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Langdon Owen1 Parsons Kinghorn Harris, pc

(801) 363-4300 lto@pkhlawyers.com

TAX ASPECTS OF BANKRUPTCY AND INSOLVENCY

1. Cancellation of Indebtedness Income. When a deal or debtor runs into financial trouble, there is often involved a reduction of debt owed. The general rule is that reduction or cancellation of indebtedness results in income to the debtor. IRC § 61(a)(12); Regs. § 61-12; U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931) (debts purchased by issuer in open market). Such income may arise in a number of ways, including on foreclosures, workouts, settlements of called guarantees, market acquisitions at a discount of debt by a debtor or on reorganization, expiration of statutes of limitations, statutory no-deficiency rules, probate proceedings, creditor write-offs and discontinuances of collection, contributions of debt for an equity interest in the debtor organization, and so on. Discharge of debt income may also arise under the tax benefit rule of IRC § 111(c) where an accrued but unpaid expense amount is deducted earlier (increasing an NOL (net operating loss)) and the indebtedness is forgiven in a later year where the NOL carryover has not expired. (IRC § 108(e)(2) would prevent this result for a cash basis taxpayer.) This income is sometimes referred to as cancellation of debt (“COD”) income.

The law in this area focuses more on the exceptions than on the general rule. However, some issues of whether cancellation income should be recognized may arise, particularly as to contingent obligations. Corporacion de Ventas de Salitre y Yoda de Chile v. Com’r., 130 F.2d 141 (2d Cir. 1942) (taxpayer's purchase at a discount of its own bonds which were payable only out of a percentage of future profits didn't give rise to income). See also, PLR 201027035; Rev. Rul. 84-176, 1984-2 CB 34 (amount owed by the taxpayer under a contract that was forgiven by the seller in return for a release of a contract counterclaim wasn't income from the discharge of indebtedness). Fully collateralized loans in default are not uncollectable and thus may not trigger COD income. See Pinn v. Com’r, TC Memo 2013-45.

Interest as well as principal can constitute forgiven debt includable in income. Brooks v. Com’r, TC Memo 2012-25 (interest forgiven on a loan from employer includible as debt discharge income where the forgiven interest was not shown by employee, a stock broker, to be deductible investment interest to the extent his investment income). The cost of issuance of debt securities may be deductible separately (IRC ' 162) amortized over the life of the debt under original issue discount principles (Reg. § 1.446-5 “as if they adjusted the yield on the debt”), but

1 This article is provided for informational purposes only. It is not intended as, and does not constitute, legal advice. Further, access to or receipt of this article by anyone does not create an attorney-client relationship. Although this article was believed to be correct within the scope of its purposes when written, it may be incorrect or incomplete, was not intended to comprehensively cover any subject, does not cover a number of related matters, and does not cover anyone’s particular situation. As such, it is not reasonable for anyone to rely upon this article with respect to any particular legal matter. Rather, readers are encouraged to retain a licensed attorney to provide individualized and current legal advice.

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nevertheless not affect discharge of indebtedness income on the cancellation of the debt. PLR 201220004.

Timing of the income from cancellation of debt is generally tied to an identifiable event which makes it clear the debt will never have to be paid. Cozzi v. Com’r, 88 TC 435 (1987). There is a rebuttable presumption that such an identifiable event occurred in a calendar year if, during a testing period (of generally 36 months) ending at the close of the year, the creditor has received no payments. Kleber v. Com’r, TC Memo 2011-233. Expiration of the statute of limitations is not conclusive because it does not extinguish the debt, but may be an identifiable event in some circumstances. A plan of liquidation can postpone the identifiable event because until all assets are liquidated and distributions are made, the amount of discharge of allowable claims cannot be known. PLR 201228023. A taxpayer receiving an advance under a loan agreement partially or completely cancellable depending on contingencies, may be able to defer the recognition of the cancellation income under the all events test (i.e., all events have occurred which fix a right to receive such income and the amount can be determined with reasonable accuracy) if the taxpayer is on an accrual basis of accounting. CCM 20124103F (loan from a state cancellable depending on how many jobs a company created or retained was a bona fide loan (rather than a prepayment for the service of job retention or creation or a contribution to capital) and cancellation income could be deferred under accrual accounting).

a. The Bankruptcy, Insolvency, Farm, and Real Property Exceptions. Section 108 of the Internal Revenue Code (“IRC”) contains a list of exceptions to the general rule of IRC § 61 that income includes cancellation of debt. Exclusions of income or attribute reduction under IRC § 108 is reported by debtors on Form 982 with their returns. These statutory exceptions will not apply, however, to the extent the taxpayer makes the election to defer COD income pursuant to IRC § 108(i) for the years 2009 and 2010 (see further discussion at 1(c)(8) below).

(1) Taxpayers In Bankruptcy. Discharge of indebtedness income will not be recognized by a debtor in a bankruptcy proceeding under Title 11 of the United States Code; this exception does not apply to other insolvency proceedings such as receiverships. This exception applies even if the debtor in the bankruptcy proceeding is solvent. IRC § 108(a)(1)(A). The cost of exclusion is the offsetting of the same tax attributes as described for the insolvency exception below. This provision may be the salvation of debtors not so deeply insolvent as to be fully covered by the insolvency exception.

(2) Insolvent Taxpayers Outside of Bankruptcy. No income from cancellation of debt is recognized to an insolvent debtor outside bankruptcy to the extent of insolvency. IRC § 108(a)(1)(B). The definition of insolvency is the excess of liabilities over the fair market value of assets. IRC § 108(d)(3). Solvency is determined immediately before the discharge. The burden of proving insolvency is on the taxpayer. See Hill v. Com’r., TC Memo 2009-101.

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Exempt assets have been ignored in the determination of solvency. Cole v. Com’r., 42 B.T.A. 1110 (1940), non-acq. 1941-1 C.B. 13; Marcus Est. v. Com’r., T.C. Memo 1975-9; Hunt v. Com’r., T.C. Memo 1989-335; PLR 9125010; TAM 9130005. If this is the rule, in a close case, a taxpayer may want to put assets into an exempt form under state law to qualify as insolvent for purposes of this exception; some courts have supported such planning, but others have found it questionable. On the other hand, Carlson v. Com’r, 116 T.C. 87 (2001) refused to follow pre-Bankruptcy Tax Act case law and counted such assets in the determination of insolvency. See also, TAM 199935002 and PLR 199932013. It is not clear, however, if liabilities associated with exempt assets are taken into account even if the exempt assets are not.

Questions arise on intangible assets (e.g., goodwill) and contingent liabilities in applying this definition. See, e.g., Merkel v. Com’r, 109 T.C. 463 (1997), 192 F.3d 844 (9th Cir. 1999) (applying an all or none test for counting indebtedness (not a discount for probability of occurrence) under which taxpayer must prove it is “more probable than not” that the taxpayer would be required to pay obligations claimed, such as a guarantee; “insolvency” definition required fair market valuation of assets, not liabilities).

A nonrecourse liability that exceeds the value of the security for it, is fully taken into account for applying the insolvency test to the extent that the excess nonrecourse debt is discharged (Rev. Rul. 92-53, 1992-2 C.B. 48). Partnership excess non-recourse debt (debt exceeding the value of the security for the debt) is treated as a liability of the partners, allocated among them under IRC ' 704(b), for purposes of determining the insolvency of the partners (which is where the exception applies in the partnership context). Rev. Rul. 2012-14, 2012-24 IRB. Unamortized premium and discount are taken into account in determining the amount of debt being canceled. IRC § 108(e)(3).

(a) Attribute Reduction. The taxpayer-debtor reduces its tax attributes (after the tax calculation for year of cancellation has been made) in the order set forth below, and to the extent the debt cancellation exceeds these attributes it has no further effect on income (H. Rep. No. 96-833, 96th Cong. 2d Sess. 11, (“H. Rep.”); S. Rep. No. 96-1035, 96th Cong., 2d Sess. 13 (“S. Rep.”).

(i) Years Affected. Within each category, reduction is in the same order of taxable years that the attributes would be used (IRC § 108(b)(4)(B) and (c)) e.g., first in, first out on general business credit and foreign tax credit carryovers (see IRC § 46(a)(1) and (b)); on Net Operating Loss (“NOL”) and on capital loss carryovers, current year then earliest year still available for carry forward, then subsequent years in order. Reduction of carryover attributes for the current year first increases the chance of expiration of the NOL or capital loss carry forward before it is recovered.

(ii) Level Affected. The no income rule and the attribute reduction rules apply at the partner level in partnerships (IRC § 108(d)(6)), at the corporate level for S-corporations (IRC § 108(d)(7)(A)).

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(b) Order of Reduction. Attribute reduction is reported on Form 982. Attributes are reduced in the following order (IRC § 108(a)(2) and (3)):

(i) NOLs (dollar for dollar). However, under the Alternative Minimum Tax rules, a corporate debtor can be subject to tax on its income from the cancellation of indebtedness no matter how much regular NOL or carry forwards it has, because the NOL carry-overs and carrybacks available to reduce alternative minimum taxable income is limited to 90% of such income (IRC § 56(d)(1)(B)(ii)). The result is generally a tax equal to at least 2% of its debt discharge income (20% AMT x 10% of AMTI). However, under the Worker, Homeownership, and Business Assistance Act of 2009 (P.L. 111-2), if an extended NOL carryback period is elected as allowed under the circumstances provided in that Act (Act ' 13; IRC ' 172(b)(1)(H); Rev. Proc. 2009-52, 2009-49 IRB), not only eligible small businesses for 2008, but almost all business taxpayers, can elect to increase the NOL carryback period for a 2008 or 2009 NOL from 2 years to 3, 4, or 5 years), then for tax years ending after 2002 the 90% limitation on the use of the deduction for alternative minimum tax purposes is suspended for the NOL for which the extended period was elected.

(ii) General Business Credit carryover under IRC § 38 (33 1/3 cents on the dollar).

(iii) Minimum Tax Credit Under IRC § 53(b) (33 1/3 cents on the dollar).

(iv) Capital losses and capital loss carryover (dollar for dollar).

(v) Basis of all (not just depreciable) assets held by debtor immediately after discharge (dollar for dollar) until basis remaining is not less than remaining debts (IRC § 1017(b)(2)) so that tax will be due if the debtor realizes more on the sale of assets than its remaining liabilities. The reduction is taken at the beginning of the year following cancellation (IRC § 1017(a)); this timing rule may cause gains to be taxed to the bankruptcy estate on a later sale of the assets. The bankruptcy trustee may find this timing rule creates problems; since it is unlikely that the discharge can be delayed, the trustee may want to sell the property before the end of the year or may want to select a tax year that will bunch other income in a year earlier than the year of discharge.

If the basis of property (including, for example, a home) is reduced by an insolvent debtor outside bankruptcy, or in bankruptcy where the property (e.g., the home) is not exempted from creditors, then (as discussed at (d) and (e) below) under IRC § 1017(d) the basis reduction causes the property to be IRC '§ 1245 or 1250 property and the reduction is treated as being depreciation subject to recapture as ordinary income on a later sale. This will, as to the home in our example, cause income to be recognized under IRC ' 1245 even if the home sale gain is otherwise excluded under the $250,000 ($500,000 joint) home sale exclusion of IRC § 121.

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(vi) Passive activity loss and credit carry-overs under IRC § 469(b) (33 1/3 cents on the dollar as to passive activity credit carryover, otherwise dollar for dollar);

(vii) Foreign tax credit (33 1/3 cents on dollar).

(c) Special Basis Election. A special election is available to reduce the basis of depreciable property before other attributes are reduced. IRC § 108(b)(5). This election could be used in order to protect the NOL for bankruptcy or other reorganization purposes. Revocation of the election requires IRS consent.

(i) Application. The election applies to taxpayers in Title 11 bankruptcy proceedings, to insolvent taxpayers outside of bankruptcy to the extent of insolvency, and to debtors entitled to the qualified farm indebtedness exception (discussed below). (Although there is a similar rule for the qualified real property exception (discussed at (4)(c) below), that rule does not treat real property held in inventory as being depreciable).

(ii) Limits. The election may reduce the basis below the amount of remaining debts. The basis reduction must, however, reduce the amount of depreciation otherwise available for the period immediately following reduction. IRC § 1017(b)(3)(B).

(iii) Real Property Inventory. A taxpayer can elect on the return for the year of discharge to reduce the basis of real property inventory. IRC § 1017(b)(3)(E).

(iv) Equity Interests. The election can also reduce basis of a partnership interest or of a stock interest in subsidiary (or chain of subsidiaries) that files consolidated return with debtor, but only if changes in the basis of those entities’ depreciable property (or real estate inventory) is made. IRC § 1017(b)(3)(C) and (D). This results, in effect, in a double reduction of basis. See Regs. § 1.1017-1(g)(2)(i).

A partner must request partnership consent to reduce the partnership’s basis if the partner owns (directly or indirectly) more than 50% of the capital and profits interests or if the reductions in the partner’s basis in depreciable property are being made with respect to the partnership’s cancellation of indebtedness income (Regs. § 1.1017-1(g)) and the partnership must consent if requested by any partners holding in the aggregate more than 50% of the capital and profits interests.

(v) Analogous Rules. See old Regs. §§ 1.1016-7 and 1.1016-8.

(vi) Recapture. Basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors; see IRC ' 1017(c)) are

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treated as depreciation deductions and can give rise to recapture income. See discussion at (d) just below.

(d) Other Basis Matters - Recapture. Basis reductions (from attribute reduction or the special election, described above, or on qualified farm indebtedness or qualified real property business indebtedness described below) are subject to recapture under the rules of IRC §§ 1245 and 1250; the § 1245 rules apply to property not otherwise § 1245 or § 1250 property such as subsidiaries (IRC § 1017(d)(1)). No recapture of general business credit results from basis reductions because it is not treated as a disposition (IRC § 1017(c)(2)); but recapture may occur when cancellation is treated as purchase price adjustment (under IRC § 108(e)(5) or otherwise).

(e) Exempt Property. Bankruptcy Code (“BC”) § 522 exempt property basis is not reduced if the taxpayer is in a Title 11 proceeding. IRC § 1017(c)(1). Thus exempt property can avoid the depreciation recapture described above.

(3) Qualified Farm Indebtedness . Debt discharge income is not recognized if it is qualified farm indebtedness. IRC § 108(a)(1)(C). Such indebtedness must be incurred directly in connection with the operation by the taxpayer of the trade or business of farming where 50% or more of the aggregate gross receipts for the 3 taxable years before the year of discharge is from farming. The amount excluded cannot exceed the sum of the adjusted tax attributes of the taxpayer and the aggregate adjusted basis of qualified property held on the beginning of the tax year following the discharge. IRC § 108(g).

(a) Adjusted Tax Attributes. The adjusted tax attributes which limit the income to be excluded under the farm exception are the same as the tax attributes affected by offsets under the other discharge exceptions discussed above, except:

(i) property basis is excluded because, as mentioned above, there is a separate specific aggregate adjusted basis requirement for farms; and

(ii) $3 is taken into account for each $1 of general business credit, minimum tax credit, foreign tax credit carryovers, and passive activity credit carryovers (IRC § 108(g)(3)(C)).

(b) Special Basis Rules. Once the adjusted tax attributes have been determined and used to establish the amount of discharge of indebtedness that may escape taxation, the tax attributes of the debtor are then reduced under IRC § 108(b)(2). Under IRC § 1017(b)(4), the basis adjustment to be made as part of adjusting the tax attributes of the debtor to offset the unrecognized debt discharge income is applied only to reduce the basis of the qualified farm property and is applied in this order:

(i) depreciable qualified property;

(ii) land used or held for use in farming; then

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(iii) other qualified property.

The elective basis adjustment under IRC § 108(b)(5) is also available for the farm exception. As discussed at 2 (d) and (e) above, basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors) are treated as depreciation deductions and can give rise to recapture income.

(4) Qualified Real Property Business Indebtedness. An exception applies to solvent debtors which are not C-corporations, and excludes from taxation discharged debt from qualified real property business indebtedness. IRC § 108(a)(1)(D). This exception will apply to individuals, estates, trusts, S-Corporations (rather than shareholders of S-Corporations), partnerships, and limited liability companies taxed as partnerships, but will not apply to real estate investment trusts and cooperatives. Although the debtor must be solvent, the exception can apply to the extent the debtor has debt discharge income over the amount needed to bring the debtor out of insolvency. Thus, a combination with the general insolvency exception may be useful.

(a) Election. This exception must be elected by the taxpayer in the taxable year of discharge or as provided in regulations (IRC § 108(d)(9)); with respect to partnerships or limited liability companies taxed as partnerships, this election is made at the partner level (the partner must not be a C-Corporation) although the determination of the qualification of the indebtedness is made at the partnership level (it is unclear whether a partner who sells the affected partnership interest before the IRC § 108(c) election must be made, remains entitled to make the election; the American Bar Association Section of Taxation has recommended that such a partner not be able to make the election, and not be taken into account in determining if more than 50% of the capital and profits interests require the partnership to reduce its inside basis of partnership assets).

(b) Trade or Business Real Property. To be qualified real property indebtedness, the debt must have been incurred or assumed in connection with real property used in a trade or business and be secured by that property, but the property need not be depreciable. IRC § 108(c)(3)(A). IRC §§1231 and 1017 appear to exclude real property of a dealer under “property used in the trade or business”, a term not specifically defined in IRC §108; but see Rev. Rul. 76-86, 1976-1 C.B. 37 and Martin, “Officials Discuss New Real Estate Debt Discharge Exceptions”, 60 Tax Notes 1422 (1993). Also, if the debt was incurred or assumed after December 31, 1992, it must be incurred or assumed to acquire, construct, reconstruct, or substantially improve such property. A refinancing of qualified debt will itself qualify to the extent the new debt does not exceed the old. IRC §108(c)(3).

(c) Basis Reduction. The price for the exception is the reduction of the basis of depreciable real property held at the beginning of the following tax year (applied first to the property securing the discharged debt), or the basis adjustment could be accelerated and applied to property held immediately before disposition if the property is sold or disposed of prior to the next tax year. IRC §§108(c)(1), 1017(a)(2), and 1017(b)(3), and Regs. §

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1.1017-1(c)(1). The basis adjustment acceleration could eliminate the benefit of the exception if the property is sold to pay off the nondischarged portion of the debt. Recapture of depreciation under IRC §1250 applies. See IRC §1017(d). The basis reduction is treated as a depreciation deduction and what would have been the straight-line depreciation is determined as if no basis reduction had been made. Fiscal year 1994 Budget Reconciliation Recommendations of the Committee on Ways and Means, Ways and Means, Committee Print: 11, 103d Cong., 1st Sess. (May 18, 1993) at 186. As discussed at 2 (d) and (e) above, basis reductions under IRC ' 1017 (on property not in a bankruptcy proceeding and exempted from creditors) are treated as depreciation deductions and can give rise to recapture income.

(i) Partnership Interest. A partner’s interest in a partnership may be treated as if it were depreciable real property in its proportionate share of the depreciable real property of the partnership, but only where the partnership’s basis in depreciable real property is reduced with respect to the partner. IRC § 1017(b)(3)(C) and Regs. § 1.1017-1(g)(2). Affiliated corporate groups are treated similarly. IRC § 1017(b)(3)(D). See discussion at (2)(c) above.

(ii) Inventory. Property held in inventory does not qualify as depreciable real property for this exception (unlike for the bankruptcy, insolvency, or farm exceptions). IRC § 1017(b)(3)(F).

(d) Special Limits. There are special limits that apply to this exception:

(i) Excess Over Value. The amount excluded cannot exceed the excess of the debt over the value of the property. IRC § 108(c)(2)(A). Regulations are expected to prevent the incurring of new debt cross collateralized by existing property in order to increase the excludable amount applicable to the property. IRC § 108(c)(5).

(ii) Basis Limit. Also, the exclusion cannot exceed the aggregate adjusted basis of depreciable real property held immediately before the discharge but determined after the basis adjustments generally applicable (if they are applicable) to offset the discharge of indebtedness exclusions under IRC § 108(b) (bankruptcy or insolvency) and (g) (farm). IRC § 108(c)(2)(B). Property acquired in contemplation of discharge is not used in determining the limitation. For provisions that may be instructive in determining what is “in contemplation”, see Regs. §§ 1.108-2(c)(3) and (4).

(iii) Inside Basis Adjustment. The inside basis of the partnership in its assets may need to be reduced under rules similar to those applicable to the IRC § 108(b)(5) special basis adjustment election (see discussion at (2)(c)(iv) above). See Regs. § 1017-1(f)(2) (but the election itself does not apply to IRC § 108(c)).

(5) Ordering of Exceptions . It is possible more than one exception could apply. They are used in this order: Bankruptcy, insolvency, then farm and qualified real

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property. The farm and qualified real property exceptions do not apply to a discharge to the extent the taxpayer is insolvent. IRC § 108(a)(2).

b. Solvent Taxpayers Outside Bankruptcy Proceedings and General Matters Relating to Discharge of Indebtedness. In determining debt cancellation income there are some other rules that will apply.

(1) Income from Nonrecourse Debt. Unless an exception applies, income is recognized on cancellation of the indebtedness (taking into account unamortized premium and discount). IRC § 61(a)(12). An old “no personal liability” exception for nonrecourse debt on property not transferred to obtain the discharge, no longer applies. The old exception was under cases such as Fulton Gold Corp. v. Com’r, 31 BTA 519 (1934) (no freeing of debtor’s assets) and Hotel Astoria, Inc. v. Com’r, 42 BTA 759 (1940). The current law recognizes income to the extent of the full nonrecourse debt discharged. See Gershkowitz v. Com’r, 88 T.C. 984(1987); Rev. Rul. 82-202; 1982-2 C.B. 36; Rev. Rul. 91-31, 1991-1 C.B. 19; IRC § 108(d)(1) treats “indebtedness” as including both recourse debt and debt subject to which the taxpayer holds property. See also Rev. Rul. 92-53, 1992-2 C.B. 48.

(2) Gift . It may be possible to argue in some circumstances for a gift or bequest exception. Compare Helvering v. American Dental Co., 318 U.S. 322 (1943) with Com’r. v. Jacobson, 336 U.S. 28 (1949) and See IRC § 108(e)(1) on no other insolvency exception. See also IRC §§ 453B(f) (gift cancellation of installment obligation gives rise to income to the creditor as a disposition of the obligation), 453B(c), 691(a)(5)(iii) (income in respect of a decedent) and Frane Est. v. Com’r., 98 T.C. 341 (1992) which was reversed by Frane Est. v. Com’r., 998 F.2d 567 (8th Cir. 1993) (self canceling installment note taxed to decedent’s estate under IRC § 691 rather than IRC § 453B). See H.R. Rep. No. 833, 96th Cong., 2nd Sess. at 15 (1980) and S. Rep. No. 1035, 96th Cong., 2nd Sess. at 19 (1980); both reports state “it is intended that there will not be any gift exception in a commercial context (such as a shareholder-corporation relationship) to the general rule that income is realized on discharge of indebtedness.”

(3) Other Arguable Exceptions. It may be possible to assert other defenses to the rule requiring the recognition of income on the discharge of indebtedness.

(a) Contingent or Contested Liabilities. The debtor should not recognize debt discharge income if the canceled debt was too contingent to create basis, or if the canceled debt was subject to a bona-fide dispute. Regs. § 1.108(b)-1(c) requires that a debt be “absolute and not contingent”. See CRC Corp. v. Com’r., 693 F.2d 281 (3d Cir. 1982) cert. denied 426 U.S. 1106 (1983); N. Sobel, Inc. v. Com’r., 40 B.T.A. 1263 (1939); U.S. v. Hall, 307 F.2d 238 (10th Cir. 1962). If the debt is for a loan of money or is liquidated, there is an accession to wealth on cancellation even if there is a dispute about payment or amount; a dispute over enforceability should only affect cancellation of debt income with respect to a debt for services or for property other than cash that is claimed to be not worth the obligation. See

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Preslar v. Com’r, 167 F.3d 1323 (10th Cir. 1999). Merely becoming unenforceable is a classic case for recognizing income from the cancellation of the unenforceable debt.

(b) Equity Not Debt. If the debt is really equity, it may not create cancellation of indebtedness income. See Selfe v. U.S., 778 F.2d 769 (11th Cir. 1985); but see Com’r. v. National Alphalfa Dehydrating and Milling Co., 417 U.S. 134 (1974) (taxpayer generally bound by the form of its transaction) and Crouch v. U.S., 692 F.2d 97, 99 (10th Cir. 1982).

(c) No Asset Increase; Guarantees. The obligation may not arise to the dignity of a debt sufficient to create income on its discharge if the debtor did not receive any consideration or obtain any increase in its assets as a result of it. See Bradford v. Com’r., 233 F.2d 935 (6th Cir. 1956); Com’r. v. Rail Joint Co., 612 F.2d 751 (2d Cir. 1932). But a guarantor who received consideration for the guaranty and obtained a release after the guaranty became payable on default of the principle debtor, may recognize debt discharge income. See analogously, Tennessee Securities, Inc. v. Com’r., TC Memo 1978-434, aff’d, 674 F.2d 570 (6th Cir. 1982) and Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975), (satisfaction of a personal loan guarantee by the guarantors' closely-held corporation constituted income to the shareholder-guarantors). However, the reduction of the debt with respect to the primary obligor does not also create debt reduction income for the guarantor even though the contingent liability is likewise reduced. Landreth v. Com’r, 50 T.C. 803 (1968). This may be the case as well when the guarantor makes a payment and the creditor restructures the primary obligor’s debt. Payne v. Com’r, 75 T.C.M. 2548. rev’d on other grounds, 224 F.3d 415(5th Cir. 2000). If the guarantor pays the debt, the primary obligor may have relief from debt income, but that income may not occur until after any subrogation or other reimbursement claim by the guarantor is released. Miller v. Com’r, 91 T.C.M. 1267 (2006).

(4) Contribution to Capital. IRC § 108(e)(6) provides that where a corporate debtor acquires its debt from a shareholder as a contribution to capital, it will recognize income to the extent the debt exceeds the basis of the shareholder in the debt. This is because the debt is deemed satisfied by a payment of money equal to the shareholder’s adjusted basis in the debt. If the cash basis shareholder has little or no basis in the debt contributed, for example accrued but unpaid interest, salary, or rent, which has been previously accrued by the corporation but not taken into income by the shareholder, or a debt upon which the shareholder has taken a bad debt deduction, the contribution of that debt to the corporation results in income to the corporation. This rule supersedes IRC § 118 which normally provides that no income is recognized on the contribution of capital to a corporation.

