Debt Cancellation

2 Hours Federal Tax Law IRS, CTEC and NASBA

IRS Provider #: UBWMF
IRS Course #: UBWMF-T-00071-15-S
CTEC Provider #: 6209
CTEC Course #: 6209-CE-0068
NASBA: 116347
The material contained within this course is for educational purposes only.
To the extent any advice relating to a Federal tax issue is contained in this communication, including in any
attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax
related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b)
promoting, marketing or recommending to another person any transaction or matter addressed in this
communication.

2015 Fast Forward Academy, LLC All Rights Reserved.

Debt Cancellation
Introduction
Course Description
Debt cancellation is an increasingly common occurrence, especially in times of a troubled economy. The
forgiveness of a debt not only has economic and financial consequences, but also specific tax
consequences and the rules regarding these tax consequences can be complicated. Taxpayers and their
advisors attempting to navigate through these turbulent waters will need a compass; this course is
designed to provide that compass.
Those who fail to abide by the complex requirements of recognizing and excluding cancellation of debt
(COD) income may encounter unpleasant surprises. In this course we will explore the basic rules for
both the inclusion of COD income in gross income and the circumstances in which COD income can be
excluded; delving into each exclusion in some detail. Using examples to illustrate the application of the
rules to specific situations, we will address calculation of the inclusion amount, the consequence of tax
attribute reduction following exclusion, and the complicated issues related to attribute reduction in the
context of S corporation and partnership borrowers.

Learning Objectives
After completing this course you will be able to:

Recognize the COD income rules

Identify circumstances in which COD income has to be included and those in which it may be
excluded from your clients gross incomes
Classify how to report both the income resulting from a cancellation of debt and the tax
attribute reduction necessary when an exclusion applies
Define key terms such as income and insolvency

Contents
COURSE DESCRIPTION .....................................................................................................................................................2
LEARNING OBJECTIVES ....................................................................................................................................................2
YOURE NOT AS POOR AS YOU FEEL ....................................................................................................................... 5
SHEPHERD V. COMMISSIONER, T.C. MEMO 2012-212 (JULY 24, 2012) ................................................................................5
THE IMPORTANCE OF UNDERSTANDING COD INCOME PRINCIPLES ..........................................................................................6
DEFINITION OF INCOME......................................................................................................................................... 7
CODE SECTION 61 ..........................................................................................................................................................7
SUPREME COURT CASES: KIRBY LUMBER AND GLENSHAW GLASS ............................................................................................7
CODE SECTION 108 ................................................................................................................................................ 9
THE STRUCTURE .............................................................................................................................................................9
EXCLUSIONS FROM GROSS INCOME UNDER 108 ................................................................................................. 9
THE BANKRUPTCY EXCLUSION ...........................................................................................................................................9
THE INSOLVENCY EXCLUSION ..........................................................................................................................................11
QUALIFIED FARM INDEBTEDNESS .....................................................................................................................................16
QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS..........................................................................................................16
QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS ...............................................................................................................18
STUDENT LOANS ..........................................................................................................................................................20
DISCHARGE OF INDEBTEDNESS ............................................................................................................................ 20
A GIFT OF FORGIVENESS.............................................................................................................................................20
THE REDUCTION IN PURCHASE PRICE .................................................................................................................. 21
AN EXCEPTION TO THE RULE...........................................................................................................................................21
ATTRIBUTE REDUCTION ....................................................................................................................................... 22
EXCLUSION OF INCOME BASED ON STATUTORY EXCEPTIONS .................................................................................................22
GUARANTEES ....................................................................................................................................................... 24
GENERAL ....................................................................................................................................................................24
RECOURSE VS. NONRECOURSE DEBT ................................................................................................................... 27
IN GENERAL ................................................................................................................................................................27
ACQUISITION OF DEBT BY RELATED PARTIES ....................................................................................................... 27
IN GENERAL ................................................................................................................................................................27
EXCEPTIONS ................................................................................................................................................................28
ALTERNATIVE MINIMUM TAX .............................................................................................................................. 29
THE PURPOSE ..............................................................................................................................................................29
APPLICATION TO S CORPORATIONS AND PARTNERSHIPS .................................................................................... 29
S CORPORATIONS .........................................................................................................................................................29

PARTNERSHIPS AND LIMITED LIABILITY COMPANIES.............................................................................................................31

REPORTING REQUIREMENTS................................................................................................................................ 32
CREDITOR REPORTING REQUIREMENTS IN GENERAL ............................................................................................................32
USING FORM 1099-C AS A COLLECTION DEVICE ................................................................................................................33
FORECLOSURES AND ABANDONMENTS .............................................................................................................................35
GLOSSARY...................................................................................................................................................................36

Youre Not As Poor As You Feel

Shepherd v. Commissioner, T.C. Memo 2012-212 (July 24, 2012)
Not unlike what has happened to many Americans struggling in a troubled economy, Bernie and Desiree
Shepherds credit card company referred their delinquent account to a collection agency. Fortunately,
the couple was able to negotiate a settlement agreement. That agreement called for payment of $5,550
in full satisfaction of their nearly $10,000 balance. After payment of the settlement amount, the credit
card company issued a Form 1099-C, Cancellation of Debt, to the Shepherds, showing that $4,412 of
indebtedness had been canceled.
Aware that cancellation of debt (COD) income may be excluded from gross income in the case of
insolvency, the Shepherds chose not to include the amount shown on the Form 1099-C as income on
their tax return. After all, the fair market value of their assets amount to a little over $750,000 and their
debt amount to close to $800,000. Or at least thats what they thought.
The IRS asserted that the aggregate value of the Shepherds two pieces of real estate, a beach house and
their personal residence, was sufficient to render them solvent, not to mention the value of Bernies
pension. Prove it, the Shepherds said. Not gonna, dont hafta, the IRS replied. The IRS was right, of
course; it is the taxpayers burden to show insolvency.
The dispute made its way to Tax Court. As to the beach house, the Shepherds offered evidence of the
valuation used for local property tax purposes. Not good enough. The Tax Court has firmly established
that a value placed on property for the purpose of local taxation, unsupported by other evidence,
cannot be accepted as determinative of fair market value for federal income tax purposes in the
absence of evidence of the method used in arriving at that valuation.1
To bolster their case, at trial Bernie testified as to his opinion of the value of the beach house
immediately before the discharge. His valuation testimony was allegedly based on comparable sales that
he assembled for the purpose of a property tax appeal. Again, the court said no dice. While
comparable sales can be persuasive evidence of fair market value, Bernie failed to offer into evidence or
describe in detail the comparable sales or their dates. Thus the Shepherds determination of the value of
the beach house could not be proved. Strike one.
As evidence of the value of their personal residence, the Shepherds offered a letter from a reputable
residential lending company showing the value of the principal residence for purpose of a loan
modification. Unfortunately, not only was the letter dated more than three years after the date of the
settlement of the debt, it also did not describe the property nor explain, even briefly, the methodology
used to determine its value. The court was unconvinced. Strike two.

Pierce v. Commissioner, 61 T.C. 424, 431 n.6 (1974); see also, Gilmartin v. Commissioner, T.C. Memo. 1973-247;
Bishop v. Commissioner, T.C. Memo. 1962-146.

Finally, Bernie argued that the value of his pension should not be considered in determining the couples
insolvency, because it was protected from his creditors. Strike three. For purposes of the insolvency
exception to COD income recognition, all assets count.

The Importance of Understanding COD Income Principles

As can be gleaned from the sad saga of Bernie and Desiree Shepherd, failure to understand the rules
regarding COD income inclusion and exclusion can result in very bad consequences. Debt cancellation is
an increasingly common occurrence, and those who fail to abide by the sometimes complicated rules
may encounter unpleasant surprises. In this course we will explore the basic rules for both the inclusion
of COD income in gross income, as well as the circumstances in which COD income can be excluded. We
will then address the consequence of tax attribute reduction that follows from exclusion of COD income
and the various reporting requirements. After completing this course you should have a firm grasp of
these rules and be able to apply them in your practice.
Furthermore, not only will a taxpayer have additional tax liability if they fail to report COD income,
penalties may apply as well. In June of 2014 Tax Court Judge Carolyn Chiechi had an opportunity to
explain this to Rouben Djoshabeh, who undoubtedly explained it to his tax preparer. Rouben and his
wife had debts of $53,451 that were cancelled by creditors. On their tax return the couple made no
entry for Other income, but instead attached a statement reporting negative $45,832 as 1099-C
nontaxable IRC sec 108 and $37,511 and $8,321 as two items of Cancellation of Debt. They then
reduced the two items of "Cancellation of Debt by the negative $45,832 of 1099-C nontaxable IRC sec
108 and, as a result, showed a total of zero as other income. Upon audit the IRS proposed a deficiency
in the amount of $53,451 and asserted the negligence penalty.
There was no substantive dispute about the COD income. The Djoshabehs, however, did challenge the
application of the negligence penalty. Code section 6662(a) imposes an accuracy-related penalty of 20
percent of the applicable underpayment. That penalty applies to the portion of any underpayment
which is attributable to negligence or disregard of rules or regulations or a substantial understatement
of tax.
The term negligence for this purpose includes any failure to make a reasonable attempt to comply
with the Code. Negligence has also been defined as a failure to do what a reasonable person would do
under the circumstances. Finally, the term also includes any failure by the taxpayer to keep adequate
books and records or to substantiate items properly.
The term disregard includes any careless, reckless, or intentional disregard of tax rules. An
understatement is equal to the excess of the amount of tax required to be shown in the tax return over
the amount of tax shown in the return.2 An understatement is substantial in the case of an individual
if the amount of the understatement for the taxable year exceeds the greater of 10 percent of the tax
required to be shown in the tax return for that year or $5,000.3

2
3

IRC 6662(d)(2)(A).
IRC 6662(d)(1)(A).

