Tax Treatment for Discharge of Debt of Disregarded Entities and Grantor Trusts Clarified

On June 10, 2016, the Treasury Department (Treasury) and the Internal Revenue Service (the IRS) issued final regulations on the federal income tax treatment of discharge of debt issued by disregarded entities (e.g., single member LLCs) and grantor trusts (e.g., investment trusts). Under the regulations, the exemption of cancellation of debt income of taxpayers that are insolvent or in a Title 11 case (bankruptcy) only applies if the owner of the disregarded entity or grantor trust is insolvent or is a debtor in a bankruptcy case. With respect to bankruptcy cases, both the owner and the disregarded entity or grantor trust would generally need to be debtors in bankruptcy cases for the exception to apply.

Additionally, the Treasury and the IRS expressed their view that debt of a disregarded entity or grantor trust should be treated as “nonrecourse” debt for purposes of the insolvency exception, providing a much needed, albeit limited, indication of their views in an area of unclear law.

Background and the Finalized Regulations

Section 61 of the Internal Revenue Code of 1986, as amended (the Code), generally provides that a debtor recognizes taxable income upon the cancellation of debt that it owes (generally because the debtor received the cash and is no longer required to pay it back). Section 108 of the Code provides an exemption from such income if the debtor is insolvent or the discharge occurs in a Title 11 case. For these purposes, a discharge is considered to occur in a Title 11 case only if the taxpayer is under the jurisdiction of the court in such case and the discharge is granted by the court or is pursuant to a plan approved by the court.

The final regulations (Regulations) issued today by the Treasury and the IRS generally adopt and clarify proposed regulations issued in 2011 concerning the application of this exemption to debt issued by disregarded entities or grantor trusts. Under the Regulations, the exemption from discharge of debt income applies only if the owner of the disregarded entity or grantor trust is insolvent or is the debtor in a bankruptcy case. It is, therefore, insufficient and irrelevant that the disregarded entity or grantor trust is a debtor in a bankruptcy case. We note, however, that under the Regulations the bankruptcy exclusion generally will apply only if both the owner and the disregarded entity or grantor trust are debtors in bankruptcy cases. This is because the exemption only applies to a discharge granted by the court in a bankruptcy case, requiring the disregarded entity or the grantor trust also to be subject to the jurisdiction of the court.

Treasury and the IRS rejected comments that would have expanded the exemption to owners of disregarded entities where the disregarded entities are debtors in a bankruptcy case, as long as, for example, their owner filed a proof of claim in the bankruptcy case or is otherwise discharged by the bankruptcy court from any indirect liability for the debt of the entity. The treatment adopted in the Regulations is consistent with the treatment of partnerships, which looks to the partners, rather than the partnership, for purposes of determining whether the requirements of this exemption are satisfied.

Treasury and the IRS argued that the Regulations are consistent with the legislative history of the exemption. The objective of the exemption is to give a financially distressed taxpayer a fresh start not impeded by a tax liability that the taxpayer is unable to pay. Because the owner of a disregarded entity or grantor trust is the person liable for the tax resulting from the discharge of the debt of the disregarded entity or grantor trust, as long as such owner is able to pay such tax, there is no reason to exempt the income under this policy. The fact that the disregarded entity or grantor trust is insolvent and cannot pay the tax is irrelevant because the tax is not imposed on that entity.

While beyond the scope of these Regulations, consistent with this approach, Treasury and the IRS expressed their view that, for purposes of this exemption, the debt of the disregarded entity or grantor trust should be treated as the debt of the owner. Therefore the owner’s share of such discharged debt is generally taken into account in determining whether the owner is insolvent.

Debt of Disregarded Entities Treated as Nonrecourse

Importantly, in the preamble to the Regulations, Treasury and the IRS also expressed their view that the debt of a disregarded entity or grantor trust should be treated as “nonrecourse” for purposes of applying the insolvency exemption, notwithstanding that the debt might technically be recourse to all the assets of the disregarded entity or grantor trust. This is the case as long as the owner neither guarantees the debt nor is otherwise personally liable for the debt. Because the treatment of debt issued by disregarded entities, such as single member LLCs, as recourse or nonrecourse for various purposes of the Code is currently unclear, the preamble provides a much needed, albeit limited, indication of the views of Treasury and the IRS on this matter.

The preamble to the Regulations indicates that Treasury and the IRS anticipate publishing additional guidance and invite taxpayer comments.

We will continue to monitor these developments closely.

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