This article will review three issues with regard to the recognition of cancellation of debt (COD) income: (1) the valuation of "exempt assets" in the determination of the debtor's insolvency, (2) rules regarding the exclusion of COD income and (3) rules regarding when COD income increases an S corporation's basis. Recent Internal Revenue Service (IRS) rulings and/or judicial decisions have clarified the income taxation consequences of each of these three issues.

The Inclusion of "Exempt Assets" in Determining Debtor's Insolvency

The IRS recently ruled that property that is exempt from creditors under the laws of the state in which the taxpayer resides is nonetheless included in the assets considered in determining insolvency. The determination of insolvency is important for purposes of determining if the taxpayer has to recognize cancellation of indebtedness income. In the recent Letter Ruling 199932013, the IRS revoked its prior position on the issue.

The Facts of the Letter Ruling

In this letter ruling, the taxpayer proposed to enter into a transaction in which one of his creditors would fully discharge his liability in exchange for a cash payment. At the time, the taxpayer was not in chapter 11 bankruptcy, and all of the creditors were subject to the laws of the state in which the taxpayer resided. Generally, a taxpayer will not recognize COD income to the extent of the taxpayer's insolvency.

Previously, the IRS has ruled that the value of the personal residence and other property exempt from the reach of the taxpayer's creditors under state law may be disregarded as assets when determining the amount of the COD income exclusion related to insolvency. However, in Letter Ruling 199932013, the IRS has revoked its position after re-analyzing the relevant laws.

"Insolvent" refers to the excess of all liabilities over the fair market value of all assets, determined immediately before the discharge of indebtedness. Neither the Internal Revenue Code (IRC) nor the Bankruptcy Code statutory language specify which assets and which liabilities are taken into consideration when determining the definition of "insolvent." In both the previous and the recent letter rulings, the IRS notes that neither the Bankruptcy Code nor the IRC committee reports clarify this definition.

Letter Ruling 199932013 Conclusion

In a previous 10-year-old ruling, the IRS determined that Congress intended to codify the judicially developed insolvency exception. In that ruling, the IRS noted the Estate of B.M. Marcus, 34 TCM 38, CCH Dec. 33, 012(M), in which the tax court held that assets exempt from the claims of creditors should not be included in the determination of a taxpayer's insolvency following cancellation of a debt. In the 1999 ruling, the IRS noted that the statutory language places no limitation on assets that are taken into account in determining a taxpayer's solvency. The IRS concluded that the plain meaning of the term "asset" would include all of the taxpayer's assets in the insolvency calculation. Generally, the IRS believes that, where the language of a statute is unambiguous, no further inquiry into the meaning of the statute is needed. Letter Ruling 199932013 also noted that when Congress intends to exclude state-exempt assets, it specifically provides such an exclusion, as it has done under the Bankruptcy Code.

According to the 1999 ruling, excluding exempt assets from the measure of insolvency would provide a taxpayer who is economically solvent (i.e., a taxpayer who has total assets exceeding liabilities) the opportunity to defer a current tax. This would occur in instances where the taxpayer has the ability to pay the tax (presumably with the sale of exempt assets, even though the assets would be exempt from the reach of creditors under state law).

Rules Regarding Exclusion of COD Income

In L.E. Preslar, CA-10, 99-1 USTC ¶50,258, a divided U.S. Court of Appeals for the Tenth Circuit (reversing and remanding a tax court case), recently narrowed the ability of taxpayers to avoid inclusion of income from the discharge of indebtedness. In the decision, the appeals court majority took a narrow and strict view of two taxpayer theories: (1) contested liability/ disputed debt exception and (2) purchase price adjustment to basis under IRC §108. The taxpayer argued these two theories to either (1) avoid the inclusion of or (2) postpone the recognition in gross income of the amount of the discharge of indebtedness.

