Particularly in tough economic times but at all other times due to business realities, cancellation of outstanding debt may be a wise move for a creditor. Cancellation of debt refers to the releasing or forgiving of a debt in whole or part. Cancellation of debt may be granted to individuals or businesses depending on the circumstances.
What many people fail to realize is that cancellation of debt can create other problems and issues that should be carefully considered before deciding to take that path. Forgiveness of a debt does not necessarily allow a tax or accounting write off of the debt for the creditor. Further, forgiveness of a debt can be a tax event for the debtor. Indeed, forgiveness of a debt may be deemed a “gift” from the creditor and actually impose gift tax on the creditor that can be substantial.
Rights of third parties can be altered by such cancellation and a creditor may find that it has waived a claim against other debtors by forgiving one debtor. The other debtors may have their own claims for contribution against the forgiven debtor who may find him or herself facing the same claims, albeit via the intermediary of the other debtors. Secured parties may lose security that they did not consider part of the forgiveness and rights to write off costs and attorneys’ fees may be lost.
Such forgiveness may be nullified by a bankruptcy court under certain circumstances and may be seen as a transfer to defraud creditors in certain circumstances.
Or, as one client put it, “I never realized that giving up trying to collect what I know will never be paid anyway could be so complex and expensive.”
It is vital for any business or individual to learn the basic law and taxation issues involved with forgiveness of debt. This article shall outline the more salient questions to be confronted.
The Basic Method
Normally a writing is required to forgive a debt so that both the debtor and the creditor have evidence of the alteration in their relationship. Oral forgiveness can occur but to make that a binding agreement would require the same criteria for any oral agreement as described in our companion article on Contracts. Note that the concept of consideration for a binding agreement would apply and in many circumstances a creditor may argue that past forgiveness was voluntary in nature and not binding on a creditor who changes his or her mind. If the forgiveness is integrated into a writing that recites some form of mutual benefit deriving from the forgiveness, then the forgiveness may be a binding obligation on the creditor. Such mutual benefit could be some token payment or even surrender of potential offsets or counterclaims.
It is also important to realize that a written forgiveness coupled with a release of all claims either party may have against the other can also be of extreme benefit to the creditor. It is not uncommon for a creditor to forgive a debt in one year but be faced with claims from the prior debtor in later years based on some aspect of their business relationship. In that case, the debtor waited some years so that the forgiveness of the debt went beyond the statute of limitations, then made claim for defective goods. The creditor was outraged but helpless to resurrect his prior claim and ended up paying for defective goods that he had “given away for free,” as he put it. It is worthwhile to seek a full and complete written release when deciding to forgive a debt.
However, many creditors simply “forget” a debt, giving up on efforts to collect, and taking no other further action. This may not constitute forgiveness of a debt required by various taxing authorities who may insist that absent formal forgiveness, the debt remains in place and no deduction for bad debt loss may be taken. Once the statute of limitations runs (usually two to four years) then the debt is usually no longer collectable unless one had filed legal action during that time.
Such abandonment of claims without formal legal action not only allows later counter claims to resurface, but brings in tax issues, discussed below.
The IRS and Forgiveness of Debt
Cancellation of debt is also termed as discharge of indebtedness. In Jones v. Cendant Mortg. Corp. (In re Jones), 396 B.R. 638 (Bankr. W.D. Pa. 2008), the court opined that the term “discharge-of-indebtedness” appearing in 26 U.S.C.S. § 61(a)(12) is interchangeable with the term cancellation of debt. Discharge of indebtedness occurs for purposes of § 61(a)(12) when it becomes clear that the debt will not be paid. The test for determining whether such an event has occurred is based on a practical assessment of the facts and circumstances relating to the likelihood of repayment.
A taxpayer is usually treated as realizing taxable income if a debt he/she owes is absolved or if it becomes unenforceable and it appears that such taxpayer will not pay the debt. Pursuant to the Internal Revenue Code, the discharge of indebtedness shall be included in the gross income of a taxpayer.
In Hill v. Comm’r, T.C. Memo 2009-101 (T.C. 2009), the court stated that case law indicates that where indebtedness from a credit card account is being discharged and the amount of income as a result of the discharge equals the difference between the amount due on the obligation and the amount paid for the discharge or if no consideration is paid for the discharge, then the entire amount of the debt is considered the amount of income that the debtor must include in income.
