The Internal Revenue Service (IRS) has issued Revenue Procedure 2009-37 (Revenue Procedure), which sets forth the exclusive procedures for taxpayers to make an election (108(i) Election) to defer recognizing cancellation of debt (COD) income under recently-enacted Section 108(i) of the Internal Revenue Code (Section 108(i)). See our prior March 20, 2009 One-Minute-Memo, The American Recovery and Reinvestment Tax Act of 2009 (the “Act”) Allows Deferred Recognition of Cancellation of Debt (COD) Income—COD Income Arising from Foreclosures/Deeds-In-Lieu Transfers Should Be Eligible for Deferral.
The Revenue Procedure provides that a taxpayer makes the 108(i) Election by: (a) attaching a statement that meets the requirements of Section 4.05 of the Revenue Procedure to the taxpayer’s timely filed (including extensions) original federal income tax return for the taxable year in which the “reacquisition” of the “applicable debt instrument” occurs (although taxpayers are granted an automatic 12 month extension for making the election, subject to the “automatic 12 month extension” rules of Treasury Regulations Section 301.9100-2(a)); and (b) if applicable, satisfying the additional requirements of Section 4.07 (Additional Requirements for Certain Partnerships Making a 108(i) Election), 4.08 (Additional Requirements for an S Corporation Making a 108(i) Election), 4.09 (108(i) Election Made on Behalf of Certain Foreign Corporations) or 4.10 (108(i) Elections Made By Certain Foreign Partnerships) of the Revenue Procedure.1
A taxpayer may treat two or more applicable debt instruments that are part of the same issue and that are reacquired during the same taxable year as one applicable debt instrument for purposes of the Revenue Procedure. However, a pass-through entity may not aggregate applicable debt instruments if its owners and their ownership interests immediately prior to the reacquisition of each applicable debt instrument are not identical.
Partial Elections Permitted
The Revenue Procedure affords the taxpayer the flexibility to make (or not make) a 108(i) Election on an “applicable debt instrument”-by-“applicable debt instrument” basis and to make such election for all, or any portion, of the COD income realized in respect of any applicable debt instrument.
Protective Elections Permitted
The Revenue Procedure also allows a taxpayer that is uncertain as to whether an event has triggered COD income to make a “protective” 108(i) Election to become effective if the IRS were to determine after the close of the taxable year in which such event occurred that the transaction did result in COD income.
Favorable “earnings and profits” guidance for real estate investment trusts (REITs) and regulated investment companies (RICs)
According to the Revenue Procedure, while the IRS and the Treasury Department intend to issue regulations that will generally provide that the earnings and profits (E&P) effect of the COD income, and the original issue discount (OID) deductions, deferred under Section 108(i) are to be reflected in the taxable year(s) in which such income is realized and/or such deductions would be allowed without regard to Section 108(i), these regulations will also provide that in the case of REITs and RICs (and also for “adjusted current earnings” purposes), the E&P effect of such deferred COD income and OID deductions are to be reflected in the taxable year that such income and/or deductions are includible in, and/or deductible from, gross income.2
Partnerships afforded flexibility to allocate their deferred COD income among their partners
In the case of COD income realized by a “pass-through entity”—which includes a partnership, limited liability company or other entity or joint venture that is treated as a “partnership” for United States federal tax purposes3—from the reacquisition of an applicable debt instrument, it is the pass-through entity (rather than its beneficial owners) that is permitted/authorized to make the 108(i) Election. The making of such election by a partnership would, however, foreclose any of its partners from taking advantage of any otherwise applicable COD exclusion (e.g., bankruptcy, insolvency or “qualified real property business indebtedness” exclusion). When Section 108(i) was enacted, taxpayers and practitioners expressed concern that (among other things) a partnership (and its general partner(s), managing member(s) or manager(s)) could find itself in a “conflict” situation viz. its partners (given the potentially different tax positions of its partners) with regard to whether or not it should make the 108(i) Election.
However, the Revenue Procedure has addressed this concern by allowing the partnership to elect to defer less than all of its COD income that it realizes in respect of an applicable debt instrument and to determine, in any manner, the portion, if any, of a partner’s allocable share of such COD income (as determined under Section 704 of the Internal Revenue Code and the regulations thereunder) that is to be treated as deferred COD income under Section 108(i) and the portion thereof, if any, that is to not be so treated (and, thus, with respect to which an otherwise available COD exclusion may apply).