An S corporation derives income when a creditor discharges the S corporation from a debt. The income derived from the cancellation of indebtedness of an S corporation is not distributed to the shareholders of an S corporation. However the income that each share holder derives generally from an S corporation is subject to taxation[i].
For the purpose of taxation, an S corporation and its share holders are considered two separate entities. The method adopted for taxing an S corporation and partnership is same. But the rules adopted for distribution of Cancellation of Debt Income (COD) in an S corporation is different from that of a partnership.
As mentioned earlier, the income of a shareholder does not increase with the cancellation of indebtedness. It is only the general income, tax credits, and deductions of the S corporation that are distributed at the shareholder level[ii]. As an exception to the general rule, the income that arises from the discharge of debt that is made before October, 12, 2001 and March, 1, 2002 under the bankruptcy proceedings is distributed among the shareholders.
However, the liability of an S corporation in insolvency, bankruptcy and indebtedness is not distributed at the shareholder level of an S corporation[iii]. Similarly the income that is received from the discharge of debt due to insolvency and bankruptcy is distributed at the corporation level and it is not distributed at the shareholder level.
Occasionally, a loss incurred by an S corporation is also not distributed among the shareholders. Hence such losses are considered income to the shareholders and it is called Net Operating Losses (NOL). An NOL is reduced from the gross income of the S corporation. The income derived from the discharge of indebtedness is also excluded from the gross income of an S corporation.
[i] Bilthouse v. United States, 2007 U.S. Dist. LEXIS 75206 (N.D. Ill. 2007)
[ii] Pugh v. Commissioner, 213 F.3d 1324 (11th Cir. 2000)
[iii] Brooks v. Comm’r, T.C. Memo 2005-204 (T.C. 2005)