Debt Relief: Breaking Down the Tax Aspects of Covid-19's Economic Impact – Part V, Application of Section 108

Parts I, II, III and IV of this series have presented a general discussion of what constitutes indebtedness, the general consequences of significant modifications of indebtedness, and a number of statutory and congressionally-enacted exceptions to cancellation of indebtedness income (“COD Income”). This installment will build on these concepts and discuss in a more pragmatic manner the application of the statutory exceptions to COD Income in § 108 of the Internal Revenue Code (the “Code”).

The general rule governing COD Income provides that, unless an exception explicitly states otherwise, a debtor who is relieved of an obligation to repay a debt, whether partially or fully, has realized an accession to wealth that must be included in the debtor’s gross income as COD Income. Section 108(a) of the Code provides a series of exceptions to the general COD Income inclusion rule, such as the exclusion from gross income of indebtedness discharged in a title 11 bankruptcy case (see Part I for additional exclusions). These exclusions, though, do not insulate taxpayers from all tax consequences resulting from the discharge of indebtedness. Instead, a number of the exclusions in § 108 provide that while a taxpayer may exclude COD Income from gross income, the taxpayer will also be required to reduce, in a specified order, the taxpayer’s tax attributes.

Reduction of Tax Attributes

Tax attributes are specific economic benefits of taxpayers in the form of losses, tax credits, and the adjusted basis of property. Section 108(b) requires that in certain instances a taxpayer must reduce his tax attributes in order to prevent the taxpayer from unfairly benefitting from the discharge of his indebtedness. Taxpayers are required to report a reduction in tax attributes under § 108 on IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

As a consequence of excluding COD Income from gross income under the § 108(a)(1)(A) bankruptcy exclusion, § 108(a)(1)(B) insolvency exclusion, or § 108(a)(1)(C) qualified farm indebtedness exclusion, the taxpayer must reduce his tax attributes by a specified amount for each $1 of COD Income excluded, as further described below. The specific attributes to be reduced, as well as the order and amount of the reduction, are discussed below.  

Section 108(b)(2) provides that taxpayers must reduce the following tax attributes in the order below:

(i) any net operating loss (“NOL”) for the taxable year of the discharge and any NOL carryover to such year;

(ii) any carryover to or from the taxable year of a discharge of an amount for purposes of determining the amount allowable as a credit under § 38 relating to general business credit;

(iii) the amount of the minimum tax credit available under § 53(b), which is based on a portion of the taxpayer’s minimum tax liability for prior years, as of the beginning of the taxable year immediately following the taxable year of the discharge;

(iv) any net capital loss carryover for the taxable year of the discharge and any capital loss carryover to such taxable year under § 1212;

(v) the basis of the property of the taxpayer;

(vi) any passive activity loss or credit carryover of the taxpayer under § 469(b) from taxable year of discharge; and

(vii) any carryover to or from the taxable year of the discharge for purposes of determining the amount of the credit allowable under § 27 for foreign taxes imposed.

Generally, the amount of the reduction of the tax attribute is equal to a one-dollar ($1) reduction for each dollar excluded from gross income. However, the reduction of general business credits, minimum tax credits, foreign tax credit carryovers, and passive activity carryovers is reduced to approximately $0.33 for each $1.00 excluded from gross income.  

Taxpayers may elect under § 108(b)(5) to apply any portion of the required tax attribute reduction to first reduce the basis of the taxpayer’s depreciable property, but the amount of the basis reduction in the depreciable property cannot exceed the aggregate adjusted bases of the depreciable property held by the taxpayer as of the beginning of the taxable year following the taxable year in which the discharge occurs. If an election is made under § 108(b)(5), other tax attributes are not also reduced by the amount to which the § 108(b)(5) election applies.

If the excluded COD Income exceeds the sum of the taxpayer’s tax attributes, the excess is permanently excluded from the taxpayer’s gross income.

Special Rules Governing Qualified Real Property Business Indebtedness and Qualified Principal Residence Indebtedness

The qualified real property business indebtedness and qualified principal residence indebtedness exclusions in § 108(a)(1)(D) and § 108(a)(1)(E), respectively, are subject to special rules, rather than the rules discussed above governing the reduction in tax attributes.