On the other hand, if the shareholder has basis in the debt in its face amount (e.g., from a loan of cash to the corporation), the corporation is treated as paying the debt and under IRC § 61(a)(12) recognizes no income even where the corporation is insolvent and the contribution of the loan to capital either does not render it solvent or renders it solvent in an amount less than the amount of the contributed debt. See Cummings’ Corporate Tax Insights on Checkpoint 11/11/2008, vol. 06, No. 21 (the purpose of IRC § 108(e)(6) “is to limit, for all purposes, the

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amount of the COD income (reported or not under Code Sec. 108(a)) to the spread between the shareholder’s basis in the obligation and its face amount (or adjusted issue price).”

(5) Subchapter-S Effect. IRC § 108(d)(7)(A), which treats income exclusion, attribute reduction, and the qualified farm indebtedness exception at the corporate level for S-corporations, prevents excludable income from passing through to the shareholder and thus prevents a basis increase in the stock under IRC § 1366(a). This section was amended, effective for discharges of indebtedness after October 11, 2001, in order to overrule Gitlitz v. Com’r, 531 U.S. 206 (2001). If stock basis had increased, future losses could have been passed through and future gains on the stock would have been less; Congress deemed this to be too great a benefit to the taxpayers.

The S-corporation usually will not have NOLs because it is a pass through organization. However, where the corporation has losses which cannot be passed through and used by shareholders because the shareholders’ basis is not sufficient to allow the losses to be used (see IRC § 1366(d)(1)), the corporation will be deemed to have an NOL for purposes of attribute reduction. IRC ' 108(d)(7)(B). This rule does not however apply to the qualified real property indebtedness exception to debt discharge income; basis reduction applies instead of the usual line-up of attribute reductions. Thus, in cases other than for the qualified real property exception, the attribute reduction will reduce pass through losses, including capital losses, which could have been used except that there was insufficient basis to do so. If there are any such losses left they are allocated among the shareholders for later use. Reg. ' 1.108-7(d)(2)(ii).

(6) Reduction in Purchase Price. No cancellation of indebtedness income is realized if the original seller of specific property reduces the purchase money debt of a solvent buyer outside bankruptcy who owns the property at the time of reduction. (IRC § 108(e)(5).) Recapture of tax credits or other items may be triggered. The purchase price reduction rule does not apply where the seller has assigned the debt, the debtor has transferred the property, or the debt is reduced by reason of factors not involving direct agreements between buyer and seller (e.g., running of statute of limitations). H.R. Rep. No. 833, 96th Cong. 2d Sess. at 13 (1980); S.Rep. No. 1035, 96th Cong., 2d Sess. at 16. The purchase price adjustment principle may apply to the purchase of services, such as educational services where student loans are forgiven when a proprietary school fails. See letter from Service to Senator Bill Nelson, INFO 2010-0141 Release Date: 6/25/2010 (purchase price adjustment based on an infirmity relating back to purchase of educational services). This exception does not apply to third party acquisition indebtedness. Query: would it apply to the assumption from a seller of the seller’s third party debt? Such a reduction could create an issue about whether an installment obligation has been disposed of (possibly triggering gain acceleration for a seller) under IRC §453B(f); the committee reports cited above state that where this code section applies, it applies to both seller and buyer, but does this mean the obligation is treated as if it did not exist (to the extent of the deemed price reduction) and not as if it was disposed of by cancellation?

(a) Case Law. There may also be a case law purchase price adjustment exception in addition to the provisions of IRC §108 (e)(5), but any such an exception

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is limited to where the debt exceeds the value of the property so that it does not apply where the market value of the property is greater than or equal to the debt after reduction. See Montgomery v. Com’r., 65 T.C. 511 (1975); Helvering v. Killian Co., 128 F.2d 433 (8th Cir. 1942). Where the value of property has not sufficiently decreased, the statutory exception, which is not so limited, may be better for the debtor. The judicial exception might not apply to third party borrowings incurred or assumed in the purchase (see Edwards v. Com’r., 19 T.C. 275 (1952), but compare Nutter v. Com’r., 7 T.C. 480 (1946)); if applied to third party borrowings the buyer and seller will end up with different purchase prices. Reductions by a third party lender will not, according to the Service, be treated as reductions in purchase price unless based upon an infirmity that clearly relates back to the original sale (e.g., fraud, or misrepresentation by seller of a material fact), at least with respect to nonrecourse debt. Rev. Rul. 92-99, 1992-2 C.B. 35. The judicial exception, for some courts, relates solely to face to face negotiations between seller and buyer as to price and not just solely to the debt (see Fifth Avenue - Fourteenth Street Corp v. Com’r., 147 F.2d 453 (2d Cir. 1944)), and does not apply where the debtor has sold the property with the obligation in its basis (see B. F. Avery & Sons, Inc. v. Com’r., 26 B.T.A. 1393 (1932)). See Preslar v. Com’r, 167 F.3d 1323 (10th Cir. 1999) requiring direct seller-purchaser negotiation. Basis is reduced and if the debt reduction exceeds basis, gain is recognized. Com’r v. Coastwise Transportation Corp., 71 F.2d 104 (1st Cir. 1934).

(b) Partnership Bankruptcy. Although the statutory exception under IRC 108(e)(5) will not apply to a bankrupt or insolvent partnership (since it does not apply in bankruptcy or to insolvent taxpayers), the Service nevertheless will not challenge purchase price adjustment treatment if the transaction otherwise qualifies but for the partnership’s bankruptcy or insolvency. Rev. Proc. 92-92, 1992-2 C.B. 505. The result is a reduction in the basis of the property securing the debt rather than debt discharge income being realized. Since the IRC § 108 exceptions are applied at the partner level, the bankruptcy or insolvency of the partnership should be irrelevant.

(c) Installment Sale. The cancellation of debt under a price reduction exception would be a disposal of an installment obligation in a transaction other than a sale or exchange and thus may cause gain to be recognized to the installment seller holding the debt. IRC § 453(f).

(7) Deductible Debt. No income (or attribute reduction) occurs if the payment of the debt would have been deductible. IRC § 108(e)(2). For accrual taxpayers, however, see IRC § 111(c) creating income with respect to deductions accrued but not paid which increase an NOL and are later forgiven before the NOL expires; that section treats an increase in a carryover as a reduction in tax for the tax benefit rule.

(8) Stock for Debt. A corporation which issues its own stock to cancel or reduce debt may realize income. IRC § 108(e)(8) provides that the corporation will be treated as having satisfied the debt with money equal to the fair market value of the stock. Thus tax attribute reduction for corporations which are insolvent or in a bankruptcy proceeding will occur. Income will result but be excluded under IRC § 108(a)(1) and tax attributes accordingly reduced

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under IRC § 108(b). Unless an exception applies, the corporation will be taxed to the extent the debt exceeds the value of the stock.

(9) Partnership Interest for Debt. Partnerships issuing a profits or capital interest in satisfaction of its debt, whether recourse or nonrecourse, are treated in a manner similar to corporations issuing stock for debt satisfaction and recognize cancellation of debt income to the extent the debt exceeds the fair market value of the interest. IRC § 108(e)(8). This income is included in the distributive shares of those who were partners immediately before the discharge. (Effective on or after 10/22/04.) See also the discussion at c(1)(c)(ii) below (regarding other aspects of debt cancellation) on a possible deemed cash distribution under IRC § 752.

(a) Value. The fair market value of the interest given in exchange for the debt will be its liquidation value, assuming a hypothetical sale of all assets (including good will and intangibles) for cash immediately after the contribution and a hypothetical liquidation. This treatment applies if certain conditions are met, otherwise the value is determined under all the facts and circumstances. The conditions to such liquidation value treatment are:

(i) maintenance of proper capital accounts,

(ii) the creditor, debtor (partnership), and partners all treat the fair market value of the debt as being equal to such liquidation value of the interest received for other tax purposes, and use consistent valuations for all equity issued in the overall transaction,

(iii) the transaction is arm’s length, and

(iv) there is no later redemption or related party purchase of the interest which is part of a plan at the time of the original exchange with a principal purpose of avoiding partnership cancellation of debt income. Regs. § 1.108-8(b)(1) and (2).

(b) Income and Basis of Partner. IRC § 721 provides tax free treatment for contributions to partnerships, but not where the partnership interest is given for the transfer to the partnership of partnership debt for rent, royalties, or interest on debt (including original issue discount). Although the contributing partner is not protected by IRC § 721, the debtor partnership itself recognizes no gain or loss under Reg. § 1.721-1(d)(2). Also, IRC § 453B, which relates to the disposition of installment obligations would continue to apply, and would not be superseded (as could occur in other situations involving the contribution of installment obligations of other persons; Regs. §§ 1.453-9(c)(2), 1.721-1(a)); thus tax could be accelerated. However, no loss would be recognized if the principal of the debt is more than the liquidation value of the partnership interest received in return for it, rather the partner’s basis in the interest would be increased by the basis in the debt and the holding period of the debt would tack on to the holding period for the interest (see IRC § 1223(1)). Regs. § 1.721-1(d)(1) and (2).

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(10) Miscellaneous Statutory Exceptions. There are special exceptions for discharges of certain student loans with a loan provision providing for discharge if the individual works a certain period of time in certain professions for a certain time (IRC § 108(f); CCA 201147001), and for discharges resulting from certain terrorist acts (Victims of Terrorism Relief Act of 2001, P.L. 107-134, at § 105(a)). Tuition reimbursement and recruitment programs where participating individuals are not required to have outstanding student loans or, if such loans exist, are not required to apply payments to such loans will not, however, be excludable. CCA 201104032.

(11) Home Mortgage. For the years 2007 through 2013, up to $2 Million ($1 Million for married taxpayer filing separately) (IRC § 108(h)(2)) of acquisition mortgage debt forgiveness on the taxpayer’s principal residence, may be excluded from income. IRC § 108(a)(1)(E). Principal residence has the same meaning as where the term is used in IRC § 121 (IRC § 108(h)(5)). Second homes do not have the benefit of the exclusion.

(a) Qualified Debt. Acquisition indebtedness is as defined in IRC § 163(h)(3)(B) (IRC § 108(h)(2)). It is indebtedness which is incurred in the acquisition, construction, or substantial improvement of the principal residence and which is secured by the residence. Refinanced debt will qualify but only up to the amount of the qualifying refinanced debt (i.e., additional debt incurred on the refinancing does not qualify). Home equity loans where the proceeds are not put into construction of the home are not acquisition debt and do not qualify.

(b) Part Qualified. If only part of a discharged loan is qualified principal residence acquisition indebtedness, only that part of the loan exceeding the nonqualified part, benefits from the exclusion. IRC § 108(h)(4).

(c) Causation. The discharge must relate to a decline in value of the home, or to the deteriorating financial condition of the taxpayer. It cannot relate, for example, to services for the lender or other factors.

(d) Bankruptcy and Insolvency. The exclusion does not apply in bankruptcy. IRC § 108(h)(3). An insolvent taxpayer outside of bankruptcy can elect not to use the home mortgage exclusion and rely instead on the more general insolvency exception of IRC § 108(a)(1)(B), discussed above at 1.a.(2). IRC § 108(a)(2).

(e) Cost of Exclusion. The price for the home mortgage exclusion is the dollar-for-dollar reduction of the basis in the home, but not below zero. IRC § 108(h)(1).

(f) No Gain Exclusion. As is the case in other cancellation of debt situations and as discussed further below in connection with foreclosures, a short sale or foreclosure may create gain for a debtor (Reg. § 1.1001-2(a)(2)), and the gain is not covered by an exclusion from COD income. However an exclusion under IRC § 121 of gain up to $250,000 ($500,000 for certain joint returns) may be available for a principal residence (not, e.g., a second

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home or rental property). See Reg. § 1.121-3 (unforeseen circumstances may allow some use of the exclusion where the 2 of 5 year rule is not fully met). Remember, however, that as discussed above in connection with attribute reduction, if the basis of a home is reduced by an insolvent debtor outside bankruptcy or in bankruptcy where the home is not exempted from creditors, then under IRC § 1017(d) the basis reduction causes the property to be IRC § 1245 property and the reduction is treated as being depreciation subject to recapture as ordinary income on a later sale.

(12) Governmental Homeowner Assistance. Certain governmental programs structured as notes for payments made by governmental programs to assist in avoiding foreclosures may be treated as, essentially, welfare payments excludable by the homeowner. See generally, Rev. Rul. 74-205, 1974-1 C.B. 20, and Rev. Rul. 98-19, 1998-1 C.B. 840. Thus forgivable loans under the Treasury Department’s Housing Finance Agency’s Hardest Hit Fund and notes under the Department of Housing and Urban Development’s Emergency Homeowner’s Loan Program or substantially similar state programs may, if the terms of the program are met, be treated as excludable social welfare payments rather than as cancellation of indebtedness income on the forgiveness of such loans or notes. Notice 2011-14, 2011-11 IRB.

The tax results of the Principal Reduction Alternative offered in the Home Affordable Modification Program sponsored by the Department of the Treasury and Department of Housing and Urban Development is described in Rev. Proc. 2013-16, 2013-7, IR 2013-8. Such a program is a significant modification which can create a deemed exchange of debt (discussed further below at section 2 in connection with debt modifications and workouts) which in turn, among other things, can create discharge of debt income (subject to information reporting, etc.). If such discharge income is not subject to an exception (e.g., the principal residence indebtedness exception or the insolvency exception), Rev. Proc. 2013-16, Sec. 6 allows reporting the income over a three year period in some circumstances. However, payments by the agency to the lender to provide an incentive to the modification are social benefit programs for the promotion of general welfare and are not includible in a recipient's gross income (see generally, Rev. Rul. 2005-46, 2005-2 CB 120, Rev. Rul. 75-246, 1975-1 CB 24) and aren't subject to information reporting, where the property is the taxpayer’s principal residence or is occupied by a legal dependent, parent, or grandparent without rent. Rev. Proc. 2013-16, Sec. 4.07, Sec. 4.09, and Sec. 5.05.

c. Other Aspects of Debt Cancellation .

(1) Partnership Application . Partnership-taxed organizations (including limited liability companies taxed as partnerships) are subject to some further rules.

(a) Partner Level. Income from the discharge of indebtedness income is recognized at the partnership level, but the exceptions to discharge of indebtedness income and basis adjustment rules are generally applied at the partner level. See IRC § 108(d)(6); Gershkowitz v. Com’r., 88 T.C. 984 (1987). Thus the bankruptcy, insolvency, qualified farm indebtedness, and qualified real property indebtedness exceptions apply at the partner level. For example, a partner who is himself bankrupt could take advantage of the

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bankruptcy exception; the bankrupt partnership itself cannot, and partners outside of bankruptcy cannot (although it may be possible some other exception, such as the insolvency exception, could apply to the partners outside bankruptcy).

(i) Where a partnership taxed organization such as an LLC is insolvent or in bankruptcy but its members are not, the members may be subject to cancellation of debt income where an exception does not apply.

(ii) A change in tax status for the organization under the check the box rules prior to the cancellation, so that the organization is taxed as a corporation and the insolvency or bankruptcy exception may apply at the corporate level, may well trigger the recognition of gain under the debt in excess of basis rules of IRC § 357. The same rule may affect any attempt by members to contribute membership interests to corporations in order to avoid the pass through of cancellation of debt income to themselves. General substance over form principles may apply to such transactions as well.

(b) Income Allocation; Basis. Discharge of indebtedness income must be separately allocated among the partners under IRC § 702(a). The receipt of such income will increase the partner’s basis in his partnership interest under IRC § 705. (See, however, Babin v. Com’r., 23 F.2d 1032 (6th Cir. 1994) aff’g T.C. Memo 92-673, which appears to be wrongly decided, but which denied a basis increase under IRC § 705 where the cancellation of indebtedness income was excluded under the IRC § 108(a)(1)(B) insolvency exception; the court did not want to allow both the exclusion of cancellation of indebtedness income and also the avoidance of gain on the liquidation of the partnership interest.)

(c) Deemed Distribution. Since the partner’s share of partnership debt is reduced by the discharge of the debt, the partner is deemed to receive a cash distribution (IRC § 752) which will reduce the partner’s basis in his partnership interest (IRC § 733). To the extent the deemed cash distribution exceeds the partner’s basis, the partner would, as in the usual situation, recognize gain from the sale or exchange of a partnership interest. IRC § 61(a)(3).

(i) Additional Basis Reduction. Note that this basis reduction in a partnership interest is separate from any other basis reduction pursuant to the attribute reduction rules with respect to the exceptions to the recognition of cancellation of indebtedness income.

(ii) 10% Partnership Interest. This deemed distribution rule will also apply where a holder of the partnership’s nonrecourse debt receives a greater than 10% interest in the partnership for partial discharge of the debt, because the remaining nonrecourse debt is no longer treated as nonrecourse as to the other partners. See Regs. § 1.752-2(c) and (d). The new partner partially discharging the debt would be deemed to receive a cash distribution to the extent of any deemed shift in the debt to the other partners. IRC § 752(b).

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(d) General Partner. The Service has taken the questionable position that at least where the taxpayer’s obligation is not direct but arises only by virtue of being a general partner, the discharge of the taxpayer’s share of the partnership obligation in bankruptcy resulted in capital gain under IRC §§ 731 and 752 (deemed cash distribution on shifts in liabilities) rather than cancellation of indebtedness ordinary income that is excludable under IRC § 108(a)(1)(A). (TAM 9619002 relies on Moore v. Com’r., T.C. Memo 1994-446 while distinguishing Marcaccio v. Com’r., T.C. Memo 1995-174).

(e) Minimum Gain. A discharge of nonrecourse debt could result in a reduction of minimum gain and thus in a minimum gain chargeback under Regs. § 1.704-2(f). It would be a first-tier item (chargeback first to disposition of partnership property subject to partnership nonrecourse liabilities at the first tier, then pro rata to the partnership's other items; Reg. § 1.704-2(f)(6)) for minimum gain chargeback purposes. Reg. § 1.704-2(j)(2)(i)(A) and Reg. § 1.704-2(j)(2)(ii)(A) (ordering rules for allocations of nonrecourse liabilities).

(f) Publicly Traded Partnerships. Although publicly traded partnerships are generally taxed as corporations (IRC ' 7704(a)), if 90% of its gross income comes from certain types of passive “qualifying” income, and some other conditions are met, corporate treatment will not occur. Cancellation of debt related to the generation of the qualifying income will itself be treated as qualifying income for this exception to corporate treatment under a safe harbor rule. Rev. Proc. 2012-28, 2012-27 IRB.

(2) Earnings and Profits. If basis is reduced (IRC § 1017), no adjustment is made to the earnings and profits (“E&P”) account of a corporation. IRC § 312(l)(1); Rev. Rul. 58-546, 1958-2 C.B. 143. The reduced depreciation deductions or increased gains on sales of assets resulting from the basis reduction will, however, affect earnings and profits in later years. If basis is not so reduced, then the excluded debt cancellation income does increase E&P. See Field Service Advice 1999-540, Vaughn No. 128. Forgiveness of debt by a creditor-shareholder may be a capital contribution and as such not increase earnings and profits, where the shareholder’s basis in the debt is at least equal to the principal amount of the debt. See IRC ' 108(e)(6)(B). For a corporate group, special rules apply to limit earnings and profits for a consolidated year in which a subsidiary has cancellation of debt income, but only for purposes of determining gain or loss on the disposition of intragroup stock; the earnings and profits are computed so as not to include excluded cancellation of debt income to the extent the amount so excluded was not applied to reduce tax attributes (other than basis in property). Earnings and profits thus increase if attributes, other than basis, are required to be reduced under IRC § 108(b)(2). IRC '' 1503(e)(1)(B), 1503(e)(2)(A).

(3) Related Taxpayers. As to both solvent and insolvent debtors in or out of bankruptcy, debt acquired from an unrelated party by a party related to the debtor is treated as having been acquired by the debtor. Related parties include IRC § 414(b) and (c) controlled entities, and persons described in IRC §§ 267(b) or 707(b).

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(a) Acquisition in Anticipation of Relationship. Under Regs. § 1.108-2, debts acquired in anticipation of becoming related to a debtor are taken into account. The regulations (Regs. § 1.108-2(c)(3)) deem any acquisition made within six months of becoming related to have been made in anticipation of the relationship, otherwise a facts and circumstances test applies. IRC § 108(e)(4).

(b) Required Statement. The debtor is required to file a statement with its tax return for the year in which the debtor became related to the holder of its debt, unless the holder reports its income on the basis that it acquired the debt in anticipation of becoming related, if either the debt is more than 25% of the assets of the holder’s group, or was acquired between 6 and 24 months of becoming related. The purpose of this required statement is to explain why the debtor believes the holder did not, under all facts and circumstances, acquire the debt in anticipation of the relationship. Regs. § 1.108-2(c)(4).

(4) Debt Restructure. An extension of time for payment or an interest rate reduction may be treated as reductions of debt giving rise to income from the cancellation of indebtedness where there is a reduction in the face amount of the debt or in the deemed principal amount of the debt. See discussion of debt modifications and workouts at 2 below.

(5) Information Returns. Financial institutions are required to file an information return disclosing any whole or partial discharge of the indebtedness in excess of $600.00 of any person during the calendar year. IRC § 6050P(a). The reporting obligation is only triggered by the occurrence of one of eight “identifiable events.” Regs. § 1.6050P-1(b)(2). The eight events include discharges by reason of bankruptcy, receivership, foreclosure, expiration of limitations periods, probate bars, discharge agreements, creditor decision to stop collection, or, for certain financial institutions, the expiration of a 36-month nonpayment testing period. Regs. § 1.6050P-1(b)(1). The Service takes the position that an identifiable event occurs in settlement agreements which result in loan write-offs for failure to give proper notices under state law which would deny recoveries where there are defective notices; at least where there is no definitive finding or admission that the notices were defective, the discharge was the result of a contract, not state law. PLR 201217001. There are a few exceptions to the identifiable event reporting rules, such as for: amounts which are not principal, foreign debtors, related person acquisition of debt, release of only some co-obligors, guarantors. The financial institution does not determine whether the discharge is taxable or excludable. A written statement must also be given to the debtor named on the information return before January 31 of the year following the year of discharge. IRC § 6050P(d). Penalties apply for failure to make the return or provide the statement. IRC §§ 6724(d)(1)(B)(viii); 6724(d)(2)(P). The mere receipt of the form 1099 C from a creditor is not determinative of the timing of the cancellation, which may be treated as cancelled in some other earlier year when it was clear the debt would not be repaid. See Stewart v. Com’r, TC Summary Opinion 2012-46 (relying on 3 year no payment rebuttable presumption for earlier cancellation). Also, the mere receipt of a form 1099C is not the same as a state law extinguishment of the debt itself. See Chivaho Credit Union v. McGuire, 2012 WL 6212706 (Ohio App. 2012).

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(a) Creditors Affected. The “applicable financial entities” required to make the return are:

(i) financial institutions under IRC §§ 581 or 591(a) or any credit union;

(ii) any regulated subsidiaries of such financial institutions or credit unions;

(iii) the FDIC, RTC, NCUA, or their sub units or other federal executive agencies (see IRC § 6050M); and

(iv) organizations significantly engaged in the trade or business of lending money (see Regs. § 1.6050 P-2).

(b) Limit to 36 Month Rule. One rebuttable presumption as to an identifiable event giving rise to the requirement of an applicable financial entity to report a discharge, is the failure of the debtor to pay over a 36 month period. This can be rebutted by a showing of significant collection activity by the creditor. This presumption applies after November 10, 2008 only to the first three types of creditor listed above, not to “significantly engaged” organizations. Regs. § 1.6050P-1(b)(2)(i)(H). However, if a significantly engaged creditor earlier was subject to such an obligation under the 36 month rule, but failed to file an information return, the reporting requirement arises upon the occurrence of any other identifiable event after 2007. Regs. § 1.6050P-1(b)(2)(v). The 36 month rule can result in the reporting of a discharge even where no actual discharge has occurred; but at least the rule has been limited to financial institutions and governmental agencies.

(6) State and Local Effect of Cancellation of Indebtedness. Under BC § 346(j), the effect of cancellation of debt is made generally consistent with federal treatment.

(a) Income. No income is recognized by the estate, debtor, or successor to the debtor on cancellation of debt, unless it is taxable under federal tax law. See IRC §§ 61 and 108.

(b) Attributes. Tax attributes for state and local purposes are reduced under the exceptions to cancellation of debt income the same as corresponding federal attributes are reduced under IRC §§ 108 and 1017. If there is additional discharge of debt income not fully applied in such reductions, any additional state or local reductions would apply to the excess.

(c) NOLs. However, the effect of a plan of reorganization on the preservation of state and local NOLs is not addressed under the Bankruptcy Code. See IRC § 381. A number of states have significant limits on NOLs where the entity was not subject to state or local tax when the NOL was incurred, allow no carrybacks, use shorter carryforward times, etc.

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(7) Loans to Pay Taxes. Loans to pay nondischargeable federal taxes, for example, through credit card charges used to pay taxes, will not be dischargeable (Bankruptcy Reform Act of 1994, P.L. 103-394, 10/22/94).

(8) Deferral of COD Income. For the years 2009 and 2010 IRC § 108(i) gives businesses the election to defer COD income arising from debt restructurings involving the reacquisition by the debtor or a related party of an applicable debt instrument, which is any debt instrument issued by a C corporation, or issued by any person in connection with the conduct of that person’s trade or business. See temporary and proposed Treasury Regulations at Reg. § 1.108(i)-0T ff, TD 9497, 08/11/2010, TD 9498, 08/11/2010. Not all states allow this deferral. Deferral of COD income does not necessarily defer other tax consequences. See, Chief Counsel Advice 201135030 (election to defer the recognition of COD income under IRC § 108(i) does not defer the recognition under Reg. § 1.446-4 of unamortized hedge gain from an anticipatory interest rate hedge allocable to repurchased debentures giving rise to the COD income).

(a) Deferral. The deferred income is ratably included in gross income over a five taxable year period beginning with the fifth (for 2009 reacquisitions) or fourth (for 2010 reacquisitions) taxable year following the year in which the reacquisition occurs.

