Bankruptcy and Insolvency Tax Developments of 1998 A Look Back
This past year brought several interesting developments in the bankruptcy and insolvency tax area on both the regulatory and judicial fronts. Several important regulations were issued by the Internal Revenue Service (IRS) as well as judicial decisions that will impact S corporation shareholders. In addition, taxpayers felt the impact in 1998 of the late 1997 decision concerning the avoidance of income by claiming insolvency on the basis of guarantees of debt.
New Tax Regulations
Effective October 2, 1998, the IRS issued final regulations amending the existing income tax regulations under IRC §108 (income from the discharge of indebtedness) and §1017 (discharge of indebtedness basis adjustment in TD 8787). The new regulations make comprehensible many of the legislative changes to the income tax rules made since the enactment of the Bankruptcy Tax Act of 1980. The main thrust of these regulations is the fine-tuning of the ordering rules for reducing the basis of assets when taxpayers exclude the cancellation of debt income from taxable gross income under IRC §108.
IRC §108 excludes any cancellation of debt from gross income, which arises from 1) bankruptcy, 2) insolvency, 3) "qualified farm indebtedness" or 4) "qualified real property business indebtedness" of any taxpayer (other than a C corporation). The cost of such an exclusion is the reduction of any tax attributes the taxpayer might possess. The order of reduction is as follows:
- net operating losses,
- general business credits,
- alternative minimum tax credits,
- capital loss carryovers,
- asset basis reduction,
- passive activity loss and credit carryovers,
- foreign tax credit carryovers.
The ordering rule for an asset basis reduction (#5 above) is the following:
- Real property used in a trade or business or held for investment, other than real property primarily held for sale in the ordinary course of business, that secured the discharged indebtedness immediately before the discharge;
- Personal property used in a trade or business or held for investment, other than inventory, accounts receivable and notes receivable that secured the discharged indebtedness immediately before the discharge;
- Remaining property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable and real property primarily held for sale in the ordinary course of business;
- Inventory, accounts receivable, notes receivable and real property primarily held for sale in the ordinary course of business;
- Property not used in a trade or business nor held for investment.
With respect to bankruptcy, insolvency and qualified farm indebtedness, the taxpayer may elect to avoid the above ordering rules and first reduce the basis in depreciable real and personal property on the first day of the year following the taxpayer's realization of cancellation of debt income. The reduction cannot reduce the asset basis to below zero. If the depreciable property bases are inadequate to offset the entire amount of excluded cancellation of debt income, then the taxpayer returns to the above general ordering rules to further reduce tax attributes for the remaining cancellation of debt income. As discussed later, a taxpayer may treat a partnership interest as depreciable property, provided the partnership agrees to carry out the necessary reductions in its asset basis.
When electing to reduce the basis of depreciable assets, the order of a basis reduction is the following:
- For acquisition debt incurred to purchase specific property, whether or not the debt is secured by the property, the basis of the acquired depreciable property is reduced in an amount equal to the income excluded as a result of the discharge of the acquisition indebtedness.
- For debt that is secured by a lien on specific property (other than inventory, notes or accounts receivable), basis in the encumbered property is reduced in an amount equal to the discharge of the debt secured by the lien.
- Remaining depreciable property used in a trade or business or held for investment, other than inventory accounts receivable, notes receivable and real property held primarily for sale in the ordinary course of business.
In addition, the taxpayer may make another election to trust real property held primarily for sale in the ordinary course of business as depreciable real property for purposes of basis reduction.
The regulations also provide that for the refinancing of existing pre-1993 debt, as well as new indebtedness, incurred or assumed by a solvent taxpayer (other than a C corporation) in connection with real property used in business, secured by that real property ("qualified real property business indebtedness") and that is discharged, that the amount excluded from the income may not exceed the excess (if any) of a) the outstanding principal amount (principal amount of debt plus all additional amounts owed before discharge—e.g., unpaid interest) of that debt immediately before the discharge over b) the net fair market value of the secured real property immediately before the discharge.
Under the regulations, a taxpayer must reduce the adjusted basis of real property to the extent of the cancellation of indebtedness income, which is excluded from gross income in proportion to the adjusted basis. This reduction is done on the first day of the tax year following the tax year in which the cancellation of debt income is excluded.
