The IRS finalized regulations (TD 9771) that were issued in proposed form back in 2011(Proposed Reg. §1.108-9, REG-154159-09, 4/13/11) regarding cancellation of debt relief provisions for bankruptcy and insolvency found in IRC §108 as they relate to grantor trusts and disregarded entities (generally single member LLCs).

The IRS had indicated when the proposed regulations were issued that some taxpayers had attempted to interpret the provisions granting relief to taxpayers who had a discharge of indebtedness involving insolvency or bankruptcy as applying at the disregarded entity level rather than at the level of the taxpayer treated as the owner of the disregarded entity.

Example. ABC, LLC is a single member LLC owned by Harry. ABC owns a piece of land which is subject to a mortgage debt of $1,000,000. The debt is not a nonrecourse debt and ABC is primary obligor although Harry has guaranteed the debt. The property has declined in value since ABC acquired it and ABC ceases payments on the debt. The lender forecloses on the property at a time when the property is worth $500,000. After the foreclosure $500,000 of the debt remains unpaid and the lender does not seek payment from either ABC, nor seek to obtain the funds under the guarantee from Harry although Harry’s net worth (without regard to the guarantee) was $1,000,000 at that date. The bank did so because virtually all of that net worth arises from value in Harry’s retirement plan that is insulated from the claims of creditors.

Harry takes the position on his tax return that although there is $500,000 of cancellation of debt income, since ABC was insolvent at the date the debt was discharged IRC §108(a)(1)(B) excludes that $500,000 from inclusion as cancellation of debt income. As well, since Harry was merely a guarantor of the debt that sort of indirect reduction in liability does not lead to COD income on Harry’s return.

The IRS indicated in the preamble to the proposed regulations that the agency did not believe this was a proper interpretation of the IRC, but they planned to issue explicit regulations that would provide specifically that the insolvency test is applied at the deemed owner level (that is, Harry’s net worth of $1,000,000 would eliminate the use of the insolvency exception). Similarly, the bankruptcy exception would only apply if the owner was discharged from liability for the debt in bankruptcy—a discharge of the LLC in bankruptcy would not serve to trigger the rules.

Reg. §1.108-9(a) provides that neither a grantor trust nor a disregarded entity shall be treated as the “taxpayer” (that is, the party who may exclude the cancellation of income) for purposes of the insolvency or bankruptcy exclusions under IRC §108(a)(1)(A) and (B), nor the related provisions found at IRC §§108(d)(1), (2), (3) and (6).

The IRS also reiterates their position, found in Action on Decision 2015-01, that the taxpayer must actually file a bankruptcy petition for the bankruptcy discharge exclusion to count—that is, a discharge of the debt in a petition filed by the disregarded entity will not trigger this rule even if the court issues a specific discharge of the taxpayer’s own liability as part of the case. Note that this position is contrary to the Tax Court’s holding in the related cases of (Estate of Martinez v. Commissioner, T.C. Memo. 2004150, Gracia v. Commissioner, T.C. Memo. 2004147, Mirarchi v. Commissioner, T.C. Memo. 2004148; and Price v. Commissioner, T.C. Memo. 2004149)

Specifically, Regulation §1.108-9(a)(2) provides (note the last sentence):

If indebtedness of a grantor trust or a disregarded entity is discharged in a title 11 case, section 108(a)(1)(A) applies to that discharged indebtedness only if the owner of the grantor trust or the owner of the disregarded entity is under the jurisdiction of the court in a title 11 case as the title 11 debtor. If the grantor trust or the disregarded entity is under the jurisdiction of the court in a title 11 case as the title 11 debtor, but the owner of the grantor trust or the owner of the disregarded entity is not, section 108(a)(1)(A) does not apply to the discharge of indebtedness income.

The regulation goes on to provide the following provision that impacts the insolvency test [Regulation §1.108-9(a)(3)]:

The insolvency exclusion. Section 108(a)(1)(B) applies to the discharged indebtedness of a grantor trust or a disregarded entity only to the extent the owner of the grantor trust or the owner of the disregarded entity is insolvent. If the grantor trust or the disregarded entity is insolvent, but the owner of the grantor trust or the owner of the disregarded entity is solvent, section 108(a)(1)(B) does not apply to the discharge of indebtedness income.

The regulation also contains a definition of “disregarded entities” that are covered by the regulation, found at Reg. §1.108-9(c)(1):

For purposes of this section, a disregarded entity is an entity that is disregarded as an entity separate from its owner for Federal income tax purposes. See §301.7701-2(c)(2)(i) of this chapter, the Procedure and Administration Regulations. Examples of disregarded entities include a domestic single-member limited liability company that does not elect to be classified as a corporation for Federal income tax purposes pursuant to §301.7701-3 of this chapter, a corporation that is a qualified REIT subsidiary (within the meaning of section 856(i)(2)), and a corporation that is a qualified subchapter S subsidiary (within the meaning of section 1361(b)(3)(B)).

The regulation has an effective date as of the date of its publication in the Federal Register (June 10, 2016). However, since the IRS believes that this has always been the law, the agency notes:

The proposed regulations and these regulations are consistent with the existing statute. Accordingly, the IRS will not challenge return positions consistent with the proposed regulations, as clarified in these final regulations, for the period prior to the effective/applicability date of these final regulations.