Discharge of indebtedness, income exclusion for grantor trusts, disregarded entities

Discharge of indebtedness, income exclusion

The Treasury Department and IRS today released for publication in the Federal Register final regulations providing guidance under section 108(a) concerning the exclusions from gross income of discharge of indebtedness income of a grantor trust or an entity that is disregarded as an entity separate from its owner.

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These regulations provide that—for purposes of applying the bankruptcy and insolvency exclusions under section 108 to the discharge of indebtedness income of a grantor trust or a disregarded entity—the term “taxpayer” refers to the owner(s) of the grantor trust or disregarded entity, not the grantor trust or disregarded entity itself. 

 

The final regulations [PDF 207 KB] adopt regulations that were proposed in April 2011 with certain changes. The final regulations apply to the discharge of indebtedness income occurring on or after the date these final regulations are published in the Federal Register (which will be June 10, 2016).

Background

Proposed regulations were issued in 2011 to address the claims by some taxpayers that the bankruptcy and insolvency exclusions under section 108 are available to the extent a grantor trust or disregarded entity is in bankruptcy or is insolvent—even if its owner is not.

The proposed regulations rejected this position, and clarified that the exclusions are available only to the extent the owner is in bankruptcy or is insolvent.The proposed regulations also provided that, in the case of a partnership, the ownership rules apply at the partner level to the partners to whom the discharge of indebtedness income is allocable. Thus, subject to the special rule for partnerships under section 108(d)(6), the proposed regulations provided that the bankruptcy exclusion applies only if the partner is under the bankruptcy court’s jurisdiction and that the insolvency exclusion applies only if the partner is insolvent.

Final regulations

The final regulations follow the proposed regulations and provide some additional guidance. 

Consistent with the proposed regulations, the final regulations provide that the bankruptcy and insolvency exclusions are applied at the owner level. The final regulations further clarify that the bankruptcy exclusion requires the owner to be a “title 11 debtor” to be considered “under the jurisdiction” of the bankruptcy court.  Moreover, when the owner is a partnership, the partner to whom the discharge of indebtedness income is allocated must be a “title 11 debtor” in order for the bankruptcy exclusion to apply. This clarifying provision was added in response to the Tax Court’s decision in the Gracia case (and related comments) that the owner could be “under the jurisdiction” of the bankruptcy court without being a title 11 debtor. The preamble to the final regulations concludes that extending the bankruptcy exception to an owner who is not a debtor in bankruptcy would be inconsistent with the intended purpose of the bankruptcy exception, as reflected in the legislative history.  

In addition, the final regulations acknowledge that a trust that is treated as a grantor trust for federal tax purposes may be treated as a business trust for purposes of eligibility to be a debtor in a bankruptcy case and, thus, have retained references in the final regulations to grantor trusts. 

Moreover, the final regulations clarify that the indebtedness of a grantor trust or a disregarded entity is considered the indebtedness of the owner for purposes of section 108(d)(1). As a result, the final regulations provide that generally such debt is to be treated as nonrecourse for purpose of the insolvency exclusion—assuming the owner has not guaranteed the indebtedness or is not otherwise liable for it under applicable law.  Accordingly, the final regulations provide that the principles of Rev. Rul. 92-53 apply to determine the extent to which such nonrecourse indebtedness is taken into account in determining the owner’s insolvency.  

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