TAXES & BANKRUPTCY: EFFECT OF DISCHARGE ON TAXABLE INCOME
(second in a series)
Last month we looked at the basic bankruptcy concepts which tax practitioners should understand to properly advise their clients, including the three types of bankruptcy filings and what types of taxes may be dischargeable in bankruptcy. This month we will examine the tax treatment of bankruptcy discharges.
GENERAL EXCLUSION FROM INCOME
Internal Revenue Code (“IRC”) Section 108(a)(1) states: “Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if (A) the discharge occurs in a title 11 [e.g., bankruptcy] case, (B) the discharge occurs when the taxpayer is insolvent, (C) the indebtedness discharged is qualified farm indebtedness, (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or (E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2015.” Section 208(a)(2) explains which of the exclusions will take priority in the case that more than one applies. Section 108(a)(3) limits the amount of the exclusion to the amount by which the taxpayer is insolvent.
To determine insolvency, the taxpayer must apply the “balance sheet insolvency” test, since the term “insolvent” is defined to mean “the excess of liabilities over the fair market value of assets.” IRC § 108(d)(3). In an audit, the taxpayer will be required to produce records, documents, and information establishing insolvency so as to entitle the taxpayer to exclude cancellation of indebtedness income from gross income. See Hugee v. Commissioner, 2013 WL 5745622 (U.S. Tax Ct. 2013).
REDUCTION OF TAX ATTRIBUTES
Section 108(b) also requires a taxpayer to reduce certain tax attributes in connection with any exclusion from gross income. Specifically, to the extent income is excluded because of a discharge, the taxpayer must reduce (i) any net operating loss for the taxable year of the discharge and net operating loss carryover, (ii) any carryover of general business credits, (iii) the minimum tax credit for the year immediately following the taxable year of discharge, (iv) any net capital loss for the year of the discharge and any capital loss carryover, (v) the basis of the property of the taxpayer, (vi) any passive activity loss or credit carryover from the taxable year of the discharge, and (vii) any foreign tax credit carryovers to or from the year of the discharge.
Section 108 and corresponding regulations also provide specific rules for certain types of assets or indebtedness being discharged. For example, Section 108(h) provides that, when the bankruptcy discharge includes qualified principal residence indebtedness, the amount excluded from income on the discharge will reduce the basis of the principal residence of the taxpayer, but not below zero. Further, the term “qualified personal principal residence indebtedness” is limited to only acquisition indebtedness (debt incurred in acquiring, constructing, or substantially improving any qualified residence (IRC Section 163(h)(3)(B))) that is secured by the residence and does not exceed $2 million (or $1 million in the case of married filing separately).
FORM 1099-C & TIMING ISSUES
In many cases, creditors whose debts are discharged in a debtor’s bankruptcy will issue Forms 1099-C, Cancellation of Debt. The issuance of the Form 1099-C may raise an issue as to the timing of the realization of cancellation of indebtedness income. While the issuance of a Form 1099-C is an “identifiable event” which may fix the timing of the income, it is not dispositive. Newman v. Commissioner, 2016 WL 3573173 (U.S. Tax Ct. June 28, 2016). Treasury Regulation 1.6050P-1(b)(2)(i), (iv) list eight “identifiable events” under which a debt is discharged for information reporting purposes, including: (a) a discharge of indebtedness under Title 11 of the U.S. Code, (b) a cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding in a federal or State court, (c) a cancellation or extinguishment of an indebtedness pursuant to an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor’s right to pursue collection of the indebtedness, and (d) a discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration.
A Form 1099-C indicates to the IRS that the creditor has forgiven the debt and will no longer make any collection attempts. Not all creditors will file a 1099-C after a bankruptcy filing. The Form 1099-C contains a code in Box 6 that identifies why the form was used, indicating whether the discharge was in bankruptcy. If a creditor issues a Form 1099-C, a taxpayer will have two options. First, the taxpayer may use the bankruptcy exclusion discussed above, if it applies. Second, the taxpayer may use the insolvency exclusion to show they were insolvent immediately before the cancellation of the debt. Under both exclusions, the taxpayer should attach Form 982 to their federal income tax return. Also, for tax years 2007 through 2016, married taxpayers may exclude up to $2 million in forgiven mortgage debt ($1 million for other filing statuses) under the Mortgage Forgiveness Debt Relief Act.
PARTNER & PARTNERSHIP DISCHARGE ISSUES
In 2004, the Tax Court decided several cases holding that a partner of a partnership which received Chapter 11 discharge relief may also exclude his share of the partnership’s cancellation of indebtedness income from gross income because, under Section 108(a)(1)(A), the partnership debt was discharged “in a title 11 case.” Martinez v. Commissioner, T.C. Memo. 2004-150; Gracia v. Commissioner, T.C. Memo. 2004-147; Mirarchi v. Commissioner, T.C. Memo. 2004-148; and Price v. Commissioner, T.C. Memo. 2004-149. The Tax Court relied on the principle of “judicial comity,” which means that the Tax Court would respect the Bankruptcy Court’s decision to discharge and release the partners from liability in a partnership title 11 case.
In 2015, the IRS issued corresponding Actions on Decision, disagreeing with the Tax Court’s holdings. The IRS argued that, because the partner was a non-debtor party to the bankruptcy, the partner should not receive corresponding relief because Section 108(a)(1)(A) provides tax relief only to the debtor in bankruptcy. Subject: Estate of Martinez v. Commissioner, AOD-2015-01, 2015 WL 461749 (Feb. 5, 2015); Subject: Gracia v. Commissioner, AOD-2015-02, 2015 WL 461750 (Feb. 5, 2015); Subject: Mirarchi v. Commissioner, AOD-2015-03, 2015 WL 461751 (Feb. 5, 2015), and Subject: Price v. Commissioner, AOD-2015-04, 2015 WL 461752 (Feb. 5, 2015). The IRS argues that the Congressional intent behind Section 108 as applied to partnership debt is to give only the petitioning debtor a “fresh start.” The IRS quotes a Senate debate: “The tax treatment of the amount of discharged partnership debt which is allocated as an income item to a particular partner depends on whether that partner is in a bankruptcy case, is insolvent (but not in a bankruptcy case), or is solvent (and not in a bankruptcy case). . . . [I]f the particular partner is bankrupt, the debt discharge amount is excluded from gross income pursuant to amended section 108 . . . .” S. Rep. No. 96-1035, at 21, 1980-2 C.B. 620, 631. Nevertheless, the Tax Court’s expansive interpretations of Section 108(a)(1)(A) have not (yet) been overturned.
In conclusion, it is very important for tax return preparers to work closely with clients who have filed bankruptcy, received a discharge in bankruptcy, received a Form 1099-C, or exercised an alternative to bankruptcy which may result in cancellation of indebtedness income. Since the facts and circumstances of each case may be different, tax professionals and their clients may wish to seek legal advice in questionable scenarios involving discharges that do not fit neatly within the listed exclusions from gross income in IRC Section 108. Tax professionals should also maintain substantiation of all exclusions from cancellation of indebtedness income.
Prepared by: Sandra D. Mertens, Esq. of Dale & Gensburg, P.C.,
200 West Adams Street, Suite 2425, Chicago, IL 60606 Phone: (312) 263-2200