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.

Abandoning A Partnership Interest

I suspect that most taxpayers know that there is a difference between long-term capital gains and ordinary income. Long-term capital gains receive a lower tax rate, incentivizing one to prefer long-terms gains, if at all possible.

Capital losses are not as useful. Capital losses offset capital gains, whether short-term or long-term. If one has net capital losses left over, then one can claim up to $3,000 of such losses to offset non-capital gain income (think your W-2).

That $3,000 number has not changed since I was in school.

And there is an example of a back-door tax increase. Congress has imposed an effective tax increase by not pegging the $3,000 to (at least) the rate of inflation for the last how-many decades. It is the same thing they have done with the threshold amount for the net investment income or the additional Medicare tax. It is an easy way to raise taxes without publicly raising taxes.

I am looking at a case where two brothers owned Edwin Watts Golf. Most of the stores were located on real estate also owned by the brothers, so the brothers owned two things: a golf supply business and the real estate it was housed in.

In 2003 a private equity firm (Wellspring) offered the brothers $93 million for the business. The brothers took the money (so would I), kept the real estate and agreed to certain terms, such as Wellspring having control over any sale of the business. The brothers also received a small partnership position with Wellspring.

Why did they keep the real estate? Because the golf businesses were paying rent, meaning that even more money went their way.

The day eventually came when Wellspring wanted out; that is what private equity does, after all. It was looking at two offers: one was with Dick’s Sporting Goods and the other with Sun Capital.  Dick’s Sporting already had its own stores and would have no need for the existing golf shop locations. The brothers realized that would be catastrophic for the easy-peasy rental income that was coming in, so they threw their weight behind the offer by Sun Capital.

Now, one does not own a private equity firm by being a dummy, so Wellspring wanted something in return for choosing Sun Capital over Dick’s Sporting.

Fine, said the brothers: you can keep our share of the sales proceeds.

The brothers did not run the proposed transaction past their tax advisor. This was unfortunate, as there was a tax trap waiting to spring.  

Generally speaking, the sale or exchange of a partnership interest results in capital gain or loss. The partners received no cash from the sale. Assuming they had basis (that is, money invested) in the partnership, the sale or exchange would have resulted in a capital loss.

Granted, one can use capital losses against capital gains, but that means one needs capital gains.   What if you do not have enough gains? Any gains? We then get back to an obsolete $3,000 per year allowance. Have a big enough loss and one would need the lifespan of a Tolkien elf to use-up the loss.

The brothers’ accountant found out what happened during tax season and well after the fact. He too knew the issue with capital losses. He played a card, in truth the only card he had. Could what happened be reinterpreted as the abandonment of a partnership interest?

There is something you don’t see every day.

Let’s talk about it.

This talk gets us into Code sections, as the reasoning is that one does not have a “sale or exchange” of a partnership interest if one abandons the interest. This gets the tax nerd away from the capital gain/loss requirement of Section 741 and into the more temperate climes of Section 165. One would plan the transaction to get to a more favorable Code section (165) and avoid a less favorable one (741). 

There are hurdles here, though. The first two are generally not a problem, but the third can be brutal.

The first two are as follows:

(1) The taxpayer must show an intent to abandon the interest; and

(2)  The taxpayer must show an affirmative act of abandonment.

This is not particularly hard to do, methinks. I would send a letter to the tax matters or general partner indicating my intent to abandon the interest, and then I would send (to all partners, if possible) a letter that I have in fact abandoned my interest and relinquished all rights and benefits thereunder. This assumes there is no partners’ meeting. If there was a meeting, I would do it there. Heck, I might do both to avoid all doubt.

What is the third hurdle?

There can be no “consideration” on the way out.

Consideration in tax means more than just receiving money. It also includes someone assuming debt you were previously responsible for.

The rule-of-thumb in a general partnership is that the partners are responsible for their allocable share of partnership debt. This is a problem, especially if one is not interested in being liable for any share of any debt. This is how we got to limited partnerships, where the general partner is responsible for the debts and the limited partners are not.

Extrapolating the above, a general partner in a general partnership is going to have issues abandoning a partnership interest if the partnership has debt. The partnership would have to pay-off that debt, refinance the debt from recourse to nonrecourse, or perhaps a partner or group of partners could assume the debt, excluding the partner who wants to abandon.

Yea, the planning can be messy for a general partnership.

It would be less messy for a limited partner in a limited partnership.

Then we have the limited liability companies. (LLCs). Those bad boys have a splash of general partnership, a sprinkling of limited partnership, and they can result in a stew of both rules.

The third plank to the abandonment of a partnership interest can be formidable, depending on how the entity is organized and how the debts are structured. If a partner wants an abandonment, it is more likely than not that pieces on the board have to be moved in order to get there.   

The brothers’ accountant however had no chance to move pieces before Wellspring sold Edwin Watts Golf. He held his breath and prepared tax returns showing the brothers as abandoning their partnership interests. This gave them ordinary losses, meaning that the losses were immediately useful on their tax returns.

The IRS caught it and said “no way.”

There were multiple chapters in the telling of this story, but in the end the Court decided for the IRS.

Why?

Because the brothers had the option of structuring the transaction to obtain the tax result they desired. If they wanted an abandonment, then they should have taken the steps necessary for an abandonment. They did not. There is a long-standing doctrine in the Code that a taxpayer is allowed to structure a transaction anyway he/she wishes, but once structured the taxpayer has to live with the consequences. This doctrine is not tolerant of taxpayer do-overs.

The brothers had a capital and not an ordinary loss. They were limited to capital gains plus $3 grand per year. Yay.

Our case this time for the home gamers was Watts, T.C. Memo 2017-114.