Back to the Library

Submit a Question

 

The Tax Resource Group: Professional Tax Research Material, Resources, and Consulting

Category: Corporations; Bankruptcy, Insolvency & Debt Discharge
Subject: Debt Discharge
Title: S Corporation--Debt Forgiveness Issues
IRC Sections: 61(a)(12), 108; 267; 1367(b)(2)
Filename: 1119.html
Date Produced: 2/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

In General/Insolvency Exception
As a general matter, cancellation of debt (COD) is taxable income under the principles set forth in IRC Section 61(a)(12). Absent some exception, COD at the S corporation level would give rise to income which would ultimately pass through to the shareholder as ordinary income.

Section 108 provides a variety of exceptions to the general rule of Section 62(a)(12), most notably Section 108(a) which excludes COD income to the extent of insolvency. Section 108(d)(7)(A) provides that in the case of an S corporation, the insolvency exception is applied at the corporate level. Thus, if the S corporation is insolvent before and after the COD event, no income is recognized. Corporate tax attributes and/or asset basis are reduced by an amount equal to the unrecognized COD income.

For purposes of the insolvency exception of Section 108(a), the term insolvent means the excess of liabilities over the fair market value of the taxpayer's assets immediately before the COD event. IRC Section 108(d)(3). Thus, the fair market value of the S corporation's assets directly impacts the amount of income potentially recognizable by the S corporation and ultimately the shareholder.

If the insolvency exception is relied upon, careful consideration should be given to the subject of attribute reduction. To the extent COD income goes unrecognized by virtue of Section 108(a), the insolvency or bankruptcy exceptions, corporate tax attributes must be reduced. See the list of attributes set forth at Section 108(b)(2). Note that basis-suspended losses of an S corporation are treated as net operating losses for this purpose. Section 108(d)(7)(B).

If the corporation lacks tax attributes or the amount of excluded COD income exceeds available attributes, it is necessary to reduce the basis of corporate assets. Reduction of asset basis can have unexpected, near-term tax consequences. The taxpayer is required to reduce the basis not only of long-term assets such as property and equipment but also of short-term assets such as accounts receivable and inventory. If a substantial amount of basis reduction must be allocated to assets which "turn over" rapidly, the exclusion of COD income is very short-lived, i.e., the income is recognized as soon as those short-term assets are realized.

Accrued Interest
I presume the corporation in question has not taken any deductions with respect to the accrued but unpaid interest either because A) the corporation uses the cash method of accounting, or B) the interest deduction is deferred until payment under Sections 267(a)(2) and 267(e)(1)(B)(ii). I presume further that if the corporation actually paid the accrued interest in question, an interest deduction would result. In essence, I presume that the interest tracing rules would not operate to characterize the interest as personal, or subject to capitalization, or otherwise not immediately deductible.

If the presumptions set forth above are correct, forgiveness of the accrued interest portion of the debt does not give rise to COD income. IRC Section 108(e)(2) provides that COD income does not arise if payment of the expense to which the canceled debt relates would give rise to a deduction. As stated above, I presume that accrued interest would give rise to a deduction if paid. Accordingly, Section 108(e)(2) would operate to shield the corporation from further incidence of COD income.

Purchase Price Adjustment
The purchase price adjustment mechanism is still available. See IRC Section 108(e)(5). To qualify, the debt in question must be purchase money indebtedness and the debtor must not be insolvent or in bankruptcy. In essence, the debt in question must have arisen from a purchase of something from the shareholder in exchange for the debt in question. Obviously, this fact pattern arises rather infrequently.

Contribution to Capital
Shareholder debt can be contributed to capital under the auspices of Section 108(e)(6) which provides that A) Section 118 shall not apply; and B) for purposes of determining the amount of COD income to the debtor, the corporation shall be treated as having satisfied the debt with an amount of money equal to shareholder's adjusted basis in the indebtedness.

On the face of this provision, it would seem that COD income would arise to the extent that the shareholder has used S corporation losses against his basis in the indebtedness. In that case, the corporation would be deemed to have satisfied the indebtedness for an amount of money which is less than the face amount of the indebtedness. However, IRC Section 108(d)(7) provides that for purposes of Section 108(e)(6), adjusted basis is determined without consideration of any adjustments provided by Section 1367(b)(2). Of course, Section 1367(b)(2) is the mechanism by which S corporation losses are offset against the basis of shareholder debt.

Bad Debt Loss
Obviously, if the contribution to capital option is chosen, there is no bad debt loss for the shareholder. Absent that, the shareholder's basis in the debt is a potential bad debt loss. Note that for this purpose, basis reductions for losses taken against shareholder debt do count for purposes of determining the magnitude of any bad debt deduction.

Obviously, the IRS scrutinizes corporation/shareholder bad debt situations very closely. The IRS routinely questions the validity of such bad debts on thin capitalization grounds or by arguing that there was no bona fide intention to repay the debt in the first instance. Also, the issue of characterization of the bad debt as business versus nonbusiness is very prevalent. Historically, shareholders have (absent very unusual circumstances) found it rather difficult to sustain business bad debt treatment in this situation.