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TAX CLINIC

notes exceeded FSUB 1’s adjusted
In general, if a shareholder gratuitously basis in them. Notably, the IRS did
not conclude that the insolvency of the
forgives debt owed by a corporation, the debtor affected the outcome as it had
transaction constitutes a contribution to in FSA 199915005. In other words,
the note forgiveness was treated as a
the capital of the corporation to the extent capital contribution despite the fact that
of the principal of the debt. Parent became solvent as a result of the
debt forgiveness.

Commentary
by its subsidiary in order to improve contribution; and S1 had to reduce Letter Ruling 202112003 confirms to
the latter’s financial position so that tax attributes under Sec. 108(b) by the taxpayers and practitioners that the
it may continue in business, we en- amount of excluded COD income under IRS may apply Sec. 108(e)(6) entirely
tertain no doubt that the cancellation the insolvency exception. despite the fact that the debtor was in-
should be held a capital contribution. solvent immediately before the cancel-
[229 F.2d at 243] Letter Ruling 202112003 lation. The IRS has ruled consistently
In Letter Ruling 202112003, the IRS with Letter Ruling 202112003 at least
In more recent guidance, the IRS reached a conclusion that seems incon- once prior, but that ruling preceded
concluded in Field Service Advice sistent with the 1999 FSA. In the facts FSA 199915005 (see Letter Ruling
(FSA) 199915005 that Sec. 108(e)(6) of the letter ruling, a foreign corpora- 8844032). The recent letter ruling is
applied only to the extent that the tion (FSUB 1) directly owned all of the noteworthy because it reaches a differ-
debtor corporation became solvent. As interests in a disregarded entity, FDRE ent conclusion from FSA 199915005
will be discussed, this result appears to 1, and FDRE 1 in turn owned all of the despite similar facts.
conflict with Letter Ruling 202112003. interests in another disregarded entity, It remains prudent for taxpayers and
In the 1999 FSA, a corporation, FP, FDRE 2. FDRE 2 directly owned all of practitioners to carefully assess their
canceled the debt of its subsidiary, S1, a U.S. corporation, Parent. Parent was circumstances in evaluating whether
when S1 was insolvent. The IRS stated: the common parent of a consolidated Sec. 108(e)(6) may apply. Notwith-
group (the Parent Group). standing the IRS ruling in Letter
In the case of debt that is canceled, FSUB 1 held certain notes issued Ruling 202112003, the extent of the
the value of a debtor corporation by Parent that were represented by the debtor corporation’s insolvency may
increases by the amount by which taxpayer to be debt for U.S. federal matter in determining whether Sec.
the corporation becomes solvent as a income tax purposes. Other members 108(e)(6) applies. For example, doubt
result of the debt that is canceled. In of the Parent Group were co-obligors remains whether Sec. 108(e)(6) ap-
the instant case, the value of S1 only on the notes. plies in circumstances similar to Letter
increased by the amount by which Since the issuance of the notes, Par- Ruling 5411085730A and Mayo when
S1 became solvent as a result of FP’s ent’s business experienced a significant the debtor continues to be “hopelessly
cancellation of S1’s indebtedness deterioration. Parent and the Parent insolvent” after the cancellation.
owed to FP. As a result, we believe Group were likely insolvent as a result Recent rulings related to Sec.
FP made a capital contribution of debt of the outstanding notes. 108(e)(6) have included a taxpayer
to S1 only to the extent S1 became The taxpayer in the letter ruling representation that the contributed
solvent as a result of FP’s cancellation of proposed that FSUB 1 would gratu- debt had a positive fair market value
the debt. [emphasis added] itously forgive a portion of the notes (FMV) at the time of the contribution
and that FSUB 1 intended that the Par- (e.g., Letter Ruling 201016048 and
The IRS concluded that S1 deter- ent Group would be solvent following Letter Ruling 200537026). If a debtor
mined there was COD income under such forgiveness. corporation remains “hopelessly insol-
Sec. 108(e)(6) for the portion of the debt The IRS ruled that Sec. 108(e)(6) vent” after a debt cancellation by its
that was a capital contribution. However, applied to the note forgiveness. Under shareholder, it may be less likely that a
the IRS also concluded that S1 had that Code section, Parent recognized canceled debt had a positive FMV.
COD income related to the amount of COD income to the extent, if any, that From Jeff Borghino, CPA, Washing-
the canceled debt that was not a capital the adjusted issue price of the forgiven ton, D.C.

8 February 2022 The Tax Adviser