Debt Cancellation

[newbie]

An LLC had debt of $80,000+ to various creditors for inventory, utilities and credit cards. The business sold and paid off some debts but still has a balance of over $60,000. The LLC consisted of 2 members. Each of the two members filed bankruptcy listing the debts of the LLC as well as there own personal debts, with all being discharged in the bankruptcy.

The LLC did not actually file bankruptcy, but is insolvent and will be disolved per lawyer. If the LLC receives 1099C's for 2006 is this a nontaxable event because the LLC is insolvent? Will a form 982 need to be filed?

Are there other issues I need to be aware of?

[Snaggletooth]

Accounting Method

You betcha there's more issues! The primary one is whether the LLC was on a cash basis or accrual basis.

At issue is whether the unpaid-for inventory was ever deducted as Cost of Goods Sold.
Debt forgiveness reduces the basis of the partners either directly or indirectly, but to the extent the cost of the inventory was never deducted, there is no such reduction.

[newbie]

This was a cash basis and the inventory was not deducted in cost of good sold. However some of the credit card purchases may have been deducted.

This is a real mess that will be tied up in legalities and I would like insight on the tax aspects and not the legal reprecussions. My sister in law made a financial investment in this business and the other member, a "trusted friend", actually ran the business. When the business sold is when it was discovered that there was a tremendous amount of debt that was never recorded in the books and which my sister in law was not aware of.

I would like to help her keep tabs on the current accountant and take this in as a learning process. I'm not blaming the accountant, he worked with the numbers he was given and as far as I know he too was "surprised" at the amount of debt actually out there.

Still searching for thoughts on:
The LLC did not actually file bankruptcy, but is insolvent and will be disolved per lawyer. If the LLC receives 1099C's for 2006 is this a nontaxable event because the LLC is insolvent? Will a form 982 need to be filed?

[Bees Knees]

TTB, page 14-8, “Exceptions to Taxable Income From Discharge of Indebtedness.”

“2) A discharge of indebtedness to the extent that the taxpayer is insolvent…”

“For purposes of IRC Section 108 the term insolvent is defined as the excess of liabilities over the FMV of assets immediately before the discharge. The amount excluded from income cannot exceed the amount by which the taxpayer is insolvent.”

Then under reduction of tax attributes, it says that the amount excluded from income reduces certain tax attributes, such as the taxpayer’s basis in the activity.