The Facts of the Case

The taxpayer purchased a ranch, part of a bankruptcy estate, to develop into a sportsman's resort area. The taxpayer obtained financing for this purchase for the most junior of the lienholders on the ranch. The taxpayer purchased the ranch from the owners and executed a note to the bank. The note paid off the outstanding mortgage loans of the two superior lienholders. The taxpayer and the bank entered into an undocumented agreement for repayment of the loan. Under the agreement, the taxpayer would sell lots on contract and assign the contracts to the bank as payment.

The bank was declared insolvent approximately two years after this transaction and was taken over by the Federal Deposit Insurance Corp. (FDIC). The FDIC refused to accept the contract assignments as payments and directed the taxpayer to cease the sales of lots on the ranch, which the taxpayer did. The taxpayer then sued the FDIC for breach of contract. A settlement was reached in which the FDIC accepted approximately 50 cents on the dollar for cancellation of the debt. On his income tax return, the taxpayer failed to include any amount of COD income. The IRS assessed a deficiency. The taxpayer challenged the assessment in tax court. The tax court ruled in favor of the taxpayer, dismissing the IRS's assessment.

Taxpayer Argument #1: Contested Liability/Disputed Debt Exception

The first taxpayer argument for the non-inclusion of the COD income was a judicially created equitable exception of contested liability/disputed debt. The taxpayer argument goes like this: The courts have ruled that since the actual amount of the debt was indeterminable until the conclusion of the litigation, no income would be generated to the taxpayer for the discharge of the debt. The taxpayer argued that he overpaid for the ranch. The overpayment was evidenced by the fact that the FDIC settled for less than the full amount of the loan.

The Tenth Circuit rejected that argument, stating that the contested liability/disputed debt exception went to the original contract. The Tenth Circuit concluded that since (1) no evidence (other than the taxpayer's self-serving testimony) was presented at the trial and (2) the taxpayer' suit was against the successor of the defunct lender (not the original owner), this legal theory did not apply. The Tenth Circuit reasoned that this theory is only applicable if the purchase price was induced by the seller through either misrepresentation or fraud. Neither of these allegations was argued in the taxpayer's suit.

Taxpayer Argument #2: Purchase Price Adjustment to Basis under §108

The taxpayer's second argument was that the COD income could be postponed under IRC §108 by adjusting his basis in the property. The Tenth Circuit rejected this theory because §108 refers to disagreements between sellers and purchasers. Such a disagreement was not the case in the taxpayer's instance.

The taxpayer also contended that under either (1) the seller financing exception, (2) common law or (3) the financing exception, he should still be allowed to defer recognition of COD income by an adjustment to his basis in the ranch. The Tenth Circuit rejected the seller-financing exception because (1) from the face of the contracts, the bank was not the owner/seller of the ranch; (2) Section 108 was enacted after several case decisions and, therefore, superseded the common law; and (3) to claim the infirmity exception, fraud or misrepresentation at the time of purchase (which was not the case) would have to be demonstrated.

Dissenting Opinion

A dissenting opinion was filed with this opinion. The dissent concluded that there was sufficient evidence to (1) affirm the tax court holding or (2) grant relief under the purchase-price-adjustment theory. However, even the dissent opinion conceded that there were caveats that could still lead to the same judicial result. The dissent opinion pointed out that the taxpayer may have conspired with the bank to mislead the bank regulators. Such a conspiracy would bar the taxpayer from seeking equitable relief. And the issue of whether the bank was the true seller or not would need to be remanded to the trial court for a determination before relief under the purchase-price-adjustment theory could be granted.

When COD Income Increases Corporation Basis

In W.C. Witzel, CA-7, 2000-1 USTC ¶50,165, the U.S. Court of Appeals for the Seventh Circuit gave a partial victory to a taxpayer regarding S corporations and COD income. The Seventh Circuit ruled that although an S-corporation shareholder could not use the S-corporation COD income to increase his basis in order to use an S corporation's suspended losses, the taxpayer could use the COD income to increase his basis for the future.

