Shareholder’s forgiveness of insolvent corporation’s debt

Jeff Borghino, CPA, Washington, D.C.

Editor: Greg A. Fairbanks, J.D., LL.M.

A debt cancellation or forgiveness by a corporation's shareholder is a common transaction. Despite the prevalence of these transactions, some critical tax consequences are uncertain, including the determination of any income from the cancellation of debt (COD income) under certain circumstances. Recently, the IRS concluded in Letter Ruling 202112003 (March 26, 2021) that an insolvent corporation should determine whether it had any COD income by applying Sec. 108(e)(6), which addresses the effect of a shareholder's forgiveness of a corporation's indebtedness. In the letter ruling's analysis, it made no difference in determining the effect of the shareholder's debt forgiveness whether the corporation was insolvent. This was a noteworthy ruling because the IRS had reached a different conclusion in the past on similar facts involving a shareholder's cancellation of an insolvent corporation's indebtedness. This item first summarizes the relevant Code provisions, then looks at past IRS guidance on this issue, and finally discusses Letter Ruling 202112003.


Sec. 61(a)(11) provides the general rule that gross income includes income from cancellation of debt except as provided by law. If a debtor repurchases a debt instrument for an amount less than its adjusted issue price (within the meaning of Regs. Sec. 1.1275-1(b), the debtor realizes COD income (Regs. Secs. 1.61-12(c)(2)(ii)).

Under Sec. 108(a), a taxpayer's gross income does not include COD income in certain circumstances. One example is when the discharge occurs and the taxpayer is insolvent (the insolvency exception). The amount excluded under the insolvency exception must be applied to reduce the taxpayer's tax attributes as specified under Sec. 108(b).

In general, if a shareholder gratuitously forgives debt owed by a corporation, the transaction constitutes a contribution to the capital of the corporation to the extent of the principal of the debt (Regs. Sec. 1.61-12(a)). Sec. 108(e)(6), the key provision in the present discussion, further provides that if a debtor corporation acquires its debt from a shareholder as a contribution to capital: (1) Sec. 118, which concerns contributions to the capital of a corporation, does not apply; and (2) such debtor corporation is treated as having satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the debt.

The legislative history indicates that to fall within the scope of Sec. 108(e)(6), the shareholder's action in canceling the debt must be related to their status as a shareholder. If the shareholder-creditor acts merely as a creditor attempting to maximize the satisfaction of a claim, the cancellation of debt is not treated as a capital contribution. For example, if the stock and bonds of a corporation are publicly held, and the creditor also happens to be a shareholder, the cancellation of indebtedness on the exchange of the bonds for stock is not treated as a contribution to capital by a shareholder for purposes of Sec. 108(e)(6) (S. Rep't No. 96-1035, 96th Cong., 2d Sess., at 19, note 22 (Nov. 25, 1980)).

Past guidance

To some extent, there has been uncertainty regarding whether a voluntary cancellation of a debt by a shareholder still constitutes a contribution to capital that does not create COD income to the extent that a canceled debt is worthless. The IRS and the courts have touched on the matter on several occasions.

In Letter Ruling 5411085730A (Nov. 8, 1954), the IRS ruled that a cancellation of a worthless debt by the shareholders of a corporation did not constitute a gratuitous cancellation because "there is nothing to forgive." A few years later, the Tax Court held in Mayo, T.C. Memo. 1957-9, that a shareholder's forgiveness of a corporation's debt was not a contribution to the corporation's capital because the corporation remained "hopelessly insolvent" after the cancellation.

