Bankruptcy filings, both personal and business, increased by 16.2% in the twelve-month period ending June 30, 2024. Business bankruptcies saw a significant rise of 40.3%, increasing from 15,724 to 22,060 cases. Non-business bankruptcies also grew, reaching 464,553, up from 403,000 the previous year.

One of the most common tax issues faced by debtors during bankruptcy is the recognition of cancellation-of-debt (COD) income. This occurs when a debt is discharged for less than the amount owed, requiring the debtor to recognize the difference as taxable income. While this concept is straightforward in theory, its application can be complex, especially in bankruptcy scenarios. The tax consequences vary significantly depending on factors such as whether the debt is recourse or nonrecourse.

The general rule is that COD income is taxable, but several exceptions and exclusions exist under the tax law. The most relevant for debtors in bankruptcy are the exclusions provided under Section 108(a)(1)(A) for bankrupt taxpayers and Section 108(a)(1)(B) for insolvent taxpayers. These provisions allow debtors to exclude COD income from their gross income under certain conditions.

Insolvency is determined by comparing the fair market value of the debtor's assets to their liabilities immediately before the debt discharge. If a debtor is insolvent, they may exclude COD income, but only to the extent of their insolvency. For bankrupt taxpayers, all COD income can be excluded if the discharge occurs under a Title 11 bankruptcy proceeding. However, these exclusions come with the requirement to reduce certain tax attributes, such as net operating losses and property basis, as a form of deferred tax recognition.

Taxpayers have the option to elect a different order in reducing their tax attributes, which requires careful planning to optimize the tax benefits. Understanding the implications of these exclusions and the associated attribute reductions is crucial for effective tax planning, particularly in times of economic uncertainty when debt restructurings are common.

Overall, the rules surrounding COD income and its exclusions are intricate, requiring a deep understanding of tax law to navigate effectively. Affected taxpayers must be vigilant in learning and understanding these tax rules, as the proper application of exclusions can significantly influence their financial outcomes during bankruptcy. Careful attention to the details of these complex rules is essential during debt workouts and restructurings to ensure that the financial benefits are maximized and potential tax liabilities are minimized.