Significant Federal Tax Implications of Debt Discharge In Insolvency

May, 2002
Joe Dawson
Dawson & Gerbic, LLP
Seattle, Washington

JOSEPH P. DAWSON is a graduate of the University of Washington in both accounting and law. While there, he served as Comments Editor of the Washington Law Review. Mr. Dawson also holds an LL.M. degree in taxation from the University of Washington, and he served as an adjunct faculty member in that LL.M. program over the past two years. He is also a Certified Insolvency and Restructuring Advisor. Mr. Dawson is the managing partner of the Seattle public accounting firm of Dawson & Gerbic, LLP; his practice there primarily involves complex business income tax planning engagements, with emphasis on the use of limited liability entities and on troubled business restructuring.

INTRODUCTION
INDEBTEDNESS
DISCHARGE OF INDEBTEDNESS
INSOLVENCY
TAX ATTRIBUTE REDUCTION
PARTNERSHIPS
S CORPROATIONS
CONSOLIDATED RETURNS
REPORTING

I. INTRODUCTION

In U.S. v. Kirby Lumber, 284 U.S. 1 (1931), the Supreme Court concluded that settlement of indebtedness at less than its face value is economically the same as disposition of assets at a profit, since both result in an increase in net assets. Therefore, the discharge of the difference between the amount due on the obligation and the amount actually paid is properly characterized as income for federal income tax purposes. That general rule is codified at Internal Revenue Code (IRC) sec. 61(a)(12) and Treas. Reg. sec. 1.61-12(a).

IRC sec. 108(e)(3) requires modification of the measurement of the debt discharge income if the obligation was issued at a discount or a premium. In that case, the amount due on the obligation must be adjusted to account for any unamortized portion of the discount or premium. The adjusted amount, described as the adjusted issue price, is then contrasted with the amount actually paid to compute the debt discharge income amount.

The debt discharge income is then generally taxed, at ordinary income tax rates. As is true for most general IRC rules, however, there are significant exceptions. Those exceptions, for the most part, are codified in IRC sec. 108.

Under IRC sec. 108(e)(2), no income is realized from the discharge of debt to the extent that payment of the debt would have given rise to a deduction for tax purposes.

IRC sec. 108(a)(1) lists four situations in which realized debt discharge income may not be recognized for federal income tax purposes. Subject to numerous other rules and requirements, non-recognition may occur if:

(A) the discharge occurs in a title 11 case;
(B) the discharge occurs when the taxpayer is insolvent;
(C) the discharged debt is qualified farm indebtedness; or
(D) the discharged debt is qualified real property business indebtedness

These materials are intended to focus on the IRC sec. 108(a)(1)(B) insolvency exception to discharge of indebtedness income, but that specific topic cannot be properly addressed without consideration of several related issues. And, as is true in many legal analyses, some of the most significant issues are definitional.

II. INDEBTEDNESS

Cancellation of an obligation results in income under IRC sec. 61(a)(12) only if that obligation is properly characterized as indebtedness of the taxpayer.

For IRC sec.108 purposes, IRC sec. 108(d)(1) makes it clear that indebtedness of a taxpayer includes any indebtedness for which a taxpayer is liable, or subject to which a taxpayer holds property. That definition resolves some potential issues, such as the proper characterization of non-recourse debt and the treatment of accounting "liabilities" such as deferred taxes which are actually valuation accounts rather than amounts owed to any creditor. Unfortunately, however, IRC sec. 108(d)(1) fails to define indebtedness, so it leaves unanswered questions concerning the treatment of certain other types of obligations.

Various commentators suggest that indebtedness for purposes of the IRC sec. 108 definition is probably created only where a taxpayer receives something of value, which it does not include in gross income for tax purposes, in exchange for the taxpayer's promise to pay. That standard has long-standing judicial support. See, e.g., Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir. 1932).

That standard provides a basis for exclusion from indebtedness characterization of two frequently encountered types of obligation.

To the extent bona fide dispute over the existence or amount of a debt results in a settlement for less than the amount which the creditor originally claimed, there has clearly never been a promise to pay. Therefore, the amount of the adjustment was never indebtedness under the suggested standard.

