Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.
Stock for Debt Exchange
If a corporation transfers its stock in satisfaction of indebtedness and the fair market value of its stock is less than the indebtedness it owes, the corporation has income (to the extent of the difference) from the cancellation of indebtedness. After 1994, a corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation must reduce its tax attributes (to the extent it has any) by the amount of excluded income.
Stock for debt exception. The stock for debt exception was repealed for transfers made after 1994 unless the corporation filed for bankruptcy (or similar court proceeding) before 1994. Generally, before 1995, a corporation did not realize income because of such stock for debt exchanges if it was in bankruptcy or to the extent it was insolvent. Consequently, there was no gross income to exclude and no reduction of its tax attributes was necessary. The principal difference between the stock for debt exception and the stock for debt exchange is that the corporation does not reduce its tax attributes under the stock for debt exception.
Earnings and profits
The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation’s property as explained earlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).
If there is a deficit in the corporation’s earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder’s terminated or extinguished interest.
For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.
Net operating losses. A loss or deduction that is disallowed for the tax year of the debt cancellation because it exceeds the shareholders’ basis in the corporation’s stock and debt is treated as a net operating loss for that tax year in making the required reduction of tax attributes for the amount of the canceled debt.