Qualified Real Property Business Indebtedness

Qualified real property business indebtedness means indebtedness which (i) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property, (ii) was incurred or assumed before January 1, 1993, or if incurred or assumed on or after such date, is qualified acquisition indebtedness (indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business and secured by such property); and (iii) with respect to which the taxpayer makes an election to have the qualified real property business indebtedness provision in § 108(c) apply.

When a taxpayer excludes COD Income from gross income under the qualified real property business exclusion, § 108(c)(1) requires that the adjusted basis of depreciable real property of the taxpayer be reduced by the amount excluded from gross income. In determining the amount of cancelled qualified real property business indebtedness that shall be excluded from the taxpayer’s gross income, § 108(c) provides two limitations: one related to the value of real property used in a trade or business (the “Excess Value Limitation”) and an overall limitation (the “Overall Limitation”).

The Excess Value Limitation provides that the amount of qualified real property business indebtedness excluded from gross income shall not exceed the excess (if any) of (i) the outstanding principal amount of such indebtedness immediately before the discharge, over (ii) the fair market value of the real property used in a trade or business, reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property as of such time. The Overall Limitation states that the amount of qualified real property business indebtedness that may be excluded from a taxpayer’s gross income shall not exceed the aggregate adjusted bases of depreciable real property (determined after any reductions under § 108(b) and § 108(g)) held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge).

Qualified Principal Residence Indebtedness

Qualified principal residence indebtedness means acquisition indebtedness, which is indebtedness incurred in acquiring, constructing, or substantially improving the principal residence of the taxpayer and secured by the principal residence, the aggregate amount of which shall not exceed $2,000,000 ($1,000,000 in the case of a married individual filing a separate return). The term “principal residence” in this context is not defined in the Code, but the Treasury Regulations indicate that all facts and circumstances must be examined on a case by case basis to determine whether a residence is a taxpayer’s principal residence, and key circumstances include the taxpayer’s place of employment and principal place of abode of the taxpayer and family members.

The principal residence exclusion in § 108(a)(1)(E) does not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer. Section 108(h) also provides that if any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, the exclusion in § 108(a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

Section 108(h)(1) requires that a taxpayer reduce his basis in his principal residence by the amount excluded from gross income under the principal residence exclusion, but the taxpayer will not be required to reduce his basis below zero.

Other § 108 Rules Governing Specific Situations

In addition to the exclusions in § 108(a), § 108 also provides a number of rules governing tax consequences in specific transactions, as well as provisions applying the § 108 rules to partnerships and S corporations. The discussion below provides a brief summary of these provisions.

Lost Deductions

Section 108(e)(2) of the Code provides that no COD Income will be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction. For example, a cash method taxpayer engaged in a trade or business that makes monthly rental payments under a lease for an office for use in their trade or business would not have COD Income if the rent were forgiven by the lessor.

Adjustments for Unamortized Premium and Discount

Generally, the amount of COD Income resulting from the discharge of indebtedness is the outstanding principal amount of the indebtedness less the amount received in satisfaction of the indebtedness. However, if an obligation was issued at a discount or a premium, § 108(e)(3) provides special rules for determining the amount of COD Income resulting from a discharge of the obligation. If the instrument was repurchased at a discount, the issuer realizes income from the discharge of indebtedness in an amount equal to the excess of the adjusted issue price over the repurchase price. If the instrument was repurchased for an amount greater than its adjusted issue price (referred to as a premium), the issuer may be entitled to a repurchase premium deduction on the repurchase. For the definition of issuer and adjusted issue price, see Part IV of this series.

Acquisition of Indebtedness by a Related Party

Section 108(e)(4) provides that for purposes of determining income of a debtor from the discharge of indebtedness, the acquisition of indebtedness by a person related to the debtor (as defined in § 267(b) and § 707(b)(1)) from a person unrelated to the debtor shall be treated as the acquisition of such indebtedness by the debtor. Generally, a debtor realizes COD Income to the extent the indebtedness is satisfied for an amount less than the issue price and, as a result of § 108(e)(4), if a related party acquires the debtor’s indebtedness for an amount less than the issue price, the debtor will have COD Income. This rule applies regardless of whether the debt remains outstanding after the related party’s acquisition. 

