Is this Ordinary and Necessary?


Bill Lentz

It's my understanding that, when a C corp emerges from a
Chapter 11 bankruptcy and has forgiveness of debt income as
a result, that such income reduces certain tax attributes
and assets rather than being taxed. For example, a C corp
that has $2,000,000 of NOL carryforwards, and incurs
$1,000,000 of debt forgiveness in a Chapter 11, would reduce
the $2,000,000 to $1,000,000 and not recognize any of the
income in the year it emerges.

Now, what if, for whatever reason, the corporation elects to
later pay some or all of the amounts that were forgiven.
The company has no legal obligation, but it's owners may
feel a moral obligation, or the owners may believe that it
is good business to attempt to repay some of the forgiven
debt (say, because the company continues to buy from the
supplier and believes that repaying the debt will lead to
better pricing.)

The question is, would these payments be deductible expenses
to the C corp? Would it matter what the reason for payment
was (e.g. because of the owners sense of moral obligation,
vs. in anticipation of better vendor relations?) If it is
deductible, where would it go on an 1120?

Thanks for any thoughts.
Bill Lentz



Michael T Wing CPA

Bill Lentz said:
Thanks for any thoughts.
It has always been my understanding that the subsequent payment
of selected debts that were discharged in bankruptcy can cause
the bankruptcy to be reopened. I am no expert in this area, but I
would refer the question to someone whom is.
I'm not sure about the tax treatment, but if the IRS argued that
such payments were a constructive dividend to the shareholders
(since it is their "moral obligation" that is being satisfied), I
wouldn't be surprised.


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