Take-Away: Gross taxable income of an individual includes income from the discharge of indebtedness. The Tax Code does, however, provide a set of exceptions to this general rule. The nature of a business, e.g. partnership vs LLC vs S corporation that has its indebtedness discharged can lead to differences in how that discharge of indebtedness income is reported and taxed. Knowing these rules of taxation will become important if our country’s economyin-crisis causes many taxpayers to be unable to pay their debts and thus seek a discharge or modification of that debt.

Background: Gross income includes income from discharge of indebtedness. [IRC 61(a)(12).] How that income is reported depends upon whether the debt that is discharged is recourse or nonrecourse as to the borrower.

  • Cancellation of Recourse Debt: A discharge of recourse loan in a foreclosure results in gain or loss on the disposition of the collateral asset and potential cancellation of indebtedness income to the debtor. The amount realized by the borrower is the smaller of (i) the fair market value of the pledged asset or (ii) the outstanding debt immediately before the transfer of the pledged asset.
  • Modification of a Recourse Debt: If the recourse loan is modified with the consent of the lender, then there no gain or loss is recognized, but there is still cancellation of indebtedness income to the borrower.
  • Cancellation of Nonrecourse Debt: The discharge of nonrecourse loan in a foreclosure results in gain or loss recognized by the borrower on the disposition of the pledged asset, but no cancellation of indebtedness income. The amount that is realized by the borrower is the full amount of the debt.
  • Modification of Nonrecourse Debt: If the nonrecourse loan is modified with the consent of the lender, then it is still possible for the borrower to incur cancellation of indebtedness income. [See Revenue Rulings 91-31 and 92-99.]

Exclusion of Cancellation of Indebtedness from Gross Income: As is often the case, the Tax Code also has a very long, not-to-mention convoluted, section that identifies the situations where the debtor who has their debt cancelled will not have to report the cancellation of indebtedness as taxable income. [IRC 108(a)(1).] A generalized list of those statutory exclusions follows, understanding that very technical definitions are omitted which define when a specific debt is qualified, per this statute.

(A) discharge in a Title 11 (Bankruptcy) case;

(B) discharge when the debtor is insolvent [this exclusion defines insolvency by the debtor’s total liabilities immediately before the discharge less the fair market value of the debtor’s assets (which include exempt assets like retirement accounts and pensions) before the discharge = the extent to which the debtor is deemed insolvent];

(C) the indebtedness discharged is qualified farm debt;

(D) In case the debtor other than a C corporation, the indebtedness discharged is qualified real property business indebtedness; and

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged prior to January 1, 2017 or is subject to an arrangement that is entered into  and evidenced in writing prior to that date.

Type of Business Debtor is Important: As a very broad generalization, if real estate or other investment assets are leveraged, it is better for an LLC or other entity that is taxed as an S corporation to have its debt discharged. The reason is that the reduction of debt owed by an S corporation that is insolvent will normally not cause taxable income to have to be recognized by the corporation’s shareholders. Insolvency which results in the exclusion of cancellation of indebtedness as taxable income, as described above, is measured at the entity level for an S corporation, as opposed to being measured at the partner level, or the individual owner level (e.g. sole proprietorship) when an entity is taxed as a partnership or it is disregarded for income tax purposes. This may come as a surprise, since normally a partnership is viewed as more advantageous than an S corporation when leveraged assets, like real estate, are owned by it and used in the business operations.

Restating Tax Consequences on Debt Reduction: When debt is reduced, the borrower must normally pay ordinary income taxes on the reduction of the debt, following the Byzantine rules of IRC 61(a)(12) and IRC 108’s narrow exclusion situations.

  • If the outstanding debt is reduced by the lender without the transfer of the underlying collateral that secures the debt, then the amount of the debt reduction is considered to be taxable ordinary income of the debtor.
  • If the loan is nonrecourse, the debtor will generally calculate taxable gain [following IRC 1001] which can lead to capital gain and potential depreciation recapture.
  • If the debt is recourse, the transaction is bifurcated: (i) ordinary gain will be recognized to the extent that the debt exceeds the fair market value of the pledged property, with capital gain recognition [IRC 1001] or depreciation recapture as if the property was sold for its fair market value.

