DEBT RELATED TAX DEVELOPMENTS

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1 DEBT RELATED TAX DEVELOPMENTS Section: 42 Loss of Building in Foreclosure or Deed in Lieu of Foreclosure May Not Trigger Recapture of Low Income Housing Credit... 3 Section: 61 Tax Court Rules No Forgiveness of Debt, Therefore No Income, On Repossession of Taxpayer's Car... 3 Section: 72 Cancellation of Policy When Policy Loan Exhausted Value of Policy Was Income under 72 and Not Cancellation of Debt... 4 Section: 102 Debt Forgiven on Student Loan Was Not a Gift from the Lender... 4 Section: 108 IRS Finalizes Regulations on Treatment of Debt-for-Equity Transfers of Partnerships... 5 Section: 108 Debt Actually Cancelled Well Before 1099C Issued... 6 Section: 108 Proposed Regulations Hold Bankruptcy or Insolvency of Disregarded Entities and Grantor Trusts Not Relevant in Determination of Taxation of Cancellation of Debts of Such Entities... 7 Section: 108 COD Income from Short Sale of Principal Residence Qualifies for 108(a)(1)(E) Relief... 8 Section: 108 Debt Discharged in Year Other Than One in Which Bank Issued 1099-C... 8 Section: 108 Treatment of 108(i) Debt Issues for S Corporations and Partnership Issued by IRS Section: 108 C Corporation Treatment of 108(i) Acceleration Rule Addressed in Temporary and Final Regulations Section: 108 Taxpayer Taxable on Cancellation of Indebtedness Income Despite Divorce Decree Stating Former Spouse Was Liable Section: 108 Debt Secured by Single Member LLC Holding Only Real Estate Can Qualify for Qualified Real Property Business Indebtedness Section: 108 Tax Not Due on Cancellation of Indebtedness, as Court Rules Actual Cancellation Occurred Years Earlier Than 1099C Issued Section: 108 IRS Finalizes S Corporation Reduction of Attributes Regulations When Debt Discharge Excluded from Income Under Section: 108 Deferral of Cancellation of Indebtedness Rules Explained Section: 163 Debt Cancellation on Loan to Acquire Stock Would Be Investment Income. 17 1

2 Section: 408 No Late Rollover Relief for Taxpayer Unable to Sell Home to Obtain Funds to Complete Rollover Section: 851 Discharge of Indebtedness Income From Requiring Debt by Regulated Investment Company Held to Be Qualifying Income Section: 1001 Deterioration of Issuer's Financial Condition Not to Be Considered in Determining if Modified Agreement Remains a Debt Instrument Section: 7434 Mother-in-Law Filing Form 1099C Not Liable to Ex-Son-in-Law for Fraudulent Information Return

3 SECTION: 42 LOSS OF BUILDING IN FORECLOSURE OR DEED IN LIEU OF FORECLOSURE MAY NOT TRIGGER RECAPTURE OF LOW INCOME HOUSING CREDIT Citation: CCA , 11/18/11 In Chief Counsel Advice , the IRS ruled that either a foreclosure or deed in lieu of foreclosure does not automatically result in an automatic recapture of low income housing credits under the provisions of IRC 42(j). Rather, a foreclosure is treated like any other disposal, thus if the facts indicate that the exception under 42(j)(6)(A) apply there would be no recapture. Generally a disposition of the building does trigger recapture under 42(j), but if it is reasonably expected the building will continue to be operated as low-income housing building for the remainder of the required period. It is important to note that this ruling does not say there will not be a recapture event in the event of a foreclosure or a deed in lieu of foreclosure. Rather, evidence must exist that the requirements of 42(j)(6)(A) have been met and obtaining such documentation is key to defending any position taken that a recapture event has not occurred. SECTION: 61 TAX COURT RULES NO FORGIVENESS OF DEBT, THEREFORE NO INCOME, ON REPOSSESSION OF TAXPAYER'S CAR Citation: Martin v. Commissioner, TC Summary Opinion , 8/4/09 Steed Martin s 1988 Toyota 4-Runner was repossessed after he stopped making payments and the lender charged off the $6, of Steed s loan. The lender took back the truck, but then issued a Form 1099-C for the en tire balance of the loan. The IRS went after Steed for the entire $6, as income, apparently basing their entire case on the Form 1099 standing alone. The Tax Court was not pleased with the IRS s position. With a recourse loan (as this would be), if the lender could only pursue collection of any amount of the loan in excess of the value of the security taken in exchange for the loan. The 1099 obviously gave no value whatsoever to the truck, and that Tax Court did not find that plausible. Rather the court found more plausible the taxpayer s position that at the time of the repossession the vehicle was worth at least the $6, balance outstanding. Thus the Court held there was no income on repossession since there was no debt forgiveness. 3

