TAX ASPECTS OF BANKRUPTCY AND INSOLVENCY

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1 TAX ASPECTS OF BANKRUPTCY AND INSOLVENCY Langdon Owen 1 Parsons Kinghorn Harris, pc (801) lto@pkhlawyers.com 1. Cancellation of Indebtedness Income. When a deal or debtor runs into financial trouble, there is often involved a reduction of debt owed. The general rule is that reduction or cancellation of indebtedness results in income to the debtor. IRC 61(a)(12); Regs ; U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931) (debts purchased by issuer in open market). Such income may arise in a number of ways, including on foreclosures, workouts, settlements of called guarantees, market acquisitions at a discount of debt by a debtor or on reorganization, expiration of statutes of limitations, statutory no-deficiency rules, probate proceedings, creditor write-offs and discontinuances of collection, contributions of debt for an equity interest in the debtor organization, and so on. Discharge of debt income may also arise under the tax benefit rule of IRC 111(c) where an accrued but unpaid expense amount is deducted earlier (increasing an NOL (net operating loss)) and the indebtedness is forgiven in a later year where the NOL carryover has not expired. (IRC 108(e)(2) would prevent this result for a cash basis taxpayer.) This income is sometimes referred to as cancellation of debt ( COD ) income. The law in this area focuses more on the exceptions than on the general rule. However, some issues of whether cancellation income should be recognized may arise, particularly as to contingent obligations. Corporacion de Ventas de Salitre y Yoda de Chile v. Com r., 130 F.2d 141 (2d Cir. 1942) (taxpayer's purchase at a discount of its own bonds which were payable only out of a percentage of future profits didn't give rise to income). See also, PLR ; Rev. Rul , CB 34 (amount owed by the taxpayer under a contract that was forgiven by the seller in return for a release of a contract counterclaim wasn't income from the discharge of indebtedness). Fully collateralized loans in default are not uncollectable and thus may not trigger COD income. See Pinn v. Com r, TC Memo Interest as well as principal can constitute forgiven debt includable in income. Brooks v. Com r, TC Memo (interest forgiven on a loan from employer includible as debt discharge income where the forgiven interest was not shown by employee, a stock broker, to be deductible investment interest to the extent his investment income). The cost of issuance of debt securities may be deductible separately (IRC ' 162) amortized over the life of the debt under original issue discount principles (Reg as if they adjusted the yield on the debt ), but 1 This article is provided for informational purposes only. It is not intended as, and does not constitute, legal advice. Further, access to or receipt of this article by anyone does not create an attorney-client relationship. Although this article was believed to be correct within the scope of its purposes when written, it may be incorrect or incomplete, was not intended to comprehensively cover any subject, does not cover a number of related matters, and does not cover anyone s particular situation. As such, it is not reasonable for anyone to rely upon this article with respect to any particular legal matter. Rather, readers are encouraged to retain a licensed attorney to provide individualized and current legal advice. 1

2 nevertheless not affect discharge of indebtedness income on the cancellation of the debt. PLR Timing of the income from cancellation of debt is generally tied to an identifiable event which makes it clear the debt will never have to be paid. Cozzi v. Com r, 88 TC 435 (1987). There is a rebuttable presumption that such an identifiable event occurred in a calendar year if, during a testing period (of generally 36 months) ending at the close of the year, the creditor has received no payments. Kleber v. Com r, TC Memo Expiration of the statute of limitations is not conclusive because it does not extinguish the debt, but may be an identifiable event in some circumstances. A plan of liquidation can postpone the identifiable event because until all assets are liquidated and distributions are made, the amount of discharge of allowable claims cannot be known. PLR A taxpayer receiving an advance under a loan agreement partially or completely cancellable depending on contingencies, may be able to defer the recognition of the cancellation income under the all events test (i.e., all events have occurred which fix a right to receive such income and the amount can be determined with reasonable accuracy) if the taxpayer is on an accrual basis of accounting. CCM F (loan from a state cancellable depending on how many jobs a company created or retained was a bona fide loan (rather than a prepayment for the service of job retention or creation or a contribution to capital) and cancellation income could be deferred under accrual accounting). a. The Bankruptcy, Insolvency, Farm, and Real Property Exceptions. Section 108 of the Internal Revenue Code ( IRC ) contains a list of exceptions to the general rule of IRC 61 that income includes cancellation of debt. Exclusions of income or attribute reduction under IRC 108 is reported by debtors on Form 982 with their returns. These statutory exceptions will not apply, however, to the extent the taxpayer makes the election to defer COD income pursuant to IRC 108(i) for the years 2009 and 2010 (see further discussion at 1(c)(8) below). (1) Taxpayers In Bankruptcy. Discharge of indebtedness income will not be recognized by a debtor in a bankruptcy proceeding under Title 11 of the United States Code; this exception does not apply to other insolvency proceedings such as receiverships. This exception applies even if the debtor in the bankruptcy proceeding is solvent. IRC 108(a)(1)(A). The cost of exclusion is the offsetting of the same tax attributes as described for the insolvency exception below. This provision may be the salvation of debtors not so deeply insolvent as to be fully covered by the insolvency exception. (2) Insolvent Taxpayers Outside of Bankruptcy. No income from cancellation of debt is recognized to an insolvent debtor outside bankruptcy to the extent of insolvency. IRC 108(a)(1)(B). The definition of insolvency is the excess of liabilities over the fair market value of assets. IRC 108(d)(3). Solvency is determined immediately before the discharge. The burden of proving insolvency is on the taxpayer. See Hill v. Com r., TC Memo

