IRS may adjust section 108(i) deferred debt-cancellation income

Plain-English summary

A sole proprietor reacquired an $800 debt for $500 but reported and elected to defer only $100 of the resulting cancellation-of-debt income instead of $300. Chief Counsel advised that, depending on fully developed facts, the IRS may use the adjustment theory to recompute the closed election year's income when determining tax consequences in open inclusion years. Section 6501 bars assessment and collection for a closed year but does not necessarily prevent an adjustment that affects another year. The IRS therefore may be able to treat the taxpayer as having realized and elected to defer the full $300, even after the 2009 assessment period expired. Field personnel were directed to seek taxpayer-specific National Office advice.

Ruling snapshot

• Question: May the IRS adjust the amount of cancellation-of-debt income deferred under a section 108(i) election when the election year is closed?
• Outcome: Advice given that an adjustment may be possible under the adjustment theory, depending on the facts.
• Key authorities: IRC §§ 108(i) and 6501; Rev. Proc. 2009-37; Commissioner v. Disston, 325 U.S. 442 (1945); ABKCO Industries Inc. v. Commissioner, 56 T.C. 1083 (1971)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201604017
           Release Date: 1/22/2016
           CC:ITA:B05:SJKim
           PRENO-125166-15

 UILC: 108.08-00
  date: November 24, 2015

     to:   James D. Hill
           Associate Area Counsel (LB&I Group 2), Counsel Manager, CIL IPG

  from:    Amy J. Pfalzgraf
           Senior Counsel, Branch 5
           Office of Associate Chief Counsel (Income Tax & Accounting)


subject:   Authority to Adjust Income Deferred under Section 108(i)

           This Chief Counsel Advice responds to your request for non-taxpayer-specific legal
           advice. This advice may not be used or cited as precedent.

                                                    ISSUE

           May the Service adjust the amount of cancellation of debt (COD) income deferred by an
           election under § 108(i)?

                                                CONCLUSION

           In certain factual situations, the Service may adjust the amount of COD income deferred
           by an election under § 108(i). Field attorneys and revenue agents handling these
           § 108(i) cases should contact the National Office for taxpayer-specific advice.

                                                   FACTS

           B is a sole proprietor. L, an unrelated individual, holds a promissory note that B made
           in connection with her business, for which $800x remains outstanding. In 2009, L
           agrees to return the note to B in exchange for $500x in cash. B’s acquisition of the note
           from L is a “reacquisition” within the meaning of § 108(i)(4).

           B attaches a statement to her timely filed 2009 return reporting $100x, not $300x, in
           total COD income in connection with the note reacquisition. On the statement, B also
PRENO-125166-15                             2

makes an election under § 108(i) to defer the inclusion of $100x in COD income to the
5-year period beginning with 2014.

In a later year, the Service discovers that B failed to include $200x in COD income in
2009.

                                 LAW AND ANALYSIS

Section 108(i)(1) of the Internal Revenue Code generally provides that, at the election of
a taxpayer, COD income in connection with a reacquisition of an applicable debt
instrument occurring in 2009 or 2010 is includible in gross income ratably over a 5-
taxable-year inclusion period beginning with the fifth taxable year following the taxable
year of the reacquisition (if it occurs in 2009) or with the fourth taxable year of the
reacquisition (if it occurs in 2010).

Section 108(i)(5)(B)(i) provides that a taxpayer makes a § 108(i) election by attaching to
its Federal income tax return for the year the reacquisition occurs a statement that
clearly identifies the applicable debt instrument acquired, the amount of income to be
deferred by the election, and any other information that the Secretary requires. The
election, once made, is irrevocable. Section 108(i)(5)(B)(ii).

Rev. Proc. 2009-37, 2009-2 C.B. 309, provides the exclusive procedures for making a
§ 108(i) election. Section 4.04 of Rev. Proc. 2009-37 allows the taxpayer to make an
election for any portion of the COD income from the reacquisition of any applicable debt
instrument.

Section 4.05 of Rev. Proc. 2009-37 lists the requisite information that every statement
submitted under § 108(i)(5)(B) must provide: (a) the identifying information of the issuer
of the applicable debt instrument; (b) a general description of the applicable debt
instrument; (c) a general description of the reacquisition transaction generating the COD
income; (d) the total amount of COD income resulting from the reacquisition and a
general description of how the COD income was computed; and (e) the amount of COD
income deferred by the election.

Section 4.11 of Rev. Proc. 2009-37 provides that a taxpayer may make a protective
election if the taxpayer concludes that a particular transaction does not result in the
realization of COD income. If the Service later determines that the transaction did result
in COD income, the Service may require the taxpayer making the protective election to
report COD income deferred pursuant to the valid and irrevocable protective election
even if the statute of limitations has expired for the year in which the COD income was
realized and the protective election was made.

Under §§ 5.01 and 5.02 of Rev. Proc. 2009-37, a taxpayer making a § 108(i) election
(other than a protective election under § 4.11) must attach a copy of the election
statement and an annual information statement to its return for each taxable year
PRENO-125166-15                             3

beginning with the first taxable year following the election and ending in the taxable year
when all COD income deferred under § 108(i) has been recognized. On the annual
information statement, the taxpayer must report for each applicable debt instrument,
among other things, the deferred COD income included for the current taxable year and
the deferred COD income that the taxpayer has not included in the current or any prior
taxable years.

Section 6501 generally limits the period during which tax may be assessed to 3 years
after the date the taxpayer files a return. However, § 6501 merely prevents assessment
and collection of tax beyond the prescribed period of limitations. Section 6501 does not
prevent an adjustment that may affect other taxable years or other tax liabilities, or does
not result in the assessment of a tax. There is a well-developed body of law that the
Service is generally able to recompute a taxpayer’s income for a closed year in
determining the deficiency for an open year (the “adjustment theory”). See
Commissioner v. Disston, 325 U.S. 442 (1945) (examination of events in closed years
was allowed to correctly determine the gift tax liability in open years); ABKCO Industries
Inc. v. Commissioner, 56 T.C. 1083 (1971) (income for a year barred by the statute of
limitations recomputed to arrive at correct amount for determining net operating loss
carryback or carryover to another year). The ability to adjust a taxpayer’s income for a
closed year is consistent with § 4.11 of Rev. Proc. 2009-37, which states that a taxpayer
making a protective election will have to include deferred COD income in income if the
Service later determines that the transaction at issue resulted in COD income, even if
the year the COD income was realized and the protective election was made is closed.

Under a given set of facts, the Service may be able to apply the adjustment theory to
adjust the amount of COD income that a taxpayer has elected to defer under § 108(i)
even if the taxable year of the election is closed under § 6501. In the above example,
the Service may be able to treat B as having realized $300x in COD income in 2009 and
having elected to defer the entire $300x amount under § 108(i), even if the 2009 taxable
year is closed under § 6501.

Whether to apply the adjustment theory of Disston and ABKCO Industries, however,
requires a thorough development of the facts in each case. For that reason, we strongly
recommend that, in handling any case that appears to involve a misstatement or error in
a 108(i) deferral, your office develop the facts fully and contact our office for taxpayer-
specific advice.

If you have any additional questions, please call our office at (202) 317-7006.