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Cancellation of Debt Income Exceptions and Exclusions

Learn about the exceptions and exclusions for cancellation of debt income, including bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness. Understand how entity classification affects debt discharge and the potential taxable consequences for partnerships.

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Cancellation of Debt Income Exceptions and Exclusions

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  1. Business Entities Chapter 12 pp. 495 - 532 2015 National Income Tax Workbook™

  2. Business Entities P. 495 • Cancellation of Debt Income • Allocation of Partnership Liabilities. • Limited Liability Companies. • Series Limited Liability Companies. • Accidental Partnerships. • Compensation of Business Owners • Selection of Business Entity

  3. Cancellation of Debt Income p. 496 • Debt reduction can be from: • Gift • Property sale with debt assumed • Compensation • Other deals • Otherwise the cancellation of debt results in taxable income unless an exception applies.

  4. Cancellation of Debt Income p. 496 • Cancellation of debt results in taxable income unless one of these exceptions applies: • Discharge due to bankruptcy. • Insolvent debtor. • Reduction of qualified farm debt. • Election to exclude qualified real property business debt if debtor is not a C Corp. • Qualified principal residence debt before 1-1-2014. • (After 2014 if renewed by Congress.) • Reduction of purchase money debt held by seller. • Limited reductions in student debt for work in designated occupations.

  5. Bankruptcy & Insolvency p. 497 • Bankruptcy – • The debt must be discharged by a court in a bankruptcy proceeding and the taxpayer must be a party to the proceeding. • Insolvency – • When FMV of the debtor’s assets is less than the debtor’s debts. • Comment: Taxable to the extent cancellation brings asset FMVs above debtor’s debt. • The computation includes all assets including those exempt in a bankruptcy proceeding such as an individuals retirement accounts.

  6. Qualified Farm Indebtedness p. 497 • 50% or more of debtor’s gross receipts in 3 taxable years preceding cancellation must be from an active farming trade or business. • Debt must have been incurred in the farming business. • Amount excludible must be reduced by: • “Adjusted tax attributes” of the debtor (defined later) and the • Adjusted basis of “qualified property”: • Any property used in any trade or business. • Any excess is taxable.

  7. Qualified Real Property Business Indebtedness p. 497 • This exception does not apply to C Corporations. • The debt must have been: • Incurred or assumed in connection with real property used in an active trade or business and • Must be secured by that real property. • Exclusion is only for debt incurred: • After 12-31-1992 and • To acquire, improve or rehabilitate real property used in the taxpayer’s trade or business.

  8. Qualified Real Property Business Indebtedness p. 498 • This exclusion is limited to the lesser of: • Excess of debt secured by the qualified real property over the property FMV OR • Aggregate of the adjusted basis of the taxpayer’s depreciable real property.

  9. Purchase Money Debt Reduction p. 498 • When seller of property agrees to reduce the purchase money debt there is no gross income to the debtor. • Debtor must not be insolvent. • Debt must not be part of a bankruptcy discharge. • Debtor must reduce the basis in the property secured by the debt.

  10. Attribution Reduction p. 498 • For exclusions due to bankruptcy & insolvency TP must reduce tax attributes in the following order: • NOL of the discharge year. • NOL carryover to that year. • General Business credit carryforward. • AMT credit for discharge year and carryforwards. • Capital loss in year of discharge. • Capital loss carryforwards to year of discharge. • Reduction of basis of all of taxpayer’s property. • Current passive activity losses & carryforwards. • Foreign tax credit carryover.

  11. Effect of Entity Classification on Debt Discharge p. 498 - 499 • The entity you choose may impact the exclusion from cancellation of debt income. • LLCs that are “Disregarded Entities” including Grantor’s Trusts & some Subs of S Corps & REITS: • The Disregarded Entity and the individual’s assets and liabilities are combined for the insolvency exclusion. • The Disregarded Entity and the individual must both be a party to the bankruptcy for the bankruptcy exclusion.

  12. Bankruptcy of SMLLC (Disregarded Entity) Ex. 12.1 p. 499 • Deb owns all of DFT which is an LLC which did not elect to be a corp and so is a disregarded entity. • DT was in Bankruptcy and the Court discharged $100,000 in debt. • If Deb was not a party to the bankruptcy proceeding the bankruptcy exclusion is not available to her. • However, check the court filings because Deb probably had to file for bankruptcy to have DT’s debts discharged.