A guarantor normally receives little or nothing of value which it might be exclude from its gross income at the time of receipt in exchange for its guarantee. Various commentators seem convinced that it is apropriate to exclude guarantees and other contingent obligations from characterization as indebtedness. See Kennedy, Countryman & Williams, Partnerships, Limited Liability Entities and S Corporations in Bankruptcy, 13-19 (2000); Tatlock, 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, A-19 (2000), and the decisions cited therein.

Even applying the suggested standard, however, the indebtedness characterization of some types of obligations is unclear.

Fortunately, the statutory pattern of the IRC, both in sec. 108 and in other exclusion sections in Part III of the Code, renders determination of the indebtedness status of many common, but unclear, obligations unnecessary.

Tort claims arising from products liability, warranty claims, and future rent obligations, for example, represent cases of potential indebtedness where it is difficult to identify or quantify any item of value which the taxpayer received in exchange. Even if these types of obligations were determined to be indebtedness, however, their discharge would escape taxation under the IRC sec. 108(e)(2) provision mentioned above, because their payment would give rise to a tax deduction.

And IRC sec. 102 makes it clear that almost any type of true gift creates no gross income to the recipient. The IRC sec. 102 exclusion is clearly broad enough to encompass cancellation of an obligation, at least in a non-business context.

III. DISCHARGE OF INDEBTEDNESS

While IRC sec. 108(d)(1) provides at least a partial definition of indebtedness for IRC sec. 108 purposes, the IRC provides no definition for discharge of indebtedness. The American Bar Association Section of Taxation, Report of the Section 108 Real Estate and Partnership Task Force, Part I, 46 Tax Law. 209, 224 (1992), suggests a two-part test to identify potentially taxable debt discharge: (1) whether at the inception of a loan transaction borrowed funds were excluded from gross income because of an offsetting obligation to repay; and, (2) if so, whether the taxpayer's obligation to repay has been cancelled, forgiven or reduced.

The ABA test for discharge seems reasonable and readily applicable when the transaction in question is solely cancellation or reduction of a loan repayment obligation, but the characterization of transactions becomes more complex if something of potential value, other than cash, is surrendered in exchange for the debt reduction. Fortunately, however, there is authoritative guidance on the inclusion or exclusion from discharge of indebtedness and its statutory consequences of many of the more common types of exchange transactions involving debt adjustments.

One of the most common exchange transactions involving debt adjustments is the satisfaction of debts with mortgaged property or with other property which the debtor owns. A transaction of this type is treated, at least in part, as a sale for tax purposes. Treas. Reg. sec. 1.1001-2(a)(1) states that the amount realized on a disposition of property includes liabilities from which the transferor is discharged as a consequence of the transaction. Treas. Reg. sec. 1.1001-2(a)(2) then modifies that inclusion in the case of recourse liabilities by excluding debt discharge income from the disposition transaction computation.

Where property subject to recourse debt is disposed of in satisfaction of the debt, and the amount of that debt exceeds the property's fair market value, the IRC sec. 1001 Regulations bifurcate the transaction. As shown in Treas. Reg. sec. 1.1001-2(c) Example (8), there is gain or loss from sale or exchange of the property to the extent that the fair market value of the property exceeds its basis, and there is debt discharge income to the extent of any excess of the debt over the fair market value of the property. This position is supported by the courts. See, e.g., Gehl v. Comm., 102 TC 784 (1994), affd 50 F3d 12 (CA8 1995), cert den 616 US 899.

In what seems a counterintuitive twist, however, the IRC sec. 1001 Regulations include the full amount of any non-recourse debts from which a transferor is discharged as a consequence of a property disposition in the amount realized on the disposition. That position, as reflected in Treas. Reg. sec. 1.1001-2(c) Example 7, prevents treatment of any portion of the debt reduction as debt discharge income.

For solvent individual taxpayers, this treatment of the discharge of non-recourse debt might prove beneficial. As pointed out above, the debt discharge income portion of any debt reduction is taxable at ordinary income tax rates. The sale or exchange portion, on the other hand, is potentially eligible for preferential long-term capital gain tax rates.

