to a fresh start does not require that the bankrupt be given a head start by being permitted to offset future earnings with depreciation or other deductions reflecting obligations which were incurred for previous benefits but were discharged in the proceeding.

The insolvency exception developed at a time when relief provisions presently available were either unknown or restricted. The elective exclusion of discharge of indebtedness income under section 108 of the Code, conditioned on a reduction of basis under section 1017, came into the law, in quite restricted fashion, under the Revenue Act of 1939, and did not become a permanent part of the law until 1951. Net operating losses, under section 172 of the Code, may now be carried back three years, and carried forward at least five, whereas at the time when the insolvency exception developed carryovers were far more limited (and, from 1933-1938, entirely unavailable)."

In many situations where there is a cancellation of indebtedness by reason of insolvency, there is a net operating loss carryover available which would offset any income recognized: the recognition of such income results in no current tax but eliminates the swelling of net operating loss carryovers by obligations which will not be paid. Further, there is no warrant for treating the taxpayer who would otherwise have derived a tax benefit from the swollen loss carryover to future years differently from a taxpayer who has already enjoyed a tax benefit deriving from discharged obligations. Only in that situation where the discharged obligation produced no tax benefit in the past and may produce no potential benefit for the future is it reasonable to view the discharge of the obligation as not giving rise to income.

Thus, proposed section 108 (b), after stating the general rule that no income shall be recognized as the result of cancellation of indebtedness by reason of insolvency, states four exceptions where income shall be so recognized: (1) to the extent that the taxpayer is made solvent as the result of such discharge; (2) to the extent that the indebtedness is reflected in the basis of property immediately following such discharge; (3) to the extent of the deductions or credits deriving from such indebtedness which resulted in a reduction of the taxpayer's tax; and (4) to the extent that deriving from such indebtedness there is a loss in or loss carryover to the taxable year in which the indebtedness is discharged.

The first two exceptions require little comment. The first, relating to solvency, is merely a restatement of existing law. As to the second, to the extent that discharged indebtedness is reflected in the basis of property, whether this is business or nonbusiness property, there seems no inequity in recognizing income from cancellation of indebtedness. This income need not be recognized currently since an election is available under section 108 (a) to reduce the basis of property instead of recognizing cancellation of indebtedness income. It should be noted that there is no requirement that the property be held by the taxpayer immediately following the discharge-in many reorganizations there will be a transfer to a successor corporation, whose basis is determined by that of its predecessor.

In paragraphs (3) and (4), the phrase "deriving from *** indebtedness" is intended to cover every situation where, but for such indebtedness, taxpayer would have had a greater tax liability, or smaller losses. No distinction is drawn between the taxpayer who accrues a deduction for salary which he does not pay, the liability for which is discharged, and the taxpayer who claims a similar deduction and pays the salary with borrowed funds (or other funds which are freed as a result of the borrowing), and then the obligation to repay the borrowed funds is discharged. Thus, determining the applicability of paragraphs (3) and (4) will be very simple. First, one determines whether liability discharged was taken into account in determining basis, under (2). If not, and the taxpayer is in a trade or business, for the period beginning with the year the

For a history of these provisions, see Eustice, supra, at 257–264.

22 Under the Revenue Act of 1918, c. 18, 40 Stat. 1057, Sec. 204 (b), there was only a one year carryback and carryover. Under the Revenue Acts of 1921 through 1928 there was no carryback and a two year carryover. Revenue Act of 1921, c. 136, 42 Stat. 227, Sec. 204 (b); Revenue Act of 1924. c. 234, 43 Stat. 253, Sec. 206(b); Revenue Act of 1926. c. 27, 44 Stat. 9, Sec. 206(b); Revenue Act of 1928, c. 852, 45 Stat. 791, Sec. 117(b). Section 117(b) of the Revenue Act of 1932, c. 209, 47 Stat. 169, changed this to a one year carryover only, and even this was eliminated in 1933. National Industrial Recovery Act, c. 209. 47 Stat. 169, Sec. 218(a). Section 122 of the Revenue Act of 1939, c. 247, 53 Stat. 862, brought back a carryover provision (three years), and a two year carryback was permitted by the Revenue Act of 1942, c. 619, 56 Stat. 798, Sec. 153 (a).

indebtedness is incurred, through the year of discharge, one determines the totality of deductions wasted without producing either a tax benefit or loss in or loss carryover to the year of discharge. Subtracting such total wasted deductions from the total indebtedness discharged gives the amount utilized or utilizable in reducing tax liability, and therefore recognized as income under paragraphs (3) and (4), subject to the election available under section 108(a). For a taxpayer not in a trade or business, income would be recognizable under subsections (3) and (4) only where the indebtedness per se was the basis for deduction or credit. To the extent of the indebtedness which was itself deducted or credited, paragraphs (3) and (4) thus parallel the tax benefit provisions of section 84.

