The Tax Effects of the Cancellation of Debt
One of the most important issues in the context of any bankruptcy, workout, or restructuring is cancellation of debt ("COD") income. This article provides a high-level overview of COD income and describes some of the common exclusions that should be kept in mind when participating in a bankruptcy, workout, or restructuring.
Cancellation of Debt Income
The Internal Revenue Code ("IRC") specifically includes as gross income amounts associated with the discharge of indebtedness, which is commonly referred to as COD income. Though numerous scenarios result in COD income, the general principle is the same in each scenario – a creditor cancels debt owed by a debtor, providing an economic benefit to the debtor that equates to taxable income. COD income is often described as "phantom" income because the debtor is deemed to receive an economic benefit without receiving any actual cash. Often, debtors are surprised to learn that COD income exists and are unable to pay the tax obligation associated with it. Fortunately, many exclusions exist in the IRC to reduce or eliminate this tax obligation. Below is a list and description of some of the most common exclusions.
The IRC provides that if a debtor’s debts are discharged in bankruptcy, the resulting COD income is excluded from the debtor’s gross income. With respect to partnerships or limited liability companies, this exclusion applies at the partner level, rather than the partnership level, making it difficult for a partnership or limited liability company to qualify for exclusion from income. With respect to an S corporation, this exclusion applies at the entity level, resulting in the COD income being excluded and not passed through to shareholders.
The IRC provides that if a debtor is insolvent and would otherwise realize COD income, the debtor may exclude the portion of that income that is equal to the amount of the debtor’s insolvency immediately prior to the discharge. Notably, a taxpayer is "insolvent" for purposes of the IRC if his total indebtedness exceeds the total fair market value of his assets. Just like the bankruptcy exclusion, this exclusion applies at the partner level, creating the same difficulties. With respect to an S corporation, this exclusion results in only the balance of the COD income that is not excluded being passed through to the shareholders.
Qualified Real Property Business Indebtedness Exclusion
The IRC provides that if a debtor incurred or assumed indebtedness for the purpose of acquiring, constructing, reconstructing, or substantially improving real property used in a trade or business, or if the indebtedness resulted from the refinancing of qualified acquisition indebtedness of real property (but only to the extent that the amount of such debt does not exceed the amount of debt being refinanced), and the indebtedness is secured by that real property, the debtor may elect to apply the qualified real property business indebtedness ("QRPBI") exclusion. Generally, the amount of COD income that is excluded is equal to the balance of the debt less the fair market value of the real property underlying the debt. The QRPBI exclusion is further limited to the excess outstanding principal amount of the indebtedness immediately before the discharge over fair market value of the real property, less the outstanding principal balance of any other qualified real property business indebtedness that is secured by the property immediately before and after the discharge. This exclusion is further limited to the aggregate adjusted bases of all of the taxpayer’s depreciable real property held immediately before the discharge of the secured debt.
One notable downside of this exclusion is that it triggers a basis reduction in the debtor’s depreciable real property. Frequently used by real estate developers, this exclusion does not apply to C corporations. With respect to partnerships, the determination of whether the debt is qualified real property business indebtedness and the applicability of the fair market value limitation is made at the partnership level. However, the decision whether to elect to apply the qualified real property business exclusion is made at the partner level on a partner-by-partner basis.
The above list of exclusions is not exhaustive. Rather, it includes the most commonly applied exclusions. Though not discussed here in detail, a number of other exclusions exist, including the qualified farm indebtedness exclusion (similar to the QRPBI exclusion), the qualified principal residence indebtedness exclusion, and the student loan indebtedness exclusion, which is limited to those who participate in certain employment in certain professions. Additionally, if a genuine dispute exists as to the amount or enforceability of the debt, the disputed debt exception may apply.
When participating in a workout or restructuring and comparing those with the alternative of bankruptcy, the effect of COD income should be considered and discussed at the beginning of the process to help evaluate and plan for the different options.
by Bryan E. Slone and Brian J. Koenig