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The last two years have been trying, to say the
least. The dot-com implosion and the events of Sept. 11 wreaked havoc
with the American and California economies. Thousands have become
unemployed and numerous businesses stand on the brink of disaster.
Faced with such unfamiliar and precarious financial straits, many
individuals and businesses have begun to approach creditors hoping to
either compromise or favorably modify existing debt. Unfortunately,
many of these same taxpayers are unaware of the tax consequences that
might result from success in their efforts.
This article is the first of a two-part
examination of the general tax consequences that might result to an
individual taxpayer from forgiveness or modification of his debts.
While these same debt forgiveness and modification rules apply
generally to all forms of business entities, some subtle and not so
subtle differences in their treatment make a general discussion of
them beyond the scope of this article. Next month we will explore the
tax consequences arising from debt modification.
Tax treatment of debt forgiveness
1. THE GENERAL RULE
In 1931, the United States Supreme Court, in
United States v. Kirby Lumber Co. (284 US 1 (1931), held that a
debtor's satisfaction of debt for less than the amount owed results
in income to the debtor in an amount equal to the difference between
the amount paid to satisfy the debt and the amount owed at the time of
settlement. Thus, satisfaction of a debt for less than the amount owed
results in income to the debtor.
Congress codified the rule of Kirby Lumber as
part of §61(a) - which provides that gross income includes income
from cancellation of indebtedness ("CODI") (Code §61(a)(12). All
references to the "Code" shall refer to the Internal Revenue Code
of 1986, as amended to the date hereof. Cali-fornia has also adopted
this rule. See Calif. Rev. & Tax. Code §17071.)
Over time, courts developed several exceptions to
the general rule of inclusion; so many in fact, that Congress finally
enacted §108 of the Internal Revenue Code to, among other things,
take control of the extent and application of these various
exceptions. After 1980, §108 stands as the only means by which a
taxpayer can exclude CODI from gross income. No judicial exceptions
remain. Consequently, unless a taxpayer can fit within one of §108's
several exceptions, he must include any CODI realized during the year.
2. STATUTORY EXCEPTIONS TO THE GENERAL RULE
a. Section 108(a) - General Exclusion
Section 108(a) sets forth the primary exceptions
to §61(a)(12), and provides that gross income shall not include any
amount of CODI if the debtor was bankrupt or insolvent at the time of
forgiveness, or the debt discharged was qualified farm indebtedness
("QFI") or qualified real property business indebtedness. ("QRPBI")
(Code §108(a)(1). Californ-ia complies with this treatment. See
Calif. Rev. & Tax. Code §17131.) Each of these exceptions is
alternative to the others.
Thus, if a taxpayer unsuccessfully claims himself
bankrupt, he might nevertheless establish himself to be insolvent.
Similarly, if a taxpayer tries unsuccessfully to avail himself of the
insolvency exception, he might nevertheless salvage the situation by
establishing the debt discharged was QFI or QRPBI.
Section 108 applies whenever a taxpayer falls
within an exception described therein. Thus, taxpayers who do not wish
to fall within the protections of §108 will need to carefully plan
avoidance.
Looking at the several exceptions described in §108(a),
one quickly discovers that, unless the debt forgiven is QFI or QRPBI,
a solvent taxpayer has no use for §108(a).
Moreover, unless debt forgiveness occurs in a manner prescribed
in §108(a), it is possible that even bankrupt or insolvent taxpayers
could be forced to recognize CODI when reporting income.
Bankruptcy requirement
To exclude CODI under the bankruptcy exception, a
taxpayer must be bankrupt. A taxpayer is bankrupt if (1) a bankruptcy
petition has been filed concerning him under Title 11 USC, (2) the
taxpayer is subject to the bankruptcy court's jurisdiction, and (3)
debt discharge is either granted by the bankruptcy court or made
pursuant to a court-approved plan of liquidation or reorganization
(Code §108(d)(1)). Unless each of these requirements is met, the
bankruptcy exception will not apply. In that case, the taxpayer might
nevertheless seek exclusion under one of the other exceptions
described in §108.
To exclude CODI under the insolvency exception, a
taxpayer must establish that he was insolvent at the time of discharge
(Code §108(a)(1) (B)). The amount excludible is limited, however, to
the amount by which the taxpayer was insolvent prior to discharge
(Code §108(a)(2)(B)). Thus, if the taxpayer's creditor forgives a
$10,000 debt, but, at the time of forgiveness, the taxpayer is
insolvent by only $4,000, only $4,000 is excludible under the
insolvency exception. Unless the taxpayer can qualify under one of §108's
other exceptions, he would include $6,000 of CODI in income under §61(a)(12).
A taxpayer is insolvent if, immediately before
the discharge event, his liabilities exceed the fair market value of
his assets (Code §108(d)(3)). For this purpose, both recourse and
nonrecourse liabilities are considered (Revenue Ruling 92-53, I.R.B.
1992-27, 7 (June 18, 1992)).
