Application of the Consolidated Tax Return Rules to Insolvent Members

Editor: Anthony S. Bakale, CPA, M. Tax.

Consolidated Returns

The tax treatment of an insolvent debtor realizing discharge of indebtedness income under the U.S. consolidated income tax return rules can vary considerably depending on the particular circumstances. As discussed below, the consolidated tax rules governing transactions involving intercompany debt obligations between members of the same consolidated group differ greatly from the rules that govern debt obligations owed by an insolvent debtor/member to a nonmember creditor. The application of these rules presents numerous tricks and traps for the unwary.

This item highlights the U.S. consolidated tax return rules that govern the treatment of cancellation of indebtedness (COD) income (see generally Regs. Secs. 1.1502-13(g) and -28). A comprehensive discussion of these rules is beyond the scope of this item. Accordingly, if a member of a consolidated group realizes COD income, taxpayers and practitioners are urged to thoroughly familiarize themselves with these rules to ensure that all relevant issues are identified and properly addressed.

Sec. 108 Gross Income Exclusion and Attribute Reduction Rules

COD is an item of gross income that is subject to current taxation under Sec. 61(a)(12), unless it is otherwise excluded. For example, COD income is excluded from current taxation if the COD event occurs in a Title 11 bankruptcy case, i.e., where the debtor/taxpayer is under the jurisdiction of the bankruptcy court. COD income is also excluded from current taxation if the taxpayer is insolvent. Sec. 108(d)(3) provides that a taxpayer is considered insolvent if its liabilities exceed the fair market value (FMV) of its assets immediately before the COD event occurs.

If COD income is excluded under the insolvency exception rules, the debtor/member is required to reduce certain specified tax attributes and asset bases in accordance with the ordering rules set forth in Secs. 108(b) and 1017. As is further discussed below, the application of these rules can have anomalous consequences.

Sec. 108 also contains a number of other rules that can either eliminate or reduce the amount of realized COD income. Of particular relevance here are the contribution-to-capital and stock-for-debt rules.

The following discussion assumes that the insolvent member does not elect under Sec. 108(b)(5) to apply attribute reduction first against depreciable property and does not elect to treat the stock of lower-tier members as depreciable property pursuant to Sec. 1017(b)(3)(D).

Shareholder Capital Contribution of Debt

Under the Sec. 108(e)(6) contribution-to-capital rule, if a corporation acquires its debt from a shareholder, the transferee corporation is treated as satisfying the debt with an amount of money equal to the shareholder’s basis in the debt. Two examples illustrate the application of this rule.

Example 1: A Co., an accrual-method debtor/corporation, accrues an unpaid expense owed to B, a cash-method creditor/shareholder. B has not recognized income yet and therefore has no basis in the obligation. If B later contributes her zero-basis liability to A Co., the corporation recognizes COD income to the extent of the face amount of the liability.

Example 2: On the other hand, if B loans money to A Co. and B’s basis in the debt is equal to the face amount of the debt, A Co. does not realize COD income on B’s contribution of the debt because B’s basis in the debt is equal to the face amount.

On the surface, this rule appears straightforward. However, to fall within the scope of Sec. 108(e)(6), the creditor/shareholder’s transfer of the debt to the debtor/corporation must be respected as a capital contribution. The following IRS memoranda illustrate situations where a debt discharge was not deemed to constitute a capital contribution.

In TAM 200101001, a subsidiary corporation’s debt owed to its parent corporation was discharged in connection with a bankruptcy proceeding. The IRS ruled that the parent did not make a capital contribution to the subsidiary because (i) the debt was not voluntarily canceled, (ii) the debt was canceled at the same rate as the other creditors, and (iii) the subsidiary did not issue any additional stock to the parent. In FSA 199915005, the IRS ruled that a parent’s cancellation of subsidiary debt did not constitute a capital contribution to the extent the subsidiary remained insolvent after the cancellation.

By contrast, in Lidgerwood Mfg. Co., 229 F.2d 241 (2d Cir. 1956), aff’g 22 T.C. 1152 (1954), the Second Circuit held that even if a debtor/subsidiary was insolvent both before and after a creditor/parent’s debt cancellation, the cancellation was a valuable contribution to the financial position of the subsidiary because it enabled the subsidiary to continue in business. See also FSA 1997 FSA LEXIS 636 (Lidgerwood followed). The capital contribution issue is more fully discussed in several treatises (see, e.g., Henderson and Goldring, Tax Planning for Troubled Corporations, ¶505 (CCH 2011); and Garlock, Federal Income Taxation of Debt Instruments, ¶1603.04[B] (CCH 2011)).

