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What’s Next?

Do you feel as challenged as I do when someone asks you to explain the term “Bidenomics”?[i] I know that it is predicated upon the imposition of higher taxes on businesses and their owners, which have not yet materialized.[ii] However one defines it, the White House tells us that it’s working, which some folks say is a good thing.

I can’t tell you with any certainty what that means. From my own relatively limited perspective, I’ve seen U.S. debt downgraded, the federal budget deficit return to pre-pandemic levels (not a good thing), banks fail, regional banks downgraded, and large layoffs at major so-called “tech” companies as well as at other large employers.

Closer to home, business owners (small and middle market) tell me they are unable to find workers, more business clients are acutely cost-conscious over fees,[iii] NYC law firms have announced large layoffs and are deferring the start dates of newly minted attorneys, other struggling firms are in merger talks, commercial landlords are using cheaper paper in restrooms, restaurants are delivering smaller meals to the office (without napkins or plastic cutlery), and the local McDonald’s has increased by two dollars its “Two For” breakfast sandwich deal. Perhaps worst of all, there are way fewer potato chips in the bags that accompany my tuna salad sandwich, and the pickles have vanished.

What can we make of all this? Depending upon which pundit you ask, we may or may not be looking at a recession in the not-too-distant future. Last week, Secretary Yellen, speaking at a climate roundtable in China (of all places), said the economy is on a “good path” and that she does not expect a recession. Still, an article in last Sunday’s Wall Street Journal stated that investment in U.S. startups declined 49% in the year ended June 30, 2023.[iv] Moreover, according to one investor quoted in the article, “What we have right now is a perfect storm resulting in more than usual shutdowns.”[v]

If the Administration’s forecast is inaccurate, then it is likely that tax advisors will experience an uptick in the number of questions from investors, business owners, and their creditors regarding the income tax consequences of debt restructurings[vi] and debt forgiveness.

A recent decision[vii] of the U.S. Tax Court illustrates the importance of determining the nature of the indebtedness and the form in which it is realized by the debtor taxpayer.

The Transaction  

Corp was a real estate development company that had elected to be treated as an S corporation for federal income tax purposes. Taxpayer was Corp’s sole shareholder and also served as its president.

Corp was the sole member of several LLCs (together, the Group One entities), each of which was treated as a disregarded entity for federal income tax purposes.[viii] One of these LLCs was, in turn, the sole member of two other LLCs (together, the Group Two entities) that were also treated as disregarded entities for income tax purposes. Separate from this structure, Taxpayer was individually the sole member of another LLC, which was also disregarded for tax purposes. This last was a member of yet another LLC that held real property in Iowa.

The Loans

Acting through the Group Two entities, Corp acquired real property in California for the purpose of commercial development. In order to finance the purchase of this property, LLCs from the Group One and from the Group Two entities obtained five loans from Holdings, an unrelated third-party lender.

Taxpayer personally guaranteed payment of all five loans, four of which were nonrecourse as to Corp. Two of the loans were mezzanine loans,[ix] which were secured by a pledge of the Group One entities’ membership interests in the Group Two entities.

One of the Group One borrowers made a capital contribution of the proceeds from their loan to two of the Group Two entities.

The Sale

Corp subsequently entered into an agreement to sell the California property to a pair of unrelated individual third-party purchasers (Buyers). Several agreements were executed on the same day by the various parties, including a membership interest purchase and sale agreement, under which the Group One entities agreed to sell their membership interests in the Group Two entities to the Buyers in exchange for nominal consideration.

In a consent and release agreement between the Group Two entities, Taxpayer, Holdings, and the Buyers, the Buyers agreed to assume Taxpayer’s personal guaranty obligations on two of the senior loans that were secured by mortgages on the California property. The consent and release agreement provided that the Buyers would make a partial payment on one of the mortgages to Holdings. As part of the consent and release agreement, Taxpayer also agreed to deliver the deed to the Iowa property in escrow, with release of the deed to Holdings to be made more than three years later. The consent and release agreement also included the following recital: “[Holdings] has agreed to consent to the Subject Transactions, the termination of the Existing Mezzanine Loans, and the assumption by [the Buyers] of the obligations of [Taxpayer] . . . subject to the terms and conditions stated below, including, without limitation, consummation of the Subject Transaction, [Holdings’s] receipt of the [payment] and the execution of the agreements and documents. . . .”

