When is a debt discharged in bankruptcy?
108(1)(1) talks about the exclusion from gross income by reason of discharge of indebtedness of the taxpayer.
The issue is what is the date of the discharge of the indebtedness in a Chapter 7 liquidation. For a large corporate bankruptcy the litigation of whether there is a legitimate debt may go on over a number of years while the corporation is in bankruptcy. Even though the corporation filed in year 1, the ultimate determination of whether the debt is legitimate, and what amount will actually be collected may be many years later. The Trustee may have preference action and fraudulent transfer litigation that goes on for years in trying to collect moneys for the creditors.
Even with a secured debt, the amount of COD may not be known until the Trustee’s final report is approved. For example, a secured creditor, ABC Mortgagee, has a Deed of Trust on a hotel worth 100,000,000. The property is foreclosed on in year 2 at a FMV of 80,000,000. Is the COD 20,000,000? The ABC Mortgagee is unsecured in the amount of 20,000,000. What if there are other assets in the corporation that are being liquidated by the Trustee and in year 4 the Trustee is able out of the remaining liquidated assets to pay the ABC Mortgagee 15,000,000 as an unsecured creditor. Now the COD is only 5,000,000. So what is the date of the discharge of the indebtedness. Year 4? Yes if Year 4 is the final year of the Corporation administration and all the assets have been abandoned, foreclosed, sold, collected, adjudicated, and admin expenses paid. The determination of what moneys are available for all claims is determined only upon the approval of the Trustees final report in year 4 of this example. There is no way of knowing what the final payouts will be until year 4.
In general, a debt is considered discharged at the point when it becomes clear that the debt will never have to be paid. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). The test for determining that point requires a practical assessment of all the facts and circumstances surrounding the likelihood of repayment of the debt. Id. Any “identifiable event” which fixes the loss with certainty may be taken into consideration. Id. (citing United States v. S.S. White Dental Mfg. Co., 274 U.S. 398 (1927)). The commencement of a bankruptcy proceeding is not an identifiable event. See Friedman v. Commissioner, 216 F.3d 537 (6th Cir. 2000), aff’g T.C. Memo. 1998-196; Alpert v. United States, 481 F.3d 404 (6th Cir. 2007), aff’g 430 F. Supp. 2d 682 (N.D. Ohio 2006). Private Letter Ruling 144654-10.
This issue is critical because under 108(b)(4) the attribute reduction Ordering Rules are made AFTER the year of the taxable year of the discharge. (108(b)(4) uses the word “discharge”, which I believe means “discharge of the indebtedness”, which is a separate issue from the discharge of a debtor and of course corporations never obtain a discharge 11 USC 727(a)(1).)
Reg Sec. 1.6050P-1(b)(2)(i) clarifies the date of discharge and the identifiable event under (b)(2)(i)(A), see below. This section again returns back to the issue of the actual date that it become clear that the debt will not be paid.
b) Date of discharge –
(1) In general. Solely for purposes of this section, except as provided in paragraph (b)(3) of this section, indebtedness is discharged on the date of the occurrence of an identifiable event specified in paragraph (b)(2) of this section.
(2) Identifiable events –
(i) In general. An identifiable event is –
(A) A discharge of indebtedness under title 11 of the United States Code (bankruptcy);
(B) A cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding in a federal or State court, as described in section 368(a)(3)(A)(ii) (other than a discharge described in paragraph (b)(2)(i)(A) of this section);
(C) A cancellation or extinguishment of an indebtedness upon the expiration of the statute of limitations for collection of an indebtedness, subject to the limitations described in paragraph (b)(2)(ii) of this section, or upon the expiration of a statutory period for filing a claim or commencing a deficiency judgment proceeding;
(D) A cancellation or extinguishment of an indebtedness pursuant to an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor’s right to pursue collection of the indebtedness;
(E) A cancellation or extinguishment of an indebtedness that renders a debt unenforceable pursuant to a probate or similar proceeding;
(F) A discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration;
(G) A discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt; or
(H) In the case of an entity described in section 6050P(c)(2)(A) through (C), the expiration of the non-payment testing period, as described in § 1.6050P-1(b)(2)(iv).
When is a debt discharged in bankruptcy for a plan of reorganization?
For entities with an approved Chapter 11 plan of reorganization where for example a certain class will not be paid at all, then it is clear the debt will not be paid and the tax attributes will be reduced in the following year. If the approved Chapter 11 plan of reorganization is based on a percentage, then there is still a question on what that exact amount will be. Further, even if the plan allows for a fixed percentage or an amount certain, approximately 90% of all chapter 11 plans are eventually converted to a chapter 7 plan. And of course with the conversion to a chapter 7 plan the amount a creditor may receive can be reduced. Also the amount received can be reduced by the chapter 7 administrative expenses. For a secured creditor the issue would be whether they will have to wait under the chapter 11 plan until all the payments are made, or alternatively whether the plan will default and the secured creditor will be able to obtain a relief from stay and foreclose, and then at what price and when.
So when is a debt discharged in bankruptcy? Certainty in bankruptcy is elusive.
Please see your attorney or tax advisor for your specific legal issues and situation. The above should not be consider legal advice.