Business Tax Preparation · Business Income

Cancellation of business debt

Every business that fails to pay a debt in full faces the same first question, and the answer is almost always the same: forgiveness is income. The work is in the exceptions, and the one a practitioner meets most often is not in IRC § 108(a) at all.

The rule

The starting point. gross income includes income from the discharge of indebtedness, and except as IRC § 108 itself provides there is no insolvency exception to that rule^TY2026 (IRC § 61(a)(11), IRC § 108(e)(1)).

The exclusions. discharge in a title 11 case, discharge while insolvent, qualified farm indebtedness, qualified real property business indebtedness for a taxpayer other than a C corporation, and qualified principal residence indebtedness^TY2026 (IRC § 108(a)(1)), ordered so that the title 11 exclusion displaces all the others, and the insolvency exclusion displaces the qualified farm and qualified real property business exclusions to the extent of the insolvency^TY2026 (IRC § 108(a)(2)), and capped so that the amount excluded on the insolvency ground may not exceed the amount by which the taxpayer is insolvent, being the excess of liabilities over the fair market value of assets determined immediately before the discharge^TY2026 (IRC § 108(a)(3), IRC § 108(d)(3)).

The price of an exclusion. net operating loss for the year of the discharge and any carryover to that year; general business credit carryovers; the minimum tax credit; net capital loss and capital loss carryovers; the basis of the property of the taxpayer; passive activity loss and credit carryovers; and foreign tax credit carryovers^TY2026 (IRC § 108(b)(2)), at one dollar of reduction for each dollar excluded, except that the general business credit, minimum tax credit, foreign tax credit and passive activity credit carryovers are reduced by 33⅓ cents for each dollar excluded^TY2026 (IRC § 108(b)(3)), the attribute reductions are made after the tax for the taxable year of the discharge has been determined^TY2026 (IRC § 108(b)(4)(A)) — with the taxpayer may elect to apply any portion of the reduction first against the basis of depreciable property under IRC § 1017, capped at the aggregate adjusted bases of depreciable property held at the beginning of the year following the discharge, and the ordinary attribute order does not apply to the amount elected^TY2026 (IRC § 108(b)(5)).

The rule that is not an exclusion at all. no income is realised from the discharge to the extent that payment of the liability would have given rise to a deduction^TY2026 (IRC § 108(e)(2)). No attribute reduction follows, because nothing was excluded under IRC § 108(a).

Purchase price adjustment. a reduction of a purchaser's debt to the seller arising out of the purchase of the property, not occurring in a title 11 case and not while the purchaser is insolvent, is treated as a purchase price adjustment rather than discharge income^TY2026 (IRC § 108(e)(5)).

Related-party acquisition. to the extent regulations provide, the acquisition of the debt by a person related to the debtor within IRC § 267(b) or § 707(b)(1), from a person who is not so related, is treated as an acquisition by the debtor^TY2026 (IRC § 108(e)(4)(A)).

Real property used in a business. debt incurred or assumed in connection with real property used in a trade or business and secured by it, incurred before 1 January 1993 or, if later, qualified acquisition indebtedness, and for which the taxpayer elects the treatment; qualified farm indebtedness is excluded^TY2026 (IRC § 108(c)(3)), subject to the exclusion cannot exceed the outstanding principal immediately before the discharge less the fair market value of the property reduced by other qualified real property business debt it secures, and cannot exceed the aggregate adjusted bases of depreciable real property held immediately before the discharge, excluding property acquired in contemplation of it^TY2026 (IRC § 108(c)(2)), and the amount excluded reduces the basis of the depreciable real property of the taxpayer under IRC § 1017^TY2026 (IRC § 108(c)(1)).

Farming. debt incurred directly in connection with the taxpayer's operation of the trade or business of farming, where 50 percent or more of aggregate gross receipts for the 3 preceding taxable years is attributable to farming, and the discharge is by a qualified person^TY2026 (IRC § 108(g)(1), (g)(2)), capped by the exclusion cannot exceed the sum of the adjusted tax attributes and the aggregate adjusted bases of qualified property held at the beginning of the year following the discharge, counting $3 for each $1 of the credit carryover attributes^TY2026 (IRC § 108(g)(3)).

Current figures

How it works in practice

Take IRC § 108(e)(2) first, because it is not an exclusion. no income is realised from the discharge to the extent that payment of the liability would have given rise to a deduction^TY2026 (IRC § 108(e)(2)). A cash method business that never deducted an unpaid invoice has no income when the supplier writes it off — not because a provision excludes the income, but because the statute says none is realised. The consequence matters: there is nothing excluded under IRC § 108(a), so IRC § 108(b) never engages and no attribute is reduced. The business simply has no item at all.

