Cancellation of Indebtedness Income for Pass-Through Entities Navigating Complex Tax, Exclusion and Deferral Issues Arising in Forms 1099-C and 982 WEDNESDAY, MARCH 13, 2013, 1:00-2:50 pm Eastern IMPORTANT INFORMATION Participate in the program on your own computer connection or phone line (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Respond to verification codes presented throughout the seminar. If you have not printed out the Official Record of Attendance, please print it now. (see Handouts tab in Conference Materials box on left-hand side of your computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding spaces found on the Official Record of Attendance form. Complete and submit the Official Record of Attendance for Continuing Education Credits included with the presentation materials. That record must include your PTIN ID #. Instructions on how to return it are included on the form. To earn full credit, you must remain on the line for the entire program. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Program: - On the web, use the chat box at the bottom left of the screen - On the phone, press *0 ( star zero) If you get disconnected during the program, you can simply call or log in using your original instructions and PIN.
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I. TRANSACTIONS CREATING CODI By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com 4
INTRODUCTION PLANNING APPROACH Get the facts! Entity considerations Some elections are made at entity level Loss utilization history Review balance sheet & projections NOL + PAL credit carryforwards Solvency of debtor 5
CANCELLATION OF DEBT IRC 61(a)(12) Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) income from discharge of indebtedness 6
COD 61(a)(12) requires inclusion of income from discharge of indebtedness Borrower receives $ or property offset by debt Accession to wealth freeing of assets Tax basis includes the debt So discharge income is balanced as offset 7
EXCEPTIONS ADJUSTMENTS 108 contains numerous exceptions 1017 requires certain basis adjustments Tax attributes ex. NOL s are reduced CODI does not include debt that would have given rise to a deduction if paid (ex. A/P of Cash Taxpayers 108(e)(2) interest) 8
DEBT Income tax effects differ RECOURSE vs NONRECOURSE Guaranty 9
GUARANTY X guarantees $1,000,000 loan to her corp Corp renegotiates loan with bank Debt reduced to $750,000 Does X have COD income? 10
ANSWER NO Mere guarantee is not sufficient Merkel v. Comm., 109 T.C. 463 (1997) aff d, 192 F.3d 844 (9 th Cir. 1999) Corp should receive 1099C Corp is primary obligor Debt restructured freed corporate assets 11
TRANSACTIONS CREATING CODI 1. Debt Discharge paying less than full debt CODI = Debt Amount > Cash Payment 2. Significant Modification of Debt: CODI = Principal Amount Old Debt > Principal Amount New Debt 3. Exchange of debt instruments CODI = Issue Price of OLD Debt > Issue Price of NEW Debt (using OID rules) 12
TRANSACTIONS continued 4. Repurchase 5. Forclosure / Short Sale 6. Debt / Equity Exchanges may be a deemed exchange if modification. 7. Not disputed amount 13
OID 1273 or 1274 Public market Issue Price is Trading Price If market quotations are available 14
CODI Generally the difference between the balance of the indebtedness and the amount of consideration accepted by the lender. Income is realized at the time the debt is satisfied. Solvent taxpayers generally report ordinary income on canceled or reduced debt. 15
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McCORMICK, TC Memo 2009-39 What is correct amount of CODI? The McCormick family received a 1099 C from Citi Financial Contest of Amount IRC 6201(d) - In any court proceeding: Taxpayer asserts reasonable dispute To income reported on an information return Taxpayer fully cooperated THEN 17
BURDEN OF PROOF SHIFTS To IRS Correct CODI was $49.66 IRS could not rely on 1099C CCA 201112008 borrowers received payments in settlement of unfair lending dispute. Viewed as equitable reformation Timing Gaffney, TC Summary 2010-128. 18
EXAMPLE 1 Debtor transfers property in a voluntary foreclosure Of RECOURSE DEBT RECOURSE DEBT - Debt for which a borrower is personally liable. Whether a debt is recourse or nonrecourse may vary from state to state, depending on state law. 19
