Understanding related party debt
- 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?
Unfortunately, there is no clear answer.
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. If the extinguishment of the debt is in effect a capital transaction it is not a gain or loss recognition event.
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.
Here are a few examples:
- “If an owner contributed inventory to the business, and that inventory had not yet been recognized in cost of sales, gain recognition is not appropriate for the forgiveness of the related liability”.
- “In the example of deferred compensation, the deferred compensation arrangement had been recognized as an expense at the time the liability was forgiven. This fact suggests that recognizing gain may be appropriate.”
In the end, this is a very muddy area of tax law.
At ShindelRock, we can help you understand the facts and document the file accordingly if you experience this type of event during a reporting year.