The accuracy-related penalty does not apply to any portion of an underpayment if it is shown that there
was reasonable cause, and that the taxpayer acted in good faith. The determination of whether the
taxpayer acted with reasonable cause and in good faith depends on all the pertinent facts and
circumstances, including the taxpayers efforts to assess the taxpayers proper tax liability, the
knowledge and experience of the taxpayer, and the taxpayers reliance on the advice of a professional,
such as an accountant.
Reliance on the advice of a professional may demonstrate reasonable cause and good faith if, under all
the circumstances, such reliance was reasonable and the taxpayer acted in good faith. In this
connection, a taxpayer must demonstrate that the taxpayers reliance on the advice of a professional
concerning substantive tax law was objectively reasonable. A taxpayer's reliance on the advice of a
professional will be considered reasonable only if the taxpayer has provided necessary and accurate
information to the professional.
According to Rouben, he should not have been liable for the negligence penalty because he gave the
accountant who prepared the return three Forms 1099 with respect to the debt that was canceled. It
was his accountant who did not include in any amount with respect to that canceled debt in income, not
him or his wife.
Other than Roubens uncorroborated testimony that they relied on the accountant who prepared their
return when they did not include in the COD income on their return, Judge Chiechi noted that the record
was devoid of evidence, such as the testimony of that accountant, that establishes the fact that Rouben
and his wife acted with reasonable cause and in good faith in failing to report the income. Therefore, the
penalty was upheld and the fact that the Djoshabehs used a paid preparer was no defense.

Definition of Income
Code Section 61
Any determination of what is or is not included in income necessarily begins with reference to section
61(a) of the Internal Revenue Code (Code). That provision defines gross income as all income from
whatever source derived, including (but not limited to) compensation for services, including fees,
commissions, fringe benefits and similar items.
Needless to say, defining income as income . . . falls somewhat short of the pinnacle of clarity. As a
result, it has been left to the courts, and most notably the U.S. Supreme Court, to add flesh to the
definition of income for tax purposes.

Supreme Court Cases: Kirby Lumber and Glenshaw Glass

A case in point involved a company called Kirby Lumber. The company had borrowed money from the
public by issuing bonds at their $1,000 face amount. A bond, of course, simply represents a loan, much
like a promissory note. Because interest rates had declined, the company was able to repurchase the
bonds (and hence retire them) for less than the face amount (approximately $900 each). The IRS
asserted that the difference between what was borrowed and what was effectively repaid (through the
7

repurchase of the bonds) constituted income to the company. The Supreme Court agreed, stating that
the companys ability to retire the debt for less than the amount originally owed amounted to a freeing
of assets giving rise to gross income consistent with the statutory definition.4
It is clear that when a taxpayer borrows money, the transaction is neutral from an economic standpoint.
The taxpayer has additional assets in the form of the money borrowed, but he or she also has an
additional obligation to repay the loan that offsets those assets. In Kirby Lumber the Supreme Court was
asked to sort out the economic consequences when part of the loan is permanently cancelled or
discharged without the necessity of payment. When that is the case, the amount the borrower has
received (the loan proceeds) exceeds the amount that it has to repay, and there is no longer an
obligation offset. This freeing of assets renders the borrower better off economically, just like a
traditional receipt of income would. A net economic gain of this sort, the Court reasoned, comprises
income to the borrower.
Prior to Kirby Lumber, the Supreme Court had made attempts to clarify the scope of the meaning of
income in the Code, but the results proved unsatisfactory. For example, the dominant approach
articulated by the Court prior to the Kirby Lumber case was that income represented gain derived from
labor or capital, or both.5 While that definition seemed logical, it did not account for the type of
economic gain encountered in Kirby Lumber.
The Court finally settled on a new definition of income in a 1955 decision involving the Pittsburgh-area
Glenshaw Glass Company (Glenshaw).6 Glenshaw was involved in antitrust litigation that resulted in a
settlement payment to Glenshaw for punitive damages for fraud and antitrust violations. The company
did not report the settlement funds as income, contending that "windfalls" flowing from the culpable
conduct of third parties were not properly characterized as income under the Code.
The Supreme Court took up the question of whether punitive damages like those received by Glenshaw
were within the scope of gross income as defined by the Code. In doing so, it held that income, as
defined in the Code, means all accretions to wealth, clearly realized, and over which the taxpayers have
complete control.7 The accretions to wealth criteria articulated in Glenshaw Glass has remained the
definitive standard of determining whether a transaction constitutes income ever since.
Note that this definition is consistent with the result in the Kirby Lumber case. The cancellation of a debt
removes part or all of the liability offset that prevents loan proceeds from being recognized as income.
With the offset removed, the taxpayer is left with a net accretion to wealth, constituting taxable income.
Note also that the reason for the cancellation of the debt is not relevant. Regardless of the reason, a
taxpayer is better off economically when a debt, or a portion thereof, does not have to be repaid. For
example, a taxpayer named Jerry Johnson claimed that he only defaulted on his debt as a result of his
being illegally and unjustly forced into early retirement from his position as a teacher, and therefore
4
5
6
7

United States v. Kirby Lumber Co., 284 U.S. 1 (1931)

Eisner v. Macomber, 252 U.S. 189 (1920).
Commissioner v. Glenshaw Glass Co., 348 U.S.426 (1955).
Id. at 431.

he should not have to suffer the consequence of income inclusion.8 The cause of the default or and
subsequent discharge, however, did not matter and the cancellation of the debt was held to be taxable
income to him.

Code Section 108

The Structure
Congress decided to codify the Kirby Lumber approach by adding Code 61(a)(12) to the Code to
specifically reference the inclusion of discharge from indebtedness in the statutory definition of gross
income. In 1980, Congress enacted the current version of Code 108, providing for certain exclusions
from the general rule contained in Code 61(a)(12) and instituting a requirement of tax attribute
reduction.
Although Code 61(a)(12) states that income from cancellation or discharge of debt is includible in
gross income, Code 108 provides for several exceptions to that general rule. Specifically excluded from
income are the following:
1.
2.
3.
4.

any discharge that occurs in a title 11 (bankruptcy) case;

any the discharge occurs when the taxpayer is insolvent;
a discharged is qualified farm indebtedness;
in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified
real property business indebtedness;
5. a discharge of qualified principal residence indebtedness (if discharged before January 1, 2013);
and
6. student loans that are discharged in exchange for an agreement by the borrower to work in
certain public service occupations.
Each of these exceptions will be discussed in detail in the next section.

Exclusions from Gross Income under 108

The Bankruptcy Exclusion
Section 108(a)(1)(A) permits a taxpayer to exclude from income debt canceled in a bankruptcy case.
For this exception to apply, the discharge has to actually occur in a bankruptcy case (not in an
out-of-court workout), the debtor has to be under the jurisdiction of the bankruptcy court, and the debt
has to be cancelled pursuant to a plan approved by the court.
In 2004 the Tax Court dealt with a series of cases dealing with COD income where there had been a
bankruptcy of the primary debtor, but also personal guarantees of the debt.9 The taxpayers involved in
each of the cases were general partners in a partnership engaged in the business of developing a
continuing care facility. When the partnership borrowed $18 million from a bank, the general partners
8
9

Johnson v. Commissioner, TC Memo 1999-162.

Estate of Martinez v. Commissioner, TC Memo 2004-150.

each executed a personal guarantee with respect to the loan. Subsequently, the partnership filed a
chapter 11 bankruptcy petition.
The bankruptcy court appointed a trustee, who negotiated with the partnership's general partners to
obtain some contribution from them to pay partnership debts. The partners involved in these court
cases each contributed funds to the partnership's bankruptcy estate in exchange for a release of all
claims arising out of the partnership. The bankruptcy court entered an order approving the contribution
agreement and released the partners from liability arising out of or relating to the partnership and the
personal guarantee agreement.
The partnership then issued Schedule K-1, Partner's Share of Income, Credits, Deductions, etc., to each of
the general partners indicating their allocable shares of partnership COD income. The partners,
however, excluded this amount from their incomes on the basis that the discharge occurred in a
bankruptcy case. The IRS contended that the COD represented taxable income because it was the
partnership, not the individual partners, which was involved in the bankruptcy case. The partners
themselves, asserted the IRS, were not under the jurisdiction of the court and therefore not entitled to
the bankruptcy exclusion from COD income.
The Tax Court sided with the partners. The court pointed out that it was by virtue of an order from the
bankruptcy court that the taxpayers were discharged and released from all liability to the trustee, bank,
and other creditors arising from the partnership and personal guarantee. Thus, the bankruptcy court
explicitly asserted its jurisdiction over the partners for this purpose. Consequently, the partners debts
were discharged in a title 11 case, and the COD was excludable from their income.
Partners and Partnerships
In early 2015 the IRS released an action on decision indicating that it would not acquiesce in four 2004
Tax Court decisions regarding the COD income of a general partner who guaranteed a partnership debt
but was not himself in bankruptcy.10 Contrary to the holdings of the Tax Court, the IRSs position is that
a general partner who guaranteed the partnerships debt and was not himself in bankruptcy may not
exclude the debt that was canceled in the partnerships title 11 case.
In the first case, Jose Martinez was a general partner in a partnership and personally guaranteed some
of the partnerships debts.11 The partnership filed a bankruptcy petition. Subsequently, the partners,
including Jose, reached a settlement agreement with the trustee of the bankruptcy estate under which
they would make payments to the estate in exchange for the release of claims or potential claims of
creditors against them relating to the partnership. The bankruptcy court approved the agreement, and
discharged and released the partners from all liability related to the partnership and their personal
guarantees of partnership debts. The same order provided that each partner was subject to the
jurisdiction of the Bankruptcy Court. The Tax Court agreed with Jose that he could exclude his share of
the partnership COD income because the partnership debt was discharged in a bankruptcy case, noting
that the bankruptcy courts order explicitly asserted jurisdiction over the partners.
10
11

AOD 2015-01.
Martinez v. Commissioner, T.C. Memo 2004-150.

