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Chapter 9

Chapter 9. Discharge of Indebtedness. Basic Formula for Federal Income Tax: Form 1040. Income (broadly conceived) $ xxx,xxx Less: Exclusions (income that is not subject to tax) (xx,xxx )

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Chapter 9

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  1. Chapter 9 Discharge of Indebtedness

  2. Basic Formula for Federal Income Tax: Form 1040 Income (broadly conceived) $ xxx,xxx Less: Exclusions (income that is not subject to tax) (xx,xxx) Total Income (income that is subject to tax) $ xxx,xxx Less: “Above the Line” Deductions (xx,xxx) Adjusted Gross Income $ xxx,xxx Less: Itemized or Standard “Below the Line” Deductions and Personal Exemptions (xx,xxx) Taxable income$ xxx,xxx Federal income tax on taxable income (see tables) $ xx,xxx Less: Tax credits (including Federal income tax withheld and prepayments of Federal income taxes) (x,xxx) Tax owed (or refund) $  x,xxx

  3. Terminology • Income from the Discharge of Indebtedness • Also known as: • “COI” Income (Cancellation of Indebtedness) • “COD” Income (Cancellation of Debt)

  4. Bowers v. Kerbaugh-Empire Co.271 U.S. 170 (1926) • Facts: Taxpayer took advantage of a fluctuation in foreign currency exchange rates to pay off a loan for a smaller amount of money in U.S. dollars than was originally borrowed. • Holding: The gain to the taxpayer was part of a larger economic loss, and no income is recognized on the discharge of the debt.

  5. U.S. v. Kirby Lumber Co.284 U.S. 1 (1931) • Facts: Taxpayer took advantage of a fluctuation in the trading price of its publicly traded debt to pay off some of its debt for less than originally owed. • Holding: The Court said the taxpayer recognized income.

  6. Discharge of Indebtedness • § 61(a)(12): Gross income includes income from discharge of indebtedness • Treas. Reg. § 1.61-12 elaborates with a few examples • Note: your capacity to pay taxes (or lack thereof) typically does not determine whether or not you have income for tax purposes

  7. § 108 • Codified and modified existing case law. • Offers a limited exception to the rule in §61(a)(12). • Very detailed, seems to cover the field, but some judicial exceptions still survive as well.

  8. § 108 • (a)(1) • Provides five categories of exclusions (for now) • Note especially (A) bankruptcy and (B) insolvency • Note also (E) qualified principal residence indebtedness • (a)(2) • Provides an ordering rule • (a)(3) • Limits the insolvency exclusion to the amount of the insolvency

  9. § 108 • (b): reduction in tax attributes • (d): definitions and special rules • defines “Title 11 Case” and “Insolvent” • (e): general rules for discharge of indebtedness • not limited to discharges in bankruptcy or insolvency; • so applies to all discharge of indebtedness situations for purposes of §61(a)(12)

  10. Problem 1(a): Donald • Donald borrowed from a bank, then had to quit his job, and the bank forgave the remaining debt. • Unless Donald can qualify for an exclusion under § 108, he will have income under § 61(a)(12) and Treas. Reg. § 1.61-12. • Do any exclusions in § 108 apply? • No: he’s not in a Title 11 (bankruptcy) case; he’s not insolvent; the debt does not appear to be qualified farm indebtedness, qualified real property business indebtedness, or qualified principal residence indebtedness.

  11. Problem 1(b): Donald, cont. • Donald borrowed from his employer, had to quit his job, and employer forgave the remaining debt. • Unless Donald can qualify for an exclusion under § 108 (which under these facts he cannot), he will have income under section 61(a)(12). • Do any exclusions in § 108 apply? No - same as (a). • Can we call the debt forgiveness a gift? Consider §102(c), Prop. Treas. Reg. § 1.102-1(f)(2), Duberstein, Schall. • Compensation for services or debt forgiveness? Does it matter? Consider Treas. Reg. 1.61-12(a).

  12. Problem 1(c): Donald, cont. • Donald borrowed from his brother, had to quit his job, and employer forgave the remaining debt. • Unless Donald can qualify for an exclusion under § 108 (which under these facts he cannot), he will have income under section 61(a)(12). • Do any exclusions in § 108 apply? • Can we call the debt forgiveness a gift? More likely: Duberstein “detached and disinterested generosity.”

  13. Problem 2(a): Kevin • Kevin received a bill for $10,000 for work performed at personal residence, challenged the bill as excessive and got it reduced to $5,000. • Assuming Kevin is solvent at all times, does Kevin have income for the difference? • Debt forgiveness income or negotiation of a reasonable fee for services rendered? • Is the $10,000 original bill “indebtedness?”

  14. Early Treasury Regulation (since retracted) Indebtedness = “an obligation, absolute and not contingent, to pay on demand or within a given time, in cash or another medium, a fixed amount.”

  15. Rev. Rul. 84-176Contested Liability/Disputed Debt Rule • Facts: Cross-claims for payment and breach of contract settled for 1/2 the outstanding bill. • Holding: Taxpayer does not have debt forgiveness income when Seller forgives $500 of debt in exchange for release from a breach of contract claim. • Rationale: When something is given in exchange for the debt discharge, then the debt discharge is not debt forgiveness income. • How far should we extend this rule?

