\[4830-01-p\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

\[TD 9080\]

RIN 1545-BC47

Reduction of Tax Attributes Due to Discharge of Indebtedness

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains regulations relating to the reduction of
tax attributes under sections 108 and 1017 of the Internal Revenue Code.
These temporary regulations affect taxpayers that exclude discharge of
indebtedness income from gross income under section 108. The text of
the~~se~~ temporary regulations also serves as the text of the proposed
regulations set forth in the notice of proposed rulemaking on this
subject in the Proposed Rules section in this issue of the **Federal
Register**.

DATES: [Effective Date]{.underline}: These temporary regulations are
effective **\[[INSERT DATE THIS DOCUMENT IS FILED WITH THE FEDERAL
REGISTER]{.underline}\]**.

[Applicability Date]{.underline}: These temporary regulations apply to
discharges of indebtedness occurring after **\[[INSERT DATE THIS
DOCUMENT IS FILED WITH THE FEDERAL REGISTER]{.underline}\]**.

FOR FURTHER INFORMATION CONTACT: Theresa M. Kolish (202 622-7930) of the
Office of the Associate Chief Counsel (Corporate) (not a toll-free
number).

SUPPLEMENTARY INFORMATION:

**Background**

[The Debt Discharge Rules]{.underline}

Pursuant to section 61(a)(12), gross income includes income from the
discharge of indebtedness (COD income). Section 108(a)(1), which
reflects the amendments enacted in the Bankruptcy Tax Act of 1980,
Public Law 96-589, section 2, 94 Stat. 3389 (1980) (1980-2 C.B. 607),
however, provides that, where the discharge occurs in a title 11 case,
where the taxpayer is insolvent, or where the indebtedness is "qualified
farm indebtedness" or "qualified real property business indebtedness,"
gross income does not include any amount that otherwise would be
includible in gross income by reason of that discharge (in whole or in
part) of the indebtedness of the taxpayer.

Although section 108(a) excludes COD income from gross income under
those circumstances, section 108(b) requires the reduction of certain
tax attributes in an amount that reflects the amount excluded from gross
income, thereby generally deferring, rather than permanently
eliminating, the inclusion of COD income. Section 108(b)(2) requires the
reduction of the following tax attributes of the taxpayer in the
following order: (A) net operating losses; (B) general business credits;
(C) minimum tax credits; (D) capital loss carryovers; (E) adjusted basis
of property; (F) passive activity losses and credit carryovers; and (G)
foreign tax credit carryovers. Section 108(b)(4)(A) provides that the
reductions are made after the determination of the tax imposed for the
taxable year of the discharge. Section 108(b)(4)(B) provides that the
reductions of net operating losses and capital loss carryovers are made
first in the loss for the taxable year of the discharge and then in the
carryovers to such taxable year in the order of the taxable years from
which each such carryover arose. If the excluded COD income exceeds the
sum of the taxpayer's tax attributes, the excess is disregarded such
that it does not result in income or have other tax consequences. See
H.R. Rep. No. 96-833, at 11 (1980).

Instead of reducing tax attributes in the order set forth in section
108(b)(2), a taxpayer may elect under section 108(b)(5) to reduce first
the adjusted bases of depreciable property to the extent of the excluded
COD income. The amount to which the election applies is limited to the
aggregate adjusted basis of the depreciable property held by the
taxpayer as of the beginning of the taxable year following the taxable
year in which the discharge occurs. If the adjusted bases of depreciable
property are insufficient to offset the entire amount of excluded COD
income, the taxpayer must then reduce any remaining tax attributes in
the order set forth in section 108(b)(2). Congress intended the election
under section 108(b)(5) to allow debtors, including debtors in
bankruptcy, to account for a debt discharge amount in a manner most
favorable to their tax situations. See S. Rep. No. 96-1035, at 10
(1980); H.R. Rep. No. 96-833, at 9 (1980).

