4 key considerations for insolvent businesses to navigate Cancellation of Debt Income (CODI)
Southfield, Mich.—September 4, 2019—Margaret Amsden, CPA, a shareholder with Clayton & McKervey, a certified public accounting and business advisory firm helping growth-driven companies compete in the global marketplace, recognizes that companies dealing with cash flow issues or undergoing insolvency are managing stressful and time-sensitive financial matters. Rather than turning to outside vendors to settle outstanding debt, Amsden advises that companies consider Cancellation of Debt Income (CODI)—which can have a significant impact on a company’s or business owner’s taxes.
“It may be tempting to go a vendor to wipe out these debts immediately and for less than face value, but it’s important to note that the amount of debt that was cancelled could be taxable,” Amsden said. “The ability to free up cash to pay the tax while insolvent can prove very difficult, so businesses need to realize that a portion of the cancelled debt—if the taxpayer is insolvent—may qualify to be excluded from income.”
According to Amsden, treatment of CODI can be complex and varies greatly among taxpayers. She points to four key considerations when navigating debt discharge income correctly.
1.) The rule vs. The insolvency exemption
The Internal Revenue Code (IRC) states that gross income includes all income from whatever source derived; therefore, if a debt is canceled or forgiven, the debtor generally must include the canceled amount in gross income for tax purposes. However, under IRC Section 108, taxpayers who are insolvent qualify for an exemption from picking up the CODI in the current tax year. This insolvency exemption aims to alleviate the need for taxpayers to sell off assets to free up cash flow to pay the tax.
2.) Defining Insolvency
Before picking up the CODI amount as taxable income in the current year, the Fair Market Value (FMV) of assets and liabilities needs to be taken into account immediately prior to the discharge to see if any portion of CODI falls under the insolvency exemption. Discharge of indebtedness conveys forgiveness of, release from, and obligation to repay a debt. IRC Section 108(d) (3) states that a debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the FMV of the assets.
3.) Reduction of Tax Attributes
Excluding the amount from income is only the first step because the taxpayer must now “pay the price” for the exclusion. This begins by determining the amount of excess nonrecourse debt, or the amount that the debt exceeds the FMV of the assets. The exclusion of the CODI amount from gross income is now required to be used to reduce the taxpayer’s tax attributes, which include:
- General Business Credits
- Net Operating Losses
- Tax Basis of Assets
The complexity of reducing these tax attributes vary by the facts and circumstances of each taxpayer.
4.) Who is the Taxpayer?
If the insolvency occurs for an individual or corporation, both are considered taxpayers and the rules are applied directly. If the insolvency occurs for a pass-through entity, it is a bit more complicated:
- An S Corporation falls into the “corporate” bucket. Even though it passes its income through the insolvency and attribute reduction, it occurs at the corporate level.
- A Partnership, however, is not a taxpayer. It is necessary to disclose the information to each individual partner, with the determination of insolvency and income exclusion determined at the individual partner level. Since no two partners in any partnership are alike, it is important to consider all the facts and circumstances surrounding the particular scenario that applies.
Regardless of a company’s tax structure and financial position, CODI is a highly sensitive and intricate tax matter. Amsden says consulting with the appropriate accounting specialists is crucial to correctly navigating the tax complexity of debt discharge income and ensuring the company or business owner receives the best tax advantage possible.
About Clayton & McKervey
Clayton & McKervey is a full-service CPA firm helping middle-market entrepreneurial companies compete in the global marketplace. The firm is headquartered in metro Detroit and services clients throughout the world. To learn more, visit claytonmckervey.com.