(b) Election. S-corporations, partnerships, and other pass-through organizations make the election at the entity level. The election is irrevocable, and is made debt instrument by debt instrument. The election does not require insolvency.

(c) Acceleration. Death, liquidation, sale of substantially all assets (including in a Title 11 or similar case), ceasing to do business, or similar circumstances, including the sale, exchange, or redemption of an interest in an electing pass-through entity (such as an S-corporation or partnership-taxed organization), will trigger acceleration of the inclusion into income (as of the day before the petition in the case of a Title 11 or similar case).

(d) Effect on Other Exceptions. The insolvency, bankruptcy, qualified farm indebtedness, and qualified real property indebtedness rules do not apply to the income from the affected discharge if the IRC § 108(i) election is made, either for the year of the election or any later year.

(e) Partnership Effects. The COD income is allocated to partners immediately prior to discharge. A decrease in a share of liabilities will not cause a deemed distribution of cash (see IRC § 752) to the extent it would be taxable under IRC § 731; this means the partner’s basis in the partnership interest will be reduced but any deemed distribution exceeding that basis will be deferred so long as the income deferral under IRC § 108(i) remains effective and will be taken into account ratably (or at acceleration) at the same time or times as that deferred income is recognized.

(f) OID Effect. The reacquisition may be by means of the direct or indirect use of a new debt instrument. If the new instrument carries original issue

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discount (“OID”), the interest deductions are deferred to the five-year recognition period and will be accelerated if the COD income is accelerated.

(9) Trust Application. Trusts can be debtors and are often pass through tax organizations, but the application of the COD rules and their exceptions for trusts which are not grantor trusts will not follow the same pattern as for partnerships or S-corporations. Rather, different treatment is required particularly because there is no basis adjustment for beneficiaries as there is for S-corp shareholders or partners, but also because trust beneficiaries are protected against debt (similar to a S-corp shareholder; so there is no freeing of assets by cancellation of trust income), trust are not always full flow through organizations and taxation depends on the receipt of or right to the income (often in trustee discretion) so that the trust may be the actual taxpayer if full income distributions are not made, and the beneficiaries may not fully ascertained. Thus it would be impossible to apply the rules at the beneficiary level, certainly for a complex trust (e.g., one in which the beneficiaries are not simply entitled to all income), and usually for a simple trust as well. Thus for trusts, it appears that the rules most likely will be applied at the trust level rather than the beneficiary level.

(10) Disregarded Organizations. The treatment of disregarded organizations and grantor trusts is a pass through to the underlying owner, and the “taxpayer” for purposes of application of the rules of IRC § 108 will be the underlying owner. Thus, analogous to partnerships, the exceptions to COD income apply at the owner level, not at the level of the disregarded entity itself. Prop. Reg. § 1.108-9. Disregarded entities may include business organizations with a single owner (see Reg. § 301.7701-3) such as a single member LLC not treated as a corporation, a qualified REIT subsidiary (see IRC § 856(i)(2)), and a qualified Subchapter S subsidiary (see IRC § 1361(b)(3)(B)), or may include a grantor trust (see IRC § 671 et seq.). Thus, for example, in order for the bankruptcy exception to apply, the owner would need to be in bankruptcy, not just the disregarded entity. If a partnership owns a disregarded entity, such as a grantor trust, the owner is the partner to whom the COD income is allocated. Prop. Reg. § 1.108-9(a).

d. Related Matters. Some other issues that may be important in dealing with troubled debtors include:

(1) Personal Holding Company. Under IRC § 542(c)(9) a debtor in a Title 11 or similar case (i.e., bankruptcy, receivership, foreclosure, etc.) will not become a personal holding company unless the major purpose of instituting or continuing the case is the avoidance of the personal holding company tax imposed by IRC § 541.

(2) Accrued But Unpaid Interest. Coordination of interest income accrual and interest deduction accrual is not always clear.

(a) Debtor. There is a split in authority as to whether an insolvent debtor can deduct accrued but unpaid interest. Compare Rev. Rul. 70-367, 1970-2 C.B. 37, Zimmerman Steel Co. v. Com’r., 130 F.2d 1011 (8th Cir. 1942) (which tend to favor deductibility), with Brainard v. Com’r., 7 TC 1180 (1946), Tampa & Gulf Coast Railway

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Company v. Com’r., 469 F.2d 263 (5th Cir. 1972), In Re Continental Vending Corp., 77-1 USTC ¶ 9121 (E.D. N.Y. 1976) (which tend against deductibility). See also discussion below at 3c in the context of foreclosures. The tax benefit rule of IRC § 111(c) may apply.

(b) Creditor. Note that generally a creditor will not accrue the interest as income where the debtor is insolvent and does not appear likely to be able to pay the interest, and there is a determinable event which triggers the cessation of accrual. See Rev. Rul. 80-361, 1980-2 C.B. 164. The creditor has the heavy burden to show why it should not further accrue interest income. Jones Lumber v. Com’r., 404 F.2d 764 (6th Cir. 1968).

(c) Original Issue Discount. Original issue discount (called “OID”) may be required to be accrued by a creditor (e.g., bond holder) under its own special rules, even if normal interest income as to the debtor can stop accruing. The OID rules also affect the deemed interest deduction for the debtor (e.g., bond issuer). TAM 9538007. OID is discussed further at 2b(6) below.

(d) Capitalized Interest. Some interest is not deductible in the normal way but is required to be capitalized, for example, where it is involved in the production of certain capital assets. IRC § 263A(f) (uniform capitalization rules). This will have an effect on the basis of an asset affected.

2. Debt Modifications and Workouts.

a. General Effect of Significant Modification . The modification of the terms of a debt instrument will be treated as an exchange of the old debt for a new debt if the modification is significant. Cottage Savings Association v. Com’r., 499 U.S. 554 (1991) (materially different terms in mortgage portfolio swap).

(1) Determination Process. There is a two-step process to determining if a deemed exchange occurred. First, Regs. § 1.1001-(c) must be consulted for what is a modification; second, the significance of the modification is determined under some specific provisions or else under a facts and circumstances test (Regs. § 1.1001-3(e)(1)). If significant, the old debt is treated as being satisfied (by an exchange even if no new instrument exists) by the amount of money equal to the issue price (which is not necessarily the face amount) of the new debt. If neither debt is publicly traded the issue price of the new debt will be its stated principal unless it does not bear adequate stated interest, and then it will have a deemed principal amount as its issue price. However, for a cash basis taxpayer, gross income does not include interest on a note replaced by another note. Scales v. Com’r, 18 TC 1263 (1952), acq., 1954-2 CB 5, rev’d on other issues, per curium, 211 F.2d 133 (6th Cir. 1954).

(2) Effects for COD, OID, Gain, Exemption. The deemed issue price may well be less than the old debt, thus giving rise to income to the debtor from the cancellation of indebtedness. The modification may also give rise to original issue discount. The creditor may be taxed on any original issue discount created, and the debtor may be able to take deemed interest deductions based upon the original issue discount, over the remaining term of the

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obligation. The creditor may recognize gain or loss on the transaction measured by the difference between the issue price of the new debt and the creditor’s adjusted basis in the old debt. Also, gain from disposition of an installment obligation may be recognized. If the modified obligation is a tax exempt bond, the deemed new bond may lose its exemption if it does not qualify under the exemption rules in effect at the time of the deemed exchange. These matters are governed by a rather complex interplay between the original issue discount rules of IRC § 1274 and the unstated interest rules of IRC § 483.

Special rules apply to any debt reacquisitions in 2009 or 2010 which are subject to IRC § 108(i) (discussed further at 1(c)(8) above).

The Principal Reduction Alternative offered in the Home Affordable Modification Program sponsored by the Department of the Treasury and Department of Housing and Urban Development creates tax results described in Rev. Proc. 2013-16, 2013-7, IR 2013-8, including a significant modification which will cause a deemed debt exchange.

b. Modifications, Their Significance, and Special Rules . Let’s take a closer look at these debt modification rules.

(1) Modifications. The existence of a modification must first be determined and is broadly defined as any alteration of any right.

(a) Unilateral Options. However, if the terms of the original instrument allow one party a unilateral right to make a modification (e.g., to change from a variable to a fixed rate) the exercise or waiver will not cause a modification unless the other party obtains a counter right in the event the first right is exercised (e.g., a right to change some other aspect or call the obligation), or must give consent (unless such consent cannot be unreasonably denied), or if the exercise requires a payment of consideration not fixed at the time the debt was issued originally, in which events the change will be treated as a modification since it is not unilateral. Failure of a party to exercise an option is not a modification. Regs. §§ 1.1001-3(c)(2)(iii)(A) and (B), and 1.1001-3(c)(3) and (5).

(b) Failure to Perform. The failure of an issuer to perform its obligations (i.e., a default) under a debt instrument is not itself a modification. Also, unless other terms are modified, the creditor’s agreement to temporarily forebear collection or acceleration is not a modification until it exceeds two years beyond the period of good faith negotiation or the time the debtor was in bankruptcy proceedings or a similar case. Regs. § 1.1001-3(c)(4).

(2) Significance of Modifications. Once it is determined that a modification exists, its significance must be tested. Even if a particular modification is not by itself significant, it can have a cumulative effect with other modifications that is significant. Regs. § 1-1001-3(f)(3). (Generally, modifications occurring more than 5 years before the modification being tested can be disregarded.) Among others, some of the changes that will be significant are:

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(a) Yield. Yield changes in excess of 25 basis points are significant (Regs. § 1.1001-3(e)(2)). Commercially reasonable prepayment penalties are not taken into account.

(b) Payments. Material deferrals of payments are significant (Regs. § 1.1001-3(e)(3)). Reasonable grace periods will not necessarily create a significant modification. Extending final maturity will be significant only if it is for more than the lesser of 5 years or 50% of the original term; but if a nonsignificant extension affects the yield by more than 25 basis points, this could make the modification significant.

(c) Put or Call. The addition or deletion, or modification of a put or call right with significant value at the time of addition or deletion, or whose value is significantly affected by the modification, will be treated as significant.

(d) Obligor. A change in the obligor is almost always significant (Regs. § 1.1001-3(e)(4)(I). Two exceptions exist for acquisitions: if IRC § 381 applies to a corporate acquisition and the new obligor is the acquiring corporation; or where the new obligor acquires substantially all the assets of the original obligor without a change in payment expectations or other significant alteration. Also, if the obligation is nonrecourse a change in obligor is not significant. A bankruptcy (Title 11 or similar case) does not create a new obligor; neither does an IRC § 338 election after a stock acquisition to treat it as if it were an asset acquisition.

(e) Credit Enhancement. A release, substitution, addition, or alteration of collateral or of a guarantee or other credit enhancement for a recourse debt, or the change in priority of the debt instrument will be significant if it results in a change of payment expectations, but (as explained at Preamble, 61 Fed. Regs. 32,926 at 32,929) a change in payment expectations does not occur if the debtor has at least an adequate capacity to meet its payment obligations both before and after the modification. Subordination of the debt is not a significant modification unless payment expectations change. A significant modification will occur if a substantial amount of the collateral, guaranty or other credit enhancement for a nonrecourse obligation is modified (e.g., by a substitution, release, or addition) (Regs. § 1.1001-3(e)(4)(iv)), unless the collateral is fungible, or is securities replaced with substantially identical securities. However, the substitution of a similar commercially available credit enhancement contract is not a significant modification. Improvements or repairs to property are not significant modifications.

(f) Conversion and Other Changes. Conversions from debt to nondebt instruments, changes from variable or contingent to fixed rates or vice-versa, changes to the currency in which an obligation is payable, or changes in conversion or exchange rights with significant value (other than where IRC § 381(a) applies or to adjust a conversion ratio for a stock dividend), will be significant modifications. Generally, absent a change in the obligor or the addition or deletion of a co-obligor, the mere change in the financial condition of the debtor is not a modification. Regs. § 1.1001-3(e)(5)(i). Regs. § 1.1001-3(f)(7) clarifies this provision

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and also clarifies Regs. § 1.1001-3(c)(2)(ii) (modification resulting in property that is not debt for tax purposes) to assure that a change in market value of an instrument due to the deterioration in the debtor’s (issuer’s) financial condition between issuance and alteration, rather than to a change in the instrument, is not to be taken into account.

(g) Regulations. Some commentators believe the final Treasury Regulations may be subject to challenge because they are interpretive (rather than legislative) and may be “unreasonable and plainly inconsistent with the revenue statutes” (Com’r. v. South Texas Lumber Co., 333 U.S. 496, 501 (1948)) at least in some respects, where the statute is not ambiguous and in need of interpretation. (See Tax Management Memorandum Vol. 37, No. 17, Spec. Ed. 1996-7, 8/19/96).

(h) Grandfathering. There is no grandfathering under the final Treasury Regulations which apply as well to any changes to any debt instrument existing as of the effective date of September 24, 1996. All prior changes to the obligation must be taken into account.

(3) Installment Obligations. If the obligation is an installment obligation (e.g., arising from the sale of an asset), the treatment of the creditor is somewhat different. A deemed disposition under IRC § 453B will cause gain or loss (e.g., from the sale) to be recognized by the creditor (i.e., accelerated), but the standards for a material modification under IRC § 453B are different than those under IRC § 1001. It is possible to have a modification that is not a disposition under IRC § 453B (see e.g., PLR 201144005 (certain changes in terms not a disposition or satisfaction); PLR 201248006 (deferring the maturity date, substituting a new obligor, and altering the interest rate, is not a disposition or satisfaction of an installment obligation)) but which is nevertheless treated as giving rise to gain or loss under IRC §§ 1001 and 1274. The gain or loss in the event of a disposition under IRC § 453B is measured by the difference between the creditor’s basis (under IRC § 453B(b), the basis is the excess of face value over the income that would be returnable if satisfied in full) and either the amount realized on a sale, exchange, or satisfaction at other than face value, or, in other cases, the fair market value of the obligation. For related parties, fair market value is not less than the face amount. IRC § 453B(f)(2). Foreclosure of a mortgage or other security interest may trigger such acceleration of income recognition. See discussion at 3 below.

(4) Adequate Interest IRC § 1274 and § 483 . Most debt modifications will be subject to the rules of IRC § 1274, but there are a number of exceptions, and if those exceptions apply, IRC § 483 will generally apply. Section 483 is now generally restricted to testing for adequate interest in seller financed transactions not otherwise governed by IRC § 1274. Generally, the interest is tested against the Applicable Federal Rates issued monthly by means of Revenue Rulings. (See (6)(b) below.)

(5) Potentially-abusive Situations. In the case of tax shelters, recent sales transactions, certain nonrecourse transactions (generally where there is less than a 20% down payment), financings for a term exceeding the useful life of the property, or debt with

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clearly excessive interst (Regs. § 1.1274-3(a)), the deemed principal amount of the new debt exchanged for property is the fair market value of the property less any other consideration received. Thus the issue price of the new debt cannot exceed the fair market value of the property even if the instrument provides adequate stated interest. This can trigger taxation under the various rules.

(6) Original Issue Discount. If the modification triggers a deemed exchange, even with no gain or loss, the analysis is not yet complete. There is a further issue involved, that of whether there is original issue discount (“OID”). For example, if principal is deferred, or if some of the interest accruing on the deferred principal is or is deemed to be, deferred, this might create original issue discount income to the lender, and a corresponding current interest deduction to the borrower (determined under the “constant yield method” of IRC § 1272(a)(1)). OID is not limited to publicly-traded debt. (It also is not limited to debt modifications.) The following explanation will seem complex and technical, and this it certainly is, although it has been greatly simplified where possible. The OID rules are, as you will see, hideously complex.

(a) What is OID? Original issue discount is the excess, if any, of the stated redemption price at maturity of a debt instrument over its issue price. The stated redemption price at maturity is the sum of all payments other than qualified stated interest. The qualified stated interest is the stated interest that is unqualifiedly due at least annually at a single fixed rate. The issue price for nonpublicly traded debt bearing adequate interest is its face amount; for publicly traded debt it is the market price at issue, or at deemed issue on a material modification.

Example: If the entire obligation is $100X payable at maturity and it is issued for $90X, the OID is $10X: $100X redemption price at maturity - 90X issue price $ 10X OID Example: If property worth $70X is bought with an obligation payable in installments over time where the total of all installments payable is $100X, and where of this $100X a $20X part is qualified stated interest, the OID will be $10X: $100X total of all payments to maturity - 20X payments which are qualified stated interest $ 80X the redemption price 80X the redemption price - 70X the price for the property (issue price) $ 10X OID

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(The foregoing example would also apply where a debt of $70X is exchanged or deemed exchanged for an obligation with an issue price of $100X; issue price on non public debt is face if it bears adequate stated interest, or a deemed principal amount if it does not.)

The effect on a deemed exchange of publicly traded debt is to make the then existing market discount (the debt of troubled debtors usually trades at a steep discount) into original issue discount, in addition to possibly triggering cancellation of indebtedness income on the deemed repayment of the old obligation with the deemed new one.

(b) Adequate Stated Interest. For OID purposes, adequate stated interest exists if the stated principal amount of the debt is less than or equal to the imputed principal amount. IRC §§ 1274(c)(2) and 1274(b). The imputed principal amount is the sum of the present values of all payments due under the instrument using a discount rate equal to the applicable federal rate compounded semi-annually with respect to the period (i.e., short term (3 years or less), midterm (9 years or less, but over 3 years), or long term (over 9 years)) determined by the weighted average maturity of the installment obligation. (The Applicable Federal Rate for a demand loan is the short term rate but it fluctuates monthly as long as any of the note remains unpaid. Reg. § 1.482-2(a)(2)(iii)(C).) The weighted average maturity is the sum of the following amounts determined for each payment other than a payment of qualified stated interest: (1) the number of complete years from the issue date until the payment is made multiplied by (2) a fraction the numerator of which is the amount of the payment and the denominator which is the stated redemption price at maturity.

(c) Possible Exceptions. Even if there were to otherwise be original issue discount, some possible exceptions may apply. Three of these are general, and there are other more specialized exceptions.

(i) All Qualified Stated Interest. The first general exception arises under Regs. § 1.1274-1(b)(1) which makes the OID issue price rules inapplicable (resulting instead in the application of IRC § 1273(b)(4)) so that the issue price will, by legislative fiat, equal the stated redemption price at maturity. This exception applies if all interest is qualified stated interest, the rate at least equals the test rate that applies, the debt is not issued in a potentially abusive situation, and the borrower does not pay lender points or interest at the time of the issuance of the debt (here, the time of the deemed exchange). Thus, this exception essentially puts the debt outside the OID rules.

(ii) De minimis Rule. Secondly, there is a de minimis rule under IRC § 1273(a)(3) that ignores OID if the excess of the stated redemption price at maturity over its issue price is less than 0.25% (or alternatively, 0.167% may be used where payments of principal are no more rapid than under a self-amortizing installment obligation) of the stated redemption price at maturity, multiplied in the usual case by the number of complete years to maturity, but in the case of an installment obligation multiplied by the weighted average maturity.

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(iii) Cash Method Election. The third general exception would be to elect cash method treatment for the obligation under IRC § 1274A. The election would be available for a deemed debt for debt exchange (such as in the case of a significant modification) unless the principal purpose of the modification is to defer interest income or deductions. To qualify for the election the stated principal must (in 2011) not exceed $3,715,200, the lender must not use the accrual method of accounting or be a dealer with respect to the property sold or exchanged (here debt instruments), the issue price rules of IRC § 1274 would otherwise have applied (this apparently makes the election an alternative exception, not an additional exception, to the first exception), and the borrower and lender together elect to have the debt treated on the cash basis by means of a joint statement signed not later than the due date including extensions for filing the return of the borrower or the lender for the tax year of the issuance (i.e., the date of the deemed exchange on the significant modification). A copy should be included with the timely-filed returns of the borrower and the lender.

(iv) Specialized Exceptions. The more specialized exceptions to the OID rules may apply where nonpublicly-traded debt is issued for nonpublicly-traded property. However, the imputed interest rules of IRC § 483 would apply. Subject to various conditions and requirements, these exceptions involve: total payments of $250,000 or less (IRC § 1274(c)(3)(C)), principal residence of an individual (IRC § 1274(c)(3)(B)), farms with a sales price not exceeding $1,000,000 (IRC § 1274(c)(3)(A)), sales of patents (IRC § 1274(c)(3)(E)), transfers of land between family members where all land sales aggregate not more than $500,000 (IRC § 1274(c)(3)(F)), property that is personal use property to the debt issuer that evidence a below-market loan or transactions involving a demand below-market loan (Regs. § 1.1274-1(b)(3)(i) and (ii), IRC § 7872), or transfers between spouses incident to divorce (Regs. § 1.1274-1(b)(3)(iii)).

c. Modification Planning Opportunities . These rules on debt modification allow for a number of planning possibilities with respect to nonpublicly-traded debt.

(1) Minimize Cancellation Income. The debt can be structured to minimize cancellation of indebtedness income by causing the issue price to equal the fair market value of the old debt and providing adequate stated interest. This could be important to a debtor that is not insolvent and wishes to avoid bankruptcy, that is not so deeply insolvent as to be able to exclude all the cancellation of indebtedness income or otherwise does not qualify for a statutory exclusion, or that is trying to preserve valuable tax attributes from being offset under a statutory exclusion.

(2) Maximize Cancellation Income or OID. The debt can be structured to maximize cancellation of indebtedness income by reducing the interest rate below an adequate stated rate to reduce the imputed principal amount. The result could be the creation of both cancellation of indebtedness income and original issue discount (OID). Original issue discount would be created if the issue price of the new obligation came as close as possible to the new obligation’s fair market value (a value less than the amount of the old debt) while pushing payments to the end of the obligation’s term. This may be useful where the debtor’s tax

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attributes have little value (e.g., expiring NOLs or tax attributes limited under IRC § 382 (e.g., by reason of a corporate acquisition)) so that offsetting them as a result of debt cancellation income will not be costly upon the application of a statutory exclusion of the debt cancellation income (e.g., the bankruptcy exception, or if sufficiently deeply insolvent, the insolvency exception); it is also useful where additional deductions for the debtor from original issue discount can be used and the creditor does not object to additional income (for example, because it is tax exempt). For example, if the stated principal amount and maturity date of the obligation were unchanged and only the rates at which interest was payable or at which it accrues were to be changed from an originally adequate rate, the following would generally result:

(a) Reduced Payment and Accrual Rate. If both the rate at which interest was currently payable and at which it accrues were to be reduced (principal and maturity remaining constant), then the imputed principal could be less than stated principal and cancellation of indebtedness income would thus be created for the debtor. The creditor would suffer a corresponding loss. Also, the amount of cancellation of indebtedness income would be OID. The debtor would receive deductions on this OID over the term of the loan, and the creditor would recognize income on the OID over the term of the modified loan.

(b) Only Payment Rate Reduced. If the accrual rate remained the same as the original interest rate, but the current payment rate was reduced, with the difference compounding annually and payable at maturity, since the modified debt continues to have adequate stated interest, there will be no cancellation of indebtedness income to the debtor or gain or loss to the creditor. OID would be created and the debtor would thus obtain deductions and the creditor income.

3. Foreclosures and Transfers of Property for Discharge. Discharge obtained by the transfer of property from the debtor to the creditor (by deed, foreclosure, or abandonment) is treated as a sale by the debtor for the face amount of debt (U. S. v. Davis, 370 U.S. 65 (1962); Kenan v. Com’r., 114 F.2d 217 (2d Cir. 1940)) and may result in capital gain or loss (Danenberg v. Com’r., 73 T.C. 370 (1979)). The debtor (solvent or insolvent) may desire this result rather than ordinary income or tax attribute reduction. On the other hand, where appreciated property is pledged as an accommodation to secure the debt of someone else, the foreclosure on the security may not be an amount realized triggering gain recognition to the pledging party. See Friedland v. Com’r, 82 T.C.M. 492 (2001); INI, Inc. v. Com’r, 69 T.C.M. 2113 (1995); Reg. § 1.1001-2(a)(1). A seller under an installment obligation may be treated as disposing of the obligation and thus accelerate the recognition of gain. IRC § 453 B. Gain can arise where property subject to debt in excess of basis is abandoned. See Yarbro v. Com’r, 737 F.2d479 (5th Cir. 1984).

a. Recourse Debt. Where the basis of property is less than fair market value but the recourse debt forgiven by the transfer of property to the creditor is greater than fair market value, there is a bifurcation and the difference between basis and value is capital gain (IRC § 1001) and the difference between value and debt is ordinary income from the discharge of indebtedness. Regulations under old IRC 1017 (§ 1.1017-1); Rev. Rul. 90-16, 1990-1 C.B.

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12; Regs. § 1.1001-2(a)(2) and (4); Regs. § 1.1001-2(c), Ex. 8; but see contrary view in Chillingirian v. Com’r., 52 T.C.M. 606 (1986), aff’d, 90-2 USTC § 50569 (6th Cir. 1990) and Aizawa v. Com’r., 99 T.C. 197 (1992). A debtor entitled to a statutory exclusion of debt discharge income may want to consider pushing for a low valuation in order to avoid capital gain and obtain debt discharge income to offset with tax attributes. See also Burnquist v. Com’r, 44 BTA 484 (1941), app. dism’d 123 F.2d 64 (8th Cir. 1941) (release of liability first followed by later surrender was treated as surrender with nonrecourse obligation). On the other hand, a debtor may want to argue that, under all the facts and circumstances, the debt has become nonrecourse (e.g., under an anti-deficiency statute if the creditor’s only source of recovery is the property), thus triggering gain or loss (as described in b below). This may be particularly so with respect to a residence that would entitle the taxpayer to the IRC § 121 gain exclusion ($250,000 single $500,000 married).

b. Nonrecourse Debt . Satisfaction of nonrecourse debt with the property secured causes the debtor to recognize gain or loss under IRC § 1001 measured by the difference between the debt and the basis of the property regardless of the value of the property. Regs. § 1.1001-2(c), Ex. (2) and Ex. (7); Temp. Regs. § 15A. 453-1(b)(3)(1); Com’r. v. Tufts, 461 U.S. 300 (1983); Rev. Rul. 76-111, 1976-1 CB 214. On partial recourse debt the Service will first allocate the payment to the nonrecourse portion absent a specific agreement between the parties (PLR 8348001). The sale treatment with respect to nonrecourse debt may give rise to gain, and this will not be excludable under a discharge of indebtedness exclusion. Attempts to convert nonrecourse to recourse debt may run afoul of IRC § 269 which prevents tax avoidance schemes. It may be desirable for a taxpayer without capital loss carryovers to have the creditor first forgive all or part of the debt in excess of the property’s value as a separate transaction.

c. Back Interest . What effect will a foreclosure have where there is back accrued but unpaid interest? The case law is not entirely clear, but the result appears to turn on these major factors: whether the fair market value of the property exceeds the basis of the property (i.e., whether the property is gain or loss property), whether the value of the property or its proceeds exceed the principal of the debt owed, whether the debt is recourse or nonrecourse, whether the debtor is solvent or insolvent, and whether the debtor is on the cash or accrual basis of accounting.

