In final regulations (TD 9771), the Service has clarified who is a "taxpayer" for purposes of excluding income from the discharge of indebtedness (COD) of a grantor trust or disregarded entity under Section 108(a)(1)'s insolvency and bankruptcy exceptions. The final regulations clarify that the owner of a grantor trust or disregarded entity is the taxpayer and that the owner, not the trust or disregarded entity, must be insolvent or in bankruptcy for the exceptions to apply. These regulations are effective for COD income arising on or after June 10, 2016. (For coverage of the proposed regulations (REG-154159-09), see Tax Alert 2011-711.)

Background

Generally, a discharge of indebtedness gives rise to gross income to the obligor. Section 61(a)(12); see also Gitlitz v. Commissioner, 531 U.S. 206, 213 (2001). Section 108(a)(1)(A) and (B) exclude from gross income COD income that occurs in a Title 11 case (bankruptcy exception) or to the extent the taxpayer is insolvent when the discharge occurs (insolvency exception).

Several types of disregarded entities exist under the IRC and regulations. With limited exceptions, a disregarded entity's activities are treated as those of the owner of the disregarded entity. For federal income tax purposes, the disregarded entity's assets, liabilities, and items of income, deduction and credit are treated as those of the owner.

A grantor trust is any portion of a trust that is treated as being owned by the grantor or another person. Like disregarded entities, items of income, deductions and credits attributable to a grantor trust are includable in computing the owner's taxable income and credits.

In proposed regulations (REG-154159-09) issued in 2011, the Service clarified that the owner of the grantor trust or disregarded entity is the taxpayer.

Final regulations

Under the final regulations, for purposes of applying the rules of Section 108(a)(1)(A) and (B) to COD income of grantor trusts or disregarded entities, the grantor trusts and disregarded entities themselves are not considered taxpayers. The IRS modified the proposed regulations to specify that that the owner of a grantor trust or disregarded entity must itself be a "debtor" under the Bankruptcy Code, not merely under the jurisdiction of the bankruptcy court. For partnerships that own a grantor trust or disregarded entity, the regulations apply to the partners of the partnership to whom the COD income is allocable.

Implications

The final regulations enshrine the IRS's long-held belief that a disregarded entity is disregarded as separate from its owner when applying certain aspects of Section 108. As the result of the final regulations, taxpayers may no longer take the position that the insolvency or bankruptcy of the grantor trust or disregarded entity permits them to exclude COD income. Additionally, while the regulations are effective for COD income occurring on or after June 10, 2016, since the IRS views these regulations as consistent with existing law, it will not challenge a return position consistent with the regulations for the period before the effective date.

The revision to the proposed regulations to specify that the owner of the grantor trust or disregarded entity must be a "debtor" under the Bankruptcy Code effectively overrules Gracia v. Comm'r¹ and associated tax court cases from 2004 (see Tax Alert 2004-543{}). In Gracia, a solvent general partner in a partnership was able to avail himself of the bankruptcy exception because his personal guaranty of the partnership's debts was discharged in the partnership's bankruptcy case. Under the final regulations, because the taxpayer in Gracia was not the "debtor" for purposes of the Bankruptcy Code, he would not be entitled to exclude the COD income under the bankruptcy exception.

The regulations do not address commenters' requests to clarify how a grantor's share of a multiple-owner grantor trust's liability should be determined, and how indebtedness of a disregarded entity is treated by the owner for purposes of determining insolvency under Section 108(d)(3). The IRS invited comments regarding the application of the rules in these situations. The preamble to the final regulations, however, states that Treasury and the IRS are of the view that, absent a guaranty by the owner, indebtedness of a grantor trust or disregarded entity should generally be treated as nonrecourse indebtedness, and that the principles of Revenue Ruling 92-53 apply to determine the extent to which the indebtedness is taken into account in determining the owner's insolvency.

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ENDNOTES

¹ T.C. Memo 2004-147; see also Mirarchi v. Comm'r, T.C. Memo 2004-148, Price v. Comm'r, T.C. Memo 2004-149, Estate of Martinez v. Comm'r, T.C. Memo 2004-150.