EXAMPLE 1 CONTINUED 1099C reports Debt cancelled in BOX 2 $465,000 Box 7 FMV $195,000 Box 3 should report accrued but unpaid interest. Request computations from lender 20
EXAMPLE 1 CONTINUED Recourse debt is bifurcated: Amount of Debt Cancelled= $465,000 Fair Market Value= - $195,000 CODI: $270,000 OR IS IT? 21
CODI 108(e)(2) Should NOT include amounts which would give rise to a tax deduction if paid How was FMV determined? 22
GAIN/LOSS Taxpayer s gain or loss is measured by the difference between the amount realized and the adjusted basis of the property. 23
EXAMPLE - RENTAL RENTAL PROPERTY Purchase Price = $500,000 Adjusted Basis = $400,000 IRC 1231 Loss = $205,000 (400,000 195,000) 24
NON RECOURSE DEBT Transfer of property: Tufts v. Commissioner Amount realized= $465,000 Basis= - $400,000 Capital Gain= $65,000 Non Recourse debt is defined as Debt for which a borrower is not personally liable. 25
WHEN IS DEBT DISCHARGED? Debt Modification Any change in terms, collateral, etc. Significant Modification Will trigger an exchange of the old debt for a new debt. 1001. Old Debt satisfied for issue price of New Debt. 26
REPURCHASE Debtor buys back its debt Related parties example: Acquire $1,000 of debt for $500. COD + OID Result OID income recognized by related party over term of new debt. Debtor has corresponding deduction. Presumption (6 months prior). 27
EXCHANGES DEBT FOR DEBT Satisfied old debt with amount of $ equal to the ISSUE PRICE of new debt. Significant modification triggers an exchange 28
EXCHANGES CONTINUED CODI = Adjusted issue price of Old Debt minus issue price of New Debt OID = Stated Redemption Price at Maturity Minus Issue Price of New Debt. USE AFR INTEREST RATE on New Debt, so debt is equivalent 29
FORM 982 FORM 982 is used to reduce tax attributes due to discharge of indebtedness. The form must be attached to a timely filed return extensions of time to file may be allowed if the taxpayer acted reasonably and in good faith under Treas. Reg. 301.9100-3. IRC 1017 provides rules for basis reduction. 30
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II. TAX TREATMENT FOR PASS- THROUGH ENTITIES By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com
ENTITY OR INDIVIDUAL Certain items are treated at the entity level Differences arise depending on entity type 108 exclusions are discussed in more detail below, but bankruptcy and insolvency exceptions are tested at the S Corp level but for partnerships at each partner s level Single member LLC s are disregarded entities SEE REV. RULE. 1999-5 for conversion to partnership 35
CONVERSION OF DEBT INTO EQUITY CORPORATE DEBTOR The Corp. is treated as having satisfied debt with $$ equal to the FMV of stock issued CODI = Debt > Value of Stock Issued 108(e)(8) Bankruptcy and insolvency exclusions may apply 36
EXAMPLE ABC owes creditor $1,000 Cancels debt for equity FMV $700 COD = $300 37
SHAREHOLDER EXCEPTION Shareholder cancellation 108(e)(6) As if corporation satisfied the debt with an amount of $ equal to the shareholder s basis in the debt No CODI if shareholder s basis in the debt is equal to the issue price; example: of loan of $ 38
PARTNERSHIP DEBTOR Similar rules apply BUT NO PARTNER EXCEPTION 721 nonrecognition not if for unpaid rent, royalties, or interest TRAP But CODI if amount of debt > FMV of partnership interest Recognized by each partner immediately before transaction Creditors basis in partnership interest 722 would include her basis in the debt exchanged 39
PARTNERSHIP continued Can debt be converted as a capital contribution? Example: debt cancelled to partner/lender as capital contribution Economic substance over form CODI resulted What if $ repaid to partner who then made a capital infusion? 40
108(i) Watch for 108(i) entity deferrals 108(i), part of the American Recovery and Reinvestment Tax Act, allowed for deferral of business CODI realized in 2009 and 2010 Deferrals must be included in income ratably over 5 years beginning in 2014 2018 Rules provided flexible elections and allocations Election at entity level 41