For insolvent taxpayers, however, the Regulations under IRC sec. 1001 effectively impose a harsher treatment on the discharge of debts on which a taxpayer has no personal liability than they do on cancellation of debts which the taxpayer actually owes. These taxpayers, after all, would pay no tax on any amount characterized as debt discharge income. Unfortunately, however, that treatment is mandated by the Supreme Court decision in Comm. v. Tufts, 461 U.S. 300 (1983).

Of course, not all reductions of non-recourse mortgage debt are actually accompanied by disposition of the property securing the debt. And, where there is no disposition of property, there is no sale or exchange. Instead, because IRC sec. 108(d)(1) defines indebtedness for IRC sec. 108 purposes to include indebtedness subject to which a taxpayer holds property, there is discharge of indebtedness income.

In Rev. Rul. 91-31, 1991-1 CB 19, the Internal Revenue Service (IRS) confirmed that when a holder of non-recourse debt who was not the seller of the property securing the debt discharges a portion of the debt but does not take the collateral, discharge of indebtedness income results from the note modification. The Tax Court has adopted the same rule. See, e.g., Gershkowitz v. Comm., 88 T.C. 984 (1987); Carlins v. Comm., T.C. Memo 1988-79.

Corporate indebtedness is sometimes transferred to a debtor corporation, either by a creditor in exchange for stock of the corporation, or by an existing shareholder as a contribution to capital.

The first type of transfer is actually just another form of debt reduction in exchange for property. And, consistent with the exchange treatment discussed above, IRC sec. 108(e)(8) treats the debtor corporation as satisfying its indebtedness with an amount of money equal to the fair market value of the issued stock. If that fair market value is less than the amount of the debt, discharge of indebtedness income is created in the amount of the difference.

In addressing the latter type of transfer, where no property is actually exchanged for the debt adjustment, IRC sec. 108(e)(6) first withdraws the protection of IRC sec. 118, the IRC section which excludes contributions to its capital from a corporation's gross income. Next, that paragraph treats the corporation as having satisfied its indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. Here, again, discharge of indebtedness is potentially created, this time for the difference between the face amount of the debt and the stockholder's basis in that debt.

Indebtedness is also often exchanged for new indebtedness. Under IRC sec. 108(e)(10), a debtor realizes discharge of indebtedness income to the extent that the adjusted issue price of the old debt exceeds the issue price of the new debt. Determination of the issue price of the new debt, in turn, depends upon whether either the old debt or the new debt is publicly traded.

IRC sec. 1273(b)(3) sets the issue price of the new debt based on the public trading price if either the old debt or the new debt is publicly traded. Debt is generally treated as publicly traded if it is part of an issue any portion of which is either traded on an established securities market or issued for securities which are so traded.

If neither the old nor the new debt is publicly traded, the issue price of the new debt is determined under IRC sec. 1274. Under IRC sec. 1274(a), where indebtedness bears a rate of interest in excess of the applicable federal rate and that interest is payable at least annually, the issue price is the stated principal amount of the indebtedness. Otherwise, the issue price is the imputed principal amount, which generally equals the net present value of all payments due under the new indebtedness computed using a discount rate equal to the applicable federal rate, compounded semiannually.

Transactions which merely modify the terms of existing indebtedness can also result in discharge of indebtedness under the IRC sec. 108 rules. Treas. Reg. sec. 1.1001-3(b) characterizes any significant modification of the terms of a debt instrument as an exchange of property.

Treas. Reg. sec. 1.1001-3(c) defines a debt modification as an alteration of any legal right or obligation of the holder or issuer, whether the modification is evidenced by express agreement (either oral or written), conduct of the parties, or otherwise. Treas. Reg. sec. 1.1001-3(e), in turn, defines a modification as significant if, based on all of the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered, are economically significant. Significant modifications under this test include changes in yield, in the timing or amount of payments, in the obligor or collateral, and in the nature of the debt instrument, the types of payments required under it, or its recourse nature.

And, even though the IRC sec. 1001 Regulations are focused primarily on the taxation of the holder of the modified indebtedness, the recharacterization of the transaction also creates potential debt discharge income for the debtor under IRC sec. 108(e)(10).

