It’s one of those moments that just makes you feel good, when a creditor says it’s ready to forgive some or all of what you owe. But some owners don’t feel quite so good a few months later, when they get hit with a tax bill. The IRS generally treats forgiven debt as taxable income, so get a handle on the tax rules first and factor that in when you decide what sort of deal to negotiate. At Delancey Street, we negotiate with merchant cash advance funders, lenders and other business creditors on behalf of struggling owners. What we can do to ease the tax pain is educate our clients so they know what’s coming and can make smart decisions. The good news for a business that is already underwater is that the tax code offers four exclusions that can keep forgiven debt off the tax bill.
There’s a concept in the tax code called cancellation of debt, and it has to do with you owing less than you did before. The classic example is when a creditor gives up on getting all the money you owe and agrees to forgive part of the balance. That doesn’t just happen when banks renegotiate loans — it also applies to foreclosures, repossessions, giving the property to the lender, or abandoning it. There’s even one more way it can happen: when a mortgage is modified. Whatever the route, once a debt you are obliged to pay is canceled, the amount that disappeared from your balance sheet counts as taxable income. And if it’s a business debt, you should report it on the proper tax form. Your creditor may send a Form 1099-C, Cancellation of Debt. You’ll need to report that amount on your tax return for the year the cancellation happened, even if you never get the 1099-C.
Four Kinds of Canceled Debt
Debt forgiveness usually generates taxable income, as we explained above. However, for a business in particular, there are four kinds of canceled debt that still count as COD income but are excluded from gross income: (1) debt canceled in a federal bankruptcy; (2) debt canceled to the extent you were insolvent at the time of cancellation; (3) canceled qualified farm debt; and (4) canceled qualified real property business debt. If the debt your business owes has been canceled and you’re wondering if the amount is taxable, these four rules are the first places to check.
The first way to exclude canceled debt from your income is in a federal bankruptcy. If you’re able to discharge debts as part of a federal bankruptcy proceeding, the money you no longer have to pay is excluded from your gross income. But bankruptcy is a decision that needs to be made with the help of a professional. It is not the right fit for every owner. When it isn’t, we will tell you right away. We are not a law firm, but when federal bankruptcy is the better option, such as Subchapter V, we will refer the owner to a vetted independent bankruptcy attorney to provide the legal services.
The second way is insolvency, and it is the one most likely to matter to an owner settling debts the business cannot pay. The big one here, for taxpayers in the right circumstances, is that when the taxpayer is insolvent, forgiven debt gets excluded from their gross income up to the point of that insolvency. Note the words to the extent: you aren’t home free just because the debt was wiped out while you were insolvent. If the debt you settled is the result of a cash advance or loan and your business was insolvent when it was canceled, all or part of the forgiven amount may be excluded, but only up to the amount of the insolvency. Any amount over and above that is still taxable as COD income. A tax professional can walk you through the calculations to make sure you understand how the income and the insolvency play against each other before you make a final decision on settling the debt.
The third and fourth ways are narrower. There are also exclusions for qualifying farm debt and real property business debt, but these might not apply to a lot of companies. For either one, the debt in question has to meet the agency’s definition of “qualified farm” or “qualified real property business,” so it’s not safe to assume that it does.
It might feel too good to be true to not have to pay taxes on canceled debt. But don’t count your chickens until they’re hatched. Excluding canceled debt from your taxable income can have other negative tax effects, including cutting down certain credits and carryovers, losses and carryovers, and basis. So all of that canceled debt could come back to haunt you in future tax years. The benefit you got from the exclusion may show up as a tax cost you pay later.
Equipment loans and other secured debt add a wrinkle. If you owe money and the lender takes some of your stuff to cover what you owe, the IRS treats it as a sale. How the agency handles the sale depends on whether you were personally liable for the money you owe. If you were, that’s called recourse debt. The lender could come after you for the balance if your property didn’t cover it. If you weren’t personally liable, that’s called nonrecourse debt; in that case the property is all the lender can have. So watch for that Form 1099-C, because it should tell you if you were personally liable or not. With recourse debt, your COD income is the amount by which the debt exceeds the fair market value of the property, assuming none of the exclusions applies, and the difference between that value and your basis is a gain or loss on the property.
Take an example. You bought a truck for your business for $20,000. You put $2,000 down and took out a recourse note for the rest. You managed to pay $4,000 on the loan before the money ran out, leaving $14,000 unpaid. The dealer comes and repossesses the vehicle, which is now worth $11,000 (its fair market value), and you two agree that $3,000 of the debt has gone up in smoke. That $3,000 is considered COD income, and you also have a $9,000 loss ($11,000 fair market value minus your $20,000 basis). If it were a nonrecourse note instead, you would have had no COD income, just a $6,000 loss ($14,000 of debt realized minus the $20,000 basis).
Special Cases
A few breaks and special cases mean you don’t have to pay tax on every dollar a creditor lets you off the hook for. As a cash-basis taxpayer, if the debt was one you could have deducted on your tax return if you’d paid it, the forgiveness is not treated as COD income. Here’s another: if, as a buyer of property, you get a purchase price reduction that the IRS calls “qualified,” that doesn’t count as income, either.
When you settle with a lender for less than the full amount you owe, the amount you don’t pay is generally considered taxable income. There are exceptions, but it’s not an area where you want to trip up and owe a surprise bill to the IRS later. Before you settle anything, have a talk with a tax professional. We are a business debt settlement company, not a law firm, so if a tax issue comes up, we refer you to a vetted independent attorney.
