A. CANCELLATION OF DEBT (COD) INCOME
1. Borrowing is Not Income: Under the US income tax system, a person (the debtor) generally can borrow money without creating taxable income because the debtor has offset the money with a liability. From a balance sheet perspective, the debtor has not increased the debtor’s net asset value – there has been no accretion of wealth.
2. Nature of COD Income:
a. Debt Discharge Generally: As a corollary, a debtor realizes income when the promise to repay a debt is cancelled, becomes unenforceable, or is significantly modified in a manner that extinguishes the debt in whole or in part or less than the outstanding amount of the debt. This outline will refer to those events as a “discharge.” From a balance sheet perspective, unless the discharge of a debt creates income, the asset side of the balance sheet will exceed the liabilities and owner’s equity side of the balance sheet. The debtor (or a related party to the debtor) may create a discharge by paying cash, property, new debt or equity to the creditor in an amount below the outstanding amount of debt, which this outline discusses in more detail.
b. Debt Discharge Exceptions: Not every debt discharge results in COD income. For instance, courts have found no COD income in connection with relief from guarantees, settling contested liabilities and debt reductions that occur in accordance with the terms of the original debt. Moreover, transactions involving compensation, the sale of property, gifts, etc. may look like COD income, may even be taxable gross income, but are not COD income.
3. COD Income vs. Gain or Loss: The discharge of debt generally is a taxable event separate from the sale or disposition of collateral securing the debt, although the events may occur concurrently. With a discharge, the debtor pays less to extinguish the debt than the amount owed, whereas with a foreclosure or other disposition of collateral, the debtor receives value for the collateral that gets applied to the debt and recovers tax basis that may generate or gain or a loss. Losses on collateral, from operations or bad debts may be available to offset the income.
4. Character and Timing: COD income creates income taxed at ordinary income tax rates. MOREOVER, COD INCOME GENERALLY GENERATES “PHANTOM” INCOME, SINCE THE DEBTOR DOES NOT RECEIVE NEW CASH WITH WHICH TO PAY THE RESULTING TAX LIABILITY. COD income can result from debts incurred for personal, investment or trade or business activities. The debtor should allocate any COD income to passive activities or non-passive activities based on the allocation of the debt proceeds. Rev. Rul. 92-92, 1992-2 CB 103. The debtor generally realizes COD income when the debt is discharged, but 2009 legislation (discussed below) allows taxpayers to defer the COD income in certain circumstances. Determining when a debt is discharged may not always be easy since negotiations and litigation over liability and collection may ensue.
5. Tax Classification of Debtor: Different rules and considerations apply to COD income of C corporations, S corporations, partnerships (including most LLCs) and individuals that affect the realization of COD income. The tax classification of the debtor matters greatly.
B. RELATED PARTY ACQUIRES THE DEBT. The debtor could arrange for one or more relatives, related entities or other friendly parties of the debtor to buy the debt from the creditor for a discounted amount.
1. General Rule: If the purchaser bears a sufficient relationship to the debtor, then the debtor is treated as acquiring the debt and reissuing a new debt. The debtor will incur COD income if the new debt is treated as being less (e.g., having an issue price less) than the outstanding amount of the original debt. IRC Section 108(e)(4).
2. Related Parties: The related party rules for this purpose are unique and broad. For instance, a son-in-law is a related person to the debtor. Moreover, the rules go beyond the normal related party rules that apply to loss disallowances by also referring to entities treated as a single employer under other rules. Generally speaking a purchaser of debt is related to the debtor if that person owns more than 50% of the debtor (or the same persons sufficiently own both the purchaser and debtor) after applying constructive ownership rules.
3. OID: In a related party debt acquisition, the debtor generally deducts the difference between the acquisition cost and the outstanding principal of the debt like interest (as original issue discount). In other words, the debtor will recover the COD income over time through interest-like deductions and the related party has interest income.
C. DEBT MODIFICATIONS. The debtor could work out modified loan terms with the creditor.
1. Significant Modifications of Debt: In 1991, the US Supreme Court in Cottage Savings Assn. v. Comm’r, 499 US 554 (1991), held that a savings and loan could swap a portfolio of residential mortgages for an economically equivalent portfolio of other residential mortgages with an unrelated taxpayer and claim a tax loss. The Court held that even though the portfolios were economically fungible the differing obligors and collateral made the portfolios materially different items of property for income tax purposes, so the exchange of was a taxable event.
