Business Entities · S corporations

Debt discharge

The general rules of IRC § 108 apply to an S corporation, but three special rules in IRC § 108(d)(7) change where they operate and what they consume. All three exist because a pass-through entity with an exclusion at one level and basis accounts at another can otherwise produce a benefit nobody intended — and the Supreme Court once held that it did.

The rule

Everything happens at the corporation. in the case of an S corporation, IRC § 108(a), (b), (c) and (g) are applied at the corporate level, including by not taking into account under IRC § 1366(a) any amount excluded under IRC § 108(a)^TY2026Verified 2026-08-21IRC § 108(d)(7)(A), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(A)). Two consequences follow immediately. Insolvency is tested against the corporation’s balance sheet, not any shareholder’s. And an amount excluded under IRC § 108(a) never enters IRC § 1366(a), so it is not a separately stated item, it is not nonseparately computed income, and it does not increase stock basis.

Included discharge income behaves normally. Where no exclusion applies, the discharge is ordinary income of the corporation, passes through under IRC § 1366(a)(1)(B), and increases stock basis under IRC § 1367(a)(1)(B) like any other income.

What the exclusions are. discharge in a title 11 case, discharge while insolvent, qualified farm indebtedness, qualified real property business indebtedness for a taxpayer other than a C corporation, and qualified principal residence indebtedness^TY2026Verified 2026-08-21IRC § 108(a)(1), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(a)(1)), and the title 11 exclusion displaces all the others, and the insolvency exclusion displaces the qualified farm and qualified real property business exclusions to the extent of the insolvency^TY2026Verified 2026-08-21IRC § 108(a)(2)(A) and (B), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(a)(2)). the amount excluded on the insolvency ground may not exceed the amount by which the taxpayer is insolvent, being the excess of liabilities over the fair market value of assets determined immediately before the discharge^TY2026Verified 2026-08-21IRC § 108(a)(3) and § 108(d)(3), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(a)(3), IRC § 108(d)(3)).

What the exclusion costs. net operating loss for the year of the discharge and any carryover to that year; general business credit carryovers; the minimum tax credit; net capital loss and capital loss carryovers; the basis of the property of the taxpayer; passive activity loss and credit carryovers; and foreign tax credit carryovers^TY2026Verified 2026-08-21IRC § 108(b)(2), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(b)(2)), at one dollar of reduction for each dollar excluded, except that the general business credit, minimum tax credit, foreign tax credit and passive activity credit carryovers are reduced by 33⅓ cents for each dollar excluded^TY2026Verified 2026-08-21IRC § 108(b)(3), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(b)(3)), and the attribute reductions are made after the tax for the taxable year of the discharge has been determined^TY2026Verified 2026-08-21IRC § 108(b)(4)(A), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(b)(4)(A)).

The S corporation’s first attribute is the suspended loss. for the attribute reduction of IRC § 108(b)(2)(A), any loss or deduction disallowed for the year of the discharge under IRC § 1366(d)(1) is treated as a net operating loss for that year — except to the extent the discharge is of qualified real property business indebtedness^TY2026Verified 2026-08-21IRC § 108(d)(7)(B), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(B)). This is the provision that makes the whole scheme work, because IRC § 1371(b)(2) means an S corporation has no net operating losses of its own to reduce.

Debt contributed to capital. where a debtor corporation acquires its own indebtedness from a shareholder as a contribution to capital, IRC § 118 does not apply and the corporation is treated as having satisfied the debt with money equal to the shareholder's adjusted basis in the indebtedness^TY2026Verified 2026-08-21IRC § 108(e)(6), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(e)(6)), and for that purpose for the purposes of IRC § 108(e)(6), a shareholder's adjusted basis in indebtedness of the S corporation is determined without regard to any adjustment made under IRC § 1367(b)(2)^TY2026Verified 2026-08-21IRC § 108(d)(7)(C), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(C)).

Current figures

How it works in practice

Test insolvency at the corporation. in the case of an S corporation, IRC § 108(a), (b), (c) and (g) are applied at the corporate level, including by not taking into account under IRC § 1366(a) any amount excluded under IRC § 108(a)^TY2026Verified 2026-08-21IRC § 108(d)(7)(A), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(A)). A shareholder who is personally destitute cannot borrow the corporation’s exclusion, and a corporation that is balance-sheet insolvent gets the exclusion however wealthy its shareholders are. The measurement is the amount excluded on the insolvency ground may not exceed the amount by which the taxpayer is insolvent, being the excess of liabilities over the fair market value of assets determined immediately before the discharge^TY2026Verified 2026-08-21IRC § 108(a)(3) and § 108(d)(3), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(a)(3), IRC § 108(d)(3)) — fair market value of assets against liabilities, immediately before the discharge, so the discharged debt itself is still in the liabilities column.

