The Internal Revenue Service recently issued final regulations, which took effect June 10, 2016, clarifying the definition of the term "taxpayer" for purposes of Internal Revenue Code Section 108, which in certain cases exempts cancellation of indebtedness income.
Cancellation of indebtedness (COD) income generally must be recognized when a debt is forgiven or cancelled.1 However, IRC Section 108 exempts COD income from taxation in specified cases.2 The IRS recently issued final regulations (final regulations) that clarify the scope of that exemption, both with respect to the discharge of debt pursuant to a taxpayer's federal bankruptcy proceeding (bankruptcy exemption) and the discharge of debt in other contexts to the extent a taxpayer's liabilities exceed its assets (insolvency exemption).3
Application of the bankruptcy exemption and the insolvency exemption is straightforward in most cases. Individuals and tax-opaque entities—such as C corporations and non-grantor trusts—simply exclude from gross income the value of any debt forgiven or cancelled pursuant to a federal bankruptcy proceeding or by virtue of insolvency. Tax-transparent entities—specifically, grantor trusts and entities disregarded for federal income tax purposes under the check-the-box regulations—have historically created uncertainty with respect to the proper application of the bankruptcy exemption and the insolvency exemption.
Prior to the issuance of the final regulations, it was unclear for purposes of applying the bankruptcy exemption and the insolvency exemption whether the term "taxpayer" referred to the tax-transparent entity at issue or instead its owner—that is, the grantor of a grantor trust or the parent of a disregarded entity. Notwithstanding that tax-transparent entities are generally ignored for federal income tax purposes, some taxpayers argued that the insolvency exemption should be available to the extent a grantor trust or disregarded entity was insolvent, even if its owner wasn’t.4 Likewise, some taxpayers took the position that the bankruptcy exemption should be available if a grantor trust or disregarded entity was a debtor in a federal bankruptcy proceeding, even if its owner wasn’t.
The final regulations reject those arguments as inconsistent with congressional intent.5 The preamble to the final regulations note that to preserve a debtor's "fresh start" after bankruptcy or a discharge of debt by virtue of insolvency, Congress enacted the bankruptcy exemption and the insolvency exemption so that debtors aren’t burdened with an immediate tax liability.6 The final regulations clarify that allowing the owner of a tax-transparent entity the benefit of the bankruptcy exemption or the insolvency exemption, when such owner isn’t itself a debtor in a bankruptcy proceeding or otherwise insolvent, would undermine this policy rationale by not subjecting all of the owner's assets to the jurisdiction of a bankruptcy court or the owner's creditors.
Thus, it’s clear now that the insolvency exemption is available only to the extent that the owner of a grantor trust or a disregarded entity is itself insolvent, and the bankruptcy exemption is available only if the owner is a debtor in a federal bankruptcy proceeding along with the grantor trust or disregarded entity at issue. The final regulations also clarify the appropriate application of both exemptions in cases in which a grantor trust or disregarded entity is owned by a partnership. The applicability of the bankruptcy exemption or the insolvency exemption in such cases is determined with reference to individual members of a partnership to whom COD income is allocable—not to the partnership itself.
1. Internal Revenue Code Section 61(a)(12).
2. IRC Section 108(a)(1).
3. TD 9771.
4. Notice of Proposed Rulemaking, Fed. Reg. Vol. 76, No. 71 p. 20593.
5. TD 9771.
6. S. Rep. No. 96-1035.