Posted by Jorge A. Guerrero, CPA
As a general rule, an individual taxpayer who is not considered insolvent or in bankruptcy may have to treat canceled debt unrelated to their personal home as taxable income. When a partnership or Subchapter S corporation has debt that is canceled or forgiven, the rules are a bit more complicated. This is due to the different requirements which each must follow.
Effect on Partnerships
When a partnership has its debt forgiven, the resulting income flows through to the individual partners. The partnership alerts the IRS of canceled debt on its tax return by answering “yes” to question 8 on schedule B (relating to canceled debt). The amount discharged is then allocated to the members and reported on schedule K-1. The insolvency and bankruptcy exclusions are therefore applied at the partner level. The partner’s may file Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness as part of their individual tax return, to claim an exclusion from income.
The IRS considers a taxpayer insolvent when his or her total liabilities before the discharge exceed the fair market value of total assets, including exempt assets such as retirement accounts and principal residence, before the discharge. The insolvency exemption applies only to the amount in which liabilities exceed assets.
Partnerships also make an election to exclude income from the discharge of qualified real property indebtedness at the partner level. The amount of income excluded reduces the partner’s depreciable basis in the real property. This election may be applied against other real business property within the partnership in which the partner has an interest, provided the other partners agree to the treatment.
Effect on Subchapter S Corporation
Subchapter S corporations handle the discharge of debt somewhat differently. They apply the insolvency and bankruptcy exclusions at the entity level, not the shareholder level. The amount discharged is reported on Schedule B of the corporate tax return and is reported and allocated to its shareholders as other income. The entity may file Form 982 to claim an exclusion from income. Any taxable portion remaining after the exclusion is passed through to the shareholder as other income.
A taxpayer may elect to exclude income from the discharge of indebtedness secured by real property used in a trade or business, as long as it is not related to farming. “Qualified real property business debt” is incurred or assumed in the acquisition, construction, reconstruction, or substantial improvement of real property. The amount of income that can be excluded for tax purposes is dependent on the lessor of two factors. The amount forgiven cannot exceed the adjusted basis of all depreciable property of the taxpayer or the excess principal amount of the outstanding debt over the fair market value of the real property securing the debt. Any amount excluded from income reduces the basis in the property effective at the beginning of the tax after the discharge occurs, or if disposed, immediately before disposal. The taxpayer must be solvent and not in bankruptcy to take advantage of the election.
When Subchapter S corporations have debt canceled on real property, they have the ability to elect the qualified real property exclusion at the entity level by filing Form 982 with their corporate tax return. The entity reduces its basis in the depreciable property for the amount of excluded income. Therefore, shareholders do not benefit from this election as partners in partnerships do.
There are also special rules for businesses which have filed for bankruptcy, have net operating losses, and those engaged in farming. Please contact one of our tax professionals to learn more about how the discharge of debt affects you and your business.