2. 1996 Regulations: Following Cottage Savings, the IRS issued regulations, finalized in 1996, to determine when and whether a change in the terms of a debt (the “Initial Debt”) will result in a significant modification of the Initial Debt to create a taxable exchange of the Initial Debt for a new debt (the “New Debt”). Treas. Reg. § 1.1001-3. The regulations provide a general rule and detailed rules and “safe-harbors” for specific types of modifications and should be reviewed any time the parties deviate from the payment or other terms of a debt instrument.
a. Specific Modifications — Changing Principal and Interest Amounts: Under the 1996 regulations, a change in the principal or interest amounts that causes the yield on the Initial Debt to change by more than ¼% (25 basis points) generally will be considered as significantly modifying the Initial Debt. This rule generally causes a reduction of principal or a change in interest rates to be a significant modification.
b. Specific Modifications — Maturity Date Extension: Under the 1996 regulations, a material deferral of scheduled payments due under the Initial Debt also will be a significant modification. However, the debtor and creditor generally can agree to extend the maturity date of the Initial Debt for up to 50% of the initial term or 5 years, if shorter, without causing a significant modification. Extensions are cumulative, so that an initial extension of time will be added to later extensions to determine if the cumulative extensions exceed the permitted time.
c. Specific Modifications — Recourse to Nonrecourse: A change in the nature of a debt from recourse to nonrecourse of from nonrecourse to recourse generally is a significant modification.
3. COD Income: A debtor may or may not incur COD income on the deemed exchange of Initial Debt for a New Debt. IRC Section 108(e)(10). Generally, the debtor will be treated as buying the Initial Debt for the face amount of the New Debt (if neither is publicly traded and) if the New Debt bears interest at the applicable federal rate (AFR published monthly by the IRS) and is payable unconditionally at least annually. THEREFORE, IF THE FACE AMOUNT OF THE NEW DEBT EQUALS THE FACE AMOUNT OF THE INITIAL DEBT AND THE DEBT BEARS INTEREST AT AFR, THE DEBTOR MAY NOT RECOGNIZE COD INCOME EVEN IF A SIGNIFICANT MODIFICATION OCCURS.
4. Gain or Loss Recognized by Creditor: The creditor may have a gain or loss on the deemed exchange of the Initial Debt for the New Debt depending upon the tax basis of the Initial Debt and the issue price of the New Debt.
D. DEBT FOR EQUITY TRANSACTIONS. The creditor could contribute the debt to the capital of the debtor or the debtor could issue its stock or partnership (LLC) interest to the creditor in exchange for the debt.
1. Capital Contributions and Equity: A creditor of a corporation (but not a partnership) generally can contribute a debt of the corporation to the corporation as a capital contribution without triggering COD income to the corporation. IRC Section 108(e)(6). The provision generally applies to the extent the creditor has tax basis in the debt, although a special rule exists for capital contributions by S corporation shareholders that ignore reductions in stock basis from passed through losses. If a corporation issues stock to the creditor then the entity may have COD income if that ownership interest has a value less than the amount of the debt. IRC Section 108(e)(8). A creditor may benefit from IRC Section 351(d)(2), which treats non-security debts of the transferee corporation as not “property,” so the creditor generally can claim a bad debt deduction on a contribution to the corporation. As mentioned above, the bankruptcy and insolvency exclusions from COD income apply at the corporate level for a corporate debtor.
2. Partnership Interest for Debt: Beginning in October 2004, a partnership that satisfies its debt by issuing a capital or profits interest is treated as satisfying the debt with cash equal to the fair market value of the capital or profits interests. IRC Section 108(e)(8). The corporate provisions discussed above that allow for capital contributions, bad debt write-offs and bankruptcy and insolvency exclusions at the entity level do not apply to such a transaction.
3. Newly Issued Proposed Regulations: Proposed regulations issued in November 2008 provide guidance to IRC Section 108(e)(8). Generally those rules provide a partnership with a “safe-harbor” in determining the value of the partnership interest issued to the creditor. Those rules also would treat the creditor’s contribution of the debt as a contribution of property to the partnership (except for the unpaid interest), which would prevent the creditor from claiming a bad debt deduction on the contribution. Comments from the Tax Section of the American Bar Association argue for a partial bad debt write-off for the creditor.
E. FORECLOSURE, DEED IN LIEU, SHORT SALES. The debtor could voluntarily or involuntarily convey collateral to the creditor.
1. General Rules: Generally, a debtor suffers the same tax consequences from disposing of collateral securing debt whether the disposition occurs involuntarily through a foreclosure process or voluntarily through a deed in lieu of foreclosure or a “short sale” to a third-party approved by the creditor. In each transaction, the debtor must determine the amount realized for the collateral, the debtor’s tax basis in the collateral and the amount of any COD income. The creditor, on the other hand, may recognize different bad debt deductions and gain or loss amounts, particularly by bidding different amounts in a foreclosure sale that differ from the fair market value of the collateral. Treas. Reg. §1.166-6.
