Deferral of COD Income
By Sean Kelley, Senior -
Income arising from the discharge of indebtedness, often referred to as “COD income”, is generally required to be included in the taxable income of a taxpayer. Internal Revenue Service Section 108, which governs the rules surrounding COD income also provides some flexibility to this rule. Section 108 states that COD income arising from the following situations can be excluded from gross income:
- The COD occurs in a Title 11 bankruptcy case,
- The COD occurs when the taxpayer is insolvent,
- The indebtedness discharged is qualified real property business indebtedness (non C-corps),
- The COD is qualified principal residence indebtedness which is discharged before January 1, 2013,
- The COD is qualified farm indebtedness.
In these circumstances, rather than including the COD in gross income, the COD can be used to reduce certain tax attributes of the taxpayer, such as NOL and credit carry forwards. This can be especially beneficial to a taxpayer who would not be able to utilize these tax attributes otherwise.
The American Recovery and Reinvestment Tax Act of 2009 added some modifications to the above rules. The new law states that COD arising from the reacquisition of an applicable debt instrument occurring after December 31, 2008 and before January 1, 2011 shall be included in gross income ratably over a five year period beginning in either the fourth or fifth taxable year following the taxable year in which the reacquisition occurs. If the reacquisition occurred in 2009, it’s the fourth following year. If it occurs in 2010, it’s the fifth following year.
The term “reacquisition” is defined by the code as an acquisition by either the debtor which issued (or is otherwise the obligor under) the debt instrument or a related person to such debtor. The debt can be acquired for cash, through the exchange of another debt instrument, (including an exchange resulting from a modification of the debt instrument), for corporate stock or partnership interest, or through a contribution of the debt instrument to capital. An applicable debt instrument can be defined as any debt instrument such as a bond, debenture, note, certificate or any other instrument or contractual arrangement constituting indebtedness issued by a C-corporation or any other person in connection with the conduct of a trade or business by such person.
As an example, let’s say that in 2009, a taxpayer reacquires for $10 million, notes issued with an adjusted issue price of $16 million. The total COD income arising from the transaction is $6 million. Assuming the deferral election is made, instead of $6 million being recognized in 2009, the taxpayer, instead, would recognize $1.2 million ($6 million divided by 5) a year over a 5 year period, beginning in 2014, which is the 5th tax year after the year of the reacquisition. If the reacquisition happened in 2010, the first year of recognition would be the 4th taxable year instead, so the initial year of recognition would still be 2014.
In a scenario where debt is reacquired through use of another debt instrument (a debt for debt exchange) and the instrument used in the exchange has original issue discount (OID), the deductions for OID on the new instrument may also be deferred, at least in part. For the years preceding the start of the five year period for recognizing the deferred income, the issuer of the new instrument is allowed no deduction for OID accruals, except to the extent the accruals exceed the debt discharge income. These disallowed OID deductions can later be deducted ratably over the same five year period for recognizing the deferred income.
With regards to partnerships and other “pass through” entities, the deferral elections are made at the entity level. An electing partnership must allocate the deferred income among its partners immediately before the discharge in the manner that it would have allocated the income had it not elected to defer it. The entity may also determine what portion of a partner’s COD income is deferred and what portion will be included in the partner’s gross income. This amount can be different for each partner or stockholder. For example, one partner’s deferred amount can be zero while another partner may elect to defer their entire portion of COD income.
A taxpayer can make the deferral election by including a statement with their tax return which clearly identifies the applicable debt instrument, the amount of COD income, and certain other prescribed information. A separate election must be made for each reacquired debt instrument. The election can be made for any portion of the COD income realized from the reacquisition and each applicable debt instrument can be treated differently. The election is not an all or nothing decision. However, once the election is made, it is irrevocable.
It is important to realize that the new deferral option is not compatible with the rules previously mentioned. Thus, if an insolvent taxpayer has COD income from the reacquisition of a debt instrument he can choose to exclude the COD income and reduce the corresponding tax attributes, OR to defer the COD income. The deferral option can potentially be very beneficial to a taxpayer who plans on utilizing their tax attributes in the future. On the other hand, the exclusion option can be more beneficial to a taxpayer who would otherwise not be able to utilize the tax attributes that will ultimately be lost. Other factors can also come in to play in determining which scenario is more attractive, such as the need for cash flow or future tax and interest rates. If the requirements for both options are met, the taxpayer and the trusted tax advisor can decide on the alternatives.
Remember, this is not an all or nothing decision, so it is possible for the taxpayer to decide to use the exclusion rules on one portion of COD income and use the deferral rules on another. When used properly and combined with the existing exclusion rules, the new deferral option can result in significant tax savings for certain taxpayers.