Qualified Farm Indebtedness – A Special Rule for Income Exclusion of Forgiven Debt

Overview

The drop in crop prices in recent months has introduced financial strain for some producers.  Bankruptcy practitioners are reporting an increase in clients dealing with debt workouts and other bankruptcy-related concerns.    

An important part of debt resolution concerns the income tax consequences of any debt relief to the debtor.  One of those rules concerns the tax treatment of discharged “qualified farm indebtedness.”  The rule can be a useful tool in dealing with the income tax issues associated with debt forgiveness for farmers that are not in bankruptcy.  There’s also another option that might come into play in certain situations – a purchase price adjustment.

That’s the focus of today’s post.

Recourse Debt

Except for debt associated with installment land contracts and Commodity Credit Corporation loans, most farm debt is recourse debt.  With recourse debt, the collateral stands as security on the loan.  If the collateral is insufficient to pay off the debt, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency. 

When the debtor gives up property, the income tax consequences involve a two-step process.   Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt.  There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property.  Then, the difference between fair market value and the income tax basis is gain or loss.  Finally, if the indebtedness exceeds the property's fair market value, the debtor remains liable for the difference and if it is forgiven, the amount is discharge of indebtedness income. 

However, special rules can apply to minimize the tax impact of discharge of indebtedness income. 

General Rules

Under I.R.C. §108(a)(1)(A)-(C), a debtor need not include in gross income any amount of discharge of indebtedness if the discharge occurs as part of a bankruptcy case or when the debtor is insolvent, or if the discharge is of qualified farm debt.  If one of these provisions applies to exclude the debt from income, Form 982 must be completed and filed with the return for the year of discharge. 

Qualified Farm Indebtedness

What is it?  The qualified farm debt rule applies to the discharge of qualified farm indebtedness that is discharged via an agreement between a debtor engaged in the trade or business of farming and a “qualified person.”  A qualified person includes a lender that is actively and regularly engaged in the business of lending money and is not related to the debtor or to the seller of the property, is not a person from which the taxpayer acquired the property, or is a person who receives a fee with respect to the taxpayer’s investment in the property. I.R.C. §49(a)(1)(D)(iv).  Under I.R.C. §108(g)(1)(B), a “qualified person” also includes federal, state or local governments or their agencies.

In addition, qualified farm debt is debt that is incurred directly in connection with the taxpayer’s operation of a farming business; and at least 50 percent of the taxpayer’s aggregate gross receipts for the three tax years (in the aggregate) immediately preceding the tax year of the discharge arise from the trade or business of farming. I.R.C. §§108(g)(2)(A)-(B). Off-farm income and passive rental arrangements can cause complications in meeting the gross receipts test. 

Solvency.  The qualified farm debt exclusion rule does not apply to the extent the debtor is insolvent or is in bankruptcy.  Farmers are also under a special rule – for all debtors other than farmers, once solvency is reached there is income from the discharge of indebtedness.  The determination of a taxpayer’s solvency is made immediately before the discharge of indebtedness.  “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets.  Both tangible and intangible assets are included in the calculation.  In addition, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not.  The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency.  Property exempt from creditors under state law is included in the insolvency calculation.  Carlson v. Comr., 116 T.C. 87 (2001).

Maximum amount discharged.  There is a limit on the amount of discharged debt that can be excluded from income under the exception. The excluded amount cannot exceed the sum of the taxpayer’s adjusted tax attributes and the aggregate adjusted bases of the taxpayer’s depreciable property that the taxpayer holds as of the beginning of the tax year following the year of the discharge.  

Reduction of tax attributes.  The debt that is discharged and which is excluded from the taxpayer’s gross income is applied to reduce the debtor’s tax attributes. I.R.C. §108(b)(1).  Unless the taxpayer elects to reduce the basis of depreciable property first, I.R.C. §108(b)(2) sets forth the general order of tax attribute reduction (which, by the way occurs after computing tax for the year of discharge (I.R.C. §108(b)(4)(A)).  The order is as follows:  net operating losses (NOLs) for the year of discharge as well as NOLs carried over to the discharge year; general business credit carryovers; minimum tax credit; capital losses for the year of discharge and capital losses carried over to the year of discharge; the basis of the taxpayer’s depreciable and non-depreciable assets; passive activity loss and credit carryovers; and foreign tax credit carryovers.

Those attributes that can be carried back to tax years before the year of discharge are accounted for in those carry back years before they are reduced.  Likewise, any reductions of NOLs or capital losses and carryovers first occur in the tax year of discharge followed by the tax year in the order in which they arose.

The tax attributes are generally reduced on a dollar-for-dollar basis (i.e., one dollar of attribute reduction for every dollar of exclusion).  However, any general business credit carryover, the minimum tax credit, the foreign tax credit carryover and the passive activity loss carryover are reduced by 33.33 cents for every dollar excluded.

If the amount of income that is excluded is greater than the taxpayer’s tax attributes, the excess is permanently excluded from the debtor’s gross income and is of no tax consequence.  Alternatively, if the taxpayer’s tax attributes are insufficient to offset all of the discharge of indebtedness, the balance reduces the basis of the debtor’s assets as of the beginning of the tax year of discharge.

Discharged debt that would otherwise be applied to reduce basis in accordance with the general attribute reduction rules specified above and also constitutes qualified farm indebtedness is applied only to reduce the basis of the taxpayer’s qualified property.  I.R.C. §1017(b)(4)(A).  The basis reduction is to the qualified property that is depreciable property, then to the qualified property that is land used or held for use in the taxpayer’s farming business, and then to any other qualified property that is used in the taxpayer’s farming business or for the production of income.  This is the basis reduction order unless the taxpayer elects to have any portion of the discharged amount applied first to reduce basis in the taxpayer’s depreciable property, including real property held as inventory.  I.R.C. §§108(b)(5)(A); 1017(b)(3)(E).

Purchase Price Adjustment

Instead of triggering discharge of indebtedness income, if the original buyer and the original seller agree to a price reduction of a purchased asset at a time when the original buyer is not in bankruptcy or insolvent, the amount of the reduction does not have to be reported as discharge of indebtedness income.  I.R.C. §108(e)(5)(A).  The seller also doesn’t have immediate adverse tax consequences from the discharge.  Instead, the profit ratio that is applied to future installment payments is impacted.  Priv. Ltr. Rul. 8739045 (Jun. 20, 1987). 

Conclusion

Farmers often have favorable tax rules.  The qualified farm indebtedness rule is one of those.  In the right situation, it can provide some relief from the tax consequences of financial distress.