  16. Zarin v. Comm’r916 F.2d 110 (3d Cir. 1990) • Facts: Gambler gets out of paying $3 million of gambling debt to casino after arguing in lawsuit that the debt was illegal under state law. • Issue: Whether Zarin had debt forgiveness income. • Holding: Even though the parties agreed on the amount of the debt, the contested liability rule applies. Because the debt was illegal, Zarin was never really liable to pay it, so no debt forgiveness income. • VERY CONTROVERSIAL OUTCOME

  17. Problem 2(b): Kevin, cont. • Kevin borrowed $20,000 to start a business, business struggles, Lender agrees to forgive part of the note. • Assuming Kevin is solvent at all times, what are the consequences of the debt forgiveness? • Consider § 61(a)(12) and exceptions under § 108. • Consider Kirby Lumber (where taxpayer paid off debt for less than originally owed and the Court said the taxpayer recognized income) • Answer = $9000 of COD income.

  18. Problem 2(c): Kevin, cont. • Kevin’s parents purchase the note for $10,000 and forgive the entire debt • See§108(e)(4): Acquisition of indebtedness by a person related to the debtor is treated as an acquisition by the debtor. • “related” determined under § 267(b), as modified by §108(e)(4)(B) • Parents are a related party, and the acquisition of the debt by the parents is treated as an acquisition by Kevin. • Treated like Kirby Lumber-type scenario • Bottom line: $9,000 is COD income; remaining $10,000 may be a gift

  19. Problem 2(d): Kevin, cont. • Contractor reduces Kevin’s bill for services rendered to Kevin’s business by $4,000. • § 108(e)(2): Income not realized to the extent of lost deductions. • If Kevin reported the amount as income, that income would just be offset by a deduction. So instead, this provision eliminates both the COD income and the deduction.

  20. Problem 2(e): Kevin, cont. • $150,000 debt incurred to purchase building • Some time later . . . • Debt balance = $130,000 • FMV of the building = $115,000 • So creditor reduces the balance due on the debt to $115,000

  21. Problem 2(e): § 108(e)(5) Purchase-money debt reduction for solvent debtor treated as price reduction. --If-- (A) the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced, [and] (B) such reduction does not occur -- (i) in a title 11 case, or (ii) when the purchaser is insolvent, and (C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness, then such reduction shall be treated as a purchase price adjustment.

  22. Problem 2(e): Kevin, cont. • § 108(e)(5) applied: • Reduction of purchase-money debt will be treated as a purchase price adjustment rather than as debt forgiveness, so long as the debtor is not in bankruptcy or insolvent. Debtor reduces basis in the property instead. • Similar conceptually both to § 108(e)(2) and to Rev. Rul. 84-176 and the contested liability or disputed debt rule. • The debt is reduced to $115,000. Kevin does not have income. The amount of the debt reduction is $15,000, so Kevin’s basis in the property is reduced by $15,000, to $135,000.

  23. Problem 3: land for debt Exchange: land worth $60,000 for debt of $75,000 • Bill exchanges with Judy land worth $60,000 for a debt of $75,000. • How much COD income does Bill have from his deal with Judy? Does he have other income?

  24. Gehl v. Comm’r50 F.3d 12 (8th Cir. 1995) • Insolvent taxpayers restructured $152,260 debt secured by family farm: • 12/30/88: conveyed 60 acres land (basis $14,384, fmv $39,000) to satisfy $39,000 of debt • 1/4/89: conveyed 141 acres of land (basis $32,000, fmv $77,725) to creditor • 1/4/89: paid $6,123 cash • Lender forgave outright the remaining $29,412 of debt • Issue: Do insolvent taxpayers have to recognize gain when they surrender land to satisfy debt? • The taxpayers argued that all income/gain from the restructuring should be excluded from taxable income under § 108(a). • The IRS agreed that the $29,412 of outright debt forgiveness was excludable from taxable income under § 108(a), but disagreed with respect to the land for debt exchanges. • Holding: The transfer of land for debt is separate from debt forgiveness. Any gain realized in such a transfer is taxable under §§ 61(a)(3) & 1001.

  25. Treas. Reg. § 1.1001-2(c)Example 8 F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value of $6,000. In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 - $6,000).

  26. Problem 3, cont. • How much COD income does Bill have from his deal with Judy? Does he have other income? • Gain on disposition of land: • amount realized: $60,000 FMV of the land • basis: $20,000 • gain on disposition of land: $40,000 • COD Income: • debt: $75,000 • property given in satisfaction: $60,000 • income from debt forgiveness: $15,000

  27. Problem 3, cont. • Is Bill’s $15,000 of COD income excludable from gross income under § 108(a)? Bill’s assets: FMV = $115,000 • plot of land (basis of $20k and FMV of $60k) • other assets (FMV $55k) Bill’s liabilities: $125,000 or $150,000? • $75k to Judy • $50k to others • $25k loan guarantee • § 108(a)(3): exclusion limited to amount of insolvency

  28. Problem 3: cont. • Judy received land with a FMV of $60,000 in exchange for $75,000 of debt. What basis will Judy take in the land received from Bill? • Philadelphia Park Amusement Co. (Chapter 4): The basis of property received in a taxable exchange is the FMV of the property received, not the FMV of the property surrendered. • Judy’s basis is $60,000, the FMV of the land received.

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