3 Exempt assets have been ignored in the determination of solvency. Cole v. Com r., 42 B.T.A (1940), non-acq C.B. 13; Marcus Est. v. Com r., T.C. Memo ; Hunt v. Com r., T.C. Memo ; PLR ; TAM If this is the rule, in a close case, a taxpayer may want to put assets into an exempt form under state law to qualify as insolvent for purposes of this exception; some courts have supported such planning, but others have found it questionable. On the other hand, Carlson v. Com r, 116 T.C. 87 (2001) refused to follow pre-bankruptcy Tax Act case law and counted such assets in the determination of insolvency. See also, TAM and PLR It is not clear, however, if liabilities associated with exempt assets are taken into account even if the exempt assets are not. Questions arise on intangible assets (e.g., goodwill) and contingent liabilities in applying this definition. See, e.g., Merkel v. Com r, 109 T.C. 463 (1997), 192 F.3d 844 (9 th Cir. 1999) (applying an all or none test for counting indebtedness (not a discount for probability of occurrence) under which taxpayer must prove it is more probable than not that the taxpayer would be required to pay obligations claimed, such as a guarantee; insolvency definition required fair market valuation of assets, not liabilities). A nonrecourse liability that exceeds the value of the security for it, is fully taken into account for applying the insolvency test to the extent that the excess nonrecourse debt is discharged (Rev. Rul , C.B. 48). Partnership excess non-recourse debt (debt exceeding the value of the security for the debt) is treated as a liability of the partners, allocated among them under IRC ' 704(b), for purposes of determining the insolvency of the partners (which is where the exception applies in the partnership context). Rev. Rul , IRB. Unamortized premium and discount are taken into account in determining the amount of debt being canceled. IRC 108(e)(3). (a) Attribute Reduction. The taxpayer-debtor reduces its tax attributes (after the tax calculation for year of cancellation has been made) in the order set forth below, and to the extent the debt cancellation exceeds these attributes it has no further effect on income (H. Rep. No , 96th Cong. 2d Sess. 11, ( H. Rep. ); S. Rep. No , 96th Cong., 2d Sess. 13 ( S. Rep. ). (i) Years Affected. Within each category, reduction is in the same order of taxable years that the attributes would be used (IRC 108(b)(4)(B) and (c)) e.g., first in, first out on general business credit and foreign tax credit carryovers (see IRC 46(a)(1) and (b)); on Net Operating Loss ( NOL ) and on capital loss carryovers, current year then earliest year still available for carry forward, then subsequent years in order. Reduction of carryover attributes for the current year first increases the chance of expiration of the NOL or capital loss carry forward before it is recovered. (ii) Level Affected. The no income rule and the attribute reduction rules apply at the partner level in partnerships (IRC 108(d)(6)), at the corporate level for S-corporations (IRC 108(d)(7)(A)). 3

4 (b) Order of Reduction. Attribute reduction is reported on Form 982. Attributes are reduced in the following order (IRC 108(a)(2) and (3)): (i) NOLs (dollar for dollar). However, under the Alternative Minimum Tax rules, a corporate debtor can be subject to tax on its income from the cancellation of indebtedness no matter how much regular NOL or carry forwards it has, because the NOL carry-overs and carrybacks available to reduce alternative minimum taxable income is limited to 90% of such income (IRC 56(d)(1)(B)(ii)). The result is generally a tax equal to at least 2% of its debt discharge income (20% AMT x 10% of AMTI). However, under the Worker, Homeownership, and Business Assistance Act of 2009 (P.L ), if an extended NOL carryback period is elected as allowed under the circumstances provided in that Act (Act ' 13; IRC ' 172(b)(1)(H); Rev. Proc , IRB), not only eligible small businesses for 2008, but almost all business taxpayers, can elect to increase the NOL carryback period for a 2008 or 2009 NOL from 2 years to 3, 4, or 5 years), then for tax years ending after 2002 the 90% limitation on the use of the deduction for alternative minimum tax purposes is suspended for the NOL for which the extended period was elected. (33 1/3 cents on the dollar). cents on the dollar). (ii) General Business Credit carryover under IRC 38 (iii) Minimum Tax Credit Under IRC 53(b) (33 1/3 dollar). (iv) Capital losses and capital loss carryover (dollar for (v) Basis of all (not just depreciable) assets held by debtor immediately after discharge (dollar for dollar) until basis remaining is not less than remaining debts (IRC 1017(b)(2)) so that tax will be due if the debtor realizes more on the sale of assets than its remaining liabilities. The reduction is taken at the beginning of the year following cancellation (IRC 1017(a)); this timing rule may cause gains to be taxed to the bankruptcy estate on a later sale of the assets. The bankruptcy trustee may find this timing rule creates problems; since it is unlikely that the discharge can be delayed, the trustee may want to sell the property before the end of the year or may want to select a tax year that will bunch other income in a year earlier than the year of discharge. If the basis of property (including, for example, a home) is reduced by an insolvent debtor outside bankruptcy, or in bankruptcy where the property (e.g., the home) is not exempted from creditors, then (as discussed at (d) and (e) below) under IRC 1017(d) the basis reduction causes the property to be IRC ' 1245 or 1250 property and the reduction is treated as being depreciation subject to recapture as ordinary income on a later sale. This will, as to the home in our example, cause income to be recognized under IRC ' 1245 even if the home sale gain is otherwise excluded under the $250,000 ($500,000 joint) home sale exclusion of IRC

5 (vi) Passive activity loss and credit carry-overs under IRC 469(b) (33 1/3 cents on the dollar as to passive activity credit carryover, otherwise dollar for dollar); (vii) Foreign tax credit (33 1/3 cents on dollar). (c) Special Basis Election. A special election is available to reduce the basis of depreciable property before other attributes are reduced. IRC 108(b)(5). This election could be used in order to protect the NOL for bankruptcy or other reorganization purposes. Revocation of the election requires IRS consent. (i) Application. The election applies to taxpayers in Title 11 bankruptcy proceedings, to insolvent taxpayers outside of bankruptcy to the extent of insolvency, and to debtors entitled to the qualified farm indebtedness exception (discussed below). (Although there is a similar rule for the qualified real property exception (discussed at (4)(c) below), that rule does not treat real property held in inventory as being depreciable). (ii) Limits. The election may reduce the basis below the amount of remaining debts. The basis reduction must, however, reduce the amount of depreciation otherwise available for the period immediately following reduction. IRC 1017(b)(3)(B). (iii) Real Property Inventory. A taxpayer can elect on the return for the year of discharge to reduce the basis of real property inventory. IRC 1017(b)(3)(E). (iv) Equity Interests. The election can also reduce basis of a partnership interest or of a stock interest in subsidiary (or chain of subsidiaries) that files consolidated return with debtor, but only if changes in the basis of those entities depreciable property (or real estate inventory) is made. IRC 1017(b)(3)(C) and (D). This results, in effect, in a double reduction of basis. See Regs (g)(2)(i). A partner must request partnership consent to reduce the partnership s basis if the partner owns (directly or indirectly) more than 50% of the capital and profits interests or if the reductions in the partner s basis in depreciable property are being made with respect to the partnership s cancellation of indebtedness income (Regs (g)) and the partnership must consent if requested by any partners holding in the aggregate more than 50% of the capital and profits interests (v) Analogous Rules. See old Regs and (vi) Recapture. Basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors; see IRC ' 1017(c)) are 5