Section 1017(a) provides that when any portion of COD income excluded
from gross income under section 108(a) is to be applied to reduce basis,
then such portion shall be applied to reduce the basis of any property
held by the taxpayer at the beginning of the taxable year following the
taxable year in which the discharge occurs. Section 1017(b)(1) provides
that the amount of reduction under section 1017(a), and the particular
properties the bases of which are to be reduced, shall be determined
under regulations.

[The Reorganization Rules]{.underline}

Section 368(a)(1) defines a reorganization to include certain types of
asset acquisitions. Under section 361, a corporation that is a party to
a reorganization recognizes neither gain nor loss when it exchanges
property, in pursuance of the plan of reorganization, solely for stock
or securities in another corporation that is a party to the
reorganization. If the corporation receives in the exchange not only
stock or securities permitted to be received without the recognition of
gain, but also other property or money, then the corporation may be
required to recognize gain. Under section 362(b), if property is
acquired by a corporation in connection with a reorganization, then the
basis is the same as it would be in the hands of the transferor,
increased by the amount of gain recognized to the transferor on such
transfer.

Section 332(a) provides that a corporation recognizes no gain or loss on
the receipt of property distributed in complete liquidation of another
corporation. Section 337(a) provides that a liquidating corporation
recognizes no gain or loss on the distribution to the 80-percent
distributee of any property in a complete liquidation to which section
332 applies. Under section 334(b)(1), if property is received by a
corporate distributee in a distribution in a complete liquidation to
which section 332 applies, the basis of such property in the hands of
such distributee is the same as it would be in the hands of the
transferor. However, in any case in which gain or loss is recognized by
the liquidating corporation with respect to such property, the basis of
such property in the hands of such distributee is the fair market value
of the property at the time of the distribution.

Section 381 provides that a corporation that acquires the assets of
another corporation in a distribution to which section 332 applies or in
a transfer to which section 361 applies (but only if the transfer is in
connection with certain reorganizations described in sections
368(a)(1)(A), (C), (D), (F), or (G)) shall succeed to, and take into
account, as of the close of the day of distribution or transfer, the
items described in section 381(c) of the distributor or transferor
corporation, subject to certain conditions and limitations. Among those
items described in section 381(c) are net operating loss carryovers,
capital loss carryovers, general business credits, and minimum tax
credits. With respect to net operating loss carryovers and capital loss
carryovers, the regulations under section 381 reflect that the acquiring
corporation succeeds to only those carryovers that remain after the
application of sections 172 and 1212 and their carryforward and
carryback provisions. See §§1.381(c)(1)-1; 1.381(c)(3)-1. Furthermore,
those regulations provide that the acquiring corporation succeeds to
only those general business credits that remain unused by the transferor
corporation after computing its taxable income for the year of the
transfer. See §1.381(c)(23)-1. Section 381(b)(1) provides that, except
in the case of an acquisition in connection with a reorganization
described in section 368(a)(1)(F), the taxable year of the distributor
or transferor corporation ends on the date of distribution or transfer.

[Interaction Between Debt Discharge and Reorganization
Rules]{.underline}

Questions have arisen regarding the application of the attribute
reduction rules of sections 108 and 1017 when a transaction described in
section 381(a) ends a taxable year in which the transferor excludes COD
income from gross income. If section 108(b)(4)(A) and section 1017 were
interpreted to require attribute reduction to occur after the close of
the taxable year of discharge and after the transfer of assets and
carryover of items described in section 381(c), then arguably no
attributes described in section 108(b)(2) would be available for
reduction.

**Explanation of Provisions**

The IRS and Treasury Department believe that the rule of section
108(b)(4)(A) prescribes an ordering of calculations. First, section
108(b)(4)(A) requires a determination of the taxpayer's tax for the
taxable year of discharge in order to identify the amounts, if any, of
the tax attributes described in section 108(b)(2) that remain available
for reduction. Second, section 108(b)(4)(A) requires the reduction of
those attributes. This ordering rule affords the taxpayer the use of
certain of its tax attributes described in section 108(b)(2), including
any losses carried forward to the taxable year of discharge, for
purposes of determining its tax for the taxable year of discharge,
before subjecting those attributes to reduction.

