The Tax Court has held that the elements necessary for the existence of discharge of indebtedness income under Section 61(a)(12) are that: (1) A taxpayer liability exists at the time of the alleged discharge; and (2) the taxpayer was in fact discharged from such liability.87 Unless the gain is excluded from income or its recognition postponed because of a statutory or judicial exception to this general rule, the amount of the debt cancellation is income in the year the debt is canceled.88 A frequently cited rationale for the rule is that the cancellation results in an accession to income by effecting a freeing of assets previously offset by the liability arising from the indebtedness.89 This provision codifies the well-settled result reached by the Supreme Court in United States v. Kirby Lumber Co.,90 that gross income includes income from the discharge of indebtedness. The theory is that to the extent that a taxpayer has been released from indebtedness, he has realized income because the cancellation frees assets previously offset by the liability arising from such indebtedness.91
1. A Debt is Considered Canceled or Discharged at the Time an Identifiable Event Occurs that Makes It Clear that the Debt Will Never Be Repaid. A debt is considered canceled or discharged at the time when an identifiable event occurs that makes it clear that the debt will never be repaid.92 The test for determining when the necessary
86
See also Treas. Reg. § 1.61-12(a) (“The discharge of indebtedness, in whole or in part, may result in the realization of income.”).
87
Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744 (1994) (“The elements necessary for the existence of discharge of indebtedness income under Section 61(a)(12) are that: (1) A taxpayer liability exists at the time of the alleged discharge; and (2) the taxpayer was in fact discharged from such liability.”); Friedman v. Commissioner, 75 T.C.M. (CCH) 2883, 2388 (1998) (“An element necessary for the existence of COD income under Section 61(a)(12) is that the taxpayer was, in fact, discharged from a liability.”).
88
Montgomery v. Commissioner, 65 T.C. 511, 521 (1975); Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3127 (1996) (“The income is recognized in the year cancellation occurs.”).
89
Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3127 (1996).
90
284 U.S. 1 (1931).
91
United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931) (“Here there was no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see nothing to be gained by the discussion of judicial definitions. The defendant in error has realized within the year an accession to income, if we take words in their plain popular meaning, as they should be taken here.”); Gershkowitz v. Commissioner, 88 T.C. 984, 1005 (1987); Cozzi v. Commissioner, 88 T.C. 435, 445 (1987) (“The general theory is that to the extent that a taxpayer has been released from indebtedness, he has realized an accession to income because the cancellation effects a freeing of assets previously offset by the liability arising from such indebtedness.”).
92
Cozzi v. Commissioner, 88 T.C. 435 (1987); Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980) (“Rather, we believe that the moment it becomes clear that the “loan” will never have to be paid, the “loan” must be viewed as having been discharged.”), supplementing 73 T.C. 491 (1979), vacated and remanded on other grounds 692 F.2d 152 (1st Cir. 1982), aff’d. in part and rev’d. in part on other grounds sub nom. CRC Corp. v. Commissioner, 693
identifiable event occurred is a practical assessment of all the facts and circumstances surrounding the likelihood of repayment of the debt.93 The substance and not the form of the discharge governs.94 The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income.95 Events that can trigger cancellation of indebtedness income can include such events as (a) a formal settlement
F.2d 281 (3rd Cir. 1982); accord Coburn v. Commissioner, 91 T.C.M. (CCH) 243, 1245 (2006); Owens v. Commissioner, 84 T.C.M. (CCH) 419, 425 n.7 (2002); Friedman v. Commissioner, 75 T.C.M. (CCH) 2383, 2388 (1998); Slavin v. Commissioner, 57 T.C.M. (CCH) 343, 347 (1989) (“A taxpayer has been forgiven or released from a debt when the facts reasonably establish that the debt will probably never be paid, that the taxpayer does not intend to repay the loan, and that the party who loaned the money does not intend to enforce its claim against the taxpayer. The facts in this case do not establish any forgiveness of any of the loans owed to the bank. No agreement of any type existed between petitioner and American Fletcher National Bank to reflect that the Bank did not intend to enforce the loans against the partnerships and/or petitioner. To the contrary, after numerous meetings to discuss the overdue loans, American Fletcher National Bank notified petitioner that he would either have to increase the collateral securing the loans or the bank would foreclose. Petitioner testified he considered but decided not to declare bankruptcy because of the effect he believed it would have on his opportunities to engage in future real estate transactions. In any event, he decided to transfer his interest to Mr. Schmadeke, who would provide additional collateral only if he obtained petitioner’s interest in the partnerships.”).
