Business Entities · Partnerships

Partnership cancellation of debt

Cancellation of partnership debt is where two systems that are individually straightforward produce a result neither of them describes. The partnership computes the discharge income and allocates it. Each partner then decides, on their own facts, whether any of it is excluded. And running alongside both, the disappearance of the debt reduces every partner’s share of partnership liabilities, which is a deemed cash distribution. The same event therefore increases a partner’s basis through the income allocation and decreases it through the liability shift, and the order in which those happen decides whether there is tax.

The rule

The income. gross income includes income from discharge of indebtedness (IRC § 61(a)(11))^TY2026

The exclusions. gross income does not include an amount otherwise includible by reason of a discharge of indebtedness where the discharge occurs in a title 11 case, occurs while the taxpayer is insolvent, is of qualified farm indebtedness, is of qualified real property business indebtedness in the case of a taxpayer other than a C corporation, or is of qualified principal residence indebtedness discharged before 1 January 2026 or under a written arrangement entered into before that date (IRC § 108(a)(1))^TY2026

And where they are applied. in the case of a partnership, the IRC § 108 exclusions, the attribute reduction rules, the qualified real property business indebtedness rules and the depreciable property election are applied at the partner level rather than at the partnership level (IRC § 108(d)(6))^TY2026

Compared with an S corporation. in the case of an S corporation the same subsections are applied at the corporate level, and any amount excluded under IRC § 108(a) is not taken into account under IRC § 1366(a) — so an S corporation shareholder gets no basis increase for excluded discharge income, while a partner does (IRC § 108(d)(7)(A))^TY2026

What an exclusion costs. an amount excluded under the title 11, insolvency or qualified farm indebtedness heads reduces the taxpayer tax attributes in order: net operating loss for the year of discharge and any carryover to it; general business credit carryovers; the minimum tax credit; capital loss for the year and capital loss carryovers; the basis of property; passive activity loss and credit carryovers; and foreign tax credit carryovers (IRC § 108(b)(1), (2))^TY2026

Who makes the elections. any election affecting the computation of taxable income derived from a partnership is made by the partnership, except the elections under IRC § 108(b)(5) and (c)(3) on discharge of indebtedness, IRC § 617 on mining exploration expenditures, and IRC § 901 on foreign taxes, which each partner makes separately (IRC § 703(b))^TY2026

The liability side. an increase in a partner share of partnership liabilities, or in the partner individual liabilities by reason of assuming partnership liabilities, is treated as a contribution of money by that partner to the partnership; a decrease in either is treated as a distribution of money to the partner (IRC § 752(a), (b))^TY2026

Basis effects. the adjusted basis of a partner interest is the basis determined under IRC § 722 or § 742, increased by the distributive share of partnership taxable income, tax-exempt income and the excess of depletion deductions over the basis of the property, and decreased but not below zero by distributions and by the distributive share of losses and of expenditures neither deductible nor chargeable to capital account (IRC § 705(a))^TY2026

And the floor. gain is not recognised to a partner on a distribution except to the extent money distributed exceeds the adjusted basis of the partner interest immediately before it; loss is not recognised except on a liquidating distribution consisting only of money, unrealised receivables and inventory, and then only to the extent the basis of the interest exceeds the money plus the basis of those items. No gain or loss is recognised to the partnership (IRC § 731(a), (b))^TY2026

Current figures

How it works in practice

The division of labour is the whole subject. The partnership determines that a discharge has occurred and how much income it produces, and reports each partner’s share as a separately stated item. It does not apply IRC § 108. Each partner then tests their own position: were they in a title 11 case, were they insolvent, and by how much. One partner may exclude the whole of their share and another none of it, on identical facts about the debt, because the test is about the partner.

Insolvency is the exclusion that most often applies and is the one where the partner-level rule bites hardest. A partner’s insolvency is measured by their own liabilities against their own assets immediately before the discharge, and their share of partnership liabilities counts among their liabilities. A partner whose personal balance sheet is comfortable cannot borrow the partnership’s insolvency, however deeply underwater the partnership is.

The contrast with an S corporation is the sharpest structural point in this topic. For an S corporation IRC § 108 is applied at the entity level, and the excluded amount is not taken into account in the pass-through (IRC § 108(d)(7)(A)) — so nothing flows out and the shareholders get no basis increase. For a partnership, the income flows out under IRC § 702, increases each partner’s basis under IRC § 705(a), and only then may be excluded by the partner. The partner keeps the basis; the S corporation shareholder does not. That difference can decide which entity form a distressed business should have been in, and it is decided years earlier than the discharge.

Exclusion is not forgiveness. Under IRC § 108(b) an amount excluded under the title 11, insolvency or qualified farm heads reduces the taxpayer’s attributes in a fixed order — net operating losses first, then credit carryovers, then the minimum tax credit, then capital losses, then the basis of property, then passive activity carryovers, then foreign tax credit carryovers. And because IRC § 108(d)(6) puts this at the partner level, it is the partner’s attributes that are reduced, including the partner’s basis in their own property, not the partnership’s.