Similarly, the IRS and Treasury believe that the rule of section 1017
prescribes an ordering of calculations. The Bankruptcy Tax Act of 1980
reflects that Congress enacted the rule of section 1017 \"to avoid
interaction between basis reduction and reduction of other attributes.\"
S. Rep. No. 96-1035, at 14 (1980); H. Rep. No. 96-833, at 11 (1980).
Without this rule, a circular calculation could be required. The
taxpayer\'s net operating loss for the year of the discharge of
indebtedness might be based in part on the amount of cost recovery
deductions allowed to the taxpayer. The amount of cost recovery
deductions, however, would depend on the taxpayer\'s basis in its
depreciable or amortizable property at the end of the year. Because net
operating losses are reduced by excluded COD income prior to the
reduction of asset basis absent an election under section 108(b)(5), the
amount of basis required to be reduced would depend on the amount of net
operating losses. Reducing the basis of property held by the taxpayer at
the beginning of the taxable year following the taxable year in which
the discharge occurs avoids this circularity.

The position that sections 108 and 1017 require the reduction of
attributes, including the basis of transferred assets, in cases where
the debtor's taxable year ends with a transfer of assets in a
transaction described in section 381 is consistent with the policies
underlying sections 108 and 1017 and the corporate reorganization
provisions, including "deferring, but eventually collecting within a
reasonable period, tax on ordinary income realized from debt discharge."
S. Rep. No. 96-1035, at 10 (1980). For example, assume that a debt of
corporation X is discharged in a title 11 case. X's attributes described
in section 108(b)(2) consist solely of basis in property. As part of a
plan of reorganization, X transfers all of its assets to a newly formed
corporation, Y. Under section 368(a)(3)(C), even though the transaction
also qualifies as a reorganization under section 368(a)(1)(F), the
transaction is treated as qualifying as a reorganization only under
section 368(a)(1)(G). If sections 108 and 1017 were interpreted to not
require a reduction of the bases of the property transferred, X would
permanently exclude from gross income the COD income, notwithstanding
that X underwent nothing more than a mere change in identity, form, or
place of organization. Accordingly, consistent with the legislative
history of the Bankruptcy Tax Act of 1980, the IRS and Treasury
Department believe that the basis reduction rules of sections 108 and
1017 apply to property of a debtor transferred in a transaction
described in section 381(a).

The legislative history of the Bankruptcy Tax Act of 1980 reflects that
Congress specifically anticipated that amounts that carry over in a
transaction described in section 381, including the basis of transferred
property, are to be adjusted under the rules of sections 108 and 1017 to
account for excluded COD income. See H.R. Rep. No. 96-833, at 32-34
(1980). The legislative history states:

> Assume that Corporation A is in a bankruptcy case commenced after
> October 1, 1979. Immediately prior to a transfer under a plan of
> reorganization, A\'s assets have an adjusted basis of \$75,000 and a
> fair market value of \$100,000. A has a net operating loss carryover
> of \$200,000. A has outstanding bonds of \$100,000 (on which there is
> no accrued but unpaid interest) and trade debts of \$100,000.
>
> Under the plan of reorganization, A is to transfer all its assets to
> Corporation B in exchange for \$100,000 of B stock. Corporation A will
> distribute the stock, in exchange for their claims against A, one-half
> to the security holders and one-half to the trade creditors. A\'s
> shareholders will receive nothing.

The transaction would qualify as a reorganization under new section
368(a)(1)(G) of the Code, since all the creditors are here treated as
proprietors for continuity of interest purposes. Thus, A would recognize
no gain or loss on the transfer of its assets to B (sec. 361). B\'s
basis in the assets would be \$75,000 (sec. 362), and B would succeed to
A\'s net operating loss carryover (sec. 381).

Under the bill, . . . \[o\]n the distribution of B stock to A\'s trade
creditors, A excludes from gross income the debt discharge amount of
\$50,000 \-- i.e., the difference between the \$100,000 debt held by
non-security creditors and the \$50,000 worth of stock given for such
debt. A may elect to reduce the basis of its depreciable assets
transferred to B by all or part of the \$50,000 debt discharge amount;
to the extent the election is not made, the debt discharge amount
reduces A\'s net operating loss carryover by the remainder of the debt
discharge amount.