10

The IRS disagrees, asserting that The Tax Courts ruling is inconsistent with the structure of Code section
108 and underlying Congressional intent. Despite the courts assertion, the IRS takes the position that
Jose was not under the jurisdiction of the bankruptcy court. It was the partnership, they point out, not
Jose, which filed the petition in the bankruptcy court. Jose was therefore not a person . . . concerning
[whom] a case under this title [title 11] has been commenced pursuant to the bankruptcy code.12
The exclusions contained in Code section 108(a), the IRS observes, applies at the partner level. The
exclusion in section 108(a)(1)(A) applies only to partners who are debtors in bankruptcy in their
individual capacities and need a fresh start. Jose was not in bankruptcy in his individual capacity and,
therefore, did not need a fresh start. Therefore, the IRS believes the Tax Court ruled incorrectly in this
case and Jose was not entitled to exclude his shares of the partnership COD income under Code section
108(a)(1)(A). The non- acquiescence extends to three similar cases with the same rationale.13

The Insolvency Exclusion

In General
Code 108(a)(1)(B) provides an exclusion for debt cancellations where the taxpayer is deemed insolvent.
Under 108(d)(3) the term insolvent means the excess of liabilities over the fair market value of
assets determined immediately before any discharge.14
Determining insolvency, however, may be a difficult task. Which assets are included in this calculation
must be determined, not to mention the difficulty that may arise in establishing fair market value. With
respect to liabilities, one issue that may need to be addressed is whether contingent liabilities should be
part of the equation. Each of these issues is taken up below.
Calculating Assets
In calculating a taxpayers insolvency, an issue that must be addressed is which assets, if any, to exclude
from the calculation. While section 108(d)(3) seems quite straightforward in stating that the "fair market
value of assets" is what is to be counted for insolvency measurement, the Code does not address
whether this means all assets or only assets that would otherwise be available to creditors.
Under bankruptcy law and state law, certain assets are beyond the reach of the taxpayers creditors.
This includes, for example, pension plans, IRAs, and some or all of the equity in personal residences. It
makes some sense, therefore, that assets that are exempt from attachment by creditors should not be
counted when calculating the taxpayers insolvency.
This reasoning initially prevailed in the Tax Court. In a 1975 case the court held that assets exempt from
the claims of creditors should not be included among the taxpayers assets for the purpose of measuring
insolvency when COD income is at issue.15 The IRS also initially concurred with that reasoning, as
12

11 U.S.C. 101(13).
Gracia v. Commissioner, T.C. Memo 2004-147; Mirarchi v. Commissioner, T.C. Memo 2004-148; Price v.
Commissioner, T.C. Memo 2004-149.
13

14
15

IRC 108(d)(3).
Marcus Estate v. Commissioner, T.C. Memo. 1975-9.

11

indicated in a 1991 private letter ruling in which it stated that: "Because the rationale for the insolvency
exception is that, where no assets are freed from claims of creditors no income is realized, only assets
that are subject to claims of a taxpayer's creditors should be used to determine insolvency."16
This thinking, however, has changed. The IRS subsequently revoked that private letter ruling.17 While
acknowledging that prior judicial opinions excluded assets exempt from creditors, the IRS now points to
the fact that Code 108 itself places no specified limitation on assets that are to be taken into account in
determining a taxpayer's solvency to support its current position that all assets should be included. The
plain meaning of the term asset in Code 108(d)(3), according to the IRS, should include all of the
taxpayer's assets in the insolvency calculation.18
Determining the fair market value of the taxpayers assets immediately before a discharge may present
logistical problems and may require an appraisal. Actual values, not just book values must be used,
and as always, it is the taxpayers burden to prove these values. What is clear, however, is that the value
of all the taxpayers assets, whether or not subject to the claims of creditors, are included in the
calculation.
Practice Tip:
Since the taxpayer must prove his or her insolvency to take advantage of this exception,
having a qualified appraiser issue an opinion of value as close in time as possible to the
date the debt is cancelled is prudent. Appraisers can generally render an opinion as of a
date in the past, but this becomes more difficult (and less reliable) as the amount of
time between the valuation date and the appraisal increases. The time to establish the
value of the assets is when the debt is cancelled, not when the exclusion is later
challenged by the IRS. Furthermore, as indicated in the Shepherd case discussed above,
the appraisal should detail the basis for the values determined.
Calculating Liabilities
The term insolvent means the excess of liabilities over the fair market value of assets immediately
before the discharge.19 This means that the discharged debt itself counts as a liability for purposes of
determining the taxpayer's insolvency. The taxpayers insolvency, or lack thereof, after the discharge is
irrelevant. Also note that the exclusion from income is limited to the extent of the debtors insolvency.
Example:
Jane has debts totaling $100,000 and the fair market value of her assets is $80,000.
Therefore, Jane is insolvent in the amount of $20,000 ($100,000 - $80,000). Suppose
one of Janes creditors forgives a debt in the amount of $30,000. Although Jane is
insolvent immediately before the discharge, she is only insolvent by $20,000, so the

16
17
18
19

Priv. Ltr. Rul. 9125010.

Priv. Ltr. Rul. 9932013.
TAM 199935002.
IRC 108(a)(3).

12

exclusion from income is limited to that amount; the remaining $10,000 of COD income
is taxable to Jane.
An issue that sometimes arises when the insolvency exclusion is sought involves the proper inclusion of
contingent liabilities in the calculation. Consider, for example, the case of Dudley Merkel and David
Hepburn.20 Dudley and David were officers of Systems Leasing Corp. and, as such, each had guaranteed
a loan to the corporation from a bank. Additionally, there was an outstanding state sales tax assessment
against the corporation.
A settlement agreement was negotiated with respect to the loan that involved the corporation paying
the bank a reduced amount. Furthermore, the settlement agreement provided that, if the corporation,
Dudley, and David were all able to avoid bankruptcy for a specified period of time, the bank would
release Dudley and David from their guarantees. With respect to the sales tax assessment, the state had
not asserted any claims against Dudley or David, although, as corporate officers, they could have been
personally responsible for the sales taxes. As such, Dudley and Davids obligations on the personal
guarantees and for the sales tax assessment were both contingent.
The IRS argued that the liabilities should not be recognized for tax purposes unless and until the all
events test21 was satisfied. These contingent obligations, according to the IRS, represented the mere
possibility of liabilities in the future that were dependent on the occurrence or nonoccurrence of future
events, and therefore should play no role in the insolvency calculation.
The IRS relied on the Tax Courts decision in Landreth v. Commissioner22 to support its argument. In that
case the court had decided that a guarantor does not realize income when the principal debtor makes
payments on the loan. Since release of the guarantees would not result in Code 108 income, argued
the IRS, "Congress could not have intended for taxpayers to use that very same debt to render
themselves insolvent under that section."23
The Tax Court rejected the IRS argument that the all events test was the appropriate criteria. Rather,
to be included as a liability for purposes of the insolvency analysis, the court held that the taxpayer must
show that it is more probable than not that he or she will be called upon to pay that obligation.
As to the bank obligation, the taxpayers had the burden of showing that it was more probable than not
that either the corporation or one of them would be in bankruptcy by the specified date. While the
record in the case indicated that the corporation was experiencing some cash flow problems, that alone
did not prove the probability of bankruptcy. Furthermore, neither of the individuals provided sufficient
details of their personal financial situations from which the court could draw a conclusion as to the
probability of either of them filing bankruptcy.
20

th

Merkel v. Commissioner, 109 TC 463 (1997), affd 192 F.3d 844 (9 Cir. 1999).
The all events test is a requirement that must be met in order for an accrual method taxpayer to report an
item of expense. Under that test, all the events which determine the existence of liability must have occurred. Reg.
1.461-1(a)(2).
22
50 T.C. 803 (1968).
23
Merkel, supra.
21

13

Finally, there was no evidence that the state would impose personal liability on Dudley and David for the
sales tax assessment. Thus the contingent liabilities could not be counted in the insolvency analysis
under the courts more probable than not standard. Although not relevant for the purposes of this
case, it is interesting to note that subsequent events revealed that neither the personal guarantees nor
the sales tax assessment ever resulted in any actual liability for Dudley and David.
Unfortunately for these two corporate officers, although the Tax Court rejected the reasoning of the IRS,
it agreed with the governments conclusion that the contingent liabilities should not be counted in the
insolvency analysis. The standard of more probable than not established by the court now sets forth
the criteria upon which the inclusion of liabilities is to be judged.
Note that the more probable than not criteria does not mean that there has to be imminent payment
required for a debt to be counted. For example, a judgment to which the taxpayer is subject will
generally be counted, even if no attempt has been made to satisfy or execute upon the judgment.
Gerald and Nancy Tobermans case illustrates this point.
Gerald Toberman presented testimony to the Tax Court that he was insolvent by at least two to three
million dollars based on notices of judgments that he presented as evidence. The Tax Court found that
this evidence was vague and conclusory and that taxpayer had failed to provide any details ... as to ...
the specific liabilities he claims to have owed.24 The U.S. Court of Appeals for the Eighth Circuit
disagreed, noting that evidence of the existence of the judgments was sufficient to count them as
liabilities in the insolvency analysis.
Practice Tip:
When relying on the insolvency exception to exclude COD income, be sure to document
each liability with promissory notes, statements, judgments, or other written evidence
of the actual amount due.
Nonrecourse debt is always included in the insolvency calculation up to the fair market value of the
property it secures. Excess nonrecourse debt is the amount of the nonrecourse debt that exceeds the
fair market value of the property securing it. This excess is included in the insolvency calculation only to
the extent that it is cancelled (i.e., the nonrecourse note is written down by the lender).
Example:
Phil owns an office building which is now worth $800,000 that secures a nonrecourse
note of $1 million. He has other assets valued at $100,000 and recourse debts of
$50,000. Suppose the recourse lender forgives $10,000 of the recourse debt. Phils
pre-discharge assets are worth $900,000 ($800,000 building + $100,000 in other assets)
and his pre-discharge debts are $850,000, because the nonrecourse debt only counts up
to the value of the building. Thus, Phil is not insolvent and the $10,000 of COD income
cannot be excluded under the insolvency exception.

24

Toberman v. Commissioner, T.C. Memo 2000-221.

