Book an
Email
Directions
Tax professionals receive questions related to cancellation-of-debt (COD) income, ramifications of debt workouts and restructurings quite frequently, especially in times of economic uncertainty. With tax season in full swing, it is important for individuals and businesses to understand the basics of COD income and what exclusions are common for businesses in this situation.
COD income can occur in many circumstances, including the modification of a debt, the issuance of equity in satisfaction of debt, the acquisition of outstanding debt at a discount by a party related to the debtor, discharge of debt within or outside a bankruptcy proceeding, and more. Unless it is specifically excluded under the tax law, COD income is taxable under Section 61.
However, there are circumstances that can lead to the exclusion of COD income based on what is stated in Sec. 108. An article from The Tax Adviser highlighted four of the most common exclusions utilized by businesses: bankruptcy exclusion, insolvency exclusion, exclusion of COD generating a tax deduction if paid, and purchase-money debt reductions.
The Bankruptcy and Insolvency Exclusions
The bankruptcy and insolvency exclusions operate similarly in excluding COD income, but there are key distinctions tax professionals need to consider between the two.
In the case of COD income alongside a Title 11 bankruptcy, the COD income can be excluded entirely due to Sec. 108(a)(1)(A). One thing to note is that the type of entity that incurs the COD income determines where the exclusion is applied. For example, if the entity is a corporation that incurred the COD income, the exclusion is applied at the corporate level, whereas if a partnership incurs the COD income, partners may not exclude the COD income unless a partner is also undergoing a Title 11 bankruptcy.
The insolvency exclusion is when a taxpayer is insolvent immediately before a COD income event and they can exclude the COD income up to the extent of their insolvency. To calculate this insolvency, one would take their excess of liabilities over the fair market value of their assets.
When COD income is excluded due to bankruptcy or insolvency, the taxpayer must generally reduce its tax attributes, such as net operating losses and basis in property, by the amount of the excluded income.
Exclusion of COD Income Generating a Tax Deduction if Paid
COD income is not realized in cases where the discharged debt would have been deductible if the debtor had paid it, such as with cash-method taxpayers who have not deducted accounts payable or debts discharged under applicable high-yield discount obligation rules to the extent that it relates to the deferred original discount.
Purchase-Money Debt Reduction
When a seller forgives a debt owed by the buyer for a property, it reduces the basis of the property instead of creating COD income. This exclusion applies solely to solvent debtors not in bankruptcy at the time of the COD income event. However, the IRS allows insolvent or bankrupt partnerships to use this exclusion if all partners adopt consistent treatment.
In conclusion, various forms of debt workouts and restructuring can result in COD income, and it is important to know what types of exclusions might apply to your situation. The attorneys at Sader Law Firm are available to answer all questions and figure out what the best course of action might be for you. Contact us at (816) 561-1818 for a free phone consultation and learn more about what actions might be your best decision.