(1) Insolvent. An insolvent cash basis debtor, owing recourse debt will not be treated as having paid interest first out of the foreclosure proceeds unless the proceeds are in excess of the principal of the debt. Where the proceeds are less than principal, the creditor will not recognize interest income and the debtor will not be entitled to an interest deduction. See Newhouse v. Com’r, 59 T.C. 783 (1973). If the proceeds exceed principal, then at least to that extent the debtor will have an interest deduction and the creditor will have interest income.

A similar result may apply, as well, to an insolvent accrual basis debtor. See also (5) below. However, there is a split of authority as to whether an insolvent accrual basis debtor can obtain the deduction at all. See 1(d)(2) above in this outline.

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(2) Solvent. On the other hand, if the cash basis debtor were solvent and did not have discharge of the indebtedness so that the debtor remained liable, then the debtor may be treated as having paid interest first, then principal in the event of foreclosure. Thus, the debtor would have an interest deduction and the creditor would have interest income. This result should also apply where a solvent accrual basis debtor of a recourse debt is not discharged.

(3) Cash Basis Nonrecourse Deficiency. If the cash basis debtor owed a nonrecourse liability, the debtor would not be treated as paying interest first and would not obtain a deduction where the principal amount exceeds the value of the property. The creditor would not have interest income. In this situation, solvency or insolvency of the debtor may not be a factor.

(4) Cash Basis Nonrecourse No Deficiency. If the debtor in (3) above suffered a foreclosure where the value of the property exceeded the principal amount of the nonrecourse debt, the payment would be treated as interest first and the debtor would obtain the deduction and the creditor would have income.

(5) Accrual Basis Nonrecourse. If the debtor, whether solvent or insolvent, owing a nonrecourse debt was on the accrual basis and the value was less than the principal, the issue will be whether to apply the tax benefit rule to recapture as interest income the interest deduction taken earlier by the accrual basis debtor.

(a) Amount Realized Theory. Under one theory, that of Allan v. Com’r, 86 TC 655 (1986) aff’d 856 F.2d 1169 (8th Cir. 1988), the deducted interest was “borrowed” and thus is added to principal to become an “amount realized” on the foreclosure (under the principle of Tufts v. Com’r, 461 U.S. 300 (1983)). The result is that there is no ordinary income-tax benefit recapture. There may be capital gain or loss. If the Allan case approach is used, it should not matter whether the value of the property is more or less than the debt, in either event the amount realized would presumably include any accrued interest and have the same result – gain or loss rather than ordinary income consequences.

(b) Other Theory. Under the other theory, the interest is not treated as an amount realized on the foreclosure. The tax benefit would be recaptured only if the value of the proceeds is less than the principal of the obligation; if the value were greater than the principal, the earlier deducted interest would be treated as having been paid and thus no recoverable tax benefit would exist.

The following chart may help summarize the likely results:

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Cash Basis Solvent Accrual Basis Solvent Cash Basis Insolvent Accrual Basis Insolvent Proceeds Principal Recourse

Interest income to creditor Interest deduction to debtor

Interest “borrowed” is paid, and debtor has no tax benefit recapture

Interest income to creditor Interest deduction to debtor

Interest “borrowed” is paid, and debtor has no tax benefit recapture (but deduction may not be allowed at all)

Proceeds Principal Recourse

No interest income to creditor No interest deduction to debtor

Tax benefit recapture to debtor for prior interest deduction

No interest income to creditor No interest deduction to debtor; Newhouse case

Tax benefit recapture to debtor for prior interest deduction (also, deduction may not be allowed at all

Proceeds Principal Nonrecourse

Interest income to creditor Interest deduction to debtor

Interest borrowed is paid and no tax benefit recapture to debtor or possibly amount realized and capital gain/loss not ordinary income

Interest income to creditor Interest deduction to debtor

Interest “borrowed” is paid, and debtor has no tax benefit recapture (but deduction may not be allowed at all) or possibly amount realized and capital gain or loss

Proceeds Principal Nonrecourse

No interest income to creditor No interest deduction to debtor

Tax benefit recapture to debtor for prior interest deduction or amount realized and capital gain/loss not ordinary income; Allan case

No interest income to creditor No interest deduction to debtor

Tax benefit recapture to debtor for prior interest deduction (also, deduction may not be allowed at all) or possibly “borrowed” interest discharged and exception to income may apply or amount realized and capital gain or loss; Allan case.

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d. Information Return. Persons lending money secured by property used

in connection with a trade or business are required under IRC § 6050J to file a Form 1096 when they acquire the security in full or partial satisfaction of the debt or if they have reason to know the debtor abandoned the property. See also 1c(5) above.

e. Foreclosure by Lender. On obtaining the property in a foreclosure by a lender (not a reacquisition of the property itself by a seller discussed in f below), the lender will recognize gain or loss based on the fair market value of the property received over the bid price applied against the debt. For a lender in the loan business, the foreclosure gain (or loss) will be ordinary; for others, it may be capital. However, there is a presumption that the bid price is fair market value, and it takes clear and convincing proof to overcome the presumption. Regs. § 1.166-6(b)(2). The taxable event is when the deficiency is determined and any equity of redemption expires. The bad debt deduction (see discussion in 4a and b below) may also apply where IRC § 1271 (discussed in 4c below) does not–for example, where the debt is grandfathered or is not extinguished under the law or the instrument; such deduction may be for partial worthlessness for a business bad debt or for total worthlessness for a nonbusiness bad debt. Only the deficiency would need to be wholly or partly worthless. It would be measured by the difference between the basis in the uncollectible debt and the bid price. Also, for an accrual basis lender, accrued but unpaid interest earlier taken into income may be deducted as part of the bad debt deduction.

f. Repossession by Seller. Where a seller repossess the property in partial or full satisfaction of the debt arising from the sale of property secured by that property, no gain or loss is recognized to the seller, even where the repossession is from the buyer’s assignee or transferee. IRC § 1038, Regs. § 1.1038-1(a)(4). The seller may assume obligations (e.g., a construction loan) or make a repurchase payment, except where the payment was provided for in the contract or the debtor was not in default or in imminent default. Regs. § 1.1038-1(a)(3). The debt is treated as not being totally or partially worthless (eliminating any bad debt deduction), and any prior bad debt deductions taken must be restored to the basis of the debt and will be taxed under the tax benefit rule. Regs. § 1.1038-1(f)(2)(I); IRC § 111; Regs. § 1.111-1. Other than this, the only gain will be either (i) the amount of payments earlier received over the amount of gain earlier reported, or (ii) the gain on the original sale less payments made by the seller on repossession, whichever is less. IRC § 1038(b)(1) and (2). For a principal residence, the IRC § 121 nonrecognition rule can be salvaged if the home is sold in a year. IRC § 1038(e). However, installment sale gain could become taxable under IRC § 453B on the disposition of the installment obligation.

f. Abandonment of Real Estate. The general rule is that abandonment of property (real estate or otherwise) may give rise to an ordinary loss deduction, rather than a capital loss arising from the sale or exchange of a capital asset. Matz v. Com’r, TC Memo 1998-334. This requires that the loss is incurred in a business or in a transaction for profit, arises from sudden termination of usefulness of the property in the business or transaction, and the property is permanently discarded from use or the business or transaction is discontinued. Regs. § 1.165-2(a). Thus, an intention and an act evidencing the intention is needed. Miners Broadcasting

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Services, Inc. v. Comm’r, TC Memo 1964-266. An abandonment may exist where title or possession is retained, if the conditions are otherwise met. See Helvering v. Gordon, 134 F.2d 685 (4th Cir. 1943). The ordinary loss is taken in the year of abandonment, and no capital loss carryover applies. Bullard v. Com’r, TC Memo 1989-244.

(1) Mortgaged Property. As we have already seen, surrender of mortgaged property by abandonment or conveyance is treated as a foreclosure and as a sale or exchange which may create a capital loss subject to capital loss limitations, possible cancellation of debt income, and so on. Helvering v. Hammel, 311 U.S. 504 (1941). This sale or exchange treatment also applies to nonrecourse debt (Yarbro v. Com’r, 737 F.2d 479 (5th Cir. 1984)), and the value of the property in such a case is not less than the debt (IRC § 7701(g)).

(2) Partnership Interests. The abandonment of a general partnership interest which does not relieve the partner of liabilities, does not create a sale or exchange or a deemed distribution of cash from relief of any liability. Citron v. Com’r, 97 TC 200 (1991). However, where there is a reduction in a partner’s share of liabilities, this is a deemed distribution of cash and a sale or exchange with respect to the partnership interest. See O’Brien v. Com’r, 77 TC 113 (1981); IRC §§ 752(b), 731(a).

g. Home Gain Exclusion. If gain would be recognized to the debtor on the foreclosure, repossession, or other disposition of the debtor’s principal residence, the gain may be partially or completely protected by the exclusion under IRC § 121 even if that provision’s 2-out-of-5-year ownership and use rule is not met, if the sale is made due to a change in employment, health, or “unforeseen circumstances.” Regs. § 1.121-3. IRC § 121 does not apply where the home is held in trust unless the trust is treated as a grantor trust.

h. Bankruptcy Planning. There may be no particular benefit to a taxpayer allowing a foreclosure to proceed and then filing bankruptcy, rather the reverse may be true depending on the level of assets available to the bankruptcy estate. Generally if the foreclosure occurs before bankruptcy, the prepetition debt will fall on the estate which will be liable for any tax (see BC § 507(a)(8)) and to the extent its assets are sufficient the debtor taxpayer will have no further obligation for the tax; if the foreclosure occurred prebankruptcy and the estate’s assets are insufficient to pay the tax, the debtor taxpayer would be liable and the tax would be nondischargeable in the bankruptcy. BC § 523(a). If the foreclosure occurs in the same year as the bankruptcy filing, the liability is not prepetition (to fall on the estate) unless the election is made to terminate the taxable year of the debtor as of the filing, under IRC § 1398(d)(2). There is a split of authority as to the effect of abandonment of property with debt in excess of basis by the bankruptcy trustee to the debtor, and thus to the secured creditor on foreclosure from the debtor; some courts find the tax should fall on the bankruptcy estate (see In re A.J. Lane Co., Inc., 133 Bankr. 264 (Bankr. D. Mass. 1991) (taxable to estate); and see also In re Rubin, 154 Bankr. 897 (Bankr. D. Md. 1992); In re Laymon, 1989 WL 252447 (D. Minn. 1989) (both cases refusing abandonment to prevent tax to debtor), while others find the tax to fall on the debtor rather than the estate (In re Olson, 930 F.2d 6 (8th Cir. 1991), the position favored by the Service (PLR 9611028). Thus if the estate will have no significant assets other than the real estate, the debtor may not want to trigger a prepetition foreclosure, but if there are sufficient other assets,

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perhaps the debtor may want to trigger the foreclosure before filing the petition in bankruptcy. See 7 b. below for other aspects of tax filing in the event of bankruptcy.

4. Bad Debt and Loss Deductions. A creditor may be entitled to take deductions in the event of troubled loans, either as a bad debt, a loss on retirement of the debt instrument, or as a worthless security loss. The worthless security loss may also be available to a stockholder of a failed company, including where the stockholder is also a creditor. Bad debt rules and loss rules are not the same and are generally mutually exclusive of each other. See Spring City Foundry Co. v. Com’r, 292 US 182 (1934); Rev. Rul. 69-458, 1969-2 C.B. 33. Bad debt deductions are under IRC § 166, while losses on corporate or government debt securities are under IRC § 165 and losses on debt instrument retirements are under IRC § 1271(a)(1). Except for an obligation to a bank, or for a receivable of an accrual basis creditor selling goods or services in the ordinary course, no bad debt deduction or worthless security loss deduction is available with respect to the debt of any political party. IRC § 271(a) and (c). The advance of money needs to be actual debt, and if made by an insider to a company in such poor financial condition that no one else will lend to it, the advance may, under the circumstances taking into account a number of factors, be deemed not to constitute debt at all, and thus not be deductible at all as a business or nonbusiness bad debt. Ramig v. Com’r., 2012 WL 5351261, 110 AFTR 2d ¶ 2012-5396 (9th Cir. 2012) unpublished decision aff’g T.C. Memo. 2011-147; A.R. Lantz Co. v. U.S., 424 F.2d 1330, 1333 (9th Cir. 1970).

a. Business Bad Debt Deduction. A bad debt deduction is available for a debt held by a corporation and (unlike nonbusiness debts for noncorporate tax payers) need not be wholly worthless to give rise to the deduction on the portion that is worthless. IRC § 166. Generally, the deduction is taken in the year charged off on the financial books of the corporation. Regs. § 1.166-3(a)(2). The debt need not be discharged or released. O. S. Stapley Co., Inc. v. Com’r., 12 BTA 811 (1928). However, if charged off earlier than the year the deduction is claimed, the deduction may still be proper for that year under certain circumstances where an earlier deduction for partial worthlessness has been disallowed. Regs. § 1.166-3(a)(2)(ii). When the debt becomes wholly worthless, the deduction is proper in that tax year for the entire amount of the debt not allowed as a deduction earlier. Regs. § 1.166-3(b). See discussion at 3e above regarding the possible deduction in foreclosures.

(1) Basis Limit. The bad debt deduction is limited to the holder’s basis in the debt. This is generally the balance of the amount paid for or advanced for the debt, plus amounts taken into income with respect to the debt, such as the account receivable held by an accrual basis creditor or accrued but unpaid interest, or original issue discount taken into income. Basis in the debt may be reduced by S-corporation losses where the loan is by a stockholder to the S-corporation (and thus treated as basis for the use of losses, which basis is reduced for losses after the stock basis has been used up) (IRC § 1367(a)(2) and (b)(2)); also, the write-off could create cancellation of debt income to the corporation affecting the shareholder. Basis may be reduced, as well, by earlier charge-offs of partially-worthless debt, even if there was no tax benefit derived from it (although if later amounts are collected, the IRC § 111 tax benefit recapture will be lessened if no tax benefit was derived). Bank of Newbury v. Com’r, 1 T.C. 374 (1942), acq. 1943 C.B. 2. There are special rules for members of a corporate

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consolidated group. Regs. §§ 1.1502-13(g)(3) and (5) and 1.1502-19(b) and (c)(iii). The taxpayer must prove basis, and there is no deduction otherwise. See Black Gold Energy Corp. v. Com’r, 99 T.C. 482 (1992) (accrual basis), aff’d, 33 F. 3d 62 (Table) (10th Cir. 1994).

(2) Trade or Business. To qualify for a business bad debt deduction, the taxpayer must be in a trade or business, and the acquisition or worthlessness of the debt must be proximately related to its conduct. IRC § 166(d)(2). A debt held by a corporation (not an S-corporation) automatically qualifies because for them, there is no nonbusiness bad debt distinction.

(a) General Factors. The relation between the debt and the business is the critical examination, and where there is a mix of connections, the dominant motive test is used. U.S. v. Generes, 405 U.S. 93 (1972). Whether the activity involved resembles investment rather than trade or business activity has been a relevant factor in some cases. Nicholson v. Com’r, T.C. Memo 1993-183. Also, holding oneself out to others as selling goods or services has been required in some cases, but is now only a factor. Groetzinger v. Com’r, 480 U.S. 23 (1987). A creditor need not be in the business of lending money or deriving receivables from sales of inventory. The shareholder’s business is not necessarily, and usually is not, the business of the corporation. Burnet v. Clark, 287 U.S. 410 (1932).

(b) Partnerships. However, the trade or business of a partnership might be attributable to partners under an aggregate theory. Butler v. Com’r, 36 T.C. 1097 (1961), acq. 1962-1 C.B. 3. However, for years after IRC § 707(a) (concerning third-party treatment of certain guaranteed payments) was adopted under the 1954 Code (with its entity focus), the motives and activities of the lending partner (particularly if a limited or passive partner) will be factors.

(i) Unrecovered Negative Capital Account. Also, partnership losses will be allocable to partners where capital contributions are made, and this may result in negative capital accounts. A nonprecedential statement by the Service, TAM 8006009, allowed a partnership a business bad debt deduction (based on a state law obligation) on the unrepaid negative capital account of a partner once the partnership began winding up its affairs and thereafter paid obligations.

(ii) Unrepaid Partner Loans. Loans on a recourse basis by a partner or member to a defunct partnership or LLC (where the partners or members are not liable except for partnership or company assets) raise interesting unresolved issues under IRC §§ 704(b) and 752. Is this unrepaid amount a contribution to capital to cover a negative capital account from company tax losses allocated to the lending partner or member (economic risk of loss was with the lending member, so the associated tax losses would have been allocated to that member, decreasing its capital account), or is this a cancellation of indebtedness creating partnership income allocable to the member (again increasing its capital account) and the member has a bad debt (which might be treated as a capital loss)? The matter is not clear, although the first view seems preferable.

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(c) Some Specific Areas. A promoter providing management or other services to corporations in which the promoter holds interests or control, is usually not in a trade or business. Whipple v. Com’r, 373 U.S. 193 (1963). However, in some cases of extensive effort, a promoter might be held to be in a trade or business. See Newman v. Com’r, TC Memo 1989-63. Loans to further a trade or business may qualify. See Smith v. Com’r, TC Memo 1994-640 (construction). Loans to obtain new clients may not qualify. Hogue v. Com’r, 459 F.2d 932 (10th Cir. 1972) (accountant). Financing an important customer or supplier may qualify. Mahone v. Spencer, 172 F.2d 638 (9th Cir. 1949); Lundgren v. Com’r, 376 F.2d 623 (9th Cir. 1967). Maintaining trade or business of being an employee, if the dominant motive, may be sufficient (Trent v. Com’r, 291 F.2d 669 (2d Cir. 1961); Litwin v. U.S., 983 F.2d 997 (10th Cir. 1993) aff’g 91-1 USTC ¶ 150,229 (D. Kan. 1991)), but it is not easy to show that the dominant motive is maintaining employment and any significant investment motive may be found to be dominant (see Haury v. Com’r, TC Memo 2012-215). The deduction will be subject to the 2% floor for miscellaneous itemized deductions (IRC § 67(a) and (b)) and to the IRC § 68 limits on overall itemized deductions, and will not be deductible for alternative minimum tax purposes (IRC § 56(b)(1)(A)(1)). The dominant motive is determined at the time of the making of the loan or guaranty for the employer. Harsha v. U.S., 590 F.2d 884 (10th Cir. 1979). A venture capitalist may be in the trade or business of being an employee of the venture capital firm managing the venture fund (which is not merely an investment) and can forgive a debt from a loan made in connection with the business and then claim the business bad debt deduction where the dominant motive in making the loan was to gain access to information from the debtor as part of the venture capital business. Dagres v. Com’r, 136 TC No. 12 (2011).

(3) Guarantor . A guarantor includes a guarantor, indemnitor, endorser, or other person secondarily liable.

(a) Basis. A guarantor has basis only when it pays the guaranteed obligation. Issuing a substitute note by the guarantor to the creditor (whether or not secured) when the original debtor is defunct is not enough; the basis exists only when the new note is paid off. Perry v. Com’r, 49 T.C. 508 (1968), acq. 1968-2 C.B. 2.

(b) Classification. A guarantor is treated as if it had made the loan directly; thus, if the guaranty arises out of the guarantor taxpayers’ trade or business, the bad debt deduction may be for a business bad debt; otherwise, it will be for a nonbusiness bad debt, even where it was part of a transaction for profit. Regs. 1.166-9(a) (the authority for which is legislative history from the Tax Reform Act of 1976 on repeal of former IRC § 166(f)); see also Putnam v. Com’r, 352 U.S. 82 (1956).

(c) Profit Motive. However, where there is no profit motive, there is not even a nonbusiness bad debt deduction. Regs. § 1.166-9(b). To demonstrate profit motive, the guarantor must receive either direct or indirect reasonable consideration for the guaranty; a guaranty of an obligation of a spouse or dependent, however, needs reasonable consideration in cash or property. Reg § 1.166-9(e)(1).

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(d) Subrogation. The lack of subrogation rights does not defeat the deduction (Stratmore v. U.S., 420 F.2d 461 (3d Cir. 1970)), but if there is a right to subrogation, its worthlessness (or partial worthlessness) is needed to trigger the deduction. Regs. § 1.166-9(e)(2).

(e) Trade or Business. Retaining the guarantor’s position in the trade or business of being an employee may be sufficient to make the deduction a business bad debt deduction. Rosenburg v. U.S., 96-2 USTC ¶ 50,583 (N.D. Ill. 1996). But if the guarantor is also a shareholder, the guaranty may be treated as a contribution to capital, and thus eliminate the deduction altogether. The courts look to the dominant motivation for the guaranty. U.S. v. Generes, 405 U.S. 93 (1972); Jerich v. Com’r, T.C. Memo 1992-136. See discussion at 4a(2) above.

(f) Interest. Interest guaranteed is not deductible as interest, but only (if at all) as part of the bad debt deduction, until the guarantor becomes primarily obligated; after becoming primarily obligated, interest is only deductible as interest. Regs. § 1.66-9(a) and (b); Jerich, supra.

b. Nonbusiness Bad Debt Deduction. A nonbusiness bad debt is treated as a short-term capital loss and must be wholly worthless to be deducted. IRC §§ 166(d)(2), 166(d)(1)(B), and 1222(2). Short-term capital losses of individuals are used to offset capital gains and up to $3,000 per year of ordinary income. IRC §§ 1211(b) and 1212(b). The deduction is limited to the basis (if any) in the debt, as described above for business bad debts. The deduction may not be available if IRC § 1271 applies on retirement of an instrument as discussed in 4c below.

c. Loss on Retirement of Instrument. A creditor holding a debt instrument is treated as receiving amounts in exchange for it when the instrument is retired. IRC § 1271(a)(1). This may result in a quicker deduction for a holder of an instrument where worthlessness is not certain, and this may be fine for a creditor whose loss will be of the same ordinary or capital character regardless of whether the bad debt deduction is used or the retirement loss is used. Whether a loss is ordinary or capital depends on the natures of the business, the debt, and the context of the loss; but even a security may in some cases not be a capital asset (e.g., where used as a hedge; see IRC § 1221(b)(2), Arkansas Best v. Com’r, 485 U.S. 212 (1988)). However, the application of IRC § 1271(a)(1) may not be quite so fine where the loss will be capital (the instrument is a capital asset) but the bad debt deduction would be ordinary (e.g., a business bad debt); in such a case, the creditor holding the instrument may want to postpone any retirement until after the deduction has been taken.

(1) Instrument . Subject to some grandfathering exceptions and some annuities, a debt instrument is “any instrument or contractual arrangement that constitutes indebtedness under general principles of Federal income tax law.” IRC § 1275(a)(1)(B). It does not have to be a capital asset and may be any written debt obligation; it might even, under regulations, cover at least some unwritten obligations. See Regs. § 1.1275-1(d).

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(2) Retirement . The key is what constitutes a retirement of an instrument. The term was construed under the 1934 Code by the U. S. Supreme Court, in McClain v. Comm’r, 311 U.S. 527 (1941), as being broader than a redemption. A retirement occurs where in exchange for payment in cash or property, the instrument is “retired” by the underlying obligation being extinguished and includes partial or successive distributions. Campbell v. Sailer, 117 F.2d 641 (5th Cir. 1955); Avery v. Com’r, 13 T.C. 351 (1949), acq. 1950-1 C.B. 1. It includes a significant modification (discussed at 2 above). See Cottage Savings Ass’n’ v. Com’r, 499 U.S. 554 (1991); Regs. § 1.1001-3(e). On a foreclosure where there is no deficiency, the mortgage note is retired, and where there is a deficiency, the note would appear to be retired when the deficiency is determined and any equity of redemption expires. If the note is a capital asset, such as where held by a person other than a bank or someone in the loan business, the loss will be a capital loss. This is true despite Regs. § 1.166-6, which (without mentioning IRC § 1271), says a bad debt deduction would apply to a mortgagee; the regulation simply can’t override IRC § 1271(a)(1). Since the use of capital losses are quite limited, this is bad news for lenders not in the business of lending. The rule is quite different (no gain or loss) if there is no foreclosure sale to a third party but there is instead a repossession of the property itself by a seller which financed the sale. See 3f above.

d. Losses on Worthless Securities. Stock is a security and so are bonds, debentures, and notes of corporations or government agencies with interest coupons or in registered form). A security is generally a capital asset, and a loss may be used in the year it becomes completely worthless. IRC § 165(g). Ordinary promissory notes are not securities under IRC § 165 (but generally are debt instruments subject to IRC § 166 or § 1271 instead). The capital loss from a worthless security which is a capital asset, may be used only against the capital gains of a corporation, or against capital gains and up to $3,000 of ordinary income per year of an individual, but may be carried back by a corporation three, and forward five, years to the extent not fully used and may be carried forward indefinitely by an individual. IRC §§ 1211(a) and (b), 1212(b).

(1) Worthless. No loss is allowed if it is due to market fluctuations however extensive they may be, so long as the stock has some recognizable value. Regs. § 1.165-4. Also, if any potential value remains, for example, in stock where loans are not likely to be enforced or the corporation is being reorganized, then even if the corporation is insolvent, the loss may be denied. See Byrd v. Com’r, 21 BTA 1183 (1931) (corporation’s land under exploration might yield oil); Hanna v. Routzahn, 16 F. Supp. 28 (D.C. OH. 1936) (stockholders continued to invest via loans and stock purchases); but see Universal Consolidated Oil v. Com’r, TC Memo 1961-246 (1961) (no value where is only speculative belief oil would be found sufficient to pay debt), Byrum v. Com’r, 58 TC 731 (1972) (possibility of recovery nil), Miami Beach Bay Shore Co. v. Com’r, 136 F.2d 408 (5th Cir. 1943) (shareholder withdrawal of support and decision to liquidate).

