Case — Deductibility of Fees Related to Cancellation of Debt

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TL Case Summ

THE QUESTION

Can a taxpayer deduct fees paid to a debt resolution company for negotiating a reduction in the amount of debt owed on a credit card?

THE DISPUTE

Taxpayer Says: The fee should be allowed as a miscellaneous itemized deduction.

Internal Revenue Service Says: The court has previously found that fees paid to a debt resolution company are not deductible.

THE LAW

From Internal Revenue Code Section 212: A deduction is allowed for ordinary and necessary expenses paid by a taxpayer during the year for the production or collection of income, subject to the 2% floor of section 67(a) (and possible application of the alternative minimum tax under which miscellaneous itemized deductions are not allowed. Sec. 56(b)(1)(A)(i)).

From Melvin v. Commissioner, T.C. Memo. 2009-199: Taxpayer conceded any claim to a deduction under section 212(1) for fees paid to a debt resolution company because of application to the taxpayer of the alternative minimum tax.

THE CAUSE OF THE DISPUTE

You can deduct ordinary and necessary expenses you incur for the production or collection of income, for the management, conservation, or maintenance of property held for the production of income, or in connection with the determination, collection, or refund of any tax. Examples include tax preparation fees, union and certain other dues, and dividend reinvestment plan service charges.

You have to itemize to claim the deduction on your federal income tax return, and the amount you can deduct is limited by your adjusted gross income and the alternative minimum tax rules, if they apply.

In this case, the taxpayer paid a debt resolution company to negotiate a reduction in the amount he owed on two credit card bills. The negotiation was successful, and the taxpayer received forms reflecting the amount of debt cancelled. The taxpayer did not report the income on his tax return, and eventually received a notice from the IRS.

In the notice, the IRS did not allow any deduction for the fee. The taxpayer believes the fee should be deductible as a miscellaneous itemized deduction, because the cancelled debt is taxable income, meaning the fee was incurred to produce income.

The IRS says the court decided in a previous case that fees paid to a debt resolution company are not deductible. In the previous case (see reference to Melvin, T.C. Memo 2009-199 above), the taxpayer argued he should be permitted to deduct a fee paid to a debt collection agency, though he conceded he was not entitled to deduct the fee under section 212. The IRS said the fee was not deductible, and the court agreed, noting the taxpayer in Melvin disclaimed any deduction under section 212 because he could not claim miscellaneous itemized deductions when calculating his alternative minimum tax. The taxpayer also acknowledged that, on account of the alternative minimum tax, a miscellaneous itemized deduction would not decrease his tax liability.

WHAT WOULD YOU DECIDE?

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

For the or for the

THE COURT’S DECISION

Download (PDF, 13KB)

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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 TaxingLessons.com and HLCarpenter.com.

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!
Sorry, wrong answer :(
For the taxpayer. The IRS erroneously relies on Melvin v. Commissioner, T.C. Memo. 2009-199. However, in that case the court simply noted in a footnote the taxpayer conceded any claim to a deduction under section 212(1) for fees paid to a debt resolution company because of application to the taxpayer of the alternative minimum tax. Melvin provides no support for the IRS position herein that fees paid to a debt resolution company, as a matter of law, may not be
deducted under section 212(1). The fees in issue here were incurred and paid for the specific purpose of obtaining discharges of credit card debt (i.e., for the purpose of realizing cancellation of indebtedness income). There is no indication the fee was excessive in amount, out of the ordinary, or not necessary. Without the fees paid to and the services provided by the debt resolution company, the taxpayer likely would have realized no cancellation of indebtedness income. The taxpayer is allowed a miscellaneous itemized deduction under section 212(1) for the fees paid to the debt resolution company, subject to the 2% floor applicable to miscellaneous itemized deductions and any applicable alternative minimum tax.
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