  13. Partnerships p. 499 • The entity you choose may impact the exclusion from cancellation of debt income. • The exclusion rules look to the partner(s) and not the partnership. • Discharge of partnership debt may be taxable to some partners and excludable for others. • Different partners may qualify for different exclusions.

  14. Partnership Debt DischargeEx. 12.2 pp. 499 - 500 • 3 Hopper family members each own 1/3 of the Hopalong, LLC, a farming PS in Rhode Island. • Claude is active manager of the PS business. • His sister Belle works elsewhere in N. Dakota. • Their sister Bunny works in Utah. • Claude arranged for a creditor to cancel $300,000 of debt owed by the PS which rec’d a 1099-C. • Each partner’s K-1 must show their share of the cancellation of debt from the PS. • How does each partner treat their share of the Cancellation of Debt Income?

  15. Partnership Debt DischargeEx. 12.2 pp. 499 - 500 • Claude was solvent & was active in the PS • He can exclude his share of the Cancellation of Debt Income under the Farming exclusion. • Belle is solvent and was not active in the farming operation. • Her share of the cancellation of debt ($100,000) is taxable income to her. • Bunny has college and other debts that exceed her assets before & after the cancellation of debt. • Her share of the cancellation of debt is excludible under the Insolvency exclusion.

  16. COD Income and Basis ReductionEx. 12.3 p. 500 • In prior example, each partner had $100,000 in debt forgiven. • If any members basis in their PS interest is less than $100,000 the excess of debt over basis is recognized gain. • It does not appear this could happen. • Each member’s share of: • Cancelled debt income increases basis • But then basis is decreased by the cancellation of the debt if an exclusion applies.

  17. S Corporation p. 500 • Again….the entity you choose may impact the exclusion from cancellation of debt income. • The tests for exclusion are made at the corporate level when the entity is an S Corp. • It feels like the exclusions should work like they do for partnerships BUT that is not what Congress decided.

  18. Changing Entity Status in Contemplation of Discharge of Debt p. 500 • Again….the entity you choose may impact the exclusion from cancellation of debt income. • Thus, you may want to change the type of the entity in anticipation of a cancellation of debt. • If so, also consider what the other tax, local law consequences and impact will be.

  19. Changing Nontax Status pp. 500 - 501 • Most State laws allow conversions between corps and LLC’s. • Fed Income Tax: • Changing from unincorporated to incorporated entity – Typically no problem: • §351 permits tax free transfer of property for • stock. • Changing from incorporated to unincorporated entity – Typically can be a problem: • §336 and §331 provide for potential gain or • loss recognition on each asset distributed.

  20. Changing Tax Status Without Changing Nontax Status p. 501 • LLC with multiple owners is a PS. • LLC with one owner is a Disregarded Entity. • LLC can “check the box” to be a corporation. • To be a C Corp a Form 8832 can be filed within 75 days after, or 12 months before, the intended effective date. • To be an S Corp file a Form 2553 as of the first day it is seeking such classification. • Form 8832 is not needed if Form 2553 is filed. • Election generally cannot be changed for 60-months. • However, a new election can be changed within 60-months if 50% of ownership changes & majority of owners were previously not owners.

  21. Separation from Owner for Bankruptcy TestEx. 12.4 p. 501 • Deb elected S Corp status for DT, LLC by filing form 2553 timely. • DT files for bankruptcy. • Treatment of DT’s cancellation of debt income is determined only by reference to DT’s as an entity since it is an S Corp. • The discharge in bankruptcy means that DT can exclude from income the cancelled debt. • Deb’s status is irrelevant. • Deb does not get a basis increase for the excluded income.

  22. Qualifying Farm Indebtedness Test for S CorporationEx. 12.5 p. 502 • Hopalong PS elected to be an S Corp by filing Form 2553 timely. • Hopalong is in the farming business. • Hopalong can exclude cancellation of debt using the qualified farm indebtedness exclusion.

  23. Pitfalls Connected with the Corporate Election p. 502 • Typically converting from unincorporated to a corporation is tax free (§351). • Exception: • Excess of liabilities over basis of property contributed to the corporation is recognizable gain to the contributing shareholder. • Speaker’s Comment: Also, your client now needs to understand that the corporation is a separate entity…..Good Luck.

  24. Gain Realized on Deemed ContributionEx. 12.6 p. 502 • Hopalong PS’s assets had an adjusted basis of $3,000,000. • Partners arranged to have $300,000 of PS debt cancelled. • Hopalong’s liabilities (before reduction) are $3,900,000. • Hopalong PS converts to Hopalong Corp. so the partners (via the PS passthrough) can avoid $300,000 in cancellation of debt income. • The 3 partners become the 3 shareholders. • The three partners transferred $3,000,000 is assets and $3,900,000 in liabilities to the corp for stock. • The three individuals each have to report their share of a $900,000 gain. • They would have been better off to stay as a PS which would have had $300,000 in cancellation of debt income.

