Throughout the ordinary course of business, you could very well find yourself in a position of insolvency leading to the restructuring of your debt. Dealing with cash flow issues or insolvency can be very stressful and time-sensitive, and many business owners and taxpayers alike shudder at the thought of finding themselves in this state. During such a time vendors may settle your outstanding debts for less than the face value simply because you lack the cash to pay each amount in full. While you might be relieved of these debts, it is important to understand that the amount of debt that is canceled could be taxable, and the ability to free up cash to pay the tax while insolvent can prove very difficult. Therefore, it is important to realize that a portion of the canceled debt, if the taxpayer is insolvent, may qualify to be excluded from income…
The Internal Revenue Code (IRC) refers to debt discharge as Cancellation of Debt Income (CODI) and its treatment varies greatly between taxpayers. Regardless of your particular company’s tax structure and financial position, CODI is a highly sensitive and complex tax matter. Therefore, navigating the tax complexity of debt discharge income correctly is crucial.
What are the Rules?
The Internal Revenue Code states that gross income includes all income from whatever source derived. Therefore, the default rule is that if a debt is canceled or forgiven, the debtor generally must include the canceled amount in gross income for tax purposes. In specific instances, there are exceptions to this rule. Under IRC Section 108, certain taxpayers qualify for an exemption from picking up the CODI in the current tax year. Specifically, this applies when the taxpayer is insolvent. This insolvency exemption aims to alleviate the need for taxpayers to sell off assets to free up cash flow to pay the tax.
What is Insolvency?
Before picking up the CODI amount as taxable income in the current year you need to consider the Fair Market Value (FMV) of your assets and liabilities immediately prior to the discharge and see if any portion of CODI falls under the insolvency exemption. Discharge of indebtedness conveys forgiveness or release from an obligation to repay a debt. IRC Section 108(d) (3) states that a debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the FMV of the assets. For example, consider these facts:
- FMV of the taxpayer’s assets: $17,500
- Taxpayer’s liabilities: ($21,000)
- Taxpayer’s excess non-recourse debt: $3,500
If $4,000 of the taxpayer’s liabilities are canceled outside bankruptcy the taxpayer may exclude only $3,500 of the $4,000 debt cancellation from income as that is the amount by which it was insolvent.
Reduction of Tax Attributes
Excluding the amount from income is not the end of the road. The taxpayer must now “pay the price” for the exclusion. This begins by determining the amount of excess nonrecourse debt, or the amount that the debt exceeds the FMV of the assets. In the example above, $3,500 is the exclusion of the CODI amount from gross income; now required to be used to reduce the taxpayer’s tax attributes, which include:
- General Business Credits
- Net Operating Losses
- Tax Basis of Assets
The complexity of reducing these tax attributes vary by the facts and circumstances of each taxpayer.
Who is the Taxpayer?
Finally, it is necessary to determine “who” the taxpayer is. If the insolvency occurs for an individual or corporation, both are considered taxpayers and the rules are applied directly. If the insolvency occurs for a pass-through entity, it is a bit more complicated. For example:
- An S Corporation falls into the “corporate” bucket and even though it passes its income through the insolvency and attribute reduction, occurs at the corporate level.
- A Partnership, however, is not a taxpayer and it is necessary to disclose the information to each individual partner, with the determination of insolvency and income exclusion determined at the individual partner level. Since no two partners in any partnership are alike, it is important to consider all the facts and circumstances surrounding the particular scenario that applies.
To learn more about navigating all potential tax planning matters for yourself and all taxpayers impacted by the transaction, contact Clayton & McKervey.
Our team is always ready to help.