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Insolvent S Corp Can't Exclude Income from Debt Cancelled as Part of Sale of Property

(Parker Tax Publishing August 2023)

The Tax Court held that the sole shareholder of an insolvent S corporation could not exclude from gross income the amount of nonrecourse debt that was cancelled in connection with a sale of property. The court found that if nonrecourse debt relief is conditioned on a sale or exchange of property, or is otherwise a part of that underlying sale or exchange, the amount of debt relief is properly included in the amount realized under Code Sec. 61(a)(3) and is not cancellation of debt income under Code Sec. 108(a)(1)(B). Parker v. Comm'r, T.C. Memo. 2023-104.


In 2012, Exterra Realty Partners, LLC (Exterra), is an S corporation for federal income tax purposes. Exterra was a real estate development company operating in California. Michael Parker was the 100 percent shareholder, president, and chief executive officer of Exterra.

Exterra was the sole member of PLF-XIII, LLC, and PLF-XIV, LLC (together, PLF entities), each of which was treated as a disregarded entity for federal income tax purposes. In turn, PLF-XIII was the sole member of Montevina Phase I, LLC, while PLF-XIV was the sole member of Montevina Phase II, LLC; both Montevina Phase I and Montevina Phase II (together, Montevina entities) were also treated as disregarded entities. Separate from this structure, Parker was individually the sole member of another disregarded entity which held real property in Iowa.

In March 2007, through the Montevina entities, Exterra purchased 23.6 acres of real property in Livermore, California (Livermore property), for the purpose of commercial development. In order to finance the purchase of the Livermore property, the PLF entities and the Montevina entities took out a total of five loans - Loans N709A, N709B, N712A, N712B, and N713 - from NRFC WA Holdings, LLC, an unrelated third-party lender.

PLF-XI used Loan N713 to contribute $1,500,000 to Montevina Phase I and $500,000 to Montevina Phase II. Parker personally signed a guaranty for payment of all five loans. Loans N709A, N709B, N712A, and N712B were each nonrecourse as to Exterra. Loans N712A and N712B were mezzanine loans - a type of hybrid financing often used in commercial real estate where the debtor typically pledges as collateral its equity interest in another entity. Loans N712A and N712B were secured by a pledge of the PLF entities' membership interests in the Montevina entities. At some point around or after March 2007, a separate entity, NRFC WA Holdings II, LLC, acquired from NRFC WA Holdings all of the loans relating to the purchase and development of the Livermore property by Exterra or its subsidiaries.

On October 4, 2012, Exterra entered into an agreement to sell the Livermore property to a pair of unrelated individual third-party purchasers. In a membership interest purchase and sale agreement, the PLF entities agreed to sell their sole membership interests in the Montevina entities to the buyers in exchange for nominal consideration. In a consent and release agreement between the Montevina entities, Parker, NRFC WA Holdings II, and the buyers, the buyers agreed to assume Parker's personal guaranty obligations on two of the loans. The consent and release agreement provided that the buyers would make a partial payment of $7,400,000 on the Phase I mortgage to NRFC WA Holdings II. As part of the consent and release agreement, Parker also agreed to deliver the deed to the Iowa property in escrow. In a pair of loan termination agreements, NRFC WA Holdings II agreed to cancel the unpaid balance of Loans N712A and N712B owed by the PLF entities, including all accrued interest and related fees and costs. Both loan termination agreements included the following recital: "In connection with the proposed sale by [the PLF entities] of all of [their] interest[s] in [the Montevina entities], [the PLF entities] and [NRFC WA Holdings II] have agreed to terminate the Loan Documents on the terms, and subject to the conditions, set forth herein."

On its original 2012 Form 1120S, U.S. Income Tax Return for an S Corporation, Exterra included in its gross receipts (1) the debt assumed by the buyers in the sale of the Livermore property and (2) the cancellation of the mezzanine loans. After offsetting cost of goods sold and deductions, Exterra reported ordinary business income of $2,741,399. Exterra subsequently filed an amended Form 1120S in which it reduced its gross receipts by $2,741,399 and attached Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). On the Form 982 Exterra reported $2,741,399 as a discharge of indebtedness excluded to the extent insolvent and reduced its basis of depreciable property and net operating loss in corresponding amounts. The $2,741,399 related to the cancellation of debt (COD) for Loan N712A and/or Loan N712B. As of October 4, 2012, Exterra was insolvent up to $2,741,399. This change resulted in Exterra's reporting zero in ordinary business income on the amended Form 1120S. Exterra issued an amended Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., to Parker to reflect the reduction in ordinary business income. Exterra did not include in income any amounts relating to Loan N713 on either its original or amended Form 1120S.