(2) Timing. The loss is deducted as if the stock or security had been sold as of the end of the year and is generally the amount of its adjusted basis at that time. When a security is entirely worthless is notoriously difficult to determine, so a worthless security loss or related carryover may be claimed within seven years from the date of the tax return, rather

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than within the usual three years. IRC § 6511. An identifiable event is generally required to fix the loss on the security under IRC § 165(g). A deemed liquidation by electing partnership tax treatment may be sufficient. AM2011-003 (Treatment of Check-the-Box Election by a Corporation to be Classified as a Partnership) (check-the-box election by insolvent foreign subsidiary to be classified as a partnership under Reg. § 301.7701-3(c)(i), allows a worthless securities deduction under IRC § 165(g) to shareholders; deemed liquidation is an “identifiable event” and IRC § 332 nonrecognition of gain or loss by a parent corporation in a subsidiary liquidation applies only to those cases in which the parent receives at least partial payment).

(3) Special Ordinary Loss Rules. Losses on the stock of certain 80%-owned subsidiaries with 90% active receipts may be treated as ordinary losses but not if the parent acquired the stock to convert capital losses to ordinary ones. IRC § 165(g)(3); Regs. § 1.165-5(d); PLR 201108001. Some small business stock losses are treated as ordinary losses under the special rules of IRC § 1244.

(4) Abandonment. It has not been clear whether or how securities can be abandoned, since legal rights will generally survive. See Bittker & Lokken, Federal Taxation of Income, Estates, and Gifts, § 25.4.4. Even if “abandoned,” the loss may not be an ordinary loss but may well be a capital loss where the security is a capital asset. IRC § 1234A treats losses on “cancellation, lapse, expiration, or other termination” of rights or obligations with respect to property which is a capital asset as gain or loss from the sale of a capital asset. This matter has been clarified by Regs. § 1.165-5(i), which applies for abandonments after March 12, 2008; it treats abandoned securities as wholly worthless upon otherwise meeting the requirements for a deduction under IRC § 165, and if the security is a capital asset, the loss would be a capital loss (unless the exception, discussed above, under IRC § 165(g)(3) applies) as a loss on a sale or exchange as of the last day of the tax year. Abandonment of a security means, under the regulation, the permanent surrender and relinquishment of all rights without the receipt of consideration, but would not necessarily require divestiture of bare legal title.

5. G-Reorganizations. The G-Reorganization provisions were adopted in the Bankruptcy Tax Act of 1980 in order to bring insolvency reorganizations more in line with other reorganization provisions. The “G” reorganization is similar to a “D” reorganization in many ways and is intended to be flexible (see, e.g., Ways & Means Comm. Rep., H. Rep. No. 96-833, 96th Cong., 2d Sess., p. 30).

a. Overlaps. IRC § 368(a)(3)(C) provides that the “G” Reorganization takes precedence over other forms of reorganization under IRC § 368(a)(1) and over IRC § 351 (transfers to controlled corporations - see also § 351(e)(2) making that section not applicable to a transfer by a debtor in an insolvency proceeding to the extent stock or securities received are used to satisfy the debtor’s liabilities) and over IRC § 332 (liquidation of subsidiary into parent). If the transaction does not qualify as a “G” reorganization, there is no necessary preclusion from qualifying as another form of reorganization (e.g., type “B” (acquisition of stock for voting stock) or type “E” (recapitalization)). S. Rep. 96-1035 at p. 36.

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b. Definitions and Basic Requirements. In order to qualify as a “reorganization” IRC § 368(a)(1)(G) requires:

(1) Transfer. A transfer by a corporation of all or part of its assets to another corporation is required. (Note: under IRC § 368(a)(3)(B) the debtor corporation must be under the jurisdiction of the court in an insolvency proceeding (although not necessarily a Title 11 bankruptcy proceeding) and the transfer must be pursuant to a plan of reorganization approved by the court).

(a) This section generally does not require “substantially all” assets (unless and IRC § 354 (acquisitive) transaction is involved).

(b) H. Rep. No. 96-833 at p. 30 does state that intent is for substantially all assets of debtor or assets consisting of active trade or business under IRC § 355 to be transferred to acquiring corporation. But Report says the test is to be applied “flexibly”. See also S. Rep. No. 96-1035 at p. 35-36.

(c) Strip offs for the benefit of creditors are not necessarily fatal (cf. Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4th Cir. 1937)). The debtor could sell one group of assets and then reorganize. It is not clear how far one can go.

(2) Insolvency Proceeding. The transaction must occur in a Title 11 or similar case (i.e. a state or federal court insolvency proceeding, including bankruptcy, receivership, foreclosure, and similar cases, IRC § 368(a)(3)(A)(ii)).

(3) Stock or Securities. In pursuance of the plan, stock or securities of the corporation (note: no requirement of “solely stock”, voting or nonvoting), to which the assets are transferred must be distributed in a transaction which qualifies under IRC §§ 354, 355, or 356.

(a) Acquisitive. IRC § 354 provides for no gain or loss if stock or securities in a corporation a party to a reorganization are exchanged solely (except for § 356) for stock or securities in such corporation or another corporation a party to the reorganization, only if: the transferee (i.e. the acquiring) corporation acquires substantially all of the assets of the transferor (debtor) and the stock, securities, and property received are distributed pursuant to plan of reorganization. The distribution is usually to creditors.

(i) Boot results under IRC § 354(a)(2)(A) if the principal amount of securities received is in excess of the principal amount exchanged (by creditor).

(ii) Boot is taxed under IRC § 356 and includes property received by a creditor transferee (i.e. “solely” does not necessarily really mean solely).

(b) Divisive. IRC § 355 provides for no gain or loss to a shareholder or security holder on distribution by one (distributing) corporation (e.g., debtor) of

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stock or securities of another corporation to shareholders or security holders in exchange for their stock or securities, if immediately before distribution the distributing corporation has 80% control of the distributed corporation, immediately after the distribution both the controlled and distributing corporations are in an active trade or business, which business has been active five years and not acquired within five years, the distributing corporation distributes all its stock or securities in the controlled corporation (or distributes an 80% controlling interest and no tax avoidance purpose exists, and the transaction is not a device to distribute earnings and profits).

(i) Stock of an existing subsidiary may be distributed.

(ii) Boot is taxable under IRC § 356 and if the principal amount of securities received exceeds those surrendered, the excess is treated as boot.

(iii) Transaction may qualify even if distribution is not pro-rata.

(iv) If the distributing corporation first transfers assets to a controlling corporation, it may qualify as a reorganization under IRC § 368(a)(1)(D) with the transferor corporation not recognizing gain or loss (IRC § 361) and with a carryover basis from transferor to transferee (IRC § 362(b)).

(c) Accrued Interest. Any consideration received by a creditor security holder attributable to accrued but unpaid interest on the creditor’s security is excluded from the rules of IRC §§ 354, 355, or 356, (and from § 351 as well). See IRC § 354(a)(2)(B), § 355(a)(3)(C), § 351(d)(3).

(i) If accrued interest has not been reported by the creditor, ordinary income will result; if interest has been previously reported by the creditor, creditor gets a loss for the unpaid portion. Interest includes original issue discount.

(ii) The allocation of consideration between principal and income in the plan or reorganization will generally be controlling for tax purposes as to the creditor and debtor. (E.g., principal first then interest or pro-rata between principal and interest, etc.) However, allocation to principal cannot exceed the face amount of the debt security until after full allocation to accrued interest.

(d) Surviving Shareholders. Under IRC § 357(c), in a G-Reorganization to which §§ 351 or 361 also applies, the survival in the reorganization by any former shareholders will expose the transaction to taxation to the extent liabilities assumed by the transferee exceed the basis of the property transferred. See IRC § 357(c)(2)(B).

c. Triangular Reorganizations. A triangular reorganization generally involves a merger with a subsidiary paid for by the parent. It may be very important to “quarantine” the debtor company in case the business does not work out or in case of an unexpected creditor who did not receive proper notice (see Mullane v. Central Hanover Bank, 339 U.S. 306 (1950)) and is not subject to discharge. (See 5 Collier on Bankruptcy, ¶ 1141.01 at

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pp. 1141-11 to 1141.14.) IRC § 368(b) defines party to a reorganization to include a parent corporation in a “G” reorganization.

(1) Forward Triangular Merger. IRC § 368(a)(2)(D) applies to a “G” Reorganization and allows a controlled subsidiary of a solvent parent to acquire the debtor by merger of the debtor into the subsidiary with stock of the parent given as consideration. Requirements:

(a) “Substantially all” of the properties of the transferor (debtor) must be acquired by the subsidiary;

(b) Transferor (debtor) is “merged” (not “consolidated”) into the subsidiary;

(c) The merger would have qualified under IRC § 368(a)(1)(A) (“A” Reorganization definition: statutory merger) had it been made directly with parent.

(d) No stock of the subsidiary is used in the transaction.

(2) Reverse Triangular Merger. IRC § 368(a)(3)(E) allows (in an insolvency proceeding) a controlled subsidiary to merge into the debtor (surviving) corporation if:

(a) No former shareholder of the surviving (debtor) corporation receives any consideration for his stock (i.e., cannot buy off a dissenting minority in a reverse merger, unlike other G Reorganization techniques);

(b) Former creditors of surviving (debtor) corporation exchange their claims for voting stock with value equal to 80% of value of debtor’s total liabilities (i.e., treat the creditors as if they were shareholders);

(c) After the transaction, the surviving (debtor) corporation holds substantially all of its properties and those of the merged corporation (other than stock of the controlling corporation distributed in the transaction). IRC § 368(a)(2)(E)(i).

(3) Drop Down. IRC § 368(a)(2)(C) allows a parent corporation to acquire part or all the assets or stock of the debtor and then transfer them to a controlled subsidiary, if, in a “G” reorganization, the requirements of IRC § 354(b)(1)(A) and (B) are met as to the acquisition of the assets or stock. See above for requirements of IRC § 354. This requires a nondivisive transaction.

d. Continuity of Interest and Related Requirements. The continuity of interest requirement for tax free reorganizations applies to a “G” reorganization (See H. Rep. No. 96-833 at p. 31 and S. Rep. No. 96-1035 at p. 36-37). This requirement is intended to prevent the qualification both of bankruptcy liquidations and of sales of property to either new or old interests supplying new capital and discharging obligations of the debtor. For a reorganization to

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be real and not just a sale that should be taxable, something of substance from the past must continue. This is usually shareholder’s interests, but bankruptcy generally eliminates or greatly reduces shareholder interests. However, it is also true that creditors become the basic interest holders, thus in a bankruptcy reorganization they should be taken into account in determining continuity of interest.

(1) Intention. Congress expects that the courts and the Treasury Department will apply the “G” reorganization continuity of interest rules to take into account the modification of the “absolute priority” rule under bankruptcy law as a result of which shareholders or junior creditors (who might have previously been excluded) may retain an interest in the reorganized corporation. S. Rep. 96-1035 at p. 36-37.

(a) No Absolute Priority Rule. Under old Chapter X of the former bankruptcy act, each class of creditors had to receive full satisfaction in descending hierarchy to the extent permitted by the value of the property with the result that the most junior creditors and shareholders might well receive no distributions. In practice this often meant a reorganization was not possible and liquidation resulted. (See 6A Collier on Bankruptcy, (14th Ed.) ¶ 11.06 discussing the absolute priority rule under old law. See also Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942) which relied heavily on the old absolute priority rule in allowing creditors to be considered in the application of the continuity of interest requirement). Under the new Bankruptcy Code, this is no longer an absolute requirement, and junior creditors and shareholders may end up receiving a distribution, including stock, securities, or other property, under a plan.

(b) Junior Interests. Thus, junior creditors (and any prior shareholders) who receive stock of the transferee corporation should count for purposes of determining continuity of interest, and this should be true even through such creditors recognize gain or loss.

(c) Possible Sale. If shareholders receive consideration other than stock of an acquiring corporation, the transaction should be examined to see if it is really a purchase rather than reorganization. S. Rep. 96-1035 at 36-3.

(2) Consideration. The consideration received for transferred assets is the key; an all debt acquisition is vulnerable since a substantial proportion of the consideration must consist of equity interests. See Southwest Natural Gas Co. v. Com’r., 189 F.2d 332 (5th Cir. 1951); Helvering v. Minnesota Tea Co., 302 U.S. 609 (1938).

(3) Historic Business. The continuity of historic business or historic business assets rules of Regs. § 1.368-1(d)(2) apply to “G” reorganizations because they apply to all reorganizations. Application of these rules in “G” reorganization context is unclear.

(a) If the debtor sells all of its assets for cash and then is acquired by another corporation in a Chapter 11 proceeding, this will not qualify.

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(b) The debtor needs to keep some “significant portion” of its historic business assets or its historic business. (Note: to keep the historic money losing business may put the acquirer into a Chapter 11 proceeding as well.)

(4) Business Purpose. There must be a business purpose for the transaction (Regs. § 1.368-1(c)), a requirement usually easy to meet in a bankruptcy case unless, perhaps, the transaction is structured the way it is solely for tax purposes.

(5) Avoiding a Reorganization. If an acquiror wants a step up in the basis of the underlying assets to market value (where the basis is less than value in the hands of the target) it may be desirable to avoid reorganization treatment, where the basis will be carried over. This may be done through a taxable sale. See CCA 2003-50-016 (Aug. 28, 2003) (involving what has been called a “Bruno sale” where, in a complex transaction, the assets were treated as sold and the basis of them not only was thus not reduced by the cancellation of indebtedness rules of IRC ' 108, but was stepped up so the acquiror could use future depreciation; the Chapter 11 bankrupt selling debtor had to reduce NOLs and other attributes (to the extent existing) by reason of cancellation of indebtedness, but this was not an adverse result in that situation); Carl N. Pickerill, “Regarding the Advisability of a Prohibition on the Taxable Asset Sale to Creditors in Bankruptcy”, 62 Tax Law. 357 (Winter 2009). See also Ralph’s Grocery Co. v. Com’r, TC Memo 2011-25 (allowing an stock acquisition of a consolidated group member with an election under IRC § 338(h)(10) election to treat the transaction as an asset sale for obtaining a step up in basis of assets, and finding no reorganization because there was no continuity of interest without creditors in “effective command”), but see for transactions after 12/12/2008, Regs. § 1.368-1(e)(6) (creditor claim against target corporation is proprietary interest if the target is bankrupt, or insolvent).

6. The Carryover of Tax Attributes.

a. In General. Tax losses of the debtor (Net Operating Loss “NOL” Carryover) may provide an important incentive to a corporation to acquire the debtor in a Chapter 11 reorganization, but some bankruptcy practitioners believe it is over emphasized by the tax bar as an incentive. There are two general methods to preserve tax losses remaining after adjustment for cancellation of indebtedness, the “G” acquisitive reorganization under IRC § 368(a)(1)(G) and § 354 (discussed above), or a go it alone plan using a recapitalization under IRC § 368(a)(1)(E). The key is to meet the requirements of IRC § 381 and avoid limitations under IRC § 382 and under § 269 on the NOL Carryover allowed under IRC § 172. In order to compare the results under a reorganization allowing for a carry forward of tax attributes, first review the results under taxable transactions (i.e., purchases):

(1) Purchase of Loss Corporation’s Assets. The loss corporation stays alive and retains its tax attributes. If the loss corporation liquidates, its tax benefits are lost. If the loss corporation later purchases the assets of a profitable business, it may be able to use its previous losses against the new profit. Rev. Rul. 63-40, 1963-1 C.B. 46; Rev. Rul. 81-25, I.R.B. 1981-4, 11. The step transaction doctrine may apply, however. If on the other hand, the assets are acquired in a tax free reorganization (other than a G Reorganization) the use of losses against

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built in gains would be limited under IRC § 384 for a five year period, and IRC § 269 and the other limitations applicable to reorganizations would apply.

(2) Stock Purchases by a Profit Corporation. These transactions are subject to the limitations of IRC §§ 382 and 269 and to the consolidated return limitations.

(3) Loss Corporation Purchases Stock of Profitable Corporation. In this transaction the loss corporation may be able to use its losses against the profit corporation’s profits if the two corporations file consolidated returns but the use of any built in gains of the profit corporation will be limited for five years under IRC § 384. If, however, the loss corporation liquidates the profit corporation or merges down into the profit corporation, the limitations of IRC §§ 381, 382, and 269(a)(2) would apply.

b. Section 381. IRC § 381 is the only provision allowing the transfer of carryovers from one entity to another; it provides that in certain transactions in which one corporation (“transferor”) (e.g., a debtor) transfers its assets to another corporation (“acquiring corporation”) the acquiring corporation succeeds to certain of the corporate tax attributes of the transferor. The affected attributes are set forth in IRC § 381(c) and include NOL carryovers (IRC § 381(c)(1)). There are only certain transactions which qualify for this special treatment:

(1) Liquidation of Solvent Subsidiary. The liquidation of a solvent subsidiary into the parent under IRC § 332 may qualify, but an IRC § 338 election to step up the basis of (and recognizing gain on) assets will kill the tax history.

(a) Liquidation of an insolvent subsidiary is not an IRC § 381 transaction (Regs. § 1.332-2(b)) and NOLs are lost. There may be an ordinary loss to the parent under IRC § 165(g)(3) (and Regs. § 1.165-5(d)) on the worthlessness of stock, or a bad debt deduction if the subsidiary was in debt to the parent.

(2) Tax-free Reorganization. A reorganization to which IRC § 361 applies under IRC § 368(a)(1) which may qualify for the special attribute carryover tax treatment under IRC § 381 are the “A”, “C”, “D”, “F”, and “G” types. For a “G” reorganization (or a “D”) to qualify, it must meet the tests of IRC § 354(b)(1)(A) and (B):

(a) Transferor (debtor) must transfer “substantially all” its assets (under a “flexible” standard if a “G” Reorganization is involved) to the acquiring corporation. A divisive “G” won’t qualify.

(b) Transferor (debtor) must distribute the consideration received (generally by liquidation) pursuant to the plan of reorganization.

c. Some Selected Loss Carryover Rules . The following are some important rules for the carryover of tax attributes in tax free reorganizations (but not including “F” reorganization rules).

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(1) One Corporation Acquiring. The acquiring corporation must be one corporation; in a reorganization it is the corporation which acquires directly or indirectly all the transferred assets of the transferor, or if none, the corporation which directly acquired the assets transferred even if it ultimately retains no such assets. Regs. § 1.381(a)-1(b)(2).

(a) E.g., debtor D transfers all assets to S, a wholly owned subsidiary of P, for P stock in a merger pursuant to a Chapter 11 plan of reorganization qualifying as a “G” reorganization. S transfers ½ the assets received from D to S’s wholly owned subsidiary S-1. S is the acquiring corporation.

(2) Close Tax Year. The taxable year of the acquired debtor corporation ends on the close of the date of transfer. IRC § 381(b)(1). A short year can mean that losses expire early. It is possible to avoid this result by having the loss corporation survive (e.g., use a “G” reorganization reverse triangular merger). Transferor must file a return for any short year. See Regs. § 1.381(b)-1(b).

(3) Proration of NOL. The acquiring corporation uses only a pro-rata portion of the NOL during its first taxable year ending after the date of transfer. Regs. § 1.381(c)(1)-1(d). If there are 16 days left in the taxable year of the acquiring corporation, then it would use the NOLs to offset 16/365th of its earnings during that taxable year.

(4) Limitation on Use of Acquiring Corporation’s NOL. An NOL carryback of the acquiring corporation can be carried back to prior taxable years of the acquiring corporation under IRC § 172 (Regs. § 1.381(c)(1)-1(b). But the acquiring corporation cannot carryback the NOL of the acquiring corporation to the premerger profits of the acquired corporation; it is used only against post-merger profits (i.e., no refund). But see Bercy Industries v. Com’r., 640 F.2d 1058 (9th Cir. 1981) rev’g. 70 T.C. 29 (1978)) (in forward triangular merger, postmerger losses of the surviving corporation (former shell) could be carried back and used to offset premerger income of transferor corporation).

(5) Incomplete Acquisition Possible. The carryover of tax attributes to the acquiring corporation is not necessarily prevented by the failure to acquire all the assets of the acquired corporation. For example a controlled corporate subsidiary might not be 100% owned by the acquiring corporation, or the acquired corporation might transfer substantially all (rather than all) of its assets to the acquiring corporation. See Regs. § 1.381(c)(1) - 1(c)(2).

d. Section 382 Limitation. Under IRC § 382 the NOL itself is not cut back, but the income against which it may be used is limited in the case of an ownership change. There is, however, a bankruptcy exception to the rule out of which a debtor may, if it chooses, elect. These rules affect only prechange losses; future losses generally are not affected. Let’s examine the general rule first, then the bankruptcy exception.

(1) Limitation. If the rule applies, the amount of post-ownership-change taxable income against which the prechange NOL (or built in losses) can be used is the value of the corporation’s stock (including preferred stock) immediately before (or after, in the case of a bankruptcy where the bankruptcy exception to the § 382 Limitation does not apply) the

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change (adjusted for redemptions etc. accompanying the change), times the long term tax exempt rate in effect for the month of the change. IRC § 382(b)(1). Thus losses can be deducted as to a limited return on the value of the stock. Losses that cannot be deducted in one year can be carried forward to the extent they have not expired. If the bankruptcy exception does not apply, there is a favorable valuation rule that will nevertheless apply in a bankruptcy situation (see d(6) below) that will tend to increase the usable NOL.

(a) Antistuffing. There is an antistuffing rule to prevent capital contributions being made to increase the limitation. Merely having a purpose of avoiding or increasing the limitation is enough to trigger the rule. Also, any capital contribution within the 2 years prior to the change are deemed to be for the proscribed purpose except to the extent such contributions are allowed by regulation. IRC § 382(l)(1)(B). The regulations should allow initial capital contributions, contributions before losses are incurred, and basic working capital contributions. (Conference Report to Accompany H.R. 3838 (H.R. 99-841 (September 18, 1986) at II-189).

(b) Nonbusiness Assets. The value of the corporation is cut back for nonbusiness assets if at least one-third of the loss corporation’s assets are nonbusiness assets such as cash, stock, or bonds whether or not held for investment, and other assets held for investment. IRC § 382(l)(4)(C). The rule looks through to the assets of controlled subsidiaries. IRC § 382(l)(4)(E).

(c) Built in Losses. If the old loss corporation has a net unrealized built-in loss, the recognized built in loss for any tax year where part of that tax year is in the five-year recognition period beginning on the ownership change date will be a “pre-change loss” subject to the IRC § 382 limitation. IRC § 382(h)(1)(B)(i). Under IRC § 382(h)(4), any part of a recognized built-in loss that exceeds the Code Sec. 382 limitation for a post-change year can be carried forward but may not be carried back. According to the Service, a taxpayer may not include any recognized built in loss in excess of the IRC § 382 limitation in computing its NOL even if the taxpayer has no taxable income for the recognition year before taking into account such loss; rather the loss is “disallowed” under IRC § 382(a) and must be carried forward. PLR 201132022.

(2) Continuity of Business Enterprise. If the corporation fails to continue its business enterprise for two years after the change, the NOL is effectively destroyed retroactively because the limitation will be zero. IRC § 382(c)(1). The continuity test is tied to that for tax free reorganizations. See Regs. § 1.368-1(d).

(3) Ownership Change. The limitation is triggered by 5% stock holders of the loss corporation increasing their stock ownership by more than 50 percentage points (out of the total 100 percentage points of value of the corporation - not the same as a 50% increase in a shareholder’s personal ownership) as of the testing date over a rolling three year testing period, by reason of either an owner shift or an equity structure shift. Note that even if a transaction to restructure a debtor does not itself trigger a sufficient change to cause losses to become unusable, nevertheless, future, unrelated stock transfers could trigger a sufficient change;

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thus, closely avoiding a change in a transaction may create serious restrictions for the next three years. Thus some corporations may want to restrict transfers for 36 months and one day or institute, as has Citigroup, a shareholder rights “poison pill” plan to discourage transfers during such period. There are some rather complex rules associated with the application of every part of the rule, some of which are:

(a) Shorter test period may apply if there has been a previous ownership change; see IRC § 382(i).

(b) Attribution of stock ownership rules apply. IRC § 382 (l)(3).

(c) Less than 5% shareholders are aggregated and treated as one 5% shareholder. IRC § 381(g)(4)(A). This rule is generally applied separately to each group of shareholders a party to the reorganization or other transaction. IRC § 382(g)(4)(B) and (C).

(d) An equity structure shift is a reorganization under IRC § 368 except divisive “G” and “D” reorganizations and “F” reorganizations. Divisive reorganizations are excluded because IRC § 381(a) prevents NOLs from being acquired in these transactions.

(e) Changes in percentage of stock ownership attributable solely to fluctuations in the relative fair market values of different classes of stock are generally not taken into account. IRC § 382(l)(3)(c).

(f) Ownership shifts may occur in any type of corporate transaction such as purchase or disposition of stock by a 5% shareholder, an exchange of property for stock under IRC § 351, a redemption or recapitalization, an issuance of stock, a reorganization that is an equity structure shift. See Regs. § 1.382-2T(e).

(g) The 5% stockholder test is met and a shareholder must be considered, if at any time during the testing period the shareholder had the requisite 5% interest, even if the interest of that shareholder later declines below 5%. IRC § 382(k)(7).

(h) There is a special rule for a 50% shareholder who takes a worthless stock deduction for a given taxable year. If the shareholder continues to hold the stock, it is treated as being newly acquired (and not as continuously owned) as of the next taxable year, thus creating an ownership shift where one would otherwise not exist, and triggering the limit on NOLs. IRC § 382(g)(4)(D).

(i) Options are treated (Regs. § 1.382-4(d)(1) and (2) as not being exercised unless on the option’s issuance or transfer a principal purpose (under all the facts and circumstances but applying a number of factors prescribed by the regulations) is to avoid or ameliorate the impact of an ownership shift under one of three tests: ownership, control, or income tests.

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(i) The ownership test looks at whether the holder of the option is provided with a substantial portion of the attributes of ownership of the underlying stock, and takes into account such matters as the relationship, at time of issuance or transfer, of the option price and the value of the underlying stock, rights to participate in management, the existence of reciprocal options, etc. Regs. § 1.382-4(d)(3) and (6)(ii).