And note where the rule does not reach. An accrual method business has already deducted the invoice, so payment would give rise to no further deduction and IRC § 108(e)(2) does nothing. The forgiveness is ordinary income, and the business must look to IRC § 108(a) or pay tax. This is the cleanest illustration in the Code of a method of accounting changing a substantive result.

Then run IRC § 108(a) in order. the title 11 exclusion displaces all the others, and the insolvency exclusion displaces the qualified farm and qualified real property business exclusions to the extent of the insolvency^TY2026 (IRC § 108(a)(2)). Title 11 displaces everything. Insolvency displaces the farm and real property exclusions to the extent of the insolvency, and the amount excluded on the insolvency ground may not exceed the amount by which the taxpayer is insolvent, being the excess of liabilities over the fair market value of assets determined immediately before the discharge^TY2026 — measured immediately before the discharge, so the debt about to be forgiven is still counted as a liability.

Every exclusion is bought with attributes. net operating loss for the year of the discharge and any carryover to that year; general business credit carryovers; the minimum tax credit; net capital loss and capital loss carryovers; the basis of the property of the taxpayer; passive activity loss and credit carryovers; and foreign tax credit carryovers^TY2026 (IRC § 108(b)(2)). Net operating losses go first, and for a business with a large carryforward the exclusion is often economically worthless — it converts a deferred deduction into a permanent one. The IRC § 108(b)(5) election reverses the order for depreciable property: the taxpayer may elect to apply any portion of the reduction first against the basis of depreciable property under IRC § 1017, capped at the aggregate adjusted bases of depreciable property held at the beginning of the year following the discharge, and the ordinary attribute order does not apply to the amount elected^TY2026. That trade is usually worth making only where the property will be held rather than sold, since a reduced basis becomes gain on disposition.

Know the two elective business exclusions. IRC § 108(c) is available to any taxpayer other than a C corporation on debt incurred or assumed in connection with real property used in a trade or business and secured by it, incurred before 1 January 1993 or, if later, qualified acquisition indebtedness, and for which the taxpayer elects the treatment; qualified farm indebtedness is excluded^TY2026 (IRC § 108(c)(3)). It is elective, it is limited twice over by the exclusion cannot exceed the outstanding principal immediately before the discharge less the fair market value of the property reduced by other qualified real property business debt it secures, and cannot exceed the aggregate adjusted bases of depreciable real property held immediately before the discharge, excluding property acquired in contemplation of it^TY2026 (IRC § 108(c)(2)) — once to the amount by which the debt exceeds the property’s value and once to the aggregate basis of depreciable real property — and the price is the amount excluded reduces the basis of the depreciable real property of the taxpayer under IRC § 1017^TY2026 (IRC § 108(c)(1)). IRC § 108(g) does the same job for farmers: debt incurred directly in connection with the taxpayer's operation of the trade or business of farming, where 50 percent or more of aggregate gross receipts for the 3 preceding taxable years is attributable to farming, and the discharge is by a qualified person^TY2026, capped by the exclusion cannot exceed the sum of the adjusted tax attributes and the aggregate adjusted bases of qualified property held at the beginning of the year following the discharge, counting $3 for each $1 of the credit carryover attributes^TY2026.

A price cut is not a discharge. a reduction of a purchaser's debt to the seller arising out of the purchase of the property, not occurring in a title 11 case and not while the purchaser is insolvent, is treated as a purchase price adjustment rather than discharge income^TY2026 (IRC § 108(e)(5)). Where the seller of property reduces what the buyer owes on the purchase, and the buyer is neither bankrupt nor insolvent, the reduction adjusts the purchase price and therefore the buyer’s basis. No income, no attribute reduction, and no election required.

Buying your own debt through a relative does not work. to the extent regulations provide, the acquisition of the debt by a person related to the debtor within IRC § 267(b) or § 707(b)(1), from a person who is not so related, is treated as an acquisition by the debtor^TY2026 (IRC § 108(e)(4)(A)). The acquisition at a discount by a related person is treated as an acquisition by the debtor, which produces discharge income to the extent of the discount.

The entity level question is settled by two adjacent paragraphs. in the case of a partnership, IRC § 108(a), (b), (c) and (g) are applied at the partner level^TY2026 (IRC § 108(d)(6)) and in the case of an S corporation, IRC § 108(a), (b), (c) and (g) are applied at the corporate level, including by not taking into account under IRC § 1366(a) any amount excluded under IRC § 108(a)^TY2026 (IRC § 108(d)(7)(A)). Identical facts, opposite answers, and the difference decides whose insolvency is measured.

