IRS Clarifies Term "Taxpayer" for Purposes of Excluding Cancellation of Debt Income

(Parker Tax Publishing June 2016)

Final regulations define the term "taxpayer" for purposes of applying exclusions to recognizing cancellation of debt (COD) income of a grantor trust or an entity that is disregarded as an entity separate from its owner. T.D. 9771 (6/10/16).

While cancellation of indebtedness generally results in taxable income to a taxpayer, Code Sec. 108 allows taxpayers to exclude certain types of cancellation of debt (COD) income. Uncertainty about who qualified for the exclusion in the case of grantor trusts or disregarded entities caused problems for tax return preparers. In final regulations issued last week, the IRS clarified who the "taxpayers" were in such situations.

Under Code Sec. 108(a)(1)(A) and (B), gross income does not include any amount which would be includible in gross income by reason of the discharge of the indebtedness of the taxpayer if the discharge occurs in a title 11 case or when the taxpayer is insolvent. A "title 11 case" is defined as a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court. Code Sec. 108(d)(1) through (3) provide the meaning of the terms "indebtedness of the taxpayer," "title 11 case," and "insolvent," for purposes of applying Code Sec. 108, and each definition uses the term "taxpayer." Code Sec. 7701(a)(14) defines "taxpayer" as any person subject to any internal revenue tax.

In proposed regulations issued in 2011, the IRS provided that the term "taxpayer," as used in Code Sec. 108(a)(1) and Code Sec. 108(d)(1) through (3), refers to the owner of the grantor trust or the disregarded entity. The proposed regulations also provided that, in the case of a partnership, the owner rules apply at the partner level to the partners to whom the discharge of indebtedness is allocable. For example, if a partnership holds an interest in a grantor trust or a disregarded entity, the applicability of Code Sec. 108(a)(1)(A) and (B) to the discharge of indebtedness income is tested by looking to each partner to whom the income is allocable. Lastly, the proposed regulations clarified that, subject to the special rule for partnerships under Code Sec. 108(d)(6), the insolvency exclusion is available only if the owner is insolvent and the bankruptcy exclusion is available only if the owner is under the bankruptcy court's jurisdiction.

The final regulations adopt the proposed regulations with minor modifications. The final regulations are primarily limited to defining the term "taxpayer" for purposes of applying the bankruptcy and the insolvency exclusions from gross income, under Code Sec. 108(a)(1)(A) and (B), to the COD income of a grantor trust or a disregarded entity.

Consistent with the proposed regulations, the final regulations provide that the bankruptcy exclusion is available only if the owner of the grantor trust or the owner of the disregarded entity is under the jurisdiction of the court in a title 11 case. It is insufficient, the IRS said, for the grantor trust or the disregarded entity itself to be under the jurisdiction of the court in a title 11 case. The regulations further clarify that the owner of the grantor trust or the owner of the disregarded entity must be under the jurisdiction of the court in a title 11 case of that owner as the "debtor," as that term is defined in title 11 of the United States Code (i.e., the title 11 debtor).

The IRS rejected practitioner recommendations to extend the bankruptcy exclusion to the owner of a grantor trust or a disregarded entity when that owner is not itself in bankruptcy, saying such extension would be inconsistent with the intended purpose of Code Sec. 108(a)(1)(A), as reflected in the legislative history of that provision. According to the IRS, Congress did not intend that a solvent, non-debtor owner of a grantor trust or a disregarded entity, which has committed some but not all of its nonexempt assets to the bankruptcy court's jurisdiction, have an exclusion from discharge of indebtedness income merely by virtue of having some of its assets subject to the jurisdiction of the bankruptcy court.

Finally, the IRS addressed a practitioner's concern over whether the holdings in certain case law would be followed by the IRS - specifically the decisions in Gracia v. Comm'r, T.C. Memo. 2004-147; Mirarchi v. Comm'r, T.C. Memo. 2004-148; Price v. Commissioner, T.C. Memo. 2004-149; Estate of Martinez v. Commissioner, T.C. Memo. 2004-150 (collectively, the Gracia cases). Because the bankruptcy court had asserted jurisdiction over non-debtor partners for certain matters, the Tax Court in the Gracia cases upheld the application of the bankruptcy exclusion to the partners of a partnership that was a title 11 debtor, despite the fact that the partners were not title 11 debtors. The IRS said that its position is that the Gracia cases failed to interpret correctly the limited scope of Code Sec. 108(a)(1)(A), which applies only to partners that are also title 11 debtors. The IRS noted that, in AOD 2015-01, it issued a nonacquiescence in the Gracia cases.

For a discussion of the exclusion of income from discharge of indebtedness, see Parker Tax ¶76,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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