Even where there have been no modifications to the underlying debt instrument, discharge of indebtedness can arise solely from the recharacterizations mandated by another IRC section dealing with indebtedness. Solely for tax purposes, IRC sec. 483 reclassifies a portion of each principal payment on certain contracts under which there is unstated interest as interest. But, again, even though the statutory provision is aimed at the taxation of the creditor, one effect is a reduction in debt principal for tax purposes. And that constitutes a debt discharge.

IRC sec. 108 even includes a provision which creates debt discharge income where there has been no adjustment to the debt. Where a person or entity which is related to the debtor, under a modified version of the definitions included in IRC sec. 267(b) and IRC sec. 707(b)(1), acquires debt from a creditor who is not so related, IRC sec. 108(e)(4) treats the transaction as an acquisition by the debtor itself. And if that acquisition is for less than the full amount of the indebtedness, there is potentially debt discharge.

Regulations expanding on IRC sec. 108(e)(4) appear at Treas. Reg. sec. 1.108-2. In addition to direct acquisitions of debt, which are covered at Treas. Reg. sec. 1.108-2(b), those Regulations provide rules for application of the IRC debt discharge provisions to indirect acquisitions in Treas. Reg. sec. 1.108-2(c).

An indirect acquisition occurs under the Regulations when the holder of a debt becomes related to the debtor, if the holder is deemed to have acquired the debt in anticipation of becoming related to the debtor. If the holder acquired the debt within six months prior to becoming related to the debtor, Treas. Reg. sec. 1.108-2(c)(3) provides an apparently irrebuttable presumption of acquisition in anticipation of the relationship.

If the debt is held for more than six months before the relationship between the debtor and debt holder is established, Treas. Reg. sec. 1.108-2(c)(2) calls for examination of all facts and circumstances in determining whether the debt was acquired in anticipation of the relationship. Specific facts which are to be considered include the intent of the parties, any pre-acquisition relationships, and the significance of the debt in proportion to the total assets of the acquirer. And, in this determination, the absence of pre-acquisition discussions between the debtor and the debt holder is expressly not conclusive of intent.

If either a direct of indirect acquisition occurs, there are two results under the applicable Regulations. First, under Treas. Reg. sec. 1.108-2(f), the debtor potentially has debt discharge income on the date the acquisition occurs. Normally, the amount of debt discharge is equal to the difference between the adjusted issue price of the debt and the related holder's basis in the debt. The income amount is based upon the fair market value of the debt rather than basis, however, if the debt acquisition was either: an indirect acquisition more than six months before the relationship occurred; or, a non-purchase transaction.

Second, the debtor is deemed to issue a new debt to the holder in the amount (either basis or fair market value) which was used in the first step to compute debt discharge income. Later payments of the full face amount of the debt, therefore, will represent original issue discount income to the holder and deductions to the debtor.

The Regulations under IRC sec. 108(e)(4) have one significant exception for short-term obligations. If debt with a maturity date within one year of the acquisition date is actually retired by its maturity date, Treas. Reg. sec. 1.108-2(e)(1) excludes that debt from amounts deemed acquired by the debtor.

IV. INSOLVENCY

As discussed above, discharge of indebtedness income is taxed at ordinary income rates when it is taxed, but it isn't always taxed. And one type of discharge which is not taxed is a discharge of an insolvent debtor, to the extent that it is insolvent. See IRC secs. 108(a)(1)(B) and 108(a)(3).

The IRC provides a definition of insolvency for IRC sec. 108 purposes. IRC sec. 108(d)(3) defines insolvency to mean the excess of liabilities over the fair market value of assets immediately before the debt discharge. That definition, however, suffers from some of the same uncertainties as the definitions discussed above, and adds some of its own.

The same types of uncertainties surrounding the meaning of indebtedness, discussed above, arise in identifying the liabilities which should be considered in evaluating insolvency. Because the purpose of the analysis is different, however, the decisions on inclusion of questionable types of obligations for the insolvency test may be different than for identifying discharge of indebtedness income.

