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.

Income And Cancellation of Bank Debt

 

There is a basic presumption in the tax Code that any accession to “wealth” is income. It isn’t much of a leap for the tax Code to then say that all income is taxable unless otherwise excluded.

Let’s next look at “wealth.” I propose a working definition as follows:

          Assets (A) = Liabilities (L) + Wealth (W)

A little algebra shows the following:

          A – L = W

Here is spiff on the above: do you have wealth if your liabilities go down?

Let’s look at the Katrina White case.

Katrina started a business in 2015. She took out a business loan for $15,000. She leased space for her business, signing a three-year lease.

The business did not work out. The family lent her $8 grand, but there was no way to save it. She had repaid the bank less than a grand when her remaining debt of $14,433 was discharged. The bank sent her a 1099, of course, as all American life events can apparently be reduced to a 1099.

Katrina never made a payment on the lease. Since rent was late for more than two months, the entire lease became due and payable. That fiasco totaled $21,700.

 She filed her return.

The IRS said she left out income of $14,433.

How?

Let’s go through it.

Katrina said that her wealth (that is, A – L = W) was as follows when the business failed:                 

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Utilities, estimated		2,500
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
Lease breach		21,700
Family loan		7,800
		61,936
Net wealth		(29,876)

The IRS wasn’t buying this. They argued that:

·      The estimated utilities were a no go.

·      The family loan wasn’t really a “loan.”

·      While we are at it, the lease breach wasn’t really a loan, as the landlord had no intention of enforcing the debt.

The IRS math was as follows:

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
		29,936
Net wealth		2,124

The matter went to Tax Court.

The Court pointed out the obvious: Katrina signed a valid and binding lease contract. Perhaps the landlord decided that there was nothing there to pursue, but it cannot be argued that she had an enforceable debt.

The Court saw the following:

Real property		28,500
Personal property		3,560
		32,060
Student loans		5,294
Utilities		961
Furniture loan		1,120
Judgements		8,128
Bank loan		14,433
Lease breach		21,700
		51,636
Net wealth		(19,576)

Let’s recap our numbers:

Wealth per Katrina was          ($29,876)

Wealth per the IRS was              $2,124

Wealth per the Court was        ($19,576)

Remember what we said at the beginning, that all income is taxable unless there is an exception?  Well, there is an exception for cancellation of debt. Several, in fact, but today we are concerned with only one: insolvency. The Code says that one does not have income to the extent that one is insolvent.

What is insolvency?

Go back to the formula: A – L = W.

To the extent that “W” is negative, one is insolvent. Another way of saying it is that one has more debts than assets.

So, who showed negative “W”?

Well, Katrina did. So did the Court.

Katrina was insolvent. That was an exception to cancellation of indebtedness income. Katrina did not have taxable income. The IRS lost.

Our case this time was Katrina White v Commissioner, T.C. Memo 2023.-77.

Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

Are You Insolvent Or Not?

There is a case called Hamilton v Commissioner. It was recently decided in the 10^th Circuit, and it caught my eye.

Since it went to a Circuit court, you may correctly assume that this case was on appeal.

Frankly, I do not see a win condition for the taxpayer here. It does, however, give us an opportunity to discuss the concept of a tax nominee.

The patriarch of our story – Mr Hamilton – borrowed over $150,000 to send his son to medical school.

Mr Hamilton injured his back in 2008 – and badly.

I presume that translated into loss of income and a difficult time servicing debt.

Mrs Hamilton finally got the student loan discharged in 2011.

A key point is that the student loan belonged to Mr Hamilton – not the son. When the loan was discharged, the tax effect is therefore analyzed at Mr Hamilton’s level, as he was the debtor.

Before the discharge, Mrs Hamilton transferred approximately $300 grand into a rarely used savings account owned by her son. He in turn gave her the username and password so she could access the account. Throughout 2011, for example, she withdrew close to $120,000 from the account.

COMMENT: There you have the issue of a nominee: whose account is it: Mrs Hamilton’s, the son’s, or both? Granted, it the son’s name is on the account, but is he acting as the face man – that is, a nominee – for someone else?

The issue in the case is whether the discharged debt of $150 grand was taxable to the Hamiltons in 2011.

In general, if your recourse debt is discharged, you have taxable income. There are several exceptions, of which one of the better known is bankruptcy. File for bankruptcy and the tax Code allows you to exclude the debt from taxable income.

But … it requires you to file bankruptcy.

There is a similar – but not quite the same – exception that has to do with insolvency. For tax purposes, one is insolvent if one’s debts exceeds one’s assets.

EXAMPLE: You have assets (house, car, savings, etc.) of $400,000. You owe $500,000. You are insolvent to the extent that your debts exceed your assets ($500,000 – 400,000 = $100,000).

Mind you, you are not filing for bankruptcy. I suppose it is possible that you could power through this stretch, cutting back personal expenditures to a minimum and applying everything else to debt. Still, you are technically insolvent.

The tax Code lets you exclude debt forgiveness from taxable income to the extent that you are insolvent.

EXAMPLE: Let’s continue with the above example. Say that $50,000 is forgiven. You are $100,000 insolvent. $50 grand is less than $100 grand, so $50 grand would be excluded under the insolvency exception.