14

Suppose, however, Phil convinces the nonrecourse lender to write the note down by
$200,000 to the current value of the building. Since the $200,000 excess nonrecourse
debt is being discharged, it now counts as a liability for the insolvency analysis. If this is
the case, Phil is now insolvent by $150,000 ($900,000 - $800,000 nonrecourse note $200,000 excess nonrecourse discharge - $50,000 recourse debt) and the $10,000 of
COD income is excluded.
Practice Tip:
Whenever a debtor owns property subject to a nonrecourse loan that has fallen in value
and the debtor is being discharged from other debts, it may be prudent to negotiate a
reduction of all or a portion of the excess nonrecourse debt to enhance the taxpayers
ability to exclude COD income. Since in a defaulted nonrecourse loan the lender can
only recoup the value of the property, the lender may be willing to write the note down
to this amount.
Note that foreclosure on real property subject to recourse debt comprising the taxpayers entire interest
in a passive activity is a fully taxable transaction for purposes of the passive activity loss rules, regardless
of whether any COD income is excluded under the insolvency exception. For example, suppose in Year 1
a taxpayer purchases real property for $1,000,000 and finances the purchase with a recourse mortgage
of $1,000,000. Assume the taxpayer leases the property to a third party, the rental activity is a passive
activity, and the real property constitutes the taxpayers entire interest in the passive activity.
Suppose the rental property accumulates net losses of $100,000 over three years and those losses are
suspended under the passive activity loss rules and carried forward to Year 4. In that year the taxpayer
defaults on the debt and the lender forecloses the mortgage. Assume the fair market value of the
property at the time of foreclosure is $825,000, that the taxpayers adjusted basis in the property is
$800,000, and that the remaining balance on the debt is $900,000 at the time of the foreclosure. Also,
assume the taxpayer is insolvent with liabilities exceeding assets by $200,000 at the time of the
foreclosure and the mortgagee cancels the remaining $75,000 debt after the foreclosure.
As a result, the taxpayer would have $25,000 gain on the foreclosure ($825, 000 fair market value $800,000 adjusted basis), and $75,000 of COD income ($900,000 debt - $825,000 fair market value). The
COD income would be excludable from gross income under 108(a)(1)(B).
Under Code section 108(b)(2)(F) any COD income from the taxable year of the discharge reduces any
passive activity loss and credit carryover of the taxpayer from the year of the discharge. However, under
Code section 108(b)(4), reductions to tax attributes are made after determination of tax for the year of
discharge. As a result, in this situation the taxpayer would not reduce the $100,000 of freed-up passive
losses by the $75,000 of COD income that is excludable.25

25

IRS ILM 201415002.

15

Qualified Farm Indebtedness

Code 108(a)(1)(C) provides an exclusion of COD income for qualified farm indebtedness. Qualified
farm indebtedness is debt that was incurred directly in connection with the operation by the taxpayer of
the trade or business of farming.26 Additionally, in order to be qualified farm indebtedness, 50% or
more of the aggregate gross receipts of the debtor for the three tax years preceding the discharge must
be attributable to the trade or business of farming.27
In addition to the qualifications that must be met by the debtor, the cancellation must be made by a
lender who that meets certain requirements. Specifically, the lender must be a person who is actively
and regularly engaged in the business of lending money and who is not:
1. a related person with respect to the debtor;
2. a person from which the debtor acquired the property (or a related person to such person); or
3. a person who receives a fee with respect to the debtors investment in the property (or a
related person to such person).28

Qualified Real Property Business Indebtedness

The Revenue Reconciliation Act of 1993 added qualified real property business indebtedness to the list
of exclusions from COD income. Qualified real property indebtedness includes debt that is: (1) assumed
or incurred in connection with the taxpayers trade or business, and (2) secured by real property.29 This
exclusion only applies to taxpayers other than C corporations and does not apply if either the
bankruptcy or insolvency exception applies.
In 2014 the IRS issued guidance regarding indebtedness secured by 100 percent ownership interest in a
disregarded entity that holds business real property.30 Under this guidance, indebtedness secured by
the ownership interest in a disregarded entity is treated as if it were secured directly by the property for
purposes of the exclusion for qualified real property business indebtedness.
Revenue Procedure 2014-20 provides a safe harbor that applies to the discharge of indebtedness of any
taxpayer, other than a C corporation, if certain requirements are met. If a taxpayer does not meet the
safe harbor requirements, the exclusion may nonetheless apply if the facts and circumstances indicate
that the debt is actually secured by the property.
Those requirements include that the taxpayer incurs the debt and owns 100 percent of the ownership
interest in a disregarded entity that in turn owns real property. The taxpayer must give the lender a first
priority security interest in its ownership interest in the entity holding the property. Furthermore, at
least 90 percent of the fair market value of the total assets (immediately before the discharge) directly
owned by the disregarded entity must be real property used in a trade or business. Any other assets
held by the disregarded entity must be incidental to its acquisition, ownership, and operation of the real
26
27
28
29
30

IRC 108(g)(2)(A).
IRC 108(g)(2)(B).
IRC 49(a)(1)(D)(iv).
IRC 108(a)(1)(D).
Rev. Proc. 2014-20.

16

property. Finally, the safe harbor requires that on default and foreclosure, the lender replaces the
taxpayer as the sole member of the property owner.
The amount of COD income excludible under this exception is limited to the excess (if any) of the
outstanding principal amount of the qualified real property business indebtedness immediately before
the discharge over the fair market value of the real property immediately before the discharge (net of
the amount of any other qualified real property business indebtedness secured by the property at that
time).
Example:
Joe owns a building that is used in a trade or business. The building is worth $150,000
and is subject to a first mortgage securing Joe's debt of $110,000 and a second
mortgage securing Joe's debt of $90,000. Joe agrees with the second mortgagee to
reduce the second mortgage debt to $30,000, resulting in a $60,000 discharge of
indebtedness. Joe may elect to exclude $50,000 of the discharge of indebtedness from
gross income. This is because the principal amount of the discharged debt immediately
before the discharge ($90,000) exceeds the fair market value of the property minus the
first mortgage debt ($150,000 $110,000) by $50,000. The remaining $10,000 of
discharge is included in gross income.31
In order to take advantage of this exclusion, the taxpayer must have an aggregate tax basis in all of his or
her depreciable real property sufficient to absorb the exclusion. If in the above example Joes aggregate
basis in his depreciable property was only $30,000, then the exclusion would be limited to $30,000 and
the remaining $30,000 of COD income would be taxable. For this purpose, the tax basis of depreciable
real property is determined after depreciation for the year of discharge is taken into account.
Furthermore, the taxpayer must affirmatively elect to use this exclusion. The election is made by
attaching a properly completed IRS Form 982 to a timely-filed income tax return (including extensions)
for the tax year in which the taxpayer is excluding the COD income.
Finally, use of this exclusion results in a reduction in the taxpayers basis in depreciable real property,
beginning with the property that secured the debt being discharged. The basis of other real property
held by the taxpayer is reduced in proportion to its relative adjusted basis. The tax effects of this basis
reduction is absorbed over the remaining depreciable life of the property, due to the loss of
depreciation deductions. The resulting increased capital gain will not be experienced until the property
is eventually sold.
Practice Tip:
Electing this exclusion avoids having to reduce other favorable tax attributes. Assume
the taxpayer has a net operating loss (NOL) carryforward that could be used in the
next tax year. If the taxpayer does not expect to dispose of the business real property

31

H Rept No. 103-111 (PL 103-66) p. 623.

17

for several years, using this option preserves the NOL for immediate use while
postponing most of the tax effects of the basis reduction.

Qualified Principal Residence Indebtedness

Taxpayers can also exclude from income any discharge of qualified principal residence indebtedness
that occurs between January 1, 2007 through December 31, 2014. The term qualified principal
residence indebtedness means debt that was used to acquire, build, or improve the principal residence
of the taxpayer, including the refinancing of such debt (up to the outstanding principal amount at the
time of refinancing). It does not matter if the mortgage is a first or second mortgage, as long as it was
used to acquire, build, or improve the home.
For purposes of Code section 108, therefore, qualified principal residence indebtedness has the same
meaning as acquisition indebtedness in Code section 163(h)(3)(B). Code section 108(h)(5) also makes
clear that principal residence for this purpose has the same meaning as in Code section 121 dealing
with the exclusion of gain on the sale of a principal residence. That section requires that, during the
5-year period ending on the date of the sale or exchange, such property has been owned and used by
the taxpayer as the taxpayers principal residence for periods aggregating 2 years or more. Therefore the
COD exclusion applies to a residence owned and used for 2 or more years during the 5-year period
ending with the discharge.
Similar to the rules related to the exclusion for qualified real property business indebtedness, this
exclusion is limited to the adjusted basis of the principal residence and that basis must be reduced by
the amount of the exclusion.
Said and Nargis Koriakos discovered that these definitions are important. The couple owned a home in
Arizona, but after a temporary job assignment in Florida, they became enamored with a lifestyle near
the water and decided to move to the sunshine state. To facilitate the purchase of a new Florida home,
the Koriakoses obtained a home equity line of credit from Wells Fargo in the amount of $146,850, which
was secured by their Arizona home. Shortly thereafter they purchased a single-family residence in Palm
Harbor, Florida and promptly moved in. The Florida home was purchased for cash, which was
accomplished, in part, by maxing out the Wells Fargo line of credit.32
After buying the Florida home, the couple abandoned their Arizona home and ceased paying its
mortgage. The Arizona home was subsequently foreclosed upon and sold at auction. Wells Fargo gave
up on collecting the equity line and issued a Form 1099-C to the Koriakoses indicating $146,850 as
cancelled debt.
There was no question that the Florida home had become the couples principal residence by the time
the debt was forgiven. An exclusion, however, would require that the Wells Fargo line of credit be used
to acquire, construct, or substantially improve the same property that secured it. However, the line of
credit was secured by the Arizona home and not by the Florida home. Code section 163(h)(3)(B)(i)
specifically requires that acquisition indebtedness be secured by the residence it is being used to
32

Koriakos v. Commissioner, T.C. Summ. Op. 2014-70.

