Debtors who attempt to discharge debts through discounted payments or repurchases of their outstanding obligations are often surprised to learn that the amount “saved” through the discount may be subject to income tax. Earlier this year, a relief provision was adopted as part of the American Recovery and Reinvestment Tax Act of 2009 (“Act”).
Section 108(i) of the Act provides that, at a debtor’s election, income realized in connection with a discount after December 31, 2008, and before January 1, 2011, may be included in income ratably over a five-year period, beginning with the debtor’s fourth or fifth taxable year following the taxable year of the discount. If a debtor makes the permitted election and repays or repurchases the debt through a discount under a new note or other instrument resulting in original issue discount (“OID”), then interest deductions for this OID also are deferred.
The new procedures issued under the Act generally require a debtor to make the Section 108(i) election by including a statement with the return of tax imposed for the taxable year in which the discounted payment or repurchase occurs that clearly identifies the applicable debt instrument. The statement must include the amount of income to which Section 108(i) applies and other information the Service may prescribe. An election may relate to all or just a portion of the discounted debt. Once made, the election is irrevocable and may not be modified.
In the case of a pass-through entity, such as a partnership or S-corporation, the entity makes the election. The income attributable to the discount is allocated and deferred among the partners in the same manner as income is included in the partners’ distributive shares. The income attributable to the discount is allocated and deferred among S-corporation shareholders pro rata only among those shareholders who were shareholders immediately before the repayment or repurchase.
Once the election is properly filed by attachment to a timely filed (including extensions) original federal income tax return for the applicable taxable year, and satisfaction of certain other requirements, the IRS will grant an automatic 12-month extension and deferral.
A debtor within the scope of the new procedures may treat multiple debt instruments that are part of the same issue and that are reacquired during the same taxable year as one applicable debt instrument for purposes of this revenue procedure. A pass-through entity may not treat multiple debt instruments as one under these procedures if the owners and their ownership interests in the pass-through entity immediately prior to the reacquisition of each debt instrument are not identical.
Current economic conditions have forced many debtors to discharge debts through discounted payments or repurchases. The new procedures offer a way to soften the tax impact otherwise associated with such actions. If you desire additional information regarding these new procedures, please contact us.
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