Tax Trap: When Debt Forgiveness Is Not a Free Pass

June 14, 2017

Heather K.P. Fincher
BakerHostetler LLP; Washington, D.C.

John R. Lehrer, II
BakerHostetler LLP; Washington, D.C.

 

Not many founders of a new business consider, at the time the new business is founded, the potential U.S. federal income tax consequences to them should the new business fail.  The type of business entity formed, and the treatment of that entity for U.S. federal tax purposes as either a corporation or a pass-through entity, can have a material U.S. federal income tax consequence to the owners of the entity if the business should fail and there is a cancellation of the debts of the business. While state laws governing corporations or limited liability companies (LLCs) can limit the liability exposure of an owner of any such entity, this liability limitation does not always apply to income taxes.

Discharge of Indebtedness Tax Overview

Gross income generally includes all income from the discharge of indebtedness under general U.S. federal income tax principles. If, however, the discharge of indebtedness occurs in connection with a Title 11 case or when a taxpayer is insolvent, some or all of the amount of the debt discharged can be excluded from inclusion in a taxpayer’s gross income. The full amount of the debt discharged can be excluded from gross income in a Title 11 case; however, the insolvency exclusion is limited to the amount of the insolvency. The price paid by a taxpayer for excluding discharge of indebtedness from gross income is a required reduction to the taxpayer’s tax attributes, including net operating losses, certain tax credits and credit carryovers, capital losses, and basis in assets.

The gross-income exclusion and attribute-reduction rules described above are applied at the entity level if the entity is a corporation or an LLC treated as a corporation for U.S. federal tax purposes. However, these exclusion and attribute-reduction rules are applied at the partner or member level, where a pass-through entity has discharge of indebtedness income. The different level at which the exclusion and attribute-reduction rules apply many times yields surprising results for taxpayers and is illustrated below.

Example #1. Discharge of Indebtedness: Corporation

Facts: Delaware corporation (USCo) is owned 40% by individual A (A) and 60% by individual B (B). USCo has $5 of assets and a liability of $125, which is the amount remaining due and owing on an unsecured loan to a bank (Bank). Given USCo’s precarious financial position and threat to declare bankruptcy, Bank has agreed to discharge $100 of USCo’s outstanding loan balance. Immediately before the discharge, A is $50 solvent and B is $100 insolvent.

Result: USCo has discharge of indebtedness income in the amount of $100. However, as USCo is insolvent at the time of the discharge in an amount equal to $120, the entire $100 of discharge of indebtedness income is excluded from USCo’s gross income for U.S. federal income tax purposes. USCo is required, however, to reduce its tax attributes as a result of this exclusion. Neither A nor B have any U.S. federal income tax consequences as a result of this discharge.

Alternative: If instead USCo had $500 of assets at the time of the discharge, the insolvency exclusion would not apply and USCo would incur a $35 U.S. federal income tax liability as a result of such discharge (assuming the applicable corporate tax rate is equal to 35%). Neither A nor B have any U.S. federal income tax consequences as a result of the discharge under these alternative facts.

Example #2. Discharge of Indebtedness: LLC Tax as a Partnership

Facts: Delaware LLC (LLC1) is owned 40% by individual A (A) and 60% by individual B (B). LLC1 is treated as a partnership for U.S. federal tax purposes. All taxable items of LLC1 are allocated to A and B in accordance with the ownership percentages in LLC1. LLC1 has $5 of assets and a liability of $125, which is the amount remaining due and owing on an unsecured loan to Bank. Given LLC1’s precarious financial position and threat to declare bankruptcy, Bank has agreed to discharge $100 of LLC1’s outstanding loan balance. Immediately before the discharge, A is $50 solvent and B is $100 insolvent.

Result: LLC1 has discharge of indebtedness income in the amount of $100. Even though LLC1 is insolvent at the time of the discharge in an amount equal to $120, the entire $100 of discharge of indebtedness income is allocated to A ($40) and B ($60). As the insolvency exception applies at the member level (i.e., to each of A and B) and not at the LLC1 level, A recognizes $40 of discharge of indebtedness income and would incur a $15.84 U.S. federal income tax liability (assuming the applicable individual tax rate is 39.6%), and B’s allocable share of the discharge of indebtedness income would be excluded from B’s gross income given the application of the insolvency exception to B. B, however, is required to reduce her tax attributes as a result of this exclusion.

Alternative: If instead LLC1 had $500 of assets at the time of the discharge, the same results would apply.

As illustrated in the above examples, the form of a legal entity and treatment for U.S. federal tax purposes can have a materially different impact on the U.S. federal income tax consequences resulting from discharge of indebtedness income at both the entity and owner levels. Therefore, careful consideration must be given to the U.S. federal income tax consequences resulting from discharge of indebtedness, even when such discharge occurs in an entity like an LLC, where the members can have limited liability, as the tax results can differ.

 

 

This article was originally published in the February 2017 edition of the Commercial Regulatory Law Committee Newsletter. Participation in ABI's committees is one of the many benefits of becoming a member.  Committees provide networking and leadership opportunities.  For additional information on how you could become involved in ABI and our Committees please visit membership.abi.org 

Previous Article
Skill and Will: Talent Is Key to the Turnaround of Distressed Municipalities
Skill and Will: Talent Is Key to the Turnaround of Distressed Municipalities

How will changing a government's compensation and benefits approach more efficiently utilize taxpayer resou...

Next Flipbook
7th Circuit Decision Might Impact State Property Tax Sales
7th Circuit Decision Might Impact State Property Tax Sales

A recent decision by the Seventh Circuit, purchasers of real property through tax sales conducted by certai...

×

Get insolvency information from the source. Subscribe to the ABI InSider!

First Name
Last Name
Thank you!
Error - something went wrong!