6 treated as depreciation deductions and can give rise to recapture income. See discussion at (d) just below. (d) Other Basis Matters - Recapture. Basis reductions (from attribute reduction or the special election, described above, or on qualified farm indebtedness or qualified real property business indebtedness described below) are subject to recapture under the rules of IRC 1245 and 1250; the 1245 rules apply to property not otherwise 1245 or 1250 property such as subsidiaries (IRC 1017(d)(1)). No recapture of general business credit results from basis reductions because it is not treated as a disposition (IRC 1017(c)(2)); but recapture may occur when cancellation is treated as purchase price adjustment (under IRC 108(e)(5) or otherwise). (e) Exempt Property. Bankruptcy Code ( BC ) 522 exempt property basis is not reduced if the taxpayer is in a Title 11 proceeding. IRC 1017(c)(1). Thus exempt property can avoid the depreciation recapture described above. (3) Qualified Farm Indebtedness. Debt discharge income is not recognized if it is qualified farm indebtedness. IRC 108(a)(1)(C). Such indebtedness must be incurred directly in connection with the operation by the taxpayer of the trade or business of farming where 50% or more of the aggregate gross receipts for the 3 taxable years before the year of discharge is from farming. The amount excluded cannot exceed the sum of the adjusted tax attributes of the taxpayer and the aggregate adjusted basis of qualified property held on the beginning of the tax year following the discharge. IRC 108(g). (a) Adjusted Tax Attributes. The adjusted tax attributes which limit the income to be excluded under the farm exception are the same as the tax attributes affected by offsets under the other discharge exceptions discussed above, except: (i) property basis is excluded because, as mentioned above, there is a separate specific aggregate adjusted basis requirement for farms; and (ii) $3 is taken into account for each $1 of general business credit, minimum tax credit, foreign tax credit carryovers, and passive activity credit carryovers (IRC 108(g)(3)(C)). (b) Special Basis Rules. Once the adjusted tax attributes have been determined and used to establish the amount of discharge of indebtedness that may escape taxation, the tax attributes of the debtor are then reduced under IRC 108(b)(2). Under IRC 1017(b)(4), the basis adjustment to be made as part of adjusting the tax attributes of the debtor to offset the unrecognized debt discharge income is applied only to reduce the basis of the qualified farm property and is applied in this order: (i) depreciable qualified property; (ii) land used or held for use in farming; then 6

7 (iii) other qualified property. The elective basis adjustment under IRC 108(b)(5) is also available for the farm exception. As discussed at 2 (d) and (e) above, basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors) are treated as depreciation deductions and can give rise to recapture income. (4) Qualified Real Property Business Indebtedness. An exception applies to solvent debtors which are not C-corporations, and excludes from taxation discharged debt from qualified real property business indebtedness. IRC 108(a)(1)(D). This exception will apply to individuals, estates, trusts, S-Corporations (rather than shareholders of S- Corporations), partnerships, and limited liability companies taxed as partnerships, but will not apply to real estate investment trusts and cooperatives. Although the debtor must be solvent, the exception can apply to the extent the debtor has debt discharge income over the amount needed to bring the debtor out of insolvency. Thus, a combination with the general insolvency exception may be useful. (a) Election. This exception must be elected by the taxpayer in the taxable year of discharge or as provided in regulations (IRC 108(d)(9)); with respect to partnerships or limited liability companies taxed as partnerships, this election is made at the partner level (the partner must not be a C-Corporation) although the determination of the qualification of the indebtedness is made at the partnership level (it is unclear whether a partner who sells the affected partnership interest before the IRC 108(c) election must be made, remains entitled to make the election; the American Bar Association Section of Taxation has recommended that such a partner not be able to make the election, and not be taken into account in determining if more than 50% of the capital and profits interests require the partnership to reduce its inside basis of partnership assets). (b) Trade or Business Real Property. To be qualified real property indebtedness, the debt must have been incurred or assumed in connection with real property used in a trade or business and be secured by that property, but the property need not be depreciable. IRC 108(c)(3)(A). IRC 1231 and 1017 appear to exclude real property of a dealer under property used in the trade or business, a term not specifically defined in IRC 108; but see Rev. Rul , C.B. 37 and Martin, Officials Discuss New Real Estate Debt Discharge Exceptions, 60 Tax Notes 1422 (1993). Also, if the debt was incurred or assumed after December 31, 1992, it must be incurred or assumed to acquire, construct, reconstruct, or substantially improve such property. A refinancing of qualified debt will itself qualify to the extent the new debt does not exceed the old. IRC 108(c)(3). (c) Basis Reduction. The price for the exception is the reduction of the basis of depreciable real property held at the beginning of the following tax year (applied first to the property securing the discharged debt), or the basis adjustment could be accelerated and applied to property held immediately before disposition if the property is sold or disposed of prior to the next tax year. IRC 108(c)(1), 1017(a)(2), and 1017(b)(3), and Regs. 7

8 (c)(1). The basis adjustment acceleration could eliminate the benefit of the exception if the property is sold to pay off the nondischarged portion of the debt. Recapture of depreciation under IRC 1250 applies. See IRC 1017(d). The basis reduction is treated as a depreciation deduction and what would have been the straight-line depreciation is determined as if no basis reduction had been made. Fiscal year 1994 Budget Reconciliation Recommendations of the Committee on Ways and Means, Ways and Means, Committee Print: 11, 103d Cong., 1st Sess. (May 18, 1993) at 186. As discussed at 2 (d) and (e) above, basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors) are treated as depreciation deductions and can give rise to recapture income. (i) Partnership Interest. A partner s interest in a partnership may be treated as if it were depreciable real property in its proportionate share of the depreciable real property of the partnership, but only where the partnership s basis in depreciable real property is reduced with respect to the partner. IRC 1017(b)(3)(C) and Regs (g)(2). Affiliated corporate groups are treated similarly. IRC 1017(b)(3)(D). See discussion at (2)(c) above. (ii) Inventory. Property held in inventory does not qualify as depreciable real property for this exception (unlike for the bankruptcy, insolvency, or farm exceptions). IRC 1017(b)(3)(F). exception: (d) Special Limits. There are special limits that apply to this (i) Excess Over Value. The amount excluded cannot exceed the excess of the debt over the value of the property. IRC 108(c)(2)(A). Regulations are expected to prevent the incurring of new debt cross collateralized by existing property in order to increase the excludable amount applicable to the property. IRC 108(c)(5). (ii) Basis Limit. Also, the exclusion cannot exceed the aggregate adjusted basis of depreciable real property held immediately before the discharge but determined after the basis adjustments generally applicable (if they are applicable) to offset the discharge of indebtedness exclusions under IRC 108(b) (bankruptcy or insolvency) and (g) (farm). IRC 108(c)(2)(B). Property acquired in contemplation of discharge is not used in determining the limitation. For provisions that may be instructive in determining what is in contemplation, see Regs (c)(3) and (4). (iii) Inside Basis Adjustment. The inside basis of the partnership in its assets may need to be reduced under rules similar to those applicable to the IRC 108(b)(5) special basis adjustment election (see discussion at (2)(c)(iv) above). See Regs (f)(2) (but the election itself does not apply to IRC 108(c)). (5) Ordering of Exceptions. It is possible more than one exception could apply. They are used in this order: Bankruptcy, insolvency, then farm and qualified real 8

