Tax Issues in Workouts and Foreclosures
Jay A. Nathanson1In these times of financial turmoil, although workouts and foreclosures are too often inevitable, the income tax consequences of these transactions are anything but inevitable. This article explores the federal income tax consequences of workouts and foreclosures and offers some considerations for those faced with these situations.
I. Income from Cancellation of Debt (“COD”)
A. General
Income from discharge or cancellation of indebtedness is generally included in gross income. This rule was most notably enunciated in the United States Supreme Court case of United States vs. Kirby Lumber Co.,2 which held that where a corporation purchases and retires its own bonds at a price less than the issue price or face value, the excess of the issue price or face value over the purchase price is taxable income. The Court based its holding on the fact that the repurchase made available additional assets equal to the amount previously offset by the obligation of bonds that had been retired and that this constituted an accession to income.
To illustrate the rationale of Kirby Lumber, assume a new entity, Company, with no assets, liabilities, or equity. Company borrows $1,000 from lender. The loan terms are interest only at five percent per year for 10 years, and all principal is due at the end of year 10. Immediately following the loan, company’s assets will be $1,000 (the loan proceeds), company’s liabilities will be $1,000 (the loan repayment obligation), and company’s equity will, of course, still be zero ($1,000 assets minus $1,000 liabilities). Following a year, with no change to company’s balance sheet, lender agrees to cancel the $1,000 loan in consideration of an immediate payment of $900. Lender might agree to this either because lender feels insecure about company’s ability to repay or because interest rates increase generally and lender feels it can make a new loan at a higher rate of interest with the proceeds. Following this transaction, company has assets of $100 ($1,000 borrowed minus $900 repaid), liabilities of zero (the entire loan has been forgiven), and equity of $100 ($100 of assets minus zero liabilities). Under the logic of the Kirby Lumber case, it is the improved balance sheet position, from zero equity to equity of $100, which mandates recognition of $100 of COD income.
The rule of Kirby Lumber is codified in § 61(a)(12) of the Internal Revenue Code of 1986, as amended (“code”), which provides that gross income includes income from the discharge of indebtedness. The Treasury Regulations promulgated under that code section further provide that an issuer realizes COD income upon the repurchase of a debt instrument for an amount less than its adjusted issue price, in an amount equal to the excess of the adjusted issue price over the repurchase price.3
Based on these authorities, forgiveness or cancellation of a loan, or repurchase or retirement of a loan by the borrower at a discount, will generally give rise to COD income. Subsequent guidance further informs us, if debt is repaid at a discount, the entire discounted portion is COD income regardless of whether the debt is recourse or nonrecourse; if nonrecourse, whether or not the debt is adequately secured; and whether all or a portion of the debt is forgiven.4
The following example illustrates these rules. Borrower borrows $1,000 from lender to purchase a building for a purchase price of $1,000. Borrower is personally obligated to repay the debt and, additionally, lender is given a first mortgage on the building to secure repayment of the debt. The building declines in value to $800, and borrower’s financial condition also deteriorates. Feeling insecure, lender agrees to reduce the principal indebtedness from $1,000 to $800 in consideration for borrower’s agreement to pledge additional collateral. In this example, borrower would recognize $200 of COD income, i.e., the reduction of the debt by $200. The result would be the same even if the debt was originally nonrecourse, meaning that borrower was not personally obligated to repay the debt and lender’s only recourse in the event of default was to foreclose upon its mortgage against the building.
B. Acquisitions of the Borrower’s Debt by a Related Person
To bar easy avoidance of recognition of COD income, the Internal Revenue Code provides that, for purposes of determining a taxpayer’s COD income, acquisition of the taxpayer’s indebtedness by a person “related” to the taxpayer, from a person who is not related to the taxpayer, is treated as acquisition by the taxpayer of its own debt.5 Accordingly, purchase of the taxpayer’s debt at a discounted price by a related party of the taxpayer will be treated the same as retirement of the debt by the taxpayer at a discounted price. To determine whether a party is related to the taxpayer, the attribution rules of Internal Revenue Code §§ 267(b) and 707(b)(1) are applied, with certain modifications, as described more fully in § 108(e)(4).
To illustrate this rule, consider the following example: Borrower owes lender $1,000 and, because of borrower’s deteriorated financial condition, lender agrees to cancel the debt for an immediate payment of $800. If borrower pays lender $800 to cancel the $1,000 debt, borrower will clearly incur $200 of COD income under the general rule discussed in Section I.A. above. Instead, in an attempt to avoid this result, borrower forms a corporation, of which borrower owns 100 percent of the stock, and this corporation purchases the debt from lender for $800. Borrower will still recognize $200 of COD income under Internal Revenue Code § 108(e)(4).
C. Indebtedness Contributed to the Capital of a Borrower Corporation
For purposes of determining a corporation’s COD income, if a debtor corporation acquires its own indebtedness as a contribution to capital from a shareholder, the corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness.6 The Internal Revenue Code in this case specifically provides that the general rule under section 118, excluding contributions to capital from gross income, will not apply. This rule will create COD income primarily in two instances: (i) where a cash basis shareholder forgives a debt, i.e., for services that the shareholder has not included into income (and, accordingly, has no adjusted basis in the debt), which an accrual basis corporation has already deducted without having paid; and (ii) where corporate debt purchased by a corporate shareholder from an unrelated third party, at a discounted price, is later contributed to the capital of the corporation by the shareholder.
A few examples will serve to illustrate this provision. An accrual basis corporation owes a cash basis employee $100 for wages and claims a deduction prior to payment. The cash basis employee, never having received the wages, has never included them in income and has a zero basis in the obligation. The employee forgives the obligation. The corporation must include the $100 as COD income. This makes sense because, if not for this result, the corporation would have enjoyed a deduction for an expense it would never pay or recapture into income.
