Tax Consequences of
Discharge of Indebtedness

by Alan D. Campbell

The Revenue Reconciliation Act of 1993 made a number of changes relating to the exceptions to the general rule requiring that discharge of indebtedness be included in gross income. But the fact that it is not included in income doesn't mean other tax adjustments don't have to be made. The exceptions and their consequences are presented.

In general, under IRC Sec. 61 (a) (12), taxpayers must include amounts representing discharge of indebtedness in their gross income. There are exceptions to this general rule contained in IRC Sec. 108. These include debt discharged under Title 11 of the bankruptcy code and a discharge when the taxpayer is insolvent or where qualified farm indebtedness is involved. RRA '93 added another exception relating to qualified real property business indebtedness. In addition, this section covers solvent taxpayers in a purchase-money debt reduction situation.

If the discharge of indebtedness meets one of the exceptions, the taxpayer excludes the discharge from gross income. In such cases, the taxpayer must reduce certain tax attributes. For these exclusion provisions, indebtedness includes debts for which the taxpayer is liable as well as any indebtedness subject to which the taxpayer holds property.

Bankruptcy and Insolvency

Gross income does not include discharge of indebtedness if the discharge occurs in a Title 11 bankruptcy case. To qualify for the exclusion under this provision, the taxpayer must be under the jurisdiction of the Bankruptcy Court and the discharge must be granted by the Court or be pursuant to a plan approved by the Court.

Discharge of indebtedness is also not included in gross income to the extent the taxpayer is insolvent. The taxpayer is insolvent to the extent the taxpayer's liabilities exceed the fair market value of the taxpayer's assets immediately before the discharge of indebtedness.

Qualified Farm Indebtedness

Gross income does not include amounts under the discharge of qualified farm indebtedness. Qualified farm indebtedness must have been incurred directly in connection with the taxpayer's trade or business of farming. Also, 50% or more of the taxpayer's gross receipts for the three taxable years before the taxable year of the discharge must be attributable to the trade or business of farming.

To qualify for this exclusion, a qualified person must make the discharge of the taxpayer's indebtedness. A qualified person is any person actively engaged in the business of lending money or any governmental agency or instrumentality. The person must not be related to the taxpayer. In addition, the taxpayer must not have acquired the property from the person or a person related to the person. Finally, the person must not receive a fee with respect to the taxpayer's property or be related to such a person.

Qualified Real Property Business Indebtedness

RRA '93 added qualified real property business indebtedness to the list of exclusions from gross income for discharge of indebtedness. This exclusion is available to all taxpayers except C corporations and is elective rather than mandatory.

Qualified real property business indebtedness is indebtedness a taxpayer incurs or assumes in connection with real property used in a trade or business. The indebtedness must also be secured by the real property and have been incurred or assumed before January 1, 1993, or qualify as acquisition indebtedness. A refinancing of such debt qualifies as long as the debt incurred upon refinancing does not exceed the amount of the refinanced debt. Qualified acquisition indebtedness includes any indebtedness incurred or assumed to acquire, construct, or substantially improve real property used in a trade or business.

This exclusion from gross income is limited to the outstanding principal amount of such indebtedness over the fair market value of the qualified real property less the outstanding principal amount of any other qualified real property business indebtedness secured by the property. This exclusion from gross income is further limited to the aggregate adjusted bases of all of the taxpayer's depreciable real property held by the taxpayer immediately before the discharge other than depreciable real property acquired in contemplation of the discharge.

Example 1. Albert owns a business building in an area in which real estate values have declined substantially. His business building now has a fair market value of $80,000 and an adjusted basis of $25,000. The building is subject to a first mortgage loan obtained in 1988 that is qualified real property business indebtedness. The current balance on this first mortgage loan is $100,000. There is also a second mortgage loan on this building in the amount of $15,000 that is also qualified real property business indebtedness. Albert owns no other depreciable real property. The first limitation on the maximum amount Albert may exclude from his gross income for discharge of indebtedness is $35,000 [$100,000 ­ ($80,000 ­ $15,000)]. The maximum amount Albert may exclude, however, is limited further to $25,000--his aggregate adjusted bases in all his depreciable real property.

Solvent Buyer of Property

If a seller discharges a debt that arose from the purchase of property, the discharge of the liability is excluded from gross income. The debtor must reduce the basis of the asset purchased by the amount of the liability discharged. This provision does not apply in the case of a debt discharged in a Title 11 bankruptcy or if the taxpayer is insolvent.

