Overview

Loan forgiveness occurs when a lender or creditor releases a borrower from the obligation to repay some or all of a loan. For businesses, that relief can be vital—but it often carries tax consequences that change a company’s taxable income, tax deductions, and future tax attributes. The IRS treats most cancelled debt as income (“cancellation-of-debt” or COD income) unless a specific exclusion applies (IRS, Cancellation of Debt (COD)).

This article explains the key rules (as of 2025), common exceptions, how to report forgiven debt, real-world examples, planning steps, and where to get authoritative guidance. It is educational only—consult a CPA or tax attorney for advice tailored to your facts.

Sources: IRS — Cancellation of Debt (COD) (https://www.irs.gov/businesses/small-businesses-self-employed/cancellation-of-debt-cod); SBA/PPP borrower guidance and IRS PPP materials.

What does the IRS normally require? (high-level rule)

  • General rule: Forgiven debt is includible in gross income and taxed like ordinary income unless an exception applies. A lender may issue Form 1099-C (Cancellation of Debt) to the borrower when it cancels $600 or more of debt, which triggers borrower reporting obligations.
  • Businesses report COD income on their federal return: corporations (Form 1120), partnerships on Form 1065 (flow-through to partners), and sole proprietors on Schedule C of Form 1040.

IRS guidance on cancellation of debt summarizes common exclusions that can prevent COD from being taxable—most notably bankruptcy and insolvency (see details below).

(Reference: IRS, “Cancellation of Debt (COD)”)

Common statutory exceptions that can exclude forgiven debt from taxable income

When an exception applies, forgiven amounts are excluded from gross income. The most relevant business exceptions include:

  • Bankruptcy: Debt discharged in a Title 11 bankruptcy case is excluded from income.
  • Insolvency: If the business (or owner, for pass-through entities) is insolvent immediately before the discharge, COD income may be excluded to the extent of insolvency. Insolvency is measured as liabilities exceeding assets.
  • Qualified farm indebtedness: Specific rules apply for farming businesses that meet criteria under IRC §108.
  • Qualified real property business indebtedness (QRBI): Under IRC §108(a)(1)(D), certain business real estate debt excluded subject to rules and limitations.

When COD is excluded under §108, taxpayers often must reduce certain tax attributes (for example, NOLs, tax basis, passive activity loss carryforwards) unless a specific election is made. Those attribute reduction rules can have lasting effects on future taxes.

(See IRS COD page for full list of exclusions.)

Special case: Paycheck Protection Program (PPP) and pandemic relief loans

PPP is the most common example businesses ask about. The Consolidated Appropriations Act (CAA, Dec. 2020) and later guidance clarified federal tax treatment:

  • Forgiven PPP loan amounts are excluded from gross income (they are not taxable) for federal income tax purposes.
  • Importantly, Congress also made expenses paid with forgiven PPP proceeds deductible, reversing the IRS’s initial 2020 guidance that would have disallowed those deductions. That means businesses do not suffer the ‘‘double-whammy’’ of excluded income plus nondeductible expenses when PPP forgiveness applies.

Key takeaways:

  • Follow current SBA and IRS PPP forgiveness guidance for documentation and timing.
  • Even though PPP forgiveness is federally non-taxable, state tax treatment can vary—some states initially decoupled from federal changes and later conformed; check your state tax authority.

(See IRS PPP guidance and SBA forgiveness materials.)

How forgiveness is reported and practical filing steps

  1. Watch for Form 1099-C from the lender: A lender that cancels a debt of $600+ generally files Form 1099-C with the IRS and sends a copy to the borrower. Receiving a 1099-C does not automatically make the amount taxable—evaluate statutory exclusions and program rules.
  2. Reconcile amounts: Compare the 1099-C, lender correspondence, and your books. Confirm whether the reported amount is principal only or includes interest and fees.
  3. Determine taxability:
  • If taxable COD: report on the business’s return for the year of cancellation. For partnerships and S corporations, COD may flow through to owners and affect basis and income allocation.
  • If excluded: attach supporting documentation and statements to explain the exclusion (e.g., evidence of insolvency, bankruptcy docket, PPP forgiveness approval).
  1. Attribute reduction: If you exclude COD under §108 and do not qualify for an exception, calculate any tax attribute reductions and apply them per the Code.
  2. Adjust estimated tax payments and payroll tax planning: Forgiven amounts that increase taxable income may create unexpected tax liabilities—update estimated taxes or withholdings as needed.

Real-world examples (simplified)

Example 1 — Taxable COD (non-pandemic business loan):

  • Business A had $100,000 principal balance canceled by a bank (Form 1099-C issued).
  • Business A has no insolvency and is not in bankruptcy. The $100,000 is generally included in Business A’s taxable income for the year and taxed according to entity type.

Example 2 — PPP loan forgiveness:

  • Restaurant B received a $75,000 PPP loan and met the forgiveness rules. Under federal law the forgiven $75,000 is excluded from income and Restaurant B may still deduct eligible payroll and rent expenses paid with PPP proceeds as allowed by statute.

Example 3 — Insolvency exclusion:

  • Construction Firm C had liabilities of $1.2M and assets of $900k immediately before a lender canceled $150k of debt. Firm C was insolvent by $300k, so $150k COD would be excluded up to the insolvent amount (subject to the mechanics of §108 and any attribute reductions).

How loan type and context change the tax outcome

  • Commercial loan vs personal guarantee: If a business guarantor repays or receives forgiveness, the tax effects may fall to the individual guarantor rather than the business.
  • Nonrecourse vs recourse debt: Nonrecourse debt forgiveness often takes the form of a property disposition and is treated differently from recourse debt cancellation.
  • Debt cancelled in a bankruptcy proceeding: Generally excluded, but be mindful of how the reorganization plan and post-bankruptcy attributes are handled.

State and local tax considerations

Not all states follow federal tax rules automatically. Some states decoupled from federal PPP treatment or handled COD exclusions differently in the years after 2020–2021. Check your state’s revenue department guidance or work with a state tax specialist to confirm state return treatment.

Common mistakes to avoid

  • Ignoring Form 1099-C: Even if you think forgiveness is excluded, reconcile the 1099-C and document the exclusion.
  • Assuming PPP or other relief automatically means no tax work: Documentation and timing matter; forgiveness approvals and eligible expense records are essential.
  • Failing to compute attribute reductions: When COD is excluded under §108, required reductions can reduce future deductions and cause surprises.

Practical tax planning tips

  • Document everything: Maintain clear records showing use of loan proceeds, forgiveness approvals, and lender letters.
  • Run tax projections after forgiveness events: Model federal and state tax impacts and update estimated tax payments.
  • Consider entity effects: Forgiveness can flow through to owners; evaluate personal tax strategy if you’re a partner or S-corp shareholder.
  • Work with a pro early: A CPA or tax attorney can help you analyze insolvency tests, make required elections, and compute attribute reductions.

Related resources on FinHelp

Final notes and professional disclaimer

Tax treatment depends on the loan type, the relief program, the taxpayer’s solvency, and recent changes in law. This article is educational and accurate as of 2025, but tax laws and agency guidance change. Consult a qualified CPA or tax attorney before making tax elections or filing returns that involve loan forgiveness.

Author’s note: In my practice I’ve seen business owners surprised by COD income where they expected relief. Early documentation, conservative tax projections, and coordination with lenders and advisors prevent the largest surprises.

Authoritative references

(Disclaimer: This content is educational and not a substitute for professional tax advice.)