LAKE COUNTY BAR ASSOCIATION CANCELLATION OF DEBT INCOME AND OTHER STRATEGIC CONSIDERATIONS RELATED TO BANKRUPTCY AND WORKOUT OF TROUBLED LOANS

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1 LAKE COUNTY BAR ASSOCIATION CANCELLATION OF DEBT INCOME AND OTHER STRATEGIC CONSIDERATIONS RELATED TO BANKRUPTCY AND WORKOUT OF TROUBLED LOANS OCTOBER 13, 2014 PRESENTED BY: DAVID J. SCHWAB OF RALPH, SCHWAB & SCHIEVER, CHTD. and VASILLI D. RUSSIS OF KELLEHER & BUCKLEY, LLC RALPH, SCHWAB & SCHIEVER, CHTD. 175 E. HAWTHORN PARKWAY SUITE 345 VERNON HILLS, IL TELEPHONE: (847) FACSIMILE: (847) KELLEHER & BUCKLEY, LLC 102 S. WYNSTONE PARK DRIVE SUITE 100 NORTH BARRINGTON, ILLINOIS TELEPHONE: (847) FACSIMILE: (847)

2 Attorney Biographies David J. Schwab. Since 1990, Mr. Schwab has developed a law practice with a focus in bankruptcy and creditor/debtor rights, business planning and restructuring, and commercial litigation. He and his law firm, Ralph, Schwab & Schiever, Chtd., are recognized by Martindale Hubbell s Bar of Preeminent Lawyers in the areas of Bankruptcy Law, Business Law, and Commercial Litigation. As a trained CPA and practicing attorney, Mr. Schwab is uniquely qualified to assist financially troubled companies, analyze their legal options, and assist them toward a successful resolution of their legal/financial issues. Mr. Schwab received his law degree from the DePaul University College of Law. While in law school, he was an executive editor of the DePaul Business Law Journal. He also served as an extern for the Hon. Robert E. Ginsberg, United States Bankruptcy Judge. In that position he researched the law and drafted legal opinions for cases being heard by Judge Ginsberg. Prior to law school, Mr. Schwab worked as a business consultant for Coopers & Lybrand (now PriceWaterhouseCoopers). He obtained his undergraduate degree in accounting from Indiana University. Recognized by his peers as an experienced lawyer in bankruptcy and financial workouts, Mr. Schwab has served as a lecturer for the Lake County Bar Association (Bankruptcy Committee), the Association of Illinois Attorney-Certified Public Accountants, the Milwaukee County Bar Association and the Federal Reserve Bank of Chicago. He is a co-author of Assignment of Rents in Bankruptcy for the Commercial Law League of America (Seminar in Advanced Bankruptcy Practice). Mr. Schwab has served as past President of Illinois Association of Illinois Attorney-Certified Public Accountants, a member of the Board of Directors of Northwest Community Bank, and has served on the DePaul University College of Law Alumni Board. He is also an active member of the American Bankruptcy Institute and the Chicago Bar Association Bankruptcy Committee. Mr. Schwab is admitted to practice in the State of Illinois and the U.S. Bankruptcy and U.S. District Courts for the Northern District of Illinois. 2

3 Vasili D. Russis. Mr. Russis' practice concentrates on the representation of closely held businesses and wealthy individuals, mainly in the areas of tax planning, estate planning, business structuring, sales, mergers, and acquisitions, trust and estate litigation, income tax compliance, asset protection, estate and trust administration, probate law, disputes with the Internal Revenue Service, matters heard before the United States Tax Court, real estate and litigation involving commercial matters. Additionally, Mr. Russis has previously represented publicly held companies in various matters. Mr. Russis obtained his Bachelor s of Science in Accountancy from the University of Illinois Urbana/Champaign and has been a certified public accountant since Mr. Russis obtained his Juris Doctorate from Chicago Kent IIT College of Law. Mr. Russis has spoken before the Chicago Bar Association and Illinois CPA Society. He also co-authored the article "Federal Court Denies Protection in Bankruptcy for Inherited IRA" for the Illinois State Bar Association. Prior to attending law school, Mr. Russis worked in the tax department at Arthur Andersen & Co. 3

