5.4 Debt Discharge: Partnership vs. S Corporation

Begin with the cancelled obligation

Cancellation of debt (COD) generally creates gross income when a lender accepts less than the amount owed. Borrowing cash originally is not income because of the obligation to repay; cancellation removes that obligation. Exceptions and exclusions can change the result, but a lender's Form 1099-C does not independently decide whether an exclusion applies. Review the underlying debt, amount cancelled, taxpayer, and circumstances immediately before the discharge.

A cash-basis taxpayer generally has no COD income to the extent paying the cancelled liability would have produced a deduction. A price reduction by the original seller of property can qualify as a purchase-price adjustment when the statutory conditions are met. A loan written off in a creditor's accounting records is not automatically a completed discharge for the debtor in that same year. These distinctions precede the bankruptcy and insolvency calculations.

Partnership: test the partners

Section 108(d)(6) generally applies the bankruptcy, insolvency, qualified farm debt, and qualified real property business indebtedness rules at the partner level. The partnership computes and allocates COD under partnership rules, but the relevant exclusion is tested against each partner's facts. A partnership's negative balance sheet does not automatically make every partner insolvent.

For insolvency, liabilities must exceed the fair market value of all assets immediately before discharge. The exclusion cannot exceed that insolvency amount. Do not use tax basis in place of fair market value, or omit assets merely because they are protected from creditors. Record what the taxpayer owns and owes at the controlling moment, with support for values.

Example: A partnership allocates $40,000 of COD to each of two equal individual partners. Partner A was insolvent by $30,000 immediately before discharge; Partner B was solvent and neither is in bankruptcy. Assuming no other exclusion, A excludes $30,000 and includes $10,000, while B includes $40,000. The partners' different results do not change the partnership's total $80,000 cancellation item.

Liability relief is a second calculation

A partner's share of a partnership liability can fall when that debt is cancelled. Under §752(b), that decrease is treated as a deemed cash distribution. Compute the partner's outside basis with the properly ordered income and other adjustments, then test the deemed distribution under §731. Income exclusion and liability relief are separate provisions, so do not merely report a net unexplained figure.

A basis worksheet should show beginning outside basis, contributions, current income including the relevant COD adjustment, actual distributions, liability increases or decreases, and deductions. Excluded COD and tax-attribute reduction require coordinated §705 and §108 rules; it is unsafe to treat all excluded amounts as ordinary tax-exempt municipal interest without reviewing the governing provisions. Taxable COD can increase basis even when no cash is received.

S corporation: test the corporation

For an S corporation, the §108 exclusions generally apply at the corporate level under §108(d)(7). Use the corporation's bankruptcy or insolvency facts. Shareholders' personal solvency does not replace that test. Excluded COD is not passed through as tax-exempt income and does not increase shareholders' stock basis. This prevents shareholders from using excluded cancellation income to release additional basis-limited losses.

Example: An S corporation has $60,000 of cancelled debt and is insolvent by $45,000 immediately before cancellation. Assuming no other exclusion, it excludes $45,000 and passes through $15,000 of taxable COD. A sole shareholder does not receive a $60,000 basis increase. The taxable $15,000 can affect stock basis under ordinary income-adjustment rules; the excluded $45,000 does not.

A shareholder's cancellation of a bona fide direct loan raises another issue. Section 108(e)(6) generally treats a shareholder contribution of debt to corporate capital as satisfaction for the shareholder's adjusted basis in the debt. If a shareholder's debt basis is below its face amount because earlier S losses reduced basis, cancellation can create COD at the corporation. Compare face amount and adjusted debt basis before labeling forgiveness tax-free capital.

Exclusion usually has a future cost

Bankruptcy or insolvency exclusion commonly requires reduction of tax attributes on Form 982. The statutory ordering generally begins with NOLs and NOL carryovers, then certain credits, capital-loss carryovers, basis, passive items, and foreign-tax-credit carryovers. An election can instead reduce depreciable property basis first within applicable limits. Attribute reduction is generally made after computing tax for the discharge year, which matters when that year's losses or credits are being used.

Keep the debt instrument, settlement agreement, insolvency computation, and beginning attribute schedules together. A return with zero taxable COD may still require Form 982 and revised carryovers. Conversely, a solvent partner cannot claim exclusion simply because a different partner qualified.

Official references

Publication 4681, Form 982 instructions, and 2025 Form 1120-S instructions, checked October 17, 2026.

Entity comparison