IRS issues final regs on COD income exceptions for disregarded entities

The IRS has issued final regulations (T.D. 9771) for determining whether disregarded entities can be considered the “taxpayer” for the bankruptcy and insolvency exceptions to cancellation of debt (COD) income rules. The final regulations generally adopt, with modifications, proposed regulations (REG-154159-09) issued in April 2011.

Under Section 61(a)(12), a taxpayer’s gross income includes income from the discharge of indebtedness, or COD income. COD income is generally included in income unless it meets one of several specific exceptions, including the bankruptcy and insolvency exceptions in Section 108(a)((1). For both exceptions, Section 108(d)(1) provides that the term “indebtedness of the taxpayer” means any indebtedness for which the taxpayer is liable or is subject to which the taxpayer holds property.

The bankruptcy exception requires a “Title 11 case,” which is defined as a case under Title 11 of the U.S. Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court and the discharge of debt is granted by the court or is pursuant to a court-approved plan. To qualify for the insolvency exception, a taxpayer’s liabilities must exceed the fair market value of the taxpayer’s assets as determined immediately before a discharge of debt.

Section 108(d)(6) provides that the bankruptcy and insolvency exceptions are applied at the partner level rather than the partnership level, but the statute doesn’t address the application of the exception to grantor trusts under Subchapter J or disregarded entities under Treas. Reg. Sec. 301.7701-2(c)(2)(i).

The final regulations state that neither a grantor trust nor a disregarded entity is considered to be a taxpayer for purposes of the bankruptcy or insolvency exceptions. The owner of a grantor trust or disregarded entity is the taxpayer for these purposes.

For example, if debt of a grantor trust or a disregarded entity is discharged in a Title 11 case, the bankruptcy exception applies only if the owner is under the jurisdiction of the court in a Title 11 case as the title 11 debtor. Similarly, the insolvency exception applies only to COD income of a grantor trust or a disregarded entity to the extent that the owner is actually insolvent. However, if a partnership holds an interest in a grantor trust or a disregarded entity, the applicability of the exceptions is determined by looking at each partner to whom the income can be allocated.

The final regulations apply to COD income occurring on or after June 10, 2016.

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.