108(i) continued Partnership permitted to allocate among partners CODI not deferred was able to be excluded under 108 108 exclusions DO NOT apply to recognition years Inclusion must occur ratably in 2014 2018 Accelerations required Death, Sale, Redemption of shareholder or partner, Sale of substantially all assets, Cessation of business, Liquidation 42
OTHER PARTNERSHIP CONSIDERATIONS Attribute reduction includes election to reduce basis in depreciable property This election may preserve NOL s Partnership interest may qualify To extent partnership is holding depreciable property IF partnership also reduces its basis in such property (to extent of partner s proportionate interest) 43
IRC 1017 IRC 1017 provides that the partners interest in the partnership is treated as depreciable real property to the extent of the partner s proportionate interest in the partnership s depreciable real property. Partner s election to treat the partnership interest as depreciable real property will result in both the partner s partnership basis and the partnership s basis in the depreciable real property allocable to such partner as reduced. Generally, the partnership may grant or withhold consent unless the taxpayer owns more than 50% partnership interest. 1250 Recapture and 751 if partnership interest reduced 44
RECAPTURE Capital asset basis reductions retain a recapture requirement Any gain on disposition is subject to recapture 45
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III. APPLICATION OF 108 By Renato Matos, Esq. CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rmatos@cbmslaw.com
108 PROVIDES EXCEPTIONS TO RECOGNITION OF CODI 1. The 108(a)(1)(A) exception for discharges in bankruptcy cases 2. The 108(a)(1)(B) exception for insolvency situations 3. The 108(a)(1)(C) exception for qualified farm indebtedness 4. The 108(a)(1)(D) exception for qualified real property indebtedness [SEE SECTION VI] 48
108 continued 5. The 108(e)(2) exception for debts that would have been deductible when paid 6. The 108(e)(5) exception for reduction of certain purchase price debt obligations 7. The 108(e)(6) exception for contribution to capital from a shareholder creditor 8. The 108(f) exception for certain student loans 9. 108(i) previously discussed 49
ATTRIBUTE REDUCTION Price to be paid for the EXEMPTIONS IRS prescribes precise order and timing Attribute reduction 108(b)(3) of tax items such as NOL s, business credits, capital loss carryovers, basis of property, passive loss carryovers, and foreign tax credit carryovers Act as a tax deferral Required even if bankruptcy and insolvency exceptions apply Occur in the following year 50
S CORPORATION ATTRIBUTE REDUCTION The Internal Revenue Service has issued Reg. 1.108-7 (effective 10/30/2009) to provide guidance for S Corporation attribute reduction These regulations describe the attribute reduction for COD income that is excluded from gross income under IRC 108(a) Excluded S Corporation COD income is not passed through to the Shareholders as income and does not increase the Shareholder s basis in stock of the S Corporation This result arose from the Job Creation and Worker Assistance Act of 2002 as a reaction to the Supreme Court holding in Gitlitz v. Commissioner in 2001. The Supreme Court allowed a double tax break which was precluded by the new rules 51
S CORP CONTINUED S Shareholders cannot take losses or deductions in excess of their basis in stock and debt owed to the Shareholder by the S Corporation Any loss or deduction that is disallowed as a result of the taxpayer having insufficient basis will be treated as an NOL of the S Corporation This deemed NOL includes all losses and deductions disallowed under the S Corporation basis rules 52
BANKRUPTCY EXCEPTION 108(A)(1)(A) Excludes CODI if discharge occurs in bankruptcy Includes Title II Discharge must be under court approval 53
INSOLVENCY 108(a)(1)(B) See Part IV Below 54
PURCHASE PRICE REDUCTION 108(e)(5) no CODI if adjust purchase money debt Obligation to ORIGINAL SELLER (not bank loan) Treated as reduction of purchase price 55
BANKRUPT OR INSOLVENT PARTNERSHIP May use the 108(e)(5) purchase price reduction If all partners treat consistently 56
IV. APPLICATION OF INSOLVENCY EXCEPTION By Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com
