Proposed Regs Explain Code Sec. 108 COD Exclusion For Grantor Trusts And Disregarded Entities

Preamble to Prop Reg, Prop Reg §1.108-9

IRS has issued proposed regs that would provide guidance in applying the Code Sec. 108 bankruptcy and insolvency exclusions for cancellation of debt (COD) income to grantor trusts and disregarded entities. Specifically, the proposed regs would clarify the meaning of the term “taxpayer,” as used in Code Sec. 108, with regard to a grantor trust or a disregarded entity. The regs would apply to COD income occurring on or after the date they are published as final regs.

Background. Under Code Sec. 61(a)(12), COD income from the cancellation of indebtedness is generally includable in gross income. However, Code Sec. 108 provides a number of exclusions. Gross income doesn't include any amount which would otherwise be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if the discharge occurs in a Title 11 case (i.e., bankruptcy) (Code Sec. 108(a)(1)(A)), or to the extent the taxpayer is insolvent when the discharge occurs. (Code Sec. 108(a)(1)(B)) The terms “indebtedness of the taxpayer” “Title 11 case,” and “insolvent” are defined for purposes of applying the COD exclusions in Code Sec. 108(d)(1) through Code Sec. 108(d)(3), with each definition using the term “taxpayer.” Code Sec. 7701(a)(14) defines a “taxpayer” as any person subject to any internal revenue tax.

The Code and regs provide for several types of disregarded entities. For example, under the “check-the-box” entity classification rules, Reg. §301.7701-2(a) provides that a business entity includes an entity with a single owner that may be disregarded as an entity separate from its owner under Reg. §301.7701-3. An example of a such a disregarded entity is a domestic single-member limited liability company (LLC) that doesn't elect to be classified as a corporation for Federal income tax purposes. In addition, some disregarded entities are created by statute—e.g., a corporation that is a qualified real estate investment trust (REIT) subsidiary under Code Sec. 856(i)(2), and a corporation that is a qualified subchapter S subsidiary under Code Sec. 1361(b)(3)(B). The disregarded entity's activities are treated in the same manner as a sole proprietorship, branch, or division of the owner (except for certain employment and excise tax rules). Thus, for Federal income tax purposes, all of the disregarded entity's assets, liabilities, and items of income, deduction, and credit are treated as the assets, liabilities, and such items of the owner of the disregarded entity.

A grantor trust is any part of a trust that is treated (under subpart E of part I of subchapter J of chapter 1) as being owned by the grantor or another person. In the case of any grantor trust, items of income, deductions, and credits attributable to the trust are includable in computing the owner's taxable income and credits.

The issue. Some taxpayers have taken the position that the Code Sec. 108(a)(1)(A) bankruptcy exception is available if a grantor trust or disregarded entity is under the jurisdiction of a bankruptcy court, even if its owner is not. Similarly, some taxpayers have contended that the Code Sec. 108(a)(1)(B) insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. The taxpayers argue that because, for Federal income tax purposes, the disregarded entity is disregarded and the “taxpayer” is the owner of the disregarded entity's assets and liabilities, the taxpayer is properly seen as being subject to the bankruptcy court's jurisdiction.

IRS doesn't believe this is an appropriate application of the Code Sec. 108 bankruptcy and insolvency provisions. (Preamble to Prop Reg)

Proposed regs. The proposed regs would provide that, for purposes of applying Code Sec. 108(a)(1)(A) and Code Sec. 108(a)(1)(B) to discharge of indebtedness income of a grantor trust or a disregarded entity, the term “taxpayer,” as used in Code Sec. 108(a)(1) and Code Sec. 108(d)(1) through Code Sec. 108(d)(3), refers to the owner(s) of the grantor trust or disregarded entity. The proposed regs clarify that, subject to the special rule for partnerships under Code Sec. 108(d)(6), the insolvency exception is available only to the extent the owner is insolvent, and bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court's jurisdiction. Further, the proposed regs would provide that grantor trusts and disregarded entities themselves will not be considered owners for this purpose. (Prop Reg §1.108-9(a))

In addition, the proposed regs would provide that in the case of a partnership, the owner rules would apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. (Prop Reg §1.108-9(b)) For example, if a partnership holds an interest in a grantor trust or disregarded entity, the applicability of Code Sec. 108(a)(1)(A) and Code Sec. 108(a)(1)(B) to COD income of the grantor trust or disregarded entity is tested by looking to the partners to whom the income is allocable. If any partner is itself a grantor trust or disregarded entity, the applicability of Code Sec. 108(a)(1)(A) and Code Sec. 108(a)(1)(B) is determined by looking through the grantor trust or disregarded entity to the ultimate owner(s) of the partner. (Preamble to Prop Reg)

References: For exceptions to the recognition of income on the discharge of indebtedness, see FTC 2d/FIN ¶J-7400; United States Tax Reporter ¶1084.01; TaxDesk ¶188,011; TG ¶12931.