Perhaps the most significant area of dispute concerning the obligations to be considered in the IRC sec. 108 insolvency computation has been the treatment of contingent liabilities. Early cases, such as Conestoga Transportation Co. v. Comm., 17 T.C. 506 (1951), acq. 1952-2 C.B. 5, indicated that contingent liabilities should be included in the insolvency computation, but in PLR 8348001 (August 18, 1983) the IRS maintained that such liabilities, in that case contested taxes and related interest, should not be included in the insolvency determination.

In Merkel v. Comm., 109 T.C. 463 (1997), affd 192 F.3d 844 (9 Cir. 1999), the courts considered inclusion of a contingent guarantee liability in the IRC sec. 108 insolvency computation. They concluded that inclusion hinged upon whether it is more probable than not that the debtor will be called upon to pay the obligation in the amount claimed.

Questions have also arisen concerning the inclusion of non-recourse debts in the IRC sec. 108 insolvency computation. Rev. Rul. 92-53, 1992-2 C.B. 48, adopts the position that non-recourse debt which exceeds the fair market value of the property which it secures is included in the insolvency computation only to the extent that such non-recourse debt is itself the subject of the discharge being tested.

And, as in many areas under the IRC, the characterization of obligations as liabilities, rather than equity, should be evaluated. See, e.g., Yale Ave. Corp. v. Comm., 58 T.C. 1062 (1972), where a corporation was found to be solvent because purported debt was determined to actually be equity.

The difficulties in identifying the liabilities to include in the IRC sec. 108(d)(3) insolvency definition are at least matched by the complications and uncertainties involved in computing the fair market value of assets required by that definition.

The IRC provides no definition of fair market value. Treas. Reg. sec. 20.2031-1(b) defines that term as the price at which property would change hands between a willing buyer and a willing seller, if both are adequately informed of the relevant facts and neither is under any compulsion to buy or sell. That definition is binding only for transfer tax purposes, but it is commonly followed for income tax analysis as well.

As that definition is normally applied in valuing businesses, the value of intangible assets is properly included, and the decided cases in the IRC sec. 108 insolvency area also generally adopt that position. See, e.g., Conestoga Transportation Co., v. Comm., supra; J.A. Maurer, Inc. v. Comm., 30 T.C. 1273 (1958) acq. 1959-2 C.B. 5. This is probably not a universal rule, however; at least where the intangible asset in question is the personal experience of an individual, it is likely that the courts will balk at assigning it a value in the insolvency computation. See, e.g., Davis v. Comm., 69 T.C. 814 (1978).

The Davis v. Comm. position on personal experience as an excluded asset seems correct if the thrust of the IRC sec. 108 insolvency exception is deemed to be the exclusion of debt discharge from taxable income only when there are no assets from which a resulting tax could be paid. And this seems to be the Tax Court's current premise.

In Carlson v. Comm., 116 T.C. 87 (2001), appeal dismissed 9 Cir., 7/23/01, the Tax Court reversed it prior precedents, which had excluded the value of any assets exempt from creditors' claims from the IRC sec. 108 insolvency computation. The Tax Court based its decision in Carlson on the view that to the extent a debtor's combined exempt and non-exempt assets exceed its liabilities, the debtor has the current ability to pay a tax on any debt discharge income.

If there are reasonably definitive answers to the IRC sec. 108 insolvency computation uncertainties discussed above, there is one major area of uncertainty where that is not yet true.

It is clear that the tax consequences of transactions which have already occurred should be included in liabilities and in the fair market value of assets when those consequences are known with certainty. And, as mentioned above, the IRS believes disputed tax liabilities should be dealt with under the prevailing insolvency computation rules for the treatment of contingent liabilities.

But there seems to be no clear authority for insolvency computation treatment if the disputed tax effect of a previous transaction is a potential asset rather than a liability, or if the transaction which is expected to someday give rise to a tax liability or benefit has not yet occurred. Resolution of the questions in this area should logically fall to the business valuation experts responsible for identifying the fair market value of assets. Their views in this area have been split for decades, however, and their problem is compounded in the IRC sec. 108 area because each change in the fair market value of assets arguably changes the amount of debt discharge subject to tax.