The rationale behind the rule in § 108(e)(4) is that when certain related parties acquire the debtor’s indebtedness at an amount less than the issue price, because of the close relationship between the acquiror and the debtor and the potential of the debtor to control the payment and terms of the debt in the hands of the related party, it is treated as if the debtor himself acquired his indebtedness for an amount less than the issue price, which would result in COD Income.

Purchase Price Reduction

Section 108(e)(5) provides that, in certain instances, a reduction of indebtedness will be considered a purchase price reduction, rather than COD Income. In order for the purchase price reduction exception in § 108(e)(5) to apply, the debt must be debt of a purchaser of property to the seller of such property which arose out of the purchase of such property, the reduction of the debt must not have occurred in a title 11 case or when the purchaser was insolvent, and, but for the rule in § 108(e)(5), the reduction would have been treated as COD Income to the purchaser.

Section 108 does not explicitly require a reduction in the basis of the purchased property after the application of § 108(e)(5), but since the purchaser’s basis in the purchased property generally includes the purchase price and the reduction in indebtedness is treated as a reduction in purchase price, it would seem that a reduction in the basis by the amount of the purchase price reduction under § 108(e)(5) would be required.

Indebtedness Contributed to Capital

Generally, when a shareholder contributes money or property to a corporation as a contribution of capital, § 118 applies to exclude the contribution from the corporation’s gross income. However, if a corporation has an outstanding obligation of indebtedness owed to a shareholder and the creditor-shareholder contributes that obligation to the corporation, § 108(e)(6) overrides § 118 and provides instead that the corporation will be treated as satisfying the debt with an amount of money equal to the shareholder’s adjusted basis in the debt. Thus, if the shareholder’s basis in the debt is equal to the outstanding principal amount of the debt, the corporation will not recognize any COD Income as a result of the shareholder’s contribution. The corporation would only recognize COD Income if the shareholder’s basis in the indebtedness was less than the outstanding principal amount of the indebtedness, in which case the amount of COD Income would be the difference between the basis and outstanding principal amount.

There is currently no guidance in the Code or Treasury Regulations addressing the application of § 108(e)(6) in a situation in which a creditor-partner contributes an obligation owed by the partnership back to the partnership, but the expansion of § 108(e)(7) and § 108(e)(8), discussed below, to treat partnerships in the same way as corporations creates questions about whether partnerships should also be treated the same as corporations under § 108(e)(6). The availability of such a capital contribution exception has been debated for many years, and practitioners and academics have made compelling cases for both sides of the argument—with some supporting the existence of such an exception and others denying that such an exception exists. Until the IRS provides guidance on the matter, though, the availability of such an exception is unclear, and taxpayers should use caution in relying on a partnership capital contribution rule analogous to § 108(e)(6).

Satisfaction of Indebtedness by Issuance of Corporate Stock or Partnership Interest

If a corporation issues stock or a partnership issues a partnership interest in exchange for the satisfaction of outstanding indebtedness, under § 108(e)(8) the corporation or partnership is treated as satisfying the indebtedness for an amount equal to the fair market value of the stock or partnership interest issued. If the fair market value of the stock or partnership interest is less than the adjusted issue price of the debt, the difference will be COD Income recognized by the corporation or partnership.

The tax consequences to a creditor receiving stock or a partnership interest in an exchange under § 108(e)(8) are beyond the scope of this post, but it is worth noting that § 108 contains a provision addressing a subsequent sale of stock or partnership interests received in such a situation. Section 108(e)(7) requires that a creditor who has either taken a bad debt deduction prior to the exchange of stock for debt or who recognized a loss on the stock-for-debt exchange and later resells the stock at a gain must recognize ordinary, rather than capital, gain in an amount up to the amount of the bad debt deduction or loss recognized.

Section 108(e)(7) also provides that under Treasury Regulations a similar rule shall be applied to creditors receiving a partnership interest, but no such Treasury Regulations have been issued to date. While it is unclear exactly how such a provision would apply without guidance from the Code or Treasury Regulations, under the principles of § 108(e)(7) it would appear that a creditor who has either taken a bad debt deduction prior to the exchange of a partnership interest for debt or who recognized a loss on the partnership interest-for-debt exchange and later resells the partnership interest at a gain would be required to recognize ordinary gain in an amount up to the amount of the bad debt deduction or loss recognized.