Paragraphs (1), (2), (3) and (4) are cumulative, except to the extent that they cannot total more than the indebtedness discharged. Obviously a deduction resulting in a prior tax benefit should be added to a loss carryover to determine the total utilized or utilizable in reducing tax liability as the result of the indebtedness. Similarly, if two taxpayers have each incurred indebtedness of $1,000, and each has derived a utilized or utilizable loss of $500 therefrom, the indebtedness is discharged in full, and one taxpayer is solvent to the extent of $100 after the discharge and the other is still insolvent, the first taxpayer is $100 better off than the second. Accordingly, in the case of the taxpayer rendered solvent income would be realized to the extent of $600.

It is believed that the tax benefit approach proposed with respect to insolvency represents an equitable balancing of the claims of the taxpaying public generally and the insolvent debtor. As to individual taxpayers, not in a trade or business, if they had taken no deductions as a result of such indebtedness (or derived no tax benefit therefrom) no income would be realized. And, for the taxpayer in business, whether individual or corporation, the intention is simply to give the insolvent taxpayer no head start in the form of a loss carryover or inflated basis to subsequent years made up of discharged obligations.

This proposal would, of course, require corresponding changes in the language of the Commission's proposed section 7-315(b) and (d).

VI. LIBERALIZATION OF THE ELECTIVE EXCLUSION FROM INCOME AND REDUCTION OF BASIS

Proposed subsection 108 (a) affords the same election available under existing law, to exclude from current income cancellation of indebtedness income, which is used instead to reduce the basis of property. Although the language of subsection (a) had to be changed substantially to avoid awkwardness, the only substantive change was to extend the privilege of this elective exclusion to certain individuals. Under existing law, the election is available only with respect to corporate indebtedness, or indebtedness incurred or assumed by an individual in connection with property used in his trade or business. Under proposed section 108(a), regardless of how an individual incurred indebtedness he could elect to exclude it and reduce basis instead, provided that the basis of property reduced was business property. Also, to the extent that income from cancellation of indebtedness was recognized under subsection 108(b)(2) because the individual retained property the basis for which reflected the discharged indebtedness, an election is available to instead reduce the basis of such property.

Considerable thought was given to whether the election under section 108 should be permitted for an obligation or liability which was deducted in computing the taxpayer's taxable income, with prior or potential tax benefit. The Bankruptcy Commission's proposed section 172(d) (7) requires reduction of the net operating loss by all liabilities the deduction of which (either directly, or indirectly) contributed thereto, and permits no such elective deferral of income recognition (or loss reduction). There is good reason for taking this approach. After all, by definition, the liability in question had already been deducted with resulting tax benefit in the past, or increase in a net operating loss providing a potential tax benefit for the future. When there is a net operating loss to absorb the income recognition, there is no need for deferral, and when the tax benefit has already been enjoyed, there seems little warrant for permitting further deferral of income recognition. However, in Rev. Rul. 67-200, 1967-1 Cum. Bull. 15, and Rev. Rul. 70-406, 1970-72 Cum. Bull. 16, the Service held that accrued interest giving rise to a tax benefit could be excluded under Code section 108 by a corporation, or by an individual in connection with business property, provided the consent to a basis adjustment was filed. Accordingly, the proposed draft sets forth the Service's position in this respect.

VII. COMPARISON WITH THE BANKRUPTCY COMMISSION PROPOSALS CONCERNING TAX BENEFIT-CANCELLATION OF INDEBTEDNESS

The proposals made here are, it is believed, consistent in spirit with the approach taken in the Bankruptcy Commission Report with respect to cancellation of indebtedness. However, there are some differences.

The Commissions' proposed section 172(d)(7) requires the reduction of a net operating loss to the extent of the cancellation of indebtedness which, because it was incurred, resulted in increasing the net operating loss either directly or indirectly. To the extent that sections 84 and 108 here proposed treat with the same subject matter, they take the more direct approach of increasing income rather than reducing a net operating loss.

To the extent that there are net operating losses (which would be the usual situation) the effect of the two proposals would be identical.