H.R. Rep. No. 96-833, at 34 (1980). The treatment of the net operating
loss and basis in the legislative history demonstrates that, in a
transaction described in section 381, the transferor's attributes,
including the basis of transferred property, that carry over to the
transferee are reduced.

Accordingly, these temporary regulations clarify that, in the case of a
transaction described in section 381(a) that ends a year in which the
distributor or transferor corporation excludes COD income from gross
income under section 108(a), any tax attributes to which the acquiring
corporation succeeds and the basis of property acquired by the acquiring
corporation in the transaction shall reflect the reductions required by
sections 108 and 1017. For this purpose, all attributes listed in
section 108(b)(2) of the distributor or transferor corporation
immediately prior to the transaction described in section 381(a),
including the basis of property, but after the determination of tax for
the year of the discharge, are available for reduction under section
108(b)(2).

These temporary regulations also clarify that the tax attributes subject
to reduction under section 108(b)(2) that are carryovers to the taxable
year of the discharge, or that may be carried back to taxable years
preceding the year of the discharge, are first taken into account by the
taxpayer for the taxable year of the discharge or the preceding years,
as the case may be, before such attributes are reduced pursuant to
section 108(b)(2).

These temporary regulations apply to discharges of indebtedness
occurring after **\[[INSERT DATE THIS DOCUMENT IS FILED WITH THE FEDERAL
REGISTER]{.underline}\]**.

**Special Analyses**

It has been determined that these temporary regulations are not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedures Act (5
U.S.C. chapter 5) does not apply to these temporary regulations, and,
because no preceding notice of proposed rulemaking is required for these
temporary regulations, the provisions of the Regulatory Flexibility Act
(5 U.S.C. chapter 6) do not apply. Pursuant to section 7805(f) of the
Internal Revenue Code, these temporary regulations will be submitted to
the Chief Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.

**Drafting Information**

The principal author of these temporary regulations is Theresa M.
Kolish, Office of Associate Chief Counsel (Corporate). However, other
personnel from the IRS and Treasury Department participated in their
development.

**List of Subjects in 26 CFR Part 1**

Income taxes, Reporting and recordkeeping requirements.

**Proposed Amendments to the Regulations**

Accordingly, 26 CFR part 1 is amended as follows:

PART 1‑‑INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding the
following entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 \* \* \*

Section 1.108-7T also issued under 26 U.S.C. 108. \* \* \*

Par. 2. Section 1.108-7T is added to read as follows:

[§1.108-7T Reduction of attributes (temporary)]{.underline}.

\(a\) [In general]{.underline}. (1) If a taxpayer excludes discharge of
indebtedness income (COD income) from gross income under section
108(a)(1)(A), (B), or (C), then the amount excluded shall be applied to
reduce the following tax attributes of the taxpayer in the following
order:

\(i\) Net operating losses.

\(ii\) General business credits.

\(iii\) Minimum tax credits.

\(iv\) Capital loss carryovers.

\(v\) Basis of property.

\(vi\) Passive activity loss and credit carryovers.

\(vii\) Foreign tax credit carryovers.

\(2\) The taxpayer may elect under section 108(b)(5), however, to reduce
first the basis of depreciable property to the extent of the excluded
COD income. If the basis of depreciable property is insufficient to
offset the entire amount of the excluded COD income, the taxpayer must
then reduce any remaining tax attributes in the order specified in
section 108(b)(2). If the excluded COD income exceeds the sum of the
taxpayer's tax attributes, the excess is permanently excluded from the
taxpayer's gross income. For rules relating to basis reductions required
by sections 108(b)(2)(E) and 108(b)(5), see section 1017 and §1.1017-1.
For rules relating to the time and manner for making an election under
section 108(b)(5), see §1.108-4.