4 SECTION: 72 CANCELLATION OF POLICY WHEN POLICY LOAN EXHAUSTED VALUE OF POLICY WAS INCOME UNDER 72 AND NOT CANCELLATION OF DEBT Citation: McGowen v. Commissioner, TC Memo , 12/14/09 The Tax Court rejected a taxpayer s argument that her income from the cancellation of her life insurance policy that took place when her outstanding loans exhausted her cash value in the policy was income from the discharge of indebtedness. Rather the Court held that the tax treatment must be computed using 72(e), treating as a gain on that the difference between their basis in the policy and the amount she was deemed to have received. While the Court didn t go into details, presumably the taxpayers were insolvent and could have excluded under 108 any discharge of indebtedness. However in this case the taxpayers didn t fail to pay the loan rather the loan was effectively paid off via the surrender (even if involuntary) of the policy that took care of the outstanding loan against the policy. SECTION: 102 DEBT FORGIVEN ON STUDENT LOAN WAS NOT A GIFT FROM THE LENDER Citation: Plotinksy v. Commissioner, TC Memo , 10/29/08 David Plotinksy s lender offered to reduce his student loan balance by $3,000 if he made 36 consecutive on time loan payments. When David met this requirement, his loan balance was reduced by $3,000 and the lender issued a Form 1099-C to David reporting that amount. While David liked the reduced balance, he really didn t like the idea that this amount was considered taxable. He argued that the $3,000 was truly a gift from the lender to him and that, under 102, the amount of the gift would be excluded from his income. The Tax Court disagreed, noting that the lender had instituted this program as a incentive to get borrowers to consolidate their loans with the particular lender. As such, this was simply a business transaction and David s accession to wealth (through a reduction in his debt obligation) was going to be taxable income. 4

5 SECTION: 108 IRS FINALIZES REGULATIONS ON TREATMENT OF DEBT-FOR-EQUITY TRANSFERS OF PARTNERSHIPS Citation: TD 9557, 11/15/11 In TD 9557 the IRS added final regulation dealing with the treatment under IRC 108(e)(8) of indebtedness satisfied by a transfer of a partnership interest from the debtor partnership. Under that provision, the debt is treated as satisfied for an amount of money equal to the fair market value of the interest. If that value is less than the outstanding debt, cancellation of debt income is recognized by the partners of the partnership immediately before the discharge. The regulation provides at Reg (b)(1) that, generally, all facts and circumstances are considered when determining the fair market value of the interest transferred. However the regulation provides for a liquidation value safe harbor fair market value interest if all of the following four conditions are satisfied: 1. The creditor, debtor partnership, and its partners treat the fair market value of the indebtedness as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-for-equity exchange; 2. If, as part of the same overall transaction, the debtor partnership transfers more than one debt-for-equity interest to one or more creditors, then each creditor, debtor partnership, and its partners treat the fair market value of each debt-for-equity interest transferred by the debtor partnership to such creditors as equal to its liquidation value; 3. The debt-for-equity exchange is a transaction that has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests; and 4. Subsequent to the debt-for-equity exchange, the debtor partnership does not redeem the debt-for-equity interest, and no person bearing a relationship to the debtor partnership or its partners that is specified in section 267(b) or section 707(b) purchases the debt-for-equity interest, as part of a plan at the time of the debt-forequity exchange that has as a principal purpose the avoidance of COD income by the debtor partnership.[reg (b)(2)(i)] Liquidation value is defined as the cash the creditor would receive if all assets of the partnership (tangible and intangible) were sold for cash equal to the fair value of the asset and the partnership then liquidated. [Reg (b)(2)(iii)] At the same time, the IRS issued regulations clarifying the income related to the discharge of nonrecourse indebtednesses would be included in any first-tier minimum gain chargeback. [ (f)(6), (j)(2)(i)(A), and (j)(2)(ii)(A)] 5

6 The IRS also clarified the regulations under 721 for the treatment of such a transaction under that section. Reg (d)(1) provides that except as otherwise provided in 721 and regulations under that section, 721 applies to transfers of partnership debt for a capital or profits interest in the partnership. Reg (d)(2) provides, however, that 721 does not apply to a debt-for-equity exchange to the extent the transfer of interest is in exchange for unpaid rent, royalties or interest accrued on or after the beginning of the creditor s holding period for the debt. SECTION: 108 DEBT ACTUALLY CANCELLED WELL BEFORE 1099C ISSUED Citation: Kleber v. Commissioner, TC Memo , 9/28/11 In Kleber v. Commissioner, TC Memo , the IRS yet again lost a case regarding cancellation of indebtedness, with the Tax Court finding that the IRS failed to overcome the rebuttable presumption that debt discharge had occurred in an earlier year under the information reporting regulations as well as the facts and circumstances indicating the debt had been cancelled well earlier. The taxpayers had entered into a lease of farmland with the Navy. She stopped making payments in mid-1998, and in late December of that year she wrote the Navy informing it she was unable to continue to pay under the lease. The Navy terminated the lease and billed the taxpayer for the unpaid rent prior to termination in February A number of letters were sent in early 1999 demanding repayment, with the last one sent in April In September of 2001 the collection action was referred to the Treasury Department. The Treasury Department returned the matter to the Defense Department on September 30, 2004 indicating the debt was uncollectible. In November of 2005 the debt was written off by the Department of Defense. The Department of Defense then issued a Form 1099C in tax year The IRS argued that the taxpayers had to pick up the income from the Form 1099C in The taxpayers argued that if there was debt forgiveness in any amount it occurred long before 2006 and also argued the amount reported was in error. The taxpayers did successfully assert the right to shift the burden to the IRS under the special provisions of 6201(d) that deals with reasonably disputing an information return. The IRS did follow up in this case and argued that 2006 was the proper year, pointing towards the referral to the Treasury Department and the eventual write off in However, the Tax Court noted that the taxpayers had received no correspondence or contact since April 1999, with the only collection activity being moving papers around inside the federal government. 6

