Discharge of Indebtedness Rules Clarified for Grantor Trusts and Disregarded Entities

On April 12, the IRS issued proposed regulations (REG-154159-09) that provide rules regarding who is the “taxpayer” for purposes of applying the Sec. 108 discharge of indebtedness rules to a grantor trust or disregarded entity.

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 proposed regulations provide that, in cases involving a grantor trust or disregarded entity, for purposes of Secs. 108(a)(1)(A) and (B) “taxpayer” would mean the owner of the grantor trust or disregarded entity. The grantor trust or disregarded entity itself would not be considered the owner.

For partnerships, the proposed regulations provide that the owner rules would apply to the partners to whom the discharge of indebtedness income is allocable. If any partner is itself a grantor trust or disregarded entity, the applicability of Secs. 108(a)(1)(A) and (B) would be determined by looking through that partner to the ultimate owner of the partner.

The proposed regulations clarify that the insolvency exception is available only to the extent that the owner is insolvent—the insolvency of the grantor trust or disregarded entity itself is not taken into account. Similarly, the proposed 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 proposed regulations would be effective on or after the date they are finalized.

The IRS has asked for comments regarding the proposed rules; comments can be submitted electronically at www.regulations.gov.