Tax Consequences of Cancellation of Debt
By Tim L. Donovan, CPA, MBA, CIRA
Debt Forgiveness for Businesses
Over the last couple of years, the Covid-19 pandemic has stressed companies financially and caused many to fall behind in payments to lenders. Often the company has been able to get their lenders to either forgive or restructure loans. When all or part of a loan is forgiven, the company will get a surprise at tax time. The amount of the loan that is forgiven is taxable income in the year of the forgiveness. This comes as a shock when the company has to write a check to IRS and state taxing authorities at a time when resources are low.
Tax Effects from Debt Forgiveness
The Internal Revenue Code (“IRC”) states that income from whatever source derived (IRC Section 61) is taxable unless specifically exempt from tax by the IRC.
When a company has a loan forgiven, they received funds that they don’t ever repay which is treated as ordinary income and called income from Cancellation of Debt (”COD”). When the loan is forgiven the lender gets a bad debt write off and the borrower experiences taxable income. Since the lender will issue a Form 1099-C, Cancellation of Debt, the IRS income matching system is looking to be sure the COD is reported.
Ways to Receive Tax Relief
Our society values a sense of fair play and does not seek to punish business owners when they are hurt by market downturns and other circumstances beyond their control (like Covid-19 mandatory shutdowns). There are several legal provisions that give an honest business owner a break and a chance to start over. One of them is Internal Revenue Code Section 108.
Section 108 provides several exceptions to the reporting of COD income which covers such things as discharge of qualified principal residence debt, student loans, and many others.
For purposes of this brief article, we’ll focus on the Bankruptcy and Insolvency exclusions and the special rules for partnerships and LLCs taxed as partnerships.
IRC Section 108(a)(1)(A)) states that gross income does not include COD if the discharge occurs in a Title 11 case. This is often misunderstood as a ‘chapter 11 case’. Title 11 covers all chapters of the
bankruptcy code. Under this section, a bankrupt company can exclude the COD from gross income.
IRC Section 108(a)(1)(B) states that gross income does not include COD when the company is insolvent. This is somewhat more complicated. Insolvency is defined using the balance sheet test. That is that, immediately before the discharge of debt, the company’s liabilities must exceed the fair market value of the company’s assets. To the extent that the company is insolvent, the COD can be excluded from income.
There’s No Free Lunch
So, the question is, “What happens to the excluded income?”. Does it simply go away? The answer is that the taxpayer must reduce tax attributes to the extent of the excluded COD income (IRC Section 108(b)). Tax attributes include any net operating loss carryovers, general business credits, minimum tax credits, capital loss carryovers, basis in remaining assets (equipment, etc.), passive activity losses, and foreign tax credit carryovers. In general, these attributes are reduced dollar for dollar by the amount of the COD excluded from income (IRC 108(b)(3)(a)).
For example, if a taxpayer has a net operating loss (“NOL”) carryover from prior years of $100,000 and excludes $60,000 COD income in the current year, the remaining NOL to be used in future years is $40,000. The idea is that, for a company that survives, the exclusion of COD acts as a tax deferral and is recovered over time by the reduction of tax attributes.
The operation of Section 108 is complicated with multiple elections available. Careful tax planning is needed.
Partnership – LLC: Tax Trap
One of the most popular business forms today is the Limited Liability Company (“LLC”) that is taxed as a partnership. Our general discussion so far works well for individuals, single member LLCs (individuals filing a Schedule C with their 1040), and corporations (including S corporations) but there is a trap for partners in a partnership or members in a (multi-member) LLC.
IRC Section 108(d)(6) contains a special rule for partnerships. For a partner in a partnership (including a member in an LLC), the exclusion of COD applies at the partner/member level rather than at the company level.
More than any other provision, this exception to the exclusion of COD for partners and LLC members has caused the most grief for my clients over many years. Many business owners are aware of the ability for an insolvent company to avoid paying tax on COD income and they assume it applies to all businesses. However, when they are told about the exception for partnerships and LLCs and that they will report the COD as income on their personal returns, they are shocked.
For a partner or a member to use the exclusions under Section 108, the individual (not the partnership or LLC) must have filed bankruptcy or be insolvent at the time of the debt forgiveness. Very often, an LLC is made up of many members and some of them are neither in bankruptcy nor insolvent even though the company is. The partnership or LLC will pass their share of the COD to them on their K-1.
When a group of individuals contemplates forming a business, they rarely think that the business may someday fail. They are filled with the excitement and optimism of the new venture. Here, too, long-term planning is needed. Everyone needs to consider what to do when the unthinkable happens.
For both S Corporations and C Corporations, the Section 108 exclusion along with the reduction of tax attributes happens at the company level leaving the owners shielded from the impact of the COD. Additionally, there are several other tax benefits to operating under the corporate form that at beyond the scope of this short article.
Amplēo is Here to Help
In some situations, it may be possible to incorporate an existing partnership or LLC to take advantage of the Section 108 exclusion. The road to incorporation of an insolvent partnership or LLC is rocky and requires much advance planning. If you or your client is in need of assistance with COD or need help taking advantage of tax relief options, call Amplēo. Our team of turnaround professionals are ready to help you plan and, hopefully, avoid negative tax consequences.