CANCELLATION OF INDEBTEDNESS (Part 3)
As we indicated in the discussion in Part 2, cancellation of debt (COD) can also occur with a partnership or S corporation. As you know neither of these type of entities pay income tax, the individual partners or shareholders pay income tax on their prorate share of the profits.
These types of businesses can have COD similar to an individual. They have debts such as real estate mortgages, lines of credit, accounts payable, leases, vehicle loans, etc. Discharge of indebtedness under title 11 and principal residence would not apply to these businesses, but all the rest would.
The IRS recognizes that these entities have credit and COD issues just like those of individual. How does the IRS give the same COD relief to partnerships and S corporations as provided to individuals if those entities do not pay tax?
The process is much more complicated. Basically each partner or shareholder must request in writing that the partnership or S corporation elect to have the COD treated for tax purposes under one of these three exclusion options:
- Qualified real business property
- Qualified farm
The computations used to elect any of these exclusions are made at the individual partner or shareholder level not at the company level. Therefore, it is possible for one partner to elect under the insolvency exclusion as he is insolvent. Another partner could elect under the qualified real business property as he was solvent. The company must report on each partner’s or shareholder’s K-1 his or her prorated portion of the COD and tax treatment the he or she specifically made by direction to the company. The company must also attach a copy of each partner’s or shareholder’s election to its Form 1065 or Form 1120S.
The company needs to reduce tax attributes to the extent of the COD effective the first day of the next tax year. Typically this is a reduction in the basis of depreciable property. Therefore, future deprecation will be reduced. The use of these methods in essence is a deferral of the recognition of income from the COD. A $100,000 of COD in year one is not taxed but the depreication expense over the next few years may be reduced by $5,000 per year which means the taxable income for those years will be increased by the same $5,000.
The partner or shareholder will have to make elections and prepare and attach Form 982 to their individual tax return as it relates to the COD that is reflected on their K-1.
COD is a very complex part of the Internal Revenue Code. This three-part overview has been presented very simply to give you an overview of an important tax treatment in light of today’s difficult economic times. We strongly suggest that you contact us, if you have COD or potential COD issues on any level. We will be able to assist you after we have an understanding of the particular facts and circumstances of your situation.