9 property. The farm and qualified real property exceptions do not apply to a discharge to the extent the taxpayer is insolvent. IRC 108(a)(2). b. Solvent Taxpayers Outside Bankruptcy Proceedings and General Matters Relating to Discharge of Indebtedness. In determining debt cancellation income there are some other rules that will apply. (1) Income from Nonrecourse Debt. Unless an exception applies, income is recognized on cancellation of the indebtedness (taking into account unamortized premium and discount). IRC 61(a)(12). An old no personal liability exception for nonrecourse debt on property not transferred to obtain the discharge, no longer applies. The old exception was under cases such as Fulton Gold Corp. v. Com r, 31 BTA 519 (1934) (no freeing of debtor s assets) and Hotel Astoria, Inc. v. Com r, 42 BTA 759 (1940). The current law recognizes income to the extent of the full nonrecourse debt discharged. See Gershkowitz v. Com r, 88 T.C. 984(1987); Rev. Rul ; C.B. 36; Rev. Rul , C.B. 19; IRC 108(d)(1) treats indebtedness as including both recourse debt and debt subject to which the taxpayer holds property. See also Rev. Rul , C.B. 48. (2) Gift. It may be possible to argue in some circumstances for a gift or bequest exception. Compare Helvering v. American Dental Co., 318 U.S. 322 (1943) with Com r. v. Jacobson, 336 U.S. 28 (1949) and See IRC 108(e)(1) on no other insolvency exception. See also IRC 453B(f) (gift cancellation of installment obligation gives rise to income to the creditor as a disposition of the obligation), 453B(c), 691(a)(5)(iii) (income in respect of a decedent) and Frane Est. v. Com r., 98 T.C. 341 (1992) which was reversed by Frane Est. v. Com r., 998 F.2d 567 (8th Cir. 1993) (self canceling installment note taxed to decedent s estate under IRC 691 rather than IRC 453B). See H.R. Rep. No. 833, 96th Cong., 2nd Sess. at 15 (1980) and S. Rep. No. 1035, 96th Cong., 2nd Sess. at 19 (1980); both reports state it is intended that there will not be any gift exception in a commercial context (such as a shareholder-corporation relationship) to the general rule that income is realized on discharge of indebtedness. (3) Other Arguable Exceptions. It may be possible to assert other defenses to the rule requiring the recognition of income on the discharge of indebtedness. (a) Contingent or Contested Liabilities. The debtor should not recognize debt discharge income if the canceled debt was too contingent to create basis, or if the canceled debt was subject to a bona-fide dispute. Regs (b)-1(c) requires that a debt be absolute and not contingent. See CRC Corp. v. Com r., 693 F.2d 281 (3d Cir. 1982) cert. denied 426 U.S (1983); N. Sobel, Inc. v. Com r., 40 B.T.A (1939); U.S. v. Hall, 307 F.2d 238 (10th Cir. 1962). If the debt is for a loan of money or is liquidated, there is an accession to wealth on cancellation even if there is a dispute about payment or amount; a dispute over enforceability should only affect cancellation of debt income with respect to a debt for services or for property other than cash that is claimed to be not worth the obligation. See 9

10 Preslar v. Com r, 167 F.3d 1323 (10 th Cir. 1999). Merely becoming unenforceable is a classic case for recognizing income from the cancellation of the unenforceable debt. (b) Equity Not Debt. If the debt is really equity, it may not create cancellation of indebtedness income. See Selfe v. U.S., 778 F.2d 769 (11th Cir. 1985); but see Com r. v. National Alphalfa Dehydrating and Milling Co., 417 U.S. 134 (1974) (taxpayer generally bound by the form of its transaction) and Crouch v. U.S., 692 F.2d 97, 99 (10th Cir. 1982). (c) No Asset Increase; Guarantees. The obligation may not arise to the dignity of a debt sufficient to create income on its discharge if the debtor did not receive any consideration or obtain any increase in its assets as a result of it. See Bradford v. Com r., 233 F.2d 935 (6th Cir. 1956); Com r. v. Rail Joint Co., 612 F.2d 751 (2d Cir. 1932). But a guarantor who received consideration for the guaranty and obtained a release after the guaranty became payable on default of the principle debtor, may recognize debt discharge income. See analogously, Tennessee Securities, Inc. v. Com r., TC Memo , aff d, 674 F.2d 570 (6th Cir. 1982) and Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975), (satisfaction of a personal loan guarantee by the guarantors' closely-held corporation constituted income to the shareholder-guarantors). However, the reduction of the debt with respect to the primary obligor does not also create debt reduction income for the guarantor even though the contingent liability is likewise reduced. Landreth v. Com r, 50 T.C. 803 (1968). This may be the case as well when the guarantor makes a payment and the creditor restructures the primary obligor s debt. Payne v. Com r, 75 T.C.M rev d on other grounds, 224 F.3d 415(5 th Cir. 2000). If the guarantor pays the debt, the primary obligor may have relief from debt income, but that income may not occur until after any subrogation or other reimbursement claim by the guarantor is released. Miller v. Com r, 91 T.C.M (2006). (4) Contribution to Capital. IRC 108(e)(6) provides that where a corporate debtor acquires its debt from a shareholder as a contribution to capital, it will recognize income to the extent the debt exceeds the basis of the shareholder in the debt. This is because the debt is deemed satisfied by a payment of money equal to the shareholder s adjusted basis in the debt. If the cash basis shareholder has little or no basis in the debt contributed, for example accrued but unpaid interest, salary, or rent, which has been previously accrued by the corporation but not taken into income by the shareholder, or a debt upon which the shareholder has taken a bad debt deduction, the contribution of that debt to the corporation results in income to the corporation. This rule supersedes IRC 118 which normally provides that no income is recognized on the contribution of capital to a corporation. On the other hand, if the shareholder has basis in the debt in its face amount (e.g., from a loan of cash to the corporation), the corporation is treated as paying the debt and under IRC 61(a)(12) recognizes no income even where the corporation is insolvent and the contribution of the loan to capital either does not render it solvent or renders it solvent in an amount less than the amount of the contributed debt. See Cummings Corporate Tax Insights on Checkpoint 11/11/2008, vol. 06, No. 21 (the purpose of IRC 108(e)(6) is to limit, for all purposes, the 10

