The check-the-box regulations (Regs. Secs. 301.7701-1 through 301.7701-3) were promulgated over 20 years ago, in December 1996. Although taxpayers and practitioners alike may take for granted the relative simplicity of entity classification offered by these regulations, they inadvertently add complexity—or, as discussed in this item, highlight existing complexity—in other areas of the tax law.
One example of highlighted complexity is in the interaction of the special rules under Sec. 108 related to cancellation-of-debt (COD) income and the prevalence of disregarded entities as debtors in lending transactions. On April 13, 2011, Treasury issued Prop. Regs. Sec. 1.108-9 (REG-154159-09) to provide some guidance in this area. On June 10, 2016, the IRS published final regulations (T.D. 9771) that adopt, with slight changes, the proposed regulations.
This item explores the underlying federal income tax issues that accompany disregarded entities acting as borrowers in lending transactions and explains some of the provisions of the final regulations. In addition, this item discusses some remaining ambiguity in this area of the tax law for recourse vs. nonrecourse liabilities and how that ambiguity may dramatically affect the tax liability of a given taxpayer.
Discharge Is Income (Generally)
Generally, when an unrelated lender discharges the indebtedness of a borrower for an amount less than its face value, the borrower must recognize COD income equal to the difference. This was originally established as common law in Kirby Lumber Co.,284 U.S. 1 (1931), and is codified under Sec. 61(a)(12).
Sec. 108 provides exceptions to the general rule of Sec. 61(a)(12). Perhaps chief among these, and most relevant to this item, are the bankruptcy exception and the insolvency exception under Secs. 108(a)(1)(A) and (B), respectively. When Congress wrote these exceptions in the Bankruptcy Tax Act of 1980, P.L. 96-589, it intended to preserve a taxpayer's "fresh start" by not imposing a tax burden precisely at the time when a taxpayer is unable to pay either the indebtedness or an associated tax on its discharge (S. Rep't No. 1035, 96th Cong., 2d Sess. 9-10 (1980)).
Though the bankruptcy exception and the insolvency exception provide for a current exclusion of COD income, the tax liability reduction may not be permanent. If a taxpayer qualifies for either of these exceptions, it is required to reduce its tax attributes (i.e., net operating losses, tax credits, asset basis, etc.) by applying the rules provided under Sec. 108(b) and Regs. Sec. 1.108-7. The reduction of the taxpayer's attributes may effectively convert the exclusion into a deferral, conceivably far enough into the future as to not hinder the taxpayer's fresh start.
To qualify for the bankruptcy exception, the statute first requires the presence of three factors:
- Sec. 108(a)(1)(A) provides that the debt in question must be discharged in a Title 11 case;
- Sec. 108(d)(1) provides that the debt in question is either a debt for which the taxpayer is liable or a debt that is subject to property that the taxpayer holds; and
- Sec. 108(d)(2) provides that the taxpayer must be "under the jurisdiction of the court" in a Title 11 case.
The final regulations add another wrinkle in the context of grantor trusts and disregarded entities by requiring that the debt discharged in the Title 11 case be that of the owner of the grantor trust or disregarded entity (i.e., the owner must also be a borrower). This regulatory provision is discussed further below.
To qualify for the insolvency exception, Sec. 108(a)(1)(B) requires that the discharge occur when the taxpayer is insolvent. The term "insolvent" for purposes of Sec. 108 is defined in Sec. 108(d)(3) as the excess of liabilities over the fair market value (FMV) of assets immediately before the debt is discharged. It is important to note that the term "liabilities" in Sec. 108(d)(3) is not defined in the statute or regulations. However, the IRS's ruling in Rev. Rul. 92-53, which is also discussed further below, provides some clarity on its meaning. Finally, Sec. 108(a)(3) limits the amount excluded under the insolvency exception to the amount of the insolvency as determined immediately before the discharge.
The Final Regulations
Consistent with the proposed regulations, the final regulations provide that for purposes of applying Secs. 108(a)(1)(A) and (B) to COD income of a grantor trust or a disregarded entity, neither the grantor trust nor the disregarded entity shall be considered the taxpayer. Rather, the owner of the grantor trust or the disregarded entity should be considered the taxpayer. Also, the final regulations provide that neither a grantor trust nor a disregarded entity should be considered an owner of another grantor trust or disregarded entity.