However, the Second Circuit in Lidgerwood Manufacturing Co., 229 F.2d 241 (2d Cir. 1956), cert. denied, 351 U.S. 951 (1956), held that a parent corporation's cancellation of its subsidiary's debt was a capital contribution, which precluded the parent's bad debt deduction, even when the corporation remained insolvent after the cancellation. The court stated:

[E]ven on the assumption that the debtors were insolvent after as well as before the cancellations, wiping out the debts was a valuable contribution to the financial structure of the subsidiaries. . . . Where a parent corporation voluntarily cancels a debt owed by its subsidiary in order to improve the latter's financial position so that it may continue in business, we entertain no doubt that the cancellation should be held a capital contribution. [229 F.2d at 243]

In more recent guidance, the IRS concluded in Field Service Advice (FSA) 199915005 that Sec. 108(e)(6) applied only to the extent that the debtor corporation became solvent. As will be discussed, this result appears to conflict with Letter Ruling 202112003. In the 1999 FSA, a corporation, FP, canceled the debt of its subsidiary, S1, when S1 was insolvent. The IRS stated:

In the case of debt that is canceled, the value of a debtor corporation increases by the amount by which the corporation becomes solvent as a result of the debt that is canceled. In the instant case, the value of S1 only increased by the amount by which S1 became solvent as a result of FP's cancellation of S1's indebtedness owed to FP. As a result, we believe FP made a capital contribution of debt to S1 only to the extent S1 became solvent as a result of FP's cancellation of the debt. [emphasis added]

The IRS concluded that S1 determined there was COD income under Sec. 108(e)(6) for the portion of the debt that was a capital contribution. However, the IRS also concluded that S1 had COD income related to the amount of the canceled debt that was not a capital contribution; and S1 had to reduce tax attributes under Sec. 108(b) by the amount of excluded COD income under the insolvency exception.

Letter Ruling 202112003

In Letter Ruling 202112003, the IRS reached a conclusion that seems inconsistent with the 1999 FSA. In the facts of the letter ruling, a foreign corporation (FSUB 1) directly owned all of the interests in a disregarded entity, FDRE 1, and FDRE 1 in turn owned all of the interests in another disregarded entity, FDRE 2. FDRE 2 directly owned all of a U.S. corporation, Parent. Parent was the common parent of a consolidated group (the Parent Group).

FSUB 1 held certain notes issued by Parent that were represented by the taxpayer to be debt for U.S. federal income tax purposes. Other members of the Parent Group were co-obligors on the notes.

Since the issuance of the notes, Parent's business experienced a significant deterioration. Parent and the Parent Group were likely insolvent as a result of the outstanding notes.

The taxpayer in the letter ruling proposed that FSUB 1 would gratuitously forgive a portion of the notes and that FSUB 1 intended that the Parent Group would be solvent following such forgiveness.

The IRS ruled that Sec. 108(e)(6) applied to the note forgiveness. Under that Code section, Parent recognized COD income to the extent, if any, that the adjusted issue price of the forgiven notes exceeded FSUB 1's adjusted basis in them. Notably, the IRS did not conclude that the insolvency of the debtor affected the outcome as it had in FSA 199915005. In other words, the note forgiveness was treated as a capital contribution despite the fact that Parent became solvent as a result of the debt forgiveness.


Letter Ruling 202112003 confirms to taxpayers and practitioners that the IRS may apply Sec. 108(e)(6) entirely despite the fact that the debtor was insolvent immediately before the cancellation. The IRS has ruled consistently with Letter Ruling 202112003 at least once prior, but that ruling preceded FSA 199915005 (seeLetter Ruling 8844032). The recent letter ruling is noteworthy because it reaches a different conclusion from FSA 199915005 despite similar facts.

It remains prudent for taxpayers and practitioners to carefully assess their circumstances in evaluating whether Sec. 108(e)(6) may apply. Notwithstanding the IRS ruling in Letter Ruling 202112003, the extent of the debtor corporation's insolvency may matter in determining whether Sec. 108(e)(6) applies. For example, doubt remains whether Sec. 108(e)(6) applies in circumstances similar to Letter Ruling 5411085730A and Mayo when the debtor continues to be "hopelessly insolvent" after the cancellation.

Recent rulings related to Sec. 108(e)(6) have included a taxpayer representation that the contributed debt had a positive fair market value (FMV) at the time of the contribution (e.g., Letter Ruling 201016048 and Letter Ruling 200537026). If a debtor corporation remains "hopelessly insolvent" after a debt cancellation by its shareholder, it may be less likely that a canceled debt had a positive FMV.


Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Contributors are members of or associated with Grant Thornton LLP.


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