Does an insolvent corporation have cancellation of debt income when a shareholder forgives its debt?

It’s common for a corporation to get loans from its owners that it eventually doesn’t pay back. When shareholders of a corporation forgive that corporation’s indebtedness to them, there are tax consequences that are not settled. Part of the answer can be found in IRS guidance, but unfortunately that guidance can be contradictory. In Letter Ruling 202112003 (March 26, 2021), the IRS applied Section 108(e)(6) to a company. In doing so, it ignored the company’s insolvent position. Forgiving a company’s debt may be a capital contribution to the company, even if the company is insolvent, based on this IRS ruling in 2021. Next is a look at the statutes and the prior IRS guidance, before explaining the 2021 IRS ruling. The ruling is important because IRS had come to the opposite conclusion once before.

Generally speaking, when someone cancels a company’s debt, that’s income to the company, under Sec. 61(a)(11), unless there’s an exception. If the owner just forgives the company’s debt, that’s income at the company’s level, at least initially. Repurchasing the debt for less than the adjusted issue price means there is COD income.

Sometimes COD income is excluded under Sec. 108(a). That’s true if the company is insolvent at the time the debt is discharged and it had liabilities larger than its assets at that time. The amount excluded reduces the company’s tax attributes. A company that’s insolvent at the time of debt forgiveness generally doesn’t owe tax on that forgiveness, but later on when it tries to get tax benefits it won’t be able to get as many because its tax attributes have been reduced.

If a shareholder forgives the company’s debt as a gift, the forgiveness is treated as a capital contribution up to the principal amount (Regs. 1.61-12(a)). Of more interest is the application of Sec. 108(e)(6). Under that section, for a company that receives a contribution of its own debt by a shareholder, Sec. 118 does not apply. The company is treated as having paid the debt with cash equal to the shareholder’s adjusted basis.

In the legislative history of Sec. 108(e)(6) (Senate Report 96-1035 (1980)), Congress explained that forgiveness must relate to the shareholder’s interest as a shareholder. A creditor maximizing their recovery is not a contribution, as with the bondholder who owns publicly traded stock of a company and decides to exchange the bonds for the stock.

Is forgiveness of worthless debt by a shareholder still a capital contribution with no COD income? The answer to that is an open question. The IRS and courts have addressed this issue several times.

In a 1954 IRS letter ruling, the IRS said a shareholder who forgave a company’s debt had nothing to forgive because the debt was worthless. In a decision called Mayo, the Tax Court said that forgiveness didn’t constitute a contribution, because the company remained hopelessly insolvent. The IRS and Tax Court have said that, if a company has no prospect of paying its debt, a shareholder’s forgiveness of the debt may not be a contribution (IRS Letter Ruling 5411085730A and Mayo, T.C. Memo. 1957-9).

But in a decision called Lidgerwood Manufacturing Co., the Second Circuit held that a parent company’s cancellation of an insolvent subsidiary’s debt was a capital contribution and the parent had no bad debt deduction.

The court in Lidgerwood Manufacturing Co. reasoned that because forgiveness of the subsidiary’s debt improved its financial status, even though it remained insolvent, voluntary cancellation of the debt so the subsidiary could continue to operate was clearly a contribution to capital. The Supreme Court declined to review Lidgerwood. This means at least one appeals court sees a contribution despite continuing insolvency.

In Field Service Advice 199915005 (1999), the IRS concluded that, to the extent that a parent corporation canceled insolvent subsidiary S1’s debt and S1 thereby became solvent, Sec. 108(e)(6) applied. To the extent that S1 remained insolvent, Sec. 108(e)(6) did not apply. This seems hard to square with the 2021 letter ruling. The FSA posited an insolvent company that is forgiven by an owner could still have COD income.

In the Field Service Advice, the IRS reasoned that the cancellation of the debt can only increase the debtor’s value by the amount by which it becomes solvent. Thus, the contribution was limited to the amount by which the debtor became solvent.

The IRS’s answer was that the portion of the canceled debt that allowed the debtor to become solvent was measured under Sec. 108(e)(6), while the remaining canceled debt constituted COD income to S1. It determined that the insolvency exclusion applied and the subsidiary’s attributes were reduced.

The Departure from the Field Service Advice

What were the facts in the 2021 ruling? FSUB 1 was a foreign corporation that owned FDRE 1, a disregarded entity. FDRE 1 owned FDRE 2. FDRE 2 owned Parent, a U.S. corporation. Parent was the head of a consolidated return group, referred to as the Parent Group.

FSUB 1 held the notes issued by Parent, which the taxpayer represented were debt for federal tax purposes. Other members of the group were co-obligors on the notes.

Parent’s business was in steep decline. The notes may have made the group insolvent.

In this case, the proposal was that FSUB 1 would gratuitously forgive some of the notes, with the intention that the Parent Group would be solvent afterwards. So the question was, would the forgiveness count as a contribution even though Parent was insolvent going in? Answer, according to the IRS: Yes.

The IRS held that Sec. 108(e)(6) applied. That meant Parent’s COD was equal to the excess of the notes’ adjusted issue price over FSUB 1’s adjusted basis. And the IRS treated the forgiveness as a capital contribution even though it made Parent solvent. Thus, unlike the 1999 Field Service Advice, the insolvency of the debtor at the time of the debt cancellation was ignored. The IRS essentially concluded that Parent’s insolvency was irrelevant, because the whole forgiven debt went under Sec. 108(e)(6), not just the amount making it solvent.

The takeaway here is that the IRS seems willing to apply Sec. 108(e)(6) fully even if the debtor is insolvent at the time of the cancellation. The IRS had agreed with that result in an earlier letter ruling (Letter Ruling 8844032) predating the Field Service Advice.

Still be careful because it’s not clear if the IRS will continue to agree to this result. That may depend on how insolvent the debtor is at the time of cancellation. If the company is hopelessly insolvent and remains hopelessly insolvent, Sec. 108(e)(6) may not apply, as in Mayo. Check your facts.

In two recent rulings, Letter Rulings 201016048 and 200537026, the taxpayers stated the debt was not worth zero. If the debtor was hopelessly insolvent, it may be harder to reach this result. A hopelessly insolvent company’s debt may not have any positive fair market value, so beware relying on Sec. 108(e)(6).