Generally, gross income, for income tax purposes, includes all income from any source. A discharge of indebtedness refers to the value realized by a taxpayer who discharges a debt for an amount less than originally agreed upon. Section 108 of the Internal Revenue Code (IRC) creates an exclusion from gross income for discharge of indebtedness income realized by certain financially troubled taxpayers, such as when the discharge occurs in bankruptcy.
Price of Exclusion
The "price" of IRC section 108 exclusion is that the taxpayer's tax attributes must be reduced by the amount of excluded discharge income. A tax attribute is a type of loss or tax credit that is adjusted when a taxpayer declares bankruptcy. Tax attributes include net operating losses and carryovers, general business credit carryovers, alternative minimum tax credit carryovers, capital loss and foreign tax credit carryovers.
Thus, under most circumstances, IRC section 108 doesn't permanently exclude income. Rather, it permits a taxpayer to defer the current recognition of ordinary discharge income by reducing the taxpayer's tax attributes. This permits deferral, but federal income tax is collected on ordinary discharge income in later tax years.
Usually excluding income requires a taxpayer to postpone his tax liability by decreasing dollar-for-dollar certain tax attributes that would otherwise be available to offset future income. However, general business credits, minimum tax credits and foreign tax carryovers must be reduced by one-third dollar-for-dollar.
Under section 108, taxpayers must reduce their tax attributes in the following order:
- Net operating losses
- General business credits
- Minimum tax credits
- Capital loss carryovers
- Basis of property
- Passive activity loss and credit carryovers
- Foreign tax credit carryovers
If a taxpayer decides that he would rather preserve loss carryovers until the next taxable year, he may elect to apply any or all of the excluded income to reduce basis in property before reducing another attribute.
Title 11 Case
A "title 11 case" is a bankruptcy case under title 11 of the United States Code, but only if the taxpayer is under the bankruptcy court's authority and it grants the discharge of indebtedness or the discharge is according to a plan approved by the court.
Extent of Exclusion Depends on Status of Taxpayer
IRC section 108 exclusion applies to all discharge income realized by a taxpayer who is subject to the bankruptcy court's authority in a title 11 case. Thus, for example, if a taxpayer in a title 11 case is only insolvent to the extent of $100, but realizes $10,000 of discharge income as a result of debts cancelled by the court, the full $10,000 will qualify for exclusion.
General Attribute Reduction Reported on Form 982
An informational return, Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)" must be filed with the taxpayer's tax return for the taxable year of the discharge. An election must be filed with the taxpayer's return for the taxable year in which the discharge occurs if the taxpayer wants to apply the excluded income first to reduce the basis of depreciable property. Include the form with a timely filed tax return (including extensions) for any year discharge of indebtedness is excluded.
Questions for Your Attorney
- How are tax attributes reduced by the amount of discharged income that is excluded from gross income?
- Do tax attributes need to be reduced in a particular order?
- Can I apply all of my excluded income to reduce basis in property before reducing another attribute?