IRS Issues Much-Needed Guidance on Election to Defer COD Income

DLA Piper | Publications | IRS issues much-needed guidance on election to defer COD in... Page 1 of 5 NEWS & INSIGHTS Publications 20 AUG 2009 IRS issues much-needed guidance on election to defer COD income TAX ALERT Stephen M. Sharkey Joseph H. Langhirt The Internal Revenue Service has provided much-needed guidance to taxpayers on procedures for electing to defer cancellation of indebtedness (COD) income from the discharge of certain indebtedness incurred in connection with carrying on a business: Revenue Procedure 2009-37 (Rev. Proc. 2009-37 or the Revenue Procedure). Set forth below are highlights of the guidance provided by Rev. Proc. 2009-37, with a particular focus on guidance for entities taxed as partnerships. Background: Deferral of COD Income under Section 108(i) Section 108(i), added to the Internal Revenue Code earlier this year by President Barack Obama’s economic stimulus legislation (the American Recovery and Reinvestment Tax Act of 2009), generally permits a taxpayer to elect to defer COD income realized in connection with a “reacquisition” of an “applicable debt instrument” after December 31, 2008, and before January 1, 2011. A taxpayer who makes the Section 108(i) election spreads the COD income that would otherwise be taken into account in the year of the reacquisition over a five-taxable-year period, beginning with the taxable year that begins in 2014. Section 108(i) deferral is available only for discharges of business indebtedness (in the statute, an “applicable debt instrument”) and transactions that generate COD income (a “reacquisition” of an applicable debt instrument). An “applicable debt instrument” generally is any debt instrument issued by http://www.dlapiper.com/irs-issues-much-needed-guidance-on-election-to-defer-cod-inco... 8/24/2009 DLA Piper | Publications | IRS issues much-needed guidance on election to defer COD in... Page 2 of 5 (i) a C corporation or (ii) any other taxpayer in connection with the conduct of a trade or business. “Reacquisition” generally means any acquisition of an applicable debt instrument by the debtor, or a person related to the debtor. The term “acquisition” includes (i) a purchase of a debt instrument for cash, (ii) the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument), (iii) the exchange of the debt instrument for corporate stock or a partnership interest, (iv) the contribution of the debt instrument to capital of a corporation or partnership and (v) the complete forgiveness of the indebtedness by the holder of the debt instrument. Section 108(i) provides special rules when COD income is realized by a taxpayer who discharges an applicable debt instrument by issuing (or being treated as issuing) a new debt instrument with original issue discount (OID). If such a taxpayer makes a Section 108(i) election, then the timing of the OID interest deductions is also deferred. A taxpayer must take into account any item of income or deduction deferred under Section 108(i) (and not previously taken into account) in the taxable year in which certain events occur (such as the liquidation of the taxpayer and upon other events specified in administrative guidance). The rule regarding acceleration of deferred COD income and OID deductions also applies in the case of certain dispositions of ownership interests in pass-through entities. The IRS stated that its purpose in issuing Rev. Proc. 2009-37 is to provide taxpayers with guidance on procedures for making an election to defer COD income under Section 108(i). As described below, the IRS went much further than simply describing the mechanics of election procedures, using the Revenue Procedure as a vehicle to clarify several important substantive issues concerning the Section 108(i) election. Election Procedures Rev. Proc. 2009-37 provides detailed guidance on the procedures that must be followed to make the Section 108(i) election. Generally, the election is made by attaching a statement meeting the requirements of the Revenue Procedure to the taxpayer's timely filed (including extensions) original federal income tax return for the taxable year in which the “reacquisition” event triggering COD income occurs. Partnerships, S corporations and certain other entities must include additional detailed information in their election statements. The Revenue Procedure also requires taxpayers who make the Section 108(i) election to maintain certain information and to include disclosure statements with their federal tax returns throughout the period that the COD income is deferred. The pleasant surprise in the Revenue Procedure, however, is the lengths to which the IRS went to provide taxpayers with maximum flexibility in making the Section 108(i) election work. The IRS seems to have embraced fully the remedial nature of Section 108(i) in fashioning taxpayer-friendly procedures for making the election, including: Automatic 12-Month Extension. The Revenue Procedure allows an automatic 12-month extension for making the Section 108(i) election. Partial Elections. The Revenue Procedure provides the ability to make the Section 108(i) election with respect to only a portion of the COD income realized by the taxpayer. For example, a taxpayer who realizes $100 of COD income can elect to defer only $40 (or any other amount) of the COD Income. http://www.dlapiper.com/irs-issues-much-needed-guidance-on-election-to-defer-cod-inco... 8/24/2009 DLA Piper | Publications | IRS issues much-needed guidance on election to defer COD in... Page 3 of 5 Debt-by-Debt Election. The Revenue Procedure offers flexibility, allowing the taxpayer to make different elections (including no elections) for different debt obligations that have generated COD income. Protective Elections. The Revenue Procedure expressly gives taxpayers the ability to make a protective Section 108(i) election, when there may be doubt whether an event – such as the modification to the terms of an existing loan – has triggered COD income. Substantive Guidance In addition to providing guidance on the timing and manner of making a deferral election, the IRS used the Revenue Procedure to resolve two particularly thorny issues with the statutory interpretation of Section 108(i). COD Income from Property Transfer. Curiously, the statutory language of Section 108(i) omits from its key definition (of the term “reacquisition”) one of the most common events that could give rise to COD income: a lender’s discharge of debt in exchange for the borrower transferring property to the lender (for example, a deed in lieu of foreclosure). Many