contribution of debt to the capital of a corporation by a shareholder.

What Is the Bankruptcy Exception?

IRC section 108(a)(1)(A) excludes COD realized in connection with a discharge of the debtor's indebtedness if the discharge occurs in a bankruptcy case, including reorganizations, under Title 11 of the United States Code if the debtor is under the jurisdiction of the court and the discharge is granted either by the court or pursuant to a plan approved by the court.

What Is the Insolvency Exception?

COD income realized while the debtor is insolvent, as defined by IRC section 108(d)(3), is excluded from income to the extent of the debtor’s insolvency.  This rule is a codification of a judicial ruling in Lakeland Grocery Co. v. Commissioner (36 B.T.A. 289 (B.T.A. 1937), which held that an insolvent debtor did not recognize COD to the extent of the debtor's insolvency, but that COD income was realized to the extent that the value of the debtor’s assets exceeded its liabilities after the cancellation.  

For the purposes of the statutory insolvency exception, IRC section 108(d)(3) defines insolvency as the excess of the debtor’s liabilities over the fair market value of the debtor’s assets. Note that all of the debtor's assets, including assets exempt from the claims of creditors under state law, are included in determining whether the debtor’s liabilities exceed his assets (Carlson v. Commissioner, 116 T.C. 87 (2001). The fair market value of property is the price at which it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts (United States v. Cartwright, 73-1 U.S.T.C. ¶ 12,926 ).

What Is the Qualified Farm Indebtedness Exception?

Qualified farm indebtedness is debt incurred directly in connection with the debtor’s operation of a farming trade or business and owed to a “qualified person” [IRC section 108(g)]. Fifty percent or more of the debtor’s gross receipts for the three preceding years must have been attributable to the trade or business of farming. The excluded amount is limited to the sum of the debtor’s adjusted tax attributes under IRC section 108(b)(2)—not counting the basis of property—plus the aggregate adjusted basis of the debtor’s “qualified property” [IRC section 108(g)(3)(B)].

What Is the Qualified Real Property Indebtedness Exception?

A noncorporate debtor may elect to exclude income arising from the cancellation of “qualified real property business indebtedness” [IRC sections 108(a)(1)(D) and 108(g)]. Qualified real property business indebtedness is debt incurred in connection with, and secured by, real property used in a trade or business.

The exclusion is limited to the amount by which qualified real property indebtedness exceeds the fair market value of the property secured by the debt. Note that the excluded amount is further limited to the adjusted basis of depreciable real property held by the debtor [IRC section 108(c)(2)(B)]. Special attribute reduction rules apply requiring the reduction of the basis of depreciable property [IRC section 108(c)(1)(A)]. There are special ordering rules if the debtor is also insolvent, or if the debt is also qualified farm indebtedness [IRC section 108(c)(3); IRC section 108(a)(2)(B)].

What Is the Exception for Purchase Price Reductions?

From time to time, a purchaser of property and the seller dispute the value of property purchased and the seller agrees to reduce the purchase price. IRC section 108(e)(5) provides that COD income is not recognized when a seller of property, through negotiations with the purchaser reduces the payment obligation of the purchaser. Rather, it is treated as a reduction of the purchase price.

Ordering rules provide that a reduction of purchase price in the context of a Title 11 bankruptcy is treated as having occurred in the bankruptcy. This means that the attribute reduction rules applicable to COD in a bankruptcy will apply. 

What Is the Exception Related to Student Loans?

IRC section 108(f)(1) and (2) exclude the forgiveness of certain student loans. The discharge, which must be contemplated by the loan agreement, must be for students who work for a period of time in certain professions or types of employers. Generally, the loans must have been made by governmental entities, schools, and other organization under a program to encourage students to serve in professions or areas with unmet needs.

What Is the Contribution to Capital Exclusion? 

As a general rule, the issuance by a corporation of its stock doesn’t give rise to gain in the corporation, as long as the value of the newly issued stock exceeds the amount of corporate debt. Under IRC section 108(e)(8), where the principal amount of the debt plus unpaid and accrued interest exceeds the fair value of the stock issued, and the exchanges occurs while the corporation is solvent or outside of a Chapter 11 bankruptcy, the debtor/corporation is treated as having satisfied the debt with money equal to the fair market value of the stock issued.

