Selected debt cancellation issues.

Sec. 61(a)(12) provides that gross income includes income from discharge of indebtedness (DOI). Generally, Sec. 108 provides special rules as to when such DOI income should not be includible in the debtor's gross income. Two fairly common situations involve a parent's contribution of accrued interest liability to the capital of its debtor-subsidiary and determining which property is eligible for basis reduction under Sec. 108(e)(5).

Example 1: A, a foreign entity, owns 100% of domestic corporation B. Several years ago, A loaned $100 to B in exchange for a note with adequate stated interest of 8%. B accrued interest of $8 on the loan each year, but did not claim a deduction (due to the deferral mechanism of Regs. Sec. 1.267(a)-3). Currently, A wants to contribute the $100 to B's capital, as well as all the accrued but unpaid interest. (B will not issue actual stock certificates to A in exchange.) The issue is whether B must report any DOI income under Sec. 61(a)(12) as to either the principal or interest.

With respect to A's contribution of the $100 principal amount to capital, no DOI income should result to B under Sec. 108(e)(6) and/or Regs. Sec. 1.61-12(a). This assumes that A's basis in the debt equals the face value of the note, which is the most likely scenario. (Sec. 108(e)(8) does not apply, because no physical shares were issued.)

The cancellation of the interest component is more complicated; it depends on the interplay between a nonrecognition provision and the tax benefit rule. Ordinarily, an accrual-method taxpayer that had previously claimed an interest deduction would be required to report DOI income when the obligation to pay that amount is discharged. However, the Tax Court has held that the specific nonrecognition policy of Sec. 108 should override that general tax benefit rule when the interest obligation is forgiven by the debtor's shareholders (Putoma Corporation, 66 TC 652 (1976)).

The IRS disagreed with this result and promptly issued Rev. Rul. 76-316, which held that the debtor would have to report DOI income under these facts. In 1980, Congress enacted Sec. 108(e)(6), overruling Putoma and explaining that the debtor-subsidiary is only permitted to avoid DOI consequences to the extent of the creditor/shareholder's basis in the debt. Since the creditor would have no basis in the receivable corresponding to the unpaid interest, there would be DOI income for the discharged interest under this rule.

Thus, in Example 1, B will never be protected by Sec. 108(e)(6) when the foreign shareholder forgives the unpaid interest. In this case, however, since B never took an interest deduction, B should not have to recognize DOI income. This result is also consistent with Sec. 108(e)(2), which provides that no DOI income is realized to the extent that payment of the liability would have given rise to a deduction.

Example 2: Domestic corporation B bought the entire business of domestic corporation S for (10. B paid S $2 in cash. B borrowed the remaining $8 from S (i.e., a "purchase money debt"). As part of the original sale, B received three pieces of property (P1, P2 and P3). Several years later, B sold P1 and purchased new property (P4) to replace the sold property. S then decided to discharge B's obligation to repay the $8. Under Sec. 108(e)(5), the discharge of the purchase money debt is treated as a purchase price adjustment, a reduction of die basis of the property sold. The issue is which property is eligible for basis reduction: the property held at the time of the reduction (i.e., P2, P3 and P4) or the original property still held at the time of the purchase (i.e., P2 and P3).

Legislative history makes it clear that if the original property has been transferred by the buyer to a third party, Sec. 108(e)(5) does not apply to determine whether an amount must be treated as DOI income; see S. Rep. No. 96-1035 (1980). Thus, the basis reduction occurs at the time of the purchase price reduction and only the basis of the original properties still held by the buyer would be reduced. In Example 2, only the basis of P2 and P3 would be reduced. The remaining DOI amount (i.e., the amount allocable to P1) would be ordinary income to B.

Planning. A debtor faces DOI income even if it has transferred the property to a related person (such as a wholly owned subsidiary). If the purchaser/debtor foresees a purchase price reduction but does not own the original property, the debtor may reacquire the property so that it actually owns the property again on the date of the reduction. The legislative history does not mandate that the debtor must have continuously owned the property from the time of the original acquisition to the moment of the subsequent price reduction. Although there may be some tax consequences associated with reacquiring such property, this planning technique should at least be considered.