If you loan someone $10,000 and then either forgive or cancel part of the loan (perhaps because it is too difficult to collect the debt) and the forgiveness or cancellation is not a gift, you probably haven’t realized that such forgiveness will create taxable income for the person whose debt is partially or entirely forgiven or cancelled. For example, I loan Betty $10,000.00 for an addition to her house with every intention of getting paid back. Betty pays me back $5,000. I cancel the remaining $5,000 for which Betty has to report as income on her personal Form 1040.
Section 61 of the Internal Revenue Code (the “Code”) provides that forgiveness of indebtedness is included in gross income. However, as with almost everything under the tax law, Section 108 of the Code provides exceptions to the general rule. The Internal Revenue Service (“Service”) recently addressed the bankruptcy and insolvency exceptions which provide that the amount of a debt cancellation is NOT included in a “taxpayer’s” gross income IF the “taxpayer” is in bankruptcy or insolvent.
What happens if, under the Code, a person is treated as the grantor of a trust or owner of a disregarded entity (“owner”) and the trust or disregarded entity is in bankruptcy or is insolvent? Is the owner the “taxpayer” entitled to the benefit of the exceptions? Owners have been taking the position that, if their disregarded entity or trust is in bankruptcy or insolvent, but the owner is not personally in bankruptcy or insolvent, the owner is considered the “taxpayer” and can take advantage of the bankruptcy and insolvency exceptions and need not report forgiveness of indebtedness income.
The Service, in final regulation 1.108-9, effective on June 10, 2016, (the proposed regulation was issued in 2011 and has not been substantively changed since 2011), makes clear that the term “taxpayer” means an owner of the disregarded entity or trust. Thus, to receive the benefit of the exceptions and avoid forgiveness of indebtedness income, the “taxpayer” owner must ALSO be in bankruptcy or insolvent even though, for Federal income tax purposes, the entity is disregarded.
ADVICE: If you think you are the lucky recipient of the complete or partial forgiveness of debt, don’t let this tax law surprise you. You will be very unhappy when you receive a Form 1099 for forgiveness of indebtedness income a couple of months before your tax return is due and have no idea that income taxes were ever due. Carefully review this regulation if an entity or trust of which you are a grantor or owner received a partial or full cancellation of indebtedness for which the bankruptcy or insolvency exception applies.
WORD OF THE WEEK: Disregarded entity, as that term is defined in the Internal Revenue Code, is an entity which is disregarded as separate from its owner. The income and expenses of the entity are reported directly on your individual tax return The best example is a single member limited liability corporation (“LLC”). While the LLC is created under state law, the Service permits the LLC to be disregarded for INCOME tax purposes. Thus, all the income and expenses can be reported directly on your own Form 1040.
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