COD Income Recognition Deferred Under IRC § 108(i) Starts Now
Demetri Yatrakis and Fritz Dela Rama
Time is up! Taxpayers who availed themselves of the income deferral benefits under Internal Revenue Code (IRC) § 108(i) for cancellation of debt income (“COD income”) realized in 2009 and 2010 must start recognizing such deferred income ratably over the next five taxable years beginning in 2014.
Although gross income includes income from discharge of indebtedness, IRC § 108(a) specifically excludes COD income (in whole or in part) if the discharge or indebtedness of the taxpayer (a) occurs in a Title 11 bankruptcy proceeding, (b) occurs when the taxpayer is insolvent, (c) is qualified farm indebtedness, (d) is qualified real property business indebtedness for taxpayers other than C corporations, or (e) is qualified principal residence indebtedness which is discharged before January 1, 2014. The exclusion under IRC § 108(a) is actually a deferral as the debtor must reduce, on a corresponding basis, valuable tax attributes such as net operating losses, various credits, capital loss carryovers, basis in assets and passive activity losses and credits.
IRC § 108(i) was added by the American Recovery and Reinvestment Act of 2009 and allowed C corporations and other taxpayers (including partnerships and S corporations) engaged in the conduct of a trade or business to defer COD income occurring in 2009 or 2010. Starting in 2014, all of the deferred COD income must be taken into account ratably over the next five taxable years. However, recognition of any deferred COD income will be accelerated upon: (a) the de ath of the debtor, (b) the liquidation of the debtor, (c) the sale of substantially all of the assets of the debtor, (d) the cessation of business of the debtor, or (e) the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-thru entity by a partner, shareholder, or other person holding an ownership interest in such entity. With respect to a discharge of partnership indebtedness, IRC § 108(i)(6) also permits deferral of the recognition of income resulting from the application of IRC § 731 and 752 (deemed distribution resulting from a decrease in liabilities) that correspond with the general deferral of income principles contained in IRC § 108(i) outlined above. Taxpayers may want to consider making use of some of these acceleration events in a taxable year in which there are excess losses and/or deductions that can be used to offset the deferral income. Alternatively, taxpayers could consider bunching or accelerating deductions to offset the deferral income.
Deferral income that is to be recognized starting in 2014 should be considered when calculating estimated taxes for these taxable years. The IRC § 108(i) deferral election (made on a debt instrument by debt instrument basis) was required to be made with the filing of the U.S. federal income tax return for the taxable year in which the COD income is realized (2009 or 2010) by the taxpayer that realized the COD income. In the case of a debtor that is a partnership (or a limited liability company taxable as a partnership), the IRC § 108(i) election was made by the partnership and binds all of the partners. This is in stark contrast to the other provisions of IRC § 108 that apply the bankruptcy and insolvency exceptions and corresponding tax attribute reduction at the partner level.
It’s time to start re-checking those old returns!