As a second example, assume a shareholder, who has loaned his corporation $1,000, agrees to forgive the debt as a capital contribution to strengthen the corporation’s balance sheet. In this case, there would be no COD income recognized by the corporation because it is treated as satisfying a $1,000 debt with $1,000 (the shareholder’s basis in the debt). Assume, however, that instead of the shareholder having been the original lender, the shareholder had purchased the debt at a discounted price of $500 from an unrelated third party before forgiving the debt as a contribution to capital. In this case, the corporation would recognize $500 of COD income, i.e., the corporation would be treated as satisfying a $1,000 obligation with $500 (the amount of the shareholder’s cost basis in the debt).
D. Indebtedness Satisfied by Corporate Stock or Partnership Interest
For purposes of determining the COD income of a debtor corporation, if a debtor corporation transfers stock to a creditor in satisfaction of debt, the corporation is treated as having satisfied the debt with an amount of money equal to the fair market value of the stock. Accordingly, to the extent the debt exceeds the fair market value of the transferred stock, the corporation would have COD income.7 Internal Revenue Code § 108(e)(8) was amended in 2004 so that rules similar to the rules applicable to corporate debt for equity swaps apply where “a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction” of a partnership debt.8
Application of this Internal Revenue Code section can be illustrated by the following example: Partner lends partnership $1,000. At a time when partnership is insolvent, the loan is converted to a 50 percent interest in partnership’s profits and capital in order to satisfy partnership’s institutional lenders. At this time, the 50 percent partnership interest issued to partner is worth only $500. Partnership will recognize $500 of COD income because it is treated as satisfying the $1,000 debt with an amount of money equal to the fair market value of the partnership interest used to satisfy the debt, i.e., $500.
Because Internal Revenue Code §§ 108(e)(6) (COD as a capital contribution) and 108(e)(8) (COD in exchange for equity) both apply to corporations and because they cover similar situations with different sets of rules, tax consequences should be carefully analyzed before either structure is chosen. For instance, where shareholder debt to a corporation has basis equal to the face amount of the debt, and the debt exceeds the value of any stock which could be issued, a capital contribution will not create COD income but a debt for equity swap will.
Partnership planning is not as flexible because § 108(e)(6) does not apply to partnerships. For instance, it is possible for COD income to be created even by pre-existing partners contributing their debt to the partnership, pro rata, for partnership interests, if the debt contributed exceeds the fair market value of the partnership interests issued for the debt and the transaction is analyzed under § 108(e)(8) rather than § 108(e)(6).
E. Indebtedness Satisfied by Issuance of Debt Instruments and Modifications of Debt Instruments
For purposes of determining a debtor’s COD income, “if a debtor issues a [new] debt instrument in satisfaction of [existing] indebtedness, [the] debtor [is] treated as having satisfied the [old] indebtedness with an amount of money equal to the issue price of [the new] debt instrument.”9 Under Treasury Regulations § 1.1001-3, a mere modification of a debt instrument may be treated as a deemed exchange of the debt instrument for a new debt instrument. If it does, COD income, if there is any, will be recognized.
Under the general rule, if there is “a significant modification of a debt instrument,” there will be a potentially taxable exchange of a new debt instrument for the old one.10 The Treasury Regulations contain a detailed set of rules that analyze the circumstances under which changes to a debt instrument will be deemed a significant modification and, accordingly, a potentially taxable satisfaction of the old debt by new debt.
Although a complete discussion of these regulations is beyond the scope of this article, examples of what changes constitute significant modifications are as follows: (i) a significant modification occurs if in certain instruments, including fixed yield instruments, there is a change in yield “by more than the greater of” (1) “¼ of one percent[,]”11 or (2) “5 percent of the annual yield[;]”12 (ii) “[a] modification that changes the timing of payments (including any resulting change in the amount of payments) … is a significant modification if it results in the material deferral of scheduled payments[;]”13 (iii) the “[s]ubstitution of a new obligor on [a] recourse”14 obligation is generally a material modification; (iv) “[t]he substitution of a new obligor [on a nonrecourse obligation] is not a significant modification[;]”15 (v)
“[t]he addition or deletion of a co-obligor … is a significant modification if [it] results in a change in payment expectations[;]”16 (vi) “[a] modification that releases, substitutes, adds or otherwise alters … a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification if the modification results in a change of payment expectations[;]”17 (vii) “[a] modification that releases, substitutes, adds or otherwise alters … a guarantee on, or other form of credit enhancement for, a nonrecourse debt instrument is [in most cases] a significant modification[;]”18 (viii) “[a] change in the priority of debt … relative to other debt of the issuer is a significant modification if it results in a change of payment expectations[;]”19 (ix) “modification of a debt instrument that results in an instrument or property right that is not debt for … tax purposes is a significant modification[;]”20 (x) in general, “a change in the nature of a debt instrument from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse) is a significant modification[;]”21 and (xi) “[a] modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.”22 Under the Treasury Regulations, a change in payment expectation occurs if, as a result of a transaction, there is either a substantial enhancement of the original capacity to meet the payment obligation and the capacity was primarily speculative and has become adequate or there is a substantial impairment and capacity goes from adequate to speculative.