The capital contribution stakes can be quite considerable. If the debt transfer is respected as a capital contribution, the debtor/corporation may realize little, if any, COD income. Consequently, the amount of Sec. 108(b) attribute reduction would be minimal (if at all). By contrast, if the transfer is not respected as a capital contribution, the debtor/corporation would likely realize COD income to the extent of the face amount of the debt (including accrued interest). This could result in a significant amount of Sec. 108(b) attribute reduction.

Issuance of Stock to Satisfy Corporate Debt

The Sec. 108(e)(8) “stock-for-debt” rule provides that if a debtor/corporation issues its stock in satisfaction of a debt obligation, COD income is realized to the extent that the face amount of the debt exceeds the FMV of the stock. If there is only one creditor/shareholder, there is a question of whether the contribution-to-capital rule or the stock-for-debt rule applies where the debtor/corporation does not issue stock. In such cases, the issuance of stock would be a meaningless gesture.

In Lessinger, 85 T.C. 824 (1985), aff’d in relevant part, 872 F.2d 519 (2d Cir. 1989), the Tax Court held that the Sec. 351 stock issuance requirement was satisfied when a shareholder transferred assets to his wholly owned transferee corporation even though stock was not issued. The court reasoned that the issuance of stock would have been a meaningless gesture because the shareholder’s ownership percentage in the transferee corporation would not have changed. Nevertheless, for COD purposes, the IRS has issued a number of letter rulings that generally respect the form adopted by the taxpayer (see Henderson and Goldring, ¶505 at p. 168, nn. 12 and 13.)

Treatment of Intercompany Debt Under the Consolidated Tax Return Rules

As explained in Regs. Secs. 1.1502-13(a)(2) and (a)(6), the consolidated tax return rules try to achieve single-entity treatment with respect to intercompany transactions. For this purpose, intercompany obligations between members are governed by the intercompany transaction rules (see generally Regs. Sec. 1.1502-13(g)). For example, in Regs. Sec. 1.1502-13(g)(7)(ii), Example (1), interest payments made on an intercompany loan are treated as interest income to the lender and interest expense to the borrower on a separate company basis. Nevertheless, consolidated taxable income is not affected because the two amounts offset. Accrued original issue discount (OID) on intercompany loans is treated as interest.

The intercompany transaction regulations achieve similar results in other applications involving intercompany debt. For example, if a creditor/member claims a partial bad debt deduction under Sec. 166(a)(2) or sells an intercompany loan to another member for an FMV amount that is less than the face amount, the intercompany regulations achieve single-entity treatment on a consolidated basis in the following ways:

First, Sec. 108 is “turned off” under Regs. Sec. 1.1502-13(g)(4)(i)(C). So, even if the borrower is insolvent, COD income would not be excluded from the debtor/member’s separate company income. Hence, there is no attribute reduction under Sec. 108(b).

Second, regardless of whether the creditor/member claims a partial bad debt deduction or sells the loan to another member, the regulations apply a deemed satisfaction and deemed reissuance rule. Thus, under Regs. Sec. 1.1502-13(g)(3), the debtor/member is deemed to satisfy the loan at FMV and then reissue the debt to the creditor/member. Assuming the FMV of the loan is less than face value, the debtor/member, regardless of solvency, recognizes COD income on a separate company basis. Moreover, because Sec. 108 does not apply, there is no attribute reduction under Sec. 108(b). The “newly reissued” loan is an OID instrument because the face amount will be greater than the new issue price.

In the case of an intercompany sale, the original creditor/member recognizes a capital loss under Sec. 1271 on a separate company basis because the debtor/member is deemed to have satisfied the note at an FMV amount less than face immediately before the sale. However, to achieve matching under the single-entity approach, the creditor/member’s capital loss is recharacterized as an ordinary loss. Thus, the character of the loss is the same as that of the creditor/member that claims a partial bad debt deduction under Sec. 166(a)(2).

In either case, the net result is the same. The debtor/member recognizes ordinary COD income, and the creditor/member recognizes an offsetting ordinary loss or deduction of matching character. Hence, consolidated taxable income is not affected. Regs. Sec. 1.1502-13(g)(7)(ii), Example (3), illustrates these rules.

