Sec. 108(e)(2) and Debt That Would Give Rise to Basis

By Bela Unell, J.D., Washington, D.C.

Editor: Mary Van Leuven, J.D., LL.M.

Gross Income

Forgiveness of liabilities generally gives rise to taxable income under Sec. 61(a)(12) (cancellation of indebtedness (COD) income), but Sec. 108 contains several exceptions to that rule. One such exception is for liabilities whose payment would give rise to a deduction (Sec. 108(e)(2)). A taxpayer is not required to recognize taxable income for the discharge of a liability when payment of the liability would have given rise to a tax deduction.

This sometimes is called a “tax benefit” rule, reflecting the idea that COD income excludes deductible expenses from which no tax benefit has resulted. However, even with corporate taxpayers, the tax benefit that results from indebtedness is not always a deduction. Some liabilities, particularly acquisition liabilities, are capitalized into the basis of stock or of various assets.

And sometimes those liabilities are not reflected in basis immediately. For example, when a taxpayer acquires property subject to contingent debt, that debt is not taken into account in basis unless and until it is paid. But what if the debt is forgiven before it is paid? A line of cases excludes the discharge of contested debt from COD income, and commentators sometimes cite those cases as establishing that there is no COD income from the discharge of contingent debt generally (see Zarin , 916 F.2d 110 (3d Cir. 1990); Whitmer , T.C. Memo. 1996-83 ; and Estate of Smith , 198 F.3d 515 (5th Cir. 1999)). Whether those cases go that far is questionable, but they are clearly inapplicable when the subject debt is fixed and determinable at the time of discharge—even if it was originally too contingent to give rise to basis.

It does not seem right that liabilities that were too contingent to have given rise to basis should give rise to COD income when canceled, yet there is apparently no explicit exclusion from COD income for them. Acquisition debt that did not give rise to basis is explicitly excluded from creating gain on a taxable sale or exchange of the property subject to the debt under Regs. Sec. 1.1001-2(a)(3), but that provision does not apply to COD income.

Martin Cowan suggests that Sec. 108(e)(2) should be read to exclude from COD income a cancellation of debt that would otherwise give rise to basis because the debt would have been covered by Section 346(j)(2) of the old Bankruptcy Code (11 U.S.C. §346(j)(2), before amendment by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8 ), which prevented states from taxing income from the cancellation of debt that had not yet given rise to a tax benefit (see Cowan, “Recent Cases Reflect Continuing IRS Uncertainties About COD Income From Contingent Debt,” 84 J. Tax’n 261 (1996)). However, he does not cite a link between the sections in the legislative history. Nevertheless, Cowan’s argument is as much about legislative policy as it is about tracing the origins of the provision—and the IRS has embraced the policy argument in a nearly identical statutory context.

Sec. 357(c) causes gain to be recognized on a transaction that otherwise qualifies as a tax-free contribution to capital under Sec. 351 to the extent that the liabilities assumed by the transferee corporation exceed the transferor’s basis in the transferred assets. Sec. 357(c)(3)(A) excludes from that calculation any liability whose payment would give rise to a deduction. Interestingly, Sec. 357(c)(3)(B) goes on to exclude from the exclusion any liability to the extent its incurrence resulted in the creation of, or an increase in, the basis of any property. So it seems that Congress was thinking about liabilities that give rise to a tax benefit in the form of basis when it drafted the exclusion for liabilities that would give rise to deductions, and yet it did not include an exclusion for liabilities whose payment would give rise to basis.

Nevertheless, when the IRS in 1995 was faced with the question of whether contingent liabilities that had not been included in basis should give rise to Sec. 357(c) gain, it concluded that such liabilities are appropriately excluded in determining liabilities for purposes of Sec. 357(c). Rev. Rul. 95-74 contains the following reasoning:

Congress concluded that including in the section 357(c)(1) determination liabilities that have not yet been taken into account by the transferor results in an overstatement of liabilities of, and potential inappropriate gain recognition to, the transferor because the transferor has not received the corresponding deduction or other corresponding tax benefit. To prevent this result, Congress enacted section 357(c)(3)(A) to exclude certain deductible liabilities from the scope of section 357(c), as long as the liabilities had not resulted in the creation of, or an increase in, the basis of any property (as provided in section 357(c)(3)(B)).

While section 357(c)(3) explicitly addresses liabilities that give rise to deductible items, the same principle applies to liabilities that give rise to capital expenditures as well. Including in the section 357(c)(1) determination those liabilities that have not yet given rise to capital expenditures (and thus have not yet created or increased basis) with respect to the property of the transferor prior to the transfer also would result in an overstatement of liabilities. Thus, such liabilities also appropriately are excluded in determining liabilities for purposes of section 357(c)(1). [Citations omitted.]

This reasoning is logically intuitive, if surprising in light of Sec. 357(c)(3)(B), in which Congress expressly legislated regarding liabilities that have created or increased basis without creating the blanket exclusion from the liabilities for such liabilities that did not yet do so. But if the argument that liabilities that would create or increase basis are excludable under a provision that excludes liabilities that give rise to deductions wins in Sec. 357(c), then it seems to follow that it would win in Sec. 108. Sec. 108(e)(2) excludes from tax the discharge of liabilities that would give rise to a deduction if paid. To the extent that this exclusion is meant to recognize the fact that the taxpayer has not yet recognized any tax benefit corresponding to the liability, then liabilities should be equally excluded to the extent the corresponding tax benefit would be basis.


Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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