Rules Issued on Income Deferral of Canceled Debt

Regulations

The IRS issued temporary and proposed regulations on August 11 relating to taxpayer elections to defer recognition of cancellation of debt (COD) income.

The American Recovery and Reinvestment Act of 2009, P.L. 111-5, enacted Sec. 108(i), providing an election to defer COD income arising from the forgiveness or reacquisition of certain debt instruments occurring between January 1, 2009, and December 31, 2010. A taxpayer making the election may include COD income in gross income ratably over a five-year period beginning with the fourth or fifth tax year after the reacquisition occurred (in 2010 or 2009 tax years, respectively). If a taxpayer making a Sec. 108(i) deferral election dies or ceases business, or substantially all the assets of the taxpayer are liquidated or sold, any remaining deferred COD income or original issue discount (OID) deductions must be included in gross income or taken in the tax year in which any of those events occurred. In a title 11 bankruptcy case, the deferred COD income is taken into account on the day before the petition is filed (Sec. 108(i)(5)(D)).

In temporary and proposed regulations, the IRS clarified various contexts in which these events accelerate deferrals of COD income (T.D. 9497 and REG-142800-09). The regulations address situations in which taxpayer corporations transfer substantially all their assets in reorganization exchanges. A literal reading of the statute could require a deferral acceleration, contrary to the purposes of Sec. 108(i) as enacted, the IRS said in a preamble. Consequently, the temporary regulations require acceleration of deferred COD income by corporations where the corporation:

• Changes its tax status;
• Ceases its corporate existence in a transaction to which Sec. 381(a) (corporate acquisition rules) does not apply; or
• Engages in a transaction that impairs its ability to pay the tax liability associated with the deferred COD income.

The IRS also issued temporary and proposed regulations regarding the application of Sec. 108(i) to partnerships and S corporations (T.D. 9498 and REG-144762-09). Since “applicable debt instruments” for which the election may be made are defined in the statute as those issued by a C corporation or other person in connection with a trade or business, the IRS addressed situations in which partnerships or S corporations may be considered issuers of applicable debt instruments. The regulations provide five safe harbors in this respect (see Temp. Regs. Sec. 1.108(i)-2T(d)(1)). Other regulations establish a method by which partnerships and S corporations may allocate differing amounts of deferred COD income among partners or S corporation shareholders and rules for the adjustment of basis and share of liabilities and other partner and shareholder items.

The regulations also address deductions by issuers of new debt instruments featuring OID in place of those that are reacquired or forgiven and for which the debtor has made a Sec. 108(i) election to defer COD income. Any deduction taken for OID by issuers of such debt instruments must also be deferred, but where the COD income deferral is subject to acceleration, an OID deduction may also be accelerated.

The rules for acceleration of deferrals apply to events occurring on or after August 13, 2010. The regulations also provide transitional rules that allow electing corporations to use provisions in the acceleration rules in a timely manner. The applicability of certain other rules is retroactive to reacquisitions of debt instruments occurring after December 31, 2008.