COD income arises to the extent that the amount of debt exceeds the value of the stock. Similar rules apply to tax partnerships that issue equity in exchange for debt.

Under IRC section 108(e)(6), if a shareholder cancels a debt owed to him by a corporation, the corporation is treated as satisfying the debt with an amount of money equal to the shareholder’s basis in the note. Accordingly, COD income only arises to the extent that the shareholder’s basis is less than the issue price of the note. Importantly, IRC section 108(e)(6) doesn’t apply to tax partnerships such as LLCs.

What, if Any, Price Is Paid for the Exclusion of COD Income?

Depending upon the basis for the exclusion, the debtor may pay a price for the favor. A debtor whose COD income is excluded pursuant to either the bankruptcy or insolvency exclusions must reduce certain tax attributes in an amount equal to the excluded COD income. (The reductions are dollar for dollar, except for tax credits, which are reduced by one-third of the COD income excluded.)

Attributions are generally required to be reduced in the following order:

  • net operating losses,
  • general business credit carryovers,
  • minimum tax credits,
  • net capital loss carryovers,
  • basis of property,
  • passive activity loss and credit carryovers, and
  • foreign tax credits.

IRC section 108(e)(5) permits a debtor to elect to first reduce the basis of depreciable property.

IRC section 1017 contains complex rules regarding the application of basis reductions, including a set or ordering rules that generally require the basis reduction to take place in the following order:

  • real property used in a trade or business or held for investment (other than property held for sale to customers in the ordinary course) securing the cancelled debt;
  • personal property used in a trade or business or held for investment (other than inventory, accounts receivables, and notes receivable);
  • any remaining property used in a trade or business or held for investment (other than inventory, accounts receivables, and notes receivable);
  • inventory, accounts receivable, notes receivable and property described in IRC sections 1221(a)(1) and (5).

Note that the debtor’s tax liability for the year of the COD is determined without ant attribute reduction under IRC section 108(b). Basis reduction occurs at the beginning of the taxable year following the year in which the COD occurred [IRC section 108(g)(2)].

What About Flow-Through Entities?

For tax partnerships, the bankruptcy and insolvency exceptions apply at the partner level, as opposed to the entity level. As a consequence, COD income realized by an insolvent or bankrupt tax partnership is not eligible for these exclusions unless the partner is insolvent (Revenue Ruling 1992-97, 1992-2 C.B. 124). Similarly, the tax attribution reduction occurs at the partner level.  

On the other hand, the bankruptcy and insolvency rules are applied to S corporations at the entity level. The excluded income does not increase the shareholder’s outside basis under IRC section 1366(a)(1)(A).

What Are the Reporting Requirements for Excluding COD Income?

In order to claim the exclusion from IRC section 108 for COD income, a debtor should file Form 982, relating to with his consent to have the basis of the debtor’s property adjusted. (Whether the failure to file Form 982 cause a debtor to lose qualification for the exclusion of COD Income is uncertain.  In any event, the regulations provide that a debtor who establishes to the satisfaction to the IRS reasonable cause for failure to file the necessary consent with the original return may file the consent with an amended return or claim for credit or refund.)  The regulations provide that where a debtor can establish, to the satisfaction to the IRS, reasonable cause for failure to file the necessary consent with the original return, they may file the consent with an amended return or claim for credit or refund.

Implications

Many of our clients are having difficulty servicing debt and are negotiating modifications and compromises of those obligations. Consideration of the federal income tax consequences upfront might avoid an unwelcome tax surprise a few months later.


[1] The compromise of unagreed debt may not give rise to COD income.  See FAQ2, infra.

2 Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994), aff'g T.C. Memo. 1992-673

3 Section 108(e)(10).  Under the applicable regulations, new debt is treated as having been issued when the modification is “significant”.  Significant modifications can include certain changes in yield through reductions of interest rate or principal; changes to the timing of payments; altering collateral or guarantees.  See Treas. Reg. Sec. 1.1001-3


Robert M. Finkel is the partner-in-charge of Moritt, Hock and Hamroff, LLP’s  New York City office where he also serves as co-chair of its tax practice group.  Mr. Finkel has been an adjunct professor at Boston University School of Law’s Graduate Tax Program since 1995.   He was an adjunct professor at the Radzyner Law School (IDC Herzliya, Israel) where he taught U.S. corporate and tax law (2005-2006)." 

 
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