S Corporation CPA discusses tax treatment of Form 1099-C, Cancellation of Debt, and Form 982, Reduction of Tax Attributes, on Form 1120-S, U.S. Income Tax Return for an S Corporation

S Corporation CPAs see corporate Form 1099-C(s), Cancellation of Debt. Because I specialize in S Corporations, Form 1120-S, Form 982, and offer a free initial phone consult, I probably field more calls about cancelled debt in S Corporations than most CPAs. One particular court case, David A. Gitlitz, et ux. et al. v. Commissioner, causes most of any confusion over Form 1099-C, Cancellation of Debt, and S Corporations. It changed the tax treatment of debt cancellation on Form 1120-S for instances after 2001. So post Gitlitz is the new normal. Please note cancelled debt taxation is complex and even more so at the Corporate level. This post is a primer and you can’t reasonably rely on it as tax advice. Please also note our virtual office means we can provide cancelled debt tax preparation and planning services wherever you’re incorporated.

Cut to the Chase

Only the realized cancelled debt income passes through to the Shareholders. See below.

Primer on Cancelled Debt in S Corporations and Form 1120-S, U.S. Income Tax Return for an S Corporation

Let’s assume:

• The S Corporation held rental property in its own name.
• The S Corporation had a short of sale of the rental property asset in 2013.
• And the bank cancelled the remaining mortgage debt in 2013 and issued Form 1099-C, Cancellation of Debt.

The S Corporation’s From 1099-C, Cancellation of Debt

The forgiven mortgage debt triggers issuance of Form 1099-C to the IRS and the S Corporation’s Registered Agent. The amount of debt cancellation appears in Box 2. Is the date correct? That can be important if the S Corporation uses the insolvency provision of Form 982, Reduction of Tax Attributes, see below.

“The cancelled debt amount in Box 2 the S Corporation’s Form 1099-C, Cancellation of Debt, may not match the actual cancelled debt incurred by the S Corporation.”
- Gary Bode, S Corporation cancelled debt CPA

The S Corporation’s Form 982, Reduction of Tax Attributes

Cancelled debt automatically becomes taxable income to the S Corporation, and then to the Shareholder’s via Schedule K-1, unless it can be excluded on Form 982, Reduction of Tax Attributes. For our rental real estate short sale scenario above, Form 982 offers three possible provisions to exclude the cancelled debt from taxable income:

• Corporate bankruptcy.
• Corporate insolvency per the IRS definition.
• Qualified real property business indebtedness.

The S Corporation can use more than one Form 982 provision to exclude some or all cancelled debt from becoming taxable income on the S Corporation’s Form 1120-S, U.S. Income Tax Return for an S Corporation.

Trap One - IRS tax Form 4797, Sales of Business Property

It seems many shareholders forget about the actual sale of the S Corporation’s rental real estate because of their cancelled debt concerns. Even though our rental property short sale example implies there’s a loss, the accumulated depreciation recapture requirements often result in a taxable gain on IRS tax Form 4797, Sales of Business Property. The calculation can be tricky.

Trap Two - The Reduction of Tax Attributes section of IRS Form 982

There’s a general perception that Form 982, when it excludes cancelled debt from S Corporation taxable income, is a free ride. And it can be. But more often it just delays taxes due to a future tax year. Why? Let’s say the S Corporation holds other rental real estate besides the one involved with the short sale. Simplistically stated, any 2013 cancelled debt exclusion raises the basis of the other properties. So there’s more gain when these other properties get sold.

Trap three - Shareholder Stock Basis

Any S Corporation cancelled debt exclusion on Form 982 changes the shareholder’s stock basis. This means the S Corporation can’t pass along ordinary income losses on Form 1120-S to shareholders.

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