7 The Court noted that the regulations governing the information reporting provisions provided at Reg P-1(b)(2)(iv) established a presumption of debt cancellation for reporting purposes if the creditor received no payment in a 36 month period, rebuttable if the lender had undertaken significant, bona fide collection activity at any time during the 12 month period ended at the close the calendar year or if facts and circumstances existing at January 31 of the following year indicated the debt had not been discharged. The Court found the 36 month period had expired in 2002, and that there had been no meaningful collection activity during The court found the facts and circumstances that existed at that time did not indicate the debt had not been effectively discharged. Thus, no matter what the amount of debt discharge truly was, the event had taken place in 2002 and not Thus the taxpayers had no income event in the year the IRS was attempting to assess the tax in. This is not the first case in recent years the IRS has lost due to attempting to assert cancellation of debt income based on a 1099C the court determined was issued well after the true date of debt discharge. Advisers need to take care not to blindly follow Form 1099Cs or, conversely, to assume there was no debt discharge just because the Form 1099C wasn t issued. In the cases to date the prior year tax has not been asserted by the IRS. However, remember that if the amount of debt was significant, the six year statute could be tripped and the IRS could then go back to the earlier year and pick up additional penalties to boot. So these taxpayer victories should remind practitioners of the care that needs to be exercised regarding debt issues. SECTION: 108 PROPOSED REGULATIONS HOLD BANKRUPTCY OR INSOLVENCY OF DISREGARDED ENTITIES AND GRANTOR TRUSTS NOT RELEVANT IN DETERMINATION OF TAXATION OF CANCELLATION OF DEBTS OF SUCH ENTITIES Citation: Proposed Reg , REG , 4/13/11 The IRS has issued proposed regulations to make explicit its position that the bankruptcy and insolvency provisions of 108(a)(1) must be applied at the taxpayer level, and not applied to disregarded entities such as single member LLCs or grantor trusts. Some taxpayers have taken the position that if a grantor trust or LLC has debts discharged in bankruptcy or is insolvent at the time debts owed by the entity are cancelled, the applicable exclusions found in 108(a)(1) apply even if the taxpayer that was treated for tax purposes as the owner of the underlying assets and liabilities is not him/herself involved in the bankruptcy or insolvent. 7

8 The proposed regulations take the position that the special rule applicable to partnerships under 108(d)(6) applies to these situations. The preamble also notes that no inference is intended that the provisions set forth in these proposed regulations are not current law. Or, to translate that piece of IRS-speak, the IRS believes the proposed regulations do reflect current law. Thus taxpayers that attempt to take the position that the cancellation income of their disregarded entity is not taxable to them will likely find the IRS disagrees with that viewpoint if the return is examined. SECTION: 108 COD INCOME FROM SHORT SALE OF PRINCIPAL RESIDENCE QUALIFIES FOR 108(A)(1)(E) RELIEF Citation: INFO , 9/24/10 Some commentators had worried that the wording of the qualified mortgage interest debt cancellation exclusion under 108(a)(1)(E) might cause the IRS to decide that if a taxpayer did not retain the property as his/her residence following the cancellation event that the rule might not apply. That is, under 108(a)(1)(E) the debt must relate to the taxpayer s principal residence, which could be read to require it to retain that status since the language is in the present tense, rather than referring to property that had been the taxpayer s principal residence. However the IRS has indicated in an information letter to Congressman Mark Schauer that it does not take such a draconian view of the provision. Responding to an inquiry from a constituent of the Congressman, the IRS indicated that she would be able to make use of the provision and would file a Form 982 to report the exclusion when she participated in a short sale related to her residence. SECTION: 108 DEBT DISCHARGED IN YEAR OTHER THAN ONE IN WHICH BANK ISSUED 1099-C Citation: Gaffney v. Commissioner, TC Summary Opinion , 8/30/10 While discharge of indebtedness does, absent the applicability of an exception under 108, result in taxable income, it only does so in the year of the actual debt discharge. That date is not necessarily set by the issuance of a Form 1099-C, an issue the Tax Court pointed out to the IRS. 8