4 INCOME FROM DISCHARGE OF INDEBTEDNESS A. Unless a statutory exception applies, income from the discharge of indebtedness owing by a taxpayer is included in income for tax reporting purpose. (a) General definition.--except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: * * * (12) Income from discharge of indebtedness; 26 U.S.C.A. 61(a)(12) (West). B. Income from discharge of indebtedness includes: 1. The satisfaction of an obligation at less than the amount owing,(i.e., negotiating a discount); 2. Cancellation or forgiveness of an obligation that is owing; 3. Material modification of existing debt through a restructuring such as an exchange of an old note for a new note or a significant change in the terms of an existing note 4. Collection period expires by lapse of time or enforcement statue 5. Outstanding indebtedness of a debtor is acquired by a related person 6. Debtor corporation acquires its indebtedness from a shareholder as a contribution to capital where the shareholder's basis in the debt is less than the "basis" owing by the corporation See Generally, Tax Aspects of Bankruptcy Law and Practice (Third Addition) Thompson West Chapters 22-23) Note - Keep in mind that gain from a foreclosure sale of property secured by a non-recourse loan (subject to recapture rules) is NOT cancellation of indebtedness income and exclusions are not available (COD income does not come from the sale or exchange of property secured by non-recourse debt) C. "Indebtedness of the taxpayer" means any indebtedness 1. for which the taxpayer is liable, or 2. subject to which the taxpayer holds property (d) Meaning of terms; special rules relating to certain provisions. (1) Indebtedness of taxpayer.--for purposes of this section, the term indebtedness of the taxpayer means any indebtedness-- 4

5 (A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property. 26 U.S.C.A. 108 (d)(1) (West) D. "Indebtedness of the taxpayer" may not include: 1. Contingent indebtedness, i.e., loan guarantee. Arguably may not be true debt. 2. Judgment debt, i.e., fine or punitive judgment. Arguably may not be true debt for "freeing of assets" consideration. 3. Contested liability. A judicially created exception that may apply in limited circumstances. See Generally, Tax Aspects of Bankruptcy Law and Practice (Third Addition) Thompson West Chapters 22-23) E. Income from discharge of indebtedness can be excluded from income if 1. The discharge occurs in a title 11 case ( Bankruptcy Case ) but only if the taxpayer is under the jurisdiction of the bankruptcy court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court. 2. The discharge occurs when the taxpayer is insolvent. The term "insolvent" means the excess of liabilities over the fair market value of assets determined immediately before the discharge. Note: Exempt property is not to be excluded in the insolvency calculation. (a) The insolvency exclusion is limited to the amount by which a taxpayer is insolvent. 3. The indebtedness discharged is qualified farm indebtedness 4. In the case of a taxpayer other than a C-corporation, the indebtedness discharged is qualified real property business indebtedness. 5. Mortgage debt secured against a qualified principal residence provided it s discharged prior to January 1, (a) Exclusion from gross income.-- (1) In general.--gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if (A) the discharge occurs in a title 11 case, (B) the discharge occurs when the taxpayer is insolvent, 5

6 (C) the indebtedness discharged is qualified farm indebtedness (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or (E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, U.S.C.A. 108(a)(1) (West) 6. Qualified farm indebtedness is debt that discharged in a farmer's in-court or out-of-court settlement where the farmer is solvent at the time the debt is discharged or to the extent he becomes solvent as a result of debt being discharged. However, the excludable amount is limited to the extent of the farmer's tax attributes, determined after applying the insolvency rules adjustment, including the basis of farmland and other business or investment property. A. A qualifying individual is one engaged in farming where (a) 50% or more of the aggregate gross receipts for the three taxable years immediately prior to the year of discharge is from farming, and (b) qualified debt was incurred directly in connection with the operation of a farming trade or business. B. Qualified farm debt is debt obtained from a person who is regularly engaged in the business of lending money and who is not related to the borrower and is not the person from whom the farmer acquired the property. 7. In the case of a taxpayer other than a C-corporation, the indebtedness discharged is qualified real property business indebtedness. The excludable amount is limited to the basis of certain depreciable property. (a) "Qualified real property business indebtedness" means indebtedness which (1) was incurred or assumed in connection with real property used in a trade or business and is secured by such real property, (2) was incurred or accrued before January 1, 1993, or if incurred or assumed after such date, is qualified acquisition indebtedness, and (3) such taxpayer selects to have this paragraph apply. (b) Qualified real property indebtedness does not include qualified farm indebtedness. 6

