Category: Bankruptcy, Insolvency & Debt
Discharge; Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayers are two S corporations, XYZ and ABC, each owned equally by the same three people. Both taxpayers are engaged in retail sales. XYZ corporation is the stronger financially. Over a period of years, XYZ directly or indirectly advanced approximately $120,000 to the ABC corporation. All assets of ABC were sold at book value to XYZ in 1992. All of XYZ's assets were sold in January of 1993. All operations of both corporations ceased as of the date of sale of assets. The advances from XYZ to ABC will never be repaid. ABC was insolvent as of the date operations ceased. The shareholders of both taxpayers have claimed losses in excess of basis. Issues 2. Does the fact that the debtor and creditor are related affect the ability to exclude the COD income through operation of either §§108, 267, or 707? 3. How is the exclusion of income handled if it is indeed available? 4. What is the effect of the shareholders having taken losses in excess of basis? Answers 2. §§108, 267, and 707 do not limit the availability of the COD exclusion as a result of the related party status of the taxpayers. 3. COD income will presumably be recognized for financial accounting purposes. On the tax return, book COD income will the reversed in Section M-1 of the return. Under §108(b), any income excluded under the insolvency exception must reduce various tax attributes. If COD income exceeds available tax attributes, the excess is ignored and has no present or future tax consequences. 4. The fact that the shareholders have taken losses in excess of basis does not appear to affect the ability of ABC to exclude COD income. The remedy for having taken losses in excess of basis is very clear, i.e., amend the returns of the shareholders. There does not appear to be a corporate level remedy nor does there appear to be any corporate level responsibility for the shareholder's actions in this regard. Discussion Based on your representations, ABC was at the last a mere shell consisting of debt to XYZ and an offsetting aggregate debit in the equity section of the balance sheet. Absent assets of any type, it would appear that ABC should have no trouble being deemed insolvent to the full extent of the intercompany indebtedness. Accordingly, all COD income should be excludible under §108(a). The fact that debtor and creditor are related parties does not appear to create a problem either under §108 or §§267 or 707. With respect to §108, there is simply no statutory language to provide any special treatment for related party situations of this type. Disallowance under §§267 and 707 require a sale or exchange in order to be applicable. It is abundantly clear that an ordinary debt cancellation alone is not deemed a sale or exchange of the debt. From a practical perspective, it seems that the COD income would be recognized for book accounting purposes and excluded as a Schedule M-1 item for tax purposes. Under §108(b), COD income excluded under the insolvency rule must reduce a list of tax attributes. It should be noted that any current year loss is treated as a tax attribute subject to reduction. Also, any loss that ordinarily would become a carryforward because such loss exceeds basis is also an attribute subject to reduction. §108(b)(2)(A). Once all available tax attributes are reduced to zero, there are no further tax consequences. Such excess is permanently excluded from taxation. (From the Committee Report under the Bankruptcy Tax Act of 1980). Not surprisingly, there appears to be no guidance with respect to the interaction of the COD exclusion with the fact pattern of shareholders having taken losses in excess of basis. It seems to me that the path for correcting the losses-in-excess-of-basis problem is clear: amend the shareholder returns. There seems to be no corporate-level remedy or responsibility for this state of affairs. Important Collateral Issues 1. It seems to me that the real exposure that presents itself with respect to the facts you have laid out is a contention that the loan from XYZ to ABC is in essence an equity investment. Clearly, the IRS has all the statutory tools it needs to make such a claim, and the taxpayers' facts are not the best one could hope for. 2. Dissolution of a corporation is generally viewed as a sale
or exchange of the shareholders' investments in the corporation
for whatever proceeds the corporation distributes in liquidation.
In this case, the corporations will distribute zero proceeds.
For purposes of the shareholders' gain or loss on dissolution,
zero proceeds will be offset against the shareholders' bases in
their stock investments. Since the shareholders have claimed losses
in excess of basis, do the shareholders effectively have negative
stock basis which will give rise to recapture on dissolution?  |