The year 2023 has witnessed a remarkable upsurge in bankruptcy filings, indicating a concerning trend. January and February alone recorded substantial increases of 19% and 18%, respectively, compared to the same months in the previous year. This persistent rise in bankruptcy filings reflects the growing economic difficulties faced by households and businesses. Experts attribute this trend to inflation and supply chain disruptions, which are expected to persist and contribute to the continued increase in bankruptcy filings.
During times of economic uncertainty, tax professionals often receive numerous inquiries regarding the consequences of debt workouts and restructurings, particularly with regards to cancellation-of-debt (COD) income. The occurrence of COD income hinges on various circumstances, including debt modification, equity issuance, discounted debt acquisition, satisfaction of debt through contingent value rights, discharge of debt within or outside bankruptcy, and asset foreclosure.
By default, COD income is generally taxable under Section 61 of the Internal Revenue Code (IRC), unless explicitly excluded under tax law. Fortunately, Section 108 of the IRC provides certain cases where COD income may be partially or entirely excluded from taxation. This article will delve into two exclusions available for COD income: the bankruptcy exclusion and the insolvency exclusion.
Under the bankruptcy exclusion, COD income resulting from the discharge of debt in a bankruptcy proceeding can be excluded from taxable income. This exclusion serves as a relief for individuals and businesses that have sought bankruptcy protection to alleviate their financial burdens. However, it is important to note that this exclusion does not apply to COD income arising from debt modifications or other circumstances unrelated to the discharge in bankruptcy.
The insolvency exclusion provides another avenue for excluding COD income from taxation. This exclusion applies to taxpayers who are insolvent immediately before the discharge of debt. Insolvency refers to a situation where an individual or business's total liabilities exceed the fair market value of their assets. In such cases, the amount of COD income that can be excluded is limited to the extent of insolvency. For a partnership, the insolvency is determined at the partner level and the exclusion is made at the partner level rather than the partnership level.
The exclusion of COD income under the bankruptcy or insolvency exclusion is generally a timing item, essentially deferring recognition of the income through a reduction in the taxpayer’s tax attributes (see Secs. 108(b) and 1017), including net operating losses, general business credit, capital loss carryovers, basis in property, foreign tax credit carryovers, etc.
As the surge in bankruptcy filings continues in 2023, individuals and businesses facing financial challenges should be aware of the tax implications of debt workouts and restructurings. While COD income is generally taxable, certain exclusions under Section 108 of the IRC offer relief for those undergoing bankruptcy or insolvency. Understanding these exclusions can help individuals and businesses mitigate their tax burdens during times of economic uncertainty and financial distress.