Reduction of Tax Attributes

Qualified Real Property Business Indebtedness. If the taxpayer makes the election to exclude the discharge of qualified real property business indebtedness from gross income, the taxpayer must reduce the basis of depreciable real property. The taxpayer makes the basis reduction to any depreciable real property held by the taxpayer at the beginning of the taxable year following the taxable year of the discharge.

Other. The taxpayer must reduce tax attributes to the extent of the exclusion from gross income for discharge of indebtedness when such discharge occurs in a Title 11 bankruptcy case, when the taxpayer is insolvent, or if the discharge relates to qualified farm indebtedness. Unless the taxpayer makes the election to reduce basis only (as described below), the taxpayer must reduce tax attributes in the following order:

* Any net operating loss and any net operating loss carryover,

* Any amount that would be used to determine the amount allowable as a general business credit under IRC Sec. 38,

* The minimum tax credit,

* Any net capital loss and any net capital loss carryover to the taxable year of the discharge,

* The basis of the taxpayer's property,

* The passive activity loss and passive activity credit carryforwards, and,

* Any foreign tax credit carried to or from the taxable year of the discharge of indebtedness.

The reductions for net operating loss and net operating loss carryover, capital loss carryovers, reductions in the basis of property, and any passive activity loss are made dollar for dollar of the amount of the excluded income. The reductions for the general business credit carryover, the minimum tax credit, the passive activity credit carryforward, and the foreign tax credit carryover are made on the basis of one third of the amount of the excluded income.

The reduction in the basis of the taxpayer's property is limited to the aggregate bases of the taxpayer's property immediately after the discharge over the aggregate amount of the taxpayer's liabilities immediately after the discharge. In reducing the basis of property, the taxpayer must reduce the basis of property held as of the beginning of the taxable year following the taxable year of the discharge. Treasury has authority to issue regulations to determine the properties that will have a reduction in basis.

The taxpayer is to make the basis adjustments on the first day of the taxable year following the taxable year of the discharge for property owned on that date. For property acquired after the first day of the taxable year following the taxable year of the discharge, the taxpayer makes the basis adjustment on the acquisition date.

If the taxpayer transfers property and receives a discharge of indebtedness, the amount that can be taken as a basis reduction is limited to the excess of the debt discharged over the fair market value of the property transferred.

Election to Reduce Basis Only

The taxpayer may elect out of this prescribed order and reduce the basis of depreciable property only by the entire amount of the discharge excluded from gross income. The taxpayer may elect to treat any real property held in inventory as depreciable property for purposes of the attribute reduction. The amount of this election is limited to the aggregate adjusted bases of the taxpayer's depreciable property as of the beginning of the taxable year following the taxable year of the discharge. If the taxpayer makes this election, the taxpayer is not subject to the limit of the aggregate bases of property over aggregate liabilities that would apply to the basis reduction of property under the normal rules.

Recapture of Basis Reductions

The taxpayer must treat any reductions in the basis of property as a deduction allowed for depreciation. For IRC Sec. 1250 property, basis reductions required because of the exclusion of discharge of indebtedness from gross income are to be disregarded for purposes of determining what straightline depreciation would have been. In addition, any property that had a basis reduction and was not IRC Sec. 1245 property or IRC Sec. 1250 property must be treated as IRC Sec. 1245 property.

Deemed Sale of Property

A taxpayer must include discharge of liabilities in determining the amount realized on a sale or exchange of property unless the discharge is considered income from discharge of indebtedness under IRC Sec. 61(a)(12). Another exception to including discharge of liabilities in the amount realized exists if the taxpayer incurred the liabilities discharged on the acquisition of the property, but such liabilities were not included in determining the basis of the property.

If the liability discharged is a recourse liability and it exceeds the fair market value of the property exchanged, the amount realized on the exchange is limited to the fair market value of the property. However, the difference between the amount of liabilities discharged and the fair market value of the property must be included in gross income as income from discharge of indebtedness unless excluded by another IRC section.

Example 2. Betty owned a personal residence with a basis of $60,000 and a fair market value of $55,000. Betty is solvent, but she owes $70,000 on a mortgage loan secured by the property and for which she is personally liable. Betty deeds the property back to the mortgagee and the mortgagee forgives the mortgage note. Betty is deemed to have sold the residence for $55,000. Thus, Betty has realized a $5,000 loss on the exchange ($55,000 ­ $60,000). Because the loss is on personal use property, the loss is not deductible. Betty must recognize $15,000 gross income from discharge of indebtedness ($70,000 ­ $55,000).