tax advisors were concerned that the IRS would feel bound to a literal interpretation of the statute and would not permit the Section 108(i) election to be made when the event triggering COD income includes the transfer of property to the lender. In Rev. Proc. 2009-37, the IRS clarified the issue by expressly including the discharge of debt in exchange for a property transfer as a “reacquisition” event for which the Section 108(i) election may be made. NOTE: Deferral under Section 108(i) applies only to COD income. It is important to note that (i) the transfer of property securing a nonrecourse loan in connection with the discharge of that loan gives rise to taxable gain, and not COD income, so that Section 108(i) deferral is not available for gain from the transfer of property securing a nonrecourse loan and (ii) the transfer of property securing a recourse loan in connection with the discharge of that loan gives rise to taxable gain or loss equal to the difference between the fair market value (“FMV”) and the tax basis of the property and COD income, for which Section 108(i) deferral is available, is limited to the excess of the amount of the loan over the FMV of the property. The Revenue Procedure does nothing to change these results. Allocation of Deferred COD Income to S Corporation Shareholders. Based on the statutory language of Section 108(i) and the tax treatment of S corporations, it originally appeared that COD income of an S corporation that makes the Section 108(i) election would be allocated to S corporation shareholders who acquire their stock after the event that triggered the COD income (the reacquisition transaction). Rev. Proc. 2009-37 resolves this inequity by providing that an S corporation’s COD income that is deferred under Section 108(i) is to be shared pro rata only among the persons who are S corporation shareholders immediately before the reacquisition transaction. Guidance for Partnerships Particularly vexing issues arise in trying to apply Section 108(i) where the taxpayer/borrower is treated as a partnership. In Rev. Proc. 2009-37, the IRS provided guidance on two of these issues. Partnership Level Election/Partner Level Consequences. The statutory language of Section 108(i) requires that, in the case of a borrower that is a partnership, the election to defer COD income must be made by the partnership, and not by the partners individually. However, the tax treatment of COD http://www.dlapiper.com/irs-issues-much-needed-guidance-on-election-to-defer-cod-inco... 8/24/2009 DLA Piper | Publications | IRS issues much-needed guidance on election to defer COD in... Page 4 of 5 income – and in particular the availability of the exclusion of COD income in the case insolvency – is determined at the partner level, after COD income is allocated to the partners. Moreover, electing Section 108(i) deferral makes statutory exclusions, such as that for insolvency, inapplicable. As a result, Section 108(i) seemed to have set up a difficult conflict between partners who would prefer to realize COD income currently – in order to make use of exclusions for COD income or net operating losses available to the partner – versus partners who would prefer to defer COD income under Section 108(i). In Rev. Proc. 2009-37, the IRS seems to have cut through the partnership Gordian knot by combining two special rules: First, the partial election described above allows a partnership to determine what amount of COD income, if any, will be deferred under Section 108(i). Second, the Revenue Procedure allows a partnership to determine how COD income that is deferred under Section 108(i) and COD income that is recognized currently is to be allocated among its partners. The Revenue Procedure does not override the rules of Section 704(b) on how COD income may be allocated to the partners, but rather it permits the partnership to determine how much of each partner’s allocable share of COD income is treated as deferred under Section 108(i) and how much is not. By combining these two rules, the IRS appears to have fashioned a creative solution to the partnership problem: the Section 108(i) election remains with the partnership as required by the statute, but the partnership (and its partners) can determine the amount of COD income that will (and will not) be subject to Section 108(i) deferral on a partner-by-partner basis. Coordination with Rules for Allocating Partnership Liabilities. When a partnership borrower realizes COD income, there is a complex interplay among (x) the allocation of the COD income to the partners, (y) the deferral of COD income under Section 108(i) and (z) the rules for allocating partnership liabilities to the partners under Section 752 of the Code. Section 108(i) contains a special rule that attempts to integrate these provisions to prevent unintentionally undoing the benefit of the Section 108(i) deferral (the Section 752 Deferral Rule). The Revenue Procedure (x) provides operating rules necessary to determine each partner’s share of partnership liabilities to apply the Special Section 752 Deferral Rule and (y) matches subsequent deemed distributions of money under Section 752 in time and amount with the deferred COD income that the partner recognizes under Section 108(i). NOTE: The special rule for allocating partnership liabilities under Section 108(i) can produce unexpected results. The special rule provides relief only to the minimum extent necessary to avoid adverse tax consequences under Section 752 from Section 108(i) deferral of COD income. Other transactions after the events triggering COD income – such as cash distributions and other decreases in partnership liabilities – may trigger taxable gain to a partner sooner than may have been expected. Rev. Proc. 2009-37 does nothing to provide relief on this front. Overall, Rev. Proc. 2009-37 provides welcome guidance in applying Section 108(i) relief, and the IRS is to be commended for providing practical solutions to problems in making the relief work for taxpayers. However, many issues with applying Section 108(i) to real-world situations remain, and borrowers looking to take advantage of Section 108(i) relief should seek advice from qualified tax professionals. http://www.dlapiper.com/irs-issues-much-needed-guidance-on-election-to-defer-cod-inco... 8/24/2009 DLA Piper | Publications | IRS issues much-needed guidance on election to defer COD in... Page 5 of 5 For more information, please contact: Bruce Wein Chair, US Tax Group Joseph Langhirt Stephen Sharkey http://www.dlapiper.com/irs-issues-much-needed-guidance-on-election-to-defer-cod-inco... 8/24/2009