United States: State Conformity to the Deferred Recognition of Certain Cancellation of Debt Income under IRC Section 108(i)

Originally published October 14, 2010

Keywords: Cancellation, debt income, IRC Section 108(i), Recovery Act, income tax

Under the American Recovery and Reinvestment Act of 2009 (the "Recovery Act"), taxpayers can irrevocably elect to defer recognition of cancellation of indebtedness (COD) income that otherwise would have been recognized on the reacquisition of an applicable debt instrument by the debtor, or a related party to the debtor. They can defer for four years if the debt is reacquired in 2009, and for three years if reacquired in 2010, regardless of whether the taxpayer is insolvent or in bankruptcy.

The deferral election is made by attaching a statement to the taxpayer's original tax return (including extensions) for the taxable year in which the reacquisition of the applicable debt instrument occurs. Beginning in 2014, the taxpayer making the section 108(i) election must recognize the COD income from the reacquired indebtedness ratably over five years (i.e., 20 percent of the COD income would be included in income each year from 2014 through 2018).
Historically, the vast majority of states have followed the federal treatment of COD income under section 108 and, as a result, would have followed the deferral through their federal conformity statutes (to the extent that the conformity date included the Recovery Act). Now, however, there is an increasing trend toward decoupling from the income deferral provision of section 108(i).

While the Recovery Act creates a timing difference for federal purposes—i.e., income realized now but recognized at a later date—many states are unwilling or unable to delay income recognition due to budget constraints. Accordingly, a number of jurisdictions have affirmatively decoupled from this provision, including: Connecticut, the District of Columbia, Florida, Indiana, Maine, Maryland, Massachusetts, Minnesota, New Jersey, North Carolina, Oregon, and Rhode Island. A taxpayer subject to taxation in a "decoupled state" would be required to recognize COD income for state tax purposes in the year in which the reacquisition of the applicable debt instrument occurs, without regard to the federal election and deferral under section 108(i).

Some states, however, have updated their federal conformity statutes to include the Recovery Act despite current-year revenue loss. In the absence of specific legislation, a state's general federal conformity regime determines the treatment of the COD income deferral—i.e., the answer may change depending on whether a state employs rolling, fixed/static, or selective conformity. Rolling conformity states, such as Illinois and New York, will generally follow the COD income deferral election provisions of the Recovery Act; thus, making a federal election will also result in a deferral of COD income for state purposes. If these rolling conformity states are inclined to decouple from the federal COD income deferral provision, they will have to enact legislation to that effect.

In contrast to rolling conformity states, states with a fixed or static conformity date prior to 2009 do not conform to section 108(i). Such a state is effectively decoupled, unless it enacts conformity legislation.

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