So too are contingent liabilities, such as
guarantees, so long as the taxpayer can establish that he will more
likely than not be called upon on the contingent debt (Merkel, et al.
v Commissioner, 192 F.3d 844 (9th Cir., 1999)).
As for which assets the taxpayer must consider,
prior to 1999 it was commonly believed that assets exempt from
creditors' claims under applicable state law were not considered.
IRS took issue with that belief in 1999, however, ruling that all
assets of the creditor should be considered when determining a
taxpayer's insolvency (Technical Advice Memorandum 199935002
(5/3/1999)).
Which assets count
In 2001 the United States Tax Court agreed with
the IRS, finding "that Congress did not intend to exclude assets
exempt from the claims of creditors under applicable State law from a
taxpayer's assets for purposes of determining whether the taxpayer
is insolvent within the meaning of §108(d)(3)." (Carlson v.
Commissioner, 116 TC 87 (2/23/ 2001)). Though the last word has not
likely been heard on this issue, for the time being taxpayers should
consider all assets of the taxpayer when conducting an insolvency
analysis under §108. To do otherwise could unnecessarily expose the
taxpayer to penalties.
To the extent a taxpayer is allowed to exclude
CODI under §108(a), he must reduce the value of his tax attributes
(Code §108(b)(1)). Unless the taxpayer elects to first reduce the
basis of his depreciable property (in which case depreciable property
would appear as item number 1 on the ensuing list) (Code §108(b)(5)),
the reduction of tax attributes will occur as follows (Code §108(b)(2)):
1. first, against net operating losses created
during or carried over to the year of discharge; then
2. general business credits carried over to or
from the year of discharge; then
3. minimum tax credits available to the taxpayer
on the first day of the tax year immediately following the year of
discharge; then
4. capital losses incurred during or carried over
to the year of discharge; then
5. the taxpayer's basis in his property; then
6. passive activity losses and credit carryover
from the year of discharge; and finally
7. foreign tax credits carried to or from the
year of discharge.
Attribute reduction occurs on the first day of
the tax year immediately following the year of discharge. Thus, if
able to, a taxpayer may utilize his tax attributes during the year of
discharge. For that reason, great care should be taken in planning for
debt discharge where the taxpayer hopes to preserve or utilize his tax
attributes to the greatest extent possible.
In those instances where a taxpayer has tax
attributes sufficient to offset the entire amount of CODI excluded
under §108(a), §108(b) transforms §108(a) from an income exclusion
provision, to an income deferral provision. Thus, the taxpayer is
never really offered an opportunity to exclude CODI. Instead, the
taxpayer defers recognition until some later date.
b. Section 108(e)(2) - Exception for Deductible
Debts
To the extent payment of a discharged liability
would give rise to a deduction for the debtor, no income results from
discharge of the debt. Thus, for example, if a cash basis taxpayer
charges $10,000 on his credit card for business supplies, and later
compromises that debt for $5,000, the difference, $5,000, would not
constitute CODI.
Instead the amount will be excluded from income
under §108(e)(2). Had the taxpayer paid the full amount of the debt,
he would have been permitted a deduction. Because he never received
that deduction, no tax benefit was captured by him. Accordingly, no
CODI results from forgiveness in that circumstance.
If the taxpayer was an accrual basis taxpayer, on
the other hand, forgiveness of the debt would give rise to CODI. In
that case the taxpayer was able to previously deduct the expense. Not
requiring the taxpayer to include the forgiven portion as CODI would
allow him to capture a deduction without having ever paid for it.
It should be noted that §108(e)(2) applies to
all taxpayers.
c. Section 108(e)(5) - Purchase Money Debt
Reduction
Section 108(e)(5), which applies only to solvent
taxpayers, provides that no CODI results where the debt of a purchaser
of property to the seller of such property is reduced so long as the
debt arose in connection with the sale of the property by the seller
to the purchaser. In that case, the debt reduction is treated as a
purchase price adjustment, not CODI. Thus, no income results under §61(a)(12).
3. RELATED PARTY RULES
No discussion of debt forgiveness would be
complete without mention of the related party rules of §108(e)(4). To
preserve the integrity of §108, Congress adopted §108(e)(4).
Section 108(e)(4) provides that CODI results to a taxpayer if a
person related to him acquires the taxpayer's debt from a person
unrelated to the taxpayer by paying an amount which is less than that
which is owed by the taxpayer. For these purposes, related persons
include the taxpayer's spouse, children, grandchildren, the spouses
of the taxpayer's children and grandchildren, corporations and
partnerships controlled by the taxpayer and certain trusts.
4. CONCLUSION
While the provisions of §61(a)(12) appear simple
at first glance, the provisions of §108 make the rule anything but
simple. Careful planning must be employed whenever a cancellation of
indebtedness event is anticipated. Failure to do so may result in
unanticipated income recognition.
Wayne R. Johnson is an attorney with the Los
Angeles (Century City) law firm of Valensi, Rose & Magaram, PLC,
where he specializes in tax, estate and business planning matters. He
holds an LL.M., Taxation from New York University School of Law.
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