1. The Exclusion. Section 108(a)(1)(A) excludes from gross income any amount includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs under title 11 United States Code. For this purpose, the term “title 11 case” means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.236 The Tax Court has read 230 I.R.C. § 108(a)(1)(A). 231 I.R.C. § 108(a)(1)(B). 232 I.R.C. § 108(a)(1)(C). 233 I.R.C. § 108(a)(1)(D). 234 I.R.C. § 108(a)(1)(E). 235
I.R.C. § 108(d)(1)(A); Waterhouse v. Commissioner, 68 T.C.M. (CCH) 774, 778 (1994) (“The term “indebtedness of the taxpayer” for purposes of Section 108 includes any indebtedness for which a taxpayer may be liable. Sec. 108(d)(1)(A). Petitioner’s obligation to repay the excess disability benefits constitutes an “indebtedness” which falls within the scope of Section 108(a) if one of the specific conditions of Section 108(a)(1) is present.”).
236
I.R.C. § 108(d)(2); see, e.g., Johnson v. Commissioner, 132 Fed. Appx. 550 (5th Cir. 2005) (“In summary, the Tax Court’s and bankruptcy court’s findings are not in tension-- the bankruptcy court found that $4,916 in debt was discharged as to creditors that filed proofs of claim against the estate, and the Tax Court made the additional finding that the CMI debts were also discharged as a result of the bankruptcy court’s order, although they were not specifically mentioned in the final order of relief. The Tax Court appropriately found that the CMI debts were discharged as a result of the grant of relief from the bankruptcy court under Bankr. Code § 727(b), so they plainly fell within the definition of discharged debt in “a title 11 case” as defined by I.R.C. § 108(d)(2), and thus were appropriately excludable under § 108(a) and applicable to offset Johnson’s NOL under § 108(b)(2).” [Footnote omitted.]).
the statute “to contemplate that, in general, in a title 11 case, the bankruptcy court must grant the discharge either in a specific order, or as part of a plan approved by the court itself.”237
2. Priority of Exclusion. The bankruptcy case exclusion of Section 108(a)(1)(A) takes precedence over the other exclusions.238 Thus, taxpayers who have their debts discharged in bankruptcy must use the bankruptcy case exclusion provided in Section 108(a)(1)(A) rather than the insolvency exclusion provided in Section 108(a)(1)(B).239
3. Reduction of Debtor’s Tax Attributes. The amount excluded from gross income under Section 108(a)(1)(A) is applied to reduce the taxpayer’s tax attributes in the order provided under Section 108(b)(2).240 If the taxpayer makes an election under Section 108(b)(5), then the amount excluded under Section 108(a)(1)(A) is used to reduce the basis of the taxpayer’s depreciable property.241
4. Special Partnership Considerations. In the case of a partner in a partnership, the bankruptcy exclusion of Section 108(a)(1)(A) is applied at the partner level.242 The Service apparently reads this requirement to mean that the partner must be in bankruptcy before the exclusion applies.243 The legislative history to the statute indicates that Congress
237
Friedman v. Commissioner, 75 T.C.M. (CCH) 2383, 2389 (1998) (“The language in Section 108(d)(2) is fairly explicit. It provides that a “title 11 case” means a case under title 11 (the bankruptcy code), but only if the taxpayer is under the jurisdiction of the bankruptcy court and the discharge of indebtedness is “granted by the court or is pursuant to a plan approved by the court”. Sec. 108(d)(2). Consequently, we read the statute to contemplate that, in general, in a title 11 case, the bankruptcy court must grant the discharge either in a specific order, or as part of a plan approved by the court itself.”).
238
I.R.C. § 108(d)(2)(A).
239
I.R.C. § 108(a)(2)(A); cf. Waterhouse v. Commissioner, 68 T.C.M. (CCH) 774, 778 (1994) (“The evidence shows that petitioner’s $52,816.33 indebtedness was discharged on January 9, 1989, and not during the course of a title 11 bankruptcy proceeding, as would be required by Section 108(a)(1)(A).”); cf. PLR 9130005 (Mar. 29, 1991) (“Taxpayers who have their debts discharged in bankruptcy must use the exclusion provided in Section 108(a)(1)(A) of the Code rather than the insolvency exclusion provided in Section 108(a)(1)(B). Section 108(a)(2) provides that the bankruptcy exclusion takes precedence over the insolvency exclusion. Therefore, where a taxpayer’s debts are discharged in bankruptcy, whether the taxpayer is insolvent is irrelevant for purposes of Section 108.”).
240
I.R.C. § 108(b)(1).
241
I.R.C. § 108(b)(1); see I.R.C. § 1017; cf. Priv. Ltr. Rul. 9409037 (Dec. 7, 1993) (“Because Target will be a debtor in a title 11 case at the time its indebtedness is discharged in accordance with Section 108(d)(2), any cancellation of indebtedness income realized by Target under the Plan will be excluded from gross income under Section 108(a)(1)(A). Target will be required to reduce its attributes in the order provided under Section 108(b)(2) by an amount equal to the discharge of indebtedness income realized in connection with the Plan but excluded from gross income under Section 108(a)(1)(A). If Target makes the election under Section 108(b)(5), then the amount equal to the discharge of indebtedness income realized in connection with the Plan but excluded from gross income under Section 108(a)(1)(A) will be used to reduce the basis of Target’s depreciable property under Section 1017.”).