7 (c) "Qualified acquisition indebtedness" means debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property securing such debt. (d) The amount excluded cannot exceed the excess of (a) the outstanding debt principal over (b) the FMV of the business real property securing such debt. (e) The excluded amount may also not exceed the adjusted basis of real property held by the taxpayer immediately before the discharge. (Basis is determined as of the first day of the next taxable year or earlier if the property is disposed after the discharge occurs and before the end of the taxable year. This provision does not apply to the extent the taxpayer is insolvent.) 8. The order in which exclusions are applied is that (i) Title 11 exclusion is applied first; followed by the (ii) insolvency exclusion; then (iii) the qualified farm and qualified real property business exclusions and (iv) if applicable, the principal residence exclusion takes precedence over the insolvency exclusion. (2) Coordination of exclusions. (A) Title 11 exclusion takes precedence.-- Subparagraphs (B), (C), (D), and (E) of paragraph (1) shall not apply to a discharge which occurs in a title 11 case. (B) Insolvency exclusion takes precedence over qualified farm exclusion and qualified real property business exclusion.--subparagraphs (C) and (D) of paragraph (1) shall not apply to a discharge to the extent the taxpayer is insolvent. (C) Principal residence exclusion takes precedence over insolvency exclusion unless elected otherwise.--paragraph (1)(B) shall not apply to a discharge to which paragraph (1)(E) applies unless the taxpayer elects to apply paragraph (1)(B) in lieu of paragraph (1)(E). 26 U.S.C.A. 108 (a)(2)(west) 9. To the extent an amount is excluded from gross income under the Title 11( Bankruptcy ), insolvency or qualified farm debt provisions, an adjustment must be made to reduce the taxpayer's tax attributes. This is the price a 7

8 taxpayer bears for the exclusion benefit. Attributes are to be reduced in the following order: (1) a net operating loss for the taxable year of the discharge and any net operating loss carryovers to such taxable year (2) any general business credit carryover to or from the taxable year of the discharge (3) any minimum tax credit available as of the beginning of the taxable year following the year of the discharge (4) any net capital loss for the taxable year of the discharge and any capital loss carryover to such taxable year (5) the basis of property of the taxpayer (6) any passive activity loss or credit carryover from the year of the discharge (7) foreign tax credit carryovers to or from the taxable year of the discharge. 26 U.S.C.A. 108 (b)(west) Additionally, under 26 U.S.C.A. 108(6)(5), a taxpayer, in lieu of the reduction of tax attributes above, can elect to reduce the basis of its depreciable property by the amount of the exclusion, 26 U.S.C.A 1017 governs the manner of these reductions. 10. Recapture needs to be taken into account when gain is present. If there is depreciation of an asset later sold at a gain, the depreciated asset is considered ordinary income, not capital gain. Treasury Regulations under IRC Section 1245 address matters with partnerships and deal with issues involving newly admitted parties. Real estate sates - 25% tax, undepreciated property otherwise depreciable (a/k/a Unrecaptured Section 1250 (gain ) - capital gains on land 8

9 IMPACT OF CANCELLATION OF DEBT ON PARTNERSHIPS I. General Provisions A. Current Law 1. I.R.C. Section 108(d)(6) debt cancellation was not excludable at the partnership level but would instead be allocated to the individual partners under I.R.C. Section Debt discharge is applied at the partner level. (6) Certain provisions to be applied at partner level.--in the case of a partnership, subsections (a), (b), (c), and (g) shall be applied at the partner level. 26 U.S.C.A. 108(d)(6) (West) 3. Although the partnership is liquidated in a Chapter 7 proceeding, the debts are not discharged since only an individual can obtain a discharge in a Chapter 7 proceeding. 11 U.S.C. Section 727(a)(1). 4. IRS Section 108(e) (8) provides when a partnership interest is transferred to a creditor in satisfaction of a debt, the partnership has COD income to the extent the debt exceeds the FMV of the interest received. II. Impact of Debt Discharge on the Partnership and the Individual Partners A. Partnership B. Partner 1. The partner's distributive share of the income of the partnership resulting from the debt discharge increases each partner's basis in the partnership. I.R.C. Section The decrease in the partnership's liabilities will result in a distribution under I.R.C. Section 752, decreasing each partner's basis in his or her partnership interest under I.R.C. Section 733. A solvent partner who has not filed a bankruptcy petition would consider the debt cancellation to be ordinary income unless the discharge occurred prior to January 1, 1987 and the partner elected to reduce the basis under the qualified business indebtedness provision. Whereas, an insolvent partner or partner in bankruptcy would be subject to rules that apply to the debt discharge of income for taxpayers under those conditions. The taxpayer would either reduce certain tax attributes or first elect to reduce the basis of depreciable property. 9

