How Cancelled Debts Affect Business Taxes: An Accountant’s Advice
Dealing with debt cancellation can be confusing when it comes to how it impacts your business’s taxes. As your accountant, I want to provide some advice on the key things you need to know when debts are forgiven or cancelled.
Overview of Debt Cancellation
Debt cancellation occurs when a creditor forgives or cancels a debt you owe without requiring repayment. This usually happens when you settle a debt for less than the full amount or when the creditor writes the debt off as uncollectible.
-Some common examples include:
- Negotiating a lump sum payment to settle a credit card balance for less than what you owed
- Having a portion of business loan principal forgiven
- Reaching an agreement with a vendor to pay a reduced amount on an outstanding invoice
- Having a creditor cease collection efforts and write off an account receivable
Tax Consequences of Cancelled Debts
The cancellation of debt generally results in taxable income for tax purposes, even though you did not actually receive any cash or assets. This means you may owe taxes on the amount of debt forgiven.
There are some exceptions, such as if the cancellation occurs in a bankruptcy case or when you are insolvent (liabilities exceed assets). But in most cases, the IRS considers forgiven debts to be taxable.
So if you are relieved of having to pay back $50,000 on a business loan, you may have to claim that $50,000 as income on your tax return.
-Exclusions from Income
There are a few scenarios where you may be able to exclude cancelled debt from your taxable income:
- Bankruptcy: Debt discharged through bankruptcy is not considered taxable income in most cases.
- Insolvency: If your business liabilities exceeded assets immediately before the debt was cancelled, you may be able exclude some or all of the cancelled debt from income.
- Non-recourse debt: This applies to a debt where the creditor’s only recourse, in case of non-payment, is to foreclose on the specific property that secured the loan. An example would be a mortgage loan used to purchase business real estate. Up to the fair market value of the property can typically be excluded.
- Farm debt: The IRS provides exclusions for farmers who had farm debt cancelled.
So in cases of bankruptcy, insolvency, non-recourse property loans, or farm debt, talk to your accountant about whether you can take advantage of income exclusions or reductions for cancelled debt.
Reporting Cancelled Debt
If you have business debt cancelled, the creditor will usually issue a Form 1099-C reporting the amount of debt forgiven. They must file this with the IRS, so don’t expect to avoid declaring the amount on your tax return.
You would then report the income from debt cancellation on your business tax return (Form 1120, 1065, etc). The cancelled debt is generally reported as ordinary income.
In some cases, you may be able to report it as capital gains instead, which has more favorable tax rates. This mainly applies to real property used in a trade or business that secured the cancelled debt.
-Be sure to talk to your accountant whenever you have debt cancelled to discuss the tax implications and proper reporting method. Proper reporting is crucial to avoid penalties and additional taxes if the IRS inquires about undeclared income.
Tax Deductions and Credits
If cancelled debt is taxable to your business, here are some potential deductions and credits:
- Net operating loss (NOL) carryovers: Canceled debt income can be offset by prior year NOLs your business has “on the books” .
- Capital loss carryovers: These losses from prior years can offset capital gain income in the current tax year.
- Business credits: Various general business credits may help reduce tax liability.
- AMT credits: If previous alternative minimum tax applies, you may have AMT credits available to reduce regular income tax.
Meet with your accountant to assess what deductions or credits could reduce your tax bill related to any cancelled business debts. Proper strategic use of things like NOL carryovers and business tax credits could offset some tax impact.
-Strategic Considerations
Here are some proactive strategies to consider regarding business debt cancellation:
- Time it strategically: If possible, try to negotiate debt forgiveness when you have significant NOLs or other tax attributes to offset the cancelled debt income.
- Review contracts: Debt cancellations may trigger clauses in other financing agreements, so review loan documents, leases, etc.
- Assess insolvency: Determine if insolvency exclusions could eliminate some taxable income from cancelled debt.
- Consider settlement options: Settling debt for a lump-sum discounted payment upfront may provide better tax treatment than straight debt forgiveness.
Consult your accounting advisor on planning moves to minimize negative tax consequences when debts are forgiven. Careful assessment of exclusions, deductions, and settlement options could really help manage tax liability.
Key Takeaways
Having business debt cancelled or forgiven can greatly help your cash flow but also create tax headaches. As your accountant, here are the key things I want you to be aware of:
- Cancelled debts generally create taxable income, even without receiving any cash
- Exceptions exist in cases like bankruptcy, insolvency, non-recourse property loans, and farm debt
- Proper reporting of cancelled debt as income is crucial to avoid IRS issues
- Net operating losses and some tax credits may help offset tax liability
- Strategic planning around debt cancellation can help minimize tax impact
Please reach out with any questions! As your advisor, I’m here to help you understand how debt cancellations specifically affect your tax situation. With some planning, we can make the best of debt relief opportunities while properly accounting for any tax implications.
Resources
For more information, check out these additional articles on cancelled debt and taxes:
- What is Cancellation of Debt Income? – Overview from r/tax
- Forgiven Debt and Insolvency – Details on insolvency exclusions
- Tax Consequences of Debt Forgiveness – FindLaw article
- Canceled Debt – Is It Taxable or Not? – IRS information