Debt Cancellation

In a pair of loan termination agreements, Holdings agreed to cancel the unpaid balance of the mezzanine loans owed by the Group One entities. Both loan termination agreements included the following recital: “In connection with the proposed sale by [the Group One entities] of all of [their] interest[s] in [the Group Two entities], [the Group One entities] and [Holdings] have agreed to terminate the Loan Documents on the terms, and subject to the conditions, set forth herein.”

Corp realized approximately $40.6 million in the aggregate from the Buyers’ assumption of the senior debt.

In addition, Corp realized approximately $12.7 million from the mezzanine debt cancelled by Holdings.

Tax Returns

For the year in which the foregoing events occurred (the “Tax Year”), Corp filed an original Form 1120-S, U.S. Income Tax Return for an S Corporation, on which it reported over $53.0 million in gross receipts, which consisted of (1) the debt assumed by the Buyers in the sale of the California property and (2) the cancellation of the mezzanine loans. After offsetting cost of goods sold and certain deductions, Corp reported ordinary business income in excess of $2.7 million.  

Amended Return

Corp subsequently filed an amended Form 1120-S, in which it reduced its “gross receipts” – amount realized – from the sale of the California property by $2.7 million. In addition, Corp filed IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, on which it reported the same amount as income from the cancellation of indebtedness.[x]  

On the Form 982, Corp reported that its liabilities exceeded the fair market value of its assets by $2.7 million immediately before the discharge. Under the Code’s insolvency exclusion,[xi] Corp excluded from its gross income $2.7 million of discharge of indebtedness income; i.e., the amount by which Corp was insolvent.[xii] The $2.7 million was related to the cancellation of two mezzanine loans owed by Group One entities. As a result of this change – recharacterizing the cancelled debt as ordinary income and claiming the insolvency exclusion – Corp reported zero ordinary business income on its amended S corporation return.

Schedule K-1

Taxpayer filed an original Form 1040, U.S. Individual Income Tax Return, for the Tax Year on which they reported $2.7 million in flowthrough income from Corp.[xiii]

Following Corp’s issuance of an amended Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., Taxpayer filed an amended income tax return to report the reduction in his flowthrough share of Corp’s ordinary business income from $2.7 million to zero.

Notice of Deficiency

The IRS examined Corp’s return for the Tax Year and issued a notice of deficiency to Taxpayer determining a tax deficiency of more than $3.0 million. The deficiency included an upward adjustment of $2.7 million to Corp’s gross receipts from the sale of the California property.  

Taxpayer timely filed a petition with the Tax Court disputing the IRS’s deficiency determinations.

The Tax Court[xiv]

The principal issue for decision before the Court was whether the income from the cancellation of Corp’s nonrecourse debt in connection with the sale to Buyers should have been included in the S corporation’s amount realized on the sale of the real property or treated as cancellation of debt (COD) income and thus excluded from gross income pursuant to the Code’s insolvency exclusion.[xv]

Tax Treatment of Debt Cancellation

The Code broadly defines gross income as “all income from whatever source derived.” It then specifies that gross income includes “[g]ains derived from dealings in property,”[xvi] as well as “[i]ncome from discharge of indebtedness.”[xvii] 

The distinction between these two categories of income — gain from the sale of property and COD income — can have significant tax consequences.

When a taxpayer sells or disposes of property, the amount realized is equal to the amount of money plus the fair market value of any property received.[xviii] 

Generally speaking, the amount realized from a sale of property includes the amount of liabilities from which the seller is discharged as a result of the sale.[xix] This is the case whether the debt is nonrecourse, meaning the creditor’s remedies are limited to the particular collateral for the debt, or recourse, in which case the creditor’s remedies extend to all the debtor’s assets. 

Nonrecourse Debt

Thus, when a taxpayer sells property encumbered by nonrecourse debt, the amount of the outstanding debt is typically included in the amount realized.[xx]  To the extent that the amount realized exceeds the taxpayer’s basis in the property, the taxpayer has gain.[xxi] 

The fair market value of the property securing the nonrecourse debt at the time of the sale of such property is not relevant for purposes of determining the amount of liabilities from which the taxpayer is discharged or treated as discharged. Thus, the fact that the fair market value of the property is less than the amount of the liabilities it secures does not prevent the full amount of those liabilities from being treated as money received from the sale of the property.[xxii] 

Recourse Debt

In contrast, the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness.[xxiii]

Thus, where the fair market value of the property that secures the recourse debt  is less than the amount of such debt, the amount realized from the sale of the property is limited to the fair market value of the property. Without more, the person selling the property remains personally liable for repayment of the balance of the debt that exceeds the fair market value of the property.