Assuming there is a significant modification of a debt instrument, under what circumstances will COD income result? The debtor will, of course, have COD income, under Internal Revenue Code § 61(a)(12) and Kirby Lumber, if there is a reduction of the principal. A debtor will also have COD income if the interest rate is reduced below the applicable federal rate. This will cause the issue price of the new debt instrument to be less than the adjusted issue price of the old debt,23 which will cause the debtor to recognize COD income under § 108(e)(10). If the holder of the debt is the original lender, such holder would be unlikely to recognize gain on the transaction because its basis in the old debt would likely equal or exceed the face amount of the new debt. However, a holder of the debt who has purchased the indebtedness at a discount from the lender or a different prior holder may be likely to have taxable gain on the transaction if the face amount of the significantly modified debt exceeds such holder’s discounted cost basis in the old debt. This is because the holder will be treated as exchanging debt with a basis that is lower than the principal amount, and presumably value, of the modified debt. Moreover, under the market discount rules, the gain may be ordinary income as opposed to capital gain.24
Application of these rules can be illustrated by the following example: Borrower borrows $1,000 from lender at five percent interest. Investor buys the debt from lender for $500. Investor and borrower then modify the debt so that it is interest free, but personally guaranteed by borrower’s father. Because of the magnitude of the interest rate change, there is a significant modification and, accordingly, there is a deemed satisfaction of an old debt for a new debt. Because the new debt does not have adequate stated interest, i.e., zero percent interest is below the applicable federal rate, the principal of the new debt is treated as less than $1,000 (because a portion of the $1,000 obligation will be treated as interest). This causes borrower to be treated as though a portion of the principal has been cancelled, causing borrower to recognize COD income. Since investor’s basis in the debt is only $500, investor will recognize gain on the deemed exchange of debt with a basis of $500 for debt with a higher face amount, i.e., $1,000 minus the portion which is imputed interest.
II. Non-COD Income
The discharge of indebtedness is not always treated as COD income. When it is not treated as COD income, while it might nevertheless be taxable, it will not be subject to the exclusions from gross income of Internal Revenue Code § 108, discussed in Section III below. As discussed below in Section VI, income from a debt foreclosure or a sale of property subject to debt is (other than in the case of recourse debt in excess of the fair market value of the collateral) treated as a sale or exchange rather than COD. In other cases, where the impetus for the discharge is not working out the debt so much as it is accomplishing some other objective, COD treatment might also be inapplicable.
For instance, cancellation of employee debt by an employer is typically compensation income and not COD income.25 The reason for this is that, in most cases, the purpose of the cancellation of employee debt by an employer is not to work out a troubled debt situation but to compensate the employee for services. Similarly, where a shareholder of a corporation is indebted to the corporation, cancellation of the shareholder debt by the corporation is generally treated as a dividend or distribution and not COD.26 The reason, once again, is that, in most cases when a corporation cancels a debt from a shareholder, it is not to work out a troubled loan, but to distribute corporate profits to the shareholder.
There are other common examples of when cancellation of a debt does not create COD income. Cancellation of an obligation as part of the settlement of a dispute may be treated as a payment of lost profits, taxable as ordinary income, instead of COD income.27 If forgiveness of a loan is intended as a gift, the discharge will be excludible from gross income as a gift.28 Finally, under Revenue Ruling 72-464, 1972-2 C.B. 214, when a debtor and creditor corporation are merged, the debt is extinguished as a matter of law and there is no COD income.
III. Exclusions of COD from Gross Income
A. General
There are certain instances where COD income is excluded from gross income. These instances are, for the most part, set forth in Internal Revenue Code § 108. The general philosophy underlying the Internal Revenue Code § 108 exclusions, particularly the bankruptcy and insolvency exclusions, is that COD income is often recognized when the taxpayer is least likely to have available assets to pay the tax. Accordingly, it is fair to defer, but not eliminate, recognition of gain from COD through basis reduction and other favorable tax attribute reduction until such time as the taxpayer has sufficient available assets to pay the tax on the COD income.
B. COD When Debtor is in Bankruptcy
Gross income does not include COD if the discharge occurs when the taxpayer is in a “title 11 case.”29 A ‘“title 11 case” means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.”30
C. COD When Debtor is Insolvent
Gross income does not include COD, even if the taxpayer is outside of bankruptcy, if “the discharge occurs when the taxpayer is insolvent.”31 A taxpayer is “insolvent” when the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets, determined immediately before the COD.32 The exclusion is limited to the amount by which the taxpayer is insolvent immediately before the discharge.
If a debtor can obtain the same tax relief from insolvency or bankruptcy, the debtor would typically prefer to rely on the insolvency exception and avoid the expense, disruption, and adverse publicity of a bankruptcy. There are certain instances, however, where the bankruptcy exception would provide broader tax relief than the insolvency exception. For instance, a debtor relying on the insolvency exception is entitled to exclude COD income only to the extent the debtor is insolvent. Moreover, assets that are exempt from creditors under state law, and might be retained notwithstanding bankruptcy, are generally included in assets for purposes of determining insolvency.33 Finally, not all debts may be taken into account in determining whether a debtor is insolvent. Contingent debts, such as a guaranty, may not be taken into account unless it is “prove[n] by a preponderance of the evidence that [the debtor] will be called upon to pay [the] obligation” in the amount claimed.34 Nonrecourse debts may only be taken into account as liabilities to the extent of the fair market of the collateral securing the debt or to the extent the excess nonrecourse debt is discharged.35 Under the bankruptcy exclusion, none of the limitations discussed in this paragraph would be relevant.
