What is the S Corporation rule for Insolvency and Cancellation of Debt? | IRS Forms 982, Reduction of Tax Attributes,1120-S, 1099-A, 1099-C, 4797 and 8825

S Corporations incur cancellation of debt, but there’s lots of contradictory Internet chatter about it. I’ll present a case study where a rental property held by an S Corporation faces foreclosure. I’ll discuss:

• Rental activity Gain and Loss on tax Form 8825.
• Tax Form 1099-A and the Gain or Loss on the “sale” of the S Corporation’s rental property on Form 4797.
• Form 1099-C and cancellation of debt issues to the S Corporation.
• Form 982 and Insolvency.
• Other provisions of Form 982, Reduction of Tax Attributes

Hi, I’m Gary Bode, a debt cancellation CPA who runs his practice as an S-Corporation. It’s sad when a CPA becomes a specialist in the notorious Form 982, Reduction of tax Attributes. But the effects of the Recession still ripple through the 2013 tax year. I don’t think any cancelled debt or S Corporation CPA would advocate self-preparation of Form 1120-S under these circumstances. The topics here are complex and you can’t reasonably use this post as tax advice. It just presents an overview. I do offer a free phone consult: (910) 399-2705.

Scenario

An S Corporation faces foreclosure on commercial rental property. The particulars:

• The S Corp paid $1M for commercial rental real estate three years ago on January 1st.
• We’re ignoring any land issues to make the case study more concise.
• Prior depreciation for the S Corporation’s rental real estate was $76,293.
• We’ll assume the Bank forecloses on July 1st of the fourth year. So depreciation in the last year is $12,821.
• Fair Market Value of rental property was $750,000 on July 1st.
• The shareholders didn’t personally guarantee the mortgage debt.
• The outstanding mortgage on July 1st of the fourth year is still $1M. So, the loan has a balloon payment down the road.
• Form 1099-A gets issued in the tax year of the foreclosure.
• Form 1099-C arrives in the following tax year.

IRS Tax Form 8825 in the year of Foreclosure

We still prepare Form 8825 for the rental property’s gain or loss for the last partial year. The S Corporation claims $12,821 depreciation even though the “sale” (please see below) requires the S Corporation to add it back else where on the return. So Form 8825 is basically the same as the first three years just with different numbers. Generally there’s a loss in the last year.

Foreclosure and IRS Tax Form 1099-A

Form 1099-A reports the transfer of the S Corporation’s rental property to the bank. While it lists the outstanding mortgage due, Form 1099-A doesn’t trigger any cancellation of debt issues. Note the bank can still pursue the S Corporation for any unpaid mortgage balance.

Tax Form 1099-A and 4797 Gain or Loss on the “sale” of the Rental Property

The foreclosure is essentially a sale of the rental property. The sale requires using Form 4797 to calculate the Gain or Loss. The Form 1099-A shows $750,000 as the FMV of the foreclosed rental property. The IRS assumes the FMV is correct.

Tax Form 1099-C, S Corporation Cancellation of Debt and Form 982: exclusion of cancelled debt via the Insolvency provision

Cancellation of Debt, as reported in Box 2 of Form 1099-C, becomes taxable income to the S Corporation unless we can exclude it via some provision of Form 982. Why? The IRS holds that debt forgiveness is equivalent to revenue. The $750 FMV offsets the $1M leaving $250K of taxable income to the S Corporation. This income transfers to Shareholders via Schedule K-1. However the S Corporation has the right to exclude some or all of that of the $250,000 cancelled debt income through three, usually, provisions of Form 982:

• Corporate Bankruptcy.
• S Corporation insolvency on the date of debt cancellation.
• The qualified real property business indebtedness.

The Insolvency Provision of Form 982

Let’s assume the S Corporation had no other liabilities or assets except the $750,000 rental property and the $1M mortgage. So there’s $250,000 of S Corporation insolvency available to apply against cancelled debt income. So there’s no taxable income to the S Corporation.

The Reduction of Tax Attributes section of Form 982

There’s no free ride with the IRS. The $250,000 increases the shareholder’s basis in the S Corporation stock.

I’m a Form 982 specialist that runs his practice as an S Corporation. Our virtual means we serve you regardless of where you live. I offer a free phone consult. (910) 399-2705.

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