Cancellation of Debt (COD) Income
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Taxpayers in the United States may have tax consequences when debt is cancelled. This is commonly known as COD (Cancellation of Debt) Income. According to the Internal Revenue Code, the discharge of indebtedness must be included in a taxpayer's gross income.[1] There are exceptions to this rule, however, so a careful examination of one's COD income is important to determine any potential tax consequences.
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[edit] Policy reasons behind COD income
[edit] Accession to wealth
The standard definition of income is found in a United States Supreme Court case entitled Commissioner v. Glenshaw Glass Co.[2] The Court defined income as 1) accession to wealth; 2) that is clearly realized; and 3) over which the taxpayer has complete dominion.[3]
Prior to this decision, the Court had already determined that the cancellation of debt was "a freeing of assets."[4] Basically, when debt is cancelled, money that would have been used to pay that debt is now free to be used on anything else the taxpayer wants. This is also known as "accession to wealth." Therefore, under Glenshaw Glass, it seems only natural to include COD income in gross income.
[edit] Symmetry
A loan by itself is neither gross income to the borrower, nor a tax deduction to the lender. This is because there is "symmetry" of assets and liabilities on both side: the borrower's increased wealth when the loan is taken out is offset by an obligation to repay that same amount. Likewise, the lender's loss of wealth by borrowing out that money is offset by the borrower's promise to pay back the entire amount.[5] Ignoring interest, both sides will be in the exact same position when the loan is repaid as they were in before the loan was even made.
When debt is cancelled, then that symmetry is destroyed. The borrower is now in a better position than if the loan was fully repaid. The taxpayer now has a greater ability to pay taxes and this is shown by including the amount of canceled debt in gross income.
[edit] Exclusions
Not all COD income must be included in gross income. There are four exceptions[6]:
- If the discharge of indebtedness occurs in a title 11 case
- If the discharge of indebtedness occurs when the taxpayer is insolvent
- If the indebtedness discharged is qualified farm indebtedness
- If the indebtedness discharged is qualified real property business indebtedness
In addition, the Code recognizes a Purchase Price Adjustment exception.[7]
[edit] Requirements
In order to qualify under these exclusions, the taxpayer's indebtedness must result from either
- indebtedness for which the taxpayer is liable; or
- indebtedness subject to which the taxpayer holds property[8]
For example, if the lender cannot legally enforce the debt, then the taxpayer is not liable for that debt and will therefore not have tax consequences.[9]
If one of the two requirements are met, then the taxpayer must show that they fall under one of the four exclusions in order to avoid tax consequences on the COD Income.
[edit] Policy Reasons Behind COD Income Exclusions
The exclusions under Section 108 are justified under various rationales. First, it is difficult to collect tax from insolvent taxpayers. The bankruptcy and the insolvency provisions defer the tax to a time when taxpayer is able to pay. The farm indebtedness provision, on the other hand, represents a political decision to subsidize farmers by offering a tax benefit.
[edit] Title 11 Case
A title 11 case is one that falls under title 11 of the United States Code (relating to bankruptcy).[10]
[edit] Insolvency
A taxpayer is insolvent when their total liabilities exceed the fair market value of assets.[11] For example, if a taxpayer has $100,000 in liabilities, but only $50,000 in assets, they are considered insolvent under the Internal Revenue Code. Therefore, a cancellation of a $20,000 debt will not need to be reported as gross income. However, if a debt of $60,000 was cancelled, the taxpayer will have $10,000 in gross income because their total liabilities no longer exceed their total assets (cancelling $60,000 in debt means the taxpayer now has only $40,000 in liabilities).
[edit] Qualified farm indebtedness
A taxpayer has qualified farm indebtedness if
- such indebtedness was incurred directly in connection with the taxpayer's trade or business in farming; and
- 50% or more of the aggregate gross receipts of the taxpayer for the three taxable years preceding the discharge is attributable to the trade or business of farming[12]
However, such a taxpayer must be a "qualified person" as defined in 26 U.S.C. § 49(a)(1)(D)(iv)[13]
There are additional rules as well regarding the total amount excludable, which cannot exceed the sum of tax attributes and business and investment assets.[14]
[edit] Qualified real business property indebtedness
A qualified real property business indebtedness is indebtedness which
- was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property;
- was either 1) incurred or assumed prior to January 1, 1993, or 2) incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property; and
- the taxpayer elects to apply this exception[15]
However, this exclusion will only reduce the basis of the depreciable real property of the taxpayer.[16]
[edit] Purchase price adjustment
Sometimes a price agreement will be reached between buyer and seller, but for some reason both agree to reduce that price at a later date. A strict reading of the Internal Revenue Code says that the amount reduced is COD income, it does not fall under one of the four exclusions, and is thus gross income. To remedy this situation, Congress passed 26 U.S.C. § 108(e)(5), also known as the purchase price adjustment. If a reduction in price occurs after the parties have already reached an agreement, the Code treats the new agreed-upon price as if it were the original price, which means there will not be COD income to the buyer.[17]
[edit] Disputed Debt Doctrine
The Disputed Debt Doctrine (also known as the Contested Liability Doctrine), is yet another exception to including COD income in gross income. This doctrine can be found in a Third Circuit Court of Appeals case, Zarin v. Commissioner.[18] In order for this exception to apply, the amount of debt must actually be disputed. This can happen if the two parties actually have a good faith dispute over the amount owed. A written instrument containing the amount of debt will probably not satisfy this requirement. However, as the court decided in Zarin, the Disputed Debt Doctrine can also apply if the debt is not legally enforeable.[19]
[edit] Notes
- ^ 26 U.S.C. § 61(a)(12)
- ^ 348 U.S. 426 (1955)
- ^ Id.
- ^ U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)
- ^ Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Edition (St. Paul: Thomson/West, 2007), 113.
- ^ 26 U.S.C. § 108(a)(1)
- ^ Id. § 108(e)(5)
- ^ Id. § 108(d)(1)
- ^ See Zarin v. Commissioner, 916 F.2d 100 (3rd Cir. 1990)
- ^ 26 U.S.C. § 108(d)(2)
- ^ Id. § 108(d)(3)
- ^ Id. § 108(g)(2)
- ^ Id. § 108(g)(1)
- ^ Id. § 108(g)(3)
- ^ Id. § 108(c)(3)-(4)
- ^ Id. § 108(c)(1)
- ^ Id. § 108(e)(5)
- ^ 916 F.2d 110 (3rd Cir. 1990)
- ^ Id.