A "grantor trust" for purposes of the final regulations is defined as any portion of a trust that is treated under Secs. 671 through 679 as being owned by the grantor or another person. In addition, a "disregarded entity" for purposes of the final regulations is defined as an entity that is disregarded as separate from its owner for federal income tax purposes. Examples of disregarded entities include a domestic single-member limited liability company that does not elect to be classified as a corporation for federal income tax purposes under Regs. Sec. 301.7701-3, a corporation that is a qualified real estate investment trust subsidiary within the meaning of Sec. 856(i)(2), and a corporation that is a qualified subchapter S subsidiary within the meaning of Sec. 1361(b)(3)(B).
To apply the insolvency exception of Sec. 108(a)(1)(B) to a grantor trust or disregarded entity, the final regulations provide that the exclusion of COD income is available only to the extent that the owner of the grantor trust or disregarded entity is insolvent. Therefore, if the grantor trust or disregarded entity is insolvent, but the owner is not, the insolvency exception is not available.
Finally, for purposes of applying the bankruptcy exception of Sec. 108(a)(1)(A) to a grantor trust or disregarded entity, the final regulations provide that the exclusion of COD income is only available if the owner of the grantor trust or disregarded entity is under the jurisdiction of the court in a Title 11 case as the Title 11 debtor.
This clarification that the owner must be a borrower of the debt under the jurisdiction of the court is the most significant difference from the proposed regulations. The preamble to the final regulations explains that this is consistent with the intended purposes of Sec. 108(a)(1)(A). The preamble cites the following excerpt from the legislative history:
The rules of the [Bankruptcy Tax Act of 1980] concerning income tax treatment of debt discharge in bankruptcy are intended to accommodate bankruptcy policy and tax policy. To preserve the debtor's "fresh start" after bankruptcy, the bill provides that no income is recognized by reason of debt discharge in bankruptcy, so that a debtor coming out of bankruptcy (or an insolvent debtor outside bankruptcy) is not burdened with an immediate tax liability. [T.D. 9771, quoting S. Rep't No. 1035, 96th Cong., 2d Sess. 9-10 (1980)]
Treasury contends that Congress, in the above excerpt, was referring to "debtor" as that term is defined in Title 11—a person or municipality concerning which a case under Title 11 has been commenced. Further, Treasury believes that Congress did not intend to give a "fresh start" to a solvent owner of a grantor trust or disregarded entity that has committed some but not all of its nonexempt assets to the bankruptcy court's jurisdiction. The exceptions under Sec. 108, Treasury argues, should not be available to a taxpayer "merely by virtue of having some of its assets subject to the jurisdiction of the bankruptcy court."
This last comment by Treasury articulates the dilemma that exists in applying debt-related rules such as the bankruptcy exception and the insolvency exception in the context of grantor trusts and disregarded entities. When a liability is housed in a separate legal entity that is regarded for state law purposes but not for federal income tax purposes, how should these rules be interpreted when their standards are met nominally but the economic substance and their underlying intent are not?
Recourse vs. Nonrecourse
Although the guidance in the final regulations is helpful, additional issues remain for recourse and nonrecourse debt of a grantor trust or a disregarded entity. Distinguishing between recourse and nonrecourse liabilities may be critical in determining the tax impact that the discharge of indebtedness has on a borrower. Not only is it a factor in determining the extent to which the insolvency exception applies, it also has implications regarding the character of the income that must be recognized (when applying the rules of Regs. Sec. 1.1001-2 upon the exchange of secured property—a discussion of these rules is beyond the scope of this item).
A nonrecourse liability absolves a debtor from personal liability when default on that liability occurs. In other words, the lender of a nonrecourse liability can only foreclose (or receive voluntarily) the property securing that particular liability and cannot seize other assets of the borrower to satisfy the debt. In contrast, a lender of a recourse liability has the power to foreclose all of the assets of the borrower to satisfy the debt. Thus, if a borrower of a nonrecourse liability that is "underwater" is only at risk of economic loss to the extent of the lower FMV of the property securing the associated debt, should the excess nonrecourse liability amount (i.e., the amount of liability that exceeds the FMV of the secured asset) be considered a liability of the borrower?
