Income And Cancellation of Indebtedness

 

I am reading a case about cancellation of indebtedness income. 

Let’s take a moment to discuss the concept of income in the tax Code. 

The 16^th amendment, passed in 1913 and authorizing a federal income tax, reads as follows: 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Needless to say, the definition of “incomes, from whatever source” became immediately contentious. 

Ask a tax practitioner for a definition of income, and it is likely that he/she will respond with “an accession to wealth.” 

That phrase comes from a 1955 Supreme Court case (Commissioner v Glenshaw Glass) which included the following: 

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." 

I am seeing three conditions, of which “accession to wealth” is but one. 

Let’s circle back to indebtedness and income.

Can one have income by borrowing money? 

Unless there is something extraordinarily odd about the loan, I would say “no.” The reason is that any increase in wealth (by receipt of the loan proceeds) is immediately offset by the requirement to repay the loan. 

Let’s say you buy a house. You take out a mortgage. 

What if you are in financial distress and mail the keys back to the mortgage company? 

Granted, the house secures the debt, but surrendering the house does not automatically release the debt. It however will likely result in your receiving the following 1099:

Like any 1099, there is a presumption of income. In this instance, there has been an exchange in the ownership of the house. There is another way to say this: the tax Code sees a sale of the property. 

It seems odd that tax sees potential income here. It is unlikely to happen if the surrendered asset is one’s principal residence, as one would have access to the $250,000/$500,000 gain exclusion. It could happen if the surrendered asset is rental or investment property, though. 

What about the debt on the property? 

Tax considers that a separate transaction. 

When the debt is discharged, the IRS has yet another form: 

Yes, it gets confusing. The system works much better when the two steps happen concurrently – such as in a short sale. In that case, it is common to skip the 1099-A altogether and just issue the 1099-C. 

NOTE: There is a twist in the straw depending upon whether the debt is recourse or nonrecourse. Believe it or not, there are about a dozen states where you can buy your principal residence with nonrecourse debt. You will not be surprised to learn that California is one of them. The upside is that you can return the keys to the bank and no longer be responsible for the mortgage. The downside is this policy was a major contributor to the burst of the housing bubble in the late aughts.

It is common for the 1099-C to be issued three years after the 1099-A. Why? The Code requires the reporting of cancellation of indebtedness on or before an “identifiable event” happens. 

An identifiable event in turn is defined as: 

1.  bankruptcy
2.  expiration of statute of limitations for collection
3.  cancellation of debt that renders it unenforceable in a receivership, foreclosure, or similar proceeding
4.  creditor's election of foreclosure remedies that statutorily bars recovery
5.  cancelation of debt due to probate proceedings
6.  creditor's discharge pursuant to an agreement
7.  discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt
8.  in specific cases, the expiration of a non-payment testing period [presumption of 36 months of no payment to the creditor]    

The three years is number (8). 

The income type we are discussing with the 1099-C is cancellation of indebtedness income. As discussed, just borrowing money does not create income. Whereas your assets may go up (you have cash from the loan or bought something with the cash), that amount is offset by the loan itself. The scales are balanced, and there is no accession to income. 

However, cancel the debt. 

The scale is no longer balanced. 

Meaning you have potential income. 

But the Code allows for exceptions. Here is Section 108: 

                (a) Exclusion from gross income

(1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2026, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2026. 

The common ones are (a)(1)(A) for bankruptcy and (a)(1)B) for insolvency. 

Bankruptcy is self-explanatory. 

Solvency is not self-explanatory. You can think of insolvency as being bankrupt but not filing for formal bankruptcy. You owe more than you own. Let’s call the difference between the two the “hole.” To the extent that that cancelled debt is less than the “hole,” there is no cancellation of indebtedness income. Once the cancelled debt equals the “hole,” the exclusion ends. At that point, your net worth is zero (-0-). Technically the next dollar is an “accession to wealth” and therefore income. 

In our case this week Ilana Jivago borrowed from Citibank. She defaulted and was eventually foreclosed on in 2009. Citibank sent her a 1099-C. Jivago argued that it was nontaxable because it was qualified principal residence indebtedness per (a)(1)(E) above. 

Qualified principal residence indebtedness is defined as:         

Indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer.

The Court looked at photographs of and admired the renovations she made in 2005 and 2006. The Court noted that Jivago did not use an interior designer, and she did much of the work herself.

The problem is that 2005 and 2006 were before she borrowed from Citibank. 