NEXT EXAMPLE: What if $125 grand was forgiven? You could exclude $100 grand and no more. That last $25,000 would be taxable, as you are no longer insolvent.

The insolvency calculation puts a lot of pressure on what to include and what to exclude in the calculation. Do you include a 401(k) account, for example? Do you include someone else’s loan on which you cosigned?

In the Hamilton case, do you include that savings account?

Under state law, the son did own the account. Tax law however will rarely allow itself to be trapped by mere formality. This judicial doctrine is referred as “substance over form,” and it means what it says: tax law will generally look at the players and on-field performance and resist being distracted by the school band and T-shirt cannons.

The Court made short work of this case.

The taxpayers argued, for example, that the son could change the username and password at any time, so it would be a leap to call him an agent or nominee for his parents.

Yep, and a delivery spaceship for intergalactic deep-dish pizza could land on Spaghetti Junction in Atlanta during rush hour.

If you can log-in with impunity and move $120,000 grand, then you have effective control over the bank account. The mother’s name was not on the account, but it may as well have been because the son was his mother’s agent – that is, her nominee.

I have no problem with that. I would have done the same for my mother, without hesitation.

What the Hamiltons could not do, however, was leave-out that bank account when they were counting assets for purposes of the insolvency calculation. It was, after all, around $300 hundred – less than a Bezos but a lot more than a smidgeon.

Did it affect the insolvency calculation?

Of course it did. That is why the case went to Court.

The Hamiltons were not insolvent. They had income from the debt discharge.

They had to try, I guess, but I doubt whether they ever had a win condition.

A Representative’s Tax Proposal for Credit Card Debt Forgivenesss

I am reading that Representative Scott Peters (D-CA) has proposed a change to the tax Code allowing forgiveness of credit card balances to be nontaxable.

I have two questions for you:

First, what is it with politicians from California?

Second, did you know that credit card forgiveness was taxable?

The tax Code is based on the concept of an increase in net wealth. The concept is simple, although it causes difficulty in application. Let’s look at the following example:

           

Monday morning you have to your name					400
Tuesday the credit card company forgave					125
Friday you got paid					1,000
You put gas in your car					(60)
You bought lunch all week					(40)
Friday afternoon you have to your name					1,425

You went from being worth $400 to being worth $1,425. Does that mean that you have $1,025 of income to report to the tax man? No, but you are thinking along the correct lines. Not every addition in our example is taxable, and not every subtraction is deductible. Let’s look at each.

•  $125 of your credit card balance was forgiven.

Code section 108 addresses the taxability when somebody forgives your debt. There are five subcategories:

·        108(a)(1)(A) applies in bankruptcy

·        108(a)(1)(B) applies if you are insolvent

·        108(a)(1)(C) applies to farm debt

·        108(a)(1)(D) applies to certain business debt

·        108(a)(1)(E) applies to your mortgage

I am not seeing an exception for credit cards, so for the time being it looks like the $125 will be income. I am assuming that you are not insolvent (meaning that you owe more than you are worth) or in bankruptcy (which sometimes follows owing more than you are worth).

• Your paycheck

That one is obvious. We should be thankful the government does not just decide to have all paychecks sent to them, allowing them to decide how much to return to us.

•  Buying gas and a week’s worth of lunches

Code section 262 disallows tax deductions for personal, living and family expenses. Granted, another Code section may override and allow a deduction for specific expenses (such as medical), but in general one cannot deduct groceries, utilities, rent and similar day-to-day-living expenses.

I would say that you have taxable income of $125 plus $1,000 = $1,125.

The credit card is a subset of “forgiveness of indebtedness” taxation. The seminal case is Kirby Lumber, which was decided by the Supreme Court back in 1931. Kirby Lumber had previously issued bonds of over $12 million. They later bought back the bonds for $137,000 less. The question before the Court was whether that $137,000 represented taxable income. It does seem a bit odd that someone can have income just from transacting in debt, but if you think of it as accession to wealth the tax reasoning becomes clearer. At the end of the day Kirby Lumber was worth $137,000 more (as it had less net debt), and the government wanted its cut.

Back to Representative Sun-Dance-Whispered-By-Hidden-Shadow, or whatever he is called back in his native land.

He is proposing that forgiveness of credit cards be excluded from income.

However, the most that a person could exclude from lifetime income is capped at $2,500.

Say that you excluded $1,000 in 2014. Under his proposal, the most you could exclude – over the rest of your life – is another $1,500. You cannot exclude more than $2,500 over your lifetime.

My first thought is that $2,500 is not enough to move the needle, if someone really got into credit card and personal debt problems. I have known and heard of people who have run up a mortgage-level balance on their credit cards.

My second thought is whether this is a wise use of the public purse. Congress provided a mortgage interest deduction because it wanted to increase home ownership. It provided a charitable deduction to promote societal benevolence and reduce strain on the public safety net. What is Congress saying by providing an exclusion for not repaying credit card debt?

And you can see how bad tax law happens. There is no theory of wealth creation, case precedence or administrative practicality at play with this proposal. An elected bludger panders, laws are passed without being read and the tax system (both the IRS and advisors) is left to making sense out of nonsense.