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Gross Income
Various forms of debt workouts and
A primer on restructurings can trigger COD income, which
cancellation-of-debt results in taxable income to the debtor unless
income and exclusions
In times of economic uncertainty, tax specifically excluded under Sec. 108.
professionals receive more frequent
questions about the ramifications of
debt workouts and restructurings, in- ■ Exclusion of COD income that exclude the COD income unless the
cluding whether cancellation-of-debt would generate a tax deduction if partner is also undergoing a Title 11
(COD) income will result. After sum- paid; and bankruptcy (Sec. 108(d)(6)).
marizing the basics of COD income, ■ Purchase-money debt reductions, as Insolvency: If Example 1 occurred
this item discusses four exclusions that defined in Sec. 108(e)(5). in an insolvency situation, the rules
are commonly used by operating busi- would be different. A taxpayer that is
nesses in this type of situation. Bankruptcy and insolvency insolvent immediately before a COD
Generally, COD income can occur exclusions income event may exclude the COD
in any of the following circumstances The bankruptcy and insolvency exclu- income but only to the extent of the
(among others): sions provided in Secs. 108(a)(1)(A) taxpayer’s insolvency (Secs. 108(a)(1)(B)
■ Modification of a debt, as defined in and (B) operate similarly to exclude and (a)(3)). The calculation for insol-
Regs. Sec. 1.1001-3; COD income. However, it is critical for vency is “the excess of liabilities over the
■ Issuance of equity in satisfaction of a tax professional to understand several fair market value of assets” (Sec. 108(d)
debt (see Secs. 108(e)(8) and distinctions between them. Consider the (3)). Although it would seem that the
108(e)(6)); following example: degree of insolvency before the COD
■ Acquisition of outstanding debt at income event can be derived from the
a discount by a party related to the Example 1: Corporation D under- equity value issued in the workout, that
debtor, as defined in Sec. 108(e)(4); goes a debt workout in which $500 is not always the case, as illustrated by
■ Issuance of a contingent value right million of debt is discharged in ex- the following example:
or similar property right in satisfac- change for (1) new debt of $200 mil-
tion of debt; lion, (2) cash of $50 million raised Example 2: In Example 1, in which
■ Discharge of the debt occurring from new senior creditors, and (3) Corporation D incurs $100 million
either within or outside a bank- preferred equity in Corporation D of of COD income, it would appear
ruptcy proceeding; and $150 million. Corporation D reports that Corporation D was insolvent
■ An asset foreclosure or similar $100 million of COD income in by at least $100 million. However,
transaction satisfying the debt. the transaction. suppose that a valuation performed
Unless specifically excluded under on Corporation D as of the date
the tax law, COD income is taxable Bankruptcy: If Example 1 oc- immediately after the COD income
under Sec. 61. In the case of certain curred pursuant to a Title 11 bank- event provides an enterprise value
foreclosure transactions, the cancella- ruptcy, Corporation D may exclude the (assets over liabilities, excluding
tion event could generate gain on the entire $100 million of COD income. debt) of $450 million and an equity
sale of the assets securing the debt; This is because, if a taxpayer’s COD value of $200 million. The post-
however, that analysis is beyond the income event occurs in a bankruptcy transaction valuation would imply
scope of this item. governed by Title 11 of the U.S. Code, that Corporation D may have been
Exclusions from the general rule all COD income is excluded (Sec. insolvent by as little as $50 million
of COD income inclusion are found 108(a)(1)(A)). Note that where the immediately before the transaction
in Sec. 108. While there are several of entity that incurred the COD income ($450 million enterprise value less
these exclusions, this item focuses on is a corporation, the exclusion applies $500 million debt before the COD
four of them that are commonly used at the corporate level. In contrast, if the income event). If that is the case,
by operating businesses: entity that incurred the COD income is only $50 million of the $100 million
■ The bankruptcy exclusion; a partnership for income tax purposes, of COD income is eligible for the
■ The insolvency exclusion; partners of the partnership may not insolvency exclusion.

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