2009 Tax Act Provides Relief From Cancellation of Indebtedness Income
March 10, 2009
Jeffrey "Jeff" Rubinger- Ft Lauderdale
On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 (the 2009 Act). Admittedly, the 2009 Act will not be of universal benefit to taxpayers. For example, the five-year net operating loss carryback is available only to businesses whose average annual gross receipts for the past three years does not exceed $15 million.
One provision of the 2009 Act, however, should provide welcome relief to a broad scope of taxpayers: Section 108(i).1 In general, under new Section 108(i), certain taxpayers are able to elect to defer the recognition of cancellation of indebtedness income (COD income) arising from a “reacquisition” of debt instruments after December 31, 2008, and before January 1, 2011. Under the new provision, the COD income that is deferred must be included in the taxpayer’s gross income ratably in the five taxable years beginning with: (i) repurchases in 2009, the fifth taxable year following the taxable year in which the repurchase occurs, or (ii) repurchases in 2010, the fourth taxable year following the taxable year in which the repurchase occurs. The provision is effective for discharges in taxable years ending after December 31, 2008.
Current Law
In general, a taxpayer is required to include COD income in its gross income. Under Section 108(a), however, a taxpayer has the ability to exclude COD income from its gross income if: (i) such taxpayer is in a Title 11 bankruptcy case, (ii) such taxpayer is insolvent, or (iii) the COD income arises with respect to certain qualified real property business indebtedness. In situations where a taxpayer is able to exclude COD income from its gross income under Section 108, such taxpayer is typically required to 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 COD income.
For all taxpayers, the amount of COD income generally is equal to the excess of the adjusted issue price of the indebtedness being satisfied over the amount paid (or deemed paid) to satisfy such indebtedness. This rule generally applies to: (i) the acquisition by the debtor of its debt instrument in exchange for cash, (ii) the issuance of a debt instrument by the debtor in satisfaction of its indebtedness, including a modification of indebtedness that is treated as an exchange (a debt-for-debt exchange),2 (iii) the transfer by a debtor corporation of stock, or a debtor partnership of a capital or profits interest in such partnership, in satisfaction of its indebtedness (an equity-for-debt exchange),3 and (iv) the acquisition by a debtor corporation of its indebtedness from a shareholder as a contribution to capital.4
Related party acquisitions
In addition to a taxpayer recognizing COD income as a result of a direct acquisition of its own debt, indebtedness directly or indirectly acquired by a person that is “related” to the taxpayer is treated as if it were acquired by the taxpayer directly.5 Thus, where a taxpayer’s indebtedness is acquired for less than its adjusted issue price by a person related to the taxpayer, the taxpayer recognizes COD income.
New Section 108(i)
As noted above, under new Section 108(i) of the 2009 Act, a taxpayer is permitted to elect to defer COD income arising from a “reacquisition” of “an applicable debt instrument” after December 31, 2008, and before January 1, 2011. Income deferred pursuant to the election must be included in the gross income of the taxpayer ratably in the five taxable years beginning with: (i) repurchases in 2009, the fifth taxable year following the taxable year in which the repurchase occurs, or (ii) repurchases in 2010, the fourth taxable year following the taxable year in which the repurchase occurs.
For purposes of this provision, an “applicable debt instrument” is defined as any debt instrument issued by: (i) a C corporation, or (ii) any other person in connection with the conduct of a trade or business by such person. A “debt instrument” is broadly defined to include any bond, debenture, note, certificate or any other instrument or contractual arrangement constituting indebtedness.
A “reacquisition” is defined as any “acquisition” of an applicable debt instrument by: (i) the debtor that issued (or is otherwise the obligor under) such debt instrument, or (ii) any person related to the debtor. For purposes of the provision, an “acquisition” includes, without limitation: (i) an acquisition of a debt instrument for cash, (ii) the exchange of a debt instrument for another debt instrument (including an exchange resulting from a modification of a debt instrument), (iii) the exchange of corporate stock or a partnership interest for a debt instrument, (iv) the contribution of a debt instrument to the capital of the issuer, and (v) the complete forgiveness of a debt instrument by a holder of such instrument.
Special rules for OID recognized in certain debt reacquisitions
If a taxpayer elects under Section 108(i) to defer the recognition of COD income in a debt-for-debt exchange in which the newly issued debt instrument issued in satisfaction of an outstanding debt instrument of the debtor has OID, then any otherwise allowable deduction for such OID can be deducted ratably only over the same five-year period in which the deferred COD income is included in the taxpayer’s gross income.
