Bankruptcy and Insolvency Tax Developments of 1998 A Look Back

<p>This past year brought several interesting developments in the bankruptcy and insolvency tax area on both the

regulatory and judicial fronts. Several important regulations were issued by the Internal Revenue Service (IRS) as

well as judicial decisions that will impact S corporation shareholders. In addition, taxpayers felt the impact in 1998

of the late 1997 decision concerning the avoidance of income by claiming insolvency on the basis of guarantees of

debt.

</p><h3>New Tax Regulations</h3>

<p>Effective October 2, 1998, the IRS issued final regulations amending the existing income tax regulations under IRC

§108 (income from the discharge of indebtedness) and §1017 (discharge of indebtedness basis adjustment in TD

8787). The new regulations make comprehensible many of the legislative changes to the income tax rules made

since the enactment of the Bankruptcy Tax Act of 1980. The main thrust of these regulations is the fine-tuning of

the ordering rules for reducing the basis of assets when taxpayers exclude the cancellation of debt income from

taxable gross income under IRC §108.

</p><p>IRC §108 excludes any cancellation of debt from gross income, which arises from 1) bankruptcy, 2) insolvency,

3) "qualified farm indebtedness" or 4) "qualified real property business indebtedness" of any taxpayer (other than a C

corporation). The cost of such an exclusion is the reduction of any tax attributes the taxpayer might possess. The

order of reduction is as follows:

</p><ol>

<li>net operating losses,

</li><li>general business credits,

</li><li>alternative minimum tax credits,

</li><li>capital loss carryovers,

</li><li>asset basis reduction,

</li><li>passive activity loss and credit carryovers,

</li><li>foreign tax credit carryovers.

</li></ol>

<p>The ordering rule for an asset basis reduction (#5 above) is the following:

</p><ol>

<li>Real property used in a trade or business or held for investment, other than real property primarily held for sale

in the ordinary course of business, that secured the discharged indebtedness immediately before the discharge;

</li><li>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;

</li><li>Remaining property used in a trade or business or held for investment, other than inventory, accounts receivable,

notes receivable and real property primarily held for sale in the ordinary course of business;

</li><li>Inventory, accounts receivable, notes receivable and real property primarily held for sale in the ordinary course of

business;

</li><li>Property not used in a trade or business nor held for investment.

</li></ol>

<p>With respect to bankruptcy, insolvency and qualified farm indebtedness, the taxpayer may elect to avoid the above

ordering rules and first reduce the basis in depreciable real and personal property on the first day of the year following

the taxpayer's realization of cancellation of debt income. The reduction cannot reduce the asset basis to below zero.

If the depreciable property bases are inadequate to offset the entire amount of excluded cancellation of debt income,

then the taxpayer returns to the above general ordering rules to further reduce tax attributes for the remaining

cancellation of debt income. As discussed later, a taxpayer may treat a partnership interest as depreciable property,

provided the partnership agrees to carry out the necessary reductions in its asset basis.

</p><p>When electing to reduce the basis of depreciable assets, the order of a basis reduction is the following:

</p><ol>

<li>For acquisition debt incurred to purchase specific property, whether or not the debt is secured by the property,

the basis of the acquired depreciable property is reduced in an amount equal to the income excluded as a result of

the discharge of the acquisition indebtedness.

</li><li>For debt that is secured by a lien on specific property (other than inventory, notes or accounts receivable), basis

in the encumbered property is reduced in an amount equal to the discharge of the debt secured by the lien.

</li><li>Remaining depreciable property used in a trade or business or held for investment, other than inventory accounts

receivable, notes receivable and real property held primarily for sale in the ordinary course of business.

</li></ol>

<p>In addition, the taxpayer may make another election to trust real property held primarily for sale in the ordinary

course of business as depreciable real property for purposes of basis reduction.

</p><p>The regulations also provide that for the refinancing of existing pre-1993 debt, as well as new indebtedness,

incurred or assumed by a solvent taxpayer (other than a C corporation) in connection with real property used in

business, secured by that real property ("qualified real property business indebtedness") and that is discharged, that

the amount excluded from the income may not exceed the excess (if any) of a) the outstanding principal amount

(principal amount of debt plus all additional amounts owed before discharge—<i>e.g.,</i> unpaid interest) of that debt

immediately before the discharge over b) the net fair market value of the secured real property immediately before the

discharge.

</p><p>Under the regulations, a taxpayer must reduce the adjusted basis of real property to the extent of the cancellation

of indebtedness income, which is excluded from gross income in proportion to the adjusted basis. This reduction is

done on the first day of the tax year following the tax year in which the cancellation of debt income is excluded.

