Income Tax Consequences of Cancellation of Debt

The topic of Cancellation of debt (called Forgiveness of Debt when I first encountered the topic in my individual tax accounting course as an undergraduate), is a particularly timely one right now as personal and business bankruptcy filings are at all time highs. The first thing to understand is that, under the general rule laid out in Internal Revenue Code Section 61 defining what constitutes gross in­come, the cancellation of debt causes gross income to increase by the amount of debt that is cancelled (IRC 61(a) (12). Many people ask why the cancellation of debt causes an increase in their taxable income. Actually, the concept is simple and makes perfect sense. For example, if you owe your bank $100,000 on a mortgage, and the bank lets you know in writing that it will accept $50,000 in full satisfaction of your mortgage, that is the same as if you had earned the cancelled $50,000 of mortgage, combined it with the $50,000 that you had earned and saved, and paid off your mortgage.
The Internal Revenue Code sets out a number of exceptions to the general rule. The exceptions are set out in Internal Revenue Code Section 108 Subsections A through E. The first exception provides that there is no inclusion of income for debts forgiven or cancelled as part of a bankruptcy under Title 11 of the U.S. Code. To qualify for this exception, the taxpayer must be under the court’s jurisdiction and discharge must be granted under a plan approved by the court. A second exception to the general rule is granted when the taxpayer is insolvent. For this purpose, insolvency occurs when a taxpayer’s liabilities exceed the fair market value of his assets. An exception to the general rule is also granted for cancellation of qualified farm indebtedness. Another exception is granted for cancellation of qualified principal residence indebtedness discharged before January 1, 2013 (IRC 108(1)(E). The final exception is granted for the cancellation of qualified real property business indebtedness for all taxpayers except C Corporations. A C Corporation is one defined under Sub­chapter C of the Internal Revenue Code. A C Corporation’s profits are typically taxed separately from those of its owners.
To claim an exclusion from gross income under one of these exceptions, a taxpayer files Form 982 “Reduction of Tax Attributes Due to Discharge of Indebtedness and IRC Section 1082 Basis Adjustment, attaching Form 982 to the debtor/taxpayer’s income tax return. A key question that often arises in this area is: what happens if a taxpayer receives a Form 1099C from a bank or other third party reporting an amount of cancellation of indebtedness income that the taxpayer/debtor thinks is wrong. In short, is issuance of a Form 1099C conclusive evidence of the amount of cancellation of debt income? Internal Revenue Code Section 6201(d) provides that, in a court proceeding, the taxpayer/debtor asserting that a Form 1099C he received is incorrect, has the burden of proving the document is incorrect, unless the taxpayer has cooperated with the IRS by providing access to and inspection of witnesses, information, and documents within his control, in which case the burden of proof is shifted to the IRS to prove that the Form 1099C is correct. The U.S. Court of Appeals in the case of Zarin v. Commissioner of Internal Revenue Service, 916 F. 2d., 110, 115 3rd Circuit 1990, set out the general rule in this area. The Court held in Zarin that there must be evidence of a dispute as that term is used in IRC 6201(d). A mere settlement, standing alone, does not prove a dispute existed. The mere fact that the creditor turned the taxpayers’ account over to a collection agency or a collection attorney by itself is not enough to establish that a dispute exists as set forth in IRC Section 6201(d). John and Mary Lou McCormack TC memo 2009-239.
The case of Briar Park v. Commis­sioner of Internal Revenue Service, 163F. 3d 313 1999, involved a situation in which a partnership (Briar Park) sold real property which had indebtedness that was greater than the selling price of the property. Briar Park argued that, since it was insolvent at the time of the transfer, none of the gain on the sale of the property should be recognized under IRC Section 61(a)(3) providing for the inclusion in gross income of gain from the sales of real property (capital gains). The Court of Appeals held that the sale of the property and the cancellation constituted one transaction rather than two. Specifically the court held that the Internal Revenue Code (Section 1001-2(a)(1)) provides that the amount realized includes the amount of liabilities from which the transferor is discharged via cancellation of indebtedness as a result of the sale or disposition.
David N. Kass is of counsel on a part time basis to The Law Offices of Victor W. Luke, A Professional Law Corporation.