BGBC Partners, LLP Tax Update:
Cancellation of Debt Income
As a store owner, you are well aware of the challenges of owning your own business. Sometimes unfortunate circumstances beyond your control can result in financial hardship. Although uncomfortable to think about, what happens when a store owner has trouble paying their debt and must negotiate a full or partial cancellation of Debt (“COD”)? That is the topic of this segment of our Tax Update.
Are you or someone you know having trouble paying the mortgage on your store? Are you struggling to pay your accounts payable or credit cards? Cash flow needs often cause companies to extend loan terms, refinance, restructure, or even default on a company debt. While the thought of being able to wipe away the debt seems like it will take care of the problems, many people forget about the tax consequences of COD Income.
Taxable income may be an unwelcome and unintended side-effect of debt modifications. COD income is phantom income, meaning it generates taxable income without any cash received. Whether restructuring an existing loan, or having all or a portion of your debt discharged, taxable COD income may be a result of the transaction. COD income can even result from a related individual or company purchasing the debt from the debtor at less than the full value of the debt.
The COD income on real property (such as the store), is the amount of the debt at the time of discharge over the fair value of the property. This is typically determined by the lender’s subsequent sale of the property. The lender will sometimes provide a Form 1099-A or 1099-C showing the amount of the discharge, but not always. The taxpayer needs to be aware of any COD issues when filing the tax return. This income could be significant and present the taxpayer with a hefty tax liability.
Fortunately, the Internal Revenue Code and case law provide several provisions which allow COD income to be excluded from taxable income. These include
Bankruptcy
Insolvency
Attribute Reduction (reducing other tax carryovers or basis)
This is a highly technical area, with each situation taking on unique characteristics. For example the insolvency exception applies at the partner level for partnerships, but at the entity level for S corporations. In addition, there are ordering elections which can be made to reduce one type of attribute over another type.
The mechanics of analyzing whether there is COD Income and how to defer it can be incredibly complex. In addition, reporting on the tax return and overall substantiation of any attribute reduction must be handled properly or additional future tax issues may arise.
As you can see, it is imperative to contact a qualified CPA to help you evaluate and properly handle situations involving COD Income and financial hardship scenarios generally. What you don’t want is for the IRS to rub salt in a financial wound by imposing penalties and interest on top of trying to collect back taxes due.
Rather, your goal in these situations is to get a fresh start and rebound as quickly as possible by focusing on what you know best – running your top notch grocery store!
BGBC Partners, LLP is a full service certified public accounting and business consulting practice.
For more information, contact Brad Bell, CPA or Steve Reed, CPA/ABV/CFF at BGBC Partners, LLP (317-633-4700).
