Taxing Lessons From Court Decisions

Decisions – A Triangle of Debt

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When your lender cancels all or part of a debt that you owe, you generally have to recognize income, unless you qualify for an exception. (Here’s a flowchart for analyzing the COD tax rules.)

But what if you’re the guarantor of the loan and not the signer? Do you have cancellation of debt income when the original signer fails to pay?

That’s one of the questions in T.C. Memo. 2014-191 (Mylander).

The taxpayer, a dentist, needed money to finance a golf course in a real estate development. A business friend agreed to invest $400,000 if the taxpayer personally guaranteed the loan. When the development failed, the business friend sought to get his money back from the taxpayer.

Another friend of the taxpayer, who was going through bankruptcy, told the taxpayer he would transfer full interest in a convenience store to the taxpayer’s business friend as payment for the $400,000 loan. In exchange, this second friend wanted the taxpayer’s guarantee on a loan that this friend owed an unrelated person. (In this way, the second friend’s bankruptcy could be finalized.)

The taxpayer agreed, and the second friend transferred the convenience store to the taxpayer’s business friend. The business friend soon discovered the convenience store was highly mortgaged and had no remaining equity. He sold the convenience store. Because he realized no gain on the sale, the taxpayer still owed him the original $400,000.

The taxpayer eventually paid off the $400,000 that he owed his business friend. However, his second friend did not complete his part of the agreement–he never made payments on the loan to the unrelated party that the taxpayer had guaranteed. The unrelated party obtained a judgment against the taxpayer and demanded payment of $310,000.

The taxpayer began making payments on the $310,000 loan. When the debt balance was $202,000, the taxpayer sold his dental practice and offered to pay $100,000 as a lump sum final payment. The loan holder agreed, forgiving the remaining $102,000 in 2010.

The taxpayer did not include the $102,000 on his tax return even though he did not meet any of the statutory exceptions to recognizing cancellation of indebtedness income. ()

Instead, the taxpayer relied on previous cases in which the tax court had decided a guarantor does not realize COD income upon the release of a contingent liability. In those cases, the court said the guarantor of a loan receives nothing in exchange for his promise and therefore has no increase in his net worth. A discharge of the debt merely prevents his net worth from being decreased. (As expressed by the court in a prior case: “The guarantor no more realizes income from the transaction than he would if a tornado, bearing down on his home and threatening a loss, changes course and leaves the house intact.”)

Based on these prior cases, the taxpayer believed he did not have COD income.

The IRS said the income was taxable and offered three arguments to prove the taxpayer’s situation was different from the prior cases.

1. The IRS said the taxpayer’s guaranty was not contingent due to a statement from the guaranty: “The liability of the undersigned Guarantor is absolute and unconditional, and is not conditional or contingent upon any other party signing this continuing Guaranty.”

The taxpayer contends the IRS is misinterpreting the guaranty. According to the taxpayer, “[t]he obligation of a guarantor is not contingent because another party may or may not have to sign the guaranty; the obligation of a guarantor is contingent upon the primary obligor defaulting.”

What do you think?


2. The IRS said the taxpayer had to recognize COD income because he did receive taxable consideration in exchange for the guaranty—namely, the transfer of the convenience store to his business friend.

The taxpayer argues that the transfer of the convenience store did not result in his receiving any taxable COD income because (1) the consideration received (i.e., the transfer of the convenience store) had no value and (2) under the prior cases any taxable consideration received by a guarantor in exchange for his guaranty is recognized for the year in which it is received and, consequently, does not affect the existence or treatment of COD income.

What do you think?


3. The IRS said the taxpayer became primarily liable for the $310,000 loan after the original borrower defaulted because the taxpayer was then obligated to pay under the state court judgment. That put him in the shoes of the original borrower, giving rise to COD income when the debt was settled for less than full value.

The taxpayer argues that even if he had become primary obligor on the debt, he did not realize any COD income when the remaining debt was forgiven because he “did not receive the benefit of the non-taxable proceeds from the loan obligation.”

What do you think?



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Exceptions under current rules: Title 11 bankruptcy, insolvency, qualified farm indebtedness, qualified real property business indebtedness, and certain student loan discharges. Note that when claiming an exception, the taxpayer generally has to adjust the basis in certain other “tax attributes.” See code section 108.
Right answer!
Sorry, wrong answer :(
We agree with the taxpayer that the guaranty created a contingent liability because his obligation to make a payment under the guaranty was contingent upon the primary obligor’s failure to pay the debt.

The guaranty in this case creates the same type of contingent liability as those we discussed in prior cases. The IRS’s argument that the guaranty was not contingent because it was “absolute and unconditional, and * * * not conditional or contingent upon any other party signing [it]” lacks merit.

Right answer!
Sorry, wrong answer :(
We agree with the taxpayer that he did not receive any valuable consideration in exchange for the guaranty. He entered into the guaranty with his second friend in exchange for the promise to satisfy the debt he owed to his business friend. The second friend did not keep the promise.

While the convenience store was transferred, it was “leveraged to the hilt” and had no value. As a result, the taxpayer’s obligation to his business friend was not reduced at all by the transfer of the store, and he was required to, and did, pay the debt in full. Then, when the second friend defaulted and the taxpayer began making payments on that debt, the friend made no good-faith attempt to make good on the promise.

Therefore, we find that the taxpayer did not receive any valuable consideration in exchange for the guaranty.

Right answer!
Sorry, wrong answer :(
We agree with the taxpayer. Even though he had become primary obligor under the guaranty, his situation remained similar to those of the taxpayers in earlier cases. We observed in those cases that “where the guarantor is relieved of his contingent liability * * * because of a release given him by the creditor, no previously untaxed accretion in assets thereby results in an increase in net worth.”

Unlike a debtor who borrows funds, a guarantor who assumes a contingent liability does not receive an untaxed accretion of assets which is accompanied by an offsetting obligation to pay. This remains the case even after the guarantor becomes a primary obligor because of the debtor’s default.
Regardless of whether the guarantor is a secondary obligor or has become a primary obligor, when the debt is discharged the guarantor’s net worth is not “increased over what it would have been if the original transaction had never occurred.”

The taxpayer did not receive any untaxed accretion of assets when he gave the guaranty. Nor did he receive any untaxed accretion of assets with respect to the guaranty when he later became primarily liable on the debt as a result of the state court judgment. Therefore, when the remaining debt was forgiven the taxpayer did not realize an untaxed increase in wealth any more than had he remained secondary obligors.