(ii) The control test looks at whether the holder of the option (or related persons) have in the aggregate, a direct or indirect ownership interest in the loss corporation of more than 50%, determined as if the increase in ownership percentage from exercise of the option (and related options) actually occurred on the issuance or transfer of the option, and takes into account the influence of the option holder or related persons over management. Regs. § 1.382-4(d)(4) and (6)(iii).

(iii) The income test looks at whether the option facilitates the creation of income (including accelerating income or deferring deductions) or value (including unrealized built-in gains) prior to the exercise or transfer of the option. Income acceleration transactions to be taken into account include those outside the ordinary course of business of the loss corporation that accelerate income or gain into the period prior to the exercise of the option, or defer deductions until after the exercise. Regs. § 1.382-4(d)(5) and (6)(iv).

(j) There are some exclusions from the deemed exercise rules and some safe harbors provided for options. Regs. § 1.382-4(d)(11) and (d)(7). The exclusions are for transfers where neither transferor or transferee are 5% shareholders after taking the option into account, the transfer is between members of separate public groups, or the transfer occurs in connection with death, gift, divorce, separation, etc. The safe harbors are for such things as:

(i) commercially reasonable stock purchase agreements with reasonable closing conditions that close in one year (not exempt from income test, however);

(ii) escrow, pledge, and security arrangements subject to customary commercial conditions;

(iii) compensatory options with customary terms and conditions for employees, directors, or independent contractors if they are nontransferable and without a readily ascertainable market value;

(iv) options exercisable only on death, disability, mental incompetency, or retirement;

(v) rights of first refusal between stockholders (or the corporation and stockholders) with customary terms;

(vi) options designated by the Internal Revenue Service as exempt from one or more tests.

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(4) Bankruptcy Exception. The bankruptcy exception applies in Title 11 and also in similar cases (IRC § 382(l)(5)(A)(i). If the exception applies the price for it is that although the § 382 limitation will not apply to limit the use of NOLs, the NOLs themselves will be cut back to some extent, by interest charges converted to stocks, unless the debtor elects not to have the exception apply to it.

(a) Creditor and Shareholder Control. In order to qualify for the IRC § 382(l)(5) exception, those who are creditors and shareholders of the debtor (old loss corporation) immediately before the change must own at least 50% of the value and voting power of the new corporation immediately after the change, and must have such ownership as a result of being shareholders or creditors before the change. Thus, the stock to meet the control test must be received in exchange for a qualifying prior interest in the old loss corporation.

(b) Old and Cold. The stock of a creditor used in meeting the 50% test can only consist of stock held by a creditor for at least 18 months, or stock received, on order of the court in the proceeding, in exchange for debt arising in the ordinary course of business of the old loss corporation (typically trade creditors, taxes, employment claims, tort, etc.) where the creditor at all times held the beneficial interest in the debt. Regs. §§ 1.382-9(d). There is a safe harbor for treating debt as continuously owned by the same owner if the owner is not (immediately after the ownership change) either a 5% shareholder, or an entity through which a 5% shareholder owns an indirect interest in the loss corporation, unless the owner’s participation in formulating the reorganization makes it evident that the owner has not held the debt long enough (Regs. § 1.382-9(d)(3)(i)). If the safe harbor does not apply, the debtor loss corporation must inquire about the facts necessary to qualify a creditor, and may rely upon a sworn statement. Regs. § 1.382-9(d)(2)(iii). Special procedures apply to widely held debt. There are eight situations in which the transferees of indebtedness will be able to tack on the time it was held by the transferor (Regs. § 1.382-9(d)(5)).

(c) Restriction Against Special Purpose Creditor. A regulation has been drafted to prevent the creation of special purpose entities to hold the debt and allow ownership to change in an attempt to avoid the old and cold requirements of the bankruptcy exception. Regs. § 1.382-9(d)(4). A debt will not be qualified if the beneficial owner of the debt has an ownership change, determined in a manner similar to a loss corporation (using the principles of IRC § 382), if:

(i) the indebtedness represents more than 25% of the fair market value of the total gross assets of the owner at the date of the change, and

(ii) the owner is a 5% entity immediately after the ownership change of the loss corporation;

(iii) the corporation may rely on a sworn statement. (Regs. § 1.382-9(d)(4)(iv)).

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(5) NOL Cutback. If the bankruptcy exception applies and the debtor does not irrevocably elect out of the exception under IRC § 382(l)(5)(H) and Regs. § 1.382-9(i), then the NOLs of the debtor loss corporation will be reduced as to post-change years.

(a) Interest. The NOL is reduced by redetermining it to take out interest deductions for interest payments or accruals converted into stock in the reorganization if the interest was paid or accrued in the three taxable years preceding the change or during the current year for the period ending with the change.

(b) Transition. Prior to the Revenue Reconciliation Act of 1993, in applying the tax attribute reductions of IRC § 108(b) (the attributes reduced under statutory exceptions to the income from cancellation of indebtedness rule) only half of the normal elimination of cancellation of indebtedness income was allowed (former IRC § 382(l)(5)(C)); this was aimed at reducing the benefit of the former stock for debt exception. Effective for stock transferred after December 31, 1994 (except in a bankruptcy case filed before December 31, 1993) (Act § 13226(a)(3)), this provision has been repealed and a new provision has been substituted in its place that only requires the elimination of the indebtedness for interest converted to stock, as described in the preceding paragraph of this outline, in applying the new stock for debt rule of IRC § 108(e)(8).

(6) Bankruptcy Cases Not Covered By Exception. If a debtor is in a Title 11 or similar case involving the exchange of debt for stock or a G-Reorganization, but the bankruptcy exception does not apply, for example because the debtor elected out of its coverage or failed the 50% continuity of interest requirement, then there is nevertheless a favorable valuation rule which will be of benefit to the debtor loss corporation. IRC § 382(l)(6) provides that the value of the old loss corporation will reflect the increase (if any) in value of the old loss corporation resulting from any surrender or cancellation of creditors’ claims in the transactions. The purpose is to increase the stock value (and thus the § 382 Limitation) by debt canceled for stock, but not increase it for new capital infused into the corporation.

(a) Value. The value (Regs. § 1.382-9(j)) of the loss corporation will be the lesser of:

(i) the value of the stock (including some interests not treated as stock for other purposes, but excluding stock issued to increase the § 382 Limitation without being subject to entrepreneurial risks) immediately after the change (which cannot exceed the amount of cash or other property used to pay for it in order to prevent arguments about the “intrinsic value” of the stock, Regs. § 1.382.9(k)(7)) (See Regs. § 1.382-9(k) for special rules on valuing the post-change stock), or

(ii) the value of assets (determined without regard to liabilities) of the loss corporation immediately before the change (See Regs. § 1.382-9(l) for special rules on valuing the prechange assets).

(b) Post-Change Redemptions. Redemptions or contractions after the change may reduce the value determined. See former Prop. Regs. § 1.382-3(k)(2).

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(7) TARP Exceptions. There are special exceptions to § 382 for acquisitions by the U.S. Treasury, and its successors, under the Troubled Asset Relief Program (TARP) designed to allow the use of losses which otherwise would be reduced. Notice 2009-38, 2009-18 IRB 901. See IRC § 382(n) (providing an exception and an exception to the exception).

e. Evasion of Taxes - § 269 . An acquisition the principal purpose of which is the evasion or avoidance of income tax will trigger the disallowance of deductions, credits, and other allowances under IRC § 269. However, in applying IRC § 269, it is highly relevant that the use of the NOLs (that presumably are the reason for the acquisition) were cut back under § 382 and thus the avoidance of tax may not be a principal purpose of the transaction. Regs. § 1.269-7.

(1) Application. IRC § 269 applies to the acquisition of at least 50% of the voting power or value of stock, the acquisition of carryover basis property from another corporation (i.e., by tax free reorganization), or the purchase and liquidation within two years of a subsidiary without an IRC § 338 liquidation.

(2) Business Continuity. Ownership changes which qualify under the bankruptcy exception of IRC § 382(l)(5) are presumed to be for the proscribed tax avoidance purpose unless the corporation carries on more than an insignificant amount of an active trade or business during and subsequent to the Title 11 or similar case. The presumption is rebutted by strong evidence to the contrary. Regs. § 1.269-3(d). The Regulations also contain a bootstrap provision that the failure of the government to seek a determination under the Bankruptcy Code is not taken into account, and any finding by the Bankruptcy Court that the principal purpose is not tax avoidance is not controlling. Regs. § 1.269-3(e).

f. Built-In Gains Limitation. The ability of loss corporations to acquire corporations with built-in gains in order to use the loss corporation NOLs is limited by IRC § 384 which provides that built in gains recognized in the 5 years after the acquisition cannot be offset by preacquisition losses except those of the acquired corporation itself. However, this provision only applies to an “A”, “C”, or “D” Reorganization (IRC § 368(a)(1)(A), (C), (D)) and not to a “G” Reorganization. IRC § 384(a)(1)(B).

g. Consolidated Return Limitations. The use of carryovers by consolidated groups is limited by the consolidated return rules as well as by the other rules discussed above. The effect of these limiting rules could greatly affect the viability of a reorganization in which the future use of NOLs is important. What follows is a very over simplified summary.

(1) CRCO. The consolidated return change of ownership (“CRCO”) rules, Regs. § 1.1502-21(d), require (in general) that the prior loss of the whole group applies only to the identical group (not to any new subsidiaries). This rule does not terminate or reduce the carryover, just limits its use to old group members. It applies when:

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(a) The parent corporation’s ownership changes 50 percentage points and the change results from a purchase or redemption (except an IRC § 303 redemption to pay estate tax).

(2) SRLY. The separate return limitation year (“SRLY”) rules, Regs. §§ 1.1502-1(f), and 1.1502-21(c) require (in general) that the NOL of a group member arising in a SRLY which is carried over or back to a consolidated return year is limited to the income of such member.

(a) Subsidiary. A subsidiary SRLY exists as to its separate return year if the subsidiary was not a group member each day of the year.

(i) The loss of an acquired insolvent subsidiary would apply to its future income only.

(ii) If the loss corporation is a parent (subject to reverse acquisition rule) it can acquire a new profitable business without subjection to SRLY rules.

(b) Reverse. A reverse acquisition occurs if the loss corporation acquires a profit corporation and the acquired (profit) corporation’s shareholders receive 50% in value of shares of the acquiring corporation. This transaction is treated as if the acquired corporation survived and the SRLY rule applies to the loss corporation.

(3) BID. The built-in deduction (“BID”) rules, Regs. § 1.1502-15, require (in general) that deductions or losses otherwise deductible in a consolidated return year which were economically accrued in a SRLY cannot be used against post-consolidation profits of the group except as to the member that accrued them.

(a) Losses Included. This includes deductions or losses accrued and deducted in a SRLY and carried over as an NOL or a capital loss carryover to a consolidated year; and as to loss assets (i.e., with a value less than basis), the BID rule applies only if the asset was acquired by the member within 10 years before the consolidated return year.

(b) Profitable Subsidiary Acquired. An affiliated group with BIDs may acquire a profitable subsidiary and offset the subsidiary’s income with the BIDs of the group.

(c) Exception. The BID limitation does not apply to a corporation if when it joined the group its aggregate adjusted basis for all assets (except cash, and except securities the fair market value of which is not less than 95% of basis, or which have been held 2 years or which are stock representing 50% of the fair market value of a corporation owned by new member or transferor) did not exceed the aggregate fair market value of all such assets by more than 15%.

h. Miscellaneous Limitations. (See Bitker & Eustice, Federal Income Taxation of Corporation and Shareholders (seventh ed. 2006) ¶ 14.47.)

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(1) Some General Problems. A transaction may fail to qualify as a “reorganization” if it lacks business purpose. In extreme cases, the corporate entity itself may be disregarded if it lacks economic reality. The no assignment of income doctrine may apply. IRC § 482 may be used to reallocate (but not disallow) income, deductions, credits, and other allowances to clearly reflect income. A corporation may become so dormant during the process of liquidation that it may be deemed nonexistent and de facto dissolved so that its tax losses cannot later be revived even if the state law corporate shell continues to exist.

(2) Lisbon Shops. The continuity of business enterprise doctrine of Lisbon Shops v. Koehler, 353 U.S. 382 (1957) may still have some validity despite statutory treatment of the problem. Under this doctrine, which arose under the 1939 Internal Revenue Code, a reorganized corporation would carryover losses only to extent that post-reorganization income is from the same business enterprise; dropping the loss business could be fatal to the entire carryover derived from that business. Strong authority exists against the continued vitality of Lisbon Shops, despite IRS views to the contrary as contained in T.I.R. 773, October 10, 1965. See Bitker & Eustice, ¶ 14.46.

7. Procedural Matters. There are some special procedural rules applicable to debtors in bankruptcy or insolvency proceedings, both under the Internal Revenue Code (“IRC”) and the Bankruptcy Code (“BC”).

a. Filing Obligations of Partnerships and Corporate Debtors. The rules for business organizations are somewhat different from those for individuals.

(1) No Separate Entity. No separate entity is created for corporations or partnerships. IRC §§ 1399, 1398. Subchapter-S status is not terminated. IRC § 1371(f).

(2) Debtor-in-Possession. In a Chapter 11 proceeding with the debtor in possession, the debtor files returns in the normal course. BC §§ 1101, 1107(a), 1106(a)(10), and 704(7). Failure to do so within 90 days of request from a tax authority for a return will result in dismissal or conversion to a Chapter 7. BC § 521.

(3) Trustee Appointed. In a Chapter 11 (or similar) proceeding with a Trustee (or receiver) appointed:

(a) Corporation with Trustee. IRC § 6012(b)(3) requires the trustee (or receiver) of a corporation to file if its “has possession of or holds title to all or substantially all of the property or business of the [debtor] corporation”. See BC §§ 704(2) and 1106(a)(1) which imply title passage to the trustee. Form 1120 is used, and must be filed regardless of whether there was any income.

(b) Partnership with Trustee. No similar express requirement as to partnerships is in the tax code, but see IRC § 6031 for the general requirement of partnership return filing. The Committee reports to the Bankruptcy Reform Act indicate that the trustee is expected to file for the partnership. S. Rep. No. 96-1035 at p. 26.

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(c) Reports of Operations. BC §§ 1106(a)(10), 704(6) and (7) impose a duty on the trustee to report to parties in interest, and a duty (if a business is operated) of filing periodic reports and summaries of operation of the business with tax authorities.

(d) Tax Payments. Under 28 USC § 960 (in the judicial code), any officers or agents (including the trustee) conducting business under authority of a United States court are subject to all federal, state, and local taxes applicable to the business to the same extent as if it were conducted by an individual or corporation. Payment is required on a timely basis unless secured by a lien and abandoned within a reasonable time or otherwise excused under bankruptcy law. Payment may be deferred to final distribution if the Chapter 7 trustee did not incur the tax, or if before the due date for the return the court finds a probable insufficiency of funds to pay administrative expenses with the same priority in a distribution (BC §§ 503(b) and 726 (b)) as the tax liability.

(e) Information on Prior Nonfiled Years. BC § 1106(a)(6) requires the trustee to furnish information, without personal liability, to tax authorities for any year the debtor has not filed a return. But see IRC § 6658(a) which provides relief from payment only and not relief from filing.

(f) Trustee Duty. It is unclear exactly when the duty to file (with personal liability for failure) arises for a trustee.

(i) It appears the trustee must file for the year in which it was appointed, including the portion of the year before appointment. See Rev. Rul. 69-600, 1969-2 C.B. 241.

(ii) However, the statute should be interpreted as imposing personal liability on the trustee only as to taxes arising during the trustee’s administration. (cf. BC § 505(d) (trustee’s right to request determination of unpaid tax liability “during administration” by file tax returns and request), IRC § 6658 (waiving penalties for taxes incurred by debtor before earlier of order for relief or (in involuntary case) appointment of trustee)). Note also: the general rule is that a fiduciary is not liable for acts occurring before it began to serve.

(g) Extension of Time. A five month automatic extension of time to file a return is available for pass through partnership taxed organizations. Reg. § 1.6081-6(a)(2). For corporations the automatic extension is six months. Reg. § 1.6081-3(a). Form 7004 is used to request the automatic extension.

(4) Liquidations. In a liquidation (i.e., Chapter 7 proceeding), the federal return filing is the same as in a reorganization case.

(5) Termination of Trusteeship. If the trusteeship is terminated during the middle of a taxable period (note this could occur by court order or automatically on conversation of a Chapter 11 to a Chapter 7 proceeding (BC § 348(3)), then if the trustee ceased being the trustee after the end of the taxable year, but before the return was due, the trustee

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would continue to have the duty to file the return for taxable years during which it served as trustee. If terminated before the end of the taxable year, the new trustee (or debtor) would have the duty to file for that year. See Rev. Rul. 69-641, 1969-2 C.B. 241.

(6) Determination of Partnership Items. Generally, under Regs. § 301.6231(c)(7), the partnership items of a partner in a bankruptcy or receivership proceeding are treated as nonpartnership items for purposes of the partnership level audit rules of IRC §§ 6221 to 6233. However, as to losses determined at the partnership level, where the bankrupt debtor-partner did not bifurcate the filing year, the Service may be required to determine the allocation of losses by a partnership level proceeding, at least in our federal judicial circuit. See Katz v. Com’r, 335 F.3d 1121 (10th Cir. 2003) (losses not converted to nonpartnership items under Regs. § 301.6231(c)-7(a)).

b. Filing Obligations of Individual Debtor Under Chapter 11 and 7 in Bankruptcy .

(1) Separate Estate Created . For federal taxes, a separate entity is created for the bankruptcy estate of an individual. IRC § 1399.

Note: this rule does not apply in Chapter 12 (farmers and fishermen) to create a separate estate; this can be a determining factor in the dischargeability of some taxes under the Bankruptcy Code. The United States Supreme Court in Hall v. U.S., 132 S.Ct. 1882, (2012) with four justices in dissent, resolved a split among the circuits by affirming the Ninth Circuit decision, U.S. v. Hall, 617 F.3d 1161 (9th Cir. 2010), which found there was no bankruptcy discharge of capital gain taxes arising from the sale of farm assets; because there was no estate, the tax couldn’t be incurred by the estate, and thus the tax could not be discharged under BC §1222(a)(2)(A), leaving the debtor responsible for the tax. For the now overruled opposing view, see Knudsen v. IRS, 581 F.3d 696 (8th Cir. 2009), and IRS v. Ficken (In re Ficken), 105 AFTR 2d 2010-2265 (10th Cir. BAP 2010) (capital gains taxes arising from the post-petition sale of farm assets were dischargeable in bankruptcy under the BC §1222(a)(2)(A) exception to priority taxes under BC §507).

(a) Bifurcation of Initial Year. The taxpayer has an election to irrevocably elect to close his or her taxable year as of the commencement of the proceedings. IRC § 1398(d)(2). The effect of making this election would be to have the tax liability of the first part of the short year payable from the bankruptcy estate. A spouse may join in the election and later in the same proceeding elect another short period. IRC § 1398(d)(2)(B). No election is allowed in a no asset case, or where the estate consists of only exempt property. IRC § 1398(d)(2)(C).

(i) Even if the tax is a claim against the bankruptcy estate, if it is not paid, the liability may later come back against individual. See discharge provisions of BC §§ 727(a) and 1141(d)(1)(A).

(ii) See discussion in 5a(6) above on determination of initial filing year partnership loss allocations.

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(b) Tax Attributes. The trustee succeeds to the individual’s tax attributes. IRC § 1398(g). On termination of the case, the debtor gets any unused attributes back. IRC § 1398(i) and (g).

(i) Attributes to Carryover. The attributes to which the bankruptcy estate succeeds are determined as of the first day of the debtor’s taxable year in which the case commences, and includes net operating loss carryovers, charitable contribution carryovers, recovery of tax benefit items, credit carryovers, capital loss carryovers, basis, holding period and character of assets, and method of accounting. The attributes carried over to the estate also includes other attributes as determined by regulations. The only regulations that have been adopted relate to the carryover of unused passive activity losses and credits and unused at-risk losses. All else remains in limbo, and the IRS has asserted that no other attributes carryover, a position that will lead to some interesting inconsistencies because under BC § 346 all state attributes do carry over. It may also be that some tax attributes will be treated as property of the debtor and thus pass to the estate under BC § 541 notwithstanding the position of the IRS. (See: Segal v. Rochell, 382 A.S. 375 (1966) (under prior Bankruptcy Act); In re Prudential Lines, 92-2 USTC ¶50,491 (2d Cir. 1991); In re Russell, 927 F.2d 413 (8th Cir. 1991). The IRS believes that IRC § 1398(g)(8) is the exclusive mechanism for inheriting tax attributes (see In re Reuter, 93-2 USTC ¶50, 642 (N.D. Calif. 1993); In re Mehr, 93-1 USTC ¶50,091 (B. Ct. D. N.J. 1993); In re Antonelli, 92-2 USTC ¶50,619 (B.Ct. D. Md., 1992); DiStasio v. U.S., 90-2 USTC ¶50, 577 (Clms. Ct. 1990)). At issue are such “tax attributes” (a term not defined in IRC § 1398(g)(8)) as debtor’s suspended investment interest deductions, debtor’s share of partnership or S-corporation losses that were suspended where debtor has insufficient basis (these probably should pass), debtor’s right to rollover gain on sale of personal residence under IRC § 1034 so as to protect the bankruptcy trustee from tax if debtor buys a new residence (probably should not pass), or the gain exclusion of IRC § 121 (In re Barden,79 AFTR 2d 97-1057, 97-1 USTC ¶ 50243 (DC NY 1996) aff’d 79 AFTR 2d 97-1064, 97-1 USTC ¶ 50244 (2d Cir. 1997) and In re Mehr, 93-1 USTC ¶50,091 (B.Ct. D. N.J. 1993) hold the prior over age 55 exclusion did not pass; In re Popa, 81 AFTR 2d 98-567 (Bankr. Ct. N.D. Ill. 1998) held the new IRC § 121 exclusion passes to the trustee).

(ii) Property of Estate. If BC § 541 “property of the estate” argument is used, presumably the property right will be determined “as of the commencement of the estate”, (generally the filing of the petition). However, tax attributes generally are “determined as of the first day of the debtors taxable year in which the case commences” (IRC § 1398(g)). These dates will be the same if the debtor makes the IRC § 1398(d)(2) short year election to terminate debtor’s taxable year as of the day before the petition is filed; but without this election, the dates will be different, and so will be the attributes inherited. For example, will the NOL under IRC § 172 arising from operations from the beginning of the year to the date of filing stay with the debtor or pass to the estate without the short year election?

(iii) Use of Losses. Estate losses may be credited back to prebankruptcy years of individual. IRC § 1398(j)(2)(A).

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(iv) Restriction on Losses. Debtor may not carry back post-bankruptcy losses to prebankruptcy periods. IRC § 1398(j)(2)(B).

(c) Tax-free Transfer. Other than for sales or exchanges, no gain or loss is recognized on the transfer of assets to the trustee or on the transfer back to the debtor at the end of the case. IRC § 1398(f)(1) and (2). This provision is intended to prevent recapture and acceleration of installment obligations. See S. Rep. No 1035 at 31.

(i) Liabilities Exceeding Basis. It is not clear whether under IRC § 1398(f)(1) and (2) a transfer involving liabilities in excess of basis will, as in the general nonbankruptcy case (see, e.g., Yarbro v. Com’r., 737 F.2d 479 (5th Cir. 1984)), be treated as a sale or exchange and thus cause gain to be recognized to the debtor; such a result would be a tax disaster to the debtor who will no longer have tax attributes to offset the gain. Whether or not an IRC § 1398(d) short year election is made, the estate will not be liable for the tax either because it will remain the debtors if no election was made, or because it will not have arisen prepetition if the election is made. See also discussion in (d) below on abandonments.

(ii) Partnership Interests. The transfer of an interest in a partnership to the trustee thus will not trigger the usual possible tax consequences of a transfer of a partnership interest, including such possible consequences as credit recapture (Regs. § 1.47-6(a)(2)(i) and (ii)), deemed cash distribution from shift of liabilities (IRC §§ 752(b) and 731(a)), ordinary income on unrealized receivables (IRC § 751(a)), partnership termination on 50% interest change in 12 months (IRC § 708(b)(1)(B)), closing of partnership tax year for transferring partner (IRC § 706(c)(2)(A)). For cases dealing with IRC § 708 on transfers to a bankruptcy estate, see Katz v. Com’r, 116 TC 5 (2001), rev'd on other issue, 335 F3d 1211 (10th Cir. 2003); Gulley v. Com’r, 79 TCM 2171 (2000); Smith v. Com’r, 70 TCM 483 (1995).

(d) Abandonments. Abandonments (under BC § 554) by the trustee during the case also appear to be nontaxable to the extent they do not involve a sale or exchange, but taxable to the extent of any sale or exchange. Without a sale or exchange the transaction should not be taxable either under or outside IRC § 1398(f)(1) and (2); see also BC § 356(g)(1)(B) which for state tax purposes does not limit tax free transfers to terminations of the estate. Transfers of property subject to debt in excess of basis are generally treated as taxable sales outside of bankruptcy. If this is the case with abandonments, the debtor may be able to avoid personal liability for gain from the subsequent foreclosure of the abandoned property by the creditor because the estate will pay the tax, and the debtor will obtain a new cost basis in the property. See In re McGowan, 95 Bankr. 104 (Bankr. D. Iowa 1988) and In re Olson, 930 F.2d 6 (8th Cir. 1991) (abandonments held not to be taxable) and compare with In re A. J. Lane & Co., 133 Bankr. 264 (Bankr. D. Mass. 1991) (abandonment held to create taxable gain to the estate; decided before regulations under IRC § 1398(f)(1) and (2)). The Service has followed the Olsen line of authority (PLR 9611028).

(i) Nonrecourse Debt. If, however, the property abandoned to the debtor is subject to nonrecourse debt, the usual rule on gain realization (excess of debt over basis is realized gain without regard to the value of the property where nonrecourse

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debt is involved; see Com’r v. Tufts, 461 U.S. 300 (1983); Regs. § 1.1001-2(a)(1)) is modified by the effect of BC § 506(a) (which provides that an undersecured creditor is treated as secured up to the value of the property, and as unsecured as to the amount of the obligation in excess of such value) and the gain to the estate should be limited to the excess of fair market value over the basis in the property. See PLR 8918016.