  25. Practitioner NoteShareholder Guarantee p. 502 • Transfer of liabilities to a corporation: • Without a business purpose or for tax avoidance are treated as taxable boot. • In excess of basis in transferred assets is treated as gain. • As long as the arrangement (including guarantees) anticipates the corporation paying the SH’s liabilities the arrangement is treated as the Corporation relieving the SH of the debt.

  26. Allocation of Partnership Liabilities p. 503 • This section of the text discusses how debt is handled in computing basis in partnerships. • LLC’s treated as partnerships will be referred to as partnerships in this chapter. • LLC Members will be referred to as partners in this chapter where the LLC is treated as a partnership.

  27. Effect of Partnership Liabilities on Basis p. 503 • When a person becomes a partner, or there is an increase in their interest in a PS, their basis is increased by the amount of debt for which they become liable. • A decrease in a partner’s share of debt decreases the partner’s basis but not below zero. • Record of debt allocation and basis need to be maintained.

  28. Effect of Partnership Liabilities on Basis p. 503 • Each partner’s share of PS liabilities depends on: • Whether the liability is with recourse or nonrecourse. • What is each partner’s economic risk if the debt is with recourse. • What are the pre-contribution minimum gain, the minimum gain on chargeback and the partners share of PS profits if the debt is nonrecourse.

  29. Effect of Partnership Liabilities on Basis p. 503 • Partnership Recourse Liability: • When any partner, or person related to a partner, bears economic risk for payment. • Partnership Nonrecourse Liability: • No Partner, or person related to a partner, has personal liability for a PS debt.

  30. Partners’ Shares of Recourse Liabilities p. 504 A Partner’s share of liabilities for purposes of allocating outside basis among the partners is the partner’s share of the hypothetical loss that would be sustained if all of the partnership assets immediately became completely worthless.

  31. Equal Allocations of Recourse LiabilitiesEx. 12.7 pp. 504 - 505 • Equal Partners Allen and Barbara each contributed $100 to AB Partnership. • AB borrowed, with recourse, $800. • AB bought a building for $1,000. • AB PS agreement provides equal allocation of all items and provides a “deficit capital account restoration obligation” on liquidation. • Partner capital & basis accounts are:

  32. Equal Allocations of Recourse LiabilitiesEx. 12.7, Fig. 12.1 pp. 504 - 505 Capital Accounts Outside Basis

  33. 90/10 Allocation of Recourse LiabilitiesEx. 12.8 p. 505 • Allen and Barbara each contributed $100 to AB Partnership. • AB borrowed, with recourse, $800. • AB bought a building for $1,000. • This time the AB PS agreement provides book and tax losses are divided: • 90% to Allen and • 10% to Barbara • Capital & basis accounts are:

  34. 90/10 Allocation of Recourse LiabilitiesEx. 12.8, Fig. 12.2 p. 505 Capital Accounts Outside Basis Only Allen has a negative capital account so is at risk for entire loss.

  35. 95/5 Allocation of Recourse LiabilitiesEx. 12.9 p. 506 • Allen and Barbara each contributed $100 to AB Partnership. • AB borrowed, with recourse, $800. • AB bought a building for $1,000. • This time the AB PS agreement provides book and tax losses are divided: • 95% to Allen and • 5% to Barbara • Capital & basis accounts are:

  36. 95/5 Allocation of Recourse LiabilitiesEx. 12.9, Fig. 12.3 p. 506 Capital Accounts Outside Basis Only Allen has a negative capital account so is at risk for entire loss.

  37. Financial Condition Disregarded Ex. 12.10 p.506 • Financial condition of partners is disregarded in making allocations. • However, there could be side agreements that protect a partner from the economic impact of the entity’s debts. • We should ask about side agreements.

  38. Agreement Between the PartiesEx. 12.11, Fig 12.4 pp. 506 - 507 • Allen and Barbara each contributed $100 to AB Partnership. • AB borrowed, with recourse, $800. • AB bought a building for $1,000. • This time the AB PS agreement provides book and tax losses are divided equally. • But, there is a side agreement that Barbara indemnifies Allen so that he will not be required to contribute any more than $650. • Capital & basis accounts are:

  39. Agreement Between PartnersEx. 12.11, Fig. 12.4 pp. 506 - 507 Capital Accounts Outside Basis

  40. Overlapping Guarantees:Proposed Regulations p. 507 • Guarantees can exceed 100% of the debt. • In such cases each owner’s share is a percentage of the guarantees of all the owners. • See Example 12.12…….

