Business Cancellation of Debt: 6 Tax Rules When a Creditor Forgives a Balance

If a creditor settles a business debt for less than what’s owed, the difference is generally taxable. It’s reported in the business’ gross income, and is ordinarily taxed as ordinary income. Bankruptcy often means no tax, but also wipes out other things that can save tax in the future. While that excludes income from the debt cancellation, you must reduce certain tax benefits such as loss carry forwards, tax credits, basis in assets. The business structure determines who reports the forgiven debt.

Debt forgiveness occurs when a creditor agrees to accept less than the full amount from the borrower and cancels the remaining balance of the debt, relieving the borrower of the obligation to make any further payments toward that debt. A financial institution may foreclose or repossess an asset (car, real estate, or equipment) and receive less than the amount due on a loan or lease. The difference is called a deficiency.

Form 1099-C

If a forgiven debt is $600 or more, a bank or other financial lender must notify the borrower and the IRS on Form 1099-C, Cancellation of Debt. The form is sent to the borrower to provide information about income that must be reported on the tax return. A copy of the 1099-C is also filed with the IRS. A business must report forgiven debt on its tax return, except in limited circumstances. Just because you did not receive a 1099-C from a creditor does not mean it’s not taxable.

For a sole proprietor, the forgiven debt is reported on Schedule C as income. Many sole proprietors pay their self-employment tax on the net profit or loss reported on their Schedule C. Taxable forgiven debt generally adds to that profit.

Excluding Cancelled Debt from Income

One exception to reporting forgiven debt as income is any debt that would be deductible if it were paid in cash. That covers a cash-method borrower’s unpaid business expenses and accrued interest. Say your business financed an equipment purchase from the seller and the seller later cuts what you owe. If the business was not in bankruptcy or otherwise insolvent when the debt was forgiven, the amount of the forgiven debt is not reported as income. Instead, the business reduces the basis of the equipment by the amount of the debt forgiven.

A business in bankruptcy at the time a debt is forgiven has no tax on the canceled debt. A business not in bankruptcy is insolvent if its liabilities exceed the value of its assets. The forgiven amount is excluded only to the extent of the business’s insolvency. Insolvency is measured immediately before the cancellation of the debt. To determine how much income to exclude, the taxpayer must first add up all assets, including retirement and pension accounts. Secondly, all liabilities must be added up. Fair market value must be used for all assets. If both exclusions apply, bankruptcy is used.

If forgiven debt is excluded from income because the business was in bankruptcy or insolvent, the amount not reported reduces certain tax benefits in the future that could have lowered your taxes. The rules for reducing tax attributes as the price of debt forgiveness provide a methodical order in which different business losses and assets are affected. First, any net operating losses available to be carried to a future year are reduced, dollar for dollar, by the amount of excluded debt cancellation. Second, tax credits are reduced by 33⅓ cents for each excluded dollar. Capital losses, property basis, passive losses and foreign tax credits come next.

The debt forgiveness rules provide a special election which permits a business to preserve some of these future tax benefits. You can choose to cut the basis of depreciable property first, instead of reducing the tax attributes that would otherwise be lost. Use a form 982 to tell the IRS about this election.

The Owner Reports the Debt Forgiveness

A sole proprietorship does not pay income tax as a separate entity, so the owner reports the debt forgiveness on their individual return. The same goes for a single-member LLC. The income belongs to the individual, with the LLC not taken into account. At the time the debt is canceled, insolvent taxpayers count both business and personal assets, including retirement accounts.

In a partnership or multi-member LLC, the partnership or LLC generally doesn’t benefit from the exclusion for insolvency or bankruptcy. Income from debt forgiveness must be passed through to each partner or member, and each tests bankruptcy or insolvency on their own. As for S corporations, both the bankruptcy and insolvency tests are calculated at the corporate level. That excluded income does not raise shareholder basis. C corporations must report forgiven debt on their own return and not through the shareholders.

In Chapter 7 bankruptcy, a C corporation is liquidated, so it doesn’t get a discharge anyway. In Chapter 11, the corporation keeps operating, discharges debt under a repayment plan and gets to take the exclusion, along with the attribute cuts. A sole proprietor in Chapter 7 is different: the filing creates a new separate bankruptcy estate that files its own tax return for income from estate assets. In Chapter 7, the individual can get a discharge of debts, with income and payroll trust fund taxes filed in the previous few years often not dischargeable.

When a lender forecloses on or repossesses an asset, the transfer is treated as a sale. A distinction that makes a difference is whether the debt is recourse or nonrecourse. Recourse debt is where you’re personally responsible for the debt if the property value is less than the remaining debt balance. On a nonrecourse loan or lease, you can only lose the collateral. There, the “amount realized” on the transfer of a secured property includes the entire debt balance, cancelling no debt income. On a recourse loan, the sale is at fair market value, and a forgiven deficiency is cancellation income that the exclusions may still cover.

The amount reported by the creditor on a 1099-C might be wrong. If the information on the form is wrong, answer it with documentation: the income belongs in the year the debt was actually discharged.

Most states follow the federal exclusions. Sometimes the forgiven debt is only federally excluded income, but will be included by the state. If you personally guaranteed a business debt in exchange for credit from a supplier or lender and you pay or settle it yourself, the tax consequences run to you, possibly including bad debt treatment.