This rule can apply also in certain cases when a debtor reacquires its debt for cash. In particular, if the taxpayer issues a debt instrument and the proceeds of such issuance are used directly or indirectly to reacquire a debt instrument of the taxpayer, the provision treats the newly issued debt instrument as if it were issued in satisfaction of the retired debt instrument. If the newly issued debt instrument has OID, the rule described above applies. Thus, all or a portion of the interest deductions with respect to such OID on the newly issued debt instrument are deferred into the five-taxable-year period in which the COD income is recognized. Where only a portion of the proceeds of a new issuance are used by a taxpayer to satisfy outstanding debt, the deferral rule applies to the portion of the original issue discount on the newly issued debt instrument that is equal to the portion of the proceeds of such newly issued instrument used to retire outstanding debt of the taxpayer.
Acceleration of deferred items
It is important to note, however, that any COD income and related deduction for OID that is deferred by an electing taxpayer (and has not previously been taken into account) generally will be accelerated and taken into income in the taxable year in which the taxpayer: (i) dies, (ii) liquidates or sells substantially all of its assets (including in a Title 11 or similar case), (iii) ceases to do business, or (iv) or is in “similar circumstances.” In the case of a pass-thru entity, such as partnership, limited liability company, or S corporation, this acceleration rule also applies to the sale, exchange or redemption of an interest in the entity by a holder of such interest.
Special rule for partnerships
In the case of a partnership (or limited liability company taxed as a partnership), any COD income that is deferred under Section 108(i) will be allocated (when ratably included in the partnership’s gross income) to the partners who were partners in the partnership immediately before the discharge of indebtedness, in the manner such amounts would have been included in the distributive shares of such partners if such income were recognized at the time of the discharge. Furthermore, any decrease in a partner’s share of liabilities that gives rise to a deemed distribution as a result of such discharge will not be taken into account at the time of the discharge, to the extent the deemed distribution would cause the partner to recognize gain. Thus, the deemed distribution resulting from a decrease in a partner’s share of partnership liabilities will be deferred with respect to a partner to the extent it exceeds such partner’s basis in the partnership, and taken into account at the same time as the income deferred under Section 108(i) is recognized by the partner.
Coordination with Section 108(a) and election procedures
Where a taxpayer elects to have Section 108(i) apply, the exclusions provided under Section 108(a) (i.e., for Title 11 bankruptcy cases, where the taxpayer is insolvent, and for qualified real property business indebtedness) will not apply to the COD income for the year in which the taxpayer makes the election or any subsequent year. Thus, for example, an insolvent taxpayer may elect under Section 108(i) to defer the recognition of COD income rather than excluding such amount from gross income under Section 108(a) and reducing its tax attributes by a corresponding amount.
With respect to the Section 108(i) election itself, it is made on an instrument-by-instrument basis; once made, the election is irrevocable. A taxpayer makes the election with respect to a debt instrument by including with its return for the taxable year in which the reacquisition of the debt instrument occurs a statement that: (i) clearly identifies the debt instrument, and (ii) includes the amount of deferred income to which the provision applies. In the case of a partnership (including a limited liability company taxed as a partnership), S corporation, or other pass-through entity, the Section 108(i) election is required to be made by entity itself and not by its partners or shareholders.
For more information, contact:
Jeffrey L. Rubinger
954.468.7862
jeffrey.rubinger@hklaw.com
toll free: 1.888.688.8500
1 All references to “Section” refer to Sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
2 If a debtor issues a debt instrument in satisfaction of its indebtedness, the debtor is treated as having satisfied the indebtedness with an amount of money equal to the issue price of the newly issued debt instrument. Similarly, a “significant modification” of a debt instrument results in an exchange of the original debt instrument for a modified instrument. In such cases, where the issue price of the modified debt instrument is less than the adjusted issue price of the original debt instrument, the debtor will have income from the cancellation of indebtedness. If any new debt instrument is issued (including as a result of a significant modification to a debt instrument), such debt instrument will have original issue discount (OID) equal to the excess (if any) of such debt instrument’s stated redemption price at maturity over its issue price. In general, an issuer of a debt instrument with OID may deduct for any taxable year, with respect to such debt instrument, an amount of OID equal to the aggregate daily portions of the OID for days during such taxable year.
3 If a corporation transfers stock, or a partnership transfers a capital or profits interest in such partnership, to a creditor in satisfaction of its indebtedness, then such corporation or partnership is treated as having satisfied its indebtedness with an amount of money equal to the fair market value of the stock or interest.
4 Where a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, the corporation is treated as satisfying such indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness.
5 In general, related persons are defined under Sections 267(b) and 707(b). With respect to entities, they will be considered related for purposes of these provisions if the same persons own more than 50 percent of the value of each entity.
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