One of the most significant tax provisions contained in the recently enacted American Recovery and Reinvestment Act of 2009 (“ARRA”) might prove helpful to certain taxpayers looking to restructure their balance sheets.

A debtor generally recognizes income from the cancellation of its debt (“COD”).. A debtor recognizes COD income when it purchases the debt instrument for less than the adjusted issue price of the debt or exchanges an old obligation for a new obligation with a reduced adjusted issue price from the old obligation, including a modification of debt that is treated as an exchange. A debtor also recognizes COD income when a person who bears a relationship to the debtor described in Code section 267(b) or Code section 707(b) acquires the debtor’s debt for less than the adjusted issue price of the debt.

Special rules exclude COD income in the cases of debtors in Title 11 bankruptcy, insolvent debtors, certain student loans, certain farm debt, and certain real property business debt. If the taxpayer excludes COD income in these cases, the taxpayer generally must reduce certain tax attributes, including net operating losses, general business credits, minimum tax credits, capital loss carryovers, and basis in property, by the amount of the discharged debt.

Under the ARRA amendments, a taxpayer may elect to defer COD income from the reacquisition of an applicable debt instrument after Dec. 31, 2008, and before Jan. 1, 2011 until the five tax years beginning with:

  1. for repurchases occurring in 2009, the fifth tax year following the tax year in which the repurchase occurs, and
  2. for repurchases occurring in 2010, the fourth tax year following the tax year in which the repurchase occurs.

For these purposes, an “applicable debt instrument” is any debt instrument issued by a C corporation or any other person in connection with the conduct of a trade or business by such person. A “reacquisition” is any acquisition of the debt instrument by the debtor that issued (or is otherwise the obligor under) the debt instrument, or a person related to that debtor.

If a taxpayer elects to defer debt discharge income from a reacquisition of an applicable debt instrument, the exclusions for title 11 bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness won't apply to the debt discharge income for the tax year of the election or any later tax year. However, if the taxpayer dies, liquidates or sells substantially all of its assets or ceases its business, any item of income or deduction that is deferred is taken into account in the tax year in which that event occurs (or in a Title 11 case, the day before the petition is filed).

In many cases, the deferral election will permit tax free operations between the date of discharge and the 2014 day of reckoning. Debtors seeking to repurchase debt in 2009 and 2010 should closely analyze whether the election to defer COD income provides them with a tax benefit.