Taxing Lessons Case Summaries

Case — Cancellation of Debt Income

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TL Case Summ


Does a taxpayer have cancellation of debt income when loan proceeds from an employee benefit plan are not repaid?


Taxpayer Says: The loan terms allowed two methods of repayment, neither of which are in default, and the loans were not discharged. There is no cancellation of debt income.

Internal Revenue Service Says: Contrary to its collection policy, the plan made no effort to collect, which is evidence the plan intended to forgive the loans and that they will never have to be repaid.


From Internal Revenue Code Section 61(a)(12): The code normally treats the discharge of indebtedness as income.

From Cozzi v. Commissioner, 88 T.C. 435, 445 (1987): Our task, when COD income is at issue, is to answer two questions: (1) is the taxpayer off the hook for any part of the debt? and (2) if so, in what year? We answer the first question by looking at the “facts and circumstances relating to the likelihood of payment” and deciding whether some or all of the debt will never have to be repaid. We look to the actions of the parties, and not just what they say, to gauge their intent. For the second question, we don’t require extreme precision, but our cases do tell us to find some identifiable event fixing the COD amount with certainty in the tax year we’re examining. This identifiable event doesn’t have to be a single overt act, but can be any event that falls within a reasonable range of events or times.


In general, unless you qualify for an exception or an exclusion, when a lender forgives a debt you owe, you have income to report on your federal tax return.

Disputes arise because answering the questions of whether you no longer have to repay the debt, and if not, in which year you were released from your obligation, is based on facts and circumstances.

In this case, the taxpayers, who owned a construction company, established a welfare benefit plan, a type of employee benefit plan that provides death (and other) benefits to employees. The plan provided the taxpayers with a death benefit equal to ten times their annual salary up to a ceiling of $6 million, and bought life insurance to fund those obligations. The plan owned the policies and allowed the taxpayers to irrevocably designate beneficiaries.

The plan also had the ability to provide loans to employee-participants in the event of an emergency or serious financial hardship. All loans had to be secured by a pledge of the employee’s death benefits, and the employee was required to sign a promissory note pledging as collateral the death benefit to which the beneficiary was entitled. Under the terms of the note, the plan could be repaid in two ways: with quarterly payments plus interest, or with a reduction in death benefits by the amount of the outstanding loan, including principal and interest.

In 1999 and 2000, the taxpayers applied for two hardship loans of $500,000 each. They made only one loan payment, in 2007. The plan made no effort to collect the balance due.

The loans were reported as “in default” on the trust’s annual tax return, though the accountant did not determine they were uncollectible.

The IRS says the lack of any collection action is proof the debts will never have to be repaid, and that the identifiable event is the filing of the 2002 annual tax return for the plan, which identified the loans as in default.

The taxpayers concede the plan hasn’t taken any collection action, but argue that’s because they’re not in default under the terms of the loans. They argue that those terms gave them two equally acceptable ways to repay–periodic payments, or waiting till they die, when the plan could collect by withholding part of the death benefit. Without a default (as the loan documents define that term) the plan isn’t allowed to collect on the loans through other means.


Make your selection, then see “The Court’s Decision” below for a full explanation

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit and

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.


Right answer!
Sorry, wrong answer :(
For the taxpayer. We find the existence of adequate collateral meant the plan had not canceled the debts. We also find the classification of the loans on the plan’s tax form too ambiguous to be the “identifiable event which fixes the loss with certainty.” We therefore find the IRS failed to prove the taxpayers had COD income in 2002. That is not the tax year at issue in these cases. (Editorial Note: The court concluded “the taxpayers may well have to pay taxes on the loans if they become ineligible for their death benefits, or when their death benefits are used to satisfy their debts.”)