242
I.R.C. § 108(d)(6).
243 Cf
. PLR 9426006 (Mar. 25, 1994) (“As an initial matter, we note that the exception set forth in Section 108(a)(1)(A) for discharges in bankruptcy will not apply to exclude any discharge of indebtedness income resulting from the restructuring of Partnership’s indebtedness to Bank. Section 108(d)(6) provides that in the case of a partnership, subsection (a) shall be applied at the partner level. Because Partnership, rather than the Partners, is in bankruptcy, the exception set forth in Section 108(a)(1)(A) does not apply to exclude discharge of indebtedness
intended that income from discharge of a partnership debt would not be excludable at the partnership level, but instead would be allocated separately to each partner.244 The Senate Committee report states that “[t]he 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).”245
In a series of four related 2004 memorandum decisions, the Tax Court adopted a broad reading of the statute and held that the bankruptcy exclusion applied to partners that were under the jurisdiction of the bankruptcy court as part of the partnership bankruptcy case (but not in bankruptcy themselves).246 In each of these cases, the partnership filed a petition in bankruptcy. As part of the partnership’s bankruptcy case, the trustee reached a negotiated settlement with some of the general partners, including the taxpayers, whereby in exchange for paying agreed- upon sums to the partnership’s bankruptcy estate, the contributing partners would be discharged from liability as permitted by the confirmed bankruptcy plan. Each of the taxpayers executed a contribution agreement and pursuant to its terms contributed a sum of money to the partnership’s bankruptcy estate in exchange for release of “all claims or potential claims of creditors against * * * [taxpayer] arising out of or related to” the partnership. The bankruptcy court subsequently entered an order approving the contribution agreement and specifically discharging and releasing the taxpayers from any and all liability to the trustee and the bank arising out of or relating to the partnership, the taxpayers’ status as general partners in the partnership and a personal guaranty agreement. In addition, the bankruptcy court’s order released the taxpayers from “the claims or potential claims of all creditors” of the partnership. With respect to each taxpayer, the bankruptcy court further ordered that such taxpayer “is subject to the jurisdiction of the Bankruptcy Court.”
The partnership issued the taxpayers Schedules K-1, allocating to each of them discharge of indebtedness income. Each of the taxpayers excluded this entire amount from his 1995 gross income. The Service issued a notice of deficiency determining that the discharged debt should be included in the taxpayers’ 1995 income.
The Tax Court held for the taxpayer. The Tax Court stated that “the relevant question is whether petitioner’s debt (as opposed to the partnership’s debt) was discharged ‘in a title 11 case.’” The court interpreted Section 108(d)(2) as having two requirements: (1) the taxpayer
income from the Partners’ gross income. Therefore, Section 108(a)(2)(A), which provides, in part, that the exception provided for in Section 108(a)(1)(D) shall not apply to a discharge that occurs in bankruptcy, does not prevent the application of Section 108(a)(1)(D) to the Partners.”); Priv. Ltr. Rul. 9409037 (Dec. 7, 1993) (“Because Target will be a debtor in a title 11 case at the time its indebtedness is discharged in accordance with Section 108(d)(2), any cancellation of indebtedness income realized by Target under the Plan will be excluded from gross income under Section 108(a)(1)(A).”). 244 S. Rep. No. 1035, 1980-2 C.B. at 631. 245 S. Rep. No. 1035, 1980-2 C.B. at 631. 246
See Gracia v. Commissioner, 87 T.C.M. (CCH) 1423, 1425 (2004); Mirachi v. Commissioner, 87 T.C.M. (CCH) 1425, 1426 (2004); Price v. Commissioner, 87 T.C.M. (CCH) 1426, 1427 (2004); Estate of Martinez, 87 T.C.M. (CCH) 1428, 1429 (2004).