In Stevens v. Comm’r, T.C. Summary Opinion 2008-61 (T.C. 2008), the court stated that “26 U.S.C.S. § 108(a) provides that a taxpayer may exclude income from the discharge of indebtedness if the discharge occurs in a bankruptcy case, or when the taxpayer is insolvent, or if the indebtedness is qualified farm or business real estate debt.” Generally, a taxpayer should include income from the cancellation of debt. However, certain cancelled debts shall not be included in gross income. The exceptions are as follows:
- If the cancellation of debt occurs in a bankruptcy case
- When the taxpayer becomes insolvent
- If the cancelled debt is a qualified farm indebtedness
- If the cancelled debt is a qualified real estate business indebtedness.
A debt is said to be discharged or cancelled when the debtor is relieved of such debt or the payment obligation. If it appears that the payment shall be enforced, then a debt is not deemed to be discharged or cancelled. In McGowen v. Comm’r, T.C. Memo 2009-285 (T.C. 2009), the court stated that a discharge of indebtedness occurs when a taxpayer is no longer legally required to satisfy his debt either partially or fully.
Gross income includes income from discharge of indebtedness. For instance, X lends $10,000 to Y. If X later accepts $ 8,000 in full payment, Y has an increase of $ 2,000 which is treated as income received.
The cancellation of indebtedness, in whole or in part, may result in the realization of income. If, for example, an individual performs services for a creditor, who in consideration thereof cancels the debt, income in the amount of the debts is realized by the debtor as compensation for his/her services. Similarly, a taxpayer realizes income by the payment or purchase of his/her obligations at less than their face value. If a shareholder in a corporation which is indebted to him/her gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation.
FORGIVENESS OF DEBT AS TAXABLE GIFT
In Helvering v. American Dental Co., 318 U.S. 322 (U.S. 1943), the court held that a cancellation of indebtedness may be a gift, exempt from the Federal income tax, where it was gratuitous and constituted the release of something to the debtor for nothing, even though the motives of the parties were purely of a business or selfish nature.
BASIC RULES OF FORGIVENESS AS INCOME
The Internal Revenue Code provides general rules for discharge of indebtedness such as:
- there should be no insolvency exception from the general rule that gross income includes income from the discharge of indebtedness.
- no income should be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.
- the amount taken into account with respect to any discharge should be properly adjusted for unamortized premium and unamortized discount with respect to the indebtedness discharged.
- for purposes of determining income of the debtor from discharge of indebtedness, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor from a person who does not bear such a relationship to the debtor should be treated as the acquisition of such indebtedness by the debtor.
- no deduction is allowed with respect to any loss from the sale or exchange of property, directly or indirectly, between members of family, provided that the family of an individual consists of the individual’s spouse, the individual’s children, grandchildren, and parents, and any spouse of the individual’s children or grandchildren.
- two entities which are treated as a single employer is treated as bearing a relationship to each other.
- purchase-money debt reduction for solvent debtor treated as price reduction, if:
- the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced,
- such reduction does not occur in a bankruptcy case or when the purchaser is insolvent, and
- such reduction would be treated as income to the purchaser from the discharge of indebtedness, and then such reduction is treated as a purchase price adjustment.
- any amount included in gross income by reason of the discharge of indebtedness is not taken into account for purpose of taxation of a real estate investment trust.
- for purposes of determining income of a debtor from discharge of indebtedness, if a debtor issues a debt instrument in satisfaction of indebtedness, such debtor is treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument.
Special rules relating to qualified principal residence indebtedness as stated in the Internal Revenue Code are:
- the amount excluded from gross income is applied to reduce the basis of the principal residence of the taxpayer.
- if any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, applies only to so much of the amount discharged as exceeds the amount of the loan which is not qualified principal residence indebtedness.
WHAT CONSTITUTES A WRITE OFF OF A DEBT?
A debt is discharged or canceled when the debtor is relieved of his/her payment obligation. Discharge of indebtedness conveys forgiveness of or release from an obligation to repay.
Indebtedness means indebtedness for which the debtor is liable or subject to which the debtor holds property. Pursuant to Internal Revenue Code, the term indebtedness of the taxpayer means any indebtedness. However, certain write-offs are not treated by the IRS as constituting income.
Pursuant to the Internal Revenue Code, gross income does not include any amount which is included in gross income by reason of discharge of indebtedness of the taxpayer if:
- the discharge occurs in a bankruptcy case,
- the discharge occurs when the taxpayer is insolvent,
- the indebtedness discharged is qualified farm indebtedness,
- in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
- the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.
However, the discharge of indebtedness income exclusion does not apply to a taxpayer who sells property in partial satisfaction of debt prior to filing a bankruptcy petition. Likelihood of future discharge of debt in bankruptcy does not qualify the taxpayer for relief under the Internal Revenue Code.
