CODI Regulations for Disregarded Entities

| 6/16/2016


On June 10, 2016, the IRS released final regulations addressing the treatment of cancellation of debt income (CODI) recognized by disregarded entities and grantor trusts. As a general rule, CODI is not taxable to a taxpayer who is insolvent or under the jurisdiction of the bankruptcy court in a title 11 proceeding. The final regulations provide that when a disregarded entity or a grantor trust is discharged of indebtedness, the owner of the disregarded entity or grantor trust is considered the taxpayer for purposes of applying the insolvency and bankruptcy exclusions.

The insolvency exclusion is available only if the owner of the disregarded entity or grantor trust is insolvent. While not explicitly stated in the regulations, the rule implies that the insolvency test is measured with respect to the combined assets and liabilities of the disregarded entity and the owner of the disregarded entity. This could lead to taxable CODI if the disregarded entity is insolvent but the owner is solvent.

If a grantor trust’s or a disregarded entity’s indebtedness is discharged in a title 11 case, the bankruptcy exclusion applies to the discharged indebtedness only if the owner of the grantor trust or disregarded entity also is under the jurisdiction of the court as a title 11 debtor. If the bankruptcy exclusion does not apply because the owner is not under the jurisdiction of the court in a title 11 case, the owner of the disregarded entity or grantor trust still can qualify for the exclusion if the owner is insolvent.

When a partnership has CODI, the insolvency exception is not determined at the partnership level. Instead, the insolvency exception is available only if the partner is insolvent. The regulations confirm that when a disregarded entity or grantor trust owned by a partnership has CODI, the availability of the insolvency exclusion also is determined with respect to the partner’s solvency. Similarly, the regulations provide that the bankruptcy exclusion is available only if the partner, and not the partnership or a disregarded entity or grantor trust owned by the partnership, is under the jurisdiction of the court in a title 11 case as the debtor.

The final regulations are effective for CODI events occurring on or after June 10, 2016, but the IRS will not challenge return positions taken prior to this date that are consistent with the proposed regulations as clarified by the final regulations.

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Howard Wagner
Partner, National Tax Services