Tax Law

Tennessee DOR Clarifies Conformity With IRC § 108

The Tennessee Department of Revenue ("the Department") recently published Letter Ruling #11-44 ("the Ruling"), which addressed many issues related to potential income or gain that may arise from the discharge of indebtedness ("COD"), as well as the ancillary effects on other tax attributes, such as net operating losses.

Generally, the Internal Revenue Code ("IRC") includes in income an amount equal to any debt owed by a taxpayer that is in any way discharged or cancelled. However, IRC § 108 provides exceptions to the general rule of income inclusion which are typically available to financially troubled taxpayers. For example, COD from income to the extent that a taxpayer is insolvent, or if the amounts were discharged in bankruptcy may be excluded from gross income. Although the COD income may initially escape taxation, the IRC does require that several tax attributes of the taxpayer be reduced. Alternatively, the IRC allows a taxpayer to elect to take a reduction in the basis of depreciable property by the amount of excluded COD income. However, such a reduction may also be required after all other tax attributes have been exhausted. Although Tennessee's franchise and excise tax law generally conforms to the IRC, there have apparently been questions as to whether or not such conformity extends to situations involving COD.

Letter Ruling #11-44

The Ruling first addresses whether Tennessee excludes debt discharged in bankruptcy from net earnings for purposes of the Tennessee excise tax. For purposes of the Tennessee excise tax, "net earnings" is generally federal taxable income with some specific statutory exceptions. According to the Ruling, an amount otherwise excludable from income under the IRC because it was discharged in bankruptcy should not be included in net earnings. The Ruling concludes that state law does not require that the discharged amount otherwise be added back to income as determined for federal tax purposes.

The Ruling next focuses on the question of whether a taxpayer must reduce a net operating loss (NOL) for the year of the discharge. Under IRC section 108(b), when reducing NOLs for COD income that is excluded from taxable income, a taxpayer should first reduce a NOL for the current year and only after that loss is exhausted should they begin reducing the NOL for prior years. However, for purposes of the Tennessee excise tax, the Ruling states that COD income is not included in net earnings, and the Tennessee NOL is defined independently from the IRC as the excess of deductions over net earnings. Thus, according to the Ruling, COD income simply cannot, in absence of a specific provision such as that in the IRC, reduce the current year NOL. The Ruling also states that no reduction is required to be made for the amount of prior year NOLs.

As discussed above, a taxpayer may elect for federal income tax purposes to reduce the basis in certain assets by the amount of COD income excluded instead of reducing certain tax attributes, though the basis in these assets may also be reduced should all other tax attributes be exhausted or nonexistent. In addressing the basis reduction, the Ruling states that since no specific state law requires a reduction in the basis of depreciable assets for excludable COD income, none is required. This reasoning is consistent with the Department's position on reductions to NOLs.

Finally, the Ruling addresses the limitation on the use of NOLs under IRC Section 382, which is designed to prevent the abusive use and acquisition of NOLs. Similar to the logic of the other issues, the Ruling explains that the Tennessee excise tax law contains no limitation on the use of NOLs upon a mere change in stock ownership when the entity that generated the losses remains in existence as a separate entity.

Financially distressed Tennessee taxpayers should be aware of the Ruling and the planning opportunities that it presents when considering various financial restructuring options.


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