To the extent that there are no net operating losses, but for example, a tax benefit previously obtained, proposed sections 84 and 108 (assuming consistent amendment of the Bankruptcy statutes) would be more burdensome to the taxpayer in nonethless requiring recognition of income-which, it is believed, is fully justified, and necessary in order to achieve some kind of parity of treatment as between cash and accrual basis taxpayers. Further, proposed sections 84 and 108 provide more beneficial treatment for the taxpayer than proposed section 172(d) (7) in two respects-they do not require reduction of a net operating loss where the deductions deriving from the cancelled indebtedness were wasted, without tax benefit past or potential, and they give the taxpayer the election of reducing basis, rather than recognizing income (or reducing the net operating loss). There is one additional difference, in that proposed section 172(d) (7) would recompute the depreciation allowance where indebtedness entering into the basis of depreciable property was cancelled; proposed section 84 (the tax benefit principle) does not apply with respect to depreciation, but proposed section 108 (b) (3) and (4) would require recognition of income because of such depreciation deductions, where the cancellation resulted from insolvency, but only to the extent that there was a tax benefit in the past, or a potential benefit (because of a loss carryover) in the present or future.

Thus, while the enactment of Bankruptcy Commission proposed section 172(d) (7) would be desirable if the proposals made in this paper are not enacted, the adoption of proposed sections 84 and 108 would render proposed section 172(b) (7) unnecessary.

Proposed sections 7-315(b) and (d) of Ch. VII of the proposed Bankruptcy Act of 1973 conflict with the treatment accorded under proposed sections 84 and 108, in essentially the same respects. Thus, proposed sections 84 and 108 would recognize income to the extent of tax benefits deriving from the cancelled indebtedness whether already obtained or potential benefits, rather than focussing instead solely on potential future benefits. Additionally, where indebtedness has entered into the determination of the basis of property held after the discharge, proposed section 108(b) would require recognition of income, which the taxpayer could elect to exclude by reducing basis. A basis which reflects discharged indebtedness is as much unwarranted, in giving the previously insolvent taxpayer a head start, as a net operating loss carryover which reflects discharged indebtedness. There is no reason why a taxpayer should be better off, taxwise, as the result of incurring indebtedness which he does not pay than if he had never incurred the indebtedness in the first place. Apart from the situation where the taxpayer is rendered solvent, where both proposals would require adjustment,23 it is only in those situations where the taxpayer would be better off tax-wise as the result of having incurred the discharged indebtedness, if no income recognition were required, that proposed section 108(b) requires recognition of income." And, of course, even this requirement is tempered by the availability of the election under section 108 (a).

The purpose of the Bankruptcy Commission's proposed subsection 312(n) is to increase earnings and profits to the extent of cancelled indebtedness not otherwise taken into account. Inasmuch as earnings and profits should be in

23 Proposed section 7-315(d) requires the basis of property to be reduced to the extent of the indebtedness discharged under the Bankruptcy Act. or the taxpayer is made solvent, whichever is lesser, except that the taxpayer may elect to have income recognized instead.

24 Thus, for a taxpayer who derived no past or potential tax benefit from the cancelled Indebtedness (and this would include virtually every taxpayer not in business) there would be no income recognition at all under proposed sections 84 and 108.

creased to the extent of discharged indebtedness without regard to tax benefit, the greater part of subsection 312 (n) is complementary to proposed sections 84 and 108. One caveat, however, is that the exceptions in paragraphs (2) and (3) deal with essentially the same subject matter as the definition of discharge in proposed section 84(b) (3). It is believed that, to the extent that the creditorshareholder has either not included in income a liability deducted by the debtor (such as interest, or rent) or has included such amount but then written it off as a bad debt, earnings and profits should be increased for the same reason that recognition of income in this situation (to the extent of the tax benefit derived) is warranted. This result would be accomplished by using in lieu of proposed subsection 312 (n) (2) and (3), the language of proposed section 84(b) (3) (A) and (B). Such a substitution would be entirely consistent with proposed section 312(o), which requires reduction of a deficit in earnings and profits to the extent that shareholders' interests have been extinguished. Shareholders whose interests have been extinguished would have claimed a tax loss therefor, and there is no reason to include in earnings and profits a deduction for a debt to the extent that the creditor-shareholder has it written off as worthless (or not taken it into income). On the other hand, when the creditorshareholder has accured a liability as income, or has not written off the debt, then there is no reason to require an increase in earnings and profits. This accommodation would be readily achieved in the manner suggested.

THE STATUTORY LANGUAGE PROPOSED

SECTION 84. RECOVERY OF PRIOR DEDUCTIONS

(a) General rule. Gross income includes all amounts attributable to the recovery or disposition of any item, or discharge of any liability, which was previously the basis of deductions or credits.

(1) whether or not the earlier treatment was proper, and

(2) whether or not gain or loss would otherwise be recognized on such recovery, disposition, or discharge,

reduced by the amount of the recovery exclusion provided in subsection (d). (b) Definitions. The following definitions shall apply for the purposes of this section.

(1) Recovery. The term "recovery" means the receipt of money or property in respect of items previously deducted or credited.

