John B. Beery
GR Review

Recent legislation has affected at least two significant areas of change relating to the federal taxation of financially troubled businesses:  an expansion of the ability of certain businesses to utilize Net Operating Losses, and the liberalization of rules permitting debtors to defer tax on income from the cancellation of certain debts.  While these rules are fairly complex in practical application, it may be useful to learn the basics of their operation to see whether further inquiry is advisable.

Net Operating Losses

Generally, a net operating loss (NOL) may be carried back only two years, and then will be carried forward 20 years.  However, under recent legislation, if an “eligible small business” so elects, an “applicable 2008 NOL” may be carried back three, four, or five years, whichever the taxpayer elects.  This permits the eligible small business to carry the 2008 NOL back to three, four, or five years preceding the tax year of the NOL, as the eligible small business elects.  

The increased carryback period applies to the portion of the taxpayer's applicable 2008 NOL that is an “eligible small business loss” (an “ESB”) —i.e., the smaller of: (a) the amount that would be the 2008 NOL if only income, gains, losses, and deductions attributable to ESBs were taken into account, or (b) the 2008 NOL.  That is, the amount that may be carried back under Code Sec. 172(b)(1)(H) is limited to the lesser of:

(i) the taxpayer's items of income, gain, loss or deduction that are allowed in calculating the taxpayer's applicable 2008 NOL and are from one or more partnerships, S corporations or sole proprietorships that qualify as ESBs, or

(ii) the taxpayer's applicable 2008 NOL. 

An eligible small business is any trade or business, whether conducted in or through a corporation, partnership, or sole proprietorship, whose average annual gross receipts for 2006 through 2008 are $15 million or less. 

The regular two-year carryback period remains available for the 2008 NOL if the taxpayer does not elect the increased carryback period for it.  Further, taxpayers that do not qualify as eligible small businesses because of their gross receipts still qualify to carry back the 2008 NOL for two years. 

Cancellation of Debt Income

Under current law, the reduction of debt obligations by a lender results in taxable income to the borrower.  This income, typically referred to as “cancellation of debt” (“COD”) income is generally treated as ordinary income in the year of the debt reduction or discharge.  However, new law is more forgiving to the debtor.

For many types of COD income recognized in 2009 or 2010, the debtor will be able to defer the recognition of this income until the 5 year period from 2014 through 2018.  During this period, the COD income will be ratably apportioned to the 5 tax years 2014 through 2018.  This may allow for a 9 year deferral of some portion of the income taxes in many cases.

The new legislation addresses a number of corollary issues which are too numerous to fully address here.  Many of these relate to circumstances which arise during the deferral period.  For example, if a taxpayer passes away during this deferral period, the deferred COD income is recognized on his or her final income tax return.  Also, in the pass-through context, partnerships and S corporations, whose income is passed-through to the owners, will be required to attribute this deferred COD income to the persons who owned interests when the COD income was recognized, even if they are no longer owners of the entity.

Summary

While many taxpayers are in the process of renegotiating the terms of their debt instruments and attempting to reduce costs, it would be wise to keep these new NOL carryback and COD deferral rules in mind, as there are significant economic benefits available through careful tax planning in these areas.

John Beery is an Associate in Gould & Ratner's Tax and Financial Group.  He may be reached at 312.899.1699 or via email at jbeery@gouldratner.com.