When the debt owed by a debtor is cancelled or forgiven, the debtor generally has cancellation of indebtedness (COD) income. COD income is generally includable in gross income, but may be excluded under section 108 of the Internal Revenue Code in some instances. A statutory exclusion exists for COD income that arises in a title 11 bankruptcy case or when the taxpayer is insolvent. Final regulations were issued recently that apply these exclusions to a grantor trust or a disregarded entity (DRE). According to the regulations, DREs include single-member LLCs that do not elect to be classified as corporations, corporations that are qualified REIT subsidiaries and corporations that are qualified Subchapter S subsidiaries.
For example, if a corporation owns 100 percent of an LLC subsidiary and the subsidiary has lent money to a third party, and that debt is forgiven, the LLC has COD income that flows through to the corporate owner. But, what if the LLC is legally in bankruptcy? Or the LLC, on a standalone basis, is insolvent? On one hand, it is appealing to say that, if the entity is legally in bankruptcy, it cannot have COD income. On the other hand, a DRE is disregarded for all federal tax purposes, unless the Internal Revenue Code or regulations provide otherwise (e.g., a DRE has payroll compliance responsibilities and has its own liabilities for payroll taxes).
In the case of determining COD income, the final regulations, effective for COD income occurring after June 9, 2016, provide that the bankruptcy and insolvency exclusions are applied at the owner level; the regulations define the term “taxpayer” for purposes of these exclusions as the owner of a grantor trust or the owner of a DRE. Consequently, if a grantor trust or DRE is insolvent, but the owner of the grantor trust or of the DRE is solvent, according to the regulations, the insolvency exclusion does not apply and the COD income is recognized.
Similarly, for the bankruptcy exclusion to apply, the owner of a grantor trust or DRE must itself be under the jurisdiction of the court as the title 11 debtor. The preamble to the regulations concludes that extending the bankruptcy exclusion to the owner of a grantor trust or DRE who is not in bankruptcy would be inconsistent with the intended purpose of the bankruptcy exclusion, as reflected in its legislative history. The preamble notes that that that debtor’s “fresh start” under the Bankruptcy Reform Act of 1978 is conditioned upon the debtor committing all of its nonexempt assets to the jurisdiction of the bankruptcy court, either for sale by the trustee or to determine an appropriate plan to repay creditors, and that the bankruptcy COD exclusion was enacted in the Bankruptcy Tax Act of 1980 to supplement the Bankruptcy Reform Act. As stated in the preamble:
Congress did not intend that a solvent, non-debtor owner of a grantor trust or a disregarded entity, which has committed some but not all of its nonexempt assets to the bankruptcy court’s jurisdiction, have an exclusion from discharge of indebtedness income merely by virtue of having some of its assets subject to the jurisdiction of the bankruptcy court.
Accordingly, for a taxpayer to claim the bankruptcy exclusion, the taxpayer must actually file a bankruptcy petition, i.e., a discharge of the debt in a petition filed by the DRE or grantor trust will not trigger the exclusion. For a partnership, section 108(d)(6) provides that the insolvency and bankruptcy exclusions apply at the partner level, and not at the partnership level. The regulations state that, if a partnership holds an interest in a grantor trust or DRE, the bankruptcy and insolvency exclusions are tested by looking at each partner to whom the income is allocable. Such partner must be under the jurisdiction of the court in a title 11 case of that partner as the title 11 debtor, or must be insolvent, for the exclusions to apply.
The position of the regulations regarding the bankruptcy exclusion is contrary to the Tax Court’s holdings in the related cases of Gracia v. Commissioner, T.C.Memo 2004-147; Mirachi v. Commissioner, T.C. Memo 2004-148; Price v. Commissioner, T.C. Memo 2004-149; and Estate of Martinez v. Commissioner, T.C. 2004-150, known as collectively as Gracia. In Gracia, some of the general partners who executed personal guaranties on the loan of a partnership that was in title 11 reached a settlement with the bankruptcy trustee to pay agreed-upon sums to the bankruptcy estate to receive discharges from their liability. Pursuant to an order, the Bankruptcy Court discharged the taxpayer (the partner) from all liability to the trustee, the bank and all creditors of the partnership. In the same order, the Bankruptcy Court explicitly asserted its jurisdiction over the partners for purpose of the discharge. Because the Bankruptcy Court had asserted jurisdiction over non-debtor partners for certain matters, the Tax Court upheld the application of the bankruptcy exclusion to the partners of the partnership, even though the partners were not title 11 debtors. The preamble to the regulations states that the IRS’s position is that these cases failed to interpret correctly the limited scope of the bankruptcy exclusion, which applies only to partners that are also title 11 debtors. In February 2015, the IRS issued Action on Decision 2015-1, nonacquiescing in the Gracia cases.
There are several areas that the Department of the Treasury and the IRS anticipate addressing in more detail in future guidance. These include when debt of a DRE is taken into account in determining an owner’s insolvency and how a grantor’s share of the liabilities of a multiple-owner grantor trust should be determined for purposes of assessing the owner’s insolvency. Although not included in the regulations, the preamble states that Treasury and the IRS are of the view that indebtedness of a grantor trust or a DRE is indebtedness of the owner and that, assuming that the owner has not guaranteed the debt and is not otherwise liable for it, the debt should generally be treated as nonrecourse debt for purposes of the insolvency exclusion. The preamble states that Treasury and the IRS will continue to review these views and provide additional guidance for further clarification. The IRS requests comments on these topics. The final regulations apply to COD income occurring after June 9, 2016.
Under these COD exclusion regulations — even though the grantor trust or DRE is the party that is the debtor, either in or outside of bankruptcy, and is the party that is legally responsible for the debt — the owner is not permitted to utilize the bankruptcy and insolvency exclusions. However, in other areas of the tax law, an owner that has no legal liability for debt can benefit from the debt of a DRE or grantor trust. For example, if a single-member LLC is a shareholder of an S corporation and lends money to the S corporation, the owner of the LLC will get basis in its S stock, even though the owner has no legal liability for the debt. Similarly, when a DRE that is created under foreign law pays foreign income taxes, such taxes are treated as taxes paid by the owner for purposes of obtaining a foreign tax credit, even though the legal liability for the taxes is that of the DRE. The difference in these instances from the bankruptcy COD exclusion relates to the specific purposes for the exclusion as set forth in the legislative history to the bankruptcy acts. The bankruptcy acts make explicit that it is the owner’s assets that must be committed to the bankruptcy court’s jurisdiction, and, therefore, conducting business through a DRE or grantor trust that enters into bankruptcy does not achieve that result. With regard to the insolvency exclusion, if it applied at the entity level, every business venture could become eligible for the exclusion if the business did not go well simply by being conducted by a DRE or grantor trust.
The position of the final regulations had been set forth in the proposed regulations, and, therefore, taxpayers were on notice concerning the IRS’s views. As to the bankruptcy exclusion, the preamble makes it clear that the IRS’s position is that the owner must be a title 11 debtor; the IRS does not accept the holding in Gracia that the bankruptcy exclusion applied to the partners of the partnership because the Bankruptcy Court had asserted jurisdiction over the non-debtor partners for certain matters, even though the partners were not title 11 debtors. The position of the final regulations that the owner of a DRE or grantor trust must be insolvent prevents taxpayers from taking advantage of the COD rules by conducting business in the form of a DRE or grantor trust.