Business Entity: These complex rules are best summarized for various business entity taxpayers are follows:

  • Disregarded LLC: The income from the discharge of indebtedness will be considered to have been received by the member-owners of the LLC;
  • LLC Taxed as Partnership: The income from the discharge of indebtedness will flow through pro-rata to each partner with insolvency determined at the partner level, i.e. for each partner;
  • LLC or Corporation Taxed as S Corporation: Insolvency will be determined at the S corporation level and not flow through as K-1 income to the S corporation shareholders;
  • C Corporation: Income from the discharge of indebtednesswill be limited to the corporation, and not its shareholders.

Following these rules, if an S corporation converts to a C corporation status before an insolvency related sale,  taxable income can be avoided by the shareholder.

Disparity in Treatment Examples (with variations:)

Basic Facts:  Rex owns real estate with a fair market value of $1.0 million. The income tax basis in the real estate is $800,000. Rex owes $2.0 million on the recourse loan that is secured by his real property.

Since Rex’s loan is recourse, Rex would realize $1.0 million of ordinary income and $200,000 of capital gain and/or depreciation recapture if the real property is taken in foreclosure by his lender. The ordinary income portion comes from the amount of Rex’s debt ($2.0 million) in excess of the fair market value of the real estate ($1.0 million.) The capital gain portion (or recaptured depreciation portion) results from a deemed sale of the real property by Rex for its fair market value ($1.0 million) less Rex’s income tax basis in the real property ($800,000.)

If Rex’s loan had been nonrecourse, then the gain that Rex would realize would be calculated under IRC 1001 which would generally result in his recognition of capital gain ($200,000) and any recapture of depreciation that Rex might have previously claimed.

If Rex’s lender agrees to reduce the amount of the outstanding principal balance of Rex’s loan but does not take ownership of Rex’s real estate, Rex will have to recognize ordinary income, unless he is insolvent [IRC 108(a)(1)(B)] or this negotiated reduction in Rex’s debt occurs in Rex’s bankruptcy proceeding [IRC 108(a)(1)(A).]

If Rex had owned the real estate in an S corporation that became insolvent, then it is possible that the exclusions under IRC 108 might allow for no taxable income to be considered as received by Rex, the S corporation’s sole shareholder, when the S corporation restructures its debt with the lender.

If Rex had owned the real estate in an S corporation, and the S corporation was converted to being taxed as a C corporation before the transaction with the lender, Rex would be shielded from any personal income tax liabilty. In contrast, had Rex owned the real estate in an LLC that elected to be taxed as a partnership, or that was disregarded for income tax reporting purposes, e.g. a single member LLC, he would not be able to do the conversion tax free if the outstanding indebtedness ($2.0 million) exceeds his income tax basis ($800,000) in the real property.

Choice of Entity: It is often recommended that encumbered real estate be held in an LLC (taxed as a partnership) or partnership as opposed to an S corporation, for many good reasons. For example (i) the partners receive tax basis for indebtedness incurred by the partnership; (ii) on a partner’s death, the tax basis of partnership assets can receive a step-up in basis with an IRC 754 election; (iii) appreciated real estate can generally be distributed from the partnership tax-free to its partners; and (iv) no restrictions apply as to who can own partnership interests. None of these attributes pertain to an S corporation.

However, if the entity may later become insolvent, and there could as a result in a reduction of the underlying debt or a foreclosure action that would cause taxable income to the sole owner or partners who own the leveraged property, it might make more sense for the LLC to elect to be taxed as an S corporation, to shield the partners (or members) from having to recognize cancellation of indebtedness income.

Conclusion: If a business that owns leveraged real estate is formed as an LLC, there should be a provision in its Operating Agreement that permits the LLC to elect to be taxed as an S corporation within 75 days after the election is made. This election cannot be done in the absence of a provision in the Operating Agreement. This provision might permit the LLC member’s personal exposure to cancellation of indebtedness income to be avoided, shifting that liability to the S corporation.