Reg. § 1.108-7 Reduction of attributes.
(a) In general
(1) If a taxpayer excludes discharge of indebtedness income (COD income) from gross income under section , (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 , however, to apply any portion of the excluded COD income to reduce first the basis of depreciable property. To the extent the excluded COD income is not so applied, the taxpayer must then reduce any remaining tax attributes in the order specified in section . 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 and , see sections and 1.1017-1. For rules relating to the time and manner for making an election under section , see .
(b) Carryovers and carrybacks The tax attributes subject to reduction under section and 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 and of this section.
(c) Transactions to which section 381 applies If a taxpayer realizes COD income that is excluded from gross income under section either during or after a taxable year in which the taxpayer is the distributor or transferor of assets in a transaction described in section , any tax attributes to which the acquiring corporation succeeds, including the basis of property acquired by the acquiring corporation in the transaction, must reflect the reductions required by section . For this purpose, all attributes listed in section immediately prior to the transaction described in section , but after the determination of tax for the year of the distribution or transfer of assets, including basis of property, will be available for reduction under section . However, the basis of stock or securities of the acquiring corporation, if any, received by the taxpayer in exchange for the transferred assets shall not be available for reduction under section .
(d) Special rules for S corporations
(1) In general If an S corporation excludes COD income from gross income under section , (B), or (C), the amount excluded shall be applied to reduce the S corporation's tax attributes under of this section. For purposes of of this section, the aggregate amount of the shareholders' losses or deductions that are disallowed for the taxable year of the discharge under section , including disallowed losses or deductions of a shareholder that transfers all of the shareholder's stock in the S corporation during the taxable year of the discharge, is treated as the net operating loss tax attribute (deemed NOL) of the S corporation for the taxable year of the discharge.
(2) Allocation of excess losses or deductions
(i) In general If the amount of an S corporation's deemed NOL exceeds the amount of the S corporation's COD income that is excluded from gross income under section , (B), or (C), the excess deemed NOL shall be allocated to the shareholder or shareholders of the S corporation as a loss or deduction that is disallowed under section for the taxable year of the discharge.
(ii) Multiple shareholders
(A) In general If an S corporation has multiple shareholders, to determine the amount of the S corporation's excess deemed NOL to be allocated to each shareholder under of this section, calculate with respect to each shareholder the shareholder's excess amount. The shareholder's excess amount is the amount (if any) by which the shareholder's losses or deductions disallowed under section (before any reduction under of this section) exceed the amount of COD income that would have been taken into account by that shareholder under section had the COD income not been excluded under section .
(B) Shareholders with a shareholder's excess amount Each shareholder that has a shareholder's excess amount, as determined under of this section, is allocated an amount equal to the S corporation's excess deemed NOL multiplied by a fraction, the numerator of which is the shareholder's excess amount and the denominator of which is the sum of all shareholders' excess amounts.
(C) Shareholders with no shareholder's excess amount If a shareholder does not have a shareholder's excess amount as determined in of this section, none of the S corporation's excess deemed NOL shall be allocated to that shareholder.
(iii) Terminating shareholder Any amount of the S corporation's excess deemed NOL allocated under of this section to a shareholder that had transferred all of the shareholder's stock in the corporation during the taxable year of the discharge is permanently disallowed under , unless the transfer of stock is described in section . If the transfer of stock is described in section , the amount of the S corporation's excess deemed NOL allocated to the transferor under of this section shall be treated as a loss or deduction incurred by the corporation in the succeeding taxable year with respect to the transferee. See section .
(3) Character of excess losses or deductions allocated to a shareholder The character of an S corporation's excess deemed NOL that is allocated to a shareholder under of this section consists of a proportionate amount of each item of the shareholder's loss or deduction that is disallowed for the taxable year of the discharge under section .
(4) Information requirements If an S corporation excludes COD income from gross income under section for a taxable year, each shareholder of the S corporation during the taxable year of the discharge must report to the S corporation the amount of the shareholder's losses and deductions that are disallowed for the taxable year of the discharge under section , even if that amount is zero. If a shareholder fails to report the amount of the shareholder's losses and deductions that are disallowed for the taxable year of the discharge under section to the S corporation, or if the S corporation knows that the amount reported by the shareholder is inaccurate, or if the information, as reported, appears to be incomplete or incorrect, the S corporation may rely on its own books and records, as well as other information available to the S corporation, to determine the amount of the shareholder's losses and deductions that are disallowed for the taxable year of the discharge under section , provided that the S corporation knows or reasonably believes that its information presents an accurate reflection of the shareholder's disallowed losses and deductions under section . The S corporation must report to each shareholder the amount of the S corporation's excess deemed NOL that is allocated to that shareholder under of this section, even if that amount is zero, in accordance with applicable forms and instructions.