must be under the jurisdiction of the bankruptcy court (but not necessarily in bankruptcy) and (2) the discharge must be granted by the court or pursuant to a plan approved by the court. The Court reasoned that the partnership’s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to the bankruptcy court order, the bankruptcy court discharged and released the taxpayer from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, taxpayer’s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over the taxpayer for this purpose. Consequently, the Tax Court concluded that the taxpayer’s debts in question were discharged “in a title 11 case” within the meaning of Section 108(d)(2) and held that the taxpayer’s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). 247 There is some question as to the correctness of the Tax Court’s decision.248
247 Gracia v. Commissioner
, 87 T.C.M. (CCH) 1423, 1424 (2004) (“The partnership’s chapter 11 bankruptcy was a case under title 11 of the United States Code. See 11 U.S.C. ch. 11 (2000). Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner’s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court’s assertion of jurisdiction over petitioner in the partnership’s chapter 11 bankruptcy case. * * * We conclude that petitioner’s debts in question were discharged “in a title 11 case” within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner’s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A).”); Mirachi v. Commissioner, 87 T.C.M. (CCH) 1424, 1425 (2004) (“The partnership’s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner’s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court’s assertion of jurisdiction over petitioner in the partnership’s chapter 11 bankruptcy case. * * * We conclude that petitioner’s debts in question were discharged “in a title 11 case” within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner’s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A).” [Citations and footnote omitted.]); Price v. Commissioner, 87 T.C.M. (CCH) 1426, 1428 (2004) (“The partnership’s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner’s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court’s assertion of jurisdiction over petitioner in the partnership’s chapter 11 bankruptcy case. * * * We conclude that petitioner’s debts in question were discharged ‘in a title 11 case’ within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner’s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A).” [Citations omitted.]); Estate of Martinez v. Commissioner, 87 T.C.M. (CCH) 1428, 1429 (2004) (“The partnership’s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released decedent from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, decedent’s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over decedent for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court’s assertion of jurisdiction over decedent in the partnership’s chapter 11 bankruptcy case. * * * We conclude that decedent’s debts in question were discharged “in a
5. S Corporation Considerations.
a. Rules for Exclusion of Cancellation of Debt Income and for Reduction of Tax Attributes are Applied at the Corporate Level. Section 108(d)(7)(A), as amended by the Job Creation and Worker Assistance Act of 2002,249 provides, in part, that the rules under Section 108(a) for the exclusion of COD income and under Section 108(b) for the reduction of tax attributes are applied at the corporate level, including by not taking into account under Section 1366(a) any amount excluded under Section 108(a).250 Thus, income from the discharge of indebtedness of an S corporation that is excluded from the S corporation’s income is not taken into account as an item of income by any shareholder and, thus, does not increase the basis of any shareholder’s stock in the corporation.251 For this purpose, a shareholder’s suspended loss is treated as a net operating loss tax attribute that is reduced.252 Thus, if the S corporation is in bankruptcy or is insolvent, any income from the discharge of indebtedness by a creditor of the S corporation is excluded from the corporation’s income, and the S corporation reduces its tax attributes (including any suspended losses).253
The legislative history provides the following illustration of these rules. Assume that a sole shareholder of an S corporation has zero basis in its stock of the corporation. The S corporation borrows $100 from a third party and loses the entire $100. Because the shareholder has no basis in its stock, the $100 loss is “suspended” at the corporate level. If the $100 debt is forgiven when the corporation is in bankruptcy or is insolvent, the $100 income from the discharge of indebtedness is excluded from income, and the $100 “suspended” loss should be
title 11 case” within the meaning of Section 108(d)(2). Accordingly, we hold that decedent’s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A).” [Citations omitted.]).
248
See generally Partners May Exclude COD Income in Connection with Partnership’s Chapter 11 Bankruptcy, Business Entities (Sept./Oct. 2004); Solvent Partners of Bankrupt Partnerships May Be Thankful for Gracia, J. Tax’n (Aug. 2004). 249 Pub. L. No. 107-147 § 402. 250 I.R.C. § 108(d)(7)(A). 251 I.R.C. § 108(d)(7)(A). 252 I.R.C. § 108(d)(7)(B). 253
Staff of the Joint Committee on Taxation, 107th Cong., 2d Sess., Technical Explanation of the Job Creation and Worker Assistance Act of 2002, 28 (2002); cf. H.R. Rep. No. 111, 103d Cong., 1st Sess., at 622-25 (1993), 1993-3 C.B. 167, 198-201 (“In applying this provision to income from the discharge of indebtedness of an S corporation, the election is made by the S corporation (sec. 1363(c)), and the exclusion and basis reduction are both made at the S corporation level (sec. 108(d)(7)). The shareholders’ basis in their stock is not adjusted by the amount of debt discharge income that is excluded at the corporate level. As a result of these rules, if an amount is excluded from the income of an S corporation under this provision, the income flowing through to the shareholders will be reduced (compared to what the shareholders’ income would have been without the exclusion). Where the reduced basis in the corporation’s depreciable property later results in additional income (or a smaller loss) to the corporation because of reduced depreciation or additional gain (or smaller loss) on disposition of the property, the additional income (or smaller loss) will flow through to the shareholders at that time, and will then result in a larger increase (or smaller reduction) in the shareholder’s basis that if this provision had not previously applied. Thus, the provision simply defers income to the shareholders.”).
eliminated in order to achieve a tax result that is consistent with the economics of the transactions in that the shareholder has no economic gain or loss from these transactions.254
b. IRS Issues Final Regulations Providing Guidance on Reduction of Tax Attributes by an S Corporation. On October 30, 2009, the Revenue Service issued final regulations that provide guidance on the manner in which an S corporation reduces its tax attributes under section 108(b) for taxable years in which the S corporation has discharge of indebtedness income that is excluded from gross income under section 108(a).255 In particular, the regulations address situations in which the aggregate amount of the shareholders’ disallowed section 1366(d) losses and deductions that are treated as a net operating loss tax attribute of the S corporation exceeds the amount of the S corporation’s excluded discharge of indebtedness income. The regulations affect S corporations and their shareholders.