As mentioned above, the meaning of the term "liabilities," as used under Sec. 108(d)(3) in the application of the insolvency exception, is not defined by the statute or regulations. Prior to the IRS's ruling in Rev. Rul. 92-53, it was uncertain what the IRS's position was about the use of nonrecourse liabilities when measuring insolvency. In Rev. Rul. 92-53, the IRS published its position, establishing that, when measuring insolvency, the following two principles apply to nonrecourse liabilities:
- Nonrecourse liabilities are always taken into account to the extent of the FMV of the property securing the nonrecourse liabilities; and
- In addition to the amount determined in the first principle, the excess nonrecourse liability amount is taken into account only to the extent that the nonrecourse liabilities are discharged.
Situation 1 in Rev. Rul. 92-53 is the baseline case in illustrating these principles. In Situation 1, the taxpayer issues a $1 million nonrecourse note secured by a building worth an equal amount. In addition, the taxpayer has other assets worth $100,000 and a $50,000 recourse note. Later, when the building declines in value to $800,000, the note is modified by reducing the principal to $825,000. In this instance, the excess nonrecourse liability amount is $200,000 (the $1 million original face amount less the $800,000 FMV of the building); the nonrecourse liability discharge is $175,000 (the $1 million original face amount less the $825,000 modified principal amount); therefore, the insolvency is measured as $125,000 (the liabilities consisting of the $50,000 recourse note plus the amounts established using the two principles enumerated above—the $800,000 FMV of the property plus the $175,000 portion of the excess nonrecourse liability that is discharged—less the FMV of the properties—$800,000 and $100,000). As a result, the taxpayer in this instance must recognize $50,000 of COD income (the $175,000 total discharge less the $125,000 insolvency).
Though Rev. Rul. 92-53 is a long-standing authority, there is inherent uncertainty in its application where the borrower of a recourse liability is a grantor trust or a disregarded entity. In such a case, the lender's only remedy exists with respect to the assets of the disregarded entity. If the regarded owner does not provide credit support (e.g., a guarantee), the recourse liability of the disregarded entity is arguably, in substance, a nonrecourse liability of the regarded owner. The lender's only remedy exists with respect to those specific assets owned by the disregarded entity, which for federal income tax purposes, are viewed as being owned by the regarded owner.
To illustrate the impact that the determination of a debt's classification as recourse or nonrecourse has, consider a hypothetical modification to Situation 1 of Rev. Rul. 92-53—the $1 million note is a recourse debt rather than a nonrecourse debt. If that were the case, the taxpayer's measure of insolvency would be $150,000 (the liabilities of $1 million and $50,000 less the $900,000 FMV of the properties). As a result, the taxpayer would recognize only $25,000 of COD income by excluding, under Sec. 108(a)(1)(B), $150,000 of the $175,000 amount discharged.
In the preamble to the final regulations, Treasury stated that it is beyond the scope of the final regulations to provide guidance whether a recourse liability of a grantor trust or disregarded entity is considered recourse or nonrecourse debt with respect to the regarded owner for purposes of applying the insolvency exception. In addition, Treasury stated that it is beyond the scope of the regulations to provide guidance regarding whether debt of a grantor trust or disregarded entity is considered debt of the regarded owner for Sec. 108 purposes.
Treasury did state in the preamble, however, that it is the view of Treasury and the IRS that debt of a grantor trust or a disregarded entity is debt of the owner for purposes of Sec. 108, and recourse debt of a grantor trust or disregarded entity that is not guaranteed by the regarded owner should generally be treated as nonrecourse debt for purposes of applying the insolvency exception. Treasury also stated its view is that the principles of Rev. Rul. 92-53 apply in determining the extent to which the debt should be taken into account in determining the owner's insolvency under Sec. 108(d)(3). Although taxpayers cannot rely on these concessions as legal authority, they do indicate the views of Treasury and the IRS and, therefore, are helpful for taxpayers that are working through these issues.
One final consideration is that although Treasury's position as stated above seems to be the generally correct answer, consider a situation where a regarded owner's only assets are 100% of the equity interests of a disregarded entity, and the disregarded entity issues a recourse note. In this instance, all of the assets of the regarded owner are subject to the recourse note, and, arguably, the recourse nature of the liability should be respected.
As illustrated by this item, a great deal of uncertainty still remains around the appropriate treatment by a regarded owner of its disregarded entity's recourse indebtedness. Though Treasury and the IRS have requested comments on these discrete issues, it is unknown when or if guidance is forthcoming. One thing that is known, however, is taxpayers and practitioners dealing with these issues will be eagerly awaiting its arrival.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.