9 In this case the taxpayer had been a president of an Arizona S corporation that was building homes in Hawaii. Due to a dispute with the entity's insurer, the taxpayer and wife sold most of their assets, abandoned their personal residence in Hawaii and moved to apartment in Arizona. However, unknown to the taxpayers the lender that held the mortgage on their residence in Hawaii began proceedings to foreclose on the Hawaii residence and the residence was sold at a foreclosure sale with a balance remaining outstanding. The mortgage in question was a recourse debt and, as such, the taxpayers were liable for the balance. This sale took place in The mortgage holder intermittently undertook collection activities on the balance due, although the balance was charged off on its books in However such activities ceased in 2001, aside from creating an asset profile on the taxpayer in In 2006 the lender finally issued a Form 1099-C reporting the discharge of indebtedness, which it mailed to the taxpayer's former address. The form contained an erroneous name, but had the taxpayer's social security number. When the IRS contacted the taxpayer about the 1099-C and non-reporting of income, the taxpayer contacted the mortgage holder about why the 1099-C was issued. The lender, in a short letter, simply remarked that it had reviewed the account and the 1099-C was correct. The taxpayer disputed the 1099-C, noting that if there was debt discharged it took place in a year other than The Tax Court noted that the taxpayer did not actively dispute the amount of the discharge, so it took the letter as satisfying the IRS's responsibility under 6201(d) to inquire when the taxpayer disputes the correctness of an information return in a matter before the Tax Court. However, the Tax Court notes that a debt becomes income at the moment it becomes clear the debt will not be repaid, and most often turns on the subjective intent of the lender as demonstrated by an objectively identifiable event and 1099-C is not dispositive. Rather the Court noted that in this case the lender ceased all significant collection activity in 2001, and took absolutely no action after 2003 except the issuance of the 1099-C in As well, a rebuttable presumption exists that an identifiable event has occurred when there is no payment received during a 36 month period. The Court concluded that while a discharge of indebtedness in the amount listed on the 1099-C had taken place, it also held that this discharge did not take place in Therefore the taxpayer had not underpaid tax in

10 SECTION: 108 TREATMENT OF 108(I) DEBT ISSUES FOR S CORPORATIONS AND PARTNERSHIP ISSUED BY IRS Citation: TD 9498, 8/11/10 The IRS issued temporary and proposed regulations outlining the application of the 108(i) cancellation of debt income deferral provisions as they apply to partnerships and S corporations. Unlike C corporations where the rules apply to all debt, for a partnership or S corporation the rule only applies to what is referred to as an applicable debt instrument. An applicable debt instrument generally is a debt instrument issued by the partnership or S corporation in connection with the conduct of a trade or business. While the regulations hold that this determination is based on all facts and circumstances, five safe harbor tests are provided where the debt will be treated as issued in connection with the conduct of a trade or business. Meeting any of the five tests will cause the debt to be treated as an applicable debt instrument. 1. At the date of issuance of the debt instrument, the gross fair value of the trade or business assets of the entity represented at least 80% of the gross fair value of the entity's total assets; 2. For the taxable year of issuance, the trade or business expenditures of the entity represented at least 80% of the entity's total expenditures for the year in question; 3. For the year of issuance at least 95% of the proceeds of debt instruments are traceable to trade or business assets under the interest tracing rules of T; 4. At least 95% of the proceeds from the debt instrument were used by the entity to acquire one or more trades or businesses within 6 months of the date the debt was issued; or 5. The entity issued the debt instrument to a seller of the trade or business to acquire the trade or business. [Reg (i)-2T(d)(1)] While COD income must be allocated in accordance with the standard 704 rules for a partnership, after the amount has been allocated among the partners, the partnership can designate what portion of each partner's COD income is subject to the election and which portion is not. [Reg T(b)(1)] For an S corporation, the COD income is shared prorata among the shareholders that are shareholders immediately before the reacquisition of the debt. [Reg T(c)(1)] 10

11 Basis generally is not adjusted for either a partner nor an S corporation shareholder on the deferred COD income until the income is taken into income by either the partner or shareholder. However, for purposes of 752 special rules apply, and for purposes of capital account maintenance deferred items are treated as if no 108(i) election had been made. There are rules in the regulation to prevent the election under 108(i) from triggering recapture of losses under 465(e). The decrease in amount at risk is not taken into account until such time as the amount is recognized in income by the partner or shareholder. Acceleration events are addressed in the regulations. These are events that trigger the early recognition of the COD income. There are separate triggers that can apply to the entity as a whole, or those that apply to individual partners or shareholders. The following events at the entity level would trigger an acceleration event for all direct and indirect interest holders: 1) liquidation of the entity, 2) sale, exchange, transfers or gifts of substantially all of the entity's assets, 3) cessation of business by the entity or 4) filing a petition in a bankruptcy or similar case. As well, for an S corporation the termination of the S election is an acceleration event under the regulations. The term substantially all of the entity's assets is defined to mean assets representing at least 90% of the fair value of the entity's net assets and at least 70% of the fair value of the entity's gross assets. Special rules are provided for partnership transfers subject to 721 where subsequent transactions result in dispositions. At the individual partner level, the following items will be treated as acceleration events: 1) death or liquidation of the partner, 2) sale, exchange, transfer or gift of all or a portion of the partners' interest, 3) redemption of the partner's interest or 4) abandonment of the partner's interest. Events 1, 2 or 4 in the context of an S corporation will cause an S corporation shareholder to have an acceleration event. If only a portion of an interest is sold, exchanged, transfers or gifted, only a proportionate amount of the COD deferral is triggered. Certain events are not treated as acceleration events. Transfers under 721 (tax free contributions to a partnership) are generally excluded, as are like kind exchanges under 1031 though for the latter the receipt of boot will be considered in determining what proportion of assets were sold. Technical terminations of a partnership under 708(b) are also not treated as acceleration events. The regulations apply to applicable debt instruments reacquired in taxable years ending after December 31,

