Taxing Lessons From Court Decisions

Decisions — Excepting debt

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Image source: Cents On A DollarID: 56416 © Cristina, Dreamstime Stock Photos
Image source: Cents On A DollarID: 56416 © Cristina, Dreamstime Stock Photos

Whatever value you assign to forgiveness, in the world of tax, forgiveness generally results in income, even though the taking-on of debt usually has no tax consequences. (While taking out debt may lead to tax consequences, such as an interest deduction, in broad terms, you get cash or other property or services and you promise to repay what you received, so you typically have no taxable economic benefit.) Cancellation of existing debt, or debt forgiveness, results in ordinary income and is a taxable event, barring exceptions and exclusions. That’s because you receive an economic benefit from not having to pay back what you borrowed.

In T.C. Memo. 2016-125 (Newman), the taxpayer opened a checking account in July 2008. Of the deposit used to open the account, $8,500 was from a single check drawn from an account the taxpayer had at another bank. After making the deposits to open the new account, the taxpayer withdrew $8,000 from the new account.

The $8,500 check from his former account bounced, and his new account was overdrawn. The taxpayer did not make any attempt to correct the over-withdrawal, and the bank closed the account in August 2008.

In December 2011, the bank issued Form 1099-C, Cancellation of Debt, for 2011 reporting COD income of $7,875. The taxpayer did not report the $7,875 as income on his 2011 federal income tax return.

In November 2013, the IRS sent a notice to the taxpayer, stating that the $7,875 of COD income constituted unreported gross income.

The first question before the court was whether the taxpayer had cancellation of debt income. Here are the facts the court considered.

— From Internal Revenue code section 61(a)(12): Gross income generally includes income from the discharge of indebtedness.

— A debt is deemed discharged the moment it becomes clear that the debt will never be repaid.

— Any ‘identifiable event’ which fixes the loss with certainty may be taken into consideration. Treasury regulation 1.6050P-1(b)(2)(i), (iv) provides an exclusive list of eight “identifiable events” under which debt is discharged for information reporting purposes. These include a rebuttable presumption that an identifiable event occurred in a calendar year if, during a testing period (generally 36 months) ending at the close of the year, the creditor has received no payments from the debtor. [In this case, the presumption was not rebutted.]

— A bookkeeping entry by a creditor does not result in COD income.

— The issuance of a Form 1099-C is an identifiable event, but it is not dispositive of an intent to cancel indebtedness.

After considering the facts, the court decided the taxpayer did have cancellation of debt income.

 

1.

The next question is, in what year did the taxpayer have cancellation of debt income? Using the above facts, what would you decide?

 

WHAT WOULD YOU DECIDE?

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THE DECISION

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2.

The final question is whether the taxpayer qualifies for the insolvency exclusion.

Consider the above facts, plus this additional information.

— In the year of the insolvency, the taxpayer testified that he owned various items of personal property including furniture, clothes, and electronics of marginal value, two watches valued at $500, and a car valued at $35,000. The taxpayer also owed $35,000 on a car loan, and $15,000 in student loans.

Internal Revenue code section 108(a)(1)(B) excludes COD income from gross income if the discharge of indebtedness occurs when the taxpayer is insolvent. The amount by which the taxpayer is insolvent is defined as the excess of the taxpayer’s liabilities over the fair market value of the taxpayer’s assets. (Section 108(d)(3).) Whether a taxpayer is insolvent and by what amount is “determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.” The amount of income excluded under section 108(a)(1)(B) cannot exceed the amount by which the taxpayer is insolvent. (Section 108(a)(3).)

 

WHAT WOULD YOU DECIDE?

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over the link beneath “The Decision”

or

THE DECISION

For a full explanation, hover your mouse over the link

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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.

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Right answer!
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The bank records reflect that all account activity leading to the overdrawn account occurred within a one-month period in 2008. The new bank did not receive any payments from the taxpayer after August 2008.

Therefore, the 36-month nonpayment testing period under regulation 1.6050P-1(b)(2)(iv) began in August 2008 and ended at the close of 2011. Because the bank did not receive any payments during this testing period, a rebuttable presumption has arisen that the debt was discharged in 2011.

The taxpayer has not rebutted the presumption that the debt was discharged in 2011. Therefore, because he has not rebutted the presumption of discharge of indebtedness, and because the Form 1099-C was issued in 2011, we find that he had COD income of $7,875 for 2011.

Right answer!
Sorry, wrong answer :(

Now that we have found the taxpayer had COD income for 2011, we must determine whether the COD income is excludable from his gross income under the insolvency exception provided in section 108(a)(1)(B).

The taxpayer owned assets in 2011 valued at a total of $35,500. The taxpayer was also liable for debts totaling $50,000. Therefore, after netting assets and liabilities, the taxpayer’s claimed amount of insolvency is $14,500.

Insolvency is a question of fact. The taxpayer has the burden of proving his claim that he was insolvent. At trial, the taxpayer provided credible testimony that his assets and liabilities were what he claimed they were.

Therefore, we accept the taxpayer’s claimed amount of insolvency and find that his liabilities at the end of 2011 exceeded his assets by $14,500.

We also find that section 108(a)(1)(B) allows him to exclude all $7,875 of COD income from his 2011 gross income because the amount of his insolvency in 2011 exceeded his COD income for 2011.

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