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Debt Cancellation2 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 thiscommunication.

©2015 Fast Forward Academy, LLC – All Rights Reserved.



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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 beexcluded; 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



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ContentsCOURSE DESCRIPTION ..................................................................................................................................................... 2

LEARNING OBJECTIVES .................................................................................................................................................... 2

YOU’RE NOT AS POOR AS YOU FEEL ....................................................................................................................... 5

SHEPHERD V. COMMISSIONER, T.C. MEMO 2012-212 (JULY 24, 2012) ................................................................................ 5 THE IMPORTANCE OF UNDERSTANDINGCOD 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

Q UALIFIED FARM INDEBTEDNESS ..................................................................................................................................... 16

Q UALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS .......................................................................................................... 16

Q UALIFIED 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



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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



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You’re 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

Shepherd’s 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 that’s what they thought.

The IRS asserted that the aggregate value of the Shepherd’s two pieces of real estate, a beach house and

their personal residence, was sufficient to render them solvent, not to mention the value of Bernie’s

pension. “Prove it,” the Shepherd’s said. “Not gonna, don’t hafta,” the IRS replied. The IRS was right, of

course; it is the taxpayer’s 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 houseimmediately 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 Shepherd’s 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 methodologyused to determine its value. The court was unconvinced. Strike two.

1 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.



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Finally, Bernie argued that the value of his pension should not be considered in determining the couple’s

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 rulesregarding 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 toexplain 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 overthe 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 IRC § 6662(d)(2)(A).

3 IRC § 6662(d)(1)(A).



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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 taxpayer’s efforts to assess the taxpayer’s proper tax liability, the

knowledge and experience of the taxpayer, and the taxpayer’s reliance on the advice of a pr ofessional,

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 taxpayer’s 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 Rouben’s 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



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repurchase of the bonds) constituted income to the company. The Supreme Court agreed, stating that

the company’s 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 anadditional 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 Glenshawwere 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 United States v. Kirby Lumber Co., 284 U.S. 1 (1931)

5 Eisner v. Macomber , 252 U.S. 189 (1920).

6 Commissioner v. Glenshaw Glass Co., 348 U.S.426 (1955).

7 Id . at 431.



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

2. any the discharge occurs when the taxpayer is insolvent;

3. a discharged is qualified farm indebtedness;

4. 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 Johnson v. Commissioner, TC Memo 1999-162.

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



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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 allclaims 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 debtbut was not himself in bankruptcy.10 Contrary to the holdings of the Tax Court, the IRS’s position is that

a general partner who guaranteed the partnership’s debt and was not himself in bankruptcy may not

exclude the debt that was canceled in the partnership’s title 11 case.

In the first case, Jose Martinez was a general partner in a partnership and personally guaranteed some

of the partnership’s 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 personalguarantees 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 court’s order explicitly asserted jurisdiction over the partners.

10 AOD 2015-01.

11 Martinez v. Commissioner, T.C. Memo 2004-150.



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The IRS disagrees, asserting that The Tax Court’s ruling is inconsistent with the structure of Code section

108 and underlying Congressional intent. Despite the court’s 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 taxpayer’s insolvency, an issue that must be addressed is which assets, if any, to excludefrom 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 taxpayer’s 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 taxpayer’s 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 taxpayer’s assets for the purpose of measuringinsolvency when COD income is at issue.15 The IRS also initially concurred with that reasoning, as

12 11 U.S.C. 101(13).

13 Gracia v. Commissioner , T.C. Memo 2004-147; Mirarchi v. Commissioner , T.C. Memo 2004-148; Price v.

Commissioner , T.C. Memo 2004-149.14 IRC § 108(d)(3).15

Marcus Estate v. Commissioner , T.C. Memo. 1975-9.



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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 tothe 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 taxpayer’s 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 taxpayer’s burden to prove these values. What is clear, however, is that the value

of all the taxpayer’s 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 taxpayer’s insolvency, or lack thereof, after the discharge is

irrelevant. Also note that the exclusion from income is limited to the extent of the debtor’s insol vency .

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 Jane’s creditors forgives a debt in the amount of $30,000. Although Jane isinsolvent immediately before the discharge, she is only insolvent by $20,000, so the

16 Priv. Ltr. Rul. 9125010.

17 Priv. Ltr. Rul. 9932013.

18 TAM 199935002.

19 IRC § 108(a)(3).



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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 guaranteeda 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 David’s 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 test”21 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 Court’s decision in Landreth v. Commissioner 22

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 Merkel v. Commissioner , 109 TC 463 (1997), aff’d 192 F.3d 844 (9

th Cir. 1999).

21 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.



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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 court’s “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 government’s 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 Toberman’s 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. Phil’s

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.



15

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 taxpayer’s

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 taxpayer’s 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 taxpayer’s 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 taxpayer’s 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 ofdischarge. 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.



17

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 ofthe 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 Joe’s 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 byattaching 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 taxpayer’s 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.



18

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 principalresidence 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 bythe taxpayer as the taxpayer’s 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 couple’s 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.



