How to Report Restructured or Settled Business Debt on Taxes

If your business has struggled with debt over the past year, you may have had to restructure or settle some of that debt to stay afloat. While restructuring or settling debt can provide much-needed financial relief, it also has tax implications that you need to properly report to avoid problems down the road.

In this article, we’ll walk through the key steps for reporting restructured or settled business debt on your taxes. We’ll cover:

• What is Cancellation of Debt Income (CODI)
• When CODI Becomes Taxable
• Exceptions Where CODI is Not Taxable
• Reporting CODI on Your Tax Return
• Settling Debt Through Bankruptcy
• Other Important Tax Considerations

Let’s dive in!

What is Cancellation of Debt Income (CODI)?

When a lender forgives or cancels a debt you owe, the amount of debt forgiven is called Cancellation of Debt Income (CODI). Some common ways CODI arises are:

• Negotiating a discounted lump sum payment on a debt
• Creditor agrees to accept less than the full amount owed
• Creditor forgives a portion of interest or fees
• Creditor reduces the interest rate or extends the repayment period

According to the IRS, “nearly any debt you owe that is cancelled, forgiven, or discharged becomes taxable income to you.”^[1] This includes business debts like accounts payable, notes payable, or accrued expenses.

When CODI Becomes Taxable

In most cases, CODI is considered taxable income that must be reported to the IRS. There are a few exceptions covered later. But in general, if you receive a Form 1099-C from a creditor reporting CODI of $600 or more, you must include this as income on your tax return.

Some examples where CODI typically becomes taxable:

• Settling credit card debt for less than the full balance
• Creditor forgives a portion of mortgage principal
• Supplier lets you pay less than the original invoice amount
• Lender reduces business loan principal and interest

The amount of CODI reported on Form 1099-C gets added to your gross income just like wages or sales income. It is subject to ordinary income tax rates up to 37% depending on your total taxable income and filing status.

Exceptions Where CODI is Not Taxable

There are some exceptions where you may be able to exclude CODI from taxable income:

Bankruptcy

If your debt was discharged as part of a bankruptcy filing under Chapter 7 or Chapter 13, the associated CODI is not taxable.^[1] This applies to business debts as well as personal debts discharged in bankruptcy.

Insolvency

If you can demonstrate that your business was insolvent at the time the debt was cancelled, you may be able to exclude some or all of the CODI from taxable income. Insolvency means your total liabilities exceeded your total assets immediately before the debt was cancelled.

You will need to file IRS Form 982 along with evidence of insolvency to claim this exception. The amount of CODI you can exclude is limited based on the extent you were insolvent.

Non-recourse Debt

If the cancelled debt is considered non-recourse, meaning the creditor’s only recourse was to repossess property secured by the debt, then the CODI may not be taxable. This most often applies to mortgage debt.

Other Exclusions

There are a few other limited exclusions like student loan debt cancelled under certain federal or state programs, farm debt, and debts cancelled in a Title 11 bankruptcy case.^[4] But these are less common for business debts.

Reporting CODI on Your Tax Return

If you receive a Form 1099-C reporting CODI that does not qualify for one of the above exclusions, you must report it as income on your business tax return. Here’s how:

Sole Proprietorships

If you operate your business as a sole proprietorship, the CODI gets reported on Schedule C along with your other business income and expenses. The amount from Form 1099-C gets included in gross receipts on Line 1 of Schedule C.

Partnerships and S-Corps

For partnerships and S-corporations, CODI is reported on Form 1065 or 1120S and flows through to the owners’ individual tax returns. Include the CODI amount on the appropriate business income line such as Line 1 for gross receipts on Form 1065 or Line 5 for gross receipts on Form 1120S.

C-Corps

C-corporations report CODI directly on Form 1120 on the line for other income. The canceled debt gets taxed at the corporate level first before any money is distributed to shareholders.

Settling Debt Through Bankruptcy

If you settle business debts by filing for bankruptcy, any CODI is excluded from taxable income. However, bankruptcy can impact your business taxes in other ways:

• Existing tax credits may be reduced or eliminated.
• Net operating loss (NOL) carryovers could be reduced by prior CODI amounts.
• ATR credits from prior years may be recaptured upon filing bankruptcy.
• Business asset sales completed shortly before bankruptcy could be re-characterized and taxed differently.

These outcomes vary based on the specifics of your bankruptcy filing and timing. Be sure to consult a tax professional to understand the implications.^[3]

Other Important Tax Considerations

Here are some other key things to keep in mind when settling or restructuring business debt:

Bad Debt Deductions

If your business writes off uncollectible accounts receivable as bad debt, this generates a deduction to offset the lost income. Bad debts for businesses are claimed as an ordinary loss on Form 1065 or 1120S, and for sole proprietors on Schedule C.^[2]

State Taxes

Most states follow federal tax law regarding CODI. But be sure to check your specific state’s guidance for any differences in reporting cancelled debt.

Mortgage Debt

Cancellation of mortgage debt used for business purposes, like an office building loan, is also reportable as CODI on business tax returns.

Timing

You must report CODI in the year it occurs, regardless of which tax year the original debt was incurred in.

Records

Keep detailed records showing the original debt amount, any payments made, correspondence with creditors, and the computation of CODI for tax reporting purposes.

Restructuring or settling business debts can be complex when it comes to taxes. Consult a trusted CPA or tax attorney to ensure you receive the maximum tax benefit while remaining compliant with all IRS rules and regulations.

With some advanced planning and foresight into the tax consequences, you can reduce the overall cost of getting your business back on track financially.

The Bottom Line

If your business has negotiated debt relief with creditors, make sure to account for any CODI correctly on your tax return. Failing to report cancelled debt as taxable income can lead to penalties, interest charges, and potential audit issues down the road. But if structured properly, settling debt can actually benefit your business by reducing taxable income in the year the CODI occurs. Get professional help navigating the complex IRS rules around debt cancellation to maximize the tax benefits for your business.

References

[1] When to Use Tax Form 1099-C for Cancellation of Debt

[2] IRS Topic No. 453, Bad Debt Deduction

[3] Tax implications of bankruptcy versus settlement

[4] IRS Topic No. 431, Canceled Debt – Is It Taxable or Not?