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