While the majority of the IRC sec. 108(d)(3) insolvency definition raises potential problems, the timing rule built into that definition creates potential planning opportunities. That definition contrasts assets and liabilities immediately before the tested debt discharge. Normally agreement on settlement terms is reached well before the settlement is completed , however, so there is an opportunity to adjust the ratio of assets to liabilities, and therefore the fact or level of insolvency, before the discharge date. See Walker v. Comm., 88 F.2d 170 (5 Cir. 1937). cert. den. 302 U.S. 692 (1937).

Any such planning, unfortunately, is complicated by the fact that the IRC does not specify when debt discharge income occurs. For discharges outside of bankruptcy, the American Bar Association Section of Taxation, Report of the Section 108 Real Estate and Partnership Task Force, Part 1, 46 Tax Law. 209, 228 (1992) suggests that, as a general rule, a debt should be considered discharged upon the earlier to occur of:

1) forgiveness by agreement of the parties;
(2) cancellation by a binding act of the creditor or by operation of applicable law (such as in certain cases the running of the statute of limitations); or
(3) a creditor's acceptance of payment of an amount less than the issue price of the debt (less and principal amounts previously repaid) in complete satisfaction of the debt.

A number of decisions cited in Tatlock, 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, A-13 (2000) reach conclusions consistent with the ABA's suggested test. The author there also adds the caution, however, that when debt is forgiven conditioned upon the happening of a future event, the discharge is not considered to occur until that future event takes place.

In many cases, of course, none of the discharge events identified by the ABA actually occur. Here, the reported decisions suggest that a de facto discharge occurs when it becomes reasonable to assume that the debt will never be paid. See, e.g., B.M. Marcus Estate v. Comm., 34 T.C. 38 (1975).

V. TAX ATTRIBUTE REDUCTION

When debt discharge income is excluded from gross income under the IRC sec. 108(a)(1)(B) insolvency exception, there are potential prices.

In some cases, IRC sec. 108(b)(2) requires an offsetting reduction of tax attributes, in the following order:

(A) net operating losses;
(B) general business credits;
(C) minimum tax credits;
(D) capital losses;
(E) property basis;
(F) passive activity losses and credits;
(G) foreign tax credits.

In insolvency situations, the property basis which must be reduced under IRC sec. 108(b)(2) includes property which would be exempt from creditors' claims in bankruptcy. Interestingly, based upon IRC sec. 1017(c)(1), that is not the case under the bankruptcy exclusion of IRC sec. 108(a)(1)(A).

There is one elective exception to the IRC sec. 108(b)(2) attribute reduction order. Under IRC sec. 108(b)(5), a taxpayer can apply any portion of its excluded discharge of indebtedness income it wishes to reduce depreciable property basis, rather than other tax attributes. The only restriction on this election is that the basis reduction cannot exceed the adjusted basis of the taxpayer's depreciable property as of the beginning of the taxable year following the year of the debt discharge.

The mechanics and timing of property basis reductions related to exclusion of discharge of indebtedness due to insolvency are governed by Treas. Reg. sec. 1.1017-1.

That Regulation requires that the reduction of basis of specific assets must be made on the first day of the taxable year following the year when the discharge took place, in the following order and in proportion to the adjusted basis of the various assets within each category:

(1) real property used in a trade or business or held for investment, other than real property treated as inventory or held primarily for sale to customers in the ordinary course of business, that secured the discharged indebtedness immediately before the discharge;
(2) personal property used in a trade or business or held for investment, other than inventory, accounts receivable, and notes receivable, that secured the discharged indebtedness immediately before the discharge;
(3) other property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable, and real property included as inventory or held primarily for sale to customers in the ordinary course of business;
(4) inventory, accounts receivable, and real property included as inventory or held primarily for sale to customers in the ordinary course of business; and
(5) property not used in a trade or business and not held for investment.

But any property basis reductions in connection with a discharge of indebtedness exclusion under IRC sec. 108 carries another cost to the taxpayer. IRC sec. 1017(c)(2) makes it clear that such basis reductions will not be treated as immediate taxable dispositions, but IRC 1017(d) subjects the property to IRC sec. 1245, and treats the basis reduction as depreciation. This is one of the methods used in the IRC to tax gains on the eventual disposition of property as ordinary income rather than capital gain.

