A taxpayer with property secured by a nonrecourse loan, who returns said property to the lender via foreclosure, deems the entire loan balance as the sales price for income tax purposes. This holds true even if the property’s fair market value is below the loan balance. But what happens when the lender consents to a payment less than the loan’s face value, facilitating a short sale by aligning with the buyer’s offer? Does this debt reduction equate to canceled debt income, or does it remain part of the sales price? Why does the distinction matter?

In the case of Parker v. Commissioner,[1] the Tax Court examined such a scenario. Their conclusion: the debt reduction should be recognized by the taxpayer as part of the sales price, not as canceled debt income.

The Transactions

While the specifics are somewhat intricate, Exterra Partners, LLC (recognized as an S corporation for federal tax purposes) sold its real estate interest in 2012 to independent entities. During these transactions, the lender to whom Exterra had outstanding balances concerning the properties consented to forgive a segment of nonrecourse loans secured by those properties.

The partnership’s tax treatment of these transactions is detailed in the court’s opinion.

For tax year 2012 Exterra filed an original Form 1120S, U.S. Income Tax Return for an S Corporation. On its original Form 1120S, Exterra reported $53,284,369 in gross receipts, which consisted of (1) the debt assumed by the Buyers in the sale of the Livermore property and (2) the cancellation of the mezzanine loans. After offsetting cost of goods sold and deductions, Exterra reported ordinary business income of $2,741,399.[2]

Initially, the partnership reported the debt reduction as part of the properties' sales price. However, they later submitted an amended return, revising their stance. The partnership then characterized the debt reduction as cancellation of debt income, enabling the corporation to omit this amount from income pursuant to IRC §108(a)(1)(B), given that the corporation was insolvent when the debt was diminished.

Exterra subsequently filed an amended Form 1120S, in which it reduced its gross receipts by $2,741,399 and attached Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). On the Form 982 Exterra reported $2,741,399 as a discharge of indebtedness excluded to the extent insolvent and reduced its basis of depreciable property and net operating loss in corresponding amounts. The $2,741,399 related to the cancellation of debt for Loan N712A and/or Loan N712B. As of October 4, 2012, Exterra was insolvent up to $2,741,399. This change resulted in Exterra’s reporting zero in ordinary business income on the amended Form 1120S. Exterra issued an amended Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., to Mr. Parker to reflect the reduction in ordinary business income.[3]

These modifications were reflected on the 100% shareholder's income tax return, both on the initial Form 1040 and a subsequently submitted amended Form 1040X.

For tax year 2012 petitioners filed an original Form 1040, U.S. Individual Income Tax Return, on which they reported $2,741,399 in flowthrough income from Exterra. Subsequently, petitioners filed a Form 1040X, Amended U.S. Individual Income Tax Return, for 2012, reflecting the amended Schedule K-1 and reporting zero in flowthrough income from Exterra.[4]

In this case, the IRS argues that the amounts in question are part of the sales price rather than a cancellation of income. Consequently, the exclusion of the debt reduction from income under IRC §108 is not applicable to the taxpayers, leading to an increased tax liability.

Analysis of Debt Cancellation

The Tax Court outlines the provisions that come into play when a taxpayer avoids the complete repayment of a debt.

Section 61(a) broadly defines gross income as “all income from whatever source derived.” Section 61(a)(3) specifies that gross income includes “[g]ains derived from dealings in property,” while section 61(a)(12) does the same for “[i]ncome from discharge of indebtedness.” See Gehl v. Commissioner, 102 T.C. 784, 789 (1994) (“[P]aragraphs (3) and (12) of section 61(a) are separate, independent, and not overlapping provisions in respect of the includability of a particular item in income.”), aff’d, 50 F.3d 12 (8th Cir. 1995). The distinction between these two subcategories of gross income — gain from property and COD income — can have significant tax consequences.[5]

The court's initial scenario delves into the tax implications that arise when a taxpayer sells property and realizes a gain.

When a taxpayer sells or disposes of property, the amount realized is equal to the amount of money plus the fair market value of any property received. §1001(b). When a taxpayer sells or otherwise disposes of property encumbered by nonrecourse debt, the amount of the outstanding debt is typically included in the amount realized. See Commissioner v. Tufts, 461 U.S. 300, 317 (1983); Crane v. Commissioner, 331 U.S. 1, 14 (1947); Milkovich v. United States, 28 F.4th 1, 8 (9th Cir. 2022); Treas. Reg. § 1.1001-2(a)(1). To the extent that the amount realized exceeds the taxpayer’s basis in the property, the taxpayer has gain. See §1001(a).[6]

Conversely, the opinion highlights the consequences faced by a taxpayer when there is a cancellation of debt.