18

acquire. Thus, because Said and Nargis used the line of credit that was secured by the Arizona home to
acquire the Florida home, Code section 163(h)(3)(B)(i) was not satisfied and the Wells Fargo line of
credit did not constitute qualified principal residence indebtedness. As a result, the $146,850 was
taxable income that could not be excluded.
The exclusion is further limited to $2 million ($1 million for married individuals filing separately).
Practitioners should be careful not to confuse this exclusion with the deduction for home mortgage
interest. While the interest deduction applies up to both a first and second residence, the exclusion only
applies to the principal residence, and taxpayers can have only one principal residence.
Practice Tip:
Note that forgiveness of qualified principal residence indebtedness is most likely to
occur in conjunction with a foreclosure, short sale, or deed in lieu of foreclosure. The
taxpayer will have gain related to such transaction if the deemed sales price exceeds the
taxpayers adjusted basis in the home. That gain, up to $250,000 ($500,000 on a joint
return) can be excluded from income under Code 121. That provision, however,
cannot be used to exclude COD income.
Example:
Harry and Harriet own a home with qualified principal residence indebtedness of
$900,000 and a $50,000 basis. They sell the house in a short sale for $600,000 and the
mortgage company forgives $300,000 of the mortgage note in excess of the sales
proceeds. Harry and Harriet can exclude the $300,000 of COD income, but they have a
gain on the sale in the amount of $550,000 ($600,000 sale proceeds - $50,000 basis).
Since they can only exclude $500,000 of gain under Code 121, they must recognize
$50,000 of capital gain income.
Interaction with Anti-Deficiency Statutes
A number of states, including Arizona and California, have adopted what are often referred to as
anti-deficiency statutes that effectively preclude a creditor from pursuing a debtor for collection of
any deficiency judgment if the value of any collateral ends up being less than the outstanding loan
balance at the time the debt is discharged. Thus, an issue regarding COD arises in these states when a
mortgage creditor approves a short sale which, by operation of state law, mandates a discharge of the
remaining liability.
The IRS has opined that a homeowners obligation under the anti-deficiency provision of California law
would be a nonrecourse obligation. As such, for federal income tax purposes, the homeowner will not
have cancellation of indebtedness income as a result of a short sale. Instead, the homeowner must
include the full amount of the nonrecourse indebtedness in amount realized from the sale.33

33

IRS ILN 2013-0036 (December 27, 2013).

19

Practice Tip:
Anti-deficiency statutes exist in various forms in a number of states. Some of these
statutes apply only to non-judicial foreclosures and there are a variety of limitations.
When a client undergoes a foreclosure, state law should be consulted to ascertain the
specific result with regard to COD income.

Student Loans
The final statutory exclusion from COD income listed in Code 108 is the exclusion for certain student
loans.34 Under this provision COD income does not include a student loan cancellation made because of
the public service work performed by the student borrower, including state loan repayment or loan
forgiveness programs that are intended to provide for the increased availability of health care services in
underserved or health professional shortage areas.35
To qualify for this exclusion, the cancellation must be made pursuant to a provision in the loan
agreement itself under which all or part of the indebtedness of the individual is cancelled if the
borrower works for a certain period of time in certain professions for any of a broad class of
employers.36 Thus the loan may provide for cancellation in the event the borrower works as a health
professional in a rural hospital. On the other hand, the loan agreement cannot require that the
borrower work for a specific hospital or in any profession.37 In no case may the exclusion apply if the
required services are performed for the organization lending the money.
Generally these programs are designed to encourage students to serve in occupations with unmet needs
or in geographic areas with unmet needs. Typically the work is under the direction of a governmental
unit or a charitable organization.

Discharge of Indebtedness
A Gift of Forgiveness
Under Code 102, gifts are not included in income. It makes sense, therefore, that a gift made in the
form of a discharge of indebtedness does not trigger COD income under Code 108. The remaining
issue is whether or not a particular debt cancellation in fact constitutes a gift.
A gift is defined as a nonreciprocal transfer made from detached and disinterested generosity, out of
affection, respect, admiration, charity or like impulses. A transfer is not a gift if it is primarily the result
of a legal or moral duty, or is a reward for services rendered, or is made because of the incentive of an
anticipated benefit of an economic nature. The precise purpose of the transfer is determined with
reference to the intention of the transferor.38

34
35
36
37
38

IRC 108(f).
IRC 108(f)(4).
IRC 108(f).
Porten v. Commissioner, T.C. Memo 1993-73.
Commissioner v. Duberstein, 363 U.S. 278 (1960).

20

Donative intent, however, is difficult to discern, particularly in the commercial context. An illustrative
case involved a company called American Dental. That company had debt from notes issued on past due
purchases of merchandise and was also in arrears on its rental payments. The companys creditors
agreed to cancel the accrued interest on the notes issued on the past merchandise purchases after a
certain date and the company negotiated a reduced sum for the back rent owed. American Dental did
not report either the forgiveness of the accrued interest or the back rent as income, taking the position
that the cancellations of debt were gifts.
The case eventually made its way to the Supreme Court, which agreed with American Dental. The Court
found that [t]he forgiveness was gratuitous, a release of something to the debtor for nothing, and
sufficient to make the cancellation here gifts within the statue.39 In another case the Tax Court found
that the cancellation of previously deducted back rent in connection with renewal of lease was gift, and
the U.S. Court of Appeals for the Eighth Circuit agreed.40 It has also been held by a court that an
employer's cancellation of employee's debt because of employee's financial need was gift rather than
compensation.41
Congress, however, decided that treating transfers made in a commercial or business context as gifts
was a dangerous precedent, and feared that the gift exception to income inclusion was subject to too
much opportunity for abuse under these circumstances. As a result, the Code now provides that
transfers from an employer to an employee do not constitute gifts.42 Furthermore, the legislative
history related to Code 108 indicates that there should be no gift exception to COD income in a
commercial context.43 Thus, the American Dental case and the other cases discussed above would likely
be decided differently in light of the current statute if they were to be litigated today.

The Reduction in Purchase Price

An Exception to the Rule
If a debt is purchase money debt, a special exception to the COD income rules applies. Purchase
money debt is seller financing, e.g., when the seller of the property also provides the loan to purchase
the property. When the seller/lender reduces the amount of debt, it is usually because the buyer has
successfully argued that he or she was overcharged by the seller in the first place. Thus, the
presumption when a seller/lender cancels part or all of the remaining debt is that the transaction is in
reality just a purchase price reduction, not a cancellation of debt in the true sense.
However, this exception applies only if the reduction would otherwise have been treated as COD income
to the buyer and neither the bankruptcy or insolvency exceptions apply. A debt reduction would not be

39
40
41
42
43

Helvering v. American Dental Co., 318 U.S. 322, 331 (1943).

Reynolds v. Boos, 188 F.2d 322 (8th Cir. 1951)
Clem v. Campbell, 62-2 USTC 9786 (N.D. Tex. 1962).
IRC 102(c)(1).
H.R. Rep. No. 833, 96th Cong., 2d Sess. 15 (1980); S. Rep. No. 1035, 96th Cong., 2d Sess. 19 (1980).

21

treated as COD income, for example, where the forgiveness is treated instead as a sale or exchange,44
or where the seller is a shareholder of the buyer and the reduction is a contribution to the buyer's
capital.45
It is imperative that the debt involved be specifically between the original buyer and the original seller. If
the debt is transferred by the seller to a third party or the purchased property is transferred by the
buyer to a third party, the purchase price adjustment exception will not apply.

Attribute Reduction
Exclusion of Income Based on Statutory Exceptions
Being able to exclude cancellation of debt (COD) income comes with a toll charge. Code 108(b)
provides that, If a taxpayer qualifies for one of the statutory exceptions resulting in exclusion of the
cancelled debt from income, the taxpayer must reduce certain favorable tax attributes by the amount
excluded from income.
Congress enacted 108 to provide relief by providing temporary tax relief for financially-strapped
debtors. Although ultimate exclusion from income may be the result, the general approach of Code
section 108 is deferral.46 The idea is to spread the immediate tax burden from COD income over a
subsequent period in which the debtor will presumably have cash flow. The manner of accomplishing
this is to require that the taxpayer reduce certain favorable tax attributes that could otherwise be used
to reduce the taxpayers tax burden in the future.
Note that the gift and purchase money exceptions provide that there is no COD income rather than
providing for an exclusion of such income; therefore these circumstances do not require attribute
reduction. The same is true with respect to the cancellation of certain student loans in return for public
service performed by the student.
The tax attributes, listed in the order in which they must be reduced, are as follows:
1. Net operating loss (NOL) and NOL carryforwards. Any net operating loss for the taxable year
of the discharge, and any net operating loss carryover to such taxable year, must first be
reduced dollar for dollar by the amount of COD income excluded.
2. General business credit. Next, any carryover to or from the taxable year of a discharge of an
amount allowable as a credit under Code 38 (relating to general business credit) must be
reduced by 33 cents for each dollar of remaining exclusion.
3. Minimum tax credit. Each dollar of remaining exclusion will reduce year by 33 cents the
minimum tax credit that would otherwise have been available under Code 53(b) as of the
beginning of the next taxable.
44
45
46

Sands v. Commissioner, T.C. Memo 1997-146.