(ii) Prior Losses. It is not clear that prior losses from the property revert to the debtor on an abandonment to the debtor, thus putting the debtor in a rather poor tax situation; but see Regs. § 1.1398-1(d)(2) on allocation to debtor of passive loss and credit and § 1.1398-2(d)(2) on IRC §465 (at risk) losses.

(2) Debtor Failure to File . A debtor in a proceeding under Chapters 7, 11, 12, and 13 must file postpetition tax returns and if it does not do so within 90 days after a tax authority files a request for the return, the case will be converted or dismissed. BC § 521.

(3) Trustee Duty. The trustee files the federal return for the bankruptcy estate for any year in which the estate’s gross income is equal to or greater than the exemption amount plus basic standard deduction for married persons filing separately. IRC § 6012(a)(9). For 2009 the filing threshold is $9,350 of gross income ($3,650 + $5,700).

(a) Income is computed in the same manner as for individuals.

(b) The trustee files form 1041. Regs. § 1.6012-3(a)(1).

(c) The estate may change its annual accounting period one time without IRS consent. The trustee may want to close the estate’s tax year before closing a Chapter 11 case and submit a short year return for prompt audit under BC § 505.

(d) The duty of a trustee to file returns and pay taxes includes trustees of liquidating trusts holding assets of bankrupt debtors. Holywell Corp. v. Smith, 503 US 47 (1992) (applying IRC §§ 6012(b)(4) on filing and 6151(a) on payment). A liquidating trust may be a grantor trust with the creditors treated as the grantors owning the trust assets and taxable on the trust income in appropriate cases. IRC § 671 et seq. Rev. Rul. 63-228, 1963-2 CB 229.

(e) An automatic six month extension of time to file a return is available for bankruptcy estates of individuals in Chapter 7 or 11 cases. Form 7004 is used to apply for the extension. Reg. § 1.6081-6(a)(2). Such an extension, however, also changes the date on which a return is “last due, including extensions” for purposes of priority and nondischargeability in bankruptcy under BC �� 507(a)(8)(A)(i) and 523(a)(1)(A), with the result that a discharge of taxes could be disallowed. Notice 2007-74, 2007-37 IRB 585, amplifying Rev. Rul. 2007-59, 2007-37 IRB 582; In re Bisch, 106 AFTR 2d 2010-6470, 437 BR 355, 2010-2 USTC ¶50644 (2010, Bktcy Ct MO).

c. Filing Obligation of Chapter 13 and 12 Debtor . In a Chapter 13 case, the debtor must file all federal, state, and local returns by any extended due date, or if delinquent,

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prior to the BC § 341 meeting of creditors (or not more than 120 days later, if the trustee extends the meeting) with respect to all tax periods ending during the four-year period prior to filing the petition; otherwise, the case may be dismissed or converted to a Chapter 7 case, and no plan can be confirmed. The bankruptcy court can grant a 30-day extension to the date set by the trustee, but not beyond an extended due date for the return. Also, current returns need to be filed in order to confirm a plan and avoid dismissal or conversion. BC §§ 1308, 1325(a), 521.

Similarly, under Chapter 12 (family farmer or fisherman proceedings which may cover individuals and corporations or partnerships engaged in such businesses; see BC '' 101(18), (19), and (19A)) the debtor files returns both before and after the petition because no separate estate is created for tax purposes.

d. State and Local Taxes. The provisions applicable to state and local income taxes are closely aligned to federal tax treatment under IRC §§ 1398 and 1399. BC § 346. This includes:

(1) Separate Estate. Separate estate treatment is required for individuals in Chapter 7 or 11 proceedings, with the trustee responsible for tax filing obligations for the estate.

(2) No Separate Estate. No separate estate will exist for corporations or partnerships where there is none for federal tax purposes.

(3) Short-period Election. The debtor’s tax period terminates prior to filing petition only where it terminates for federal purposes (i.e., through the IRC § 1398 election by the debtor). This bifurcation of the tax year would place the burden of taxes for the prepetition period on the estate.

(4) Transfer. Transfer from the debtor to the estate of property is not a sale, nor is transfer back from the estate to the debtor (e.g., on abandonment), unless it would be a sale for federal purposes.

(5) Attributes. Any new estate succeeds to the tax attributes of the debtor for carryovers to later years. The attributes revert to the debtor on the closing of the estate. The estate may use any state or local carrybacks to prepetition periods where the carrybacks are similar to federal carrybacks.

(6) Filing with No Income. The trustee must file state and local returns for a corporation during Chapter 7 proceedings, even if there is no net taxable income over the period of administration, including for any minimum franchise or income taxes imposed without income.

(7) Withholding. The trustee must withhold and pay state and local taxes on the payment of claims for wages, dividends, interest, or other payments.

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(8) Partnerships . Partnership income, gain, loss, deduction, or credit passes through to the partners or members where the gain or loss results from a distribution of property or from a distributive share distributed or considered distributed from the partnership postpetition. Partnership returns are required only where federal law requires them. The estate is not liable for taxes imposed on partners or members.

e. Other Miscellaneous Tax-related Matters.

(1) Notice of Fiduciary Status. The trustee should give the IRS notice of its fiduciary position on Form 56. IRC § 6036; Regs. § 301.6036-1.

(2) Court Notifies Service. Bankruptcy Rule 203 provides for the clerk of the bankruptcy court to notify the District Director of the IRS on the filing of a petition. The court clerk maintains a list of addresses of various tax agencies to receive notices and requests for tax determinations. BC § 505(b). See Rev. Proc. 2006-24.

(3) Deductible Administrative Expenses. During the administration of a Chapter 11 case involving an individual, the Trustee’s fees and administration expenses under BC § 503 and court costs and fees under 28 U.S.C. Chapter 123, § 1191 et seq. are deductible. No deduction is taken if it is otherwise not allowable, e.g., capital expenditures (IRC § 263), expenses for tax exempt interest (IRC § 265), or certain taxes (IRC § 275). The trustee may carry back unused expenses 3 years and forward 7 years, but only the estate may benefit. IRC § 1398(h)(2).

(4) Disclosure by and to Debtor. The estate’s return is disclosed to the debtor and vice versa under IRC § 6103(e). In an involuntary case, the debtor’s return is not disclosed until an order for relief is granted unless the court finds disclosure necessary in order to determine whether an order for relief should be granted.

(5) Stay of Tax Court. To resolve the issue raised by Halpren v. Com’r, 96 T.C. 895 (1991), BC § 363(a)(8) now provides that the automatic stay on Tax Court proceedings only applies to an individual’s taxes for periods ending prior to the bankruptcy petition (i.e., the entry of an order for relief), and not to postpetition taxes. For corporations, the bankruptcy court determines the tax periods which may be determined by the Tax Court.

(6) Chapter 11 Disclosure Statement. A Chapter 11 reorganization plan disclosure statement needs to discuss the federal tax consequences of the plan to the debtor, any successor to the debtor, and to a hypothetical investor. However, the bankruptcy court may do a cost-benefit analysis on the adequacy of disclosure, for example, with respect to smaller cases. BC § 1125(a)(1).

(7) Chapter 11 Plan Payment of Tax . Under a plan of reorganization, taxes with interest where required (e.g., for administrative claims, or to determine present value of a claim) at tax law rates (often punitive) as of the month of confirmation must be paid in regular installments within five years of the order for relief or, under a “most-favored nations” provision, in a manner not less favorable than the most-favored nonpriority unsecured claim. BC

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§§ 511, 1129(a)(9). This applies not just to unsecured claims but also to secured tax claims. BC § 1129(a)(9)(C)(iii) and (D). Thus, secured tax claims otherwise subject to the same cram down as other secured claims under BC § 1129(b)(2), must nevertheless receive these payment terms.

(8) Tax Matters Partner in Bankruptcy . The bankruptcy of the person designated as the tax matters partner terminates that designation. Regs. § 301.6231(a)(7)-1(1)(1)(iv). This may void action taken by a bankrupt tax matters partner, the effect of which is a two-edged sword. See Barbado #7 Ltd. v. Com’r, 92 TC 804 (1989) (voided extension of limitations period; adverse to government) and Computer Programs Lambda, Ltd. v. Com’r, 89 TC 198 (1987) (tax court petition ineffective to commence partnership action; adverse to taxpayers).

(9) General Tax Priority. Taxes incurred prepetition and which are unsecured generally have eighth priority in bankruptcy cases. BC § 507(a)(8). This eighth priority applies to, among others, income taxes for which a return was due within three years prior to filing, assessed within 240 days of filing, or which remain assessable after filing; withholding taxes in any capacity for any period; and assessed property taxes payable without penalty within one year of filing. Postpetition taxes are entitled to administrative second priority. BC § 507(a)(2). Gap period (before an order for relief) taxes in an involuntary case receive third priority. BC § 507(a)(3). Certain employment taxes incurred prepetition but paid postpetition receive fourth priority to the extent the wages to which they apply receive that priority (i.e., earned within 180 days of the date of filing or of the date the debtor stops business, whichever is first). BC § 507(a)(4). Unsecured tax claims not entitled to eighth priority (or some other specified priority) are treated as general unsecured claims.

(10) General Tax Lien Treatment. A general federal tax lien arises automatically on assessment. IRC § 6321. (Other special liens (e.g., estate taxes) can arise automatically even without assessment or filing and can shift to the assets of transferees in some circumstances. See, e.g., IRC § 6324). However, until filed pursuant to IRC § 6323(f), the general tax lien is treated as unperfected in bankruptcy and may be set aside. BC § 545(2). Also, for purposes of determining what claims are secured claims, claims are treated as secured only to the extent of the value of the collateral. BC § 506(a)(1). Thus, valuation fights are common.

(a) Superpriority. Some claims have superpriority status over the federal tax lien pursuant to tax lien law. IRC § 6323. The term “purchaser” as used in the Bankruptcy Code for purposes of BC § 545(2) is not necessarily the same as a “purchaser” as used in IRC § 6323(b) for determining superpriority status; rather, IRC § 6323 has a higher standard for purposes of the superpriority determination. See In re Walter, 45 F.3d 1023 (6th Cir. 1995); In re Berg, 95-2 USTC ¶ 50,634 (Bankr. 9th Cir. 1995). This prevents the use of IRC § 6323(b) superpriority in conjunction with BC § 545(2) as a means to avoid the tax lien, in the jurisdictions following this distinction, unless the higher standard is met. If whatever applicable standard is met for superpriority, the tax liens against superpriority items can be set aside, whether in a Chapter 7 or a Chapter 11 proceeding.

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(b) Secured Tax – Chapter 7. If a filed lien is not otherwise set aside in a Chapter 7 bankruptcy case, the lien may nevertheless be set aside to the extent of prepetition fines, penalties, and forfeitures which are not compensation for actual pecuniary loss. BC § 724(a). The tax and penalty may still be nondischargeable even if the lien is lifted. These liens for penalties, etc., are not avoidable in a Chapter 11 bankruptcy proceeding. To the extent the tax lien is not set aside, the property subject to the lien is used to pay any senior liens, then unsecured priority claims (administrative, wage, etc., claims under BC § 507(a)(11)-(7)), then the secured tax claim. See BC § 724(b)(6). Even after a bankruptcy discharge of taxes (to the extent available), a preexisting tax lien can be enforced in rem against the liened assets, including liened IRAs. Miles v. Com’r, 399 Fed. Appx. 231, 106 AFTR 2d 2010-6563, (9th Cir. 2010), cert denied (2011), aff’g T.C. Memo. 2007-208, 2007 WL 2187596.

(c) Secured Tax – Chapter 11. The Chapter 11 plan confirmation rules are described at 7.e.(7) above, and require certain payments for secured taxes over five years. Secured tax claims also receive the protections against impairment of other secured claims. BC §§ 1126(c) and (f), 1129(a) and (b). As previously noted, penalty liens are not subject to set aside if otherwise perfected.

(11) Joint Return Refund. Although where only the debtor has income or credits, withheld taxes will be refunded to the debtor’s bankruptcy estate (In re Kleinfeldt, 91 AFTR 2d 2003-364, 287 B.R. 291 (10th Cir. BAP 2002), where there is any other refundable credit relating in part to the nondebtor spouse filing a joint return with the debtor, the refund from the withheld taxes on the debtor spouse’s income does not automatically belong to the debtor’s estate but must be allocated according to the allocation methods generally used for tax matters. Crowson v. Zubrod (In re Crowson), 105 AFTR 2d ¶ 2010-904, 2010 WL 2093334 (10th Cir BAP 2010). See Rev. Rul. 74-611, 1974-2 CB 399, Rev. Rul. 80-7, 1980-1 CB 296.

(12) Restriction on Levy. In a bankruptcy or receivership case, the Service is restricted from levying on assets in the custody of the court until a levy would not interfere with the work of the court or the court consents. Regs. ' 301.6331-1(a)(3). However if the notice of levy is filed before the bankruptcy petition, it is the equivalent of seizure and the court may not be able to prevent sale of the property. See In re Pittsburgh Penguin Partners, 598 F2d 1299 (3d Cir. 1979) (served one day before petition); but see In re A & J Auto Sales Inc. (d/b/a Wise Auto Sales), 223 BR 839 (DC NH1998) (levy served moments before petition, but cars seized few hours after the petition violated the “exercise control” language of 11 USC 362(a)(3) automatic stay provision where taxpayer had actual possession although IRS had constructive possession at the time of the petition).

f. Bankruptcy Court Jurisdiction Over Tax Matters .

(1) Jurisdiction . Bankruptcy Courts are not Article III Courts under the United States Constitution and the entire bankruptcy jurisdiction of the District Court cannot be referred to the Bankruptcy Court. Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50 (1982). The District Courts may refer part of their jurisdiction to the Bankruptcy Courts.

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(a) Core. Under BC § 157(b)(1) bankruptcy judges may hear and determine all cases under Title 11 and all core proceedings under Title 11 and may enter appropriate orders and judgments.

(b) Noncore. A bankruptcy judge also may hear a proceeding that is not a core proceeding but is otherwise related to a case under Title 11, but unless, the parties consent otherwise, the bankruptcy judge only proposes findings and conclusions subject to de-novo review by the District Court. BC § 157(b)(1).

(2) IRS Claim Filed by Others. BC § 501(b) and (c) provide that the Trustee or the debtor or any person liable with the debtor may file an IRS claim on behalf of the IRS. However BC § 106 provides that sovereign immunity is waived only if the government files its own claim (i.e. immunity is then waived as to any compulsory counterclaim); thus no refund claim is available from filing a claim for the IRS, rather the IRS is drawn in only as to a deficiency and the possible discharge of the deficiency.

(a) The Debtor is more likely than the trustee to use this procedure. The debtor does not care about a refund which would pass to the estate, but does care about the discharge of tax claims.

(3) Refund Claim. If there is a refund claim and the government has not filed a claim in the bankruptcy proceeding, under BC § 505(a)(2)(B) a procedure is available to have the bankruptcy court determine the claim:

(a) The trustee makes an administrative request for refund.

(b) The Bankruptcy Court may then determine the matter (under BC § 505(a)(1)) at the earlier of 120 days after such request or a determination by the tax authority. Note: this shortens the otherwise applicable period of 6 months for the IRS to respond under IRC § 6532(a)(1). See also IRC § 6532(a)(5). The procedures for the trustee of a debtor or for the debtor in possession to claim refunds are set forth in Rev. Proc. 2010-27, 2010-31 IRB.

(4) Determination of Unpaid Tax. The Trustee may, under BC § 505(b), request an immediate determination of any unpaid tax liability incurred during administration of the case. See Rev. Proc. 81-17, IRB 1981-20, 9.

(a) The Trustee files tax return and determination request.

(b) The Trustee, debtor, and successor to debtor are discharged from liability for such tax (except for a false or fraudulent return) upon payment of the tax shown on the return if the government does not notify the trustee within 60 days that the return has been selected for examination or if the examination is not completed and the trustee notified of any tax due within 180 days. The court for cause may extend the 180 days.

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(c) After the IRS examination, the court may determine the tax due, and payment of this amount discharges the trustee, debtor, and debtor’s successor.

(5) Release of Stay. A court determination of the tax releases the automatic stay as to the tax so that tax authority may assess the tax against the estate, debtor, or successor to debtor as the case may be. BC § 505(c).

(6) Determination of Tax Aspects of a Plan of Reorganization. Bankruptcy plans of reorganization sometimes turn on their tax consequences, and the Bankruptcy Court is required to determine if the plan is feasible before approving it. See BC § 1129(a)(11).

(a) Property. Tax attributes may constitute property under BC § 541 to be protected where they affect plan feasibility. See In re Prudential Lines, 928 F.2d 565, 569-70 (2d Cir. 1991), cert. denied, 112 S. Ct. 82 (1991), and compare with In re Coral Petroleum, Inc., 60 B.R. 377, 389 (Bankr. S.D. Tex. 1986); In re Russell, 927 F.2d 413, 417 (8th Cir. 1991).

(b) Future Tax Determinations. Bankruptcy Courts may be able to exercise jurisdiction to make tax determinations under BC §§ 505(a) (tax matters generally) or 1146 (state and local taxes) as to the future tax consequences of a reorganization. The Service strongly opposes this.

(i) Declaratory Judgment Act. Under 28 U.S.C. § 2201 declaratory relief is available, but generally not as to Federal taxes; however, since 1978 that section has expressly excepted proceedings under BC §§ 505 or 1146 from the prohibition. See In re Goldblatt Bros., Inc., 106 B.R. 522 (Bankr. N.D. Ill. 1989); A.J. Lane & Co., 133 B.R. 264 (Bankr. D. Mass. 1991). A case or controversy is required. See Aetna Life Ins. Co. v. Haworth, 300 U.S. 227, 240-41 (1937); Maryland Casualty Co. v. Pacific Coal & Oil Co., 312 U.S. 270, 273 (1941). The issue may be ripe even though the Service has not threatened an assessment. See In re Kilen, 129 B.R. 538 (Bankr. N.D. Ill. 1991).

(ii) Anti-Injunction Act. Under IRC § 7421(a) no suit to restrain the assessment or collection of any tax may generally be maintained. However, the policies of the Bankruptcy Code may override this. See Bostwick v. United States, 521 F.2d 741 (8th Cir. 1975) (decided under prior Bankruptcy Act). This is likely to be a hard fought issue in coming years.

(7) Determination of Attorney’s Fees in Tax Matters. Where a debtor successfully litigates a tax issue in bankruptcy court against the Service, attorney’s fees may be available. The court may rely on IRC § 7430 rather than BC § 523(d) regarding such attorney’s fees. See In re Hudson, 345 B.R. 477 (Bankr. N.D.N.Y. 2006). Although not directly discussed in the Hudson case, courts have found the Bankruptcy Court, although not an Article III court under the U. S. Constitution (see Northern Pipeline Const. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982)), to be a court of the United States for purposes of jurisdiction to award fees against the Service under IRC § 7430(c)(6), but the authorities are split. Compare In re Brickell,

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899 F.2d 1136 (11th Cir. 1990) (no such jurisdiction based on analogy to § 2412 of the Equal Access to Justice Act) with In re Germaine, 152 B.R. 619 (B.A.P., 9th Cir. 1993) (jurisdiction not limited to Article III courts) and In re Grewe, 4 F.3d 299 (4th Cir. 1993) (bankruptcy courts derive jurisdiction through the district courts under 28 USC § 157, and thus have jurisdiction).

(8) Tax or Bankruptcy Policies. There can be a difference between tax and bankruptcy policies, and in such cases, a bankruptcy court may need to reconcile the policies, choose between them, or abstain from deciding. See Central Valley AG Enterprises v. U. S., 531 F.3d 750 (9th Cir. 2008), rev’g 326 B.R. 807 (E.D. Cal. 2005) (policy of BC § 505(a) to protect creditor body from dissipation where debtor failed to contest tax, trumped tax policy of finality in partnership level audits where partner failed to timely file petition; the res judicata exception of BC § 505(a)(2)(A) to bankruptcy court jurisdiction under BC § 505(a) to determine the amount or legality of any tax did not apply because the tax was not “contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case” on a mere failure to file a challenge). See also cases in which bankruptcy courts have abstained from deciding tax matters under BC § 505(a) (which is not mandatory), such as In re New Haven Projects LLC, 225 F.3d 283, 288 (2d Cir. 2000); see also 28 U.S.C. § 1334(c)(1) (abstention), and In re Cody, Inc., 338 F.3d 89 (2d Cir. 2003) (such abstention may not be subject to appeal).

g. Deficiency Procedures .

(1) Automatic Stay. The Automatic stay under BC § 362 stays any Tax Court case, assessment, or collection of a prepetition tax claim, but the IRS may send a 90 day letter. See BC § 362(b)(9). When the stay is lifted the debtor has an additional 60 days to file a tax court petition (assuming the 90 day limit has not previously run). IRC § 6213(f)(1). The stay may be lifted in the middle of a bankruptcy case. The Bankruptcy Court thus has discretion to decide whether to determine a matter itself (under BC § 505) or to lift the stay (under BC § 362(e)) and allow the matter to proceed before the Tax Court. See S. Rep. No. 96-1035, p. 48-50. Violation of automatic stay by the IRS may now cause the IRS to be subject to monetary damages, because sovereign immunity is waived as to compensatory money damages (no punitive damages are allowed) regardless of when the bankruptcy case was commenced (Bankruptcy Reform Act of 1994, P.L. 103-394, 10/22/94; See Act § 113 amending BC § 106), and for cases commenced after October 21, 1994 the automatic stay will not apply to audits, demands for tax returns, assessments of tax, and notice of assessment and demand for payment (See Act § 116 amending BC § 362(b)(9)). The Tax Court has found it is not a violation of the stay for it to dismiss (without prejudice) a collection due process petition at the request of the debtor-taxpayer where no decision is required in favor of the tax authorities because IRC ' 7459(d) does not apply to require such a decision on a dismissal other than for want of jurisdiction. Settles v. Com’r, 138 TC No. 19 (2012).

(2) Proof of Claim. A proof of claim may be filed despite an outstanding 90 day letter or tax court case. IRC § 6213(f)(2).

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(3) Trustee Intervention. The Trustee may intervene in a Tax Court case. IRC § 7464.

(4) Immediate Deficiency Assessment. IRS may make an immediate assessment of a deficiency,

(a) In a receivership proceeding (IRC § 6871(a)) or

(b) Of the debtor’s estate in a bankruptcy case or

(c) Of the debtor’s prepetition deficiency only if the matter is res judicata pursuant to a determination in the bankruptcy case. IRC § 6871(b); BC § 505(c).

(5) Limitations Suspended. The period of limitation under IRC §§ 6501 or 6502 as to the assessment or collection of taxes are suspended during bankruptcy proceedings. IRC § 6503(h)(1) tolls the assessment period during the time the assessment cannot be made (i.e. until discharge, case closure, or dismissal) plus an additional 60 days. The collections limitation is also tolled until discharge, case closure, or dismissal, plus an additional six months. IRC § 6503(h)(2). See also the general 30 day additional tolling period for creditors under BC § 108(c).

h. Penalty Provisions. IRC § 6658 provides that under IRC §§ 6651, 6654, 6655, there will be no penalties on the debtor or the trustee for failure to make timely payment of tax during a bankruptcy proceeding if:

(1) Tax Incurred by Estate. A court order finds probable insufficiency of funds to pay administrative expenses.

(2) Tax Incurred by Debtor Prior to Order for Relief or Appointment of Trustee. The tax was incurred by the debtor prepetition (or in an involuntary case, before the appointment of the trusts), and the bankruptcy proceeding was begun before the return was due, or the date for imposing the penalty occurs on or after the bankruptcy proceeding commenced.

(3) No Relief on Payroll Taxes. These relief provisions do not apply with respect to liability for penalties for failure to timely file or pay or deposit any employment tax required to be withheld by the debtor or trustee. IRC § 6658(b); S. Rep. No. 96-1035, p. 51.

i. Discharge of Taxes. Debt discharge in bankruptcy is governed by BC §§ 727 (Chapter 7 liquidations), 1141(d) (Chapter 11 reorganizations), 1328 (Chapter 13 wage earner plans), and 1228 (Chapter 12 family farmers). Exceptions to discharge are covered by BC § 523.

(1) General Discharge Requirements. In order to obtain a discharge the debtor must meet the requirements of the specific discharge section governing the debtor’s case.

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(a) Chapter 7. In Chapter 7 cases, only individuals receive discharges (corporations and partnerships that liquidate don’t need a discharge).

(b) Chapter 11. In Chapter 11 cases the individual, corporation, or partnership may receive a discharge upon confirmation of the plan, but individuals can only discharge the debts dischargeable if the case were a chapter 7 proceeding and corporations and partnerships that go out of business get no discharge. BC § 1141(d)(1) and (3).

(c) Chapters 12 and 13. A debtor in Chapters 13 and 12 may receive a discharge of taxes provided for by the plan or disallowed under BC § 502, when all plan payments have been made. BC §§ 1328(a) and 1228(a); see CCA 201005029 (describing discharge of taxes in Chapter 13 proceeding). The Chapters 13 and 12 discharge may include priority taxes and penalties that would not otherwise be dischargeable under Chapter 7, presumably because plans under Chapter 13 and 12 must provide the amount paid on each claim be greater than it would be under Chapter 7 (see BC § 1325(a)(4)). Secured taxes, interest, and penalties are paid with interest under the Chapter 13 or Chapter 12 plan, but unsecured taxes, interest, and penalties with priority, although paid in full under the plan, need not be paid with interest (which can be helpful in dealing with nondischargable taxes). BC §§ 1322(a)(2) and (c), 1222(a)(2) and (c). Some courts have allowed the discharge of taxes mentioned in a plan even if they are not actually paid. (See In re Ryan, 78 B.R. 175 (Bankr. E.D. Tenn. 1987); In re Goodwin, 58 B.R. 75 (Bankr. D.Me. 1986)) a situation that can arise with late filed or nonfiled tax claims, or where a determination of liability on a prepetition debt (e.g., derivative liabilities) does not occur until after the bar date for a proof of claim. Also, some courts have allowed the discharge under Chapter 13 of fraudulently induced debts, such as fraudulent under-reporting of taxes, where the debtor repays the debt over time. (See In re Little, 116 B.R. 615 (Bankr. S.D. Ohio 1990); Johnson v. Edinboro State College, 728 F.2d 163, 166 n.4 (3d Cir. 1984).

