A client recently posed a question regarding insolvency. The client had a single member LLC with a significant amount of debt and significant personal assets. Their business was going under. Would personal assets (the client has a significant amount) be counted by the IRS? If so, would the business still be deemed insolvent?
Question
I have a single member LLC with a significant amount of debt. The business is going under and the debt will be forgiven by the lender. How can I minimize my tax liability on discharge of indebtedness income? I am particularly concerned because I have significant personal assets, and if those are counted by the IRS, the business would not be deemed insolvent.
Quick Answer
Taxable income can be avoided by claiming the insolvency exclusion under Section 108 of the Internal Revenue Code and combining it with some clever structuring.
Details – Specifics
If your LLC is a disregarded entity that realizes dischargeofindebtedness (DOI) income, then the insolvency exclusion applies to the discharged indebtedness of the LLC only to the extent the owner of the LLC is insolvent.
.If an individual is the sole owner of the LLC, then the insolvency exclusion of DOI income is applied at the individual’s level.
Better yet, if an S corporation is the sole owner of the LLC, then the insolvency exclusion of DOI income is applied at the corporate level. Here, the shareholders’ financial condition is irrelevant. Therefore, the amount of cancelled debt that may be excluded from taxable income is the extent to which LLC’s liabilities exceed the fair market value of its assets.
How it’s done
Discharge of Indebtedness (“DOI”).
a. Taxpayers must include in gross income “income from discharge of indebtedness.”
b .Any DOI income recognized by an S corporation passes through to, and is reported by its shareholders.
Insolvency Exclusion.
Under the insolvency exclusion, DOI income is excluded from gross income if the discharge occurs when the taxpayer is insolvent.
a .Limitation. The amount excluded under the insolvency exclusion is limited to the amount of insolvency.
Example:
S corp owes Lender $1.5 million. The fair market value of S corp’s assets is $2,750,000 million. The S corp’s liabilities $3 million, which includes the $1.5 million debt. S corp’s insolvency amount is $250,000 ($2,750,000 assets less $3 million liabilities).
If Lender forgives $400,000 on the loan, then the insolvency exclusion is limited to $250,000, the insolvency amount. Thus, debt forgiveness results in $150,000 of taxable DOI income to the S corp ($400,000 forgiven less $250,000 insolvency amount). The $150,000 of taxable DOI income will pass through to the sole shareholder.
b .Definition of Insolvent. “Insolvent” means the excess of liabilities over the fair market value of assets as determined immediately before the DOI.
Disregarded Entities.
If a disregarded entity realizes DOI income, the insolvency exclusion applies to the discharged indebtedness of a disregarded entity only to the extent the owner of the disregarded entity is insolvent. Our client was very solvent, and the LLC would not have qualified for the insolvency exemption.
S Corporations
.a. S corporations generally pass through items of income, loss, and other tax attributes to its shareholders.
b. However, whether the insolvency exception applies is determined at the S corporation level and not at the shareholder level.
c .By transferring the ownership of the LLC to an S corporation (we also could have checked the box to have the LLC be taxed as an S corporation), we limited the insolvency test to the assets of the business – which was insolvent. Our client’s personal assets were not counted.
Reduction of Tax Attributes.
a. The amount excluded under the insolvency exclusion reduces certain tax attributes that are carried over to the tax year of discharge.
b. The amount of reduction equals the excluded DOI income.
c. The tax attributes requiring reduction are to be reduced in the following order:
i.Net operating losses,
ii. General business credit
iii.Minimum tax credit,
iv.Capital loss carryovers,
v. Basis reduction of property,
vi Passive activity losses and credit carryovers, and
vii. Foreign tax credit carryovers.
d. When an S corporation recognizes DOI income, there is a corresponding reduction in the entity’s tax attributions at the corporate level. Since S corporations do not have net operating losses, for example, this may affect a shareholder’s distributive share of losses and deductions that were excluded for the taxable year of the DOI.
The result may be a readjustment of each shareholder’s excess losses that carry forward in the years following the DOI year.
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