1

New Haven

London

Greenwich

New York

Geneva

Hong Kong

Milan

Understanding the Complex Tax Consequences of Debt Discharge

Sanford J. Davis, Esq.

November 2, 2010

Overview of Issues…• What is Cancellation of Debt (COD) Income?

• IRC § 61 – recourse and non-recourse debt

• Actual and deemed debt exchanges of debt instruments

• Cash and property settlements

• Is the COD Income Excluded From Income by Statute?• Panoply of statutory exclusions (§ 108(a)) and exceptions (§ 108(e))

• Ordering Rules

• Required Attribute Reduction and elective basis reduction

• New Section 108(i) Election Apply to Defer COD Recognition?

• Should you elect?

• Consequences

• Reporting Requirements • IRC § 6050P for creditor and Form 982 for debtor

2

COD Income Defined and Taxability

• US v Kirby Lumber Co., 284 US 1931• When a company settles its debt for less than the face amount a

taxable gain has occurred

• Commissioner v Glenshaw Glass Company 384 US 426 (1955)• Any undeniable accession to wealth

• Clearly realized

• Over which the taxpayer has dominion

• IRC § 61(a)(12)• Specifically includes COD Income as an item of gross income

3

2

Cancellation of Debt Giving Rise To COD --Recourse vs. Nonrecourse Debt

• Recourse – Personally Liable• COD income realized if debt forgiven

• Non-Recourse – No Personal Liability • Debt is secured by an asset that is transferred

• Income does not arise under COD income provisions

• Debt included in amount realized on disposition of property

• Commissioner v. Tufts 461 U.S. 300 (1983)

• Amount realized included entire balance of debt even if in excess of value of property

4

Recourse Debt - Gain or Loss on Disposition

• Transfer of property to the creditor/lender in full or partial satisfaction of the debt, may result in gain or loss on the disposition of the property and COD income

• Taxpayer is treated as satisfying an amount of debt equal to the value of the property transferred

• COD income arises to the extent that debt exceeds FMV of property

5

Recourse Debt – Case 1

• B has $1,000,000 of outstanding recourse debt on a loan from C.

• B’s financial situation has declined and C accepts real estate worth $900,000 in full satisfaction of the debt.

• $100,000 of COD Income results to B ($1 MM - $900 K)

• Assuming B’s adjusted basis in the real estate were $1.2M, purchased at the market peak in 2006, B would recognize a $300K loss

• Alternatively, if B’s adjusted basis is $300,000, then B would recognize a $600 K gain on the deemed sale

6

3

Non-Recourse Debt – Case 2

• SB borrows $1,000,000 from C on a non-recourse basis. When B’s financial situation deteriorates, C accepts real estate worth $900,000 in full satisfaction of the debt.

• If B’s basis in the real estate were $500 K, B would not recognize any COD income

• B would recognize a $500 K gain on the deemed sale of the real estate under Tufts – i.e., amount realized equals entire non-recourse debt even if higher than property FMV

• In the case of non-recourse debt FMV of property is not relevant to tax consequences

7

Recourse Debt vs.Non-Recourse Debt –Other Factors

• Gain or loss may be capital or ordinary to Debtor depending on the nature and use of the property and long or short-term depending on holding period

• Allocating income from gain on deemed sale and COD • FMV of property will determine how much COD Income arises

• Where COD meets exclusion under IRC § 108 (discussed below), Debtor may wish to assign a lower value to property to minimize gain on sale and increase COD Income

• Where no COD exclusion, Debtor may want high value converting COD income to capital gain on sale

8

When Is Debt Cancelled or Discharged

• Settlements in cash or cash and property transfers for less than the debt amount

• Debt Modification under IRC § 1001 • Parties either exchange new debt for old debt or merely

modify portions of existing debt instrument (DI)

• Issue price of the new or deemed DI is less than outstanding balance of the old DI (measured by adj. Issue price)

• Debt discharged in bankruptcy when plan is approved

4

Deemed Debt Exchanges Via Modifications

If restructuring significantly modifies existing debt, newdebt/equity is deemed exchanged for old debt. Reg. § 1.1001-3.

Regulations general test is whether modification is economicallysignificant based on all facts and circumstances.

Specific Rules

• Change in yield

• Change in timing

• Change of obligors

• Change in security

• Change in nature of debt instrument

Deemed Debt Exchanges Via Modifications (continued)

Changes pursuant to an instrument's original terms are not modifications, except:

• Changes in obligor or recourse nature of instrument.

• Changes transforming debt into equity (other than pre-wired

conversions).

Exercises of unilateral options are not modifications (but unilateral options do not exist in workouts).