The basis reduction for this type of indebtedness is done in the following order:
- Any depreciable qualifying real property used in a trade or business other than real property (held primarily for sale in the ordinary course of business) that secured the discharged indebtedness immediately before the discharge;
- Any other depreciable real property (other than real property held primarily for sale in the ordinary course of business);
- Any remaining depreciable property used in a trade or business, (other than inventory, accounts receivable, notes receivable and real property held primarily for sale in the ordinary course of business).
A partner may treat his partnership interest as depreciable real property if the partnership consents to making the corresponding adjustments to the basis of the partnership's depreciable property. Whenever a partner is requesting the partnership to reduce this "inside basis," it must be done before the due date, including extensions for filing the partner's income tax return for the year in which the partner has cancellation of indebtedness income.
Of paramount importance is that, whenever a taxpayer elects to reduce basis rather than to reduce tax attributes, a complete Form 982 must be attached to a timely filed tax return for the year in which the taxpayer has cancellation of debt income excluded from income under IRC §108. A failure to timely file would require the taxpayer to seek discretionary relief from the IRS under Reg. §301.9100-3T, which entails a private letter ruling permitting a late election. However, judicial developments were not as friendly as the regulatory developments.
Decisions from the Bench
In 1998, the tax court did a complete reversal of position in M.T. Nelson, 110 TC 114 (1998), in which it held that, pursuant to IRC §108(d)(7)(A), any cancellation of indebtedness income excluded from income by an insolvent S corporation did not flow through to its S corporation shareholders in the form of exempt income that then increases their basis in the S corporation. In so doing, the court withdrew its earlier opinion in P.D. Winn, TC Memo 1997-286 and substituted TC Memo 1998-71.
In Nelson, the reviewed opinion agreed with the government's position that the cancellation of indebtedness income is excluded from gross income at the corporate level, does not pass through to the shareholders and that the correlative reduction in tax attributes also applies at the corporate level. The court held that since the excluded income was not a pass-through item of income, it could not increase a shareholder's basis in the S corporation. Further, any other reading of the statute would have produced a windfall insofar as a shareholder would not only defer taxable income through tax attribute reduction, but also would increase stock basis. This would-be double-dip seems to have been closed completely.
In D.B. Merkel, 109 TC 463 (1997), the tax court provided a barrier for taxpayers trying to exclude cancellation of indebtedness from income on the basis of insolvency. In this case, two married couples, each of whom owned 50 percent of a computer leasing corporation, had personally guaranteed the corporation's bank indebtedness; its unpaid balance was in excess of $3.1 million at the time of the corporation's default. About six weeks after the default, the bank and the parties came to an agreement that ultimately provided for a final payment of $1.1 million and a release of secured collateral. Thereafter, the corporation was released from its liability as the maker of the note and the taxpayers were released as the corporation's guarantors. Up to the time of these releases the bank had never made any formal written request or demand for payment by the taxpayers pursuant to their guarantees. During the same time period, the North Carolina Department of Revenue proposed a sales and use tax assessment of more than $980,000 against the taxpayer's corporation for failure to collect and pay over sales tax, and this was also abated in full.
At no time had North Carolina ever pursued the individual shareholders in their possible fiduciary capacity as responsible persons.
The triggering event for the tax case was the receipt by both couples of $359,721 in cancellation of indebtedness income flowing from a partnership. Each couple excluded this income from its gross income on the basis of insolvency due to the existence of the bank guarantees and the sales tax assessment, which caused their liabilities to exceed the fair market value of their assets.
The tax court analyzed the facts under the seminal Kirby Lumber1 decision's "freeing of assets" theory and found that the indiscriminate inclusion of contingent obligations into the calculation of post discharge liabilities, without any consideration as to how speculative the obligation may be, would render meaningless any inquiry as to which assets are freed upon discharge of indebtedness. The court felt that Congress, in enacting the insolvency exclusion, intended to make a debtor's ability to pay an immediate tax on income from discharge of indebtedness the controlling factor in determining whether a tax burden is imposed. This ability or inability to pay an immediate tax is a factual question.
The tax court ruled that a taxpayer claiming the benefit of the insolvency exclusion has the burden to prove 1) that it is more probable than not that the taxpayer will be called upon to pay the obligation in the amount claimed as a liability, and 2) that the total liabilities so proved by the taxpayer exceed the fair market value of the taxpayer's assets. Thus, taxpayers will not be able to exclude income unless they can construct a balance sheet of insolvency based upon real and not speculative liabilities.