Example 3. Assume the same facts as in Example 2 except the fair market value of the residence is $67,000. Betty is deemed to have sold the residence for $67,000. Thus, Betty has to recognize a $7,000 long-term capital gain ($67,000 - $60,000), unless she meets the criteria for deferral of the gain under IRC Sec. 1034. Betty also must recognize $3,000 gross income from discharge of indebtedness. This $3,000 is not eligible for deferral under IRC Sec. 1034.

If the liability discharged is a nonrecourse liability, then the full amount of the liability discharged is included in the amount realized on the sale or exchange of property. This applies even if the amount of the nonrecourse liability is greater than the fair market value of the property.

Partnerships and S Corporations

For a partnership, certain exclusions from gross income allowed by IRC Sec. 108 for discharge of indebtedness and the corresponding reduction in tax attributes are to be made at the partner level rather than by the partnership. The applicable exclusions relate to insolvency, bankruptcy in a Title 11 case, qualified farm indebtedness, and qualified real property business indebtedness. However, for an S corporation such exclusions from gross income and the corresponding reduction in tax attributes are to be made at the corporate level and not at the shareholder level.

Discharge of Debt that Would Have Been Deductible

The debtor excludes discharge of indebtedness from gross income to the extent the payment of the debt would have given rise to a deduction.

Example 4. Dara sells life insurance policies and receives a commission. The life insurance company pays Dara the commission at the time the policy is sold. However, the commissions are not earned until the customer has kept the policy for one year. Dara must pay any commissions not earned back to the life insurance company. Additionally, Dara must include the unearned commissions in her gross income when they are received rather than when they are earned because of the claim of right doctrine. Then, Dara decides to quit selling life insurance. She owes $6,000 in unearned commissions to the life insurance company. Although Dara has a positive net worth, she does not have the money to repay the commissions. The life insurance company forgives the $6,000 debt. Dara has no gross income because if she repaid the $6,000 in commissions, she would have been entitled to a deduction for restoring an amount held under claim of right under IRC Sec. 1341.

Contribution to Capital

Before RRA '93, when a shareholder gratuitously forgave a debt owed to him by the corporation, the forgiveness was treated as a contribution to capital to the extent of the principal of the debt. To such extent, the corporation recognized no gross income under IRC Sec. 118.

IRC Sec. 118 no longer results in a shareholder's forgiveness of a corporation's debt being treated as a contribution to capital. When a corporation exchanges its indebtedness to a shareholder for a contribution to capital, the corporation will be deemed to have satisfied the indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness.

The shareholder will recognize no gain or loss on the exchange. The shareholder would be deemed to have made a contribution to the corporation's capital for which the shareholder would receive basis. The corporation will recognize gross income from the discharge of indebtedness only to the extent the corporation's book balance of the debt exceeds the shareholder's adjusted basis in the debt. This income would be excluded from the corporation's gross income if the corporation is insolvent or is in a Title 11 bankruptcy case.

Example 5. Etter Corporation issued a $20,000 note to shareholder Baker. At a time when the balance on the note is $18,000, Baker sells the note to shareholder Carlton for its fair market value of $16,000. Carlton has an adjusted basis in the note equal to its $16,000 cost. Then Carlton forgives the debt as a contribution to Etter Corporation's capital at a time when Etter Corporation is solvent and not in a Title 11 bankruptcy case. Etter Corporation is deemed to have paid the debt with an amount of money equal to Carlton's $16,000 adjusted basis. Carlton recognizes no gain or loss. Etter Corporation recognizes $2,000 gross income for the excess of the book balance of the note over the amount of the deemed payment ($18,000 ­$16,000).

If the shareholder forgave the debt in consideration for goods or services provided to him by the corporation, however, the corporation would recognize gross income.

Transfer of Corporate Stock to Discharge a Debt

The courts created another exception to the general rule that discharge of indebtedness results in gross income. This exception applied when a corporation exchanged its own stock for its debt. Congress modified this judicially created exception in 1980, 1984, and again in 1990.

Congress made the stock-for-debt exception inapplicable unless the corporation was insolvent or in a Title 11 bankruptcy case. The stock transferred could not be a nominal amount, and unsecured creditors could not receive a substantially disproportionate amount of stock. In 1990, Congress made certain disqualified preferred stock ineligible for the stock-for-debt exception. Under this stock-for-debt exception, if an insolvent or bankrupt corporation transferred stock in satisfaction of a debt, the corporation did not recognize gross income and did not have to reduce tax attributes.

