A debt is discharged or canceled when the debtor is relieved of his/her payment obligation[i]. Discharge of indebtedness conveys forgiveness of or release from an obligation to repay[ii].
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[iii]:
- for which the taxpayer is liable, or
- subject to which the taxpayer holds property.
In order for discharge of indebtedness income to occur, a taxpayer should be discharged from liability. Such liability, or debt, is viewed as having been discharged when it becomes clear that the debt will never have to be paid[iv].
Gross income includes income from discharge of indebtedness[v]. For instance, C lends $ 1,000 to D. If C later accepts $ 800 in full payment, D has an increase of $ 200 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[vi]. 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.
A taxpayer is generally treated as realizing taxable income if a debt he/she owes is forgiven, or if it’s unlikely ever to be enforced against him/her, or if it becomes unenforceable against him/her and the indications are that he won’t pay it.
However, income is not realized by a taxpayer by virtue of the discharge of his/her indebtedness as a result of an adjudication in bankruptcy, or by virtue of a composition agreement among his/her creditors, if immediately thereafter the taxpayer’s liabilities exceed the value of his/her assets[vii].
The Internal Revenue Code excludes from gross income, the income arising from discharge of indebtedness applicable generally to all corporations, whether or not financially sound[viii].
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[ix]:
- 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, discharge of indebtedness income exclusion does not apply to a taxpayer who sells property in partial satisfaction of debt prior to filing bankruptcy petition. Likelihood of future discharge of debt in bankruptcy does not qualify taxpayer for relief under the Internal Revenue Code[x].
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.
The Internal Revenue Code provides general rules for discharge of indebtedness such as[xi]:
- 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.
- for purposes of determining income of the debtor from discharge of indebtedness, if a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, such corporation will be treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness.
- if a creditor acquires stock of a debtor corporation in satisfaction of such corporation’s indebtedness, such stock is treated as depreciable property.
- the aggregate amount allowed to the creditor as deductions by reason of the worthlessness or partial worthlessness of the indebtedness, or as an ordinary loss on the exchange, is treated as an amount allowed as a deduction for depreciation.
- a debtor’s indebtedness is satisfied by corporate stock or partnership interest, if:
- a debtor corporation transfers stock,
- or a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, such corporation or partnership shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock or interest.
- 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.
The Internal Revenue Code further provides for some special rules for discharge of qualified farm indebtedness such as[xii]:
- discharge must be by qualified person.
- indebtedness of a taxpayer is treated as qualified farm indebtedness if:
- such indebtedness was incurred directly in connection with the operation by the taxpayer of the trade or business of farming, and
- 50 percent or more of the aggregate gross receipts of the taxpayer for the three taxable years preceding the taxable year in which the discharge of such indebtedness occurs is attributable to the trade or business of farming.
- amount excluded cannot exceed sum of tax attributes and business and investment assets.
Special rules relating to qualified principal residence indebtedness as stated in the Internal Revenue Code are[xiii]:
- 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.
The concept of discharge of indebtedness income requires taxpayers who have incurred a financial obligation that is later discharged in whole or in part, to recognize as taxable income the extent of the reduction in the obligation[xiv]. Two rationales are identified by the courts for this rule: 1) the rule is based on the premise that the taxpayer has an increase in wealth due to the reduction in valid claims against the taxpayer’s assets. 2) taxation is appropriate because the consideration received by a taxpayer in exchange for his/her indebtedness is not included in income when received because of the obligation to repay and the cancellation of that obligation removes the reason for the original exclusion.
In Kentucky & I. T. R. Co. v. United States, 330 F.2d 520 (6th Cir. Ky. 1964), the court held that the Internal Revenue Code do not exempt from taxation a gain realized by the taxpayer attributable to the discharge of its indebtedness, but simply provides a means whereby the taxpayer may elect to defer the gain by applying it to the reduction of the basis of any property held by it during the taxable year in which such discharge of said indebtedness occurred.
[i] United States v. Centennial Sav. Bank FSB, 499 U.S. 573 (U.S. 1991)
[ii] Philip Morris Inc. v. Comm’r, 71 F.3d 1040 (2d Cir. 1995)
[iii] 26 USCS § 108
[iv] Friedman v. Comm’r, 216 F.3d 537 (6th Cir. 2000)
[v] 26 USCS § 61
[vi] Commissioner v. Motor Mart Trust, 156 F.2d 122 (1st Cir. 1946)
[viii] Helvering v. American Dental Co., 318 U.S. 322 (U.S. 1943)
[ix] 26 USCS § 108
[x] In re Brubeck, 1989 Bankr. LEXIS 2323 (Bankr. S.D. Ind. 1989)
[xi] 26 USCS § 108
[xiv] Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999)