Regulations Would Toughen Tax Rules for Owners of Bankrupt Disregarded Entities

A taxpayer whose debts are forgiven generally has cancellation of debt (COD) income subject to exceptions including one for bankruptcy and one for insolvency. Some taxpayers have taken the position that the bankruptcy exception is available if a grantor trust (trust used in family or business planning) or disregarded entity (e.g., a single-member limited liability company taxed directly to owner) is under the jurisdiction of a bankruptcy court, even if its owner is not.

Similarly, some taxpayers have contended that the insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. The IRS has issued proposed regulations that would clarify that the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction, and the insolvency exception is available only to the extent the owner is insolvent. They would apply to COD income occurring on or after the date they are published as final regulations.

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