INSOLVENCY 108(a)(1)(B) excludes DOI if the discharge occurs when the taxpayer is insolvent Income excluded shall not exceed the amount by which the taxpayer is insolvent Insolvency is computed immediately before the discharge 58
ASSETS/LIABILITIES Insolvency is the excess of liabilities over the FMV of assets Assets include exempt assets including pensions which could be withdrawn Consider obligations that offset assets With sufficient degree of certainty Taxpayers must prove application of insolvency Look at obligation, not ability to pay 9 th Cir. applied more likely than not test Contingent liabilities only if can prove payment is required 59
BURDEN OF PROOF Local tax assessment is not accepted Obtain qualified appraisal at time of discharge IRS s determinations in a notice of deficiency are presumed correct Taxpayer bears burden of proof that such determinations are not correct 60
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NONRECOURSE DEBT Asset 1 FMV $1,000; $900 Recourse Debt Asset 2 FMV $2000; $2300 Nonrecourse Debt TP s Liability = $900 + $2000 + amount of nonrecourse debt cancelled Therefore, cancellation of up to $200 of nonrecourse debt may be excluded from CODI If recourse debt is cancelled, TP is not insolvent (assets $3,000; liabilities $2,900) Rev. Rul. 92-53 62
PARTNERSHIPS Insolvency (and bankruptcy) is tested at each individual partner s level CODI may be excluded only by those partners who are themselves bankrupt or insolvent Attribute reduction is applied at the individual partner level 63
S CORPORATIONS Insolvency and bankruptcy exceptions are applied at the corporate level No basis step up allowed 64
V. QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS By Renato Matos, Esq. CAPELL BARNETT MATALON & SCHOENFELD, LLP. ATTORNEYS AT LAW (516) 931-8100 rmatos@cbmslaw.com 65
QRPBI QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS Taxpayers other than C Corporations can exclude from gross income discharge of qualified real property business indebtedness Amount excluded must reduce the taxpayers basis in real property Amount cannot exceed the basis of real property held by the taxpayer Anti-Stuffing provision disallows purchase in contemplation of such discharge 66
ELECTION Elective exclusion USE FORM 982 Qualified real property business indebtedness - debt incurred to acquire, construct, or substantially renovate real property special rules for pre-1993 debt Used in a trade or business, and Secured by such real property Note that the insolvency and bankruptcy exceptions come first 67
LIMITATIONS & RECAPTURE The exclusion cannot exceed The amount by which the principal amount of the debt exceeds the fair market value of the property securing the debt, or The aggregate adjusted bases of the taxpayer s depreciable real property The basis reduction is treated as ordinary income RECAPTURE upon sale of the property based upon the IRC 1250 depreciation rules using the straight line method of depreciation 68
PARTNERSHIP PARTNERSHIP discharge and whether the debt was incurred in connection with a real property trade or business is made by reference to the business of the partnership The ELECTION to exclude or discharge real property business indebtedness is made at the partner level on a partner by partner basis 69
IRC 1017 IRC 1017 provides that the partners interest in the partnership is treated as depreciable real property to the extent of the partner s proportionate interest in the partnership s depreciable real property. Partner s election to treat the partnership interest as depreciable real property will result in both the partner s partnership basis and the partnership s basis in the depreciable real property allocable to such partner as reduced. Generally, the partnership may grant or withhold consent unless the taxpayer owns more than 50% partnership interest. 1250 Recapture and 751 apply if partnership interest reduced 70
S CORPORATION Election made at corporate level + attribute reduction No adjustment to shareholder stock Acts as a deferral 71
PRINCIPAL RESIDENCE Temporary Exclusion before January 1, 2013 - EXTENDED QUALIFIED principal residence indebtedness Not a second home Later 121 Exclusion may protect basis reduction Insolvency Exclusion may be preferable 72