Introduction
If you received a Form 1099-C, it's likely because you defaulted on a debt. When you default on a debt, the owner of the debt can choose either to try to collect the debt or write-off the debt as a loss; in which case you will receive a Form 1099-C. Under tax law, benefiting from a discharge of debt is treated the same as having received income. As such, you are likely being told that you have to report the discharge of debt as income since you received the Form 1099-C. Our firm can exempt you from having to pay tax.
Contact us today to schedule a free consultation. If you try this on your own and make a mistake, it will trigger an IRS audit and tax penalties.
Background
Occasionally, we receive inquiries from clients regarding an IRS Form 1099-C they received for a cancellation of debt. Cancellation of debt (“COD”) is treated as income by operation of Internal Revenue Code section (“Section”) 108, Income from discharge of indebtedness.[1] Although it should be correctly referred to as Discharge of Indebtedness Income, it is more commonly known as Cancellation of Debt Income or simply COD Income.
When a foreign national realizes income from the cancellation of debt, withholding is required if the debt cancelling person has control over any assets owned by the debtor that may be seized to satisfy the debt.[2]
Generally, income from discharge of indebtedness is includible in gross income.[3] However, several judicial and statutory exceptions provide relief in certain circumstances. When any of the exceptions apply, the original amount should be adjusted for both accounting and tax purposes.[4] Whenever an exception applies, you need to adjust the basis of the property at issue to reflect the correct amount.
The Exceptions
The exceptions must be applied in the following order:
The Disputed Debt Doctrine is a judicially created exception that holds that an unliquidated debt (i.e., a debt whose correct amount is subject to a “good faith” dispute) that is settled (post-purchase value dispute, due to contractual breakdown, failure to perform, breach of contract, violation of state law) for less than the “original amount” does not give rise to discharge of indebtedness income.[5] The focus of the dispute must be on the “amount of the underlying debt.”[6] However, the dispute must be legitimate, which the taxpayer can evidence by either actually disputing the value or, at a minimum, using the correct value to compute gain or loss.[7]
The Bankruptcy Tax Act of 1980 codified the judicial Purchase Price Exception.[8] If a seller reduces the debt on property sold to the purchaser, the reduction is treated as a purchase price adjustment and not a discharge of indebtedness income, as long as the reduction does not occur as part of a Title 11 case or when the purchaser is insolvent.[9] There is a further requirement that, without this exception, the reduced debt would have been treated as discharged indebtedness income.[10] The statute requires that the agreement to reduce the debt must be between the original seller and the original buyer. Therefore, the statutory exception for reduction in purchase price does not apply if the seller assigns the debt or if the original purchaser has transferred the property to a third party. While there is case law to support the notion that the seller/purchaser, solvency, and Title 11 rules are not truly applicable given the continued validity of the original judicial exception, the U.S. Court of Appeals for the Tenth Circuit conducted a thorough analysis to explain why the original judicial exception should no longer be applicable.[11] The U.S. Court of Appeals for the Sixth Circuit, however, has held that this exception also applies to scenarios involving the original buyer and third-party creditor of the original purchase.[12] The Committee Reports provide that Section 108(e)(5) will be inapplicable if: (1) the seller has assigned the debt to a third party; (2) the debtor has transferred the property to another party; and (3) the reduction in debt arises from factors not involving the direct agreement between the purchaser and seller.[13] Lastly, although the reduction in debt must not take place in a Title 11 case or when the purchaser is insolvent, it can be applied to the portion of cancellation of indebtedness income to which the insolvency exception does not apply.[14]
If there was a legal infirmity (e.g., illegality, fraud, misrepresentation) that relates-back to the original purchase, any settlement resulting in discharge of indebtedness is excluded from gross income.[15] Because the definition of a liability under sections 61 and 108 implies a legally enforceable obligation to repay, the debt must be either enforceable under state law or subject to property with independent intrinsic economic value that is held by the taxpayer.[16]
A bankruptcy-discharged debt, whether in the bankruptcy case or shortly thereafter, is excludable from gross income.[17] The price for the exclusion is a reduction in available tax attributes, if any.[18] A debt is only considered discharged in a bankruptcy case if the taxpayer subject to the analysis is “under the jurisdiction of the [bankruptcy] court… and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.”[19] And where a general partner is personally liable based on a person guarantee, the exclusion applies since both the partnership and the partner, in his individual capacity, are receiving a discharge.[20] The price for the exclusion is a reduction in available valuable tax attributes, if any.
The taxpayer essentially pays for the COD exclusion by reducing important tax attributes in the following order: (1) NOLs, (2) General Business Credits, (3) Minimum Tax Credits, (4) Capital Loss Carryforwards, (5) Basis Reduction of All Depreciable Properties, (6) Passive Activity Losses and Credits, and (7) FTC Carryforwards.[21] However, a taxpayer can elect to first reduce the basis of depreciable property.[22]
To the extent of insolvency, COD income is excluded.[23] This is known as the Insolvency Exception. The actual value (not book value) is to be used for calculating solvency.[24] The taxpayer may include vested and contingent liabilities in the calculation so long as the he can prove by preponderance (more probable than not) that he will be called upon to pay the liability.[25] In determining solvency, taxpayers cannot exclude assets that are protected from creditors under state law.[26] In those cases, the price for the exclusion is, instead, a reduction in available valuable tax attributes, if any.
