IRS Provides Important Rules on How to Defer Taxable Income from Debt Forgiveness

Mario J. Fazio

In 2009, Congress provided a tax break to businesses that have debt written down or forgiven by a lender or creditor. Under existing rules, a lender’s forgiveness of the principal amount of  debt may be treated as taxable income to the borrower, unless the borrower is insolvent or in bankruptcy.  However, even if the borrower is insolvent prior to the debt reduction, taxable income may result if the debt reduction results in the borrower’s assets exceeding its liabilities after the debt reduction.  The 2009 law, which is codified under Section 108(i) of the Internal Revenue Code, now permits a borrower to elect to defer the reporting of taxable income arising upon such a debt forgiveness.

The election is available only for debt forgiven during 2009 or 2010.  The election permits the business to defer the taxable income until 2014 and to report the income ratably over five years.  That is 20% of the debt reduction would be reported in each of 2014 through 2018, instead of reporting the entire amount as taxable income in 2009 or 2010.  This is important tax relief because a business with financial problems that is able to negotiate a reduction of its debt with its lender or other creditors typically is not in a position to pay additional tax on account of the write-down of the debt. 

In Rev. Proc. 2009-37, the IRS provides guidance on the election and specific rules for S corporations, limited liability companies and partnerships.  The IRS has stated that the election to defer is made by the entity.  For S corporations and partnerships, including LLCs taxed as partnerships, this means that the entity and not the individual owners must make the election. 

For partnerships, the so-called “insolvency exception” under Section 108 of the Internal Revenue Code applies at the partner level and not the partnership level.  Thus, even though the partnership may be insolvent, a partner would have to include his share of the debt reduction as taxable income unless the partner was also insolvent.  For many real estate investments, which are typically held by an LLC or limited partnership, the entity may be insolvent due to depressed values of the commercial real estate, but the partners often are not.  Section 108(i) provides a very welcome tax break by allowing the partners to defer the income and pay the resulting tax over 5 years starting with 2014.

If you would like to discuss this topic, contact Mario J. Fazio at (216) 831-0042 or at mfazio@meyersroman.com

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