When net operating losses, capital losses or property basis are reduced, IRC sec. 108(b)(4)(B) requires reductions first to the losses of the debt discharge taxable year, and then to carryovers to that taxable year in the order of the taxable years during which the carryovers arose. IRC sec. 108(b)(4)(C) applies the same ordering rule to tax credits.

IRC sec. 108(b)(3) requires reduction of any losses at the rate of one dollar of loss for each dollar of excluded discharge of indebtedness income. Because tax credits reduce the actual tax liability, rather than merely taxable income, that paragraph requires credit reduction of only 33-1/3 cents for each dollar of excluded income.

There is a significant exception to the IRC sec. 108(b)(3) computational rule, however. In the case of reductions in property basis, other than those due to an election under IRC sec. 108(b)(5), IRC sec. 1017(b)(2) limits the required basis reduction to the excess of the taxpayer's aggregate property basis over its aggregate liabilities immediately after the discharge. But there is also a potentially significant exception to this exception; Treas. Reg. sec. 1.1017-1(b)(3) provides that aggregate liabilities must be reduced by the amount of any cash on hand in applying the statutory exception.

Clearly there will be situations where the amount an insolvent taxpayer's debt discharge exceeds its tax attributes subject to reduction. That excess permanently escapes taxation. See S. Rep. No. 1035, 96th Cong., 2d Sess. 13 (1980); H.R. Rep. No. 833, 96th Cong. 2d Sess. 11 (1980).

VI. PARTNERSHIPS

Partnerships act as conduits for tax purposes. Based upon IRC sec. 702(a), items of income, loss and deduction flow through to the partners, and any tax consequences from those items are recognized at the partner level. Partners can deduct partnership losses only to the extent of their basis in their partnership interest, however.

Each partner's basis in its partnership interest is increased under IRC sec. 705(a) by the amount of any income which passes through to the partner. On the other hand, IRC sec. 752(b) treats any reduction in a partner's share of partnership debt as a distribution of money, and IRC sec. 733 requires a partnership interest basis reduction for such distributions.

Debt discharge is an item of partnership income which passes through to the partners under IRC sec. 702(a)(8). Under the terms of IRC sec. 108(d)(6), each partner's eligibility for the IRC sec. 108(a)(1)(B) insolvency exclusion of its share of debt discharge income depends upon that partner's individual solvency status, rather than that of the partnership.

Moreover, only the individual partners are eligible to make the IRC sec. 108(b)(5) depreciable property basis reduction election. Interestingly, however, while IRC sec. 1017(b)(3)(C) generously allows each partner to include its proportionate share of partnership depreciable property within that election, that inclusion requires partnership consent to a corresponding basis reduction.

VII. S CORPORATIONS

Like partnerships, S corporations also act as conduits for tax purposes in most instances. IRC sec. 1366(a) includes pass-through provisions which are quite similar to those for partnerships under normal circumstances. And, like partnerships, owners of S corporations can deduct losses only to the extent of their basis in the corporation.

There are major differences in the computation of basis between partnerships and S corporations, however. S corporation basis includes only the remaining investment in corporate stock and in corporate liabilities owed directly to shareholders, and there are no basis adjustment provisions identical to those in IRC sec. 752.

There are also significant differences between the rules related to partnerships and to S corporations for IRC sec. 108 purposes. IRC sec. 108(d)(7) requires determination of eligibility for the insolvency exclusion of debt discharge income at the corporate level rather than at the shareholder level. Therefore, the IRC sec. 108(b) attribute reduction rules are also applied at the corporate level, and IRC sec. 1366(d)(1) characterizes losses suspended for lack of shareholder basis as corporate net operating losses potentially subject to reduction under IRC sec. 108(b)(2)(A).

The IRC sec. 108 rules for S corporations also differ from those for C corporations in one significant respect. As discussed above, IRC sec. 108(e)(6) normally requires corporate recognition of debt discharge income when corporate debt with a reduced basis in a shareholder's hands is contributed to the capital of the corporation. However, IRC sec. 108(d)(7)(C) adds back S corporation basis reductions due to net operating losses previously passed through to the shareholder under IRC sec. 1367 for purposes of the IRC sec. 108(e)(6) computation.