In contrast, a COD that is not part of a sale or exchange of property generally results in COD income, which may then be subject to certain statutory exclusions. See §108(a)(1); see also Estate of Delman v. Commissioner, 73 T.C. 15, 31-32 (1979). Relevantly, section 108(a)(1)(B) allows a taxpayer who is insolvent at the time of a debt cancellation to exclude COD income from gross income. The amount of this exclusion is limited to the amount of the taxpayer’s insolvency, i.e., the amount by which the taxpayer’s liabilities exceed the fair market value of their assets. §108(a)(3); see White v. Commissioner, T.C. Memo. 2023-77, at *3.[7]

Since the S corporation was insolvent when the debt was diminished, if this reduction signifies a cancellation of debt, then the entire debt reduction would be excluded from income. Conversely, if this isn’t the proper treatment, the whole amount of the debt reduction would be incorporated into the properties’ sales prices, leading to a heightened taxable income.

The ruling continues by detailing the legal criteria the court must use to ascertain whether this transaction qualifies as a cancellation of debt that's eligible for exclusion under IRC §108.

In deciding whether debt relief results in gain or COD income, we focus on the facts and circumstances surrounding how the taxpayer-debtor satisfied or extinguished the underlying debt. See Danenberg v. Commissioner, 73 T.C. 370, 381 (1979); Peninsula Props. Co. v. Commissioner, 47 B.T.A. 84, 91-92 (1942). If nonrecourse debt relief is conditioned upon a sale or exchange of property or is otherwise a part of that underlying sale or exchange, the amount of debt relief is properly included in the amount realized and is not COD income. See Simonsen, 150 T.C. at 211 (focusing on fact that lender’s willingness to cancel mortgage debt was completely dependent on debtor’s willingness to convey proceeds from sale of residence); Sands v. Commissioner, T.C. Memo. 1997-146, 73 T.C.M. (CCH) 2398, 2403 (rejecting taxpayer’s contention that COD was “separate and distinct” from transfer of ownership in property), aff’d without published opinion sub nom. Murphy v. Commissioner, 164 F.3d 618 (2d Cir. 1998); Treas. Reg. § 1.1001-2(a)(1) (“[T]he amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.” (Emphasis added.)); see also 2925 Briarpark, Ltd. v. Commissioner, 163 F.3d 313, 319 (5th Cir. 1999) (concluding that debt relief “was closely intertwined” with underlying sale of property and thus included in amount realized on sale), aff’g T.C. Memo. 1997-298. In such an instance, it is immaterial whether debt relief takes the form of an assumption of debt by a purchaser or a cancellation by a lender. See 2925 Briarpark, Ltd. v. Commissioner, 163 F.3d at 319; Simonsen, 150 T.C. at 212-13.[8]

The IRS argues that, based on the case’s circumstances, the debt reduction was intrinsically linked to the sales in question.

Respondent contends that the $2,741,399 relating to the cancellation of Loans N712A and N712B is taxable to Exterra as gain derived from the sale of the Livermore property. See §61(a)(3). Respondent emphasizes that Loans N712A and N712B were nonrecourse to Exterra and were canceled as part of the sale of the Livermore property.[9]

Conversely, the taxpayers advocated for a different interpretation of the debt reduction.

Petitioners take a rather different approach. In their briefing petitioners sidestep the threshold inquiry — whether the debt cancellation was part of the sale of the Livermore property and thus gave rise to gain — and focus on their contentions that either Exterra or petitioners themselves were insolvent at the time the debt was discharged. Cf. Gehl, 102 T.C. at 789 (“Only after it is determined that [section 61(a)(12)] applies does one reach the question of the impact of insolvency and therefore the applicability of section 108.”); Danenberg, 73 T.C. at 384 (rejecting taxpayers’ argument that their insolvency precluded inclusion of debt relief in amount realized).[10]

Following its summary of the taxpayers’ stance and the ominous referencing of segments from the two cases cited immediately after, the Tax Court determined, as anticipated, that the solvency status of either party was inconsequential until the issue of whether the debt reduction was integral to the sale had been settled. As well, the recourse nature of the debt was to be tested solely by reference to the corporation, regardless of whether the lender might have had recourse against the shareholder.

