EXCLUSION OF INCOME FROM DEBT CANCELLATION
Income resulting from the cancellation of debt (COD) is excluded from a bankrupt or insolvent corporation’s gross income for U.S. federal income tax purposes.[1] In non-bankruptcy situations, exclusion is limited to the amount of the taxpayer’s insolvency.[2] For purposes of section 108, a taxpayer is insolvent in the amount that the taxpayer’s liabilities exceed the fair market value (FMV) of the taxpayer’s assets, determined immediately before the discharge.[3]
For a company treated as a partnership for tax purposes, insolvency is determined at the partner level rather than the partnership level for purpose of excluding COD income.[4] As a result, financially stable owners of an insolvent partnership often are not able to exclude COD income realized in a workout of the partnership’s debt. In some circumstances, however, partners may benefit from a special rule allowing them to account for part of the partnership’s debt when determining their own insolvency for the purpose of applying the COD exclusion.[5]
REDUCTION OF TAX ATTRIBUTES
A corporation that excludes COD income due to either bankruptcy or insolvency is required to reduce tax attributes. Sections 108(b) and 1017 provide corresponding rules that act to reduce the taxpayer’s basis in property owned at the beginning of the year following the discharge, generally by the amounts excluded from gross income under section 108.[6]
Net operating loss (NOL) carryforwards are an attribute subject to reduction. At the same time, section 382, which operates to limit the utilization of corporate NOLs and built-in losses following an ownership change, provides certain taxpayers with favorable rules for the utilization of NOLs upon emergence from the bankruptcy proceeding.[7] As a result, understanding the consequences of the interplay between attribute reduction and the section 382 limitation is critical to taxpayers contemplating bankruptcy.