12 SECTION: 108 C CORPORATION TREATMENT OF 108(I) ACCELERATION RULE ADDRESSED IN TEMPORARY AND FINAL REGULATIONS Citation: TD 9497, 8/11/10 The IRS issued temporary and proposed regulations that impact C corporations that have deferred recognition of cancellation of indebtedness income under 108(i). These regulations deal largely with the provisions of the acceleration of inclusion of the deferred gain under the provisions of 108(i)(5)(D). Generally that section provided that gain would be accelerated on certain events which include the death of the taxpayer, the liquidation or sale of substantially all the assets of the taxpayer (including in a title 11 or similar case), the cessation of business by the taxpayer, or similar circumstances... per the statute. The IRS held that while technically appearing to be a triggering event, it would be contrary to the stated goal of 108(i) for the acceleration provisions to apply to transactions where 381(a) applies to allow the acquiring corporation to succeed to the tax attributes of the acquired corporation, specifically in the liquidation of a subsidiary under 332 or a transfer in an A, C, D, F or G reorganizations where 361 applies. Thus the regulations hold that such transactions will not be triggering events to accelerate the recognition of income. Rather under the temporary and proposed regulations a C corporation will trigger acceleration if certain events that threaten ultimate collection of the tax take place. Those events are 1) a change in the entity's tax status, 2) the cessation of existence of the corporation in a transaction to which 381(a) does not apply or 3) engages in a transaction that reduces the net value of the corporation to such an extent that the ultimate collection of the tax is threatened. The regulations provide a net value acceleration rule test that, if violated, will trigger the recognition in the third circumstance. Generally the net value acceleration rule is triggered generally if a corporation enters into an impairment transaction and the corporation at that points fails a mechanical net value test. An impairment transaction is any transaction that impairs the corporation's ability to pay the amount of the Federal income tax liability on the deferred COD income. Specifically such transactions would include distributions (including 381(a) transactions), redemptions, below market sales, donations and incurrence of additional indebtedness without a corresponding increase in asset value. Excluded from the treatment are value for value exchanges, including ones to which 351 (tax free incorporation) or 721 (tax free contributions to partnerships) apply. If an impairment transaction takes place, the net value acceleration rule is triggered if the gross value of the corporation's assets is less than 110% of the sum of the the corporation's total liabilities and the tax on the net amount of the tax that would be due on the deferred items under 108(i). The tax due is computed by using the tax that would due at the highest applicable rate for the taxable year on the outstanding deferral, even if the corporation's actual tax rate is not that rate. 12

13 If the acceleration provision is triggered, then the entire remaining deferral is subject to tax at the time of the impairment transaction. However a corporation can escape this treatment if if value value is restored to the corporation by the due date of the corporate return, including extensions. The corporation must restore the lesser of the value of amounts that were removed in one or more impairment transactions (net of any amounts previously restored under this option) or the amount of the shortfall under 110% rule. Special rules are provided that allow a member of a consolidated group to, at any time, trigger all of its remaining deferred COD income. The regulations also provide that earnings and profits are not increased for the deferred amount of income until such time as the item is brought into income for the corporation. Generally the rules apply to acceleration events occurring on on or after August 11, Given that the rules appear to be more generous than the literal reading of the law would allow, the regulations allow a corporation to elect to treat acceleration events occurring before August 11, 2010 under these rules and, if necessary, to restore value by the fifteenth day of ninth month following August 11, SECTION: 108 TAXPAYER TAXABLE ON CANCELLATION OF INDEBTEDNESS INCOME DESPITE DIVORCE DECREE STATING FORMER SPOUSE WAS LIABLE Citation: Jensen v. Commissioner, TC Memo , 4/15/10 Paul Jensen borrowed funds from Citibank, but in his divorce agreement his former spouse was made specifically liable to repay that debt. When she failed to do so, Citibank issued a 1099-C naming Paul that showed discharge of debt income. Paul claimed that since the divorce agreement clearly stated his former spouse was liable to repay this debt, he did not need to report the income. The Tax Court did not agree. The Court found Paul was the original borrower, and that while the divorce decree gave Paul a right to seek reimbursement from his former spouse for any amount he had to pay, it did not change the fact that he was obligated to Citibank and when he did not pay on that obligation, he had discharge of indebtedness income. 13