Comparison of the bankruptcy and insolvency exclusions can be illustrated by an example. Assume debtor owes bank $10,000; debtor has $100,000 in a 401(k) plan, exempt from creditors under relevant state law; there is a lawsuit pending against debtor for $100,000, the outcome of which is highly uncertain; debtor has no other assets or liabilities; and bank is willing to cancel the $10,000 debt for pennies on the dollar. If bank cancels the debt outside of bankruptcy, debtor will likely have $10,000 of COD income because, in determining insolvency, the exempt 401(k) plan assets would be included as assets and the lawsuit liability would probably not be included as a liability because it is too speculative. If the debt to bank is settled in a bankruptcy of the debtor, however, the bankruptcy exclusion would likely apply so that no COD income would be recognized.
D. COD Which is Qualified Real Property Business Indebtedness
Gross income does not include COD “in the case of a taxpayer other than a C corporation, if the [COD] is qualified real property business indebtedness.”36 This exclusion is generally intended to benefit certain businesses that are not necessarily insolvent or bankrupt, but have business real property that is worth less than the indebtedness encumbering it and have an opportunity to work out the debt. In such cases, indebtedness may be discharged without recognition of COD income in some circumstances.
“Qualified real property business indebtedness” [(“QRPBI”)] means indebtedness which –
(A) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property,
(B) was incurred or assumed before January 1, 1993, or … is “qualified acquisition indebtedness,” [including refinanced debt of such indebtedness], and (C) with respect to which [the] taxpayer makes an election to have [these rules apply.]37
“[Q]ualified acquisition indebtedness [(“QAI”)] means … indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve … property.”38 COD income from QRPBI is “applied to reduce the basis of [any] depreciable real property of the taxpayer.”39 COD excluded as QRPBI also cannot exceed the excess of “(i) the outstanding principal” of the debt “over (ii) the fair market value of the real property” secured by the debt (reduced by other QRPBI “secured by such property”).40 COD excluded as QRPBI also cannot “exceed the aggregate adjusted bases of depreciable real property … held by the taxpayer immediately before the” COD.41
An example of when the QRPBI exclusion can apply is as follows: manufacturer is neither insolvent nor in bankruptcy, but the factory where manufacturer’s operations are conducted has declined in value such that its value is $1,000 and the qualified acquisition indebtedness secured by the factory is $1,200. The debt is nonrecourse. Lender agrees to reduce the debt to $1,000 if manufacturer agrees to personally guaranty the debt. If manufacturer makes the appropriate election, the $200 of COD income will be excluded from income under the QRBPI exclusion. Manufacturer will also be required to reduce the basis of depreciable real property of manufacturer. As a result of this, if manufacturer’s reduced basis property is later sold, the $200 amount which has been excluded from income under the QRPBI exclusion will then be included in income as additional gain because of the reduction in basis.
E. COD Which is Qualified Principal Residence Indebtedness
Gross income does not include COD which is “qualified principal residence indebtedness” (QPRI) “discharged before January 1, 2013.”42 ‘“[Q]ualified principal residence indebtedness’ means acquisition indebtedness [of up to $2 million] … with respect to the principal residence of the taxpayer.” Acquisition indebtedness, for this purpose, means indebtedness “incurred in acquiring, constructing, or substantially improving” a principal residence of the taxpayer that is “secured by [the] residence,” as well as certain refinancing of the debt.43 For purposes of this section, the term “principal residence” has the same meaning as used in Internal Revenue Code § 121 regarding exclusion of gain from the sale of a principal residence. If a taxpayer has multiple residences, the one used a majority of the time is generally the principal residence.44
The QPRI exclusion can be illustrated as follows: homeowner buys home for $1 million, putting down $100,000 and borrowing $900,000 from lender, which debt is secured by home. Borrower is neither insolvent nor bankrupt. The value of home plummets to $700,000, and lender agrees to reduce the mortgage to $700,000 if homeowner pledges additional collateral to secure the reduced debt. Under the QPRI exclusion, the $200,000 of COD income generated by reducing the debt from $900,000 to $700,000 would be excluded from homeowner’s gross income.
The QPRI rules can present a trap for certain taxpayers who have borrowed against equity in their homes to pay off expenses unrelated to home acquisition, construction or substantial improvement. If the lender forgives these types of mortgages in a workout or foreclosure, the borrower will have COD income unsheltered by the QPRI exclusion. While gain on foreclosure could be sheltered under Internal Revenue Code § 121, up to $250,000 ($500,000 if married filing jointly), in the case of a foreclosure of recourse debt in excess of the fair market value of the property, the excess will be treated as COD income rather than gain on foreclosure, as discussed in Section VI below.
The amount of COD from QPRI that is excluded reduces the basis of the taxpayer (but not below zero) in the taxpayer’s principal residence.45 This might not cost the taxpayer in many cases, since gain on sale of a personal residence is often sheltered under Internal Revenue Code § 121, as discussed above. The QPRI exclusion does not apply if the loan is discharged for any reason other than the taxpayer’s financial condition or “decline in the value of the residence,” such as the provision of services for the lender.46
F. COD, the Payment of Which Would Give Rise to a Deduction
COD is not income “to the extent [the] payment of the liability would have given rise to a deduction.”47 For example, if a cash basis taxpayer is released from the obligation to pay deductible wages for which it has not yet taken a deduction, there would be no COD income as a result of such release.
G. Other Exclusions and Special Rules
There are other instances where COD income can be excluded from gross income that should be noted for sake of completeness, but which will not be described in detail in this article. These potential exclusions include, but are not necessarily limited to, the following: (i) discharges of qualified farm indebtedness;48 (ii) certain reductions of purchase money indebtedness;49 (iii) certain discharges of student loans;50 and (iv) debt discharges or modifications that take place in the context of corporate tax-free recapitalizations under Internal Revenue Code § 368(a)(1)(E).