Indebtedness Satisfied by Issuance of New Debt Instrument

Section 108(e)(10) provides that for purposes of determining income of a debtor from the discharge of indebtedness, if a debtor issues a debt instrument in satisfaction of indebtedness, such debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument. If the issue price of the new debt instrument is less than the issue price of the original debt instrument, the debtor will have COD Income equal to the difference in the issue price.

For the definition of issue price and information on when a modification of a debt instrument will be considered an issuance of a new debt instrument, see Part IV of this series.

Student Loans

Section 108(f) addresses situations in which a discharge of student loans will not result in COD Income to the debtor. Section 108(f)(1) provides that in the case of an individual, gross income does not include any amount which, but for § 108(f)(1), would be includible in gross income by reason of the discharge, in whole or in part, of any student loan if such discharge was pursuant to a provision of such loan under which all or part of the indebtedness of the individual would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers. Section 108(f) also provides an exclusion from gross income for discharges on account of death or total permanent disability of the debtor-student.

Special Rules for Partnerships

When a debtor is a partnership, special consideration must be taken to determine at what level any COD Income exclusions will apply. Section 108(d)(6) provides that the exclusions from gross income in § 108(a), the rules regarding the reduction in tax attributes under § 108(b), the rules governing the discharge of qualified real property business indebtedness in § 108(c), and the rules governing the discharge of qualified farm indebtedness in § 108(g) shall be applied at the partner, rather than partnership, level. For example, if a partnership has COD Income, which will flow through to partners, whether a partner is eligible for an exclusion in § 108(a), such as the insolvency exclusion, is determined by looking at whether the individual partner, rather than the partnership, is insolvent.

Section 108(e)(8) also provides that if a partnership interest is issued under § 108(e)(8) in satisfaction of indebtedness, COD Income is determined at the partner, not partnership, level based on the partners of the partnership immediately before the issuance of the partnership interest for debt. There is currently no guidance in the Code or Treasury Regulations addressing the application of the § 108(e)(6) capital contribution rule, discussed above, in the partnership context. The IRS has stated in a Technical Advice Memorandum that the § 108(e)(5) purchase price reduction rule, discussed above, applies at the partnership, rather than partner, level.

Special Rules for S Corporations

Section 108(d)(7) provides that the exclusions in § 108(a), reduction in tax attributes rules in § 108(b), special rules governing the discharge of qualified real property business indebtedness in § 108(c), and special rules for the discharge of qualified farm indebtedness in § 108(g) will be applied at the corporate level. Any gain resulting from COD Income is passed on to the S corporation’s shareholders, and COD Income that is excluded from gross income does not pass through to the shareholders for income recognition or shareholder basis purposes.

Section 108 also provides special rules for the intersection of the S corporation rules and the COD Income rules. Section 108(d)(7)(B) provides that for purposes of § 108(b)(2)(A), governing the reduction of tax attributes, any loss or deduction which is disallowed for the taxable year of the discharge under § 1366(d)(1) shall be treated as a net operating loss for such taxable year, except to the extent the qualified real property business indebtedness exclusion in § 108(a)(1)(D) applies to the discharge. Section 108(d)(7)(C) provides that, for purposes of the capital contribution rule in § 108(e)(6), a shareholder’s adjusted basis in the indebtedness of an S corporation shall be determined without regard to any adjustments made under § 1367(b)(2). 

Conclusion

Excluding COD Income from gross income under a § 108(a) exclusion prevents taxpayers from recognizing and paying tax on income they did not actually receive, but the procedural rules throughout § 108 still require taxpayers to account for the exclusion of COD Income through a reduction in tax attributes. The rules governing reductions in tax attributes are complex, and § 108 also contains a number of additional rules governing precise situations such as the treatment of S corporations, partnerships, and specific transactions. Taxpayers should consult a tax attorney for assistance with such matters.

The next installment in this series will change courses, moving on from § 108 and beginning a discussion of the tax aspects relating to bankruptcy from the perspective of both individuals and business entities. 

For any questions on this or any other tax-related matter, please feel free to contact Charles Pulman at cpulman@meadowscollier.com or by phone at (214) 749-2447 and Annie McGinnis at amcginnis@meadowscollier.com or by phone at (214) 749-2412. This blog was written based on the law as in effect on August 4, 2020.