14 SECTION: 108 DEBT SECURED BY SINGLE MEMBER LLC HOLDING ONLY REAL ESTATE CAN QUALIFY FOR QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS Citation: PLR , 12/31/09 The taxpayers had a loan that was secured by their interest in a single member LLC, an LLC formed solely to hold a piece of real estate and which is treated for tax purposes as a disregarded entity. The taxpayers are negotiating to refinance that indebtedness. The real estate securing that debt has declined in value and the taxpayers believe that some of the debt will end up being cancelled as part of the refinancing operation. They sought a ruling from the IRS that even though the debt is secured by the LLC interest rather than directly by the real estate, the reduction in indebtedness would still be able to qualify as qualified real property business indebtedness under 108(c)(3)(A). The IRS ruled that the existence of the LLC as a disregarded entity means that the property is treated as being owned directly by the taxpayer. The ruling notes that it would incongruent to pay attention to the LLCs for purposes of determining whether the debt is secured by real property when that LLC is otherwise disregarded for federal tax purposes. The IRS therefore held that merely having the property titled in the name of the LLC, and then having the interests pledged against the debt, did not remove the ability for such a debt to qualify for treatment as qualified real property business indebtedness under 108(c)(3)(A). Therefore, if the debt otherwise meets the requirements, the debt cancellation could be excluded from income and the basis of the property reduced. Since, for environmental liability concerns, a number of property acquisitions have been structured in this form (many times at the behest of the lender), this ruling gives comfort that this technicality will not remove such real estate related debt from the potential relief provisions of 108(c)(3)(A). SECTION: 108 TAX NOT DUE ON CANCELLATION OF INDEBTEDNESS, AS COURT RULES ACTUAL CANCELLATION OCCURRED YEARS EARLIER THAN 1099C ISSUED Citation: Linkugel v. Commissioner, TC Summary , 12/1/09 The IRS was found to have raised the issue of whether Thomas Linkugel had cancellation of indebtedness income for a year that was long after the actual effective discharge had taken place. Thomas and his then wife lost their home through foreclosure in After application of the sales proceeds, $35,247 remained unpaid on the recourse obligation. 14

15 The lender took no further action to collect that note. However the lender did file a Form 1099-C for 2006 reporting cancellation of indebtedness income and the IRS asserted that Thomas was taxable on that amount in that year. The Tax Court did not agree. The Court noted that the sole evidence the IRS relied upon in determining that discharge took place in 2006 was the 1099-C. However, the court noted that under 6021(d) at trial the IRS was required to do further investigation if a taxpayer fully cooperated and had raised a reasonable question about the accuracy of the information return. The Court found that actual discharge had taken place long before 2006, noting no collection activities had taken place since the foreclosure date. The court notes that the actual date of discharge is fact specific, but a key factor is the intent of the lender and the existence of an identifiable event quite often the actual act of foreclosure. SECTION: 108 IRS FINALIZES S CORPORATION REDUCTION OF ATTRIBUTES REGULATIONS WHEN DEBT DISCHARGE EXCLUDED FROM INCOME UNDER 108 Citation: TD 9127, Reg (d), 10/30/09 The IRS has finalized the revisions of the regulations found at (d) dealing with how an NOL is to be reduced when income from debt discharge is excluded in the S corporation context under IRC 108. The tests under IRC 108(a) for exclusion from discharge of debt from income are tested at the S corporation level, pursuant to IRC 108(d)(7). However, if debt discharge is excluded from income various tax attributes are reduced, one of the first being any net operating loss of the taxpayer. S corporations obviously don t have such an item, so IRC 108(d)(7)(B) provides that losses disallowed under IRC 1366(d)(1) at the shareholder level are treated as the NOL for these purposes. The regulations outline how this net operating loss is to be handled by the S corporation. The overall disallowed losses of all shareholders are treated as the deemed NOL and the S corporation reduces those losses. The reduction is allocated among the shareholders under the methods contained in these regulations and then reported back to the shareholders. Reduction is prorated based on the various types of losses or deduction that each shareholder has. Shareholders are required to report their disallowed losses to the corporation to enable this calculation. However, if a shareholder either fails to provide this information after reasonable attempts are made to obtain it by the corporation, or the corporation determines that the information provided to it is in error, the corporation can make its own calculation of a shareholder s disallowed loss and use that. The regulations contain comprehensive examples of how to calculate the amount of disallowed loss and allocate it among the shareholders. 15