Additionally, under § 453, gain from certain dispositions of property, where at least one payment is to be received after the year of disposition, will be taxed under the installment method, provided all other requirements for this treatment in the statute are met. In this case, the gain is recognized ratably, based on the ratio of gross profit to contract price, as payments are made over the entire period of payments. Accordingly, gain incurred by the holder of a debt instrument in a transaction constituting a significant modification should be reportable under the installment method if the various requirements are met.
It should also be noted that there are special rules which coordinate application of the various exclusions when two or more apply in the same situation.51
IV. Reduction of Tax Attributes52
COD excluded from gross income under the bankruptcy, insolvency, and the qualified farm indebtedness (“QFI”) exclusions is applied to reduce certain tax attributes of the taxpayer under the rules of Internal Revenue Code § 108(b)(2). The theory behind the attribute reduction rules is that while a taxpayer should not be required to pay tax on COD income at a time when the taxpayer is least likely to have the assets to pay the tax, e.g., when insolvent or in bankruptcy, the government should be given the chance to collect the lost tax in the future at a time when the taxpayer is more likely to have sufficient assets to pay the tax. This is to be accomplished by attribute reduction. For instance, by reducing basis as a price for exclusion of COD from income, the taxpayer will incur more tax upon selling the reduced basis property, at which time the proceeds of sale will be available for paying tax. By reducing net operating losses (“NOLS”), a taxpayer will be required to pay more tax when the taxpayer has income, which would have otherwise been sheltered by the NOLS having been reduced as a result of the exclusion from income of COD.
Unless a special election is made under Internal Revenue Code § 108(b)(5) to first reduce the basis of depreciable property, tax attributes are reduced in the following order: (1) net operating losses (“NOLS”) for the year of COD and net operating loss carryovers to the year of COD; (2) general business credits carried over to or from the year of COD under § 38; (3) minimum tax credits under § 53(b) available as of the year immediately following the year of the COD; (4) capital losses for the year of COD and capital loss carryover to the year of the COD; (5) reduction of basis of property of the taxpayer; (6) any passive activity loss or credit carryovers of the taxpayer under § 469(b) for the taxable year of the COD; and (7) foreign tax credit carryovers under § 27.
The reductions in tax attributes in respect to COD excluded from gross income are generally applied on a dollar for dollar basis. The reductions in credits, however, are 33-1/3 cents per dollar excluded.53 The reductions in attributes are made following the year of COD so that, for instance, NOLS carried over to the year of discharge can be used to offset COD income in the year of discharge before the NOLS are reduced for the following year.54 A “taxpayer may elect to apply any portion of the reduction” in tax attributes to reduce the basis of depreciable property, to the extent of the aggregate adjusted basis of the taxpayer in all depreciable property as of the year following the year of the COD.55 Such reduction is in lieu of any other reduction.
If a taxpayer’s NOLS are nearly expired and the taxpayer has no immediate use for them, the taxpayer would likely reduce those instead of basis. On the other hand, a taxpayer with immediate use of NOLS might elect to reduce basis so as to retain the losses.
Complex rules for computing reduction in basis of property are contained in Internal Revenue Code § 1017 and the Treasury Regulations promulgated thereunder. Further discussion of these rules is beyond the scope of this article.
V. Application of the Code Section 108 Exclusions from Gross Income to Partnerships, S Corporations and Disregarded Entities
Partnerships, S corporations, and disregarded entities are all pass-thru entities, which means any COD income they recognize is passed through to the owners and taxed to them and not to the entity. Despite this basic similarity in tax treatment, there are significant differences in tax treatment as well. “In the case of a partnership,” determination of application of the various exclusions under Internal Revenue Code § 108(a), reduction of tax attributes under § 108(b), the QRPBI rules under § 108(c), and the rules for QFI under § 108(g) are “applied at the partner level.”56 “In the case of an S corporation,” however, these same rules are “applied at the corporate level.”57
These operating rules often make it more difficult for partners and partnerships to avail themselves of the various exclusions of COD from gross income than it is for S corporations and their shareholders. For example, assume both a partnership and an S corporation, each insolvent by $5 million, each participating in a workout with a lender pursuant to which $5 million of principal indebtedness is being forgiven, and each with owners that are neither insolvent nor subject to any bankruptcy. In the case of the S corporation workout, there would be no recognition of COD income because the corporation is insolvent to the extent of the forgiveness. In the case of the partnership workout, however, $5 million of COD income would be recognized by the partners because the Internal Revenue Code § 108 exclusions of COD from income are tested at the partner – as opposed to the partnership – level, and such exclusions are applicable at the partner level in this case. The result would be the same if the S corporation and partnership were each subject to a federal bankruptcy instead of, or in addition to, being insolvent
In the case of disregarded entities, rules more analogous to the partnership rules are likely to apply. For instance, if a single member limited liability company that has not elected to be taxed as a corporation is subject to a bankruptcy or is insolvent, any COD income of the entity would likely be recognized by the sole member unless such member was also subject to bankruptcy or insolvent.
In light of the foregoing, one might think it would behoove a financially troubled partnership or disregarded entity, with highly solvent owners, facing potential COD income, to convert to an S corporation, or even a C corporation, prior to the debt discharge being consummated. Unfortunately, in such case, the incorporation itself would likely be taxable under Internal Revenue Code § 357(c) if the liabilities assumed by the corporate transferee are in excess of the bases of the properties transferred, or under § 357(b) if a principal purpose of the assumption of liabilities by the corporate transferee is to avoid federal income tax on the exchange or there is not a bona fide business purpose.
