COD in insolvent member of affiliated group does not affect tax attributes of other members.

An affiliated group is made up of legally separate entities. Each entity will engage in its own transactions, and may even engage in unrelated businesses. As a result of these activities, it is possible for one or more members of the affiliated group to become insolvent even as other members (and even the group as a whole) remain solvent. Although most of the affiliated group rules of the Internal Revenue Code continue to apply, there are complex issues that will require careful consideration.

The central rules governing Federal taxation of cancellation of debt (COD) income are in Sec. 108. COD income is taxable unless the circumstances fall into a specific exception, such as bankruptcy or insolvency. If COD income escapes Federal income taxation through one of these exceptions, the debtor reduces carryforward tax attributes, such as net operating losses (NOLs), credit carryforwards and the adjusted bases of assets owned by the debtor. The theory is that these tax attributes will reduce the taxable income of the debtor corporation in future years, that the cancelled debt was used to "buy" these tax attributes, and that if the debt will not be repaid, the debtor should not get the advantage of the related deductions.

The situation is more complex when the tax laws intertwine the debtor with other entities that may or may not meet the same exceptions. For example, the income of a partnership is taxed to the partners. The bankruptcy and insolvency exceptions are based on the status of each partner rather than the partnership itself. This means that a partnership may be in bankruptcy, but the partners may suffer taxable income from the cancellation of the partnership's debt. Although shareholders of an S corporation are treated similarly to partners in a partnership, the bankruptcy and insolvency exceptions are based on the status of the corporation only. Thus, a bankrupt shareholder may pay tax on COD income passed through from a solvent, nonbankrupt S corporation.

Affiliated groups face similar issues. The tax attributes of one member affect the tax liabilities of the affiliated group. For example, a loss suffered by one member may be used to offset taxable income earned by another. If an insolvent member of an affiliated group has COD income and another member has an NOL carryforward, should the other member's NOL carryforward be reduced? If the affiliated group is considered a single entity for Sec. 108, the answer is yes. If the affiliated group is treated as an aggregation of separate entities for Sec. 108, the answer is no.

In Letter Ruling 9121017, some members of an affiliated group were insolvent. (It appears from the ruling that other members of the affiliated group were solvent at the time.) The insolvent members settled some of their liabilities by transferring assets whose fair market value (FMV) was less than the liability to the creditors. The difference between the amount of the liability and the FMV of the assets used to settle the liability was COD income.

The IRS decided that an affiliated group is an aggregate of separate entities for Sec. 108. Each insolvent member of the affiliated group qualified for the insolvency exception up to the amount of its insolvency. Each company that remained insolvent after the discharge would not recognize any taxable COD income. Each company solvent after the discharge would recognize taxable COD income to the extent it became solvent.

The Service also concluded that each member of the affiliated group that availed itself of the insolvency exception would reduce its own tax attributes to the extent of the COD excluded under Sec. 108. The tax attributes of the other members would not be affected by the discharge.

The ruling noted that Sec. 108 repeatedly referred to "the taxpayer" as the entity subject to the COD provisions. "Taxpayer" is generally thought of as a singular entity. The ruling also looked at Sec. 1017, which contains the rules for reducing the basis of assets as a result of cancellation of indebtedness. In particular, Sec. 1017(b)(3)(D) provides that a corporation may treat stock of a subsidiary as depreciable property for the reduction of basis if the subsidiary consents to reduce the basis of its depreciable assets accordingly. The IRS concluded that Congress did not intend the attribute reduction rules to affect other members of the affiliated group unless there was a specific election to do so.

The ruling then looked at the consolidated return regulations. These regulations provide that a member's basis in the stock of another member is adjusted for the results of operations of the subsidiary's operations each year. If the subsidiary is profitable, the basis of the stock is increased by undistributed earnings. If the subsidiary suffers a loss, the basis of the stock is reduced by the loss. If the loss is greater than the current adjusted basis of the stock, the difference is an excess loss account taxed to the affiliated group when the member disposes of the subsidiary stock. The Service concluded that these rules would impose a "tax cost" on the affiliated group for the use of losses of any member, so it would not be necessary to reduce the tax attributes of any other member for COD income.

Letter rulings may not be used as precedent except by the taxpayer that requested the ruling. However, they can indicate the IRS's thinking on important issues. Tax advisers to insolvent members of affiliated groups and to affiliated groups with insolvent members (which could include receiverships) should be aware of this ruling. Actions taken by some members to "work out" debts can affect other members of the affiliated group. However, this ruling indicates that it may be possible to isolate some of the Federal tax effects of cancelling the indebtedness of a member of an affiliated group and to save the tax attributes of other members.