  41. Overlapping Guarantees:Proposed Regulations Ex. 12.12 p. 507 • Abigail & Meaghan are equal members in SIS, LLC. • SIS is treated as a PS. • SIS borrows $1,000 from the bank. • Abigail guaranteed $1,000 & Meaghan guaranteed $500 of the PS bank loan. • SIS’ $1,000 increase in debt increases outside basis of partners as follows: • Abigail = $1,000 X (1,000 / 1,500) = $ 667 • Meaghan = $1,000 X ( 500 / 1,500) = 333 • Total increase in debt & outside basis $ 1,000

  42. Top Dollar & Bottom Dollar Guarantees:Proposed Regulations p. 507 • The proposed regulations ensure that economic risk exists before guarantees impact capital accounts and basis. • Facts and circumstances are used to determine each partner’s risk.

  43. Related Person Guaranteeing DebtEx. 12.13 p. 507 • Clyde owns 100% of Bubco, an S Corp. • Bubco is a 1/3 owner in AMB, LLC. • AMB, LLC is treated as a partnership. • Bubco does not guarantee any of AMB’s debts. • Clyde does guarantee 1/3 of AMB’s debts. • Bubco has an economic risk of loss to the extent of Clyde’s guarantee.

  44. Economic Risk p. 508 • To be treated as economic risk from a guarantee, indemnity or similar arrangement the guaranteeing partner must meet all 5 of the first criteria listed on page 508. • If the risk is from a guarantee arrangement it must also meet the 6th item listed on page 508. • If the risk is from a indemnification, reimbursement or similar arrangement it must meet the 7th item (but not the 6th) listed on page 508.

  45. Guarantee of First and Last DollarsEx. 12.14 pp. 508 - 509 • James, Evelyn & Josephine are equal members in LIT, LLC which is taxed as a partnership. • LIT borrowed $1,000 from bank. • James guaranteed $300 and Evelyn guaranteed $200 but only if bank recovers less than $200. • James’ economic risk of loss is $300. • Evelyn’s guarantee has no economic risk since James’ guarantee ensures she will not have to pay • $300 of debt is allocated to James. • $700 of debt is without recourse & so allocated.

  46. Indemnification of Guarantees Ex. 12.15Guarantee of Vertical Slice Ex. 12.16 p. 509 These are additional examples of determining whether there is economic risk sufficient to provide basis in a partnership indemnification of a guarantee or a vertical slice. (Vertical slice – Guaranteeing a % of a loan.)

  47. Nonrecourse Liabilities Defined p. 510 • Nonrecourse liability: • When lender has no recourse against borrower except to take possession of property pledged as security for the debt. • Partnership nonrecourse debt: • Lender makes a nonrecourse loan to a PS. • Partner nonrecourse debt: • Lender makes a loan to PS and the PS guarantees the loan. • No partner bears any economic risk.

  48. Nonrecourse Liabilities Defined p. 510 • Generally, PS nonrecourse liabilities are allocated according to profit-sharing ratios. • Two categories of PS nonrecourse debt: • Nonrecourse Liability Associated Directly with Pledged Property. • Nonrecourse Liability NOT Associated Directly with Pledged Property.

  49. Nonrecourse Liability Associated Directly with Pledged Property. pp. 510 - 511 • Nonrecourse debt falls into three categories & ordering is: • Minimum Gain Chargeback: • Basis is less than the debt due to depreciation, etc. • Debt allocated according to dep. deduction allocation. • Precontribution gain: • Partner contributes property when basis is less than debt. • Difference (gain) is allocated to contributing partner. • Excess Nonrecourse Liability: • Any other nonrecourse debt. • Allocated on profit or deduction allocation.

  50. Nonrecourse Liability Secured by Contributed Property Ex. 12.17 p. 511 • Alfie contributed property for 1/3 interest in ABC, PS. Property basis $400,000 subject to $450,000 nonrecourse debt. • Brenda & Clarence each contributed cash for 1/3 interest. • $60,000 Deprec. deducted in 2 years of operation. • Deprec. was allocated equally to the 3 partners. • After two years Della admitted as ¼ owner partner. • Allocation of liability for inclusion in each partner’s basis is shown on Fig 12.5, page 511.

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