Your creditors have forgiven a sizable chunk of your outstanding debt, whether by wiping out a portion of your balance, or something else. This is often called a debt settlement. Does that part of the debt that has been forgiven count as “income” to you? And if so, is the resulting “income” the sort of thing that’s taxable? If a 1099-C has landed on your desk, that is the question in front of you. The answer is yes, but that’s only the start of it. Here’s the rule: (1) if a creditor has agreed to accept less than the full amount of a debt, (2) the remaining balance is considered a form of income, and (3) the business owes income taxes on the “forgiven” amount. Of course the rules are not nearly that simple.
Forgiven Debt Is Reported as Income
Under current law, it is the general rule that forgiven debt is reported as income to the debtor: unless Section 108 specifically excludes it, cancellation-of-debt income, or COD income, is taxable under Section 61. First, keep in mind that COD income is not limited to a forgiving lender. A modification of the debt can trigger it. Exchange of stock for cancellation of debt and purchase of a debt by a related person at a discount can also result in COD income. So can a contingent value right handed over to settle the debt, a discharge inside or outside bankruptcy, or a foreclosure. In other words, you need to consider COD tax consequences anytime a debt is effectively written off, not just for clean slates. Settlements and other partial debt discharges (less than 100% payoffs) can generate a potentially large and unexpected tax bill.
Exceptions to the COD Rule
There are some exceptions to the COD rule, and understanding these is critical because “cancellation of debt” does not always have a straightforward application. Section 108 has several, and four come up most often for operating businesses:
- bankruptcy,
- insolvency,
- debts that would have been deductible if paid, and
- purchase-money debt reductions.
Bankruptcy exclusions are sweet. When the discharge happens in a Title 11 bankruptcy case, the rule is simple. All the COD income is excluded. For a corporation, the exclusion applies at the corporate level. Partnerships, and LLCs taxed as partnerships, are different, because the test is applied to each partner: if the partner is in bankruptcy, the debt forgiveness is excluded, and if not, it isn’t.
The insolvency exclusion doesn’t require a bankruptcy filing, but it is narrower. The insolvency method only allows the taxpayer to exclude up to the amount it’s insolvent. In other words, a taxpayer can exclude up to the amount of debts owed over the fair market value of its assets immediately prior to debt reduction. It can take significant calculations to figure out if the business is insolvent at that moment. You would have to perform a fair market value of the assets versus total liabilities. This is not easy and sometimes that value is underestimated or overestimated. It is tempting to read your degree of insolvency straight off the deal. However, if you prepare a new balance sheet right after your debt is discharged, you may conclude that you were in fact only technically insolvent by a much lesser amount and thus only able to exclude a smaller amount of your forgiven debt from your income. Taxpayers should be sure they understand how their valuation is done and its limitations and assumptions before relying on it.
Back to partnerships for a moment. Same with the insolvency exception– if the partner was insolvent, the debt forgiveness is excluded. But if the partnership was insolvent, but each partner is solvent, the debt forgiveness is included. Rev. Rul. 2012-14 says that a partner can, in some circumstances, include part of the partnership liabilities when figuring out if the partner is insolvent.
But then comes the part nobody tells you at the settlement table. Excluding the income under the bankruptcy or insolvency rules is generally a timing item. The income is deferred, and in exchange you have to adjust (reduce) several “specified tax attributes,” including your business credits. The order is set by the Code. Net operating losses go first, a dollar for each dollar excluded, followed by the general business credit carryovers, minimum tax credits, capital loss carryovers, the basis of your property, passive activity loss and credit carryovers, and foreign tax credit carryovers. The credits, along with passive activity loss and credit carryovers, are cut by 33 1/3 cents per excluded dollar; NOLs, capital losses and basis lose a full dollar each.
The timing works in your favor, though. The reduction only happens after the tax for the year of the forgiveness has been figured, so you first go through all of the bookkeeping to calculate the total tax for the year. Then when that’s done you start thinking about the reductions in the attributes. That means you can still use your NOLs and other attributes for the rest of that year. After you get your taxes done for the year in which you received a discharge of debt, first reduce current year losses and then move onto the old net operating loss (NOL) carryovers. And if you sell an asset after the forgiveness but in the same year, its basis isn’t reduced in figuring your gain or loss.
You can also elect to reduce the cost basis in depreciable property first, ahead of any other attribute. That choice may benefit taxpayers holding long-lived assets like 39-year real property, who expect to utilize their NOLs quickly, though Section 382 limits on using NOLs need to be checked. Without the election, basis is not reduced below your total liabilities immediately after the forgiveness. At that point the basis reduction shuts down - no more basis reduction allowed. Whatever excluded income is left is often called “black hole” COD income. Anything “black holed” will not be subject to further property basis reduction or any attribute.
Not every forgiven bill is income, either. Say you buy goods or services on credit, and a few months later your creditors forgive the debt. If you’re a cash-method taxpayer, your accounts payable show the debt but you don’t have a deduction unless you pay the bill. Because paying it would have given you a deduction, the forgiveness creates no COD income and no attribute reduction. On the accrual method, though, if you already deducted the expense, you must include as income the amount of debt forgiven.
Purchase-money debt reduction is another exception. If you bought property by giving the seller a note and the seller later forgives some or all of it, the debt reduction is treated as an adjustment to the price you paid for the property, and you decrease the adjusted tax basis of the property. You can only use the purchase money debt reduction under Sec. 108(e)(5) if you’re solvent, outside of bankruptcy. But, according to Rev. Proc. 92-92, in a partnership, if all partners agree to treat the loan the same way, the IRS will let you use 108(e)(5) to reduce your purchase money debt–even if you are bankrupt or insolvent.
The Bottom Line
So what’s the bottom line? Section 108 is complicated, but unless you fall under one of its exclusions, you’ll have a lot more income in the tax year you reach a debt settlement. And qualifying for the bankruptcy or insolvency exclusion doesn’t make the bill vanish: you may have significant consequences later in the form of reduced tax attributes. Don’t let creditors or their lawyers give you a “legal opinion” that the deal is free of income tax consequences. It is important, when considering a potential write-off or settlement, to understand how that decision will affect your bottom line tax bill.
