Section 108(i): Deferring Cancellation of Debt Income

Section 108(i) of the Internal Revenue Code was a temporary tax measure enacted as part of the American Recovery and Reinvestment Act of 2009. The provision allowed certain taxpayers to postpone the recognition of income that would normally arise when they repurchased their own debt for less than its face value. This deferral applied specifically to debt reacquisitions that took place during the 2009 and 2010 calendar years.

The core purpose of this section was to provide liquidity and tax relief, enabling companies to improve their balance sheets without an immediate, corresponding tax liability. The rules established a specific framework for who could qualify and how the deferred income would eventually be taxed. As the deferral and subsequent income recognition periods have concluded, this provision is no longer applicable to any transactions.

Qualifying for the Election

To take advantage of the Section 108(i) deferral, a taxpayer had to meet a specific set of criteria. The election was available to a range of business entities, including C corporations, S corporations, partnerships, and sole proprietorships conducting a trade or business. The election itself was made at the entity level for pass-through businesses like partnerships and S corporations.

A central requirement was the nature of the debt itself. The provision applied only to an “applicable debt instrument,” which was defined as debt issued by a C corporation or any other person in connection with their trade or business. This included common forms of debt like bonds, debentures, and notes. The transaction had to be a “reacquisition,” meaning the issuer or a related party bought back the debt.

The timing of this reacquisition was strictly limited. The transaction must have occurred within a specific two-year window: after December 31, 2008, and before January 1, 2011. A taxpayer making this election for a portion of their COD income could still potentially apply other exclusions under Section 108, such as the insolvency exception, to the remaining amount.

Mechanics of Deferral and Recognition

Once a taxpayer qualified and made the election, the COD income was not reported in the year the debt was repurchased. Instead, its recognition was postponed. The deferred income was then brought back into taxable income ratably over a five-year period.

For debt repurchased in 2009, the five-year recognition period started in the fifth taxable year following the reacquisition, which for most calendar-year taxpayers was 2014. For debt repurchased in 2010, the recognition period began in the fourth taxable year after the event, which was also 2014. This structure meant income recognition for all electing taxpayers ran from 2014 through 2018.

To illustrate, if a company reacquired its debt in 2009 and generated $500,000 in COD income, it would have deferred this entire amount. Starting with its 2014 tax return, the company would have recognized $100,000 of this income each year for five consecutive years, concluding in 2018. A related rule also deferred any deductions for original issue discount (OID) created in the transaction, aligning the timing of deductions with the income inclusion.

Events Triggering Accelerated Income Recognition

The five-year recognition schedule was not absolute and could be cut short by certain events. If one of these triggering events occurred, any remaining deferred COD income had to be recognized immediately in the tax year of the event.

Primary acceleration events included:

• Death of an individual taxpayer
• Liquidation or dissolution of a corporate or partnership entity
• Sale or exchange of substantially all the assets of the taxpayer
• Cessation of the trade or business to which the specific debt related

For partnerships and S corporations, the rules were slightly more complex. A sale or exchange of an interest in the pass-through entity by a partner or shareholder was also considered an acceleration event for that individual’s share of the deferred income. These rules were designed to prevent taxpayers from avoiding the eventual tax liability by disposing of the business or its assets before the five-year recognition period was complete.