(e) Examples The following examples illustrate the application of this section:
Example 1.
(i) Facts. In Year 4, X, a corporation in a title 11 case, is entitled under section 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 .
(ii) Analysis. Pursuant to 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 is applied to reduce tax attributes. Thus, the amount of the net operating loss carryover that is reduced under section and of this section is $50,000.
Example 2.
(i) Facts. The facts are the same as in Example 1, 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. Pursuant to of this section and section , 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 is applied to reduce tax attributes. Thus, the amount of the net operating loss that is reduced under section and of this section is $50,000.
Example 3.
(i) Facts. In Year 2, X, a corporation in a title 11 case, has outstanding 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 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 that satisfies the requirements of section 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. On the distribution of Y stock to X's creditors, under section , X is entitled to exclude from gross income the debt discharge amount of $100,000. (Under section , X is treated as satisfying $100,000 of the debt owed the 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 of this section, the amount of X's net operating loss to which Y succeeds pursuant to section and the basis of X's property transferred to Y must take into account the reductions required by section . Pursuant to 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 . In addition, X's basis in the asset is reduced by $20,000, the extent to which the COD income excluded under section 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 . Pursuant to section , X recognizes no gain or loss on the transfer of its property to Y. Pursuant to section , Y's basis in the asset acquired from X is $45,000.
Example 4.
(i) Facts. The facts are the same as in Example 3, except that X elects under section to reduce first the basis of its depreciable asset.
(ii) Analysis. As in Example 3, on the distribution of Y stock to X's creditors, under section , 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 of this section, the amount of X's net operating loss to which Y succeeds pursuant to section and the basis of X's property transferred to Y must take into account the reductions required by section . As a result of the election under section , 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 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 . Pursuant to section , X recognizes no gain or loss on the transfer of its property to Y. Pursuant to section , Y's basis in the asset acquired from X is $0.
Example 5.
(i) Facts. During the entire calendar year 2009, A, B, and C each own equal shares of stock in X, a calendar year S corporation. As of December 31, 2009, A, B, and C each have a zero stock basis and X does not have any indebtedness to A, B, or C. For the 2009 taxable year, X excludes from gross income $45,000 of COD income under section . The COD income (had it not been excluded) would have been allocated $15,000 to A, $15,000 to B, and $15,000 to C under section . For the 2009 taxable year, X has $30,000 of losses and deductions that X passes through pro rata to A, B, and C in the amount of $10,000 each. The losses and deductions that pass through to A, B, and C are disallowed under section . In addition, B has $10,000 of section losses from prior years and C has $20,000 of section losses from prior years. A's ($10,000), B's ($20,000) and C's ($30,000) combined $60,000 of disallowed losses and deductions for the taxable year of the discharge are treated as a current year net operating loss tax attribute of X under section (deemed NOL) for purposes of the section reduction of tax attributes.
(ii) Allocation. Under section , X's $45,000 of excluded COD income reduces the $60,000 deemed NOL to $15,000. Therefore, X has a $15,000 excess net operating loss (excess deemed NOL) to allocate to its shareholders. Under of this section, none of the $15,000 excess deemed NOL is allocated to A because A's section losses and deductions immediately prior to the section reduction ($10,000) do not exceed A's share of the excluded COD income for 2008 ($15,000). Thus, A has no shareholder's excess amount. Each of B's and C's respective section losses and deductions immediately prior to the section reduction exceed each of B's and C's respective shares of the excluded COD income for 2008. B's excess amount is $5,000 ($20,000−$15,000) and C's excess amount is $15,000 ($30,000−$15,000). Therefore, the total of all shareholders' excess amounts is $20,000. Under of this section, X will allocate $3,750 of the $15,000 excess deemed NOL to B ($15,000 × $5,000/$20,000) and $11,250 of the $15,000 excess deemed NOL to C ($15,000 × $15,000/$20,000). These amounts are treated as losses and deductions disallowed under section for the taxable year of the discharge. Accordingly, at the beginning of 2010, A has no section carryovers, B has $3,750 of carryovers, and C has $11,250 of carryovers.