Exclusions From Cancellation of Indebtedness (COD) Income

• Bankruptcy – title 11 case (Chapters 7, 11, 12 and 13)

• Insolvency – to the extent of the debtor’s insolvency immediately before the COD Event (tested by fair market value standard)

• Qualified Real Property Business Indebtedness (QRPBI) of Non-C corps

• Debt incurred to acquire, construct or substantially improve real property

• Realty must secure the discharged liability

• Elective method // exclusion limited by complex formula

• Utility to non-C corp outside insolvency or bankruptcy

• Qualified Farm Indebtedness (QFI)

• Qualified Principal Residence Indebtedness (QPRI)

• COD Exceptions Applied to Partnerships (P/S) at Partner Level

• Consolidated Group – exceptions apply per group member

5

Insolvency Exclusion – IRC § 108(a)(1)(B)

• Taxpayer can exclude COD Income only to the extent that the taxpayer is insolvent at the time the COD Income is realized –IRC § 108(a)(3)

• Liability and asset valuations are determined immediately beforethe cancellation of debt event

• Amount of liability is adjusted issue price of debtExempt assets are NOT excluded from the calculation Is not an election, so timely filing Form 982 not required

Qualified Real Property Business Indebtedness – 108(a)(1)(D)• Debt was incurred or assumed in connection with real

property used in a trade or business

• Debt is secured by the real property

• Proceeds used to acquire, construct, reconstruct or substantially improve the real property

• Or debt incurred before 1993

• Taxpayer elects to apply this exclusion

• Limits based on the value and adjusted basis of the property

• Not available to C corps

14

Qualified Principal Residence Indebtedness – IRC §108(a)(1)(E) and 108(h)

• Enacted in 2007 -- extended to discharges through 2012

• Maximum of $2 M can be excluded ($1 M if married single filer)

• Must be “qualified acquisition indebtedness” or QAI• Debt incurred in acquiring, constructing or substantially improving a

principal residence, AND

• Secured by the principal residence

• Principal residence defined by IRC § 121 gain exclusion

• COD must relate to either decline in the residence’s value or decline in the taxpayer’s financial situation

• Includes refinanced debt to extent of original QAI

6

• COD Exclusion Rules of Priority• Bankruptcy preempts all other exceptions

• Insolvency pre-empts QFI and QRPBI to extent of insolvency

• QFI and QRPBI can be used after insolvency to COD Income balance

• COD Income Exception Attribute Reduction – Order of Priority• NOLs for year of COD and then prior year NOLS

• Tax credits (General business and minimum tax)

• Capital loss carryovers

• Basis of Taxpayer property

• Passive activity loss (PAL) and credit carryovers

• Foreign Tax Credit (FTC) carryovers

IRC § 108 – Select COD Income Issues – Priorities and Attribute Reduction

IRC § 108–Select COD Income Issues – Attribute Reduction

• Attribute Reduction // Timing –• Occurs after determination of tax for Tax Year of COD income event

• Taxpayer can use tax attributes such as NOLs to offset non-COD Income or COD Income not eligible for COD Income Exclusion (I.e., before attribute reduction)

• Form 982 Election To First Reduce Asset Basis –• Valuable tool to preserve current utility of NOLs

• Regular basis reduction (absent Form 982 election) is limited toexcess of aggregate basis of properties over aggregate liabilities

• Permits basis reduction to zero – no floor

• Partner-Level Basis Reduction – P/S interest is treated as “depreciable” to extent of pro rata share of underlying P/S depreciable property

IRC § 108(e) – Other Exclusions From COD Income

• (e)(6) – Contribution To Capital

• Permits existing shareholder that holds debt instrument to contribute to the capital of the corporation

• Tax-free to extent of tax basis in the contributed debt

• (e)(5) – Purchase Price Reduction

• Seller financing may be restructured provided debtor is not in aTitle 11 case or insolvent.

• Treated as a purchase price adjustment

• (e)(8) – Corp or P/S Equity For Debt – unlike (e)(5) driven by FMV

• (e)(9) – Debt for Equity Exchange

• Tax-free to extent of FMV of equity (stock or LLC interest)

• Debt is deemed satisfied with $

7

IRC § 108(e)(10) and Deemed Exchanges –

• (e)(10) – Debt for Debt Exchanges

• Old debt is treated as satisfied to extent of issue price of newdebt

• Will result in both COD on old debt and OID on the new debt

• Issue price determined by OID rules - private and public instruments

• (e)(10) – Deemed Debt Exchanges

• Modifications of material terms of debt instrument will be deemed a debt-for-debt exchange triggering potential COD and OID issues.