Congress repealed the stock-for-debt exception altogether as part of RRA '93 for transfers after 1994. There is an exception to this repeal for transfers that are a part of a Title 11 or similar case that was filed on or before December 31, 1993.

Under current law, if a corporation transfers stock to a creditor, whether or not the creditor is an existing shareholder, the corporation will be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock. In general, the corporation must recognize as gross income the difference between the book value of the debt and the fair market value of the stock. However, if the transfer occurs in a Title 11 bankruptcy case or if the corporation is insolvent, this income is excluded from gross income. In such cases, the corporation must now reduce tax attributes.

Example 6. Foster Corporation satisfies a $50,000 debt by transferring stock with a fair market value of $42,000 to the creditor. Foster Corporation must recognize $8,000 ($50,000 ­ $42,000) gross income.

The creditor would recognize gain or loss equal to the difference between the fair market value of the stock received and the adjusted basis of the indebtedness. The creditor must treat such stock as IRC Sec. 1245 property. Also, any amounts allowed to the creditor for a bad debt deduction or as an ordinary loss on the exchange of the debt for the stock will be treated as a depreciation deduction and therefore subject to recapture as ordinary income under IRC Sec. 1245. The gain on the exchange of such stock under IRC Sec. 354(a), 355(a), or 356(a) will be limited to the gain recognized under those provisions.

If a debtor satisfies an indebtedness by issuing another debt instrument in exchange, the debtor will be deemed to have satisfied the indebtedness with an amount of money equal to the issue price of the new debt instrument. The issue price must be determined in accordance with the provisions of IRC Secs. 1273 and 1274. These provisions use present value rules to ensure the issue price approximates fair market value.

The debtor would recognize gross income to the extent the book balance of the indebtedness exceeds the issue price of the new debt instrument. The creditor would recognize gain or loss equal to the difference between the issue price of the debt instrument received and the adjusted basis of the indebtedness. Unlike stock, however, the debt instrument is not treated as IRC Sec. 1245 property.

Acquisition by a Related Party

If a person related to the debtor acquires the debtor's indebtedness from an unrelated person, such acquisition will be treated as if the debtor acquired the indebtedness. Thus, the debtor may be deemed to have gross income from discharge of indebtedness when a related person acquires the debtor's indebtedness. Of course, the provisions of IRC Sec. 108 that provide for exclusion of the discharge of indebtedness from gross income would apply to the debtor.

A related person for purposes of determining gross income of the debtor from discharge of indebtedness includes certain family members of an individual. These family members include the individual's spouse, brothers and sisters, children, grandchildren and other lineal descendants, parents, ancestors, and any spouse of the individual's children or grandchildren. Two entities treated as a single employer under IRC Sec. 414(b) or IRC Sec. 414(c) will be treated as a related person. Other related persons are those described in IRC Sec. 267(b) and in IRC Sec. 707(b)(1).

Compensation for Services

In general, if a debtor performs services and, in return, receives a discharge from a debt, the debtor must recognize the amount discharged as gross income from the performance of services. The amount discharged would also be subject to Social Security tax, income tax withholding, and unemployment taxes if the debtor is an employee. The discharge of indebtedness will be subject to self-employment tax if the debtor is self-employed. Gross income, however, does not include any debt discharged under the provisions of a student loan in which the individual is discharged of part or all of such loan for working for a certain period of time in certain professions.

Gift

Gross income does not include the value of any property received by gift. Proving discharge of business indebtedness is excludable from gross income as a gift is difficult. Taxpayers, however, have been successful in some cases in persuading the courts the discharge was, in fact, a gift. The fact that the discharge of a debt is voluntary does not establish that such forgiveness is a gift. The fact a business creditor settles a debt for partial payment does not necessarily mean the creditor intended the forgiveness of part of the debt to be a gift. If there is a business purpose for a voluntary discharge of the indebtedness of a family member, the debtor will likely be unsuccessful in excluding such a discharge as a gift. The most likely case of exclusion of discharge of indebtedness from gross income as a gift would be a discharge of a debt owed to a family member solely for personal purposes. *

Alan D. Campbell, PhD, CPA, CMA, is an associate professor of accounting at the University of Southwestern Louisiana.

AUGUST 1995 / THE CPA JOURNAL