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Background on Cancellation of Indebtedness

In United States v. Kirby Lumber Company, the U.S. Supreme Court first established the principle that the benefit to a debtor on partial or complete discharge of a liability is taxable income. Prior case law had held to the contrary. The principle is now codified.

Under Internal Revenue Code Section 61, except as otherwise provided, gross income means all income from whatever source derived including specifically income from discharge of indebtedness. Code Section 108(e)(1) reaffirms this principle in the absence of an applicable exception. However, at least 14 exceptions exist to the general rule.

Nontaxable Debt Discharge Under Section 108(a)

Section 108(a)(1) sets forth many of the exceptions to the general rule that income from discharge of indebtedness is taxable. These exceptions include:

• Discharge in a Title 11 (bankruptcy) case;
• Discharge when the taxpayer is insolvent;
• Qualified farm indebtedness;
• In the case of a taxpayer other than a ‘C’ corporation, qualified real property business; and
• Qualified principal residence indebtedness (2007-2012).

Nontaxable Debt Discharge under Other Portions of Section 108

Other exceptions to the general rule that relief from indebtedness is taxable are found in other parts of Section 108. These exceptions include:

• If the payment would have given rise to a future deduction;
• A reduction in a purchaser’s debt to a seller;
• Exchanges of debt for stock or other equity capital; and
• Student loans by a government or educational institution that self-cancel upon provision of service in certain professions in need areas (but not if the service is for the educational institution).

Nontaxable Debt Discharge Not Under Section 108

A third set of exceptions to the general rule taxing relief from indebtedness emerged through caselaw and other interpretations. These exceptions include:

• Discharge from indebtedness in a gift context;
• Cancellation of contingent indebtedness;
• Where debt forgiveness is part of a larger “loss” transaction;
• Where no increase in a debtor’s assets arises from discharge of indebtedness; and
• Where a bona fide disputed debt is settled.

Timing of Cancellation of Indebtedness Income

When cash changes hands, income is realized at the time the debt is satisfied for less than the amount owed. When cash does not exchange hands because there is no partial repayment, income is realized when it is clear that the debt will not be repaid. This may occur as the result of court decision, agreement, expiration of a statute of limitations or otherwise.

Bankruptcy Tax Issues – Filing

Bankruptcy Code Section 1398 creates a “separate taxpayer” for the assets of an individual in a Chapter 7 or 11 case that is not dismissed. This applies to cases under which the bankruptcy estate succeeds to most tax attributes of the individual including net operating loss and capital loss carryovers, passive activity and “at-risk” losses, as well as basis and accounting method. These attributes are denied to the individual who pays taxes on wage income and any other income not belonging to the estate.

The estate must file a tax return if its gross income exceeds the sum of one personal exemption plus the standard deduction for married individuals filing separately. A bankrupt individual with non-exempt assets may elect to commence a new individual tax year with the bankruptcy by filing a tax return for the short year within the non-extendable 3 ½ -month period following the bankruptcy. If the debtor has a tax liability for the short period, there is no personal liability if the estate has sufficient assets to pay the tax and the election is made.

Bankruptcy Tax Issues – Collection

Bankruptcy Code Section 362(e) stays IRS collection activity and shifts issues related to the legality of a tax into the Bankruptcy Court (which is generally considered as the most favorable forum for taxpayers).

An individual may discharge certain tax obligations in bankruptcy but, among others, may not discharge trust fund (payroll and sales tax) obligations, as well as income taxes where three years have not passed from the extended due date of the return and two years have not passed from the date of filing the return. In the case of tax deficiencies, at least 240 days must have passed from the date of assessment. Liabilities out of fraud are nondischargeable as are liabilities arising from an IRS-prepared “substitute for return.” Most courts including the Fourth Circuit deny discharge even if an actual return is filed after a substitute for return. IRS will challenge discharge of tax liabilities (generally with success) of individuals who lead extravagant lifestyles.

It appears as if moderate and upper income individuals (beginning typically in upper five figures) required to pay a portion of consumer indebtedness over a five-year period with disposable income pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act are not required to repay a portion of tax debts as they are not “consumer” in nature.

A lien by IRS against exempt property is unaffected by a bankruptcy as the discharge is only of the person. The Tax Court has determined that IRS can levy on a pension post-bankruptcy as it was not an asset of the bankruptcy estate.

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