Easy win for the IRS.

Our case this time was Jivago v Commissioner, Docket No. 5411-21.

Caution With S Corporation Losses

I was talking with a financial advisor from Wells Fargo recently.

No, it was not about personal investments. He advises some heavy-hitting clients, and he was bouncing tax questions off me.

The topic of entrepreneurial money came up, and I mentioned that I still prefer the S corporation, although LLCs have made tremendous inroads over the last decade-plus.

The reason is that S corporations have a longer – and clearer – tax history. One can reasonably anticipate the tax predicaments an S can get itself into. The LLCs – by contrast - are still evolving, especially in the self-employment tax area.

But predictability is a two-edged blade. Catch that S-corporation knife wrong and it can cost you big-time.

One of those falling knives is when the S corporation expects to have losses, especially over successive years.

Let’s take a look at the Hargis case.

Let’s say you buy and renovate distressed nursing homes. You spend cash to buy the place, then pay for renovations and upgrades, and then – more likely than not – it will still be a while before full-occupancy and profitability.

Granted, once there it will be sweet, but you have to get there. You don’t want to die a half mile from the edge of the desert.

Here is the flashing sign for danger:

26 U.S. Code § 1366 - Pass-thru of items to shareholders

(d) Special rules for losses and deductions

(1) Cannot exceed shareholder’s basis in stock and debt The aggregate amount of losses and deductions taken into account by a shareholder under subsection (a) for any taxable year shall not exceed the sum of—

(A) the adjusted basis of the shareholder’s stock in the S corporation (determined with regard to paragraphs (1) and (2)(A) of section 1367(a) for the taxable year), and

(B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (determined without regard to any adjustment under paragraph (2) of section 1367(b) for the taxable year).

An S corporation allows you to put the business income on your personal tax return and pay tax on the combination. This sidesteps some of the notorious issues of a C corporation – more specifically, its double taxation. Proctor & Gamble may not care, but you and I as a 2-person C corporation will probably care a lot.

Planning for income from an S is relatively straightforward: you pay tax with your personal return.

Planning for losses from an S – well, that is a different tune. The tax Code allows you to deduct losses to the extent you have money invested in the S.

It sounds simple, doesn’t it?

Let’s go through it.

Your stock investment is pretty straightforward. Generally, stock is one check, one time and not touched again.

Easy peasy.

But you can also invest by lending the S money.

OBSERVATION: How is this an “investment” you ask. Because if the S fails, you are out the money. You have the risk of never being repaid.

But it has to be done a certain way.

That way is directly from you to the S. I do not want detours, sightseeing trips or garage sales en route. Here there be dragons.

Hargis did it the wrong way.

What initially caught my eye in Hargis was the IRS chasing the following income:

·      $1,382,206 for 2009, and

·      $1,900,898 for 2010

Tax on almost $3.3 million? Yeah, that is going to hurt.

Hargis was rocking S corporations. You also know he was reporting losses, as that is what caught the IRS’ eye. The IRS gave him a Section 1366 look-over and said “FAIL.”

Hargis’ first name was Bobby; his wife’s name was Brenda. Bobby was a nursing home pro. He in fact owned five of them. He stuck each of his nursing homes in its own S corporation.

Standard planning.

The tax advisor also had Bobby separate the (nursing home) real estate and equipment from the nursing-home-as-an-operating business. The real estate and equipment went into an LLC, and the LLC “leased” the same back to the S corporation. There were 5 LLCs, one for each S.

Again, standard planning.

Bobby owned 100% of the five nursing homes.

Brenda was a member in the LLCs. There were other members, so Brenda was not a 100% owner.

The tax problem came when Bobby went out and bought a nursing home. He favored nursing homes down on their luck. He would buy at a good price, then fix-up the place and get it profitable again.

Wash. Rinse. Repeat.

But it took money to carry the homes during their loss period.

Bobby borrowed money:

(1) Sometimes he borrowed from the LLCs

(2) Sometimes he borrowed from his own companies

(3) Sometimes he borrowed from a bank

Let’s discuss (1) and (2) together, as they share the same issue.

The loan to the S has to be direct: from Bobby to the S.

Bobby did not do this.

The loans were from the other companies to his S corporations. Bobby was there, like an NFL owner watching from his/her luxury box on Sunday. Wave. Smile for the cameras.

Nope. Not going to work.

