Cancellation of Debt – IRS Issues Final Regulations for Disregarded Entities and Grantor Trusts

Under current IRS rules, taxpayers must include income from the cancellation of debt (“COD”), also referred to as “discharge of indebtedness,” in gross income. There are certain exceptions to the inclusion of such income, two of which are bankruptcy and insolvency.

The term “indebtedness” under Internal Revenue Code (“IRC”) Section 108 means any indebtedness for which the taxpayer is liable or is subject to which the taxpayer holds property.

A “taxpayer” is defined by the IRS as any person subject to any internal revenue tax. For these purposes, a taxpayer is the owner of a grantor trust or disregarded entity.

A bankruptcy exception is granted only under a Chapter 11 bankruptcy, as defined by the Internal Revenue Code (IRC). Further, the discharge of debt through bankruptcy must be granted by the court. To qualify for the insolvency exception, a taxpayer’s liabilities must exceed their assets immediately before the time of discharge.

A disregarded entity is defined as an entity that is separate from its owner for federal income tax purposes. Typical examples include single member limited liability companies, qualified REIT subsidiaries, and qualified S Corporation subsidiaries.

A grantor trust is an entity owned by the grantor or another person.

The IRS had issued proposed regulations in 2011 with respect to whether grantor trusts or disregarded entities can be considered the “taxpayer” for purposes of those exceptions. It was determined that those entities themselves were not considered taxpayers, since they are not owners. The proposed regulations stated that for partnerships, the bankruptcy and insolvency exceptions are applied at the partner level, not the entity level.

Final regulations issued by the IRS have adopted these proposals, with modifications.

In summary, the final regulations state that neither a grantor trust nor a disregarded entity are considered to be taxpayers for the purposes of bankruptcy or insolvency exceptions. The owner of the grantor trust or disregarded entity is the taxpayer for these purposes. That said, the bankruptcy exception would apply if the owner is under Chapter 11 court jurisdiction as the debtor. For the insolvency exception to apply, the owner must be insolvent. If a partnership holds interest in either a grantor trust or disregarded entity, the exceptions are determined at the partner level.

The final regulations apply to COD income occurring on or after June 10, 2016.

For assistance with filing requirements and to ensure proper tax compliance, contact a Marcum professional.