Changes to the § 108 Exclusion Rule

Normally, under Internal Revenue Code § 61(a)(12), income from the discharge of indebtedness is includable in gross income, however, such income may be excludable from gross income under certain exceptions found in Internal Revenue Code § 108.  § 108(a)(1)(A) and (B) excludes from gross income any amount that would be includable in gross income if the discharge occurs as a result of a title 11 bankruptcy case or when the taxpayer is insolvent.  The taxpayer themselves must be subject to the jurisdiction of the court to claim an exclusion of income by discharge under a title 11 case pursuant to § 108(d)(2).

On April 13, 2011, the Treasury Department and IRS published a notice of proposed rulemaking (REG-154159-09) in the Federal Register 76 FR 20593.  The proposed rule provided that for the purposes of applying the § 108 exclusion to the discharge of indebtedness income of a grantor trust or a disregarded entity, that the term “taxpayer” refers specifically to the owner of that trust or entity.   What this means practically for § 108 is that the owner of a grantor trust or a disregarded entity may not claim this exclusion if they themselves are not filing for bankruptcy.  The change has a severe effect on small business entrepreneurship as now, if a taxpayer were to run a business through a disregarded entity, and that business failed and the debts were written off in bankruptcy, they could no longer claim the § 108 exclusion on the income from the discharge of indebtedness, but instead, it would be includable in their gross income.