Generally, a write-off of debt is cancellation of a debt in the account books of a creditor. When a creditor writes off a debt and charges the debtor on the extra amount after the written off debt, it can be taken as evidence that the debtor is discharged from that written off debt. But it may not be conclusive evidence as to the discharge of the liability. A debt can be said to be fully discharged when the account as to the debt is settled and all the audit and administrative procedures are finalized without any liability to the debtor.
However, if the debtor makes entry in his/her account books to the effect that a debt is being written off, it can be considered as an evidence of discharge of debt. However, it may not be considered conclusive evidence.
The resolutions of a corporation stating that some uncollectible debts should be written off are not a discharge of a debt. But entry made in the books of a corporation or other activities of the corporation writing off debts amounts to cancellation of debt.
When a liability is forgiven it will not be added to the income of the debtor in assessing the tax of a debtor.
A loan taken by a student from an institution for the purpose of joining an educational institution is called student debt. In order to avail the loan, an educational institution should be a regularly functioning institution. It means that an educational institution must be one functioning in a fixed place, with fixed curriculum, and with regular students attending regularly.
Generally, if a person to whom a student owes a debt cancels that debt, that canceled amount will be taxable as the student’s income. This income is termed as cancellation of indebtedness income. However, in certain cases a discharged student debt will not be considered as income if the discharge was made under a specific provision. For example, there can be a provision that requires whole or part of a debt to be discharged if a person serves public offices for a certain period. But, exclusion from cancellation of indebtedness income will not apply to a debt discharged by a tax exempt institution and if the discharge was in relation to work done for the grantor of the loan.
There are certain governmental loan repayment programs that provide an alternative to repayment of loan by requiring the students to perform public services for a specified period, for example, the requirement of public services in areas which need more medical professionals. National Health Service Corps Loan Repayment Program and State Loan repayment programs under the Public Health Service Act provide for such loan repayments. A student loan under these programs would be discharged only if the requirement of public service is satisfied.
Student loans entitled for exemption from inclusion as income on discharge of debts are loans granted by:
- the U.S., or an agency of the U.S.,
- a U.S. state, territory, or possession; the District of Columbia; or any political subdivision of the preceding units,
- A tax exempt public benefit corporation which has power over public hospitals and the employees are public employees under law.
- An educational institution, which is being funded on the basis of an agreement between any of the bodies mentioned above or under its own program intended to persuade students to serve the public. Under this program, public service by the student must be for government bodies or tax exempt organizations.
Certain refinancing loans are also excluded from cancellation of indebtedness income. Discharge of a loan by an educational institution mentioned under 26 USCS § 170(b)(1)(A)(ii) and tax exempted organization[x] will not be included in income of a person if the earnings from that are used for refinancing another student loan.
WRITING OFF DEBTS OF SOLVENT DEBTORS: THE TAX
In order to cancel or discharge a debt, the debtor must be relieved of his or her payment obligation. For effecting the cancellation of debt, a possibility of enforcement of payment should not exist. Cancellation of debt income exists when:
- a creditor accepted less than full face amount of balance due even though property securing taxpayer’s mortgage notes had been completely destroyed by hurricane in an earlier year;
- a taxpayer prepaid his mortgage at a discount; and the statute of limitations barred a creditor from instituting a debt collection suit;
- a shareholder dies before repaying a loan from his corporation, and in effect the debt is forgiven, his estate can be taxed on the loan amount as cancellation of debt income.
Any person paying the tax is treated as realizing taxable income:
- If a debt he owes is forgiven,
- If it is unlikely ever to be enforced against him, or
- If it becomes unenforceable against him and the indications are that he won’t pay it.
The taxation of cancellation of debt income to the debtor depends on whether the debtor is solvent, insolvent, or bankrupt. However, all cancellation of indebtedness does not result in cancellation of debt income. Debt discharge may also be in the form of compensation.
For the existence of a cancellation of debt income, there has to be a legal debt, and a debtor-creditor relationship between the parties. In case of a dispute regarding whether a taxpayer owes any part of an alleged debt, a later settlement of the dispute is treated as the amount of the debt, and it will not give rise to cancellation of debt income.
INSOLVENT DEBTORS AND WRITE OFF TAX EFFECT
A discharge is the release of a debtor from payment of debts in a bankruptcy proceeding.
A discharge order permanently prohibits creditors of the debtor from taking any form of collection action on discharged debts, including legal action. Courts discharge debts in bankruptcy proceedings in order to relieve debtors of the requirement to pay off their debts. A discharge applies only to debts incurred before bankruptcy proceedings.