As best we can tell, much of petitioners’ briefing is premised on a misconception that facts relating to Mr. Parker in his personal capacity are relevant to the question of whether there was income to Exterra in 2012 (and only then, flowthrough income to Mr. Parker as its 100% S corporation shareholder). In determining whether to sustain respondent’s upward adjustment to Exterra’s gross receipts (and thus the corresponding deficiency with respect to petitioners), we respect Exterra’s separate corporate existence. See Durando v. United States, 70 F.3d 548, 552 (9th Cir. 1995) (“[I]t [is] improper to treat income earned by [an S] corporation through its trade or business as though it were earned directly by its shareholders. . . .”); Crook v. Commissioner, 80 T.C. 27, 33 (1983) (“The separate existence of corporations is firmly established under the tax law, and this Court has recognized that the business of a subchapter S corporation is separate and distinct from that of its shareholders.” (internal citation omitted)), aff’d, 747 F.2d 1463 (5th Cir. 1984). Accordingly, petitioners’ observation, for instance, that Loans N712A and N712B were recourse as to Mr. Parker personally, is simply irrelevant to the issue before us.[11]

The Tax Court shifted its focus to determine whether the debt reductions were incorporated into the sales price, resulting in a gain (due to their direct connection to the sale if the debts were nonrecourse), or if they constituted cancellation of debt income.

We agree with respondent that the issue in this case is the threshold question of whether the cancellation of Loans N712A and N712B gave rise to gain or COD income for Exterra.[12]

The ruling determines that the reduction in the debts was incorporated into the sales price, and therefore was not appropriately categorized as cancellation of debt income as the taxpayers had argued.

The parties have stipulated that Loans N712A and N712B were nonrecourse as to the PLF entities and Exterra. While the original loan agreements for Loans N712A and N712B are not part of the stipulated record, the parties further stipulated that Loans N712A and N712B were each mezzanine loans. The record establishes that Loan N712A and N712B were each secured by the PLF entities’ pledge of their respective membership interests in the Montevina entities. Because the PLF entities and the Montevina entities were disregarded entities for federal income tax purposes, we treat Exterra as owning the underlying assets (i.e., the Livermore property), subject to the nonrecourse mezzanine Loans N712A and N712B, before the sale. See Treas. Reg. § 301.7701-2(a) (“[I]f the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.”); see also Pierre v. Commissioner, 133 T.C. 24, 42 (2009) (Halpern, J., dissenting) (“A sole proprietorship is generally understood to have no legal identity apart from the proprietor.”), supplemented by T.C. Memo. 2010-106. In turn the sale of the PLF entities’ membership interests in the Montevina entities is characterized for federal income tax purposes as a sale of the encumbered Livermore property by Exterra. See DAF Charters, LLC v. Commissioner, 152 T.C. 250, 260 (2019) (“[A]ny items of income and loss generated by the [disregarded] entity are directly attributable to and reported by the entity’s owner for Federal tax purposes. . . .”); see also Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies §2:83 Westlaw (database updated June 2023) (“The transfer of the interest in a disregarded entity is not treated as a transfer of the interest for federal tax purposes, but rather as a transfer of the assets of the disregarded entity.”).

The record is further clear that the cancellation of Loans N712A and N712B was part of the sale by Exterra (through the disregarded entities) of the Livermore property to the Buyers. As the relevant loan termination agreements between the PLF entities and NRFC WA Holdings II represented, the loan cancellation was made “[i]n connection with the proposed sale.” Further, the loan termination agreements were executed on October 4, 2012 — the same date that the various other agreements effecting the sale of the Livermore property, including the consent and release agreement to which NRFC WA Holdings II was a party, were executed. The COD was part and parcel of the global agreement to convey the Livermore property, with NRFC WA Holdings II accepting new personal guaranties, a partial payment by the Buyers, and the escrowed deed to the Iowa property in consideration of that cancellation.[13]

Consequently, the debt reductions were taxable and transferred to the shareholder’s tax return.

We conclude that NRFC WA Holdings II's cancellation of Loans N712A and N712B was dependent on Exterra's sale of the Livermore property to the Buyers and was a part of the same sale transaction. See Simonsen, 150 T.C. at 211. Accordingly, given that Loans N712A and N712B were nonrecourse as to Exterra, the amount of debt relief was properly includible in Exterra's amount realized on the sale of the Livermore property and gave rise to gain to the extent in excess of Exterra's basis in the property. See Treas. Reg. § 1.1001-2(a)(1). In turn, that gain flowed through to petitioners' personal income tax returns via Mr. Parker's 100% shareholder interest in Exterra.[14]

[1] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/canceled-debt-was-gain-includable-in-s-corporation%e2%80%99s-income/7h285 (retrieved August 11, 2023)

[2] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[3] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[4] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[5] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[6] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[7] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[8] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[9] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[10] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[11] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[12] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[13] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023

[14] Parker v. Commissioner, TC Memo 2023-104, August 10, 2023