11 amount of the COD income (reported or not under Code Sec. 108(a)) to the spread between the shareholder s basis in the obligation and its face amount (or adjusted issue price). (5) Subchapter-S Effect. IRC 108(d)(7)(A), which treats income exclusion, attribute reduction, and the qualified farm indebtedness exception at the corporate level for S-corporations, prevents excludable income from passing through to the shareholder and thus prevents a basis increase in the stock under IRC 1366(a). This section was amended, effective for discharges of indebtedness after October 11, 2001, in order to overrule Gitlitz v. Com r, 531 U.S. 206 (2001). If stock basis had increased, future losses could have been passed through and future gains on the stock would have been less; Congress deemed this to be too great a benefit to the taxpayers. The S-corporation usually will not have NOLs because it is a pass through organization. However, where the corporation has losses which cannot be passed through and used by shareholders because the shareholders basis is not sufficient to allow the losses to be used (see IRC 1366(d)(1)), the corporation will be deemed to have an NOL for purposes of attribute reduction. IRC ' 108(d)(7)(B). This rule does not however apply to the qualified real property indebtedness exception to debt discharge income; basis reduction applies instead of the usual line-up of attribute reductions. Thus, in cases other than for the qualified real property exception, the attribute reduction will reduce pass through losses, including capital losses, which could have been used except that there was insufficient basis to do so. If there are any such losses left they are allocated among the shareholders for later use. Reg. ' (d)(2)(ii). (6) Reduction in Purchase Price. No cancellation of indebtedness income is realized if the original seller of specific property reduces the purchase money debt of a solvent buyer outside bankruptcy who owns the property at the time of reduction. (IRC 108(e)(5).) Recapture of tax credits or other items may be triggered. The purchase price reduction rule does not apply where the seller has assigned the debt, the debtor has transferred the property, or the debt is reduced by reason of factors not involving direct agreements between buyer and seller (e.g., running of statute of limitations). H.R. Rep. No. 833, 96th Cong. 2d Sess. at 13 (1980); S.Rep. No. 1035, 96th Cong., 2d Sess. at 16. The purchase price adjustment principle may apply to the purchase of services, such as educational services where student loans are forgiven when a proprietary school fails. See letter from Service to Senator Bill Nelson, INFO Release Date: 6/25/2010 (purchase price adjustment based on an infirmity relating back to purchase of educational services). This exception does not apply to third party acquisition indebtedness. Query: would it apply to the assumption from a seller of the seller s third party debt? Such a reduction could create an issue about whether an installment obligation has been disposed of (possibly triggering gain acceleration for a seller) under IRC 453B(f); the committee reports cited above state that where this code section applies, it applies to both seller and buyer, but does this mean the obligation is treated as if it did not exist (to the extent of the deemed price reduction) and not as if it was disposed of by cancellation? (a) Case Law. There may also be a case law purchase price adjustment exception in addition to the provisions of IRC 108 (e)(5), but any such an exception 11

12 is limited to where the debt exceeds the value of the property so that it does not apply where the market value of the property is greater than or equal to the debt after reduction. See Montgomery v. Com r., 65 T.C. 511 (1975); Helvering v. Killian Co., 128 F.2d 433 (8th Cir. 1942). Where the value of property has not sufficiently decreased, the statutory exception, which is not so limited, may be better for the debtor. The judicial exception might not apply to third party borrowings incurred or assumed in the purchase (see Edwards v. Com r., 19 T.C. 275 (1952), but compare Nutter v. Com r., 7 T.C. 480 (1946)); if applied to third party borrowings the buyer and seller will end up with different purchase prices. Reductions by a third party lender will not, according to the Service, be treated as reductions in purchase price unless based upon an infirmity that clearly relates back to the original sale (e.g., fraud, or misrepresentation by seller of a material fact), at least with respect to nonrecourse debt. Rev. Rul , C.B. 35. The judicial exception, for some courts, relates solely to face to face negotiations between seller and buyer as to price and not just solely to the debt (see Fifth Avenue - Fourteenth Street Corp v. Com r., 147 F.2d 453 (2d Cir. 1944)), and does not apply where the debtor has sold the property with the obligation in its basis (see B. F. Avery & Sons, Inc. v. Com r., 26 B.T.A (1932)). See Preslar v. Com r, 167 F.3d 1323 (10th Cir. 1999) requiring direct seller-purchaser negotiation. Basis is reduced and if the debt reduction exceeds basis, gain is recognized. Com r v. Coastwise Transportation Corp., 71 F.2d 104 (1 st Cir. 1934). (b) Partnership Bankruptcy. Although the statutory exception under IRC 108(e)(5) will not apply to a bankrupt or insolvent partnership (since it does not apply in bankruptcy or to insolvent taxpayers), the Service nevertheless will not challenge purchase price adjustment treatment if the transaction otherwise qualifies but for the partnership s bankruptcy or insolvency. Rev. Proc , C.B The result is a reduction in the basis of the property securing the debt rather than debt discharge income being realized. Since the IRC 108 exceptions are applied at the partner level, the bankruptcy or insolvency of the partnership should be irrelevant. (c) Installment Sale. The cancellation of debt under a price reduction exception would be a disposal of an installment obligation in a transaction other than a sale or exchange and thus may cause gain to be recognized to the installment seller holding the debt. IRC 453(f). (7) Deductible Debt. No income (or attribute reduction) occurs if the payment of the debt would have been deductible. IRC 108(e)(2). For accrual taxpayers, however, see IRC 111(c) creating income with respect to deductions accrued but not paid which increase an NOL and are later forgiven before the NOL expires; that section treats an increase in a carryover as a reduction in tax for the tax benefit rule. (8) Stock for Debt. A corporation which issues its own stock to cancel or reduce debt may realize income. IRC 108(e)(8) provides that the corporation will be treated as having satisfied the debt with money equal to the fair market value of the stock. Thus tax attribute reduction for corporations which are insolvent or in a bankruptcy proceeding will occur. Income will result but be excluded under IRC 108(a)(1) and tax attributes accordingly reduced 12