Priv. Ltr. Rul. 9822005.
See H.R. REP. No. 96-833, at 8-9 (1980)

22

4. Capital loss carryovers. If the foregoing has not fully absorbed the amount of COD income
excluded, then any net capital loss for the taxable year of the discharge, and any capital loss
carryover to such taxable year under Code 1212 is reduced dollar for dollar.
5. Basis reduction. Next, the taxpayers basis in assets is reduced dollar for dollar. First, the
taxpayer reduces the basis of real property used in a trade or business (other than inventory) or
held for investment that secured the discharged indebtedness immediately before the
discharge. The taxpayer then reduces the basis of personal property used in a trade or business
or held for investment (other than inventory, accounts receivable, and notes receivable) that
secured the discharged indebtedness immediately before the discharge. After that the basis of
any remaining property used in a trade or business or held for investment (other than inventory,
accounts receivable, notes receivable) is reduced. Next come inventory, accounts receivable,
notes receivable, and real property held as inventory. Finally, the taxpayer must reduce the
basis of any property not used in a trade or business nor held for investment, including the
taxpayers home.
6. Passive activity loss and credit carryovers. If the first five categories of tax attribute reductions
do not equal the full amount of COD income excluded under Code 108, the taxpayer must next
reduce any passive activity loss or credit carryover by 33 cents for each dollar of excluded COD.
7. Foreign tax credit carryovers. Finally, if none of the foregoing tax attribute reductions absorb
the amount of COD income excluded, the taxpayer reduces any carryover of foreign tax credits
by 33 cents for each dollar of remaining exclusion.
If these tax attribute reductions do not equal the amount of COD income that the taxpayer excludes
under Code 108, there is no additional effect on the taxpayer. There is no recapture of excess excluded
amounts. In other words, any remaining exclusion is without tax consequence to the taxpayer.
Alternatively, the taxpayer may elect to reduce the basis of depreciable property instead of reducing the
tax attributes listed above. This may be prudent if some or all of the tax attributes that would otherwise
have to be reduced could be utilized by the taxpayer relatively quickly. By electing to reduce the basis of
depreciable property instead, the tax effects are spread out over the remaining depreciable life of the
property in the form of lost depreciation deductions. Of course, if this election is made the exclusion is
limited to the aggregate adjusted basis in the taxpayers depreciable property.
The election to reduce basis rather than other tax attributes is made by attaching IRS Form 982,
Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to the
taxpayers return for the year in which the cancellation occurs. This form is also used to report both the
exclusion from income itself and the corresponding tax attribute reduction in the event the basis
reduction election is not made.
Note that the taxpayer may or may not receive an information return indicating the income from the
cancellation of debt. IRS Form 1099-C is only required to be filed by certain lenders, most notably
financial institutions and lenders having a significant trade or business of lending money. Otherwise, the
lender cancelling the debt is under no obligation to report it on a Form 1099 or otherwise. Note that
23

Instead of issuing a Form 1099-C, a cancellation of debt related to the foreclosure of a residence by a
lending institution may be reported on Form 1099-A.

Guarantees
General
A guarantor does not realize COD income upon the release of a contingent liability. The Tax Court has
observed that the situation of a guarantor is not like that of a debtor who as a result of the original loan
obtains a nontaxable increase in assets. Rather, the guarantor obtains nothing except perhaps a taxable
consideration for his promise. Where a debtor is relieved of his obligation to repay the loan, his net
worth is increased over what it would have been if the original transaction had never occurred. This
constitutes an accretion to wealth clearly realized and thus is taxable under the principles of Glenshaw
Glass. However, where the guarantor is relieved of his contingent liability, either because of payment by
the debtor to the creditor or because of a release given him by the creditor, no previously untaxed
accretion in assets thereby results in an increase in net worth. A lack of understanding of these
principles may lead the IRS to an erroneous conclusion, as was the case with respect to the audit of a
dentist and his wife that wound up in Tax Court in 2014.47
Howard Mylander was a dentist in Baker City, Oregon. His wife, Jacquelyn, was a homemaker. They lived
together in Nampa, Idaho, approximately 110 miles from Baker City. Sometime in the 1980s, the
Mylanders were involved in a real estate development project in Fairfield, Idaho, called Hidden Paradise
Ranch. They invited Glenn Koch, a businessman and a friend of Dr. Mylander, to invest $400,000 to help
finance the construction of a golf course in Hidden Paradise. After reviewing the project Koch agreed to
invest provided that Howard and Jacquelyn personally guaranteed his investment. The Mylanders
agreed to pay Koch $400,000 in the event that Hidden Paradise went under, and Koch then invested the
$400,000. As often happens, the Hidden Paradise project subsequently failed, and Koch did not receive
any return on his $400,000 investment. Unhappy, Koch not surprisingly sought payment from the
Mylanders.
Around the same time, the Mylanders met Rodney and Katherine Ledbetter. The Ledbetters had
engaged in an unrelated business venture with a man named Hershell Murray. That venture failed
sometime in the late 1980s. In 1989 the Ledbetters filed for bankruptcy and Murray filed a claim against
the Ledbetters in the bankruptcy action alleging that the Ledbetters had defrauded him of money.
Murray and the Ledbetters reached an agreement whereby Murray agreed to settle his claim in the
bankruptcy action in exchange for $500,000 in promissory notes from the Ledbetters. Under the terms
of the promissory notes, the Ledbetters were jointly and severally liable to Murray for $500,000, plus
interest, over five years. Murray conditioned the deal on the Mylanders' guaranteeing $300,000 of the
$500,000 debt.

47

Mylander v. Commissioner, T.C. Memo 2014-191.

24

Rodney Ledbetter convinced the Mylanders to guarantee the $300,000 by promising to pay off the Koch
debt. Ledbetter owned a convenience store in Nevada, which he led the Mylanders to believe was worth
at least $400,000 and could be transferred to Koch to satisfy the Koch debt in full. Ledbetter also
promised to indemnify the Mylanders for any payments they made to Murray under the guaranty. With
Howard and Jacquelyn Mylander on board, the Ledbetters entered into a stipulation agreement with
Murray to pay the $500,000, plus interest, over five years.
To that end, Howard Mylander signed an Unconditional Continuing Guaranty stating that he
unconditionally guaranteed and became surety for the full and prompt payment to Murray at maturity,
whether by acceleration or otherwise, and at all times thereafter, the principal amount of $300,000. The
guaranty was later amended to include Jacquelyn as a guarantor.
Ledbetter then transferred his ownership interest in the Nevada store to Koch. Unfortunately, none of
the other parties knew that the Ledbetters had leveraged the store to the hilt, leaving it with very little
equity. As the new owner, Koch became obligated to service the debt on the store, which required him
to pay more than $50,000 each month. Needless to say, Koch soon realized the Nevada store was
essentially worthless and found a buyer who agreed to purchase it for an amount equal to what he had
paid servicing the debt up until that point, in addition to assuming the liabilities. Because no part of the
Koch debt was satisfied by the transfer and sale of the Nevada store, the Mylanders remained obligated
to pay the full $400,000 to Koch, which they eventually did.
The Ledbetters, on the other hand, where not so conscientious and did not make any payments on their
promissory notes to Murray. Consequently, pursuant to the guaranty, Murray obtained a state court
judgment against the Mylanders for $310,000. The Ledbetters sent several checks to the Mylanders,
ostensibly to meet their obligations under the indemnity; however, each of those checks was returned
to for insufficient funds and the Mylanders ended up receiving nothing of value from the Ledbetters.
Eventually, after the Mylanders had paid down the Murray debt substantially, Howard and his
colleagues sold their dental practice. With extra cash on hand from the sale of the dental practice, he
offered to pay Mr. Murray a lump sum of about one-half the balance if he would agree to forgive the
remaining amount. Murray accepted the offer.
The Mylanders did not report any of this forgiveness as COD income. Upon audit, the IRS asserted that
the amount forgiven by Murray was taxable income and proposed a deficiency. The IRS, however, was
wrong, and that was because they misinterpreted the guaranty.
The guaranty in this case created a contingent liability because the Mylanders obligation to make a
payment under the guaranty was contingent upon the Ledbetters' failure to pay the debt. The court
found no merit in the IRSs argument that the guaranty was not contingent because it was not
conditioned upon any other party signing it. By definition, a guaranty creates a secondary obligation
under which the guarantor promises to be responsible for the debt of another. The guarantor is only
secondarily liable and only becomes obligated on the debt in the event the debtor does not perform the
primary obligation.

25

The IRS also argued that this case was special because the Mylanders received consideration in
exchange for the guaranty. Specifically, the IRS argued that the Ledbetters' transfer of the Nevada store
to Mr. Koch constituted taxable consideration to the Mylanders and, therefore, the transfer of the store
constituted COD income. The Mylanders pointed out that the consideration received (i.e., the transfer of
the Nevada store from Ledbetter to Koch) had no value and any taxable consideration received by a
guarantor in exchange for his guaranty is recognized for the year in which it is received and,
consequently, does not affect the existence or treatment of COD income.
Again the Tax Court was persuaded by the Mylanders, pointing out that they entered into the guaranty
with Murray in exchange for the Ledbetters' promise to satisfy the Koch debt and to indemnify the
Mylanders for any loss they might incur with respect to the guaranty. The Ledbetters, however, did not
keep either promise. While they did transfer the Nevada store to Koch, it was leveraged to the hilt and
had no value. As a result, the Mylanders obligation to Koch was not reduced at all by the transfer of the
store, and they were required to (and did) pay the Koch debt in full. Then, when the Ledbetters
defaulted and the Mylanders began making payments on the Murray debt, the Ledbetters sent checks
to them that were returned for insufficient funds. The Ledbetters made no good faith attempts to make
good on their indemnity. Therefore, the court found that the Mylanders did not receive any valuable
consideration in exchange for the guaranty.
In the alternative, the IRS asserted that the Mylanders must recognize COD income because they
became primary obligors on the Murray debt when the Ledbetters defaulted. It certainly is true that .
default on the primary contract by a debtor ripens an unconditional guaranty into an actionable
liability of the guarantor separate and apart from that of the principal debtor. At that point the
guarantors obligation becomes absolute and is no longer secondary. This argument, however, illustrates
an incorrect application of the economic rationale that renders COD income taxable in the first place.
True enough, when the Ledbetters defaulted, a cause of action against the Mylanders accrued to
Murray, which led to a state court judgment against them and the subsequent covenant not to execute.
Under the state court judgment as well as the covenant not to execute, the Mylanders secondary
obligation became a primary obligation.
However, even if they had become primary obligors on the Murray debt, they did not realize any COD
income when the remaining debt was forgiven because they did not receive the benefit of the
non-taxable proceeds from the loan obligation. Unlike a debtor who borrows funds, a guarantor who
assumes a contingent liability does not receive an untaxed accretion of assets which is accompanied by
an offsetting obligation to pay. This remains the case even after the guarantor becomes a primary
obligor because of the debtors default. Regardless of whether the guarantor is a secondary obligor or
has become a primary obligor, when the debt is discharged the guarantors net worth is not increased
over what it would have been if the original transaction had never occurred.
Applying the economic rationale of the COD income rules correctly, the Tax Court concluded that the
Mylanders did not receive any untaxed accretion of assets when they gave the guaranty. Nor did they
receive any untaxed accretion of assets with respect to the guaranty when they later became primarily
26

liable on the Murray debt as a result of the state court judgment. Therefore, when the remaining debt
was forgiven, the Mylanders did not realize an untaxed increase in wealth any more than had they
remained secondary obligors.

