Corporate State Income Tax Issues Associated with Cancellation Of Debt Income

As we hear about the increase in bankruptcies and debt restructuring, corporations often assume that the state income tax treatment will mirror that of the Internal Revenue Service. This is far from the truth in many states.  In our experience, the state tax consequences are often thought of at the last minute or ignored entirely.  In fact, it is not unusual for these issues to be addressed during the preparation of the state income tax returns and are rarely analyzed in depth.  We’d rather see our clients be proactive!

Cancellation of Debt

Income from the cancellation of debt (COD) can be excluded from federal income.  This is dependent on the level of insolvency.  If a corporation has excluded COD income, they are required to reduce tax attributes (net operating losses, credits, capital loss carryovers, basis of property, passive activity loss and credits carryovers and foreign tax credits).   Federal rules dictate an ordering of the attribute reduction unless certain elections are made. To the degree you are able to consider the state consequences prior to the execution of any debt restructuring, a corporation may be able to preserve state income tax attributes.  Further, in some instances, a state income tax gain could be inadvertently generated, causing a tax liability for state purposes even when none was generated for federal tax purposes.

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