Understanding related party debt forgiveness

Many times a debt between related parties is reduced or forgiven. This raises many questions:

  • Are there tax consequences as a result of this?
  • Does the lender have a tax loss to report?
  • Does the borrower have a gain on forgiveness of debt?

A partnership tax return on Form 1065, Item 8, Schedule b, asks if there has been debt that has been forgiven, changed or modified.

There are loans that in essence are capital transactions.  The debt also becomes, in effect, a capital transaction.

According to FASB ASC Section 470-50-40 (Debt Modification and Extinguishments), if the extinguishment of the debt is in effect a capital transaction it is not a gain or loss recognition event.

ASC Section 505-10-25, Equity, states that credits from transactions in the entities own stock should be excluded from the determination of net income.

For related party transactions the same type of analysis is required.

For related party goods and services subsequently forgiven, i.e., accrued expenses owed to a related party, the recognition of gain is determined on a case-by-case basis. If the original transaction has not yet been recognized as a cost, gain recognition is not appropriate if there is a forgiveness. If the transaction has been recognized as an expense then there is gain recognizable.

Because this is a muddy area of tax law, be sure to contact a ShindelRock tax professional if you find yourself in need of assistance in this area.