Recourse vs. Nonrecourse Debt

In General
Recourse debt is defined as an amount of debt as to which a taxpayer is liable, regardless of the value of
property securing the debt. Nonrecourse debt, in contrast, limits the creditor to the value of the
property securing the debt; if the property value is insufficient, the nonrecourse debtor has no liability
for the shortfall.
Discharge of nonrecourse debt does not generally result in COD income.

Acquisition of Debt by Related Parties

In General
COD income may be triggered when debt is acquired by a party that is related to the debtor.48 For
purposes of the COD rules, the debtor is deemed to acquire the indebtedness (and therefore retire it)
when a party related to the debtor makes the acquisition. Since such acquisition does not involve the
payment of the debt by the debtor, the acquisition itself triggers the COD income rules.49
For this purpose a related party includes:
1. ancestors, lineal descendants, spouses, brothers and sisters (whether by the whole or
half-blood);
2. an individual and a corporation more than 50 percent in value of the outstanding stock of which
is owned, directly or indirectly, by or for such individual;
3. two corporations which are members of the same controlled group (as defined in subsection
(f));
4. a grantor and a fiduciary of any trust;
5. a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both
trusts;
6. a fiduciary of a trust and a beneficiary of such trust;
7. a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both
trusts;
8. a fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock
of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor
of the trust;

48
49

Reg. 1.108-2.
Reg. 1.108-2(a).

27

9. a person and an organization to which Code 501 (relating to certain educational and charitable
organizations which are exempt from tax) applies and which is controlled directly or indirectly
by such person or (if such person is an individual) by members of the family of such individual;
10. a corporation and a partnership if the same persons own more than 50 percent in value of the
outstanding stock of the corporation and more than 50 percent of the capital interest, or the
profits interest, in the partnership;
11. an S corporation and another S corporation if the same persons own more than 50 percent in
value of the outstanding stock of each corporation;
12. an S corporation and a C corporation, if the same persons own more than 50 percent in value of
the outstanding stock of each corporation;
13. except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an
estate and a beneficiary of such estate.
14. a partnership and a person owning, directly or indirectly, more than 50 percent of the capital
interest, or the profits interest, in such partnership; and
15. two partnerships in which the same persons own, directly or indirectly, more than 50 percent of
the capital interests or profits interests.
Example:
Jim owes Roberta $5,000 on a promissory note he gave to Roberta last year. Jims
brother Bill purchases the promissory note from Roberta. Upon the purchase of the
promissory note by Bill, Jim is deemed to have received COD income unless it is
otherwise excluded under the general rules of Code 108 discussed above.

Exceptions
The related party acquisition rules, however, do not apply to indebtedness with a stated maturity date
that is within one year after the date on which the acquisition occurs, if the indebtedness is, in fact,
retired on or before its stated maturity date.50
Example:
Jim owes Roberta $5,000 on a promissory note that becomes due and payable on
November 1, 20X1. On January 10, 20X1 Jims brother Bill purchases the promissory
note from Roberta. Assuming the note actually is retired by November 1, 20X1 (by Jim
paying the amount owed to Bill or by Bill forgiving the amount due as a gift to Jim),
there is no COD income triggered by the acquisition. If, however, the note remains
unpaid and outstanding after November 1, 20X1, the acquisition triggers COD income to
Jim.
In addition to the exception from the related party acquisition rules noted above, acquisitions of
indebtedness by securities dealers in the ordinary course of their business will not trigger the COD
income rules.51

50
51

Reg. 1.108-2(e)(1)
Reg. 1.108(e)(2).

28

Alternative Minimum Tax

The Purpose
Currently, COD income does not give rise to an alternative minimum tax preference.52 For taxable years
beginning before 1990, a corporation that excluded COD income could become subject to the
alternative minimum tax because alternative minimum taxable income included 50% of the excess of
adjusted net book income of the corporation over alternative minimum taxable income. Adjusted net
book income included COD income that had been excluded from gross income under Code 108(a).
Subsequently, Congress amended Code 56(g)(1) to replace the book income preference with an
adjusted current earnings and profits preference, which generally treats 75% of the excess of adjusted
current earnings over alternative minimum taxable income computed without regard to adjusted
current earnings and profits or the alternative net operating loss deduction as income subject to the
alternative minimum tax.53

Application to S Corporations and Partnerships

S Corporations
Generally, the COD exclusion rules with respect to S corporations are applied at the corporate level.54
However, because S corporations are flow-through entities, they generally do not have net operating
losses. Since the first tax attribute that must be reduced in the event COD income is excluded is the NOL,
a substitute, or deemed NOL must be used in the case of an S corporation. That deemed NOL is the
corporate shareholders aggregate suspended losses that result form basis limitations, as explained
below.55
S corporation shareholders can only deduct flow-through losses to the extent they have basis in their
stock or in loans they have made to the S corporation. Once this basis has been fully absorbed by losses,
any future losses are suspended until such time as the shareholders basis increases (through
corporate earnings or additional capital contributions). As indicated above, the S corporation
shareholders aggregate suspended losses (if any) that exists when S corporation COD income is
excluded is treated as the corporations deemed NOL.
Example:
George owns 60 shares of ABC, Inc., an S corporation, and has a basis of $20 in his
shares. Phyllis owns 40 shares of ABC and has a basis of $30. During the current year,
ABC experiences a loss of $100, $60 of which flows through to George and $40 of which
flows through to Phyllis. Since Georges basis is only $20, he can only recognize that
amount of the loss; the remaining $40 of his share of the loss is suspended. Phyllis can
52
53
54
55

7611(f)(2) of the Revenue Reconciliation Act of 1989,

IRC 56(g)(4)(B)(i).
IRC 108(d)(7)(A).
IRC 108(d)(7)(B).

29

recognize $30 of her share of the loss (her basis) and the remaining $10 loss is
suspended as to her. The shareholders aggregate suspended losses are therefore $50
($40 as to George and $10 as to Phyllis). If the corporation should subsequently have
$50 or more of COD income excluded pursuant to one of the provisions of Code 108,
the shareholders suspended losses would be eliminated through attribute reduction.
A somewhat complicated computational issue arises when the amount of an S corporations deemed
NOL exceeds the amount of the S corporations COD income that is excluded under Code 108. In this
case, the excess deemed NOL (i.e., the amount of the aggregate suspended losses that exceeds the
income exclusion) must be allocated back to the shareholder or shareholders of the S corporation so
that they may continue to be carried forward as suspended losses.56 When there is only one
shareholder, this does not present a problem.
Example:
Assume George is the only shareholder of ABC, Inc., an S corporation. George has $50 of
suspended losses from previous years. During the current year, the S corporation has
$30 of COD income that is excluded under Code 108. Georges suspended losses are
treated as deemed NOL and are reduced by $30 due to tax attribute reduction caused
by the excluded COD income. The remaining $20 reverts back to its former suspended
loss status.
If an S corporation has multiple shareholders, to determine the amount of the S corporations excess
deemed NOL to be allocated to each shareholder, there must be a calculation, with respect to each
shareholder, of the shareholders excess amount. The shareholders excess amount is the amount (if
any) by which the shareholders suspended losses (before any reduction as a deemed NOL) exceed the
amount of COD income that would have been taken into account by that shareholder had the COD
income not been excluded under Code 108.57
Example:
George owns 60 shares of ABC, Inc., an S corporation, and has suspended losses of $100.
Phyllis owns 40 shares of ABC and has suspended losses of $50. ABC has $100 of COD
income during the current year, which is excluded under Code 108. If the COD income
were not excluded, $60 would be allocated to George and $40 to Phyllis. Thus, Georges
excess amount is $40 ($100 - $60) and Phylliss excess amount is $10 ($50 - $40).
Each shareholder that has an excess amount is then allocated an amount equal to the S corporations
excess deemed NOL multiplied by a fraction, the numerator of which is the shareholders excess amount
and the denominator of which is the sum of all shareholders excess amounts.58 If a shareholder does

56
57
58

Reg. 1.108-7(d)(2)(i).
Reg. 1.108-7(d)(2)(ii)(A).
Reg. 1.108-7(d)(2)(ii)(B).

30

not have a shareholders excess amount, none of the S corporations excess deemed NOL is allocated to
that shareholder.59
Example:
In the above example, ABC has an excess deemed NOL of $50 (Georges suspended
losses of $100 plus Phylliss suspended losses of $50, minus the $100 of excluded COD
income). This excess deemed NOL is allocated 100/150 (i.e., 2/3) to George and 50/150
(i.e., 1/3) to Phyllis. As a result, after the attribute reduction caused by the excluded
COD income, George will be left with $33.33 of suspended losses ($50 x 2/3) and Phyllis
will have $16.67 of suspended losses ($50 x 1/3).
Of course, whoever makes these calculations must have access to information about each shareholders
suspended losses. Typically, the corporation itself does not keep track of this information, so each
shareholder must supply it.
Under the regulations, if an S corporation excludes COD income from gross income under Code 108(a)
for a taxable year, each shareholder of the S corporation must report to the S corporation the amount of
the shareholders suspended losses, even if that amount is zero. If a shareholder fails to do so, or if the S
corporation knows that the amount reported by the shareholder is inaccurate, or if the information, as
reported, appears to be incomplete or incorrect, the S corporation may rely on its own books and
records, as well as other information available to the S corporation, to determine the amount of the
shareholders suspended losses. Furthermore, the S corporation must report to each shareholder the
amount of the S corporations excess deemed NOL that is allocated back to that shareholder, even if
that amount is zero.60

Partnerships and Limited Liability Companies

Partnerships and limited liability companies taxed as partnerships under Subchapter K are similar to S
corporations in that they are flow-through entities. However, they are treated much differently for
COD income purposes. Rather than applying Code 108 at the entity level (as with S corporations), Code
108 is generally applied at the partner level.61
As a result, any COD income experienced by the partnership is allocated to the partners pursuant to the
partnership agreement, just like any other income amounts. Each partner then applies the provisions of
Code 108 to determine if his or her share can be excluded and, if so, which of the partners tax
attributes must be reduced.
Where a C corporation or S corporation is a partner, the insolvency determination is made at the
corporate level. However, where a partnership is a partner (i.e., a tiered partnership), the insolvency
determination is made at the level of that partnership's partners.