In J.D. Houge, DC Ore., 2000-1 USTC ¶50,149, however, the U.S. District Court of Oregon (whose decision is appealable to the Ninth Circuit) ruled that the taxpayer (1) could use COD income to increase his shareholder basis and (2) take the suspended losses against other income.

Both courts disagreed, either in part or totally, with a recent holding of the U.S. Court of Appeals for the Tenth Circuit. In D.A. Gitlitz, CA-10, 1999-2 USTC ¶50,645, the Tenth Circuit ruled that the taxpayer could offset his suspended losses at the corporate level, but he could not increase his basis by the S-corporation COD income.

However, the Seventh Circuit Witzel decision noted that the recently adopted Regulation 1.1366-1 could have caused the result to be different had the case been for a tax year starting after Aug. 17, 1999.

The Facts of the Case

In all three cases, the facts are similar. The taxpayer is a shareholder with no basis in the stock of an S corporation with which to allow him to take the losses incurred by the S corporation. Since the taxpayer is prevented from taking these losses, the losses are suspended and treated like NOLs for tax-attribute purposes. The S corporation usually goes bankrupt, or has all its assets seized due to insolvency, resulting in COD income to the S corporation. Under §108, this income is tax-exempt to the S corporation.

The taxpayer argument is this: Since an S corporation is a pass-through entity, the tax-exempt COD income should (1) pass through and (2) increase the shareholder's basis. This increased S-corporation basis will then allow the shareholder to take the suspended losses from the S corporation against income from other sources.

The result of such a treatment would be a double windfall for the taxpayer in that he gets to (1) increase his basis with tax-exempt income and (2) reduce his tax liability on other income by the suspended losses of the S corporation.

The IRS's position is that under §108, the COD income can only be used to reduce tax attributes. In these cases, the tax attributes are the S-corporation (1) NOLs or (2) suspended losses. According to the IRS, because the COD income escapes taxation, it cannot be used to increase the shareholder basis in the stock.

The Courts' Decisions

In the Seventh Circuit case, the appeals court found that both arguments had merit. However, the appeals court concluded that the proper interpretation of the Code should prevent a windfall to the taxpayer. The result is that the COD income would be reduced by the suspended losses at the corporate level before passing through to the taxpayer.

However, the Seventh Circuit then disagreed with the Tenth Circuit, ruling that any remaining COD income could pass through to the taxpayer. Such a pass-through would increase his basis for the future, i.e., for the future sale of the S-corporation stock. This position is in complete contrast to the Oregon District Court decision. That district court took exactly the opposite view.

The Oregon court ruled that the taxpayer's interpretation of §108 was more appropriate to the statutory language. The district court concluded that if the result was a double windfall for the taxpayer, then it was up to Congress to address the situation.

Accordingly, the taxpayer in that case got to (1) increase his basis with the COD income and (2) take the S corporation's suspended losses against other income. The district court found the interpretation by the Tenth Circuit in Gitlitz to be contrary to sound judicial interpretation of the Code.

An Unresolved Issue

This still leaves the question of if, or when, COD income increases a shareholder basis in an S corporation. The answer to this question for tax years prior to Aug. 18, 1999, is to look to the court opinions in the circuit in which the taxpayer resides. However, the prudent taxpayer should be prepared to answer the IRS's challenge to his basis calculations. As the Seventh Circuit pointed out, the adoption of Regulation 1.1366-1 could change the result of Witzel and, by implication, all the other cases. Regulation 1.1366-1 states that COD income is (1) not considered tax exempt for pass-through purposes and (2) permanently excluded from the gross income of an S corporation (effective for tax years on or after Aug. 18, 1999). This regulation would appear to resolve the ambiguous language of §108, providing more support to the IRS's position on COD income and to the Gitlitz decision.

Summary and Conclusion

This article reviewed three issues regarding the recognition of COD income: (1) determination of debtor's insolvency, (2) exclusion of COD income and (3) increase in S-corporation basis. Recent statutory authority, judicial precedent and administrative rulings provide professional guidance with respect to these three issues.