16 SECTION: 108 DEFERRAL OF CANCELLATION OF INDEBTEDNESS RULES EXPLAINED Citation: Revenue Procedure , 8/18/09 In Revenue Procedure the IRS gave guidance on the application of 108(i), added by American Recovery and Reinvestment Act of 2009, which provided for a deferral of recognition on gain from cancellation of indebtedness in certain situations. The new Revenue Procedure is the exclusive method for making an election to defer recognition of gain, and also provides details on the information required to be provided by a taxpayer electing the benefit of this provision. Section 108(i) applies to debt instruments issued by a C corporation, or by any other person in connection with the conduct of a trade or business. The deferral option is available for a reacquisition of the debt (including indirect reacquisitions as defined by Reg (c)), which is defined as any of the following: Acquisition of debt instrument for cash or other property debt) Exchange of the debt for another debt (including via a modification of the original Exchange of the debt for corporate stock or a partnership interest Contribution of the debt instrument to capital or Complete forgiveness of the debt by the holder of the debt The debt must be reacquired after December 31, 2008, and before January 1, 2011 to be eligible to make the election (or, put more simply, in 2009 or 2010). Recognition of the gain is made ratably over a five year period beginning, effectively, in 2014 (regardless of whether the reacquisition took place in 2009 or 2010). If the election is made, the taxpayer cannot make use of the exclusions for this debt that might otherwise be available for insolvency, bankruptcy, qualified farm and/or qualified real property indebtedness found in Section 108. However, the procedure provides that a taxpayer may make a partial election of this section covering only the portion of the debt not otherwise excludable under those provisions of

17 The Revenue Procedure also allows for taxpayers to file protective 108(i) elections that would apply if it is determined that a transaction did not qualify for an exclusion under Section 108. However, there is a downside to the protective election should the IRS determine, after the statute has closed on the year in which the forgiveness took place, that the transaction did not qualify for the original 108 exclusion claimed, the taxpayer will be required to recognize the income in the later years that is, the election is treated as effectively made in the closed year. Without the election, the IRS would have only been allowed to assess tax for the year of discharge, and the statute would have rendered the IRS unable to go after that tax. The Procedure provides detailed rules for the election, as well as information to be provided to passthrough interest holders as this election is made at the entity level for both partnerships and corporations. With the broad definition of reacquisition which includes loan modifications and early payoffs for cash, this provision may apply to many taxpayers that otherwise fail to qualify for Section 108 relief on the restructuring (or even full forgiveness) of debts related to business activities or in C corporations. At a minimum, consideration must be given to discussing pros and cons of a protective election under this procedure for any taxpayer that is claiming other Section 108 relief. SECTION: 163 DEBT CANCELLATION ON LOAN TO ACQUIRE STOCK WOULD BE INVESTMENT INCOME Citation: PLR ,12/24/09 The taxpayer in PLR was asking the IRS to rule that amounts of debt treated as cancelled on debt that had been secured by and used to acquire stock was to be treated as investment income under IRC 163(d). The IRS granted something close to that ruling, but the nuances of the IRS agreement indicates some of the complexity related to debt forgiveness, including whether what a taxpayer has is truly debt forgiveness. The loans in question were nonrecourse loans used by the taxpayer to acquire stock. Due to a change in state regulations impacting the entities that had loaned the money to the taxpayer to purchase the entities, the lenders now could directly hold the stock and looked to acquire that stock from the taxpayer. As part of that transaction the taxpayer would not end up paying certain amounts of interest due and accrued under the note prior to the date of the sale transaction. 17

18 The IRS gave three different rulings. The IRS ruled that any amounts in the transaction properly treated as cancellation of indebtedness under IRC 61(a)(12) would be investment income. The IRS also noted any amount properly treated as part of the sales price under 1001 and Reg (a) would be governed by 163(d)(4)(B) (the capital gain/loss rules) in determining if it was investment income. Finally the IRS gave no ruling on the treatment as investment income if the amounts were determined to be properly included as income under any other provision of the IRC. The complication is that the loan was a nonrecourse loan. In that case, Reg (a) may require the taxpayer to view the transaction as exchanging the entire loan (including the unpaid interest) for the stock, since the lender has no rights beyond taking the stock in the event of default. However, if the debt was rather reduced, then it may be governed by IRC 61(a)(12). As well, depending on other factors in the relationship between the parties, it s possible that the IRS might view the actual transaction to be something other than either of the above two possibilities. The IRS in this ruling clearly reserved the right to question the underlying assumption that the transaction was debt cancellation, but did agree that if it was then the amount would be investment income. SECTION: 408 NO LATE ROLLOVER RELIEF FOR TAXPAYER UNABLE TO SELL HOME TO OBTAIN FUNDS TO COMPLETE ROLLOVER Citation: PLR , 11/18/11 In PLR , the IRS declined to grant a taxpayer a waiver of the 60 day rollover period that was tied to problems selling the taxpayer s residence. In the ruling request, the taxpayer s daughter, acting under a power of attorney, withdrew funds from her IRA to be used to pay for an assisted living facility. She intended to replace those funds with the proceeds from the sale of the taxpayer s residence. However, the daughter discovered the property had become run down due to the lack of care that had taken place due to her mother s dementia. As well, the poor real estate market made it more difficult to sell the property than the daughter had expected it to be. Thus the sixty day period expired before the residence could be sold. The taxpayer asked the IRS to waive the 60 day period due to this hardship. The IRS declined to do so, noting that while the taxpayer may have been unfit to manage her affairs, the daughter was actually doing so during the entire period in question. As well, the ruling makes clear that if a taxpayer borrows from an IRA with the hope of being able to replace the funds due to a later access to funds (in this case selling the residence), the taxpayer has to accept the risk if the access to the funds does not take place. 18