For 2012 Parker and his wife filed an original Form 1040, U.S. Individual Income Tax Return, on which they reported $2,741,399 in flowthrough income from Exterra. Subsequently, the Parkers filed an amended return reflecting the amended Schedule K-1 and reporting zero in flowthrough income from Exterra. In 2016, the IRS issued to the Parkers a notice of deficiency for 2012, which included an upward adjustment to Exterra's gross receipts of $2,741,399. The Parkers took their case to the Tax Court.

Code Sec. 61(a) broadly defines gross income as all income from whatever source derived. Code Sec. 61(a)(3) specifies that gross income includes gains derived from dealings in property, while Code Sec. 61(a)(12) does the same for income from the discharge of indebtedness. The distinction between these two subcategories of gross income - gain from property and COD income - can have significant tax consequences.

Under Code Sec. 1001(b), when a taxpayer sells or disposes of property, the amount realized is equal to the amount of money plus the fair market value of any property received. Reg. Sec. 1.1001-2(a)(1) provides that when a taxpayer sells or otherwise disposes of property encumbered by nonrecourse debt, the amount of the outstanding debt is typically included in the amount realized.

In contrast, a COD that is not part of a sale or exchange of property generally results in COD income, which may be subject to a statutory exclusion. Relevantly, Code Sec. 108(a)(1)(B) allows a taxpayer who is insolvent at the time of a debt cancellation to exclude COD income from gross income. Where nonrecourse debt relief is conditioned on a sale or exchange of property or is otherwise a part of that underlying sale or exchange, the amount of debt relief is properly included in the amount realized and is not COD income. For example, in Simonsen v. Comm'r, 150 T.C. 201 (2018), the Tax Court focused on the fact that the lender's willingness to cancel mortgage debt was completely dependent on the debtor's willingness to convey the proceeds from the sale of a residence.


The Tax Court held that the cancellation of Loans N712A and N712B by NRFC WA Holdings II was dependent on Exterra's sale of the Livermore property and was a part of the sale transaction. Accordingly, given that the cancelled loans were nonrecourse as to Exterra, the court held that the amount of debt relief was properly includable in Exterra's amount realized on the sale of the Livermore property and gave rise to gain to the extent in excess of Exterra's basis in the property. In turn, that gain flowed through to the Parkers' personal income tax returns via their 100 percent shareholder interest in Exterra.

In the court's view, the threshold question in this case was whether the cancellation of the loans gave rise to gain or COD income to Exterra. The court found that Loans N712A and N712B were secured by the PLF entities' pledge of their respective membership interests in the Montevina entities. Because the PLF entities and the Montevina entities were disregarded entities, Exterra was treated as owning the underlying assets (i.e., the Livermore property), subject to the nonrecourse mezzanine Loans N712A and N712B, before the sale. The sale of the PLF entities' membership interests in the Montevina entities was, in turn, characterized for tax purposes as a sale of the encumbered Livermore property by Exterra.

Further , it was clear to the Tax Court that the cancellation of Loans N712A and N712B was part of the sale by Exterra (through the disregarded entities) of the Livermore property. The court noted that the loan termination agreements provided that the loan cancellations were made "in connection with the proposed sale." The court also pointed out that the loan termination agreements were executed on October 4, 2012 - the same date as the various other agreements effecting the sale of the Livermore property, including the consent and release agreement to which NRFC WA Holdings II was a party, were executed. In the court's view, the COD was part and parcel of the global agreement to convey the Livermore property, with NRFC WA Holdings II accepting new personal guarantees, a partial payment by the buyers, and the escrowed deed to the Iowa property in consideration of that cancellation.

For a discussion of gains derived from dealings in property, see Parker Tax ¶70,701. For a discussion of cancellation of indebtedness income, see Parker Tax ¶72,301.

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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