How the COD Rules Apply to Grantor Trusts and Disregarded Entities

The IRS finalized regulations (T.D. 9771) that provide rules for determining who is the “taxpayer” for purposes of applying the Sec. 108 discharge-of-indebtedness rules to a grantor trust or disregarded entity. The final rules adopted proposed regulations issued in 2011 with few changes in response to comments (REG-154159-09).

Secs. 108(a)(1)(A) and (B) exclude discharged debt from a taxpayer’s income if the discharge occurred in a bankruptcy case or to the extent the taxpayer is insolvent when the discharge occurs. The regulations provide that, in cases involving a grantor trust or disregarded entity, for purposes of Secs. 108(a)(1)(A) and (B), “taxpayer” means the owner of the grantor trust or disregarded entity. The grantor trust or disregarded entity itself is not considered the owner.

For partnerships, the owner rules apply to the partners to whom the discharge-of-indebtedness income is allocable. If any partner is itself a grantor trust or a disregarded entity, the applicability of Secs. 108(a)(1)(A) and (B) is determined by looking through that partner to the ultimate owner of the partner. The final regulations emphasize that the case law treating the partnership as the party whose insolvency is relevant (e.g.,Gracia, T.C. Memo. 2004-147) has not been adopted as the IRS’s position.

The regulations clarify that the insolvency exception is available only to the extent that the owner is insolvent—the insolvency of the grantor trust or the disregarded entity itself is not taken into account. Similarly, the regulations clarify that the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to a bankruptcy court’s jurisdiction—if the grantor trust or disregarded entity is under a bankruptcy court’s jurisdiction and the owner is not, the exception is not available. The final regulations reject a comment suggesting different treatment and clarified that, consistent with the intent underlying the Sec. 108(a)(1)(A) bankruptcy exclusion, the owner must be under the jurisdiction of the bankruptcy court to qualify for the exclusion.

The IRS requested comments on how a multiowner grantor trust should be treated under the rules and how to determine if the debt of a disregarded entity is recourse or nonrecourse.

The regulations apply to the discharge of indebtedness income occurring on or after June 10, 2016, the date they were published as final in theFederal Register.