Deferring COD Income: Burden May Outweigh Benefit
The election provided in the American Recovery and Reinvestment Act of 2009 (ARRA) to defer until 2014 and spread over five years cancellation of debt income (CODI) has been touted as an attractive relief option for taxpayers struggling with cash flow problems. However, partnerships and S corporations and their owners should weigh against that potential tax benefit complex recordkeeping and reporting requirements that can arise, especially in the case of partial elections and the provision's interaction with exclusions for bankruptcy and insolvency. The election is available for CODI resulting from the reacquisition in 2009 and 2010 tax years of applicable debt instruments. An applicable debt instrument is one issued by a C corporation or any other person in connection with a trade or business conducted by that person (IRC [section] 1080)(3)). For prior JofA coverage, see "Tax Consequences of Mortgage Discharge," Nov. 2009, page 54. SOLOMONIC WISDOM REQUIRED The bankruptcy or insolvency exclusion is determined at the partner or shareholder level (section 108(d)(6)), whereas the deferral election is made at the partnership or S corporation level (section 108(i)(5)(B)(iii)). An example of a simple partnership containing only two limited partners, one of whom is bankrupt and one of whom is solvent, illustrates the potential conflict. The insolvent or bankrupt partner would want to rely on the exclusion, whereas the solvent partner would want to rely on the new election to effectuate the deferral. Since the deferral trumps the exclusion, the partners would be placed in an adversarial position, and the general or tax matters partner of that partnership would be faced with a task requiring the wisdom of Solomon. This and other points are addressed in the statute and guidance, including temporary and proposed regulations issued Aug. 11, 2010 (TD 9498 and REG-144762-09; see "Tax Matters: COD Income Deferral Regs Issued," page 66). The electing partnership must first allocate all of the CODI to partners in the partnership immediately before the debt cancellation in the manner in which the income would be included in their distributive shares without regard to section 1080). The partnership may elect a full or partial deferral of CODI under section 1080). The partnership may then determine by any manner how much of each partner's allocable share of the CODI represents a portion of the deferred amount and how much is taken into account for the tax year of the debt reacquisition. In other words, for each qualifying debt reacquisition, each partner may be allotted a portion of deferred income up to the amount of that partner's share of CODI and the partnership's aggregate section 1080) deferral for that reacquisition. See Temp. Treas. Reg. [section] 1.108(i)-2T. In the simple example above, the partnership could elect to defer 50% of the CODI and report as income the other 50%. The deferred amount could be allocated to the solvent partner, allowing that partner to defer the income until 2014 and recognize it ratably over the next five years, while currently recognized income could be allocated to the insolvent partner, who may rely on the bankruptcy or insolvency exclusion. ISSUES OF SCALE The further problem is that not all partnerships are as small and as simple as the above example. Consider a large national partnership with diverse partners who are strangers to each other, and whose financial conditions are not readily known. In addition to the complexity of determining each partner's preferences for allocating a partial deferral, voluminous disclosures and statements must be distributed to them with Schedule K-1 and attached to their returns. …