13 under IRC 108(b). Unless an exception applies, the corporation will be taxed to the extent the debt exceeds the value of the stock. (9) Partnership Interest for Debt. Partnerships issuing a profits or capital interest in satisfaction of its debt, whether recourse or nonrecourse, are treated in a manner similar to corporations issuing stock for debt satisfaction and recognize cancellation of debt income to the extent the debt exceeds the fair market value of the interest. IRC 108(e)(8). This income is included in the distributive shares of those who were partners immediately before the discharge. (Effective on or after 10/22/04.) See also the discussion at c(1)(c)(ii) below (regarding other aspects of debt cancellation) on a possible deemed cash distribution under IRC 752. (a) Value. The fair market value of the interest given in exchange for the debt will be its liquidation value, assuming a hypothetical sale of all assets (including good will and intangibles) for cash immediately after the contribution and a hypothetical liquidation. This treatment applies if certain conditions are met, otherwise the value is determined under all the facts and circumstances. The conditions to such liquidation value treatment are: (i) maintenance of proper capital accounts, (ii) the creditor, debtor (partnership), and partners all treat the fair market value of the debt as being equal to such liquidation value of the interest received for other tax purposes, and use consistent valuations for all equity issued in the overall transaction, (iii) the transaction is arm s length, and (iv) there is no later redemption or related party purchase of the interest which is part of a plan at the time of the original exchange with a principal purpose of avoiding partnership cancellation of debt income. Regs (b)(1) and (2). (b) Income and Basis of Partner. IRC 721 provides tax free treatment for contributions to partnerships, but not where the partnership interest is given for the transfer to the partnership of partnership debt for rent, royalties, or interest on debt (including original issue discount). Although the contributing partner is not protected by IRC 721, the debtor partnership itself recognizes no gain or loss under Reg (d)(2). Also, IRC 453B, which relates to the disposition of installment obligations would continue to apply, and would not be superseded (as could occur in other situations involving the contribution of installment obligations of other persons; Regs (c)(2), (a)); thus tax could be accelerated. However, no loss would be recognized if the principal of the debt is more than the liquidation value of the partnership interest received in return for it, rather the partner s basis in the interest would be increased by the basis in the debt and the holding period of the debt would tack on to the holding period for the interest (see IRC 1223(1)). Regs (d)(1) and (2). 13

14 (10) Miscellaneous Statutory Exceptions. There are special exceptions for discharges of certain student loans with a loan provision providing for discharge if the individual works a certain period of time in certain professions for a certain time (IRC 108(f); CCA ), and for discharges resulting from certain terrorist acts (Victims of Terrorism Relief Act of 2001, P.L , at 105(a)). Tuition reimbursement and recruitment programs where participating individuals are not required to have outstanding student loans or, if such loans exist, are not required to apply payments to such loans will not, however, be excludable. CCA (11) Home Mortgage. For the years 2007 through 2013, up to $2 Million ($1 Million for married taxpayer filing separately) (IRC 108(h)(2)) of acquisition mortgage debt forgiveness on the taxpayer s principal residence, may be excluded from income. IRC 108(a)(1)(E). Principal residence has the same meaning as where the term is used in IRC 121 (IRC 108(h)(5)). Second homes do not have the benefit of the exclusion. (a) Qualified Debt. Acquisition indebtedness is as defined in IRC 163(h)(3)(B) (IRC 108(h)(2)). It is indebtedness which is incurred in the acquisition, construction, or substantial improvement of the principal residence and which is secured by the residence. Refinanced debt will qualify but only up to the amount of the qualifying refinanced debt (i.e., additional debt incurred on the refinancing does not qualify). Home equity loans where the proceeds are not put into construction of the home are not acquisition debt and do not qualify. (b) Part Qualified. If only part of a discharged loan is qualified principal residence acquisition indebtedness, only that part of the loan exceeding the nonqualified part, benefits from the exclusion. IRC 108(h)(4). (c) Causation. The discharge must relate to a decline in value of the home, or to the deteriorating financial condition of the taxpayer. It cannot relate, for example, to services for the lender or other factors. (d) Bankruptcy and Insolvency. The exclusion does not apply in bankruptcy. IRC 108(h)(3). An insolvent taxpayer outside of bankruptcy can elect not to use the home mortgage exclusion and rely instead on the more general insolvency exception of IRC 108(a)(1)(B), discussed above at 1.a.(2). IRC 108(a)(2). (e) Cost of Exclusion. The price for the home mortgage exclusion is the dollar-for-dollar reduction of the basis in the home, but not below zero. IRC 108(h)(1). (f) No Gain Exclusion. As is the case in other cancellation of debt situations and as discussed further below in connection with foreclosures, a short sale or foreclosure may create gain for a debtor (Reg (a)(2)), and the gain is not covered by an exclusion from COD income. However an exclusion under IRC 121 of gain up to $250,000 ($500,000 for certain joint returns) may be available for a principal residence (not, e.g., a second 14

15 home or rental property). See Reg (unforeseen circumstances may allow some use of the exclusion where the 2 of 5 year rule is not fully met). Remember, however, that as discussed above in connection with attribute reduction, if the basis of a home is reduced by an insolvent debtor outside bankruptcy or in bankruptcy where the home is not exempted from creditors, then under IRC 1017(d) the basis reduction causes the property to be IRC 1245 property and the reduction is treated as being depreciation subject to recapture as ordinary income on a later sale. (12) Governmental Homeowner Assistance. Certain governmental programs structured as notes for payments made by governmental programs to assist in avoiding foreclosures may be treated as, essentially, welfare payments excludable by the homeowner. See generally, Rev. Rul , C.B. 20, and Rev. Rul , C.B Thus forgivable loans under the Treasury Department s Housing Finance Agency s Hardest Hit Fund and notes under the Department of Housing and Urban Development s Emergency Homeowner s Loan Program or substantially similar state programs may, if the terms of the program are met, be treated as excludable social welfare payments rather than as cancellation of indebtedness income on the forgiveness of such loans or notes. Notice , IRB. The tax results of the Principal Reduction Alternative offered in the Home Affordable Modification Program sponsored by the Department of the Treasury and Department of Housing and Urban Development is described in Rev. Proc , , IR Such a program is a significant modification which can create a deemed exchange of debt (discussed further below at section 2 in connection with debt modifications and workouts) which in turn, among other things, can create discharge of debt income (subject to information reporting, etc.). If such discharge income is not subject to an exception (e.g., the principal residence indebtedness exception or the insolvency exception), Rev. Proc , Sec. 6 allows reporting the income over a three year period in some circumstances. However, payments by the agency to the lender to provide an incentive to the modification are social benefit programs for the promotion of general welfare and are not includible in a recipient's gross income (see generally, Rev. Rul , CB 120, Rev. Rul , CB 24) and aren't subject to information reporting, where the property is the taxpayer s principal residence or is occupied by a legal dependent, parent, or grandparent without rent. Rev. Proc , Sec. 4.07, Sec. 4.09, and Sec c. Other Aspects of Debt Cancellation. (1) Partnership Application. Partnership-taxed organizations (including limited liability companies taxed as partnerships) are subject to some further rules. (a) Partner Level. Income from the discharge of indebtedness income is recognized at the partnership level, but the exceptions to discharge of indebtedness income and basis adjustment rules are generally applied at the partner level. See IRC 108(d)(6); Gershkowitz v. Com r., 88 T.C. 984 (1987). Thus the bankruptcy, insolvency, qualified farm indebtedness, and qualified real property indebtedness exceptions apply at the partner level. For example, a partner who is himself bankrupt could take advantage of the 15