2. Recourse vs. Nonrecourse Debts Generally: The recourse versus nonrecourse character of the debt determines the amount realized for the collateral. If the creditor can only take back the collateral in satisfaction of the debt and cannot obtain a judgment for any short fall in value (deficiency), then the debt should be considered to be nonrecourse. Generally, a note or deed of trust evidencing the debt will contain provisions indicating whether the debt is recourse or nonrecourse. “Bad boy” carve-outs, which make the debt recourse upon the occurrence of one or more acts or events, can make the determination of the recourse vs. nonrecourse character of a debt very challenging. Recourse and nonrecourse liability allocation provisions for partnership tax and at risk rules apply similar, but their own set of, rules.
3. California Law: California law makes purchase money debts to buy a dwelling lived in by the buyer nonrecourse obligations of the buyer. Cal. Code Civ. Proc. Section 580b. The refinancing of an otherwise nonrecourse purchase money debt may not preserve the nonrecourse status for the newly created debt since the debtor used the proceeds to pay off debt not purchase a dwelling. California law also prevents a creditor that non-judicially forecloses on commercial or investment property from seeking to obtain and collect any short fall in payment. Cal. Code Civ. Proc. Section 580d. However, because the creditor elects whether to foreclose judicially or non-judicially, that provision does not prevent the debt from being recourse.
4. Amount Realized vs. COD Income: If a debt secured by collateral is recourse, the amount realized by a debtor upon disposing of the collateral is its fair market value at the time of the transaction. The difference in the debt discharged in the transaction over the fair market value of the collateral generally is COD income. The debtor would have a loss on the difference between the tax basis of the collateral and its fair market value. THE TAX TREATMENT OF RECOURSE DEBT CREATES A POTENTAL WHIPSAW OF ORDINARY COD INCOME AND SEVERELY LIMITED CAPITAL LOSSES. If a debt secured by collateral is nonrecourse, then the full amount of the outstanding debt should be included in the amount realized for the collateral even though the debt exceeds the fair market value of the Collateral. Comm’r v. Tufts, 461 US 300 (1983). For this purpose, the outstanding debt includes previously deducted interest.
5. Application of Payments: Generally, promissory notes require that any payments are first applied to outstanding interest and then to a reduction of principal. The debtor may attempt to claim an interest deduction in connection with a disposition of collateral. The creditor may need to argue that the insolvency of the debtor, a forced final payment and the recourse nature of the debt allows the creditor to avoid treating a portion of the cash and property received from the debtor as interest income.
F. EXCEPTIONS TO COD INCOME.
1. Excluded COD Income Caused by Insolvency or Bankruptcy: If a debtor is insolvent or in bankruptcy under U.S.C. Title 11 at the time of a discharge of all or part of a debt, then that person can exclude the resulting COD income from “taxable” gross income. Insolvency means the excess of liabilities over the fair market value of assets, which has raised issues about assets, liabilities and valuations to use. Generally, a taxpayer must reduce favorable tax attributes, such as loss carryforwards, credits and tax basis by the amount of the excluded COD income at the beginning of the next tax year. The attribute reduction occurs after determining the taxable income for the year of the discharge. Generally, the aggregate tax basis in a taxpayer’s assets cannot be reduced below the taxpayer’s aggregate liabilities. If a taxpayer has excluded COD income in excess of tax attributes to reduce the taxpayer still can exclude the COD income. The taxpayer gets a “fresh start.” TAX ATTRIBUTE REDUCTIONS EFFECTIVELY SHIFT COD INCOME INTO LATER YEARS BY TAKING AWAY DEDUCTIONS THAT OTHERWISE WOULD EXIST IN FUTURE YEARS. IRC Section 108(a), (b).
2. Qualified Real Property Business Indebtedness Exception: Beginning in 1993, a debtor that is not a C corporation may avoid COD income by electing to reduce the depreciable basis of real property under the qualified real property business indebtedness exception. That exception generally can apply if a debtor holds secured real property for use in a trade or business to the extent the discharge in principal does not make the principal of the debt be less than the fair market value of the real property (reduced by other debts). Generally, each partner of a partnership has the ability to use the exception by electing to reduce the tax basis of their partnership interests and depreciable property held by the partnership under detailed ordering rules. IRC Section 108(a)(1)(D) and (c). This exception generally only applies to debt incurred to buy or improve real property and only if the bankruptcy and insolvency exceptions do not otherwise apply.
3. Accrued, but not Deducted Interest: A debtor will not recognize COD income for accrued, but not deducted interest expense, if when paid, would create a deduction under the debtor’s method of accounting. IRC Section 108(e)(2).