However, if this remaining debt is cancelled, the cancellation is not treated as part of the sale or exchange of the property. Instead, the cancellation generally results in ordinary COD income, which may then be subject to certain statutory exclusions.[xxiv]

Insolvency Exclusion

Of relevance to the present case, the Code[xxv] allows a debtor-taxpayer who is insolvent at the time of a debt cancellation to exclude COD income from their gross income. The amount of this exclusion is limited to the amount of the taxpayer’s insolvency; i.e., the amount by which the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets.[xxvi] 

Amount Realized or COD?

The Court explained that, in deciding whether debt relief results in gain from the sale of an asset or COD income, the Court must focus on the facts and circumstances surrounding how the taxpayer-debtor satisfied or extinguished the underlying debt. According to the Court, if nonrecourse debt relief is conditioned upon a sale or exchange of property, or is otherwise a part of that underlying sale or exchange, the amount of debt relief is properly included in the amount realized and is not COD income.[xxvii]  In such an instance, it was immaterial, the Court stated, whether debt relief takes the form of an assumption of debt by a purchaser or a cancellation by a lender. 

The IRS contended that the $2.7 million relating to the cancellation of the two mezzanine loans was taxable to Corp as gain derived from the sale of the California property, emphasizing that these loans were nonrecourse to Corp and were cancelled as part of the sale of the property.

Taxpayer took a different approach, sidestepping the threshold inquiry — whether the debt cancellation was part of the sale of the California property and thus gave rise to gain — and focused on their contention that either Corp or Taxpayer was insolvent at the time the debt was discharged. 

The Court, however, observed that much of Taxpayer’s argument was premised on a misconception[xxviii] that facts relating to Taxpayer in his personal capacity were relevant to the question of whether there was income to Corp which then flowed through to Taxpayer as Corp’s only shareholder.

The Court stated that, in determining whether to sustain the IRS’s upward adjustment to Corp’s gross receipts (and thus the corresponding deficiency with respect to Taxpayer), it had to respect Corp’s separate corporate existence from Taxpayer. The Court explained that it would be improper to treat income earned by the S corporation through its trade or business as though it were earned directly by its shareholder.[xxix]  

Accordingly, the Court continued, Taxpayer’s assertion that the two mezzanine loans were recourse as to Taxpayer personally was simply irrelevant to the issue before the Court.[xxx]

The Court agreed with the IRS that the threshold issue was whether the cancellation of the mezzanine loans gave rise to gain or to COD income for Corp.

The Court noted that parties had stipulated that the loans were nonrecourse as to the Group One entities and to Corp. The parties further stipulated that the loans were each mezzanine loans that were secured by the Group One entities’ pledge of their membership interests in the Group Two entities. Because both sets of entities were disregarded for federal income tax purposes, the Court treated Corp as owning the California property subject to the nonrecourse mezzanine loans before the sale.[xxxi]  In turn, the sale of the Group One entities’ membership interests in the Group Two entities was characterized for federal income tax purposes as a sale of the encumbered California property by Corp.[xxxii] 

The record further demonstrated that the cancellation of the two mezzanine loans was part of the sale by Corp, albeit through the disregarded entities, of the California property to the Buyers. As the relevant loan termination agreements between the Group One entities and Holdings represented, the loan cancellation was made “[i]n connection with the proposed sale.” Further, the loan termination agreements were executed on the same date that the various other agreements effecting the sale of the property, including the consent and release agreement to which Holdings was a party, were executed.

Thus, the COD was part and parcel of the global agreement to convey the California property, with Holdings accepting new personal guaranties, a partial payment by the Buyers, and the escrowed deed to the Iowa property in consideration of the cancellation.

Accordingly, given that the loans were nonrecourse as to Corp, the amount of debt relief was properly includible in Corp’s amount realized on the sale of the property and gave rise to gain to the extent it exceeded Corp’s basis in the property.[xxxiii] In turn, that gain flowed through to Taxpayer’s personal income tax return via his shareholder interest in Corp.


The Court held that the $2.7 million was properly includible in Corp’s amount realized on the sale of the property and sustained the notice of deficiency.