VI. Lender Foreclosures, Deeds in Lieu of Foreclosure and Sale of Encumbered Property
If a workout or forgiveness of indebtedness in default is not accomplished, a foreclosure by the creditor, a voluntary reconveyance to the creditor, or a third party sale is likely. It is important to distinguish between repayment or modification of debt at a discount and conveyance of the collateral securing the debt to the lender, voluntarily or in foreclosure, in satisfaction of the debt. While repayment or modification at a discount causes COD income, transfers of property under a foreclosure, a deed in lieu of foreclosure, and a voluntary sale (with a single exception to be discussed below) are all sales or exchanges and not cancellations of debt for tax purposes.58 Gain recognized by the debtor in any such transaction will “be the excess of the amount realized … over the adjusted basis” in the property.59
To illustrate the distinction, assume borrower owns a building having an adjusted basis of $500, subject to a mortgage (it could be either recourse or nonrecourse in this example) of $1,000, and having a fair market value of $1,000. If borrower defaults and lender takes the building in foreclosure, discharging the debt, the transaction will be a sale or exchange, and borrower will recognize capital gain of $500 ($1,000 amount realized by discharge of the debt, minus $500 adjusted basis). If, instead, the lender accepts $800 in satisfaction of the $1,000 debt, borrower would have COD income of $200.
While the result in the above example is the same whether the debt involved is recourse or nonrecourse, this is not always the case. If the exchanged property is subject to a nonrecourse liability, gain will equal the excess of the liability plus any other consideration received by the debtor minus the debtor’s adjusted basis in the property. This is the result even if the amount of the nonrecourse liability exceeds the fair market value of the property.60 No portion of the gain will be COD, and the exclusions from income under Internal Revenue Code § 108 will be inapplicable.
If the exchanged property is subject to a recourse debt, the result is the same (if the borrower is released from any further liability) unless the recourse debt exceeds the fair market value (“FMV”) of the collateral. In this case, the transaction is bifurcated as follows: (i) to the extent the FMV of the property is less than the debt and the debt is released, there is COD income, and (ii) to the extent the FMV of the property exceeds the debtor’s basis, there is gain from a sale or exchange.61 To the extent the debtor remains liable for the excess of the recourse debt over the FMV of the collateral, there would be no COD. “[I]n the absence of clear and convincing [proof] to the contrary,” “the fair market value of … property” foreclosed on will be the price bid in at the foreclosure.62
To illustrate application of the bifurcation rule, assume borrower defaults on a recourse loan secured by property, and reconveys the secured property to lender in satisfaction of the debt when the debt is $12,000, the FMV of the property is $10,000, and the basis of the property is $8,000. In this case, borrower will have COD income of $2,000 (the excess of the debt of $12,000 over the then-FMV of the property of $10,000), and a $2,000 capital gain (the excess of the FMV of the property of $10,000 over the basis of the property of $8,000). If the debt in the example is nonrecourse, borrower would have $4,000 of capital gain (the excess of the debt of $12,000 over the basis of the property of $8,000).
If borrower in this example was insolvent, borrower might prefer the situation involving recourse debt, because the $2,000 of COD income would be excluded from income. If none of the Internal Revenue Code § 108 exclusions apply, borrower might prefer the situation involving nonrecourse debt, in which case the $4,000 of gain will be capital gain, which could be subject to favorable rates if the property is held by borrower for more than 12 months before it is foreclosed upon or sold.
The bifurcation rule, if applied literally, could cause particularly harsh results where the FMV of the collateral is both less than the recourse debt and less than the adjusted basis of the property. While one might never expect to incur income in excess of the debt over basis in a foreclosure or sale, in this case there could be COD ordinary income in the amount of the debt over the FMV, and a capital loss (which would generally not be deductible against the COD income) measured by the excess of the adjusted basis over the FMV. For instance, assume – hopefully for sake of illustration only – borrower owns a building having an adjusted basis of $1,000, subject to recourse debt of $1,000, but the value of which has plummeted to $100. In a foreclosure in which borrower is released, borrower would recognize $900 of COD income (the debt minus the FMV) and a capital loss of $900 (the amount of the adjusted basis in excess of the FMV of the property). Absent the special rules involving COD income, the borrower would have no gain or loss upon the disposition of property subject to debt equal to the adjusted basis, absent the receipt of additional consideration.
As indicated with respect to the previous examples, the difference in tax treatment between foreclosures and debt modifications opens the door to various planning possibilities. For instance, if the debtor is solvent and not in bankruptcy, and no other exclusion under Internal Revenue Code § 108 applies, the debtor might prefer a foreclosure over a debt reduction so as to obtain capital gain rather than ordinary income treatment. On the other hand, an insolvent or bankrupt debtor might prefer a workout to a foreclosure. While the workout will cause ordinary income instead of capital gain, the income might be excluded under § 108.
Additional planning is required in the case of principal residence indebtedness. In such case, gain on a foreclosure could be excluded from gross income to the extent permitted under Internal Revenue Code § 121, which provides for exclusion of certain gain on the sale of a principal residence. Gain on a debt modification or workout might be excluded to the extent the QPRI exclusion under § 108 applies. If the gain on foreclosure would exceed the statutory limit of $250,000 ($500,000 for married filing jointly), a discharge under the QPRI rules might be preferable because of the higher $2 million limit. On the other hand, if the residence is encumbered by a deed of trust that is not “acquisition indebtedness,” i.e., a mortgage incurred to pay bills unrelated to the real estate, since the QPRI rules might be inapplicable, a foreclosure, giving rise to Internal Revenue Code § 121 treatment, might be preferred.