16 bankruptcy exception; the bankrupt partnership itself cannot, and partners outside of bankruptcy cannot (although it may be possible some other exception, such as the insolvency exception, could apply to the partners outside bankruptcy). (i) Where a partnership taxed organization such as an LLC is insolvent or in bankruptcy but its members are not, the members may be subject to cancellation of debt income where an exception does not apply. (ii) A change in tax status for the organization under the check the box rules prior to the cancellation, so that the organization is taxed as a corporation and the insolvency or bankruptcy exception may apply at the corporate level, may well trigger the recognition of gain under the debt in excess of basis rules of IRC 357. The same rule may affect any attempt by members to contribute membership interests to corporations in order to avoid the pass through of cancellation of debt income to themselves. General substance over form principles may apply to such transactions as well. (b) Income Allocation; Basis. Discharge of indebtedness income must be separately allocated among the partners under IRC 702(a). The receipt of such income will increase the partner s basis in his partnership interest under IRC 705. (See, however, Babin v. Com r., 23 F.2d 1032 (6th Cir. 1994) aff g T.C. Memo , which appears to be wrongly decided, but which denied a basis increase under IRC 705 where the cancellation of indebtedness income was excluded under the IRC 108(a)(1)(B) insolvency exception; the court did not want to allow both the exclusion of cancellation of indebtedness income and also the avoidance of gain on the liquidation of the partnership interest.) (c) Deemed Distribution. Since the partner s share of partnership debt is reduced by the discharge of the debt, the partner is deemed to receive a cash distribution (IRC 752) which will reduce the partner s basis in his partnership interest (IRC 733). To the extent the deemed cash distribution exceeds the partner s basis, the partner would, as in the usual situation, recognize gain from the sale or exchange of a partnership interest. IRC 61(a)(3). (i) Additional Basis Reduction. Note that this basis reduction in a partnership interest is separate from any other basis reduction pursuant to the attribute reduction rules with respect to the exceptions to the recognition of cancellation of indebtedness income. (ii) 10% Partnership Interest. This deemed distribution rule will also apply where a holder of the partnership s nonrecourse debt receives a greater than 10% interest in the partnership for partial discharge of the debt, because the remaining nonrecourse debt is no longer treated as nonrecourse as to the other partners. See Regs (c) and (d). The new partner partially discharging the debt would be deemed to receive a cash distribution to the extent of any deemed shift in the debt to the other partners. IRC 752(b). 16

17 (d) General Partner. The Service has taken the questionable position that at least where the taxpayer s obligation is not direct but arises only by virtue of being a general partner, the discharge of the taxpayer s share of the partnership obligation in bankruptcy resulted in capital gain under IRC 731 and 752 (deemed cash distribution on shifts in liabilities) rather than cancellation of indebtedness ordinary income that is excludable under IRC 108(a)(1)(A). (TAM relies on Moore v. Com r., T.C. Memo while distinguishing Marcaccio v. Com r., T.C. Memo ). (e) Minimum Gain. A discharge of nonrecourse debt could result in a reduction of minimum gain and thus in a minimum gain chargeback under Regs (f). It would be a first-tier item (chargeback first to disposition of partnership property subject to partnership nonrecourse liabilities at the first tier, then pro rata to the partnership's other items; Reg (f)(6)) for minimum gain chargeback purposes. Reg (j)(2)(i)(A) and Reg (j)(2)(ii)(A) (ordering rules for allocations of nonrecourse liabilities). (f) Publicly Traded Partnerships. Although publicly traded partnerships are generally taxed as corporations (IRC ' 7704(a)), if 90% of its gross income comes from certain types of passive qualifying income, and some other conditions are met, corporate treatment will not occur. Cancellation of debt related to the generation of the qualifying income will itself be treated as qualifying income for this exception to corporate treatment under a safe harbor rule. Rev. Proc , IRB. (2) Earnings and Profits. If basis is reduced (IRC 1017), no adjustment is made to the earnings and profits ( E&P ) account of a corporation. IRC 312(l)(1); Rev. Rul , C.B The reduced depreciation deductions or increased gains on sales of assets resulting from the basis reduction will, however, affect earnings and profits in later years. If basis is not so reduced, then the excluded debt cancellation income does increase E&P. See Field Service Advice , Vaughn No Forgiveness of debt by a creditor-shareholder may be a capital contribution and as such not increase earnings and profits, where the shareholder s basis in the debt is at least equal to the principal amount of the debt. See IRC ' 108(e)(6)(B). For a corporate group, special rules apply to limit earnings and profits for a consolidated year in which a subsidiary has cancellation of debt income, but only for purposes of determining gain or loss on the disposition of intragroup stock; the earnings and profits are computed so as not to include excluded cancellation of debt income to the extent the amount so excluded was not applied to reduce tax attributes (other than basis in property). Earnings and profits thus increase if attributes, other than basis, are required to be reduced under IRC 108(b)(2). IRC '' 1503(e)(1)(B), 1503(e)(2)(A). (3) Related Taxpayers. As to both solvent and insolvent debtors in or out of bankruptcy, debt acquired from an unrelated party by a party related to the debtor is treated as having been acquired by the debtor. Related parties include IRC 414(b) and (c) controlled entities, and persons described in IRC 267(b) or 707(b). 17

