On August 17, 2009, the Internal Revenue Service released Revenue Procedure 2009-37, 2009-36 I.R.B. 309 (Sept. 8, 2009) (Revenue Procedure) describing the steps that taxpayers should follow in making elections to defer cancellation of indebtedness income (COD income) under Section 108(i) of the Internal Revenue Code. Section 108(i) was enacted last spring by the American Recovery and Reinvestment Tax Act and is the principal tax relief provision in the economic stimulus legislation available to taxpayers in workout situations. 

Section 108(i) permits taxpayers to elect to defer the recognition of COD income realized in 2009 and 2010 and then to recognize that COD income ratably over five taxable years beginning in 2014. The recognition of COD income that has been deferred is accelerated if substantially all the assets of the business that recognized the COD income are sold or the business is otherwise terminated. The recognition of COD income is also accelerated if an owner of a pass-through entity that has elected to defer COD income sells, exchanges, or redeems its interest in such entity. Interest deductions attributable to original issue discount (OID) on debt that is modified or issued by the obligor as part of the workout are similarly deferred if a Section 108(i) election is made.

Section 108(i) applies to COD income realized from the "reacquisition" of an "applicable debt instrument." An "applicable debt instrument" is any debt instrument issued by a regular (subchapter C) corporation and any debt instrument issued by any other taxpayer in connection with a trade or business. A "reacquisition" includes the following transactions (Eligible Transactions):

(a) the purchase of a debt instrument for cash or other property by the obligor (or a person related to the obligor);

(b) an exchange of a debt instrument for a new debt instrument, including a deemed exchange resulting from a modification of the debt instrument;

(c) an exchange of the debt instrument for stock or a partnership interest;

(d) a contribution of the debt instrument to the capital of a corporation, partnership, or LLC; and

(e) the complete forgiveness of the debt instrument.

The Revenue Procedure clarifies that an election under Section 108(i) may be made with respect to all or part of a debt instrument in an Eligible Transaction.

The Section 108 election is available only for COD income resulting from an Eligible Transaction. Gain resulting from any payment of debt with property, including by foreclosure or deed in lieu of foreclosure, is not COD income. As a result, Section 108(i) is not available to defer the current taxation of such gain.

Following the enactment of Section 108(i), numerous commentators expressed concern as to how the election would operate with respect to partnerships, S corporations, REITs and RICs, and members of consolidated return groups. The Revenue Procedure resolves the principal issues raised with respect to each of these entities in a taxpayer-favorable manner.


Under Section 108, the tax consequences of partnership COD income are usually determined at the partner level, not the partnership level. Section
108(i) departs from this general rule by requiring the Section 108(i) election to be made at the partnership level and causing the election to be binding on all of an electing partnership's partners. Once an election is made under Section 108(i) to defer COD income, none of the other normal exclusion or deferral rules for COD income is available. Therefore, the new statutory provision’s apparent departure from the general rule created a potential conflict among partners because no partner would be able to avail itself of other exclusions or deferral options if a Section 108(i) election were made at the partnership level.

A partner might want to avoid deferral under Section 108(i) if it were insolvent or bankrupt, has expiring NOLs, or wants to defer the COD by using the qualified real property business indebtedness provisions. Thus, for example, if a partnership had some solvent partners and some insolvent partners, the solvent partners might want the partnership to make the Section 108(i) election, while the insolvent partners would not want the partnership to make the election because they would lose the ability to use the insolvency exclusion. The Revenue Procedure solves this problem.

The Revenue Procedure not only permits the Section 108(i) election to be made with respect to all or part of the COD income from an Eligible Transaction, it also permits a partnership to allocate the deferred COD income from an Eligible Transaction to partners who seek deferral under Section
108(i) and the COD income that is not deferred (included COD income) to the partners who do not want to avail themselves of the deferral opportunity.

Complex Internal Revenue Code rules allow partners to include the partnership's debt in their basis for their partnership interests and require partners, at times, to recognize gain if partnership debt is reduced. The Revenue Procedure defers the gain partners have to recognize from a reduction of the partnership's debt for which there is an election under Section 108(i) until the COD income is recognized. However, subsequent reductions of the partnership’s debt from other than an Eligible Transaction or for which no election has been made under Section 108(i) could force a partner to recognize gain sooner than it otherwise would have.

S Corporations

Section 108(i) also permits S corporations to elect to defer all or part of realized COD income from an Eligible Transaction (and, if applicable, interest deductions attributable to OID on debt that is modified or issued by the obligor as part of the workout).

The Internal Revenue Code requires an S corporation to allocate all of its items of income, loss, and deduction on a pro rata basis. The Revenue Procedure modifies this rule slightly by requiring that any COD income deferred by reason of the Section 108(i) election be allocated pro rata among only those shareholders that were shareholders immediately before the Eligible Transaction. Thus, new equity investors in the S corporation will effectively be shielded from the deferred tax liability associated with the Section 108(i) election. Moreover, because the amount of the deferred COD income will be reduced by any amount that is accelerated when an S corporation shareholder sells or redeems his shares, continuing shareholders should generally be allocated amounts that are proportionate to the income amounts they have deferred. Because it is unclear whether the acceleration rule applies in the case of a dividend-equivalent redemption that is not treated as a redemption or exchange for tax purposes, there nevertheless may be some circumstances in which the allocation of deferred COD income is disproportionate to the shareholdings at the time of the Eligible Transaction.