There was a split in the circuits about whether post-petition gain in a Chapter 12 bankruptcy is taxed to the debtor or is discharged as an administrative expense if there are insufficient funds to pay the tax. Under Knudsen v. IRS, 581 F.3d 696 (8th Cir. 2009) capital gains taxes arising from the post-petition sale of farm assets were dischargeable in bankruptcy under the BC §1222(a)(2)(A) exception relating to priority taxes under BC §507; the Tenth Circuit Bankruptcy Appellate panel came to the same conclusion in IRS v. Ficken (In re Ficken), 430 B.R. 663, 105 AFTR 2d 2010-2265 (10th Cir. BAP 2010) but was rev’d by 433 Fed. Appx. 682 (10th Cir. 2011) based on U. S. v. Dawes, 652 F.3d 1236 (10th Cir.2011). The opposite result to that in Knudsen occurred in U.S. v. Hall, 617 F.3d 1161 (9th Cir. 2010) which found that since there was no separate estate for tax purposes, the tax couldn’t be incurred by the estate and thus could not be discharged under BC §1222(a)(2)(A), leaving the debtor responsible for the tax. The Hall case was affirmed by the United States Supreme Court resolving, with four justices in dissent, the split among the circuits. Hall v. U.S., 132 S.Ct. 1882 (2012).

(d) General Exceptions to Discharge. The general exceptions to discharge are specified in BC § 523; such exceptions include fraud, child support, willful or malicious injury to another, etc. Also under BC § 523(a)(1) certain taxes are not allowed to be

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discharged. Furthermore, loans to pay nondischargeable federal taxes cannot be discharged (Bankruptcy Reform Act of 1994, P.L. 103-394, 10/22/94) in bankruptcy cases commenced after October 21, 1994.

(e) Failure to Object to Discharge. A Chapter 13 plan confirmed without objection to a provision purporting to discharge an otherwise nondischargeable claim may be binding on the parties. In re Pardee, 193 F.3d 1083 (9th Cir. 1999); Andersen v. UNIPAC-NEBHELP (In re Andersen), 179 F.3d 1253 (10th Cir.1999). Otherwise, except for exceptions to discharge based on such things as fraud, fiduciary defalcation, embezzlement, larceny, and willful and malicious injury (BC ' 523(a)(2),(4), and (6)) for which the bankruptcy court has exclusive jurisdiction, the discharge exemptions may also be determined by a non-bankruptcy court pursuant to concurrent jurisdiction, (see e.g., Cummings v. Cummings, 244 F.3d 1263 (11th Cir. 2001)), and may be determined without a specific time limit under the Bankruptcy Code or Federal Rule of Bankruptcy Procedure 4007 (although other time limits may apply).

(f) Effect on Liens. Even after a bankruptcy discharge of taxes (to the extent available), a preexisting tax lien can be enforced in rem against the liened assets, including liened IRAs. Miles v. Com’r, 399 Fed. Appx. 231, 106 AFTR 2d 2010-6563, (9th Cir. 2010), cert denied (2011), aff’g T.C. Memo. 2007-208, 2007 WL 2187596.

(2) Specific Tax Related Exceptions. There are a number of tax related exceptions to discharge.

(a) Fraud and Willful Misconduct. No discharge is allowed for taxes with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat the tax. BC § 523(a)(1)(C). Something more than a mere failure to pay is required, but how much more is not clear.

(b) Nonfiled or Late Filed Returns. No discharge is allowed for taxes with respect to which a required return was not filed. BC § 523(a)(1)(B)(i). Also, if the return was filed late, and, in addition, was filed in the two years before the date of the filing of the petition or after the petition, the discharge will be denied. BC § 523(a)(1)(B)(ii). If the late return was filed before the two years before the petition, the taxes may (unless otherwise excluded) be dischargeable.

(i) Returns filed after assessment of the tax liability (for example, based on a Service prepared substitute return) have been held in the Tenth Circuit to be returns for purposes of 11 USC § 523(a)(1)(B); the court refused, however, to consider the argument that returns include only documents that qualify as returns under the tax law based on the four part Beard test (Beard v. Com’r, 82 TC 766 (1984), aff’d 793 F.2d 139 (6th Cir. 1986)) because the government had not raised this issue in the bankruptcy court. In re Savage, 81 AFTR 2d 98-814, 218 BR 126 (10th Cir. BAP, 1998). A bankruptcy court in the Tenth Circuit has said that the Sixth Circuit decision in the case of In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999), rev’g. 80 AFTR 2d 97-6708, 214 BR 847 (DC OH 1997), cast doubt on the continued vitality of Savage. Ehrig v. U.S., 93 AFTR 2d 2004-1681, 308 BR 542 (Bktcy OK 2004). The Hindenlang

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case applied the Beard test and held that there was no real return where the return filed after assessment had no tax purpose. The factors under the Beard test are: (1) there must be sufficient data to calculate tax liability; (2) the document must purport to be a return; (3) the taxpayer must execute the return under penalty of perjury; and (4) there must be an honest and reasonable attempt to satisfy the requirements of the tax law. See also Chief Counsel Advice 200235025. The Tenth Circuit Bankruptcy Appellate Panel has since agreed that a return filed after assessment is not subject to discharge of taxes, taking into account the Beard test on what is a return. In re: Wogoman, 110 AFTR 2d ¶ 2012-5039, 2012 WL 2562323 (10th Cir. BAP 2012).

(ii) Other courts are split on this issue. Cases tending to generally agree with the Tenth Circuit Savage reasoning that returns filed after assessment are returns, include: Colsen v. U.S., 446 F.3d 836 (8th Cir. 2006), aff’g 95 AFTR 2d 2005-1533, 322 BR 118, (8th Cir. BAP 2005), aff’g 94 AFTR 2d 2004-5005, 311 BR 765 (Bktcy Ct ID 2004); In re Nunez, 83 AFTR 2d 99-591, 232 BR 778 (9th Cir. BAP 1999); In re McGrath, 80 AFTR 2d 97-8241, 217 BR 389 (Bktcy Ct. NY 1997). See also Moroney v. U.S., 352 F.3d 902 (4th Cir. 2003), aff’g 90 AFTR 2d 2002-7353, (DC Va. 2002) (return disregarded but no per se rule; possible good faith filing, for example if it increases tax amount). Cases tending to agree with the Sixth Circuit that there is no return if one is filed after assessment, include: U.S. v. Payne, 431 F.3d 1055 (7th Cir. 2005), rev’g & rem’g 95 AFTR 2d 2005-1032 (DC IL 2005), aff’g 93 AFTR 2d 2004-1286, 306 BR 230 (Bktcy Ct. IL 2004), earlier proceeding 90 AFTR 2d 2002-6628, 283 BR 719 (Bktcy Ct. IL 2002); Hetzler v. U.S., 88 AFTR 2d 2001-6624, 262 BR 47 (Bktcy Ct NJ 2001); Pierchoski v. U.S., 84 AFTR 2d 99-5599, 243 BR 639 (Bktcy Ct. PA 1999); Sgarlat v. U.S., 88 AFTR 2d 2001-6403, 271 BR 688 (Bktcy Ct. FL 2001). McCoy v. Mississippi State Tax Comm., 666 F.3d 924 (5th Cir. 2012), would hold that all late-filed returns are not subject to discharge.

(c) Gap Period Taxes. Taxes arising during the gap period between an involuntary petition and the earlier of the appointment of a trustee or the order for relief are treated the same as if the claims arose before the petition and are excepted from discharge. BC §§ 523(a)(1)(A), 507(a)(2), and 502(f).

(d) Priority Taxes. If the tax is a type granted eighth priority (for cases commenced after October 21, 1994, under the Bankruptcy Reform Act of 1994, P.L. 103-394, 10/22/94) under BC § 507(a)(8), generally because it is not too old, the discharge will be denied.

(i) Income and Gross Receipts Taxes. No discharge will be allowed for three classes of priority income or gross receipts taxes:

1) The first class is: taxes for a taxable year ending on or before the date of the petition for which a return is last due including extensions, within three years of the date of the petition. BC § 507(a)(7)(A)(i). See Wood v. U.S., 866 F.2d 1367 (11th Cir. 1989) which applied the statute literally to a taxpayer who had filed for an extension to the due date of the return even though without the extension he may have been discharged.

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2) The second class is: taxes assessed within 240 days of the filing of the petition, or if an offer in compromise was pending, within an additional time equal to the time the offer was pending after assessment during the 240 day period plus another thirty days. BC § 507(a)(7)(A)(ii). The tax assessment procedures are determinative. See In Re Hartman, 110 Bankr. 951 (Bankr. D. Kan. 1990).

3) The third class is: taxes arising before the date of the petition not yet assessed but assessable, by agreement or otherwise, after the date of filing the petition. BC § 507(a)(7)(A)(ii). See In Re Crist, 85 Bankr. 807 (Bankr. N.D. Ia. 1988).

(ii) Trust Fund Taxes. A tax required to be collected or withheld and for which the debtor is liable in whatever capacity, is not dischargeable. BC §§ 523(a)(1)(A) and 507(a)(7)(C). This includes (y) income tax and FICA tax withheld from employees’ wages (including IRC § 3505 lender liability), and also the IRC § 6672 100% penalty (which would also receive priority and nondischargeability as a penalty for actual pecuniary loss under BC § 507(a)(7)(G)) and (z) sales taxes (and responsible person 100% penalties for sales tax). See In Re George, 95 F.2d 718 (Bankr. 9th Cir. 1989).

(iii) Other Taxes. Property taxes have priority, and are nondischargeable, if assessed and payable within one year of the petition. BC § 507(a)(7)(B). The employer’s share of FICA and FUTA taxes, and excise taxes arising before the petition for which a return is due within three years of the petition are not dischargeable. BC §§ 523(a)(1)(A), 507(a)(7)(D) and (E).

(e) Refunds; Pecuniary Penalties; Interest. Erroneous refunds or credits of taxes get the same priority, and thus the same dischargeability treatment, as the tax to which they relate. BC § 507(c). Penalties for actual pecuniary loss, rather than true punitive penalties, are given priority and nondischargeability status under BC § 507(a)(7)(G). Interest on taxes has the same priority as the taxes (see Richcreek v. I.R.S., 61 AFTR 2d 88-1071 (S.D. Ind. 1988)) and if it has priority, should (logically) be nondischargeable (see In Re Barbier, 77 Bankr. 799 (Bankr. D. Nev. 1987)).

(f) Punitive Penalties. Under BC § 523(a)(7), punitive penalties are denied discharge even though they do not have priority, but that section also excepts from the denial of discharge (and thus allows the possibility of discharge) penalties as to:

(i) Dischargeable Taxes. Dischargeable taxes, (i.e., those not referred to in BC § 523(a)(1) which refers to nondischargeable priority taxes, nonfiled, late filed, and fraudulent returns) may give rise to dischargeable tax penalties. BC § 523(a)(7)(A).

(ii) Three Years Before Petition. Also taxes imposed with respect to a transaction or event that occurred before three years before the filing of the petition may give rise to dischargeable tax penalties. Such penalties, if old enough, may be dischargeable even if the tax they relate to is nondischargeable. In Re Roberts, 906 F.2d 1440

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(10th Cir. 1990); In Re Burns, 887 F.2d 1541 (11th Cir. 1989); but see also Cassidy v. Com’r., 814 F.2d 477 (7th Cir. 1987) which was rejected by Roberts and Burns.

(3) Liens. The discharge of the tax does not discharge or release any lien that may have been imposed and filed with respect to nonexempt property. BC § 522(c)(2)(B); In Re Isom, 901 F.2d 744 (9th Cir. 1990).

(4) Exempt Property. Nondischargeable taxes may be collected against property otherwise exempt from creditors under the Bankruptcy Code. BC § 522(c)(1). Rather, IRC ' 6334 determines any property exempt from seizure to pay federal tax.

j. Late Filed Claims of IRS. The IRS files claims in bankruptcy proceedings and its claims are generally priority claims. In bankruptcy proceedings creditors are given notice of the proceedings by the debtor and are required to file claims by a court imposed bar date. How late filed IRS claims are handled may vary depending on the type of bankruptcy proceeding involved. At issue is whether the IRS keeps its priority or not.

(1) Chapter 7. B.C. § 726(a)(2) and (a)(3) allows distribution to late filed unsecured claims, and BC § 726(a)(1) does not distinguish timely and late priority claims. Thus, if the IRS makes its proof of claim (i) before the trustee makes any distribution and before the court closes the estate and (ii) without bad faith or prejudice to other creditors, then the priority will be retained. In re Brenner, 160 B.R. 302 (Bankr. E.D. Mich. 1993, In re Century Boat, 986 F.2d 154 (6th Cir. 1993), U. S. v. Cardinal Mine Services, 916 F.2d 1087 (6th Cir. 1990). See also BC §§ 501 and 502, and Bankruptcy Rule 3002(c). This result has been codified under the Bankruptcy Reform Act of 1994, P.L. 103-394 (Act § 213(b) amending BC § 726(a)(a), at least to the extent that BC § 726(a)(1) now allows tardily filed claims before the trustee commences distribution; the issues of estate closing and good faith are not dealt with in the amendment.

(2) Chapter 13. In a Chapter 13 case BC § 726 does not apply, and the courts have split. See In re Zimmerman, 156 B.R. 192 (Bankr. W.D. Mich. 1993) and In re Turner, 157 B.R. 904 (Bankr. N.D. Ala. 1993) (Strict application of Bankruptcy Rule 3002 to bar claims after bar date); In re Hausladen, 146 B.R. 557 (Bankr. D. Minn., 1992) (late filed claims may be allowed under Chapter 13). The results under Zimmerman and Turner may allow a debtor to manipulate time periods so as to discharge taxes otherwise payable in full in a chapter 13 case. However, under the Bankruptcy Reform Act of 1994, P.L. 103-394 (adding BC § 502(b)(9)) these problems should become less frequent because the time for a governmental unit to file a claim has been extended to 180 days after the order for relief (generally, the date of the voluntary petition) or such later time as the Federal Rules of Bankruptcy Procedure may provide.

k. Sovereign Immunity. Bankruptcy Reform Act of 1994, P.L. 103-394 (See Act § 113 amending BC § 106) now waives sovereign immunity in order to allow governmental units to be sued for monetary damages in a number of circumstances. However, punitive damages are made unavailable. The areas in which a governmental unit may be held responsible include damages for violation of the automatic stay, the recovery by the trustee or debtor in possession under BC §§ 542(a) (estate assets) or 547(b) (preferential transfer) of assets

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seized by or received by the IRS from the debtor prepetition. Begier v. U.S., 496 U.S. 53 (1990) held that voluntarily made payments of trust fund taxes could not be recovered as preferential transfers and drew a distinction with involuntary payments; thus with the waiver of sovereign immunity the issue of recovering involuntary payments of trust fund taxes will be an area of future development.

Last Updated 10/30/12

TAX ASPECTS OF BANKRUPTCY AND INSOLVENCY

Langdon T. Owen, Jr. Parsons Kinghorn Harris, pc

lto@pkhlawyers.com

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2

TABLE OF CONTENTS

TAX ASPECTS OF BANKRUPTCY AND INSOLVENCY ........................................................ 1

1. Cancellation of Indebtedness Income.................................................................................. 1

a. The Bankruptcy, Insolvency, Farm, and Real Property Exceptions ........................... 2 (1) Taxpayers In Bankruptcy ............................................................................................ 2 (2) Insolvent Taxpayers Outside of Bankruptcy............................................................... 2

(3) Qualified Farm Indebtedness ...................................................................................... 6 (4) Qualified Real Property Business Indebtedness ......................................................... 7

(5) Ordering of Exceptions ............................................................................................... 8 b. Solvent Taxpayers Outside Bankruptcy Proceedings and General Matters Relating to Discharge of Indebtedness ................................................................................................... 9

(1) Income from Nonrecourse Debt.................................................................................. 9 (2) Gift .............................................................................................................................. 9

(3) Other Arguable Exceptions ......................................................................................... 9 (4) Contribution to Capital ............................................................................................. 10 (5) Subchapter-S Effect .................................................................................................. 11 (6) Reduction in Purchase Price ..................................................................................... 11 (7) Deductible Debt ........................................................................................................ 12 (8) Stock for Debt ........................................................................................................... 12 (9) Partnership Interest for Debt ..................................................................................... 13 (10) Miscellaneous Statutory Exceptions ......................................................................... 14 (11) Home Mortgage ........................................................................................................ 14 (12) Governmental Homeowner Assistance. .................................................................... 15

c. Other Aspects of Debt Cancellation . ............................................................................ 15

(1) Partnership Application ............................................................................................ 15 (2) Earnings and Profits .................................................................................................. 17 (3) Related Taxpayers ..................................................................................................... 17 (4) Debt Restructure ....................................................................................................... 18 (5) Information Returns .................................................................................................. 18 (6) State and Local Effect of Cancellation of Indebtedness ........................................... 19

(7) Loans to Pay Taxes ................................................................................................... 20 (8) Deferral of COD Income. ......................................................................................... 20 (9) Trust Application. ..................................................................................................... 21 (10) Disregarded Organizations........................................................................................ 21

d. Related Matters ............................................................................................................... 21 (1) Personal Holding Company ...................................................................................... 21 (2) Accrued But Unpaid Interest .................................................................................... 21

2. Debt Modifications and Workouts .................................................................................... 22

a. General Effect of Significant Modification ................................................................... 22 (1) Determination Process .............................................................................................. 22 (2) Effects for COD, OID, Gain, Exemption .................................................................. 22

b. Modifications, Their Significance, and Special Rules.................................................. 23

(1) Modifications ............................................................................................................ 23 (2) Significance of Modifications ................................................................................... 23

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(3) Installment Obligations ............................................................................................. 25 (4) Adequate Interest IRC § 1274 and § 483 .................................................................. 25

(5) Potentially-abusive Situations ................................................................................... 25 (6) Original Issue Discount............................................................................................. 26

c. Modification Planning Opportunities ........................................................................... 28 (1) Minimize Cancellation Income ................................................................................. 28 (2) Maximize Cancellation Income or OID .................................................................... 28

3. Foreclosures and Transfers of Property for Discharge ................................................... 29

a. Recourse Debt.................................................................................................................. 29 b. Nonrecourse Debt............................................................................................................ 30 c. Back Interest.................................................................................................................... 30

(1) Insolvent .................................................................................................................... 30 (2) Solvent ...................................................................................................................... 31 (3) Cash Basis Nonrecourse Deficiency ......................................................................... 31 (4) Cash Basis Nonrecourse No Deficiency ................................................................... 31

(5) Accrual Basis Nonrecourse ....................................................................................... 31 d. Information Return. ....................................................................................................... 33

e. Foreclosure by Lender .................................................................................................... 33

f. Repossession by Seller. ................................................................................................. 33

g. Abandonment of Real Estate ......................................................................................... 33

(1) Mortgaged Property .................................................................................................. 34 (2) Partnership Interests .................................................................................................. 34

h. Home Gain Exclusion ..................................................................................................... 34

i. Bankruptcy Planning. ................................................................................................... 34

4. Bad Debt and Loss Deductions .......................................................................................... 35

a. Business Bad Debt Deduction ........................................................................................ 35

(1) Basis Limit ................................................................................................................ 35 (2) Trade or Business ...................................................................................................... 36 (3) Guarantor .................................................................................................................. 37

b. Nonbusiness Bad Debt Deduction ................................................................................. 38

c. Loss on Retirement of Instrument ................................................................................. 38

(1) Instrument ................................................................................................................. 38 (2) Retirement ................................................................................................................. 39

d. Losses on Worthless Securities ...................................................................................... 39

(1) Worthless .................................................................................................................. 39 (2) Timing ....................................................................................................................... 39 (3) Special Ordinary Loss Rules ..................................................................................... 40 (4) Abandonment ............................................................................................................ 40

5. G-Reorganizations .............................................................................................................. 40 a. Overlaps ........................................................................................................................... 40 b. Definitions and Basic Requirements ............................................................................. 41

(1) Transfer ..................................................................................................................... 41 (2) Insolvency Proceeding .............................................................................................. 41 (3) Stock or Securities .................................................................................................... 41

c. Triangular Reorganizations ........................................................................................... 42

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(1) Forward Triangular Merger ...................................................................................... 43 (2) Reverse Triangular Merger ....................................................................................... 43 (3) Drop Down................................................................................................................ 43

d. Continuity of Interest and Related Requirements ....................................................... 43 (1) Intention .................................................................................................................... 44 (2) Consideration ............................................................................................................ 44 (3) Historic Business ...................................................................................................... 44 (4) Business Purpose ...................................................................................................... 45 (5) Avoiding a Reorganization. ...................................................................................... 45

6. The Carryover of Tax Attributes. ..................................................................................... 45

a. In General ........................................................................................................................ 45 (1) Purchase of Loss Corporation’s Assets..................................................................... 45 (2) Stock Purchases by a Profit Corporation .................................................................. 46 (3) Loss Corporation Purchases Stock of Profitable Corporation .................................. 46

b. Section 381 ....................................................................................................................... 46 (1) Liquidation of Solvent Subsidiary ............................................................................ 46 (2) Tax-free Reorganization ........................................................................................... 46

c. Some Selected Loss Carryover Rules ............................................................................ 46 (1) One Corporation Acquiring ...................................................................................... 47 (2) Close Tax Year ......................................................................................................... 47 (3) Proration of NOL ...................................................................................................... 47 (4) Limitation on Use of Acquiring Corporation’s NOL ............................................... 47

(5) Incomplete Acquisition Possible............................................................................... 47 d. Section 382 Limitation .................................................................................................... 47

(1) Limitation .................................................................................................................. 47 (2) Continuity of Business Enterprise ............................................................................ 48 (3) Ownership Change .................................................................................................... 48 (4) Bankruptcy Exception ............................................................................................... 51 (5) NOL Cutback ............................................................................................................ 52 (6) Bankruptcy Cases Not Covered By Exception ......................................................... 52

(7) TARP Exceptions...................................................................................................... 53 e. Evasion of Taxes - § 269 ................................................................................................. 53

(1) Application ................................................................................................................ 53 (2) Business Continuity .................................................................................................. 53

f. Built-In Gains Limitation ............................................................................................... 53

g. Consolidated Return Limitations .................................................................................. 53

(1) CRCO ........................................................................................................................ 53 (2) SRLY ........................................................................................................................ 54 (3) BID ............................................................................................................................ 54

h. Miscellaneous Limitations .............................................................................................. 54

(1) Some General Problems ............................................................................................ 55 (2) Lisbon Shops ............................................................................................................. 55

7. Procedural Matters ............................................................................................................. 55 a. Filing Obligations of Partnerships and Corporate Debtors ........................................ 55

(1) No Separate Entity .................................................................................................... 55

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(2) Debtor-in-Possession ................................................................................................ 55 (3) Trustee Appointed ..................................................................................................... 55 (4) Liquidations .............................................................................................................. 56 (5) Termination of Trusteeship ....................................................................................... 56 (6) Determination of Partnership Items .......................................................................... 57

b. Filing Obligations of Individual Debtor Under Chapter 11 and 7 in Bankruptcy ... 57 (1) Separate Estate Created............................................................................................. 57 (2) Debtor Failure to File ................................................................................................ 60 (3) Trustee Duty.............................................................................................................. 60

c. Filing Obligation of Chapter 13 and 12 Debtor ........................................................... 60 d. State and Local Taxes ..................................................................................................... 61

(1) Separate Estate .......................................................................................................... 61 (2) No Separate Estate .................................................................................................... 61 (3) Short-period Election ................................................................................................ 61 (4) Transfer ..................................................................................................................... 61 (5) Attributes................................................................................................................... 61 (6) Filing with No Income .............................................................................................. 61 (7) Withholding .............................................................................................................. 61 (8) Partnerships ............................................................................................................... 62

e. Other Miscellaneous Tax-related Matters .................................................................... 62 (1) Notice of Fiduciary Status ........................................................................................ 62 (2) Court Notifies Service............................................................................................... 62 (3) Deductible Administrative Expenses ........................................................................ 62 (4) Disclosure by and to Debtor ..................................................................................... 62 (5) Stay of Tax Court ...................................................................................................... 62 (6) Chapter 11 Disclosure Statement .............................................................................. 62 (7) Chapter 11 Plan Payment of Tax .............................................................................. 62 (8) Tax Matters Partner in Bankruptcy ........................................................................... 63 (9) General Tax Priority. ................................................................................................ 63 (10) General Tax Lien Treatment. .................................................................................... 63 (11) Joint Return Refund. ................................................................................................. 64 (12) Restriction on Levy. .................................................................................................. 64

f. Bankruptcy Court Jurisdiction Over Tax Matters ..................................................... 64

(1) Jurisdiction ................................................................................................................ 64 (2) IRS Claim Filed by Others ........................................................................................ 65 (3) Refund Claim ............................................................................................................ 65 (4) Determination of Unpaid Tax ................................................................................... 65 (5) Release of Stay .......................................................................................................... 66 (6) Determination of Tax Aspects of a Plan of Reorganization ..................................... 66

(7) Determination of Attorney’s Fees in Tax Matters. ................................................... 66

(8) Tax or Bankruptcy Policies. ...................................................................................... 67 g. Deficiency Procedures . .................................................................................................. 67

(1) Automatic Stay.......................................................................................................... 67 (2) Proof of Claim........................................................................................................... 67 (3) Trustee Intervention .................................................................................................. 68

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(4) Immediate Deficiency Assessment ........................................................................... 68 (5) Limitations Suspended .............................................................................................. 68

h. Penalty Provisions ........................................................................................................... 68 (1) Tax Incurred by Estate .............................................................................................. 68 (2) Tax Incurred by Debtor Prior to Order for Relief or Appointment of Trustee ......... 68

(3) No Relief on Payroll Taxes ....................................................................................... 68 i. Discharge of Taxes .......................................................................................................... 68

(1) General Discharge Requirements ............................................................................. 68 (2) Specific Tax Related Exceptions .............................................................................. 70 (3) Liens .......................................................................................................................... 73 (4) Exempt Property.. ..................................................................................................... 73

j. Late Filed Claims of IRS ................................................................................................ 73

(1) Chapter 7 ................................................................................................................... 73 (2) Chapter 13 ................................................................................................................. 73

k. Sovereign Immunity........................................................................................................ 73