Of course, the Court’s decision was spot on. That said, there may be circumstances in which it will be more difficult to parse through the layers of entities, including partnerships, and the contractual arrangements among them, to determine the true nature of a particular indebtedness. As always, it will behoove the parties to avoid leaving much room for interpretation beyond what they intended.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] The Administration describes the President’s economic policy as comprising three pillars: investment in “infrastructure” (broadly defined), empowerment of labor, and lower costs through competition. 

[ii] I suppose that means the implementation of the President’s economic program is being funded by additional federal debt.

[iii] “To be acutely conscious is a disease, a real, honest-to-goodness disease.” Notes From Underground (1864), by Fyodor Dostoevsky. 

[iv] Startups Wilt Amid Draught in Funding, by Berber Jin, Aug. 13, 2023.

[v] You know, the ones founded by someone with an idea for a product or a new service, who pours almost everything they have into it, and if all goes well will make them fabulously wealthy while also creating many new jobs.

[vi] Don’t overlook the Cottage Savings regulations – Reg. Sec. 1.1001-3.

[vii] Parker v. Comm’r, United States Tax Court (filed August 10, 2023).

[viii] Reg. Sec. 301.7701-3(b)(1)(ii).

[ix] A mezzanine loan is a type of hybrid financing often used in commercial real estate, where the debtor typically pledges as collateral its equity interest in another entity.  With respect to a mezzanine loan, the creditor thus sits in an intermediate position to recover from the debtor, junior to any mortgage debt but senior to equity. 

[x] Generally, the amount by which a taxpayer benefits from the discharge of indebtedness is included in the taxpayer’s gross income. However, under certain circumstances (described in IRC Sec. 108), the taxpayer can exclude the amount of discharged indebtedness from gross income. The taxpayer must file Form 982 to report the exclusion.

[xi] IRC Sec. 108(a)(1)(B).

[xii] Corp also reduced its basis for depreciable property and its net operating loss in corresponding amounts. The Code requires the reduction of the taxpayer’s tax attributes in order to recapture at a later time (at least in theory) the present tax benefit arising from the exclusion of the debt cancellation from the taxpayer’s gross income. The taxpayer must file Form 982 to report the reduction of these tax attributes. IRC Sec. 108(b).

[xiii] IRC Sec. 1366.

[xiv] The Court began its discussion by explaining that where a notice of deficiency issued to a shareholder of an S corporation includes adjustments to both S corporation items and other items unrelated to the S corporation, the Court has jurisdiction to determine the correctness of all adjustments in the shareholder-level deficiency proceeding. Thus, the Court stated, it had jurisdiction to redetermine the correctness of the IRS’s adjustments to Taxpayer’s flowthrough share of Corp’s income and any other determinations in the notice of deficiency.

[xv] In general, the IRS’s determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving them erroneous. Rule 142(a)(1).  

[xvi] IRC Sec. 61(a)(3).

[xvii] IRC Sec. 61(a)(11). 

[xviii] IRC Sec. 1001(b).

[xix] Reg. Sec. 1.1001-2(a). This assumes that the liability was incurred by reason of the acquisition of the property and was taken into account in determining the transferor’s basis for such property. Reg. Sec. 1001-2(a)(3).

[xx] See Commissioner v. Tufts, 461 U.S. 300, 317 (1983); Crane v. Commissioner, 331 U.S. 1 (1947); Reg. Sec. 1.1001-2(a)(1).

[xxi] IRC Sec. 1001(a).

[xxii] Reg. Sec. 1.1001-2(b).

[xxiii] Reg. Sec. 1.1001-2(a)(2).

[xxiv] IRC Sec. 108(a)(1).

[xxv] IRC Sec. 108(a)(1)(B).

[xxvi] IRC Sec. 108(a)(3). The debtor does not experience an accretion in value if the cancellation eliminates only the “excess” debt.

[xxvii] Reg. Sec. 1.1001-2(a)(1). “[T]he amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.”

[xxviii] Perhaps founded on partnership tax principles?

[xxix] Compare IRC Sec. 1366(b) dealing with the character of the item included in a shareholder’s pro rata share.

[xxx] Compare Reg. Sec. 1.752-1 and 1.752-2, which treat a partnership liability as a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability. Consider also the basis consequences arising therefrom.

[xxxi] Reg. Sec. 301.7701-2(a). “[I]f the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.”

[xxxii] The transfer of the interest in a disregarded entity is not treated as a transfer of the interest for federal tax purposes, but rather as a transfer of the assets of the disregarded entity.

[xxxiii] Reg. Sec. 1.1001-2(a)(1).