Debts which cannot be discharged include certain taxes, child support, alimony, student loan, and court fines. To be proclaimed bankrupt, one must file a motion requesting to be declared bankrupt with the U.S. Bankruptcy Court. Bankruptcy is a legally declared inability of an individual or organization to pay their creditors. Insolvency is a financial term that means one has liabilities or debts in excess of his/her assets.
A bankruptcy discharge varies with the type of case a debtor files. A bankruptcy discharge releases a debtor from personal liability for certain types of debts. Once discharged, the debtor is no longer legally required to pay the discharged debts. However, a valid lien is not avoided by discharge. A secured creditor may enforce a lien to recover the property secured by the lien.
In the U.S., tax payers may have tax consequences when a debt is discharged. This is called Cancellation of Debt income (COD). Gross income includes all income from whatever sources and includes income from the discharge of indebtedness[i]. However, gross income does not include COD income if the debt discharge occurs in a Title 11 case[ii] ;i.e., in bankruptcy or to the extent the taxpayer is insolvent[iii]. When a discharge happens in a bankruptcy case or while the debtor is insolvent, the debtor does not have COD income. Relief from inclusion in gross income is limited to discharge of indebtedness income. Exemption is available only if a taxpayer is under the jurisdiction of a court in such a case and the discharge is granted by the court or in a court-approved plan.
S CORP DEBT WRITEOFF
An S corporation derives income when a creditor discharges the S corporation from a debt. The income derived from the cancellation of indebtedness of an S corporation is not distributed to the shareholders of an S corporation. However the income that each shareholder derives generally from an S corporation is subject to taxation.
For taxation purposes, an S corporation and its shareholders are considered two separate entities. The method adopted for taxing an S corporation and partnership is the same. But the rules adopted for distribution of Cancellation of Debt Income (COD) in an S corporation are different from that of a partnership.
As mentioned earlier, the income of a shareholder does not increase with the cancellation of indebtedness. It is only the general income, tax credits, and deductions of the S corporation that are distributed at the shareholder level. As an exception to the general rule, the income that arises from the discharge of debt that is made before October, 12, 2001 and March, 1, 2002 under the bankruptcy proceedings is distributed among the shareholders.
However, the liability of an S corporation in insolvency, bankruptcy and indebtedness is not distributed at the shareholder level of an S corporation. Similarly the income that is received from the discharge of debt due to insolvency and bankruptcy is distributed at the corporation level and it is not distributed at the shareholder level.
Occasionally, a loss incurred by an S corporation is also not distributed among the shareholders. Hence such losses are considered income to the shareholders and it is called Net Operating Losses (NOL). An NOL is reduced from the gross income of the S corporation. The income derived from the discharge of indebtedness is also excluded from the gross income of an S corporation.
DEBT EXCHANGE AND FORGIVENESS OF DEBT
Debt for debt exchange means the exchange of an existing debt with a new debt by the debtor. An existing debt can be exchanged even by combining debt and equity securities. A debt for debt exchange procedure benefits both the creditor and the debtor. A debt exchange procedure is a good substitute for a refinancing procedure.
A debt exchange procedure provides the following advantages:
- it provides the creditor with a lower face amount of debt;
- it provides the creditor with an opportunity to change the terms and conditions of the outstanding debt;
- it also provides a long and extended term for maturity of the debt;
- it helps a creditor, who is facing an uncertainty as to cash flow, by giving the creditor an opportunity to restructure the balance sheets; and
- it helps the debtor to make his/her debt a new one without paying cash except for the professional fees and transaction costs.
For the purpose of debt exchange, it is assumed a debtor has satisfied the old debt with an amount of money equal to the new debt instrument’s issue price. A debtor who makes a debt exchange will get a Cancellation of Debt (COD) income. This COD income is actually the aggregate of the old debt’s issue price and the new debt’s issue price. The issue price of the new and the old debt are calculated according to the Original Issue Discount (ODI) Rules.
The initial relief a debtor may feel to avoid liability is often replaced with the stark realization that tax may be due and, since taxes are often not dischargeable in bankruptcy, the taxes may be a greater burden than the original debt. That, however, is the exception and the debtor facing forgiveness as well as the creditor offering it simply have to realize that a writing providing for such forgiveness (or at least correct entry on the books) as well as some tax planning is required to achieve this transaction with the least disruption.
Most debtors, however, simply ignore the requirements and get on with their business lives…until if things get better their CPA gives them some very unwelcome news. Better to be educated and prepared ahead of time.