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as a capital contribution. For example,
Corporations & Shareholders if the stock and bonds of a corporation
are publicly held, and the creditor also
Shareholder’s forgiveness of happens to be a shareholder, the cancel-
insolvent corporation’s debt lation of indebtedness on the exchange
A debt cancellation or forgiveness by a of the bonds for stock is not treated as a
corporation’s shareholder is a common contribution to capital by a shareholder
transaction. Despite the prevalence of for purposes of Sec. 108(e)(6) (S. Rep’t
these transactions, some critical tax No. 96-1035, 96th Cong., 2d Sess., at
consequences are uncertain, includ- 19, note 22 (Nov. 25, 1980)).
ing the determination of any income
from the cancellation of debt (COD Past guidance
income) under certain circumstances. To some extent, there has been uncer-
Recently, the IRS concluded in Let- tainty regarding whether a voluntary
ter Ruling 202112003 (March 26, cancellation of a debt by a shareholder
2021) that an insolvent corporation still constitutes a contribution to capital
should determine whether it had any that does not create COD income to the
COD income by applying Sec. 108(e) extent that a canceled debt is worthless.
(6), which addresses the effect of a The IRS and the courts have touched on
shareholder’s forgiveness of a cor- the matter on several occasions.
poration’s indebtedness. In the letter In Letter Ruling 5411085730A
ruling’s analysis, it made no difference (Nov. 8, 1954), the IRS ruled that a
in determining the effect of the share- cancellation of a worthless debt by the
holder’s debt forgiveness whether the the insolvency exception must be applied shareholders of a corporation did not
corporation was insolvent. This was to reduce the taxpayer’s tax attributes as constitute a gratuitous cancellation be-
a noteworthy ruling because the IRS specified under Sec. 108(b). cause “there is nothing to forgive.” A few
had reached a different conclusion in In general, if a shareholder gra- years later, the Tax Court held in Mayo,
the past on similar facts involving a tuitously forgives debt owed by a T.C. Memo. 1957-9, that a shareholder’s
shareholder’s cancellation of an insol- corporation, the transaction constitutes forgiveness of a corporation’s debt was
vent corporation’s indebtedness. This a contribution to the capital of the cor- not a contribution to the corpora-
item first summarizes the relevant poration to the extent of the principal tion’s capital because the corporation
Code provisions, then looks at past of the debt (Regs. Sec. 1.61-12(a)). Sec. remained “hopelessly insolvent” after
IRS guidance on this issue, and finally 108(e)(6), the key provision in the pres- the cancellation.
discusses Letter Ruling 202112003. ent discussion, further provides that if However, the Second Circuit in
a debtor corporation acquires its debt Lidgerwood Manufacturing Co., 229 F.2d
Background from a shareholder as a contribution to 241 (2d Cir. 1956), cert. denied, 351 U.S.
Sec. 61(a)(11) provides the general rule capital: (1) Sec. 118, which concerns 951 (1956), held that a parent corpora-
that gross income includes income from contributions to the capital of a corpora- tion’s cancellation of its subsidiary’s debt
cancellation of debt except as provided tion, does not apply; and (2) such debtor was a capital contribution, which pre-
by law. If a debtor repurchases a debt corporation is treated as having satisfied cluded the parent’s bad debt deduction,
instrument for an amount less than its the debt with an amount of money equal even when the corporation remained
adjusted issue price (within the meaning to the shareholder’s adjusted basis in insolvent after the cancellation. The
of Regs. Sec. 1.1275-1(b), the debtor the debt. court stated:
The legislative history indicates that
realizes COD income (Regs. Secs. to fall within the scope of Sec. 108(e)(6), [E]ven on the assumption that the
IMAGE BY OLAFSPEIER/ISTOCK income does not include COD income the shareholder’s action in canceling the debtors were insolvent after as well as
1.61-12(c)(2)(ii)).
Under Sec. 108(a), a taxpayer’s gross
debt must be related to their status as a
before the cancellations, wiping out
the debts was a valuable contribution
shareholder. If the shareholder-creditor
in certain circumstances. One example
is when the discharge occurs and the
acts merely as a creditor attempting to
to the financial structure of the sub-
taxpayer is insolvent (the insolvency
sidiaries. . . . Where a parent corpora-
maximize the satisfaction of a claim,
exception). The amount excluded under
tion voluntarily cancels a debt owed
the cancellation of debt is not treated
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