19 The IRS is generally insistent that taxpayers looking for relief must show one of the factors enumerated in Rev. Proc , which generally includes showing errors committed by a financial institution, death, hospitalization, postal error, incarceration and/or disability. The ruling does suggest that if the taxpayer herself had withdrawn the funds and only later had the daughter taken over control that the IRS might have been willing to find the withdraw itself was due to the disability of the taxpayer (dementia has been held to be such a disability by the IRS in prior rulings). But with that not being the case here, the IRS refused to grant relief. SECTION: 851 DISCHARGE OF INDEBTEDNESS INCOME FROM REQUIRING DEBT BY REGULATED INVESTMENT COMPANY HELD TO BE QUALIFYING INCOME Citation: PLR , 2/12/10 A regulated investment company (RIC) had borrowed funds in order to make various qualified investments. Now those debts are trading at a substantial discount to their par value, and the fund believes it makes economic sense for its investors to reacquire this debt at the lower price. But doing so would generate substantial discharge of indebtedness income and if that income is not considered qualifying income under 851(b)(2) the company would not longer be an RIC a result the entity wished to avoid. The IRS ruled that to the extent the original proceeds of the debt instruments could be traced to purchase of qualified income securities within the meaning of Reg T, the discharge of indebtedness income would be qualifying income under 851(b)(2) as other income derived with respect to the fund s business of investing in securities. SECTION: 1001 DETERIORATION OF ISSUER'S FINANCIAL CONDITION NOT TO BE CONSIDERED IN DETERMINING IF MODIFIED AGREEMENT REMAINS A DEBT INSTRUMENT Citation: TD 9513, Reg , 1/6/11 The IRS published in final form modifications to Reg that provide protection from consideration of a debt issuer s financial condition in certain cases when determining if a modified instrument remains debt. That factor is important because if it is determined the item has changed from debt to equity or some other asset, generally the transaction would become a taxable exchange under IRC Under Reg (f) changes in the instrument that derive solely from a deterioration in the issuer s financial condition (such as a decrease in the fair market value of the obligation) will not be considered in determining if the new item is debt so long as there is no substitution of a new obligator or the addition or deletion of a co-obligor. 19

20 The new provisions of Reg (f) will apply to alteration of the terms of a debt instrument on or after January 7, However, taxpayers may rely on the revisions for alterations of debt instruments occurring before that date. SECTION: 7434 MOTHER-IN-LAW FILING FORM 1099C NOT LIABLE TO EX-SON-IN-LAW FOR FRAUDULENT INFORMATION RETURN Citation: Cavoto v. Hayes, CA7, U.S.T.C. 50,247 (affirming DC-IL, U.S.T.C. 50,503), 2/28/11 A divorce that spilled over into the arena of Form 1099C was the key issue in the case of Cavoto v. Hayes, CA7, U.S.T.C. 50,247 (affirming DC-IL, U.S.T.C. 50,503). In this case, Robert Cavoto was suing his former mother-in-law because she had issued a Form 1099C to him. Mr. Cavoto had, per his former mother-in-law, borrowed $30,000 from her, an amount which he did not repay to her. Her other daughter, a CPA, advised her to issue Mr. Cavoto a Form 1099-C. That caused the IRS to issue a notice to him demanding $11,000 in taxes, interest and penalties. Eventually the IRS decided not to pursue this collection, but Mr. Cavoto sued to be paid the legal fees he had incurred in defending the IRS notice. Robert had two objections. First, he claimed he truly did not owe the $30,000. Second, he noted that his mother-in-law was not in any of the businesses that are required to issue a Form 1099C, as that form is only required to be issued by certain entities. Robert claimed that either action amounted to issuance of the 1099C fraudulently, and he asked for damages under IRC The trial court found that even though his mother-in-law was not required to issue a Form 1099C, the mere issuance of the form was not fraud. As well, the Court found that his mother-in-law had a good faith belief she had been owed the $30,000 and was not repaid, thus she did not fraudulent file the form. The Court of Appeals affirmed the District Court, but noted that the case should have been dismissed without worrying about either issue that Robert raised. Damages under IRC 7434 can only be awarded for the information returns specified at IRC 6724(d)(1)(A). The Court noted that a Form 1099C isn t covered in that list, and thus no damages could have been awarded even for a fraudulent Form 1099C. 20