VII. Treatment of Guarantors
Although the tax treatment of a guarantor released from a guaranty is not completely settled, we are not without some guidance. There appears to be little question that release of a guarantor before the guarantor becomes primarily liable does not result in COD income to the guarantor.63 There is also some support for the proposition that release of a guarantor does not result in COD income even if the release occurs after the guarantor becomes primarily liable. One argument in support of this position is that a guarantor, unlike a borrower, receives no increase in its assets or wealth as a result of the guaranty. Accession to income was the basis of recognizing COD income in Kirby Lumber.64 In addition, under Internal Revenue Code § 108(e)(2), there is no COD income resulting from the cancellation of a deductible debt, and payment of a guaranty will often give rise to a deduction under Treasury Regulations § 1.166-9(d).65
VIII. Treatment of Creditors
Treatment of creditors in certain instances has already been addressed. In general, Internal Revenue Code § 166 permits a bad debt deduction to creditors for debts owed to them which become worthless during the taxable year. There is also a deduction for debts which become partially worthless. Whether and when a debt becomes worthless is a question of fact. The amount of the deduction is generally limited to the creditor’s adjusted basis in the debt under § 1011.66 Non-corporate creditors are only permitted capital losses, and not ordinary deductions, for non-business bad debts.67
IX. The American Recovery and Reinvestment Act of 2009 (the “Act”)
The rules under Internal Revenue Code § 108 have been temporarily modified by the addition of § 108(i) under the act. The purpose of new § 108(i) is to provide alternative relief to certain taxpayers recognizing certain types of COD income in 2009 and 2010. Taxpayers to which § 108(i) applies essentially have a choice: (i) they can elect to defer the COD income completely for a four- or a five-year period and then pay tax on it ratably over an additional five-year period and forfeit forever the benefit of all of the § 108 exclusions, e.g., bankruptcy or insolvency; or (ii) they may fail to make the new special deferral election and retain the benefit of all of the § 108 exclusions.
More specifically, § 108(i) provides that “at the election of the taxpayer, [COD income] in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument” is included “in gross income ratably over a 5-taxable-year period.”68 If the reacquisition occurs in 2009, the five-year period begins in the fifth year after the reacquisition and, if in 2010, the fourth year after the reacquisition. The election referred to is made on taxpayer’s income tax return, is irrevocable, and in the case of “pass-thru entities” is made by the entity.69
A “reacquisition” is defined in Internal Revenue Code § 108(i)(4)(A) to include “any acquisition of [a] debt instrument by” the debtor-issuer, or other obligor, or a related person, within the meaning of § 108(e)(4). An acquisition is defined broadly, in § 108(i)(4)(B), as “an acquisition of the debt instrument [by the taxpayer] for cash, [an] exchange of the debt instrument for another … (including an exchange resulting from a modification…), the exchange of [a] debt instrument for corporate” or partnership equity, “the contribution of the debt instrument to capital[,]” or “the complete forgiveness of the … debt instrument.” An ‘“applicable debt instrument’ means a debt instrument … issued by … a C corporation” or by another “person in connection with … a trade or business.”70 It is unclear whether a foreclosure of recourse debt which gives rise to COD income, under the bifurcation rule discussed in Section VI above, constitutes a reacquisition.
As previously mentioned, if a taxpayer elects to have the Internal Revenue Code § 108(i) deferral apply, the bankruptcy, insolvency, QFI, and QRPBI exclusions will not apply in any year.71 If none of these exclusions apply, unless the taxpayer has expiring net operating loss carryovers, the election under § 108(i) should be attractive. In other cases, the results of the § 108(i) deferral election will need to be carefully weighed against the impact of the COD income, the extent to which one or more exclusions apply, and the impact of any required tax attribute reduction. In the case of partnerships, this analysis is likely to be complex and subject to conflicts of interest because, while the § 108(i) deferral election is made at the partnership level, the § 108 exclusions and attribute reductions apply at the partner level. Moreover, the various partners are likely to be in different situations with respect to those key considerations. Perhaps, in the case of partnerships, it would have made more sense for the § 108(i) election to be made at the partner level because the § 108 exclusions are tested at the partner level.
The taxation of COD income deferred under § 108(i) is accelerated in the case of certain events with respect to the taxpayer, including death, liquidation, sale of substantially all of the assets, cessation of business, and similar events. In the case of pass-thru entities, the acceleration rule applies on the sale or redemption of an interest in the entity.72 Presumably this means that only the portions of COD income allocated to the sold or redeemed interests would be accelerated.
X. Concluding Remarks
The topic addressed in this article is subject to so many rules and exceptions to the rules, so many of which are detailed and complex, that even an article of this length can do no more than provide an overview, or perhaps only examples, of many of the critical issues to be considered. The author hopes at least this much has been accomplished.
Footnotes
1 Jay A. Nathanson is an officer in the Corporate and Tax Departments of Greensfelder, Hemker & Gale, P.C. and a graduate of the University of Miami School of Law.
2 284 U.S. 1, 3 (1931).
3 Treas. Reg, § 1.61-12(c)(2)(ii). Adjusted issue price is defined in Treas. Reg. § 1.1275-1(b).
4 Rev. Rul. 91-31, 1991-1 C.B. 19; Rev. Rul. 82-202, 1982-2 C.B. 35. The exclusions from gross income of Internal Revenue Code § 108 similarly apply to both recourse and nonrecourse debt. I.R.C. § 108(d)(1).