59
60
61

Reg. 1.108-7(d)(2)(ii)(C).
Reg. 1.108-7(d)(4).
IRC 108(d)(6).

31

Example:
Partnership X has three partners: individual A, Corporation B, and Partnership C. Assume
Partnership Cs partners are Hank and Harry. Partnership X has COD income that flows
through to Individual A, Corporation B, and Partnership C. To determine if the
insolvency exclusion applies to any of the partners, insolvency would be determined by
Individual A, Corporation C, and Hank and Harry as partners of Partnership C(not
Partnership C itself).
The same approach does not hold true, however, with respect to the qualified real property business
indebtedness exclusion under Code 108. The determination of whether debt constitutes qualified real
property business indebtedness is made at the partnership level. Then, the election to apply the
exclusion provision is made at the partner level on a partner-by-partner basis.62
There was also a special provision that allowed partnerships (and limited liability companies taxed as
partnerships) to elect to defer recognition of COD income that occurred in 2009 or 2010.63 If the
election was made, no COD income would be recognized until 2014, and then it would be recognized
evenly over a five year period (2014 2018). Complicated special allocation rules accompanied this
deferral election. Since deferral is no longer available, those rules are not discussed in this course.

Reporting Requirements
Creditor Reporting Requirements in General
In general, any applicable entity that discharges an indebtedness of any person in the amount of $600
or more during the calendar year must file an information return on IRS Form 1099-C. An applicable
entity is either: (1) a government agency; (2) a financial institution or credit union; or (3) any
organization, a significant trade or business of which is the lending of money. Note that companies and
private parties that are not financial institutions and not in the business of lending money have no
requirement to file an IRS Form 1099-C in the event of a cancellation of debt.
Practice Tip:
The 1099 reporting rules are often confusing to taxpayers, and it is not unusual for
lenders that are not applicable entities to file IRS Form 1099-C, even though they are
not required to do so. Note that there is no penalty for filing an IRS Form 1099-C that is
not required (assuming it is accurate). On the other hand, borrowers need to be aware
that they will not necessarily receive a 1099-C reflecting debt that has been cancelled.
Tax preparers should make specific inquiries regarding cancelled debts, and not just rely
on the absence of a 1099-C as evidence that the taxpayer has no COD income.
An applicable entity files an IRS Form 1099-C only when there has been an identifiable event. The
regulations specify seven such identifiable events as follows:
62
63

IRC 703(b)(1).
IRC 108(i).

32

1. A discharge of indebtedness under title 11 of the United States Code (bankruptcy);

2. A cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a
receivership, foreclosure, or similar proceeding in a federal or state court;
3. A cancellation or extinguishment of an indebtedness upon the expiration of the statute of
limitations for collection of an indebtedness, or upon the expiration of a statutory period for
filing a claim or commencing a deficiency judgment proceeding;
4. A cancellation or extinguishment of an indebtedness pursuant to an election of foreclosure
remedies by a creditor that statutorily extinguishes or bars the creditor's right to pursue
collection of the indebtedness;
5. A cancellation or extinguishment of an indebtedness that renders a debt unenforceable
pursuant to a probate or similar proceeding;
6. A discharge of indebtedness pursuant to an agreement between an applicable entity and a
debtor to discharge indebtedness at less than full consideration; and
7. A 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.64
In the case of an expiration of the statute of limitations for collection of an indebtedness, an identifiable
event occurs only if, and at such time as, a debtor's affirmative statute of limitations defense is upheld in
a final judgment or decision of a judicial proceeding, and the period for appealing the judgment or
decision has expired.65
If a taxpayer excludes some or all of the COD income reported to them, the taxpayer is obligated to file
IRS Form 982, Reduction of Tax Attributes of Indebtedness and Basis Adjustment, with their tax return in
the year the canceled indebtedness is reported by their creditor on Form 1099-A and or 1099-C.

Using Form 1099-C as a Collection Device

Practitioners should be aware that there may be Circular 230 implications for a tax professional who, as
an alternative to pursuing collection of an earned fee from a client, files a Form 1099-C with the IRS to
report the amount of the clients unpaid bill as a discharged debt. The IRS Office of Professional
Responsibility (OPR) issued guidance in 2015 in response to a question from a practitioner who
indicated that they wanted to use Forms 1099-C as a collection technique with delinquent or non-paying
clients. The practitioner indicated that the firm periodically wrote-off balance due amounts as
uncollectible based on established criteria. As to those amounts, the firm wanted to complete and file
Forms 1099-C identifying each such client as the debtor and reporting the unpaid account balance as
the amount of debt discharged in box 2 of the form. The firm would simultaneously send Copy B of
the form to the client for purposes of reporting the discharged amount on the client's income tax
return(s). The goal would be to encourage the client to pay, or make him or her report additional
income in an amount equal to the free services obtained.

64
65

Regs. 1.6050P-1(b)(2)(i).
Regs. 1.6050P-1(b)(2)(ii).

33

OPR noted that the provisions in the Code relating to discharge of indebtedness and reporting
discharges on federal tax or information returns are separate and distinct from the provisions governing
practice before the IRS. A tax professional who prepares and submits any form to the IRS, including
information returns filed on their own behalf, should know the purpose of the form, the situations in
which the form must or should be used, and the rules and instructions as to the time and manner for
filing the form.
If a tax professional repeatedly uses Forms 1099-C as a business strategy to collect unpaid fees when the
tax professional knows, or should know, that the facts and circumstances do not provide a basis for
doing so, the conduct calls into question the tax professionals fitness to practice before the IRS. A
pattern of issuing Form 1099-C with a reckless disregard as to the existence of a debt (because, for
example, the former client does not have a fixed contractual liability to repay a sum previously
received), or the absence of an identifiable event triggering a reporting requirement, is inconsistent with
the standards of competency and professionalism embodied in the rules of practice.
A number of provisions concern responsibilities in connection with client communications. Section
330(b)(4) (Title 31), for example, allows for discipline, after notice and proceeding, for a representative
who, with intent to defraud, willfully and knowingly misleads or threatens the person being represented
or a prospective person to be represented. Several provisions of Circular 230 also are relevant, and
should be kept in mind. Section 10.22(a) of Circular 230 requires a tax professional to exercise due
diligence in (1) preparing and filing returns, documents, and other papers relating to IRS matters, (2)
determining the correctness of oral or written representations made by the tax professional to the IRS,
and (3) determining the correctness of oral or written representations made to clients. Section 10.35
requires tax professionals to possess the necessary competence to engage in practice before the IRS.
To be competent, a tax professional must have the appropriate level of knowledge, skill, thoroughness,
and preparation necessary for the matter for which the practitioner is engaged. Section 10.51(a)(4)
identifies as incompetence and disreputable conduct, the giving of false or misleading information to
the Department of the Treasury or any officer or employee thereof.
Code section 6050P, which establishes the requirement to file an information return reporting a
discharge of debt (Form 1099-C), is directed only at applicable entities and excludes from such
reporting any discharge below $600. As noted above, an applicable entity includes any organization a
significant trade or business of which is the lending of money.66
OPR concluded that it would be difficult to conceive of a situation in which a tax professional principally
engaged in providing tax services would be an applicable entity justifying the use of Form 1099-C to
attribute income to an arguably scofflaw client for the nonpayment. They refused to conclusively opine
to the practitioner posing the question, however, noting that every case will depend on its own
particular facts and circumstances, including the existence (or not) of a debt, with the crux of the

66

IRC 6050P(c).

34

analysis turning on whether the client can be said to have received previously untaxed funds from an
applicable entity for which there is an obligation for repayment.67

Foreclosures and Abandonments

Should the debtors property be foreclosed upon, or in the event of abandonment, the taxpayer should
receive an IRS Form 1099-A, Acquisition or Abandonment of Secure Property that will show the
information needed to figure gain or loss. In addition, the taxpayer may also receive IRS Form 1099-C if
the lender has canceled part of the debt on the property. However, the lender has the option of
including the information needed to calculate gain or loss on either Form 1099-A on Form 1099-C.

67

2015 TNT 25-14.

35

Glossary
antitrust

bankruptcy
collection
agency
contingent
delinquent
indebtedness
insolvency
Nonrecourse
debt

promissory note
trustee

Opposing or intended to restrain trusts, monopolies, or other large combinations

of business and capital, especially with a view to maintaining and promoting
competition.
Legally declared insolvency, or inability to pay creditors.
A firm that collects unpaid bills for other firms and is usually compensated by
receiving a percentage of the amount collected.
Dependent for existence, occurrence, character, etc., on something not yet certain;
conditional
Past due; overdue.
The total of a person's debts
Having insufficient assets to meet debts and liabilities; bankrupt
A type of loan that is secured by collateral, which is usually property. If the
borrower defaults, the issuer can seize the collateral, but cannot seek out the
borrower for any further compensation, even if the collateral does not cover the
full value of the defaulted amount.
A written promise to pay a specified sum of money to a designated person or to his
or her order, or to the bearer of the note, at a fixed time or on demand.
A person, usually one of a body of persons, appointed to administer the affairs of a
company, institution, etc.

36