On July 2, 2013, the IRS issued final regulations (T.D. 9622) on the application of Sec. 108(i), providing guidance to C corporations regarding the accelerated inclusion of deferred cancellation of debt (COD) income and accelerated deduction of deferred original issue discount (OID). The regulations also cover the calculation of earnings and profits (E&P) as a result of a Sec. 108(i) election.
As a general rule, a taxpayer realizes income from discharge of indebtedness by the payment or purchase of its own obligations at less than face value (Regs. Sec. 1.61-12(a)). Sec. 108(i) was added to the Code by the American Recovery and Reinvestment Act of 2009, P.L. 111-5, which was enacted on Feb. 17, 2009, as part of an economic stimulus package in response to the Great Recession.
Sec. 108(i)(1) provides an election for deferral of the inclusion of COD income arising in connection with the reacquisition of an applicable debt instrument after Dec. 31, 2008, and before Jan. 1, 2011. An applicable debt instrument is one issued by a C corporation or any other person in connection with the conduct of a trade or business by that person (Sec. 108(i)(3)(A)). If an election is made, a taxpayer’s deferred COD income is generally includible in gross income ratably over a five-tax-year period, beginning with the taxpayer’s fourth or fifth tax year following the tax year of the reacquisition.
Sec. 108(i)(2) provides that if, as part of a reacquisition to which Sec. 108(i)(1) applies, a debt instrument is issued in exchange for the applicable debt instrument, and there is any OID with respect to the newly issued debt instrument, then no deduction is allowed to the issuer of the debt instrument for the portion of the OID that:
- Accrues before the first tax year in the five-tax-year period in which the COD income attributable to the reacquisition of the debt instrument is includible; and
- Does not exceed the COD income from the reacquisition of the debt instrument.
However, the aggregate amount of deductions disallowed is deductible ratably over the five-tax-year period in which the COD income attributable to the reacquisition of the debt instrument is includible.
A debt instrument is treated as issued in exchange for an applicable debt instrument if its proceeds are used directly or indirectly by the issuer to reacquire the applicable debt instrument. If only a portion of the proceeds from a debt instrument is used to reacquire an applicable debt instrument, the OID deduction deferral rules apply to the portion of any OID on the newly issued debt instrument that is equal to the portion of the proceeds from the instrument used to reacquire the outstanding instrument.
Sec. 108(i)(5)(D) requires that inclusion of income or deduction deferred under Sec. 108(i) is accelerated by any of several events:
- The death of the taxpayer;
- The liquidation or sale of substantially all the assets of the taxpayer (including in a title 11 bankruptcy or similar case);
- Cessation of business by the taxpayer;
- The sale, exchange, or redemption of an interest in a partnership, S corporation, or other passthrough entity by a partner, shareholder, or other person holding an ownership interest in the entity; or
- Similar circumstances.
In such a case, the deferred item of income or deduction is taken into account in the tax year in which that event occurs (or for a title 11 bankruptcy, the day before the petition is filed).
On Aug. 17, 2009, the IRS issued Rev. Proc. 2009-37, which outlined the procedures for making a Sec. 108(i) election. It also identified additional information to be disclosed on annual returns regarding the amount of deferred COD income included in gross income, the amount of deferred OID deducted, and the amount of any remaining deferred items.
On Aug. 13, 2010, the IRS published temporary regulations (T.D. 9497) and proposed regulations (REG-142800-09) in the Federal Register regarding the acceleration of deferred COD income and deferred OID deductions under Sec. 108(i)(5)(D) for C corporations, and the calculation of E&P as a result of an election under Sec. 108(i). After considering comments it received in response to the proposed regulations, the IRS issued final regulations without substantive changes.
The IRS stated in the preamble to the temporary regulations that acceleration events generally are intended to preserve collectibility of the tax liability associated with the deferral of COD income. Collection may clearly be likely to be hampered by some acceleration events, such as the death of the taxpayer. However, one statutory acceleration event, the liquidation or sale of substantially all the assets of the taxpayer, may not raise such concerns in some common instances, specifically, certain corporate nonrecognition transactions. Therefore, the regulations provide that an electing corporation in such instances will accelerate deferred COD income only if the corporation:
- Changes its tax status;
- Ceases its corporate existence in a transaction to which Sec. 381(a) (corporate reorganization by liquidation of subsidiary or stock transfer) does not apply; or
- Engages in a transaction that impairs its ability to pay the tax liability associated with its deferred COD income.
For purposes of determining an impaired ability to pay the associated tax liability under the third condition, the regulations provided a “net value acceleration rule.” Under this rule, an electing corporation generally is required to accelerate all of its remaining deferred COD income if it engages in an impairment transaction (a volitional transaction that reduces an electing corporation’s asset base), and immediately after the transaction, the gross value of the electing corporation’s assets is less than 110% of the sum of its total liabilities and the tax on the net amount of its deferred items.
In addition to the mandatory acceleration provisions, the regulations contain an election provision under which an electing member of a consolidated group (other than the common parent) may at any time accelerate in full the inclusion of its remaining deferred COD income with respect to all applicable debt instruments. The preamble to the temporary regulations stated that allowing this provision is consistent with other consolidated return provisions that mitigate the double taxation of income or gain. With regard to E&P, the regulations provided that COD income generally increases E&P in the tax year it is realized, and deferred OID deductions generally decrease E&P in the tax year in which they would be allowed without regard to the deferral rules of Sec. 108(i).
For purposes of the OID rules under Sec. 108(i)(2), if the proceeds of any debt instrument are used directly or indirectly by the issuer or a person related to the issuer to reacquire an applicable debt instrument, the debt instrument shall be treated as issued for the applicable debt instrument that is being reacquired. The regulations list three circumstances in which the proceeds of an issuance of a debt instrument will be treated as being used indirectly to reacquire an applicable debt instrument.
The regulations also provide guidance for C corporations and deferred OID. Under the regulations, all or a portion of a C corporation issuer’s deferred OID deductions with respect to a debt instrument are taken into account to the extent that an electing entity or its owners include all or a portion of the deferred COD income to which the C corporation issuer’s deferred OID deductions relate. In addition, a C corporation issuer is required under the regulations to accelerate its remaining deferred OID deductions even though the deferred COD income to which it relates continues to be deferred if the issuer (1) changes its tax status or (2) ceases to exist in a transaction to which Sec. 381(a) does not apply.
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.