\(b\) [Carryovers and carrybacks]{.underline}. The tax attributes
subject to reduction under section 108(b)(2) and paragraph (a)(1) of
this section that are carryovers to the taxable year of the discharge,
or that may be carried back to taxable years preceding the year of the
discharge, are taken into account by the taxpayer for the taxable year
of the discharge or the preceding years, as the case may be, before such
attributes are reduced pursuant to section 108(b)(2) and paragraph
(a)(1) of this section.

\(c\) [Transactions to which section 381 applies]{.underline}. In the
case of a transaction described in section 381(a) that ends a taxable
year in which the distributor or transferor corporation excludes COD
income under section 108(a), any tax attributes to which the acquiring
corporation succeeds and the basis of property acquired by the acquiring
corporation in the transaction shall reflect the reductions required by
section 108(b). For this purpose, all attributes listed in section
108(b)(2) of the distributor or transferor corporation immediately prior
to the transaction described in section 381(a), but after the
determination of tax for the year of the discharge, including basis of
property, shall be available for reduction under section 108(b)(2).

\(d\) [Examples]{.underline}. The following examples illustrate the
application of this section:

[Example 1]{.underline}. (i) [Facts]{.underline}. In Year 4, X, a
corporation in a title 11 case, is entitled under section 108(a)(1)(A)
to exclude from gross income \$100,000 of COD income. For Year 4, X has
gross income in the amount of \$50,000. In each of Years 1 and 2, X had
no taxable income or loss. In Year 3, X had a net operating loss of
\$100,000, the use of which when carried over to Year 4 is not subject
to any restrictions other than those of section 172.

\(ii\) [Analysis]{.underline}. Pursuant to paragraph (b) of this
section, X takes into account the net operating loss carryover from Year
3 in computing its taxable income for Year 4 before any portion of the
COD income excluded under section 108(a)(1)(A) is applied to reduce tax
attributes. Thus, the amount of the net operating loss carryover that is
reduced under section 108(b)(2) and paragraph (a) of this section is
\$50,000.

[Example 2]{.underline}. (i) [Facts]{.underline}. The facts are the same
as in [Example 1]{.underline}, except that in Year 4 X sustains a net
operating loss in the amount of \$100,000. In addition, in each of Years
2 and 3, X reported taxable income in the amount of \$25,000.

\(ii\) [Analysis]{.underline}. Pursuant to paragraph (b) of this section
and section 172, the net operating loss sustained in Year 4 is carried
back to Years 2 and 3 before any portion of the COD income excluded
under section 108(a)(1)(A) is applied to reduce tax attributes. Thus,
the amount of the net operating loss that is reduced under section
108(b)(2) and paragraph (a) of this section is \$50,000.

[Example 3]{.underline}. (i) [Facts]{.underline}. In Year 2, X, a
corporation in a title 11 case, has outstanding trade debts of \$200,000
and a depreciable asset that has an adjusted basis of \$75,000 and a
fair market value of \$100,000. X has no other assets or liabilities. X
has a net operating loss of \$80,000 that is carried over to Year 2 but
has no general business credit, minimum tax credit, or capital loss
carryovers. Under a plan of reorganization, X transfers its asset to
Corporation Y in exchange for Y stock with a value of \$100,000. X
distributes the Y stock to its trade creditors in exchange for release
of their claims against X. X\'s shareholders receive nothing in the
transaction. The transaction qualifies as a reorganization under section
368(a)(1)(G) that satisfies the requirements of section 354(a)(1)(A) and
(B). For Year 2, X has gross income of \$10,000 (without regard to any
income from the discharge of indebtedness) and is allowed a depreciation
deduction of \$10,000 in respect of the asset. In addition, it generates
no general business credits.