The Revenue Procedure's treatment of deferred COD income contrasts with the treatment of included COD income to which the normal proration rule applies. Persons becoming shareholders of an S corporation before the close of the taxable year in which the included COD income is realized would receive a prorated share of included COD income under the normal proration rule. While continuing shareholders may have suspended losses available to offset their share of such included COD income, persons acquiring shares after an Eligible Transaction (but before the close of the taxable year) are likely to condition their investment on the making of the Section 108(i) election.

In contrast to its treatment of partnerships, the Revenue Procedure does not permit S corporations to make special allocations to their shareholders of deferred and included COD income amounts. Because exclusions of COD income for bankruptcy, insolvency, qualified real property business indebtedness, and qualified farm indebtedness are determined at the S corporation level (and not at the level of the individual shareholder), a rule permitting the special allocation of deferred COD income would not have offered the same planning opportunities under Section 108 for S corporations that it does for partnerships. However, S corporations may want to take into account the existence or absence of other types of tax attributes possessed by their individual shareholders in the year of an Eligible Transaction in deciding whether a deferral election is advisable under the Revenue Procedure.

In addition, it should be noted that the Revenue Procedure does not modify the pro rata allocation rule with respect to deferred deductions attributable to OID on debt that is modified or issued as part of the workout. Thus, all current and future S corporation shareholders will bear the detriment of these lost deductions if a Section 108(i) election is made.

REITs and RICs

The tax qualification of REITs and RICs depends upon their ability to obtain sufficient annual dividends-paid deductions to eliminate taxable income. Dividends-paid deductions, in turn, depend on the existence of "dividends"—distributions made out of current or accumulated earnings and profits. To match taxable income with dividends-paid deductions, REITs and RICs must therefore recognize taxable income and earnings and profits concurrently. In most circumstances, however, earnings and profits are adjusted when earnings are realized economically rather than in accordance with tax accounting rules. 

An issue existed as to whether income deferred by reason of a Section 108(i) election would be matched with sufficient earnings and profits to support dividends-paid deductions in the taxable years to which the income was deferred. The Revenue Procedure resolves this problem by providing that the deferred COD income and deferred OID deductions adjust earnings and profits in the taxable years in which they are recognized and not in the years in which they are economically realized. 

Consolidated Return Groups

Workouts involving debt obligations between members of consolidated return groups ("intercompany obligations") are governed by special rules under the consolidated return regulations (Treas. Reg. § 1.1502-13).  These regulations apply not only to obligations that are issued and transferred within the consolidated group ("intercompany transactions") but also to obligations of members that are acquired by other members from nonmembers ("inbound transactions") and to obligations of members that are held by other members and then transferred to nonmembers ("outbound transactions"). The consolidated return regulations generally treat each of these types of transfers as a deemed satisfaction and reissuance of the obligation at its current fair market value with concomitant recognition of COD income by the obligor and of loss by the holder.

Because the consolidated return regulations determine the character of these income and loss items as if they were realized by a single entity in the case of intercompany transactions and outbound transactions, commentators considered a Section 108(i) deferral election to be unnecessary in these two cases. Accordingly, Revenue Procedure 2009-37 indicates that the Section
108(i) election may be made only with respect to intercompany obligations that are the subject of inbound transactions, where the character of the items realized by the obligor and holder are determined on a separate entity basis. Note, however, that the Section 108(i) election will not defer the recognition of any loss realized by the nonmember holder transferring the obligation in the inbound transaction, only the recognition of the COD income and future OID within the consolidated return group.

Election Procedures

Under the Revenue Procedure, the Section 108(i) election is made by attaching a statement to a timely filed (with extensions) original return for the taxable year of the Eligible Transaction. The Revenue Procedure additionally allows (a) taxpayers unsure of how much COD income has been realized to make a supplemental election to determine what percentage of any additional COD income should be deferred and (b) taxpayers unsure of whether they have engaged in an Eligible Transaction to make a protective election to defer any COD that is later determined to have been realized. At the present time, it is unclear whether both elections can be made by a taxpayer with respect to the same workout transaction. There are special recordkeeping requirements for partnerships and S corporations, and careful attention should be paid to the Revenue Procedure election procedures, recordkeeping requirements, and filing requirements.

The Internal Revenue Service intends to issue additional guidance on the matters covered by Revenue Procedure 2009-37, which may take the form of regulations. Because Section 108(i) will not affect transactions occurring after 2010, any such guidance is likely to be issued shortly. The Tax Group of Ballard Spahr LLP is able to assist taxpayers in developing comments on Revenue Procedure 2009-37 in anticipation of the issuance of additional guidance by the IRS.  We also will advise taxpayers involved in workout situations on the desirability of making a Section 108(i) election.

Contact Information

Please contact Ballard Spahr Partners Wayne R. Strasbaugh, 215.864.8328 or strasbaugh@ballardspahr.com, or Wendi L. Kotzen, 215.864.8305 or kotzenw@ballardspahr.com, for additional information and assistance.

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