4. Purchase Price Reduction: The debtor and creditor could agree to adjust downward the purchase price of property sold by the creditor for the debt (seller financed). By its terms, this statutory exception applies only to seller financing, to solvent taxpayers and to transactions that otherwise would generate COD income. IRC Section 108(e)(5). The IRS has taken the position that a purchase price exception applies to third-party, non-seller nonrecourse financing only if it “is based on an infirmity that clearly relates back to the original sale,” such as the seller’s inducement of a higher price by misrepresenting a material fact or by fraud. The IRS also has stated that it generally will not challenge a purchase reduction under IRC Section 108(e)(5) if the transaction would satisfy that exception but for the insolvency or bankruptcy of a buyer that is a partnership. Rev. Proc. 92-92, 1992-2 CB 505.
5. Partnership Tax Rules: The partnership tax rules overlay the foregoing rules. For instance, the allocation of debt and COD income among partners depends upon the terms of a partnership/operating agreement, guarantees and other agreements. IRC Sections 704 and 752; Rev. Rul. 92-97, 1992-2 CB 124. A partnership also must treat a reduction of debt as a distribution of cash to the partners to whom it is allocated, and potentially as a reduction of minimum gain, which could create gain to partners. Generally, such a reduction may be treated as an advance of money taken into account at the end of the year. Rev. Rul. 94-4, 1994-1 CB 196.
6. S Corporation Tax Rules: S corporation tax rules overlay the foregoing rules as well. See IRC Section 108(d)(7). Most notably, the shareholders in Gitlitz v. Comm’r, 531 US 206 (2001), succeeded in convincing the US Supreme Court that gross income excluded under IRC Section 108 increased the tax basis of their stock to free-up losses suspended under IRC Section 1366(d). Because of the decision, Congress amended IRC Section 108(d)(7) to prevent what was effectively a “double dip” – no income, but deductions – generally for discharges occurring after October 11, 2001.
G. 2009 AND 2010 COD INCOME DEFERRAL.
1. Generally: For debt discharges occurring in 2009 and 2010, a debtor can elect to defer COD income realized from the “reacquisition” of an “applicable debt instrument” (both of those terms are defined). IRC Section 108(I). The debtor can defer recognition of the COD income occurring in those two years until 2014. Even then the debtor gets to defer the COD income over five years. For instance, if a debtor realizes $1.0 million of COD income in 2009 from the reacquisition of an applicable debt instrument and elects to defer the income, the debtor would include $200,000 of COD income in gross income in each of 2014 through 2018. An “applicable debt instrument” is a debt instrument issued by a person “in connection with” that person’s trade or business. A “debt instrument” includes a bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness as defined in IRC Section 1275(a). A “reacquisition” is any “acquisition” of the debt instrument by the debtor (or otherwise the obligor) or a person related to the debtor, including: (I) an acquisition of the debt instrument for cash, (ii) the exchange of the debt for another debt (including from a modification), (iii) the exchange of the debt for corporate stock or a partnership interest, (iv) the contribution of the debt to capital, and (v) the complete discharge of the debt. The related party rules of IRC Section 108(e)(4) (discussed above) apply in determining whether a person is related to the debtor.
2. No Exclusion or Attribute Reduction: If a debtor elects to defer COD income under this provision, the bankruptcy, insolvency and qualified-real-property-business-indebtedness exclusions from COD income (discussed above) will not apply to that COD income for any tax year. Since the debtor will recognize all of the COD income, the debtor will not reduce any tax attributes that would occur if the debtor excluded the COD income from gross income under the bankruptcy or insolvency exclusions.
3. Acceleration of Deferred COD Income: If the debtor dies, liquidates, sells substantially all the debtor’s assets, or ceases or terminates its business, the debtor recognizes the COD income still deferred at that time. This rule also applies to the sale, exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by an owner.
4. Special Rules: The deferral of COD income under this provision affects other items and tax treatments, so special rules apply. For instance, the debtor must also generally defer original issue discount (OID) deductions.
5. Partnership Allocations: A partnership must allocate any deferred COD income or OID to the partners immediately before the reacquisition of the applicable debt instrument in the same manner the partnership would have used for those items if the partnership had recognized the COD income or OID at that time. Partners do not take into account any decrease in the partners’ shares of partnership liabilities as a result of the reacquisition to the extent the decrease would cause the partner to recognize gain under IRC Section 731. A partner takes into account any decrease in partnership liabilities deferred under this rule, at the same time, and to the same extent, as the partnership recognizes the deferred COD income.
6. Manner of Election: A debtor defers COD income under this provision by including an election on the debtor’s tax return for the tax year in which the transaction occurs. The debtor cannot revoke the election. For partnerships, S corporations, or other pass-through entities, the entity makes the election. An entity election may cause a fight among partners in different financial positions. The IRS may require specific information regarding the election on tax returns for later tax years.
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