(iii) Character. Immediately prior to the section reduction, B's $20,000 of section losses and deductions consisted of $8,000 of long-term capital losses, $7,000 of section losses, and $5,000 of ordinary losses. After the section tax attribute reduction, X will allocate $3,750 of the excess deemed NOL to B. Under of this section, the $3,750 excess deemed NOL allocated to B consists of $1,500 of long-term capital losses (($8,000/$20,000) × $3,750), $1,312.50 of section losses (($7,000/$20,000) × $3,750), and $937.50 of ordinary losses (($5,000/$20,000) × $3,750). As a result, at the beginning of 2010, B's $3,750 of section carryovers consist of $1,500 of long-term capital losses, $1,312.50 of section losses, and $937.50 of ordinary losses.
Example 6.
(i) A and B each own 50 percent of the shares of stock in X, a calendar year S corporation. On March 1, 2009, X realizes $12,000 of COD income and excludes this amount from gross income under section for X's 2009 taxable year. On June 30, 2009, A sells all of her shares of stock in X to C in a transfer not described in section . X does not make a terminating election under section . The COD income (had it not been excluded) would have been allocated $3,000 to A, $6,000 to B, and $3,000 to C under section . Prior to the section reduction, for the taxable year of the discharge the shareholders have disallowed losses and deductions under section (including disallowed losses carried over to the current year under section ) in the following amounts: A—$5,000, B—$13,000, and C—$2,000. The combined $20,000 of disallowed losses and deductions for the taxable year of the discharge are treated as a current year net operating loss tax attribute of X under section (deemed NOL).
(ii) Under section , X's $12,000 of excluded COD income reduces the $20,000 deemed NOL to $8,000. Therefore, X has an $8,000 excess net operating loss (excess deemed NOL) to allocate to its shareholders. Under of this section, none of the $8,000 excess deemed NOL is allocated to C because C's section losses and deductions immediately prior to the section reduction ($2,000) do not exceed C's share of the excluded COD income for 2008 ($3,000). However, each of A's and B's respective section losses and deductions immediately prior to the section reduction exceed each of A's and B's respective shares of the excluded COD income for 2009. A's excess amount is $2,000 ($5,000−$3,000) and B's excess amount is $7,000 ($13,000−$6,000). Therefore, the total of all shareholders' excess amounts is $9,000. Under of this section, X will allocate $1,777.78 of the $8,000 excess deemed NOL to A ($8,000 × $2,000/$9,000) and $6,222.22 of the $8,000 excess deemed NOL to B ($8,000 × $7,000/$9,000). However, because A transferred all of her shares of stock in X in a transaction not described in section , A's $1,777.78 of section losses and deductions are permanently disallowed under of this section. Accordingly, at the beginning of 2010, B has $6,222.22 of section carryovers and C has no section carryovers.
Example 7. The facts are the same as in Example 6, except that X, with the consent of A and C, makes a terminating election under section upon A's sale of her stock in X to C. Therefore, the COD income (had it not been excluded) would have been allocated $6,000 to A, $6,000 to B, and $0 to C. Under of this section, none of the $8,000 excess deemed NOL is allocated to A because A's section losses and deductions immediately prior to the section reduction ($5,000) do not exceed A's share of the excluded COD income for 2009 ($6,000). However, each of B's and C's respective section losses and deductions immediately prior to the section reduction exceed each of B's and C's respective shares of the excluded COD income for 2009. B's excess amount is $7,000 ($13,000−$6,000), C's excess amount is $2,000 ($2,000−$0). Therefore, the total of all shareholders' excess amounts is $9,000. Under of this section, X will allocate $6,222.22 of the $8,000 excess deemed NOL to B ($8,000 × $7,000/$9,000) and $1,777.78 of the $8,000 excess deemed NOL to C. Accordingly, at the beginning of 2010, B has $6,222.22 of section carryovers and C has $1,777.78 of section carryovers.
(f) Effective/applicability date
(1) Paragraphs (a), (b), (c), and Examples 1, 2, 3, and 4 of of this section apply to discharges of indebtedness occurring on or after May 10, 2004.
(2) Paragraph (d) and Examples 5, 6, and 7 of of this section apply to discharges of indebtedness occurring on or after October 30, 2009. of this section applies on and after July 23, 2014. For rules that apply before that date, see 26 CFR part 1 (revised as of April 1, 2014).
[T.D. 9080, 68 FR 42592, July 18, 2003; 68 FR 56556, Oct. 1, 2003. Redesignated and amended by T.D. 9127, 69 FR 26039, May 11, 2004; T.D. 9469, 74 FR 56111, Oct. 30, 2009; T.D. 9682, 79 FR 42677, July 23, 2014]