Bobby needed to lend directly and personally. Didn’t we just say no detours, sightseeing trips or garage sales? Bobby, the loan had to come from you. That means your personal check. Your name on the personal check. Not someone else’s name and check, no matter how long you have known them, whether they are married to your cousin or that they are founding team owners in your fantasy football league.  What part of this are you not understanding?  

Fail on (1) and (2).

How about (3)?

There is a technicality here that hosed Bobby.

Bobby was a “co-borrower” at the bank.

A co-borrower means that two (or more) people borrow and both (or more) sign as primarily liable. Let’s say that you and I borrow a million dollars at SunTrust Bank. We both sign. We are co-borrowers. We both owe a million bucks. Granted, the bank only wants one million, but it doesn’t particularly care if it comes from you or me.

I would say I am on the hook, especially since SunTrust can chase me down to get its money. Surely I “borrowed,” right? How else could the bank chase me down?

Let’s get into the why-people-hate-lawyers weeds.

Bobby co-borrowed, but all the money went into one of the companies. The company paid any interest and the principal when due to the bank.

This sounds like the company borrowed, doesn’t it?

Bobby did not pledge personal assets to secure the loan.

Bobby argued that he did not need to. Under applicable state law (Arkansas) he was as liable as if the loan was made to him personally.

I used to like this argument, but it is all thunder and no rain in tax-land.

Here is the Raynor decision:

[n]o form of indirect borrowing, be it guarantee, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.”

Bobby does not have the type of “debt” required under Section 1366 until he actually pays the bank with some of his own money. At that point, he has a subrogation claim against his company, which claim is the debt Section 1366 wants.

To phrase it differently, until Bobby actually pays with some of his own money, he does not have the debt Section 1366 wants. Being hypothetically liable is not the same as being actually liable. The S was making all the payments and complying with all the debt covenants, so there was no reason to think that the bank would act against Bobby and his “does it really exist?” debt. Bobby could relax and let the S run with it. What he could not do was to consider the debt to be his debt until his co-borrower (that is, his S corporation) went all irresponsible and stiffed the bank.

COMMENT: Folks, it is what it is. I did not write the law.

Bobby failed on (3).

The sad thing is that the tax advisors could have planned for this. The technique is not fool-proof, but it would have looked something like this:

(1) Bobby borrows personally from the bank

(2) Bobby lends personally to his S corporation

a.     I myself would vary the dollars involved just a smidge, but that is me.

(3) Bobby charges the S interest.

(4) Upon receiving interest, Bobby pays the bank its interest.

(5) Bobby has the S repay principal according to a schedule that eerily mimics the bank’s repayment schedule.

(6) Bobby and the S document all of the above with an obnoxious level of paperwork.

(7) Checks move between Bobby’s personal account and the business account to memorialize what we said above. It is a hassle, but a good accountant will walk you through it. Heck, the really good ones even send you written step-by-step instructions.

Consider this standard CTG planning for loss S Corporations with basis issues.

The IRS could go after my set-up as all form and no substance, but I would have an argument – and a defensible one.

Hargis gave himself no argument at all. 

He owed the IRS big bucks.

A Rollover As Business Startup Got “ROB”bed

We have talked before about ROBS. This is when one borrows money from his/her IRA to start a business.  ROBS have become increasingly popular, and I have wandered in tax Siberia by being negative on them. I know a CPA in New Jersey who even used a ROBS to start his practice. I gave him some slack (but just a little) as he is a general accounting practitioner and not a tax specialist.

Here is the question I hear: what is one’s downside if it goes south? They can’t eat me, right?

My answer: you have blown up your IRA via a prohibited transaction. A prohibited is nothing to take lightly. It contaminates your IRA. All of it. Even the monies you leave behind in the IRA. This is a severe case of terminal.

Now I have a case to share with my clients: Ellis v Commissioner.

Mr. Ellis accumulated a sizable 401(k). In 2005 he formed an LLC (CST) to sell used cars. He moved $319,500 from his 401(k) to an IRA to acquire the initial membership units of CST. He worked there as general manager and received a modest W-2. CST made a tax election to be taxed as a corporation. It did this to facilitate the ROBS tax planning.

Mr. Ellis, his wife and children also formed another LLC (CDJ LLC) in 2005 to acquire real estate. Mr. Ellis did not use his IRA to fund this transaction.

In 2006 CDJ LLC leased its real estate to CST for $21,800. No surprise.

Mr. Ellis also received a larger – but still modest – W-2 for 2006.

