American Recovery and Reinvestment Tax Act to the Rescue with the Creation of IRC §108(i)
by Erik J. Burgos *
SC&H Group Tax & Advisory Services; McLean, Va.
The creation of §108(i) of the Internal Revenue Code (IRC), through the enactment of §1231 of the American Recovery and Reinvestment Tax Act of 2009 (PL 111-5, 123 Stat. 338), allows companies that buy back their troubled debt at a discount to restructure their balance sheet and possibly avoid bankruptcy without suffering major federal income tax consequences. Generally, under IRC §108(i), “cancellation of debt (COD) income realized in connection with a debt reacquisition, after Dec. 31, 2008, and before Jan. 1, 2011, of an applicable debt instrument is includible in gross income ratably over a five-taxable-year inclusion period.”[1] The five-taxable-year period begins with the taxpayer’s fifth taxable year following reacquisitions that occur in 2009 and the fourth taxable year following reacquisitions that occur in 2010.[2]
Within IRC §108(i), “applicable debt instrument” means any debt instrument, including bonds, debentures, notes, certificates or any other instrument or contractual arrangement constituting indebtedness, which is issued by a C corporation or any person in connection with the conduct of a trade or business by that person.[3] An IRC §108(i) “reacquisition” occurs with any acquisition of a debt instrument by the [issuing debtor] debtor. The debtor can also be the obligor of the debt or a related person to the debtor.[4] A debt instrument can be acquired through any of the following ways: (1) cash, (2) an exchange of a debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument), (3) an exchange of the debt instrument of corporation stock or a partnership interest, (4) a contribution of the debt instrument for capital and (5) a complete forgiveness of the indebtedness by the holder of the debt instrument.[5]
A taxpayer must elect for IRC §108(i) to apply,[6] and once the election is made, it is irrevocable.[7] Also important to note is that the election is made at the entity level,[8] meaning that elections for pass-through entities are made by the partnership or S corporation, not the partners or members. However, for purposes of IRC §108(i), regulated investment companies and real estate investment trusts are not considered pass-through entities. Therefore, these entities cannot elect IRC §108(i).[9]
In general, if a taxpayer makes a §108(i)(1) election and reacquires (or is treated as reacquiring) the applicable debt instrument generating the COD income for a new debt instrument with original issue discount (OID), then interest deductions for this OID are also deferred for the same five-taxable-year period.[10] However, an interest deduction is not allowed if it accrues before the first taxable year in the five-taxable-year period and the amount of OID does not exceed the COD income.[11] Further, if the amount of OID accruing before the first taxable year exceeds the COD income, the deduction is disallowed in the order in which the OID is accrued.
* The author gratefully acknowledges the contributions to this article of his colleagues at SC&H Group Tax & Advisory Services LLC: Kim Ruiz and Claire Hawse.
1. 26 CFR 601.105(2.01).
2. IRC §108(i)(1)(A), (B).
3. IRC §108(i)(3).
4. IRC §108(i)(4)(A).
5. IRC §108(i)(4)(B).
6. IRC §108(i)(1).
7. IRC §108(i)(5)(B)(ii).
8. IRC §108(i)(5)(B)(iii).
9. 26 CFR 601.105(2.01).
10. IRC §108(i)(2) and 26 CFR 601.105(2.01).
11. IRC §108(i)(2)(A)(i)(I), (II).
