A primer on cancellation-of-debt income and exclusions

Editor: Mo Bell-Jacobs, J.D.

In times of economic uncertainty, tax professionals receive more frequent questions about the ramifications of debt workouts and restructurings, including whether cancellation-of-debt (COD) income will result. After summarizing the basics of COD income, this item discusses four exclusions that are commonly used by operating businesses in this type of situation.

Generally, COD income can occur in any of the following circumstances (among others):

• Modification of a debt, as defined in Regs. Sec. 1.1001-3;
• Issuance of equity in satisfaction of debt (see Secs. 108(e)(8) and 108(e)(6));
• Acquisition of outstanding debt at a discount by a party related to the debtor, as defined in Sec. 108(e)(4);
• Issuance of a contingent value right or similar property right in satisfaction of debt;
• Discharge of the debt occurring either within or outside a bankruptcy proceeding; and
• An asset foreclosure or similar transaction satisfying the debt.

Unless specifically excluded under the tax law, COD income is taxable under Sec. 61. In the case of certain foreclosure transactions, the cancellation event could generate gain on the sale of the assets securing the debt; however, that analysis is beyond the scope of this item.

Exclusions from the general rule of COD income inclusion are found in Sec. 108. While there are several of these exclusions, this item focuses on four of them that are commonly used by operating businesses:

• The bankruptcy exclusion;
• The insolvency exclusion;
• Exclusion of COD income that would generate a tax deduction if paid; and
• Purchase-money debt reductions, as defined in Sec. 108(e)(5).

Bankruptcy and insolvency exclusions

The bankruptcy and insolvency exclusions provided in Secs. 108(a)(1)(A) and (B) operate similarly to exclude COD income. However, it is critical for a tax professional to understand several distinctions between them. Consider the following example:

Example 1: Corporation D undergoes a debt workout in which $500 million of debt is discharged in exchange for (1) new debt of $200 million, (2) cash of $50 million raised from new senior creditors, and (3) preferred equity in Corporation D of $150 million. Corporation D reports $100 million of COD income in the transaction.

Bankruptcy: If Example 1 occurred pursuant to a Title 11 bankruptcy, Corporation D may exclude the entire $100 million of COD income. This is because, if a taxpayer’s COD income event occurs in a bankruptcy governed by Title 11 of the U.S. Code, all COD income is excluded (Sec. 108(a)(1)(A)). Note that where the entity that incurred the COD income is a corporation, the exclusion applies at the corporate level. In contrast, if the entity that incurred the COD income is a partnership for income tax purposes, partners of the partnership may not exclude the COD income unless the partner is also undergoing a Title 11 bankruptcy (Sec. 108(d)(6)).

Insolvency: If Example 1 occurred in an insolvency situation, the rules would be different. A taxpayer that is insolvent immediately before a COD income event may exclude the COD income but only to the extent of the taxpayer’s insolvency (Secs. 108(a)(1)(B) and (a)(3)). The calculation for insolvency is “the excess of liabilities over the fair market value of assets” (Sec. 108(d) (3)). Although it would seem that the degree of insolvency before the COD income event can be derived from the equity value issued in the workout, that is not always the case, as illustrated by the following example:

Example 2: In Example 1, in which Corporation D incurs $100 million of COD income, it would appear that Corporation D was insolvent by at least $100 million. However, suppose that a valuation performed on Corporation D as of the date immediately after the COD income event provides an enterprise value (assets over liabilities, excluding debt) of $450 million and an equity value of $200 million. The post-transaction valuation would imply that Corporation D may have been insolvent by as little as $50 million immediately before the transaction ($450 million enterprise value less $500 million debt before the COD income event). If that is the case, only $50 million of the $100 million of COD income is eligible for the insolvency exclusion.

This example illustrates the importance of understanding valuations performed around the time of a COD income event. While beyond the scope of this item, is it reasonable to question whether the pre- and post-equity value of a corporation would change solely by the amount of COD income? In theory, the value of the assets of a business would not change as a result of debt cancellation. However, to reasonably rely upon a valuation of the business immediately after the discharge event, it may be worthwhile for a taxpayer or adviser to understand the methodologies and assumptions used in such a valuation.

As with the bankruptcy exclusion, if the debtor is an entity taxed as a partnership, the exclusion is applied at the partner level (or higher if it is a multitier partnership); the partner must therefore be insolvent to exclude COD income (Sec. 108(d)(6)). Note that in certain cases a partner may include a portion of the partnership liabilities in determining the partner’s solvency (Rev. Rul. 2012-14).

Attribute reduction: The exclusion of COD income under the bankruptcy or insolvency exclusion is generally a timing item, essentially deferring recognition of the income through a reduction in the taxpayer’s tax attributes (see Secs. 108(b) and 1017).

1. The taxpayer must reduce its attributes in the following order:
2. Net operating losses (NOLs) (a dollar for each dollar excluded);
3. General business credit (331/3 cents for each dollar excluded);
4. Minimum tax credit (331/3 cents for each dollar excluded);
5. Capital loss carryovers (a dollar for each dollar excluded);
6. Basis in property (a dollar for each dollar excluded);
7. Passive activity loss and credit carryovers (331/3 cents for each dollar excluded); and
8. Foreign tax credit carryovers (331/3 cents for each dollar excluded).