How this has changed

The architecture of IRC § 108 has been stable for business debt since the Bankruptcy Tax Act of 1980, and none of the provisions on this page was amended by Pub. L. 119-21. The 2026 rules are the 2025 rules.

Two changes elsewhere in the section are worth knowing because a reader working from a general summary of IRC § 108 will meet them, and neither reaches a business discharge. IRC § 108(a)(1)(E) lapsed. The exclusion for qualified principal residence indebtedness applies only to a discharge occurring before 1 January 2026 or made under a written arrangement entered into before that date. Pub. L. 116-260 § 114(a) set the date in December 2020 and no later Act moved it, so 2026 is the first year in more than a decade without the exclusion. IRC § 108(f)(5) was replaced. Pub. L. 119-21 § 70119(a) amended the student loan discharge paragraph generally, effective for discharges after 31 December 2025; the prior paragraph, added by Pub. L. 117-2 § 9675(a), covered discharges in 2021 through 2025. It is a different rule, not an extension of the old one.

The one live drafting point for a business is the reporting threshold. IRC § 6050P requires an applicable entity to report a discharge, and the threshold there was not among the figures Pub. L. 119-21 § 70433 raised — that section reached IRC § 6041 and IRC § 6041A. A business will therefore see Forms 1099-C at the old level while receiving far fewer Forms 1099-NEC, which is a combination that invites the wrong inference about which amounts are income.

Exam focus

The single most productive habit is to ask whether the taxpayer ever got a deduction for the liability. If not, IRC § 108(e)(2) answers the question before any exclusion is considered, and answers it without attribute reduction.

Second, know the precedence in IRC § 108(a)(2) and know that insolvency is measured immediately before the discharge and caps the exclusion at the amount of the insolvency.

Third, remember that an exclusion is paid for. Expect a question in which the excluded amount and the attribute reduction are the same figure, and the point is that the taxpayer is no better off.

Finally, keep the entity rules straight — partner level under IRC § 108(d)(6), corporate level under IRC § 108(d)(7)(A) — because they decide whose balance sheet is tested.

Check yourself

1. A cash method landscaping business owes $18,000 for materials it has never paid for or deducted. The supplier forgives the debt. What does the business report?

Answer: Nothing. no income is realised from the discharge to the extent that payment of the liability would have given rise to a deduction^TY2026 (IRC § 108(e)(2)) — payment would have given rise to a deduction, so no income is realised. There is no exclusion under IRC § 108(a), so IRC § 108(b) does not apply and no attribute is reduced.

2. The same facts, except the business uses the accrual method and deducted the $18,000 in the year the liability was fixed. What changes?

Answer: It has $18,000 of ordinary income under IRC § 61(a)(11). IRC § 108(e)(2) gives it nothing, because payment would now produce no further deduction, and no IRC § 108(a) exclusion applies to a solvent business outside bankruptcy.

3. A solvent business buys equipment from a manufacturer, owes $200,000 on the purchase, and persuades the manufacturer to accept $170,000 in full settlement. Is the $30,000 income?

Answer: No. a reduction of a purchaser's debt to the seller arising out of the purchase of the property, not occurring in a title 11 case and not while the purchaser is insolvent, is treated as a purchase price adjustment rather than discharge income^TY2026 (IRC § 108(e)(5)) — the debt runs to the seller, arose out of the purchase, and the buyer is neither in a title 11 case nor insolvent, so the reduction is a purchase price adjustment. The buyer’s basis in the equipment falls by $30,000 instead.

4. A company insolvent by $400,000 excludes $250,000 of discharge income and holds a $180,000 net operating loss carryforward and $90,000 of general business credit carryovers. What is reduced?

Answer: The net operating loss first, in full — $180,000, dollar for dollar under one dollar of reduction for each dollar excluded, except that the general business credit, minimum tax credit, foreign tax credit and passive activity credit carryovers are reduced by 33⅓ cents for each dollar excluded^TY2026. The remaining $70,000 of exclusion then reduces the general business credit carryover, but at 33⅓ cents per dollar, so the carryover falls by about $23,333. Anything still unabsorbed moves down the IRC § 108(b)(2) list.

5. May a C corporation elect to exclude a discharge of the mortgage on its office building under IRC § 108(c)?

Answer: No. IRC § 108(a)(1)(D) is confined to “a taxpayer other than a C corporation,” so the election is unavailable however clearly the debt meets the IRC § 108(c)(3) definition. The corporation must look to bankruptcy or insolvency.