VIII. CONSOLIDATED RETURNS

Consolidated returns are governed by the Regulations under IRC sec. 1502. Because those Regulations provide no rules in connection with the application of IRC sec. 108, the commentators take the position that debt discharge rules generally apply to the affiliated corporations on a separate company basis. See, e.g., Crestol, Hennessey & Yates, The Consolidated Tax Return: Principles - Practice - Planning, 5-228 (Fifth Ed. 2001);

At least as to the debt discharge provisions of IRC sec. 108(a), including the IRC sec. 108(a)(1)(B) insolvency exclusion, the IRS has apparently not challenged this approach in the treatment of debt discharge by non-affiliated creditors. Under Treas. Reg. sec. 1.1502-13(g)(3)(ii)(B)(2), however, the bankruptcy and insolvency exclusions are unavailable in connection with discharges of intercompany debt between affiliates.

And it is less clear whether the IRC sec. 108(b) attribute reduction rules are properly applied on a separate company basis. Older private letter rulings support separate company attribute reduction. See, e.g., PLR 9121017 (February 21, 1991); PLR 9122067 (March 6, 1991); PLR 9650019 (September 11, 1996).

A 1998 Field Service Advice, however, took a different position. There, the IRS ruled that when a member of a consolidated group excludes debt discharge income under IRC sec. 108(a) the entire consolidated net operating loss of the group is subject to reduction under IRC sec. 108(b), no matter what portion of that net operating loss is attributable to the member with the excluded income.

That Field Service Advice dealt with exclusion of discharged intercompany debt. And, as noted above, the IRC sec. 1502 Regulations no longer even permit an insolvency exclusion of that type of debt discharge income. Nevertheless, that Field Service Advice raises significant attribute reduction questions.

IX. REPORTING

In contrast to many aspects of federal income tax, there are relatively few reporting requirements imposed on taxpayers in connection with the various rules discussed above.

A copy of Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and the related instructions is attached. That Form requests information concerning exclusions of debt discharge from gross income under IRC sec. 108(a) and resulting reductions of tax attributes under IRC sec. 108(b).

Some commentators believe that Form 982 is not required under normal circumstances. See, e.g., McQueen & Williams, Tax Aspects of Bankruptcy Law and Practice, 23-10 (1997). In most respects the application of IRC sec. 108(a) and 108(b) are mandatory, whether or not Form 982 is filed. And, in fact, during 1997 the IRS withdrew Treas. Reg. sec. 1.108(a), which previously required Form 982 for IRC sec. 108(a) qualification.

Form 982 does become necessary, however, if a taxpayer wishes to make the IRC sec. 108(b)(5) election to reduce depreciable property basis first under IRC sec. 108(b). See Treas. Reg. sec. 1.108-4.

In an insolvency situation, treatment of debt acquisition by a related party as creating excludible debt discharge income is normally desirable. If that characterization is not desired, however, Treas. Reg. sec. 1.108-2(c)(4) identifies another significant required disclosure. A taxpayer's failure to make the disclosures identified in Treas. Reg. sec. l.108-2(a)(4)(iv) creates a presumption that an acquisition of its debt by a related holder was done in anticipation of becoming related to the debtor. And that, in turn, as discussed above, triggers debt discharge.

While insolvent taxpayers may not have to file many forms or statements in connection with discharge of their debts, however, they should normally expect to receive some.

Creditors who lend money secured by property in connection with a business are required by IRC sec. 6050J to file a 1099-A information return if they acquire the security property in full or partial satisfaction of the debt, or if they have reason to know that the debtor has abandoned the property.

Based upon the instructions to Form 1099-A, the only exceptions to this reporting requirement are loans to individuals secured by tangible personal property used solely for personal purposes and some loans to exempt foreign persons secured by foreign property.

IRC sec. 6050P requires applicable entities to file a 1099-C information return if they discharge $600 or more of any person's indebtedness. A list of applicable entities for this purpose, all of which are financial institutions or governmental agencies, appears in the attached instructions to the information returns.