19

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

taxpayer’s 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 homeowner’s obligation under the anti -deficiency provision of California law

would be a nonrecourse obligation. As such, for federal income tax purposes, the homeowner will nothave 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).



20

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 ofemployers.”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 withreference to the intention of the transferor.38

34 IRC § 108(f).

35 IRC § 108(f)(4).

36 IRC § 108(f).

37 Porten v. Commissioner , T.C. Memo 1993-73.

38 Commissioner v. Duberstein, 363 U.S. 278 (1960).



21

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

40 Reynolds v. Boos, 188 F.2d 322 (8th Cir. 1951)

41 Clem v. Campbell , 62-2 USTC ¶9786 (N.D. Tex. 1962).

42 IRC § 102(c)(1).

43 H.R. Rep. No. 833, 96th Cong., 2d Sess. 15 (1980); S. Rep. No. 1035, 96th Cong., 2d Sess. 19 (1980).



22

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 thebuyer 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 taxpayer’s 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 publicservice 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 Sands v. Commissioner , T.C. Memo 1997-146.

45 Priv. Ltr. Rul. 9822005.

46 See H.R. REP. No. 96-833, at 8-9 (1980)

http://www.law.cornell.edu/uscode/text/26/usc_sec_26_00000038----000-




23

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 taxpayer’s 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

taxpayer’s home.

6.

Passive activity loss and credit carryovers. If the first five categories of tax attribute reductionsdo 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 taxpayer’s 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

taxpayer’s 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





24

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 theseprinciples 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.



25

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 IRS’s 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.



26

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 makegood 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

guarantor’s 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 debtor’s default. Regardless of whether the guarantor is a secondary obligor orhas become a primary obligor, when the debt is discharged the guarantor’s 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



27

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 stockof 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 Reg. §1.108-2.

49 Reg. §1.108-2(a).



28

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. Jim’s

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 Jim’s 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 Reg.§ 1.108-2(e)(1)

51 Reg. §1.108(e)(2).



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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 corporation’s “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 whichflows through to Phyllis. Since George’s 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 §7611(f)(2) of the Revenue Reconciliation Act of 1989,

53 IRC §56(g)(4)(B)(i).

54 IRC § 108(d)(7)(A).

55 IRC § 108(d)(7)(B).



30

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 corporation’s deemed

NOL exceeds the amount of the S corporation’s 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. George’s 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 corporation’s excess

deemed NOL to be allocated to each shareholder, there must be a calculation, with respect to each

shareholder, of the shareholder’s “excess amount.” The shareholder’s excess amount is the amount (if

any) by which the shareholder’s 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, George’s

“excess amount” is $40 ($100 - $60) and Phyllis’s excess amount is $10 ($50 - $40).

Each shareholder that has an excess amount is then allocated an amount equal to the S corporation’s

excess deemed NOL multiplied by a fraction, the numerator of which is the shareholder’s excess amount

and the denominator of which is the sum of all shareholders’ excess amounts.58 If a shareholder does

56 Reg. § 1.108-7(d)(2)(i).

57 Reg. § 1.108-7(d)(2)(ii)(A).

58 Reg. § 1.108-7(d)(2)(ii)(B).



31

not have a shareholder’s excess amount, none of the S corporation’s excess deemed NOL is allocated to

that shareholder.59

Example:

In the above example, ABC has an excess deemed NOL of $50 (George’s suspended

losses of $100 plus Phyllis’s suspended losses of $50, minus the $1 00 of excluded CODincome). 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 shareholder’s

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 ofthe shareholder’s 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

shareholder’s suspended losses. Furthermore, the S corporation must report to each shareholder the

amount of the S corporation’s 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 partner’s 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 insolvencydetermination is made at the level of that partnership's partners.

59 Reg. § 1.108-7(d)(2)(ii)(C).

60 Reg. § 1.108-7(d)(4).

61 IRC § 108(d)(6).



32

Example:

Partnership X has three partners: individual A, Corporation B, and Partnership C. Assume

Partnership C’s 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 relyon 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 IRC § 703(b)(1).

63 IRC § 108(i).



33

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 client’s 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 Regs. § 1.6050P-1(b)(2)(i).

65 Regs. § 1.6050P-1(b)(2)(ii).



34

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 professional’s 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 opineto 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).



35

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 debtor’s 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 theinformation 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.



Glossary

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

of business and capital, especially with a view to maintaining and promoting

competition.

bankruptcy Legally declared insolvency, or inability to pay creditors.

collectionagency

A firm that collects unpaid bills for other firms and is usually compensated byreceiving a percentage of the amount collected.

contingent Dependent for existence, occurrence, character, etc., on something not yet certain;

conditional

delinquent Past due; overdue.

indebtedness The total of a person's debts

insolvency Having insufficient assets to meet debts and liabilities; bankrupt

Nonrecourse

debt

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.

promissory note A written promise to pay a specified sum of money to a designated person or to hisor her order, or to the bearer of the note, at a fixed time or on demand.

trustee A person, usually one of a body of persons, appointed to administer the affairs of a

company, institution, etc.

pdfs debt cancellation

Documents