SH left and relieved of debt

[David]

LLC taxed as a S Corp had 3 shareholders. One SH left during 2013.

The company has debt. How and where in the ATX program do I show that the SH was relieved of 1/3 of the debt?

Doesn't this debt relief get reported on the K-1 as taxable income?

Thanks.

[David]

OK, maybe I need more information?

The debt was from the departing member's father to the LLC, signed by all 3 members. The remaining members tried to get the departing member to pay her portion of the debt but she refused.

The termination agreement stated that the debt to the departing member's father has to be paid in full within 30 days of the departing member's termination date. The remaining members paid the debt in full with a loan from one of the members and from another debt from that same member's parents.

The termination agreement also states that the departing member is released from company debt and all other claims.

The departing member had a basis at 12/31/12 of $9K - $7K stock basis and $2K debt basis. She left in February 2013 so there will be a little more profit added to her basis.

How and where in the ATX program do I show that the SH was relieved of 1/3 of the debt? Doesn't this debt relief get reported on the K-1 as taxable income? Or is it netted against the SH basis and then the remaining amount is taxed to the SH?

Thanks.

[jasdlm]

I'm not positive, but I'll go out on a limb to get the conversation started. I think it is netted against the SH basis, given that the LLC has elected S-corp status. I don't think there is COD income in this particular situation.

Please note that I'm not certain; just giving my opinion and hoping that others who are more knowledgeable will join the conversation.

[David]

Thanks for responding. I'm thinking the same but like you I am not certain.

I thought I was the only one who never dealt with this before.

The problem is that the previous CPA told the 2 remaining members that the departing member will have to pay tax on 1/3 of the debt that she is walking away from. If this is correct, I don't know where to show that on the K-1. Does the S Corp issue a 1099-C to the departing member for 1/3 of the debt? Remember, the debt was from the departing member's father.

Since I have never dealt with this before I want to make sure I am doing the right thing, especially trying to explain to the remaining members that the departing member has no repercussion from walking away from the corporation and the corporation debt.

I would appreciate input from those of you who have dealt with this issue. I have to have the S Corp tax return completed tomorrow.

Thanks.

[kcjenkins]

I think she does have COD income from the debt she was relieved of. And yes, I'd have the S Corp issue a 1099-C to the departing member for her share of the debt. Thank goodness they did the legal paperwork that establishes what actually happened.

[michaelmars]

were the shareholders personally liable for the debt?

[kcjenkins]

David said they all three signed the original loan documents. So, yes, all personally liable.

[David]

OK, someone pointed out reg 1.301-1(m). It states that cancellation of debt of a shareholder by a corporation is treated as a property distribution. So, I guess this is reported as a distribution on the K-1 - unless the reg is referring to C Corps only.

Thanks everyone for your help.

[David]

After thinking more about reg 1.301-1(m) could the cancellation of debt of a shareholder by a corporation mean a direct loan to the shareholder from the corporation and not corporation debt guaranteed by the shareholder?

Hmmmmm....... so instead of reporting it as a property distribution on the K-1 are we back to the S Corp issuing a 1099-C?

[jasdlm]

The S-Corp wasn't relieved of debt, so I don't see how it would flow through her K1. I think the 1099 C is the right answer, and only because she had personally guaranteed the note. KC, is this correct?

[David]

That makes sense. So a 1099-C would not be correct if the departing member did not personally guarantee the loan?

What if 1 member/shareholder personally guranteed the corporation debt and the other 2 members/shareholders did not and the 2 members/shareholders who did not personally guarantee the loan terminated their interest in the S Corp? The remaining member of the S Corp is left holding the bag and no 1099-C is issued to the other 2 members?

Thanks for your help.

[kcjenkins]

The S-Corp wasn't relieved of debt, so I don't see how it would flow through her K1. I think the 1099 C is the right answer, and only because she had personally guaranteed the note. KC, is this correct?

That is right based on my understanding of the original agreement. It was not cancellation of debt to the shareholder of a loan from the corporation.

[kcjenkins]

That makes sense. So a 1099-C would not be correct if the departing member did not personally guarantee the loan?

What if 1 member/shareholder personally guaranteed the corporation debt and the other 2 members/shareholders did not and the 2 members/shareholders who did not personally guarantee the loan terminated their interest in the S Corp? The remaining member of the S Corp is left holding the bag and no 1099-C is issued to the other 2 members?

Thanks for your help.

If the departing member was not LIABLE for the debt, they are not being RELIEVED of the debt. So no COD issue. The one who had personally guaranteed the corporation debt is in the same position as before.