Then trace what the exclusion consumes. IRC § 1371(b)(2) prevents an S corporation from generating a net operating loss carryover at the corporate level, so the first item on the IRC § 108(b)(2) list would ordinarily be empty. IRC § 108(d)(7)(B) fills it: for the attribute reduction of IRC § 108(b)(2)(A), any loss or deduction disallowed for the year of the discharge under IRC § 1366(d)(1) is treated as a net operating loss for that year — except to the extent the discharge is of qualified real property business indebtedness^TY2026Verified 2026-08-21IRC § 108(d)(7)(B), opened at law.cornell.edu/uscode/text/26/108. The economic effect is that the shareholders pay for the exclusion with the losses they were unable to deduct for want of basis — which is exactly the right answer, because those losses were funded by the debt that has now been forgiven.

The election is the corporation’s. IRC § 1363(c)(1) makes every election affecting the computation of items a corporate election, and the two exceptions in IRC § 1363(c)(2) are the mining exploration election and the foreign tax credit election. So the IRC § 108(b)(5) election to reduce the basis of depreciable property first is made on Form 1120-S by the corporation. Contrast IRC § 703(b), which pushes the IRC § 108(b)(5) and IRC § 108(c)(3) elections down to each partner individually. Two pass-through regimes, opposite answers.

Excluded income is not tax-exempt income. income permanently excludible from gross income in all circumstances in which the provision applies — § 101 death benefits and § 103 municipal interest qualify; § 108 discharge of indebtedness income and § 109 lessee improvements do not^TY2026Verified 2026-08-21Reg. § 1.1366-1(a)(2)(viii), opened at law.cornell.edu/cfr/text/26/1.1366-1 (Reg. § 1.1366-1(a)(2)(viii)). The regulation names IRC § 108 expressly as an example of income that is excluded but not permanently excludible, so it does not qualify as tax-exempt income. This is the same conclusion IRC § 108(d)(7)(A) reaches by a different route, and it matters for both stock basis and the accumulated adjustments account.

Watch what happens to the shareholder’s loan. Where the corporation’s creditor is a shareholder and the shareholder simply forgives the debt as a contribution to capital, where a debtor corporation acquires its own indebtedness from a shareholder as a contribution to capital, IRC § 118 does not apply and the corporation is treated as having satisfied the debt with money equal to the shareholder's adjusted basis in the indebtedness^TY2026Verified 2026-08-21IRC § 108(e)(6), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(e)(6)). If the shareholder’s basis in the note equals its face amount there is no discharge income at all — the corporation is treated as having paid it in full. And for the purposes of IRC § 108(e)(6), a shareholder's adjusted basis in indebtedness of the S corporation is determined without regard to any adjustment made under IRC § 1367(b)(2)^TY2026Verified 2026-08-21IRC § 108(d)(7)(C), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(C)), so the reductions that earlier losses made to the shareholder’s debt basis are ignored for this purpose. Without that rule the shareholder’s own suspended losses would manufacture discharge income for the corporation.

How this has changed

The closing words of IRC § 108(d)(7)(A) were added to reverse a Supreme Court decision. In Gitlitz v. Commissioner, decided 9 January 2001 and reversing 182 F.3d 1143, the Court held two things. First, that excluded discharge of indebtedness is an item of income that passes through and increases shareholders’ bases in the stock — the exclusion in IRC § 108(a) stops the amount being included in gross income, but does not stop it being an item of income. Second, that the pass-through happens before the attribute reduction, because IRC § 108(b)(4)(A) directs that the reductions be made after the tax for the year of the discharge has been determined, and determining that tax requires the basis adjustment and pass-through to have happened already. On the facts, the shareholders’ basis increase equalled their losses, so no suspended losses survived to be reduced. Congress responded in Pub. L. 107-147 § 402(a), inserting into IRC § 108(d)(7)(A) the words ”, including by not taking into account under section 1366(a) any amount excluded under subsection (a) of this section”. The first of the Court’s two holdings is now displaced by statute, and the sequencing question the second answered no longer arises.

That history is worth keeping because the reasoning survives elsewhere. The Gitlitz problem was never about discharge income as such; it was about the interaction of an exclusion with a basis account in a pass-through entity. The partnership regime is built the other way round: IRC § 108(d)(6) provides that in the case of a partnership, IRC § 108(a), (b), (c) and (g) are applied at the partner level. That is the mirror image of IRC § 108(d)(7)(A) and produces a different answer on identical facts — see the partnership cancellation of debt topic.

