BGBC Partners, LLP Tax Update: Cancellation of Debt Income
Sometimes businesses hit a rough patch and need a fresh start. The business can seek to renegotiate its existing debt with creditors or seek bankruptcy protection. The tax code takes an expansive view of what constitutes taxable gross income by its section 61 declaration “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:…”. Consequently, any “cancellation of debt income” potentially constitutes taxable gross income. The bank or other creditor is required to issue a Form 1099-C for the Cancellation of Indebtedness to both the business and the IRS.
There are strategies available to defer or even exclude the cancellation of debt income. The tax code also contains an entire code section titled “Income from discharge of indebtedness” (section 108) which specifically states that gross income does not include the discharge of indebtedness if any of the following exist:
(A) The discharge occurs in a title 11 bankruptcy case;
(B) The discharge occurs when the taxpayer is insolvent;
(C) The indebtedness is qualified farm indebtedness;
(D) In the case of a taxpayer other than a C corporation, the indebtedness is qualified real property business indebtedness.
The bankruptcy and insolvency exceptions above are the two most frequently used to avoid cancellation of debt income. Insolvency simply means the excess of liabilities over the fair market value of the assets. For an S corporation, the bankruptcy or insolvency requirements are applied at the S corporation level. For partnerships, the requirements are applied at the partner level.
If the requirements for exclusion are met, one additional requirement is that certain tax beneficial attributes must be reduced in a specific order prior to exclusion from income. These attributes in order are:
1) Net Operating Losses;
2) General Business Credits;
3) Minimum Tax Credits (these relate to alternative minimum tax paid in prior years);
4) Capital loss carryovers;
5) Basis reductions of assets (which could affect the depreciation tax deduction);
6) Passive loss and credit carryovers;
7) Foreign tax credit carryovers.
As you can see, if your business has realized a cancellation of indebtedness the rules can be complex. Therefore, it is a good idea to check with an experienced C.P.A. to help you navigate through the provisions affecting the amount taxable and the potential deferral or exclusion opportunities.
