Green Tree Planning

Disregarded Entities (LLC’s, Sub-S Corps, Grantor Trusts) and Discharged Indebtedness

INTERESTING QUESTION

Suppose a grantor trust or disregarded entity[i] becomes insolvent or bankrupt – but its owner is not.  Is the owner exempt from income tax if the trust or entity is discharged from indebtedness? 

Some taxpayers take the position that the exception described below is available to the extent the trust or entity is insolvent or bankrupt since the taxpayer is considered for income tax purposes as “owner” of the trust or disregarded entity’s assets and liabilities.

EXECUTIVE SUMMARY

The proposed regulations make it clear that the IRS and Treasury will take the position that[ii] the insolvency exception under Code Section 108(a)(1) is available only to the extent the owner is insolvent.  The proposed regulations also clarify that the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction.

THE LAW

Income from the discharge of indebtedness is generally includable in gross income.[iii] A limited exception applies under Code Section 108.  Under that Code Section, an amount that normally would be includable in gross income by reason of the discharge of indebtedness of the taxpayer[iv] is excludable – if the discharge occurs (a) in a Title 11 bankruptcy case or (b) to the extent the taxpayer is insolvent when the discharge occurs.

THE SUB-QUESTION IS: WHO IS THE TAXPAYER?

A grantor trust is any part of a trust that is treated as being owned by the grantor or another person so its items of income, deductions, and credits attributable to the trust are includable in computing the taxable income and credits of the owner.

The activities of a disregarded entity are treated in the same manner as those of a sole proprietorship, branch, or division of the owner so that all assets, liabilities, and items of income, deduction, and credit of a disregarded entity are treated as assets, liabilities, and items of the owner of the disregarded entity.  Accordingly, for Federal income tax purposes, all assets, liabilities, and items of income, deduction, and credit of a disregarded entity are treated as

MORE ON THE PROPOSED REGS

First, the proposed regulations specify that, for purposes of applying section 108(a)(1)(A) and (B) to discharge of indebtedness income of a grantor trust or a disregarded entity, the term taxpayer refers to the owner(s) of the grantor trust or disregarded entity and, therefore, the trusts or entities themselves will not be considered owners for this purpose.[v]

Second, the proposed regulations further provide that grantor trusts and disregarded entities themselves will not be considered owners for this purpose.

Third, the proposed regulations provide that, in the case of a partnership, the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. 

PROPOSED EFFECTIVE / APPLICABILITY DATE

The regulations are proposed to apply to discharge of indebtedness income occurring on or after the date final the regulations are published in the Federal Register. No inference is intended that the provisions set forth in the proposed regulations are not current law. 

Source: LISI Income Tax Planning Newsletter #8  (April 19, 2011) at http://www.leimbergservices.com   Copyright 2011 Leimberg Information Services, Inc.  

Citations:   REG-154159-09; IRC Sec. 108

The regulations are proposed to apply to discharge of indebtedness income occurring on or after the date final the regulations are published in the Federal Register. No inference is intended that the provisions set forth in the proposed regulations are not current law. 

Footnotes:

[i] Several types of disregarded entities exist under the Code and regulations. For instance, § 301.7701-2(a) of the Procedure and Administration Regulations provides that the term business entity includes an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701-3; an example of a disregarded entity under this provision is a domestic single member limited liability company that does not elect to be classified as a corporation for Federal income tax purposes. Additionally, some disregarded entities are created by statute; examples of statutory disregarded entities include a corporation that is a qualified REIT subsidiary (within the meaning of section 856(i)(2)), and a corporation that is a qualified subchapter S subsidiary (within the meaning of section 1361(b)(3)(B)).

[ii] Subject to the special rule for partnerships under Code Section 108(d)(6).

[iii] Code Section 61(a)(12).

[iv] Section 7701(a)(14) defines a taxpayer as any person subject to any internal revenue tax, and section 108(d)(1) through (3) provides other relevant definitions.

[v] For a partnership, the ownership rules would apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable.