On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009, which significantly modified Section 108 of the Internal Revenue Code relating to discharge of indebtedness income. Specifically, if a taxpayer (or a related party) reacquires its own indebtedness in 2009 or 2010, at the irrevocable election of such taxpayer (on a debt by debt basis), the taxpayer may recognize any related discharge of indebtedness income ratably over 5 years (i.e., at 20% each year).
Proponents of this language said it was necessary to keep businesses that were already struggling from high debt levels from being hit with an additional tax burden at a time when they can least afford to pay it. Under prior law, if a taxpayer or related party reacquired its own debt at less than the issue price, it was required to pay federal income tax on the difference between the original price and the amount paid to reacquire the debt.
For example, assume a business borrowed $5 million five years ago. Today, due to the credit crisis, interest rates on corporate debt are far higher than they were five years ago; and, as a result of the current recession, the business’s credit rating may be much lower. Thus, that $5 million debt may now be worth only $4 million. If the business reacquires this debt in exchange (a) for cash, (b) with another debt instrument; (c) with corporate stock or a partnership interest, or (d) for a contribution of such debt to capital, the $1 million difference is considered discharge in indebtedness income. Under prior law, the entire $1 million difference would have been taxable in the year of the reacquisition. Under the new law, the taxpayer can elect to have this income deferred and recognized over 5 years.
This new election encourages businesses to repurchase their own debt, which should make them more liquid and put them in a better position to withstand the current economic climate.
In addition to the 5-year ratable deferral, the election permits taxpayers to avoid adverse tax consequences they otherwise would be subject to if they relied instead on current exceptions to the recognition of the discharge of indebtedness income (i.e., relating to Title 11 bankruptcy cases, insolvency, and qualified farm indebtedness). These exceptions generally require the non-electing taxpayer to reduce certain tax attributes, including net operating losses, general business credits, minimum tax credits, capital loss carrybacks, basis reductions, and passive activity loss and credit carryovers by the amount of the discharge of indebtedness. A taxpayer can avoid these adverse tax consequences by making an election to defer its discharge of indebtedness income as described here.
"Reacquisition" means any "acquisition" by either (a) the debtor which issued (or is otherwise the obligor under) the debt instrument, or (b) a "related person" to such debtor. For this purpose, an "acquisition" includes providing cash, the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of a debt instrument), the exchange of the debt instrument for corporate stock or a partnership interest, the contribution of the debt instrument to capital, and even the complete forgiveness of the indebtedness by the holder of the debt instrument.
Application Debt Instrument
The deferral applies to any "Applicable Debt Instrument," which is defined as any "debt instrument" which was issued by a "C" corporation or any other person in connection with the conduct of a trade or business by such person. A "debt instrument" in turn, means any bond, debenture, note, certificate, or any other instrument or contractual arrangement constituting indebtedness but does not include certain annuity contracts. 5-Year Deferral Period
The deferral is facilitated by including the discharge of indebtedness income in such taxpayer's gross income ratably over a 5-year period as follows:
- for a 2009 reacquisition, starting 2014 through 2018
- for a 2010 reacquisition, starting 2015 through 2019
Limitations and Special Rules
For partnerships that make the election to defer any discharge of indebtedness income, any income so deferred must be allocated to its partners immediately before the discharge in the manner such amounts would have been included in the distributive shares of such partners under Section 704 (i.e., the rules relating to distributive shares) if such income were recognized at such time. Any decrease in a partner's share of partnership liabilities as a result of such discharge will not be taken into account for purposes of Section 752 (i.e., the rules for the treatment of partner liabilities) at the time of the discharge to the extent it would cause the partner to recognize gain under Section 731 (i.e., the rules for recognition of gain or loss on distribution). Any decrease in partnership liabilities so deferred must be taken into account by such partner at the same time, and to the same extent remaining in the same amount, as income deferred is recognized as described above.
If the taxpayer makes such an election, for the taxable year of the election and any subsequent taxable year the taxable income cannot exclude such deferred discharge of indebtedness income from gross income if it also would otherwise qualify for discharge under other existing provisions of Section 108(a) of the Code:
- Title 11 bankruptcy cases
- taxpayer insolvency
- qualified farm indebtedness
- in the case of a taxpayer other than a C corporation, qualified real property indebtedness.
However, any item of income or deduction which is deferred as the result of the election to defer the discharge of indebtedness income (and has not been previously taken into account) must be taken into account in the taxable year in which the following events occur:
- the death of a taxpayer
- the liquidation or sale of substantially all of the assets of the taxpayer (including a Title 11 bankruptcy or similar case, in which case the day before the petition is filed)
- the cessation of business by the taxpayer
- the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by a partner, shareholder, or other person holding an ownership interest therein
- any similar circumstances
Special rules relate to the deferral of deductions relating to original issue discount in debt for debt exchanges.