Estimated reading time: 2 minutes

The article in brief:

• Cancellation of debt can generate significant tax liabilities.
• Companies can reduce such liabilities by demonstrating they are insolvent.
• Without experienced advisors, the process of proving insolvency can be challenging.

Lenders may forgive, but the IRS doesn’t forget.

Generally, when a taxpayer is relieved of all or a portion of a debt obligation, income must be recognized, and taxes must be paid on that income. There are, however, a few exceptions from the general income recognition rule under Section 108 of the Internal Revenue Code.

Under Section 108 and its provisions on cancellation of indebtedness income (CODI), a taxpayer does not need to recognize income in several cases including Title 11 bankruptcy and certain types of real property business indebtedness (as long as the borrower is not a C-corporation). A third type of exception, an insolvency exclusion, can extinguish or significantly reduce the tax liability associated with CODI to the extent of the insolvency.

In exchange for allowing companies to avoid CODI, however, tax attributes including net operating losses and certain tax credits must be reduced accordingly. This presents substantial planning opportunities for companies, but the process is intricate, time-intensive, and may require sophisticated modeling.

Companies seeking to take advantage of the insolvency exclusion need to be ready to show—and defend—their position in the event tax authorities start asking questions. The right advisors supporting the case for insolvency can help.

Insolvency and the Acceleration in Insolvencies

Despite insolvencies potentially going unreported, there is a reasonable inference that they have increased, especially considering the 72% rise in commercial bankruptcies in the U.S. in 2023 compared to the previous year.

Increasing inquiries from companies seeking to avail themselves of the insolvency exception further support this claim. Factors contributing to the acceleration in bankruptcies and insolvencies include slowing economic growth and challenges in servicing floating-rate debt or refinancing fixed-rate debt due to the sharp increase in interest rates over the last couple of years.

Claiming, Defending, and Applying the Insolvency Exclusion

To benefit from the insolvency exclusion, companies must quantify the extent of their insolvency effective immediately before their debt is discharged by considering liabilities and assets. If a company’s liabilities exceed the fair market value of its assets, it is considered insolvent to the extent of the difference.

Liabilities are not statutorily defined in this context, but tax courts suggest that if it is more probable than not that a taxpayer will be called upon to satisfy the obligation, it should be included in liabilities.Assets, also not statutorily defined, are determined using fair market value. A valuation report from an independent third party is often issued to determine the fair market value of assets.

Conclusion

Claiming insolvency can be a powerful tool for gaining relief from CODI when a company’s debt is forgiven. However, the process for claiming the exclusion is complex, requires quick action, and is subject to scrutiny by tax authorities.

Companies claiming the exclusion have seen their insolvency claim rejected for failure to adequately document how the fair market value of assets and the amount of liabilities were determined. An independent advisor with the right experience can equip a company to make a compelling case if questions arise.