Category: Corporations; Bankruptcy, Insolvency & Debt Discharge
Subject: Sale of Stock by Bankrupt Shareholder
Title: COD Income at Corporate Level
IRC Sections: 382, 108(e)(8), 61(a)(12)
Filename: 1242.html
Date Produced: 06/95

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Background
Individual (TP) is bankrupt and under the jurisdiction of a court in a Chapter 7 matter. TP owns 100% of the stock of a closely held C corporation. TP has been offered $9,000 for the stock. The corporation has a large NOL ($733,000). The corporation also owes TP approximately $700,000.

Issues
1. If TP sells the stock, are there any special rules available to bankrupts to mitigate the effect of Section 382?

2. Is the closely-held corporation exposed to debt cancellation income either now or in the future if the debt between TP and the corporation is left in place?

Answers
1. There are a variety of special rules applicable to bankrupt taxpayers that affect the application of Section 382, principally Section 382(l)(5) and the G-reorganization provisions. However, in both cases, these rules come into play only if the corporation is itself bankrupt and the change of ownership results therefrom. There is no indication of any mitigating provisions that come into play if the shareholder is bankrupt and the change of ownership results from or is in connection with bankruptcy at the shareholder level.

2. In general, cancellation of debt (COD) occurs when, based on all the facts and circumstances as well as controlling local law, it becomes apparent that the creditor will not pursue the debt in question. It seems to me that at the very least, COD will occur when the statute of limitation expires on collection of the debt in your state. There are a number of cases so holding. See, for example, Securities Co., (DC) 48-1 USTC ¶9239, 85 FSupp 532; C.T. Miller Trust, 76 TC 191, Dec. 37,654; Great Northern Ry. Co., (DC) 292 Fed. 903.; and Northern American Coal Corp., (CA-6) 38-1 USTC ¶9303, 97 F2d 325.

I think the creditor's intention not to pursue the debt could easily manifest itself far sooner than the running of the statute of limitations, e.g., when the shareholder writes off the debt for tax purposes.

I am of the strong opinion that it is unwise to allow this debt to stand on the books of the closely-held company. The shareholder should contribute the debt to capital. No COD income will result under Section 108(e)(6) assuming the basis of the debt in the shareholder's hands is equal to the face amount of the debt.

It is very important that no additional shares be issued as a result of the contribution to capital in order to avoid possible application of Section 108(e)(8). If additional shares were issued in exchange for contribution of the debt, COD income would result to the extent the face amount of the debt exceeds the fair market value of the stock issued in cancellation of the debt.

There is no reduction of corporate tax attributes as a result of excluding what would otherwise be COD income. Attribute reduction only results from COD exclusion under the insolvency/bankruptcy exceptions. Section 108(b).

Presumably the worthless debt in TP's hands would result either in a nonbusiness bad debt loss (a capital loss) if the debt remains in place or a worthless stock loss (also a capital loss) if the debt is contributed. Both scenarios require TP to prove worthlessness.