• Extensive regulations on when a material modification results ina deemed exchange

• (e)(4) – Purchase of Debt By Party Related To Debtor

• Triggers COD as if debt retired directly; debt deemed reissued from debtor to RP.

Discharge of Deductible Items –IRC § 108(e)(2)

• No COD Income from discharge of debt to the extent that payment of the discharged debt would be deductible (e.g. business interest owed by a cash method taxpayer)

• Not applicable to an accrual method taxpayer who has already taken the deduction

• Caveat: may apply to accrual basis taxpayer if no tax benefit under if no tax benefit from the deduction under IRC § 111 tax benefit rule == but an unused NOL is not within this rule

21

2009 Deferral of COD Income – IRC § 108(i)• Only applies to debt issued by C corps or in connection with the

conduct of a trade or business• Discharge must take place during 2009 or 2010• Must be a “qualifying reacquisition”

• Cash purchase, debt for debt, debt for equity, contribution to capital or total forgiveness

• COD Income taken into income ratable for 5 years starting in 2014

• Cannot deduct OID on the replacement debt until pick up the COD Income on the retirement of the original debt

• Provision is elective• Original guidance via Rev. Proc. but various temporary and

proposed regs now issued

8

IRC § 108(i) – Flexibility For Partnerships

• Rev. Proc. 2009-37 provides two very liberal rules• Partial Election Concept -- flexible utilization of COD

Exclusions in conjunction with IRC §108(i) neither reflected in statute nor envisioned by legislative history

• Allows partnerships to “allocate” to each partner a COD “deferred income” amount and tailor partner-level treatment to suit their needs and objectives

IRC § 108(i) – Flexibility Within Partnership• Partnership Allocation Process -- Deferral Mechanics

• Deferred COD Income may be recognized in disproportionate amounts relative to allocable share of COD Income

• Sounds like a “special allocation” of income but not truly – rather in effect a partner-level partial IRC §108(i) election relative to regular COD Income allocations

• e.g., Partner with 5% profits interest does not defer recognition of any allocable share of the COD income while Partner with 50% interest may defer a portion of the COD income allocable to it (e.g., 1/5th) and currently realize the balance (or 4/5ths) of its COD Income allocation

• P/S must (I) compile all the requested IRC §108(i) election preferences from each Partner and (ii) determine the aggregate or effective deferral percentage – this becomes the P/S-level election percentage (per Applicable Debt Instrument)

IRC § 108(i) – Acceleration of COD Income

• Acceleration of IRC 108(i) Deferred Amount – upon certain events

• Death

• Liquidation or sale of substantially all of the taxpayer’s assets

• Cessation of business

• Sale or exchange and redemption of a P/S interest – a purchaser of an interest does not realize as taxable income the transferor’s COD deferred amount (though it would be reflected in transferee’s capital account)

9

Attribute Reduction

• What happens when COD Income is Excluded Under the Bankruptcy or Insolvency Exclusions?

25

Attribute Reduction - IRC § 108(b)• If COD Income is excluded under IRC § 108(a), then the

debtor generally must reduce tax attributes under IRC §108(b) in the following order:

• Net operating losses

• General business credits

• AMT credits

• Capital loss carryovers

• Basis of assets

• Passive activity loss carryovers

• Foreign tax credits

• Reduction of NOLs, capital losses, PALs and asset basis is $-for-$

• Credit reduction is 33.33 cents per dollar of COD exclusion

26

Attribute and Basis Reduction Rules• Partner-Level Basis Reduction – P/S interest is treated as “depreciable”

to extent of pro rata share of P/S depreciable property • Partnership must agree to reduce the “inside” basis of its assets

• Form 982 Election To First Reduce Asset Basis – IRC § 108(b)(5)• Valuable tool to preserve current utility of NOLs

• Regular basis reduction absent Form 982 election is limited to excess of aggregate basis of properties over aggregate liabilities

• Form 982 election permits basis reduction to zero – no floor (compare QRPBI)

• Attribute Reduction // Timing –• Occurs after determination of tax for Tax Year of COD income event

• Taxpayer can use tax attributes such as NOLs to offset non-COD Income or COD Income not eligible for COD Income Exclusion

27

10

Allocation of Basis Reduction Among Assets – IRC § 1017

• Can elect to reduce basis of depreciable property before reducing attributes such as net operating losses and capital loss carryovers

• Spreads the loss of tax benefits over depreciation period rather than immediately eliminating tax attributes that might offset large amounts of income in years immediately following the discharge

28

Reporting Rules

• IRC § 6050P• Lenders must report COD Income over $600

• Use Form 1099-C

29

Reporting Rules

• Form 982• Reports exclusion of COD Income

• Reports attribute reductions

• Make elections regarding which exclusions to use and ordering of attribute reduction

30