The two elections that could change that outcome — reducing basis first under IRC § 108(b)(5), and the qualified real property business indebtedness election under IRC § 108(c)(3) — are among the very few that IRC § 703(b) removes from the partnership and gives to each partner individually. Partners in the same partnership may elect differently.

Finally, the liability side, which is where the arithmetic goes wrong. The discharge of a partnership debt reduces every partner’s share of partnership liabilities, and IRC § 752(b) treats that as a distribution of money. Basis therefore moves twice: up by the allocated discharge income under IRC § 705(a)(1)(A), and down by the deemed distribution. Where the income is excluded, only the downward movement happens — the partner has no income to increase basis with, and a deemed distribution that may exceed what basis remains, producing gain under IRC § 731(a)(1). The exclusion can therefore convert ordinary discharge income into capital gain rather than eliminating tax altogether.

Scenarios

How this has changed

The structural rules have been stable. IRC § 108(d)(6) has applied the exclusions at the partner level since the modern discharge rules were enacted, and IRC § 703(b)(1) has carved the IRC § 108 elections out of the partnership’s control for as long.

The exclusion that has moved is qualified principal residence indebtedness, which by its own terms in IRC § 108(a)(1)(E) reaches only a discharge occurring before 1 January 2026, or one made under a written arrangement entered into before that date. It is rarely relevant to a partnership, since the debt must relate to a principal residence, but it is worth noting as the one head of IRC § 108(a)(1) with a live expiry written into the statute rather than an indexed figure — and as of the current year, the primary window has closed.

The area to watch is not the statute but the arithmetic that surrounds it. Because the discharge is simultaneously an income event under IRC § 61(a)(11) and a liability event under IRC § 752(b), the sequencing determines the answer, and the sequencing is not stated in either section. Where the income is taxed, basis rises before the deemed distribution reduces it and the two largely offset. Where the income is excluded, only the reduction happens. That asymmetry is a consequence of how the provisions interact rather than of any rule about discharge income, and it is the single most valuable thing to understand about this topic.

Exam focus

The reliable question gives a partnership discharge and two partners in different personal positions, and asks how much each includes. The answer turns entirely on IRC § 108(d)(6): compute and allocate at the partnership, exclude at the partner, and never let one partner’s insolvency help another.

The second shape asks for the difference between a partnership and an S corporation on the same facts. Two points carry it: the S corporation applies IRC § 108 at the entity level, and the excluded amount is not taken into account under IRC § 1366(a), so no basis increase reaches the shareholder.

Where a question gives a partner’s outside basis alongside a discharge, check for the IRC § 752 consequence. If the income is excluded, expect IRC § 731(a)(1) gain; if it is taxed, expect the basis movements to offset.

Check yourself

1. A partnership’s debt is forgiven, producing $300,000 of discharge income allocated equally to three partners. One is insolvent by $250,000. Who may exclude what?

Answer: only the insolvent partner, and only up to her insolvency. IRC § 108(d)(6) applies the exclusions at the partner level, so her $100,000 share is excluded under IRC § 108(a)(1)(B) because her insolvency exceeds it. The other two include $100,000 each. The partnership’s own solvency is irrelevant to all three.

2. How does the answer change if the entity is an S corporation?

Answer: entirely. Under IRC § 108(d)(7)(A) the exclusions are applied at the corporate level, so the corporation’s own insolvency is what is tested, and the shareholders’ personal positions do not matter. Any amount excluded is not taken into account under IRC § 1366(a), so it does not pass through and gives the shareholders no basis increase.

3. A partner excludes $80,000 of discharge income on the ground of insolvency. What happens next?

Answer: attribute reduction under IRC § 108(b). The excluded amount reduces the partner’s own tax attributes in order — net operating loss for the year and any carryover, general business credit carryovers, the minimum tax credit, capital losses and carryovers, the basis of the partner’s property, passive activity loss and credit carryovers, and foreign tax credit carryovers. It is the partner’s attributes, not the partnership’s, because IRC § 108(d)(6) applies subsection (b) at the partner level.

4. A partner with an outside basis of $15,000 has $90,000 of discharge income allocated to him, all of which he excludes as insolvent. His share of partnership liabilities falls by $90,000. What does he report?

Answer: $75,000 of gain. The excluded income does not increase his basis, but the $90,000 reduction in his share of partnership liabilities is a deemed distribution of money under IRC § 752(b). Basis falls to zero and the excess is gain under IRC § 731(a)(1), treated as gain from the sale or exchange of the partnership interest. The exclusion converted ordinary income into capital gain.

5. May a partnership make the IRC § 108(c)(3) election to exclude qualified real property business indebtedness on behalf of all its partners?

Answer: no. IRC § 703(b)(1) removes the IRC § 108(b)(5) and (c)(3) elections from the general rule that elections affecting partnership taxable income are made by the partnership, and gives them to each partner separately. Partners in the same partnership may elect differently on the same discharge.