Ronald B. Cohen


Cancellation of indebtedness ordinarily will be treated as income to a debtor corporation unless the debt was forgiven by a stockholder. In the latter case, the corporation normally treats the resulting benefit as a contribution to capital. However, there is a much more delicate situation when the debt is the result of unpaid salaries, interest, or other corporation expenses. In the typical case, these items would have reduced the income of the corporation in the year of accrual, but would not have been picked up as income by the cash basis stockholder. Therefore, the effective result of forgiveness of salaries and interest would be that a corporation could eliminate tax on the amounts accrued, while the stockholders would have no tax until dissolution, at which time they would receive a "return of capital" and pay only at the capital gain rates. The specific problem is not mentioned in the Code and is likewise ignored in the Regulations. Consequently, a thorough look at what the case law has been is needed to see how current transactions of this nature are likely to be handled by the courts.