Two 2026 changes in IRC § 108 do not touch this topic but are worth knowing. The exclusion in IRC § 108(a)(1)(E) for qualified principal residence indebtedness applies only to a discharge before 1 January 2026 or one made under a written arrangement entered into before that date, and no later Act has moved the date. And Pub. L. 119-21 § 70119(a) amended IRC § 108(f)(5) generally with effect for discharges after 31 December 2025. Both are individual provisions and neither reaches a corporate discharge, but a reader working from a general summary of IRC § 108 will meet them.

Exam focus

The highest-yield fact in this topic is the level at which everything happens. Insolvency, the exclusion and the attribute reduction are all corporate. Any question that offers a shareholder’s insolvency as a reason to exclude is testing exactly this.

The second is the basis consequence, and it is worth learning as a pair. Excluded discharge income does not increase stock basis; included discharge income does. A great many questions turn on nothing else.

The third is IRC § 108(d)(7)(B). Know that the shareholders’ suspended losses stand in for the net operating loss that an S corporation cannot have, and know why: IRC § 1371(b)(2).

Finally, keep the two pass-through regimes apart. Subchapter S applies IRC § 108 at the entity and makes the IRC § 108(b)(5) election a corporate one; subchapter K applies it at the partner and makes the election a partner’s. Identical facts, opposite answers.

Check yourself

1. An S corporation is insolvent by $90,000 when a creditor forgives $140,000. How much is excluded, and what happens to the rest?

Answer: $90,000 is excluded under IRC § 108(a)(1)(B), because the amount excluded on the insolvency ground may not exceed the amount by which the taxpayer is insolvent, being the excess of liabilities over the fair market value of assets determined immediately before the discharge^TY2026Verified 2026-08-21IRC § 108(a)(3) and § 108(d)(3), opened at law.cornell.edu/uscode/text/26/108. The remaining $50,000 is ordinary discharge income of the corporation, passes through under IRC § 1366(a)(1)(B), and increases each shareholder’s stock basis under IRC § 1367(a)(1)(B).

2. Following that exclusion, the corporation has no net operating loss and no credit carryovers. What is reduced?

Answer: for the attribute reduction of IRC § 108(b)(2)(A), any loss or deduction disallowed for the year of the discharge under IRC § 1366(d)(1) is treated as a net operating loss for that year — except to the extent the discharge is of qualified real property business indebtedness^TY2026Verified 2026-08-21IRC § 108(d)(7)(B), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(B)). The shareholders’ losses disallowed for the year of the discharge under IRC § 1366(d)(1) are treated as a net operating loss and reduced first, dollar for dollar. If they are exhausted, the reduction moves down the IRC § 108(b)(2) list to the basis of the corporation’s property.

3. A shareholder of an insolvent S corporation is personally solvent and wealthy. Does that affect the corporation’s exclusion?

Answer: No. in the case of an S corporation, IRC § 108(a), (b), (c) and (g) are applied at the corporate level, including by not taking into account under IRC § 1366(a) any amount excluded under IRC § 108(a)^TY2026Verified 2026-08-21IRC § 108(d)(7)(A), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(A)). The exclusion and the insolvency test are applied at the corporate level, and the shareholder’s own balance sheet is irrelevant. The answer would differ for a partnership, where IRC § 108(d)(6) applies the exclusions at the partner level.

4. May a shareholder who disagrees with the corporation’s IRC § 108(b)(5) election make her own?

Answer: No. IRC § 1363(c)(1) makes any election affecting the computation of items derived from an S corporation a corporate election, and the only exceptions in IRC § 1363(c)(2) are the mining exploration and foreign tax credit elections. The contrast is IRC § 703(b), which does give the choice to each partner.

5. A shareholder whose debt basis in a $150,000 note has been reduced to zero forgives the note as a contribution to capital. How much discharge income does the corporation have?

Answer: None. where a debtor corporation acquires its own indebtedness from a shareholder as a contribution to capital, IRC § 118 does not apply and the corporation is treated as having satisfied the debt with money equal to the shareholder's adjusted basis in the indebtedness^TY2026Verified 2026-08-21IRC § 108(e)(6), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(e)(6)), and for the purposes of IRC § 108(e)(6), a shareholder's adjusted basis in indebtedness of the S corporation is determined without regard to any adjustment made under IRC § 1367(b)(2)^TY2026Verified 2026-08-21IRC § 108(d)(7)(C), opened at law.cornell.edu/uscode/text/26/108 (IRC § 108(d)(7)(C)) — so the relevant basis is $150,000, ignoring the IRC § 1367(b)(2) reductions. The corporation is treated as having satisfied the debt with $150,000 of money.