The IRS swooped in on 2005 and 2006. They wanted:

·        Income taxes of $135,936 for 2005

·        Alternatively, income taxes of $133,067 for 2006

·        Early distribution penalties of 10%

·        Accuracy-related penalties of $27,187 for 2005 or $26,613 for 2006

What set off the IRS?

·        Mr. Ellis engaged in “prohibited transactions” with his IRA.

·        When that happened, his IRA ceased to be an “eligible retirement plan” as of the first day of that taxable year.

·        Failure to be an “eligible retirement plan” means that that the IRA was deemed distributed to him.

·        As he was not yet 59 ½ there would be early distribution penalties in addition to income tax.

When did this happen? Take your pick:

·        When Mr. Ellis used his IRA to buy membership interests in CST in 2005

·        When CST paid him a W-2 in 2005

·        When CST paid him a W-2 in 2006

·        When CST paid CDJ LLC (an entity owned by him and his family) rent in 2006

OBSERVATION: Do you see the danger with the ROBS? Chances are that you will be giving the IRS multiple points at which to breach your tax planning. You have to defend all points. Failure to defend one – just one – means the IRS wins.

Code section 4975 defines “prohibited transactions” with respect to a retirement plan, including IRAs. Its purpose is to prevent taxpayers from self-dealing with their retirement plan. The purpose of a retirement plan is to save for retirement. The government did not allow tax breaks intending for the plan to be a piggybank or an alternative to traditional bank loans.

Self-dealing with one’s retirement plan is per-se prohibited. It is of no consequence whether the deal is prudent, in the best-interest-of or outrageously profitable. Prohibited means prohibited, and the penalties are correspondingly harsh.

The Court proceeds step-by-step:

(1) CST did not have any shares or units outstanding when Mr. Ellis invested in 2005. Fortunately, there was precedent (in Swanson v Commissioner) that a corporation without shareholders is not a disqualified person for this purpose.

Mr. Ellis won this one.

(2) Mr. Ellis, feeling emboldened, argued that Code section 4975(c) did not apply because he was paid reasonable compensation for services rendered, or for the reimbursement of expenses incurred, in the performance of his duties with the plan.

The Court dryly notes that he was paid for being the general manager of CST, not for administrating the plan. Code section 4975(c) did not apply. Ellis was a disqualified person, and transfers of plan assets to a disqualified person are prohibited.

Mr. Ellis argued that the payment was from the business and not from his plan. The Court observed that the business was such a large piece of his IRA that, in reality, the business and his IRA were the same entity.

Mr. Ellis lost this one.

(3) Having determined the W-2 a prohibited transaction, it was not necessary for the Court again to consider whether the rent payment was also prohibited.

The Court goes through the consequences of Mr. Ellis blowing-up his IRA:

(1) Whatever he moved from his 401(k) to his IRA in 2005 is deemed distributed to him. He had to pay income taxes on it.

a.     The Court did observe that – since the IRA erupted in 2005 - it couldn’t again erupt in 2006. Thank goodness for small favors.

(2) Since Mr. Ellis was not age 59 ½, the 10% early distribution penalty applied.

(3) Since we are talking big bucks, the substantial underpayment penalty also applied for 2005. Ellis could avoid the penalty by showing reasonable cause.  He didn’t.

I suppose one could avoid IRA/business unity argument by limiting the ROBS to a small portion of one’s IRA. That would likely require a very sizeable IRA, and what would “small” mean in this context?

I disagree with the Court on the reasonable cause argument. ROBS are relatively recent, and takes a while for a body of law, including case law, to be developed. I find it chilling that the Court thought that the law and its Regulations were sufficiently clear that Mr. Ellis should have known better. Whereas I disagree with many of the ROBS arguments, I acknowledge that they are reasonable arguments. The Court evidently did not feel the same.

OBSERVATION: How long do you think it will be before ROBS are a “reportable transaction,” bringing disclosure to its promoters and attention to the taxpayer?

My thoughts?  I intend to give this case to any client or potential client who is considering a ROBS. I can see situations where a ROBS can still pass muster – if the taxpayer is a true and passive investor, for example. Problem is, that is not how ROBS are promoted. They are marketed to the prematurely and involuntarily unemployed, and as a way to fund a Five Guys Burgers and Fries franchise or that accounting practice in New Jersey. Odds are you will be working there, as you are too young to retire. You will not be passive. If you were passive, why not just buy Altria or Proctor & Gamble stock? You don’t need a ROBS for that.