10 IMPACT OF CANCELLATION OF DEBT ON S-CORPORATIONS Unlike partnerships, the treatment of cancellation of debt for S-Corporations is made at the corporation level. Whether a shareholder is bankrupt, insolvent or entitled to utilize any other exclusions is irrelevant. (7) Special rules for S corporation. (A) Certain provisions to be applied at corporate level.-- In the case of an S corporation, subsections (a), (b), (c), and (g) shall be applied at the corporate level, including by not taking into account under section 1366(a) any amount excluded under subsection (a) of this section. 26 U.S.C.A. 108(d) (7) (West) SEPARATE ENTITY RULE Upon the filing by a debtor who is an individual under either a Chapter 7 or Chapter 11 Bankruptcy Case, the bankruptcy estate is treated as a separate taxable entity. 26 U.S.C.A. 1398(a) (West). Section 1398 applies only when a debtor who is an individual files under Chapter 7 or Chapter 11 of the Bankruptcy Code, but a separate taxable entity is not created in Chapter 12 or U.S.C.A. 1398(a) (West). SHORT YEAR ELECTION Upon the filing of a bankruptcy case, a debtor who is an individual has a right to make a short year election. 26 U.S.C.A. 1398(d) (2) (West). A short year election permits a debtor to shift pre-petition tax liabilities to priority claims against a bankruptcy estate. 11 U.S.C.A. 507(a) (8). DETERMINATION OF INCOME OF A BANKRUPTCY ESTATE The items to be included in gross income of a bankruptcy estate consist of gross income of the estate beginning on and continuing after the date the case is commenced. 26 U.S.C.A. 1398(e) (1) (West). However, the bankruptcy estate will not include gross income of the debtor if received or accrued by the debtor before the commencement date. Id. Conversely, the gross income of the debtor will not include any income item to the extent that such item is included in the gross income of the bankruptcy estate. 26 U.S.C.A. 1398(e) (2) (West). 10

11 CANCELLATION OF DEBT INCOME Whether the debtor of the bankruptcy estate reports cancellation of debt income depends upon when the taxable event occurs. If the taxable event occurs before commencement of the case, generally the debtor should recognize income under Sub- Section 61(a) (12) of the Internal Revenue Code ( I.R.C. ) (26 U.S.C.A. 61(a) (12) (West)) unless it can be excluded under Section 108(a) of the I.R.C. (26 U.S.C.A. 108(a) (West)). If the taxable event occurs after commencement of the case, then the bankruptcy estate should recognize income under Section 61(a) (12) (26 U.S.C.A. 61(a) (12) (West)) of the I.R.C. unless it can be excluded under Section 108(a) (26 U.S.C.A. 108(a) (West)) of the I.R.C. AS A RESULT, A DEBTOR CAN CONTROL THE FILING OF A BANKRUPTCY AND THUS CAN DIRECT WHETHER A TAXABLE EVENT OCCURS PRE OR POST BANKRUPTCY THROUGH THE USE OF A SHORT YEAR ELECTION UNDER SECTION 1398 (D)(2) OF THE I.R.C. 26 U.S.C.A. 1398(d) (2) (West). PASS-THROUGH ENTITIES However, the timing when a cancellation of debt income event occurs with regard to pass through income is less certain. The recognition of gain or loss by an individual member of an LLC or a partnership and shareholder of an S-Corporation is assessed on the last day of the tax year of the entity (e.g. December 31 st ) or calendar year tax payers. 11

11/3/2011. Debt & Taxes

11/3/2011. Debt & Taxes Debt & Taxes Elizabeth A. Maresca Clinical Associate Professor Fordham Law School, New York, NY Tax & Consumer Litigation Clinic I. General Rules: Income from discharge of indebtedness, exemptions and