\(ii\) [Analysis]{.underline}. On the distribution of Y stock to X\'s
trade creditors, under section 108(a)(1)(A), X is entitled to exclude
from gross income the debt discharge amount of \$100,000. (Under section
108(e)(8), X is treated as satisfying \$100,000 of the debt owed the
trade creditors for \$100,000, the fair market value of the Y stock
transferred to those creditors.) In Year 2, X has no taxable income or
loss because its gross income is exactly offset by the depreciation
deduction. As a result of the depreciation deduction, X's basis in the
asset is reduced by \$10,000 to \$65,000. Pursuant to paragraph (c) of
this section, the amount of X's net operating loss to which Y succeeds
pursuant to section 381 and the basis of X's property transferred to Y
must take into account the reductions required by section 108(b).
Pursuant to paragraph (a) of this section, X's net operating loss
carryover in the amount of \$80,000 is reduced by \$80,000 of the COD
income excluded under section 108(a)(1). In addition, X's basis in the
asset is reduced by \$20,000, the extent to which the COD income
excluded under section 108(a)(1) did not reduce the net operating loss.
Accordingly, as a result of the reorganization, there is no net
operating loss to which Y succeeds under section 381. Pursuant to
section 361, X recognizes no gain or loss on the transfer of its
property to Y. Pursuant to section 362(b), Y's basis in the asset
acquired from X is \$45,000.

[Example 4]{.underline}. (i) [Facts]{.underline}. The facts are the same
as in [Example 3]{.underline}, except that X elects under section
108(b)(5) to reduce first the basis of its depreciable asset.

\(ii\) [Analysis]{.underline}. As in [Example 3]{.underline}, on the
distribution of Y stock to X\'s trade creditors, under section
108(a)(1)(A), X is entitled to exclude from gross income the debt
discharge amount of \$100,000. In addition, in Year 2, X has no taxable
income or loss because its gross income is exactly offset by the
depreciation deduction. As a result of the depreciation deduction, X's
basis in the asset is reduced by \$10,000 to \$65,000. Pursuant to
paragraph (c) of this section, the amount of X's net operating loss to
which Y succeeds pursuant to section 381 and the basis of X's property
transferred to Y must take into account the reductions required by
section 108(b). As a result of the election under section 108(b)(5), X's
basis in the asset is reduced by \$65,000 to \$0. In addition, X's net
operating loss is reduced by \$35,000, the extent to which the amount
excluded from income under section 108(a)(1)(A) does not reduce X's
asset basis. Accordingly, as a result of the reorganization, Y succeeds
to X's net operating loss in the amount of \$45,000 under section 381.
Pursuant to section 361, X recognizes no gain or loss on the transfer of
its property to Y. Pursuant to section 362(b), Y's basis in the asset
acquired from X is \$0.

\(e\) [Effective date]{.underline}. This section applies to discharges
of indebtedness occurring after **\[[INSERT DATE THESE REGULATIONS ARE
FILED WITH THE FEDERAL REGISTER]{.underline}\]**.

Par. 3. Section 1.1017-1 is amended by adding paragraph (b)(4) to read
as follows:

[§1.1017-1 Basis reductions following a discharge of
indebtedness]{.underline}.

\* \* \* \* \*

\(b\) \* \* \*

\(4\) For further guidance, see §1.1017-1T(b)(4).

\* \* \* \* \*

Par. 4. Section 1.1017-1T is added to read as follows:

[§1.1017-1T Basis reductions following a discharge of indebtedness
(temporary)]{.underline}.

\(a\) through (b)(3) \[Reserved\]. For further guidance, see
§1.1017-1(a) through (b)(3).

\(4\) [Transactions to which section 381 applies]{.underline}. In the
case of a transaction described in section 381(a) that ends a taxable
year in which the distributor or transferor corporation excludes COD
income from gross income under section 108(a), the basis of property
acquired by the acquiring corporation in the transaction shall reflect
the reductions required by section 1017 and this section. For this
purpose, the basis of property of the distributor or transferor
corporation immediately prior to the transaction described in section
381(a), but after the determination of tax for the year of the
discharge, shall be available for reduction under section 108(b)(2). See
§1.108-7T. This paragraph (b)(4) applies to discharges of indebtedness
occurring after **\[[INSERT DATE THESE REGULATIONS ARE FILED WITH THE
FEDERAL REGISTER]{.underline}\]**.

\(c\) through (i) \[Reserved\]. For further guidance, see §1.1017-1(c)
through (i).

Deputy Commissioner for Services and Enforcement.

Approved:

Assistant Secretary of the Treasury.