</p><p>The basis reduction for this type of indebtedness is done in the following order:

</p><ol>

<li>Any depreciable qualifying real property used in a trade or business other than real property (held primarily for sale in the ordinary course of business) that secured the discharged indebtedness immediately before the discharge;

</li><li>Any other depreciable real property (other than real property held primarily for sale in the ordinary course of

business);

</li><li>Any remaining depreciable property used in a trade or business, (other than inventory, accounts receivable, notes

receivable and real property held primarily for sale in the ordinary course of business).

</li></ol>

<p>A partner may treat his partnership interest as depreciable real property if the partnership consents to making the

corresponding adjustments to the basis of the partnership's depreciable property. Whenever a partner is requesting

the partnership to reduce this "inside basis," it must be done before the due date, including extensions for filing the

partner's income tax return for the year in which the partner has cancellation of indebtedness income.

</p><p>Of paramount importance is that, whenever a taxpayer elects to reduce basis rather than to reduce tax attributes, a

complete Form 982 must be attached to a timely filed tax return for the year in which the taxpayer has cancellation

of debt income excluded from income under IRC §108. A failure to timely file would require the taxpayer to seek

discretionary relief from the IRS under Reg. §301.9100-3T, which entails a private letter ruling permitting a late

election. However, judicial developments were not as friendly as the regulatory developments.

</p><h3>Decisions from the Bench</h3>

<p>In 1998, the tax court did a complete reversal of position in <i>M.T. Nelson,</i> 110 TC 114 (1998), in which it held

that, pursuant to IRC §108(d)(7)(A), any cancellation of indebtedness income excluded from income by an insolvent

S corporation did not flow through to its S corporation shareholders in the form of exempt income that then

increases their basis in the S corporation. In so doing, the court withdrew its earlier opinion in<i> P.D. Winn,</i> TC

Memo 1997-286 and substituted TC Memo 1998-71.

</p><p>In <i>Nelson,</i> the reviewed opinion agreed with the government's position that the cancellation of indebtedness

income is excluded from gross income at the corporate level, does not pass through to the shareholders and that the

correlative reduction in tax attributes also applies at the corporate level. The court held that since the excluded

income was not a pass-through item of income, it could not increase a shareholder's basis in the S corporation.

Further, any other reading of the statute would have produced a windfall insofar as a shareholder would not only

defer taxable income through tax attribute reduction, but also would increase stock basis. This would-be double-dip

seems to have been closed completely.

</p><p>In <i>D.B. Merkel,</i> 109 TC 463 (1997), the tax court provided a barrier for taxpayers trying to exclude cancellation

of indebtedness from income on the basis of insolvency. In this case, two married couples, each of whom owned 50

percent of a computer leasing corporation, had personally guaranteed the corporation's bank indebtedness; its unpaid

balance was in excess of $3.1 million at the time of the corporation's default. About six weeks after the default, the

bank and the parties came to an agreement that ultimately provided for a final payment of $1.1 million and a release

of secured collateral. Thereafter, the corporation was released from its liability as the maker of the note and the

taxpayers were released as the corporation's guarantors. Up to the time of these releases the bank had never made any

formal written request or demand for payment by the taxpayers pursuant to their guarantees. During the same time

period, the North Carolina Department of Revenue proposed a sales and use tax assessment of more than $980,000

against the taxpayer's corporation for failure to collect and pay over sales tax, and this was also abated in full.

</p><p>At no time had North Carolina ever pursued the individual shareholders in their possible fiduciary capacity as

responsible persons.

</p><p>The triggering event for the tax case was the receipt by both couples of $359,721 in cancellation of indebtedness

income flowing from a partnership. Each couple excluded this income from its gross income on the basis of

insolvency due to the existence of the bank guarantees and the sales tax assessment, which caused their liabilities to

exceed the fair market value of their assets.

</p><p>The tax court analyzed the facts under the seminal <i>Kirby Lumber</i>^{<small><a href="#1" name="1a">1</a></small>} decision's "freeing of assets" theory and

found that the indiscriminate inclusion of contingent obligations into the calculation of post discharge liabilities,

without any consideration as to how speculative the obligation may be, would render meaningless any inquiry as

to which assets are freed upon discharge of indebtedness. The court felt that Congress, in enacting the insolvency

exclusion, intended to make a debtor's ability to pay an immediate tax on income from discharge of indebtedness

the controlling factor in determining whether a tax burden is imposed. This ability or inability to pay an immediate

tax is a factual question.

</p><p>The tax court ruled that a taxpayer claiming the benefit of the insolvency exclusion has the burden to prove 1)

that it is more probable than not that the taxpayer will be called upon to pay the obligation in the amount claimed

as a liability, and 2) that the total liabilities so proved by the taxpayer exceed the fair market value of the taxpayer's

assets. Thus, taxpayers will not be able to exclude income unless they can construct a balance sheet of insolvency

based upon real and not speculative liabilities.

</p><hr>

<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} <i>U.S. v. Kirby Lumber Co.,</i> 284 U.S. 1 (1931). <a href="#1a">Return to article</a>