18 (a) Acquisition in Anticipation of Relationship. Under Regs , debts acquired in anticipation of becoming related to a debtor are taken into account. The regulations (Regs (c)(3)) deem any acquisition made within six months of becoming related to have been made in anticipation of the relationship, otherwise a facts and circumstances test applies. IRC 108(e)(4). (b) Required Statement. The debtor is required to file a statement with its tax return for the year in which the debtor became related to the holder of its debt, unless the holder reports its income on the basis that it acquired the debt in anticipation of becoming related, if either the debt is more than 25% of the assets of the holder s group, or was acquired between 6 and 24 months of becoming related. The purpose of this required statement is to explain why the debtor believes the holder did not, under all facts and circumstances, acquire the debt in anticipation of the relationship. Regs (c)(4). (4) Debt Restructure. An extension of time for payment or an interest rate reduction may be treated as reductions of debt giving rise to income from the cancellation of indebtedness where there is a reduction in the face amount of the debt or in the deemed principal amount of the debt. See discussion of debt modifications and workouts at 2 below. (5) Information Returns. Financial institutions are required to file an information return disclosing any whole or partial discharge of the indebtedness in excess of $ of any person during the calendar year. IRC 6050P(a). The reporting obligation is only triggered by the occurrence of one of eight identifiable events. Regs P-1(b)(2). The eight events include discharges by reason of bankruptcy, receivership, foreclosure, expiration of limitations periods, probate bars, discharge agreements, creditor decision to stop collection, or, for certain financial institutions, the expiration of a 36-month nonpayment testing period. Regs P-1(b)(1). The Service takes the position that an identifiable event occurs in settlement agreements which result in loan write-offs for failure to give proper notices under state law which would deny recoveries where there are defective notices; at least where there is no definitive finding or admission that the notices were defective, the discharge was the result of a contract, not state law. PLR There are a few exceptions to the identifiable event reporting rules, such as for: amounts which are not principal, foreign debtors, related person acquisition of debt, release of only some co-obligors, guarantors. The financial institution does not determine whether the discharge is taxable or excludable. A written statement must also be given to the debtor named on the information return before January 31 of the year following the year of discharge. IRC 6050P(d). Penalties apply for failure to make the return or provide the statement. IRC 6724(d)(1)(B)(viii); 6724(d)(2)(P). The mere receipt of the form 1099 C from a creditor is not determinative of the timing of the cancellation, which may be treated as cancelled in some other earlier year when it was clear the debt would not be repaid. See Stewart v. Com r, TC Summary Opinion (relying on 3 year no payment rebuttable presumption for earlier cancellation). Also, the mere receipt of a form 1099C is not the same as a state law extinguishment of the debt itself. See Chivaho Credit Union v. McGuire, 2012 WL (Ohio App. 2012). 18

19 (a) required to make the return are: Creditors Affected. The applicable financial entities any credit union; institutions or credit unions; (i) (ii) financial institutions under IRC 581 or 591(a) or any regulated subsidiaries of such financial (iii) the FDIC, RTC, NCUA, or their sub units or other federal executive agencies (see IRC 6050M); and (iv) organizations significantly engaged in the trade or business of lending money (see Regs P-2). (b) Limit to 36 Month Rule. One rebuttable presumption as to an identifiable event giving rise to the requirement of an applicable financial entity to report a discharge, is the failure of the debtor to pay over a 36 month period. This can be rebutted by a showing of significant collection activity by the creditor. This presumption applies after November 10, 2008 only to the first three types of creditor listed above, not to significantly engaged organizations. Regs P-1(b)(2)(i)(H). However, if a significantly engaged creditor earlier was subject to such an obligation under the 36 month rule, but failed to file an information return, the reporting requirement arises upon the occurrence of any other identifiable event after Regs P-1(b)(2)(v). The 36 month rule can result in the reporting of a discharge even where no actual discharge has occurred; but at least the rule has been limited to financial institutions and governmental agencies. (6) State and Local Effect of Cancellation of Indebtedness. Under BC 346(j), the effect of cancellation of debt is made generally consistent with federal treatment. (a) Income. No income is recognized by the estate, debtor, or successor to the debtor on cancellation of debt, unless it is taxable under federal tax law. See IRC 61 and 108. (b) Attributes. Tax attributes for state and local purposes are reduced under the exceptions to cancellation of debt income the same as corresponding federal attributes are reduced under IRC 108 and If there is additional discharge of debt income not fully applied in such reductions, any additional state or local reductions would apply to the excess. (c) NOLs. However, the effect of a plan of reorganization on the preservation of state and local NOLs is not addressed under the Bankruptcy Code. See IRC 381. A number of states have significant limits on NOLs where the entity was not subject to state or local tax when the NOL was incurred, allow no carrybacks, use shorter carryforward times, etc. 19

20 (7) Loans to Pay Taxes. Loans to pay nondischargeable federal taxes, for example, through credit card charges used to pay taxes, will not be dischargeable (Bankruptcy Reform Act of 1994, P.L , 10/22/94). (8) Deferral of COD Income. For the years 2009 and 2010 IRC 108(i) gives businesses the election to defer COD income arising from debt restructurings involving the reacquisition by the debtor or a related party of an applicable debt instrument, which is any debt instrument issued by a C corporation, or issued by any person in connection with the conduct of that person s trade or business. See temporary and proposed Treasury Regulations at Reg (i)-0T ff, TD 9497, 08/11/2010, TD 9498, 08/11/2010. Not all states allow this deferral. Deferral of COD income does not necessarily defer other tax consequences. See, Chief Counsel Advice (election to defer the recognition of COD income under IRC 108(i) does not defer the recognition under Reg of unamortized hedge gain from an anticipatory interest rate hedge allocable to repurchased debentures giving rise to the COD income). (a) Deferral. The deferred income is ratably included in gross income over a five taxable year period beginning with the fifth (for 2009 reacquisitions) or fourth (for 2010 reacquisitions) taxable year following the year in which the reacquisition occurs. (b) Election. S-corporations, partnerships, and other passthrough organizations make the election at the entity level. The election is irrevocable, and is made debt instrument by debt instrument. The election does not require insolvency. (c) Acceleration. Death, liquidation, sale of substantially all assets (including in a Title 11 or similar case), ceasing to do business, or similar circumstances, including the sale, exchange, or redemption of an interest in an electing pass-through entity (such as an S-corporation or partnership-taxed organization), will trigger acceleration of the inclusion into income (as of the day before the petition in the case of a Title 11 or similar case). (d) Effect on Other Exceptions. The insolvency, bankruptcy, qualified farm indebtedness, and qualified real property indebtedness rules do not apply to the income from the affected discharge if the IRC 108(i) election is made, either for the year of the election or any later year. (e) Partnership Effects. The COD income is allocated to partners immediately prior to discharge. A decrease in a share of liabilities will not cause a deemed distribution of cash (see IRC 752) to the extent it would be taxable under IRC 731; this means the partner s basis in the partnership interest will be reduced but any deemed distribution exceeding that basis will be deferred so long as the income deferral under IRC 108(i) remains effective and will be taken into account ratably (or at acceleration) at the same time or times as that deferred income is recognized. (f) OID Effect. The reacquisition may be by means of the direct or indirect use of a new debt instrument. If the new instrument carries original issue 20