Tax Treatment of Shareholder Debt Under Section 108(e)(6)

When a company is relieved from an obligation to repay a debt for less than the full amount owed, it generally recognizes Cancellation of Debt (COD) income under Internal Revenue Code Section 61. The logic is that the forgiveness of debt frees up assets and represents an accession to wealth for the debtor, which is subject to taxation. The tax code, however, provides a series of exceptions under Section 108 that can alter this outcome. These provisions address specific situations, such as bankruptcy and insolvency. A particular rule within this framework applies when a shareholder contributes the corporation’s debt back to the company, which has distinct tax implications.

The Contribution to Capital Rule Explained

Section 108(e)(6) provides a specific framework for when a shareholder forgives a debt owed to them by their own corporation as a “contribution to capital.” This means the shareholder is acting in their capacity as an owner to bolster the corporation’s financial position, rather than as a third-party creditor settling a claim.

The core mechanic of this rule is that the corporation is treated as if it satisfied the debt with money equal to the shareholder’s adjusted basis in that debt. This is a departure from the general rule under Section 118, which allows contributions to a corporation’s capital to be excluded from gross income. This provision explicitly overrides the general rule, creating a direct link between the shareholder’s investment and the potential income recognized by the corporation.

The tax outcome for the corporation is therefore not determined by the face value of the forgiven debt. Instead, the determining figure is the shareholder’s tax basis in the loan. If the shareholder’s basis is equal to the full face value of the debt, the corporation recognizes no COD income from the transaction.

Determining Shareholder Basis in the Debt

The shareholder’s adjusted basis in the debt is the central element for applying this rule. A shareholder’s initial basis in a loan is the amount of money they lent to the corporation. This basis can change over time, and the rules for these adjustments differ significantly depending on whether the business is a C Corporation or an S Corporation.

For a C Corporation, a shareholder’s basis in a loan they made to the company generally remains fixed at the original principal amount. Unless the shareholder has taken a specific action like claiming a bad debt deduction, their basis does not decrease. This stability means that in most C Corporation scenarios, the shareholder’s basis will be the full face value of the debt.

The situation is more complex for an S Corporation due to its pass-through nature. An S Corporation’s profits and losses are passed through to its shareholders annually. If the corporation incurs losses, these losses first reduce the shareholder’s basis in their stock. Once the stock basis is reduced to zero, any excess losses then reduce the shareholder’s basis in any debt the corporation owes them.

For example, if a shareholder has a $20,000 stock basis and a $50,000 loan to their S Corp, and the S Corp passes through a $35,000 loss, the shareholder’s stock basis is reduced to zero. Their debt basis is then reduced by the remaining $15,000 loss to $35,000.

Calculating Corporate COD Income

The calculation of a corporation’s COD income follows a direct formula: the face value of the contributed debt minus the shareholder’s adjusted basis in that debt equals the corporation’s COD income. For a C Corporation example, a sole shareholder loaned their C Corp $100,000, and their basis in this debt is the full $100,000. If the shareholder later contributes this debt to the corporation’s capital, the calculation is: $100,000 (Face Value of Debt) – $100,000 (Shareholder’s Adjusted Basis) = $0, meaning the C Corporation recognizes no COD income.

Now, examine an S Corporation with a different history. A sole shareholder loaned their S Corp $100,000. Over several years, passed-through losses reduced the shareholder’s stock basis to zero and then reduced their debt basis by $75,000, leaving an adjusted debt basis of $25,000. If this shareholder contributes the $100,000 debt to capital, the calculation is: $100,000 (Face Value of Debt) – $25,000 (Shareholder’s Adjusted Basis) = $75,000. The S Corporation recognizes $75,000 of COD income.

Tax Attribute Reduction Consequences

When a corporation generates COD income, it may be able to exclude that income from its gross income under the tax code’s exceptions for bankruptcy or insolvency. A taxpayer can exclude COD income to the extent they are insolvent immediately before the debt discharge. This exclusion is not a permanent forgiveness but a deferral, and the cost is a mandatory reduction of the corporation’s tax attributes.

This process is governed by Section 108(b), which specifies the tax attributes that must be reduced and the order of reduction. The reduction is dollar-for-dollar for the amount of COD income excluded. The standard order is:

• Net Operating Losses (NOLs) for the current year and any NOL carryovers
• General business credit carryovers
• Minimum tax credits
• Capital loss carryovers
• Basis in property
• Passive activity loss and credit carryovers
• Foreign tax credit carryovers

For credits, the reduction is 33 1/3 cents for each dollar of excluded income. A taxpayer can elect to alter this order and first reduce the basis of depreciable property before other attributes.