5 I.R.C. § 108(e)(4).
6 I.R.C. § 108(e)(6).
7 I.R.C. § 108(e)(8).
8 Proposed Regulations have been issued relating to the application of I.R.C. § 108(e)(8) to partnerships and their partners. Proposed Regulations § 1.108-8(a) provides rules for valuing the partnership interest at liquidation value for purposes of determining the amount of COD income recognized by the partners. Proposed Regulations § 1.108-8, 73 Fed. Reg. 64903 (proposed October 31, 2008) (to be codified at 26 C.F.R., pt. 1). Proposed Regulations § 1.721-1(d), following the general rule under I.R.C. § 721, provides for no gain or loss to the creditor on transferring debt to a partnership for a partnership interest, other than debt for unpaid rent, royalties, or interest. Proposed Regulations § 1.721-1, 73 Fed. Reg. 64903 (proposed October 31, 2008) (to be codified at 26 C.F.R. pt. 1).
9 I.R.C. § 108(e)(10). The issue price of a debt instrument is generally determined under §§ 1273 & 1274 for purposes of § 108(e)(10).
10 Treas. Reg. § 1.1001-3(b).
11 Treas. Reg. § 1.1001-3(e)(2)(ii)(A).
12 Treas. Reg. § 1.1001-3(e)(2)(ii)(B).
13 Treas. Reg. § 1.1001-3(e)(3).
14 Treas. Reg. § 1.1001-3(e)(4).
15 Treas. Reg. § 1.1001-3(e)(4)(B).
16 Treas. Reg. § 1.1001-3(e)(4)(G)(iii).
17 Treas. Reg. § 1.1001-3(e)(4)(G)(iv).
18 Treas. Reg. § 1.1001-3(e)(4)(G)(iv)(B).
19 Treas. Reg. § 1.1001-3(e)(4)(G)(v).
20 Treas. Reg. § 1.1001-3(e)(5).
21 Treas. Reg. § 1.1001-3(e)(5)(ii).
22 Treas. Reg. § 1.1001-3(e)(6).
23 See generally I.R.C. §§ 1274 and 1275 and the Treasury Regulations thereunder.
24 I.R.C. §§ 1001, 1276-1278.
25 Treas. Reg, § 1.61-12(a).
26 Treas. Reg, § 1.301-1(m).
27 OKC Corp. v Comm’r, 82 T.C. 638, 652 (1984).
28 I.R.C. § 102(a).
29 I.R.C. § 108(a)(1)(A).
30 I.R.C. § 108(d)(2).
31 I.R.C. § 108(a)(1)(B). Under § 108(e)(1), § 108(a)(1)(B) provides the sole insolvency exception to the inclusion of cancellation of indebtedness into income.
32 I.R.C. § 108(d)(3).
33 Carlson vs. Com’r., 116 T.C. 87, 101 (2001); I.R.S. Priv. Ltr. Rul. 199932013 (Aug. 13, 1999); I.R.S. Tech. Adv. Mem. 199935002 (May 3, 1999).
34 Merkel vs. Comm’r., 192 F.3d 844, 851 (9th Cir. 1999).
35 Rev. Rul. 92-53, 1992-2 C.B. 48. The rationale is that excess nonrecourse debt that is not discharged does not give rise to a tax liability to a debtor without sufficient net assets to pay the income tax as does excess nonrecourse liabilities that are discharged, nor does it tie up any asset to the extent of the excess amount. This is perhaps inconsistent with the position of the Internal Revenue Service in Rev. Rul. 91-31, 1991-1 C.B. 19, that undersecured nonrecourse debt that is discharged is indebtedness for purposes of determining the amount of COD income.
36 I.R.C. § 108(a)(1)(D).
37 I.R.C. § 108(c)(3).
38 I.R.C. § 108 (c)(3)(C)(4).
39 I.R.C. § 108(c)(1)(A).
40 I.R.C. § 108 (c)(2)(A).
41 I.R.C. § 108(c)(2)(B).
42 I.R.C. § 108(a)(1)(E).
43 See I.R.C. §§ 108(h)(2) and 163(h)(3)(B).
44 Treas. Reg. § 1.121-1(b)(2).
45 I.R.C. § 108(h)(1).
46 I.R.C. § 108(h)(3).
47 I.R.C. §108(e)(2).
48 I.R.C. § 108(a)(1)(C).
49 I.R.C. § 108(e)(5).
50 I.R.C. § 108(f).
51 I.R.C. § 108(a)(2).
52 I.R.C. § 108(b).
53 I.R.C. § 108(b)(3)(B).
54 I.R.C. § 108(b)(4)(A).
55 I.R.C. § 108(b)(5).
56 I.R.C. § 108(d)(6).
57 I.R.C. § 108(d)(7)(A).
58 Treas. Reg. § 1.1001-2(a)(1).
59 I.R.C. § 1001(a).
60 Commissioner vs. Tufts, 461 U.S. 300, 307 (1983); Treas. Reg. §§1.1001-2(a)(1), 1.1001-2(a)(4)(i), 1.1001-2(b), and 1.1001-2(c) (Example 7).
61 Treas. Reg. §§ 1.1001-2(a)(2) and 1.1001-2(c) (Example 8); Rev. Rul. 90-16, 1990-1 C.B. 12.
62 Treas. Reg. § 1.166-6(b)(2).
63 I.R.S. Tech. Adv. Mem. 7953004 (September 7, 1979).
64 See 284 U.S. 1, 3 (1931).
65 While release of a guarantor might not create COD income for the guarantor, it could create income for the borrower or lender by constituting a “significant modification” of a debt instrument, as discussed above. Treas. Reg. § 1.1001-3(e)(4)(iv).
66 I.R.C. § 166(b).
67 I.R.C. § 166(d).
68 I.R.C. § 108(i)(1).
69 I.R.C. § 108(i)(5)(B).
70 I.R.C. § 108(i)(3)(A).
71 I.R.C. § 108(i)(5)(C).
72 I.R.C. § 108(i)(5)(D).