Generally, when a taxpayer is relieved of a debt obligation, income must be recognized. However, certain exceptions apply and for insolvent companies or Chapter 11 reorganizations, Section 108(a) of the Internal Revenue Code provides partial or full exclusion of cancellation of debt (COD) income from taxable income.
A debtor usually realizes debt discharge income at the time a debt is repurchased or satisfied for less than its outstanding balance. Modification of a debt obligation may also require the debt income to be recognized. Absent cancellation or satisfaction, COD income may be triggered by the occurrence of an event indicating that the debt will not be repaid, e.g. a settlement agreement between the creditor and debtor; judicial approval of the settlement, or a write-off of debt by the creditor.
Valuation Key Component
As noted above, two of the most common exceptions to the recognition of COD income are the bankruptcy and insolvency exceptions. The insolvency exclusion is applicable to an insolvent company only to the extent of its insolvency. Determining the degree of insolvency is a key step since this will dictate the amount of COD income which may be excluded. The first step is to value the assets of the company. The valuation should encompass all underlying assets including real estate, personal property, intangible assets and goodwill. Once the value of the total assets is determined, it is compared to the total liabilities of the company prior to the cancellation of debt. If the liabilities exceed the fair market value of the total assets, the company is considered insolvent for Section 108 purposes. In this situation, COD income may be excluded to the extent that the total liabilities exceed the fair market value of the assets, with the result that no income tax is incurred on the excluded COD income. If one of the exclusions apply and COD income is not recognized, the taxpayer must reduce its tax attributes to the extent of the exclusion. Tax attributes which must be reduced include (but are not limited to), for example, net operating loss carryovers, general business credits, and tax basis of property. The following is an example of the determination of exclusion of COD income under the insolvency exception:
- D Corp. has assets of $150 and liabilities of $200 and is thus insolvent to the extent of $50.
- Creditor cancels debt for stock worth $150.
- D Corp. satisfies $150 of the debt with stock and has $50 of debt cancellation.
- Debtor does not realize income because the amount of debt forgiven ($50) does not exceed the amount by which ¾ D Corp. is insolvent.
Frequently, in Section 108 situations, stock is issued in lieu of the canceled debt. A valuation of the stock is then required. The valuation is critical since the market value of the stock impacts the income which may be excluded and thus has tax consequences. Because these valuations can be complex, it is important to engage a qualified independent valuation specialist.
Temporary Income Deferral for Reaquisitions of
In addition to the exclusions for companies that are insolvent and/or in a Chapter 11 reorganization, The American Recovery and Reinvestment Act of 2009, also known as the Stimulus Bill, has provided a temporary opportunity for taxpayers to defer the recognition of cancellation of debt (COD) income resulting from certain reacquisitions of debt instruments. The provision, Section 108(i) of the Internal Revenue Code, states that an issuer can defer COD income resulting from the repurchase of applicable debt instruments. An applicable debt instrument is any debt instrument, such as a bond, debenture or note issued by a C Corporation or other person in connection with the conduct of a trade or business.
The deferral only applies to reacquisitions of applicable debt instruments which occurred in 2009 or 2010. A reacquisition refers to an acquisition by the debtor or person related to the debtor. The acquisition can be an acquisition for cash; an exchange for another debt instrument (including a modification of the same instrument); an exchange of stock or a partnership interest for the debt instrument; a contribution to capital, or complete forgiveness of the indebtedness by the holder of the debt instrument.
If the reacquisition occurred in 2009, the taxpayer can defer income for a period of five years beginning five years after the year of the discharge. If the reacquisition occurs in 2010, the COD income can be deferred for five years beginning four years after the year of discharge. The deferral election is made by including a statement which identifies the applicable debt instrument, the amount of COD income, and other required information, on the tax return for the taxable year during which the reacquisition occurred. A valuation is an important step in determining the amount of COD income.
Electing companies should be aware that if they decide to liquidate, file for bankruptcy, sell their assets or terminate business, the deferred income will be accelerated and due in the taxable year in which such an event occurs.
Only One Benefit Allowed
Companies that take advantage of the deferral under the Stimulus Bill are not permitted to also take advantage of the exclusion in Section 108(a) with respect to the same COD income. However, as clarified by Rev. Proc. 2009-37, partial elections are permitted; therefore, an election under Section 108(i) may be made for a portion of the debt discharge income while other exclusions under Section 108 may be available for the remainder of the debt discharge income. Therefore, it is important for eligible companies to have a thorough analysis performed to determine which provision offers the most advantageous result. For more information, contact your VRC representative.