(2) Disposition. The term "disposition" includes any transfer of property in respect of which deductions or credits were previously taken, unless the basis for such property to the transferee is determined by the basis of such property to the transferor.

(3) Discharge. The term “discharge” includes any manner in which any liability which was previously the basis of deduction or credit is eliminated, extinguished, discharged, forgiven or reduced, in whole or in part, except

(A) to the extent of the creditor's basis for the debtor's liability which is discharged, when discharge occurs in a transaction as a result of which the transferee's basis for property transferred is determined by the basis of such property to the transferor, or

(B) to the extent of payment therefor, measured by the fair market value of any stock or other property distributed to the creditor with respect to such liability, plus money and the principal amount of any securities (or portion thereof) of a corporate obligor so distributed. (c) Characterization. Income included under this section shall have the same character, whether ordinary or capital and, if the latter, whether long-term or short-term, as the prior deductions or credits.

[(4)] (d) Recovery Exclusion.

(1) In general.-The term "recovery exclusion," [with respect to bad debt, prior tax, or delinquency amount], means the amount, determined in accordance with regulations prescribed by the Secretary or his delegate, of the deductions or credits allowed, on account of [such bad debt, prior tax, or delinquency amount,] the item recovered or disposed of, or the liability discharged, which [did not result] has not resulted

(A) in a reduction of the taxpayer's tax under this subtitle (other than the tax imposed by sections 531 or 541), or

(B) in a loss in or loss carryover to the taxable year of the recovery, disposition or discharge,

reduced by the amount excludable in previous taxable years with respect to such [debt, tax, or amount] item or liability under this section.

(2) Special Rule for Accumulated Earnings and Personal Holding Taxes. An item recovered or disposed of, or a liability discharged, which has resulted only in a reduction of the tax imposed by either section 531 or section 541 shall be taken into account only in calculating liability with respect to such taxes.

(3) Prior Laws.-Reference in this section to any provision of this title includes corresponding provisions of prior revenue laws.

(e) Exception where other specific provision made.—Where specific provision is made elsewhere in this chapter with respect to the effect of the earlier deduction or credit on subsequent recovery, disposition, or discharge, this section is inapplicable.

(f) Cross References.—

(1) For rules relating to certain dispositions of section 38 property, see section 47.

(2) For determination of gain or loss on distribution of installment obligations, see section 453(d).

(3) For inclusion of prepaid subscription income, when liability to furnish or deliver periodicals ceases, see section 455(b).

(4) For inclusion of prepaid dues income, when liability to render services or make available membership privileges ceases, see section 456(b).

(5) For deduction and recapture of certain mining exploration expenditures, see section 617.

(6) For inclusion in gross income of gain from disposition of certain depreciable property, see section 1245.

(7) For inclusion in gross income of gain from disposition of certain depreciable realty, see section 1250.

(8) For rules relating to war loss recoveries, see sections 1314 through 1337.

(9) For computation of tax where taxpayer recovers a substantial amount deducted from gross income because held by another under claim of right, section 1346.

(10) For rules relating to recovery of unconstitutional federal taxes, see section 1346.

(11) For treatment of recoveries of foreign expropriation losses, see section 1351.

SECTION 108. INCOME FROM DISCHARGE OF INDEBTEDNESS

(a) Exclusion by Election.1 At the election of the taxpayer, gross income shall not include income by reason of discharge of indebtedness, provided that such taxpayer files a consent to the adjustment of basis of property, pursuant to the regulations prescribed under section 1017. If the taxpayer is an individual, such election shall be available only with respect to property used in a trade or business, unless income is recognized under subsection (b)(2), in which_event such election is available with respect to the property there described. In [such case] the case of such an election, the amount of any income of such taxpayer attributable to any unamortized premium (computed as of the first day of the taxable year in which such discharge occurred) with respect to such indebtedness shall not be included in gross income, and the amount of the deduction attributable to any unamortized discount (computed as of the first day of the taxable year in which such discharge occurred) with respect to such indebtedness shall not be allowed as a deduction.

(b) Exclusion by Reason of Insolvency-Notwithstanding section 61(a) (12), no income shall be recognized as the result of discharge of indebtedness by

1 As presently written, the caption and first sentence of subsection 108 (a) are as follows: (a) Special Rule of Exclusion.-No amount shall be included in gross income by reason of the discharge, in whole or in part, within the taxable year, of any indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds property, if(1) the indebtedness was incurred or assumed

(A) by a corporation, or

(B) by an individual in connection with property used in his trade or business, and

(2) such taxpayer makes and files a consent to the regulations prescribed under section 1017 (relating to adjustment of basis) then in effect at such time and in such manner as the Secretary or his delegate by regulation prescribes.