93
Id. see, e.g., Carlins v. Commissioner, 55 T.C.M. (CCH) 227, 234 (1988) (“The abandonment of a worthless collateral which represents a debt’s sole payment source is an “identifiable event” which establishes the moment when the underlying debt is discharged.”); Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744, 746 (1994) (“The test for determining when the necessary identifiable event occurred is a practical assessment of all the facts and circumstances surrounding the likelihood of repayment of the debt.”); Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1282 (2006) (“A debt is deemed discharged as soon as it becomes clear, on the basis of a practical assessment of all the facts and circumstances, that it will never have to be repaid.”).
94
Friedman v. Commissioner, 216 F.3d 537, 547 (6th Cir. 2000) (“First and foremost, in order for COD income to occur under Section 61(a)(12), the taxpayer must have been discharged from a liability. Such liability, or debt, must be viewed as having been discharged when it becomes clear that the debt will never have to be paid. The test for determining such a moment is a practical assessment of the facts and circumstances relating to the likelihood of payment. “Any “identifiable event” which fixes the loss with certainty may be taken into consideration.” (quoting Cozzi, 88 T.C. at 445)); Cozzi v. Commissioner, 88 T.C. 435, 445 (1987) (“Whether a debt has been discharged is dependent on the substance of the transaction.”); accord Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1281 (2006) (“Whether a debt has been discharged is dependent on the substance of the transaction.”); Rinehart v. Commissioner, 83 T.C.M. (CCH) 1379, 1380 (2002) (“The nonreceipt of a Form 1099 does not convert taxable income into nontaxable income.”).
95
Exch. Sec. Bank v. United States, 492 F.2d 1096, 1099 (5th Cir. 1974) (“The right to receive cancellation of the debt accrued to appellants in March, 1959, and it was reaffirmed by the judicial order in August, 1959. At that point it was determined with certainty that the debt could never be enforced. The faint possibility of required revival as a consequence of a future appeal to this Court did not change the actual realization of the gain.” [Citations omitted.]); accord Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1282 (2006) (“The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income.”); Toberman v. Commissioner, 80 T.C.M. (CCH) 81, 85 (2000) (“A debt is deemed to be discharged as soon as it becomes clear, on the basis of a practical assessment of all the facts and circumstances, that it will never have to be paid. Any identifiable event that fixes with certainty the amount to be discharged may be taken into consideration. The event may or may not be overt; ‘ultimately, it is the actions of the taxpayer in the context of the circumstances of a case’ that determine whether an abandonment or discharge of indebtedness has taken place.” [Citations omitted.]), rev’d on other grounds, 294 F.3d 985 (8th Cir. 2002); Rivera v. Commissioner, 66 T.C.M. (CCH) 1682, 1683 (1993) (“The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income.”).
agreement;96 (b) waiver of a reimbursement claim;97 (c) the abandonment of security;98 (d) a unilateral discharge by a creditor;99 and (e) the entry of an item on corporate books.100 The fact that a creditor, however, has failed to remove a debt from its books does not mean that the debt has not been canceled.101
2. An Agreement to Cancel a Debt in the Future Will Not Be Deemed to Discharge the Indebtedness if the Cancellation is Contingent Upon Future Events. The Tax Court has held that “[i]t is well settled that an agreement to cancel debt in the future will not be deemed to discharge the indebtedness immediately if the cancellation is contingent upon future events.”102
B. Determining Amount of Cancellation of Indebtedness. A cancellation of