Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.