Any attribute reduction occurs after the final tax determination for the tax year of the COD income event (Sec. 108(b)(4) (A)). A taxpayer that undergoes a COD income event during the tax year may therefore utilize its NOLs or other tax attributes during the remainder of its tax year. In reducing NOLs, any current-year loss of the taxpayer is reduced first before moving to the oldest NOLs (Secs. 108(b) (2)(A) and (b)(4)(B)). Likewise, the basis in any assets disposed of after the COD income event but during the same tax year is not reduced in determining the gain or loss on the disposition.

While taxpayers generally must follow the attribute reduction order listed above, a taxpayer may make an election to first reduce its basis in depreciable property prior to reducing any other tax attributes (Sec. 108(b)(5)). Such an election could benefit a taxpayer with a significant amount of long-lived property, such as 39-year property, and that expects to utilize NOLs more quickly. A taxpayer making such an election needs to understand any Sec. 382 limitations that could limit NOL utilization following the COD income event.

Note also that where a taxpayer does not make such an election and reduces the basis in its property, the taxpayer’s property basis is not reduced below the amount of the taxpayer’s total liabilities (as of immediately after the COD income event) (Sec. 1017(b)(2)). Any excluded COD income remaining at this point does not require further attribute reduction and is often referred to as “black hole” COD income.

Example 3: Continuing with the previous example, Corporation D undergoes a debt workout in which $500 million of debt is discharged and $100 million of COD income is realized, all of which is excludable under the insolvency exclusion. Following the workout, the corporation has $250 million of total liabilities, including new debt. The corporation also has $80 million of NOLs and no other tax attributes other than an asset basis of $265 million. The corporation must reduce its NOLs to zero and must reduce its asset basis by $15 million to $250 million. The corporation does not reduce its asset basis by the full $20 million — the total amount of excluded COD income remaining after reducing its NOLs — because it does not reduce its asset basis below its total liabilities of $250 million. The remaining $5 million of COD income is excluded with no corresponding tax attribute reduction (black hole COD income).

Note also that if excluded COD income occurs within a consolidated return tax group, the taxpayer must also apply the rules of Regs. Sec. 1.1502-28 in determining attribute reduction. Broadly speaking, these rules reflect both a single-entity approach and a groupwide approach, as the attribute reduction is not limited to the tax attributes of the debtor group member that experienced the COD event.

Two other exclusions from COD income

Operating businesses commonly use other exclusions from COD income besides those for bankruptcy and insolvency. These include the following:

Exclusion of COD income that would generate a tax deduction if paid (Sec. 108(e)(2)): The discharge of liabilities that would have been deductible if the debtor had paid them is not included in gross income, nor does the discharge trigger attribute reduction. For example, if a cash-method taxpayer incurred but did not yet deduct an account payable, cancellation of the payable does not create COD income. (By contrast, if the taxpayer is on the accrual method of accounting and has already deducted an expense, cancellation of the debt creates COD income.) As another example, if a debtor did not yet deduct interest on a loan due to the applicable high-yield discount obligation (AHYDO) rules and the debt is discharged, the debtor does not realize COD income to the extent it relates to the deferred original issue discount.

Purchase-money debt reduction (Sec. 108(e)(5)): If a buyer of property issues a debt instrument to the seller in exchange for the property and the seller subsequently forgives the debt (either in whole or in part), the forgiveness results in a reduction in the basis of the purchased property rather than COD income. The statute states that this exclusion applies only to solvent debtors not in bankruptcy at the time of the COD income event. In the case of an insolvent or bankrupt partnership, however, the IRS has stated that it will not prevent the partnership from using the Sec. 108(e)(5) exclusion, provided that all the partners in the partnership adopt treatment consistent with that of the partnership (see Rev. Proc. 92-92).

Keep these exclusions in mind

Various forms of debt workouts and restructurings can trigger COD income, which results in taxable income to the debtor unless specifically excluded under Sec. 108. Two key Sec. 108 exclusions are the bankruptcy and insolvency exclusions. These exclusions operate similarly but with important differences. If a taxpayer excludes cancellation of debt from income under the bankruptcy or insolvency exclusion, the taxpayer must account for that benefit by correspondingly reducing its tax attributes.

Other situations in which COD income does not arise include where the liability discharged would have been deductible if paid by the taxpayer and in the case of a purchase-money debt reduction. Tax advisers should keep these tax considerations relating to COD income events top of mind during times of economic turmoil, when debt workouts and restructurings often occur.

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP. Contributors are members of or associated with RSM US LLP. For additional information about this item, contact Nick Gruidl, CPA, MBT (Nick.Gruidl@rsmus.com), Washington, D.C.; Joseph Wiener, J.D., LL.M. (Joseph.Wiener@rsmus.com), New York City; and Sarah Lieberman, J.D. (Sarah.Lieberman@rsmus.com), Washington, D.C.