Lastly, pursuant to Regs. Secs. 1.1502-13(g)(3)(i)(B) and (g)(3)(i)(B)(5), the deemed satisfaction and deemed reissuance rule does not apply where an intercompany obligation is extinguished (e.g., as a contribution to capital) provided that the creditor/member’s adjusted issue price of the debt (generally the face amount) is equal to the debtor/member’s basis. Otherwise, as provided in Regs. Sec. 1.1502-13(g)(3)(ii)(A), the deemed satisfaction and deemed reissuance rule applies, and the group needs to take into account the resulting tax consequences.

Treatment of Debt Owed to a Nonmember Under the Consolidated Tax Return Rules

In contrast to the single-entity approach taken under the consolidated intercompany transaction rules, Regs. Sec. 1.1502-28(a) generally applies a separate company approach when an insolvent debtor/member realizes COD income in cases where the insolvent debtor/member owes money to a nonmember. Under the separate company approach, insolvency is measured on a separate company basis taking into account only the assets and liabilities of the insolvent member. Notably, the insolvent member’s assets include stock and securities of other members, and its liabilities include debts owed to other members.

Regs. Secs. 1.1502-28(a)(2) through (4) provide a multistep approach with respect to applying the Secs. 108(b) and 1017 attribute reduction rules. The first step contemplates that attribute reduction is applied to the insolvent member that recognized the COD income with respect to that member’s separate company attributes. Secs. 108(b)(2) and Regs. Sec. 1.1017-1(a) prescribe the specific order in which the insolvent member’s attributes are reduced.

It should be noted that Regs. Sec. 1.1017-1(a) provides that attribute reduction of the member’s property occurs as of the first day of the tax year following the COD event. In addition, Regs. Sec. 1.1017-1(b)(3) limits the amount of basis reduction to the aggregate bases of the insolvent member’s property over the aggregate amount of liabilities immediately after the COD event—again, as determined on a separate company basis.

For example, assume an insolvent member’s attributes consist of (i) its allocable share of consolidated net operating losses (NOLs) (as determined under Regs. Sec. 1.1502-21(b)(2)(iv)), (ii) fixed assets that secure the discharged debt, (iii) stock in a lower-tier subsidiary, and (iv) an intercompany loan receivable. The attribute reduction rules are applied to reduce NOLs and the bases of property in the following order: first, allocable NOLs; second, fixed assets; third, stock in lower-tier members (but not below zero); and, finally, the intercompany loan receivable.

As alluded to above, the application of the attribute reduction rules may pose a potential trap. If attribute reduction is applied to reduce the basis of the intercompany loan receivable, there is an asymmetry between the insolvent member’s basis in the loan and the face amount owed to the other member. As explained above, if at a later time a deemed satisfaction and deemed reissuance triggering event occurs, separate company gain and loss may not offset when computing consolidated taxable income. Regs. Sec. 1.1502-28(b)(5)(ii) appears to contemplate this possibility. It may be possible to ameliorate this issue through advance planning.

The next step applies a lookthrough approach with respect to lower-tier members. If the basis of a lower-tier member’s stock is reduced, the lower-tier member is treated as realizing COD income on the last day of the tax year during which the actual COD event occurs. Attribute reduction as prescribed by Secs. 108(b) and 1017 is applied as described above (including the limitation on the reduction of basis).

The regulations touch on another potential trap relating to Sec. 1245 taint. Regs. Sec. 1.1502-28(b)(4) provides that the reduction of basis in a lower-tier member’s stock is treated as a depreciation deduction to the extent that the amount of the reduction exceeds the amount of the member’s attributes that are reduced under the lookthrough rule. This excess amount could be subject to Sec. 1245 recapture upon the later occurrence of certain triggering events.

For example, if, under the tax-free liquidation rules of Secs. 332 and 337, the lower-tier member distributes its assets in liquidation to its immediate parent, the lower-tier member’s stock basis disappears. This could trigger immediate income recognition of the Sec. 1245 taint notwithstanding the application of Secs. 332 and 337. Similarly, if the stock of the lower-tier member is later sold to an unrelated corporation and the parties make a joint Sec. 338(h)(10) deemed asset sale election, the deemed Sec. 332 liquidation of the target lower-tier member could also be a triggering event. In the more ordinary case, if the group sells the stock of the lower-tier member whose stock is “tainted,” any gain recognized could be characterized as ordinary income rather than capital gain income to the extent of the Sec. 1245 taint.

Conclusion

The consolidated tax return rules that govern the treatment of member debt owed to other members of the same consolidated group and member debt owed to nonmember creditors are extremely complicated. Taxpayers and their advisers should be diligent in understanding how these rules operate in order to avoid pitfalls and traps.

EditorNotes

Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.