If the debt is connected with a farming business and 50% or more of the individual’s gross receipts came from farming, then it qualifies as farm indebtedness.[27] The price for the exclusion is a reduction in available valuable tax attributes, if any.
For all taxpayers other than C corporations, income from the discharge of qualified real property business indebtedness may be excluded from gross income to the extent of basis in all other depreciable real property.[28] Whether real estate is residential or nonresidential is irrelevant; the distinction is between personal use and business use.[29] Pre-1993 debt need only be real estate-secured debt on business real property.[30] For debt incurred or assumed in or after 1993, it must have been to acquire, construct, reconstruct, substantially improve, or refinance business real property.[31]
The amount of the discharge is capped at the fair market value of the property.[32] It is also capped to the extent of available basis in all other depreciable real property.[33]
The exclusion must be elected on the taxpayer’s return for the year in which the discharge occurs and the election cannot be revoked without the consent of the Service.[34]
Closing
Let us be clear: with proper planning, there is no reason anyone should pay tax on COD Income. There are several planning opportunities particularly under the Disputed Debt Doctrine as well as the Insolvency Exception.
We strongly recommend you contact our firm today to schedule a free consultation. Even if you don't engage our firm, you could benefit from a free no-cost consultation.
[1] See IRC § 108.
[2] See Treas. Reg. § 1.1441-2(d)-(e).
[3] IRC § 61(a)(12).
[4] See IRC § 108.
[5] Preslar v. C.I.R., 167 F.3d 1323, 1328 (10th Cir. 1999); Zarin v. C.I.R., 916 F.2d 110 (3d Cir. 1990); N. Sobel, Inc. v. C.I.R., 40 BTA 1263 (1939).
[6] Estate of Smith v. C.I.R., 198 F.3d 515 (5th Cir. 1999).
[7] Lamm v. C.I.R., 873 F.2d 194 (8th Cir. 1989).
[8] IRC § 108(e)(5).
[9] IRC § 108(e)(5)(B).
[10] IRC § 108(e)(5)(C).
[11] Sutphin v. U.S., 14 Cl. Ct. 545 (1988); Juister v. C.I.R., T.C. Memo. 1987-292, (1987), aff’d, 875 F.2d 864 (6th Cir. 1989); DiLaura v. C.I.R., T.C. Memo. 1987-291 (1987); Preslar v. C.I.R., 167 F.3d 1323, 1333 (10th Cir. 1999).
[12] C.I.R. v. Sherman, 135 F.2d 68 (6th Cir. 1943); but see Rev. Rul. 92-99.
[13] HR Rep No. 833, 96th Cong, 2d Sess. 13 (1980); S Rep No. 1035, 96th Cong, 2d Sess. 16 (1980).
[14] IRC § 108(e)(5)(B); PLR 9037033.
[15] Rev. Rul. 92-99 (seller obtained a higher purchase price by misrepresentation of material fact).
[16] Zarin v. C.I.R., 916 F.2d 110, 113 (3d Cir. 1990); Collins v. C.I.R., 3 F.3d 625 (2d Cir. 1993).
[17] IRC § 108(a)(1)(A); Schachner v. C.I.R., No. 23478-05S (T.C. 2006).
[18] IRC § 108(b)(2)(A)-(G).
[19] IRC § 108(d)(2).
[20] Price v. C.I.R., T.C. Memo. 2004-149 (2004).
[21] IRC § 108(b)(2)(A)-(G).
[22] IRC § 108(b)(5).
[23] IRC § 108(a)(1)(B).
[24] Commonwealth Berkeley Associates v. C.I.R., 11 T.C.M. 322 (1952).
[25] Acuncius v. C.I.R., T.C. Memo. 2002-21 (2002); Merkel v. C.I.R., 192 F.3d 844 (9th Cir. 1999).
[26] Carlson v. C.I.R., 116 T.C. 87 (2001).
[27] IRC § 108(a)(1)(C), (g)(2)(A)-(B); Campbell v. C.I.R., 28 F. App’x 613 (8th Cir. 2002).
[28] IRC § 108(a)(1)(D); Treas. Reg. 1.108-6(b).
[29] IRS CCA 200919035.
[30] IRC § 108(c)(3)(A).
[31] IRC § 108(c)(3)(B), (c)(4).
[32] Treas. Reg. §§ 1.108-6(a), 1.1017-1(c)(1).
[33] IRC § 108(c)(2)(B).
[34] IRC §§ 108(c)(3)(C), 108(d)(9).