No COD income from loans

Expiration of state limitation period on loan collection wasn’t conclusive of debt discharge.
By Maria M. Pirrone, CPA, LL.M.

The Tax Court excused a taxpayer from reporting cancellation-of-debt (COD) income on two loans, finding the first loan remained outstanding and the second loan qualified for the insolvency exclusion under Sec. 108(a)(1)(B).

Facts: The petitioner, Harold Johnston, was the co-founder of Summit Communications Inc. Al Hee was the founder of Sandwich Isles Communications Inc. (SIC). Hee actively pursued Johnston for an executive position at SIC with an employment offer that included a salary, benefits, and a $450,000 loan. In May 1998, Johnston and SIC executed an employment agreement that stated that the SIC loan would become due if Johnston's employment with SIC was ever terminated. In 1998, Johnston obtained a second loan of $20,000 from SIC's parent company, Waimana Enterprises Inc.

In 2000, Johnston resigned his position with SIC, which triggered his repayment obligations on the SIC loan under the employment agreement. SIC and Waimana did not demand repayment of the SIC loan at that time, nor did Johnston receive a Form 1099-C, Cancellation of Debt, discharging the SIC loan.

On Feb. 13, 2002, Summit filed a petition with a U.S. bankruptcy court that led to its dissolution. Johnston went back to work for SIC in 2005. Waimana wrote off its loan in 2007 due to Johnston's insolvency.

As a result of an audit of SIC's return, the IRS audited Johnston's return for 2007. During the audit, Johnston agreed to an income adjustment of $20,000 related to the Waimana loan. In 2013, the IRS issued Johnston a notice of deficiency in which it claimed he had failed to report COD income related to the SIC loan for the 2007 tax year and determined a deficiency of $251,320 and an accuracy-related penalty under Sec. 6662(a) of $50,264.

Issues: Sec. 61(a)(12) defines "gross income" broadly as all income from whatever source derived, including from discharge of indebtedness. The Tax Court has held that whether a debt has been discharged depends on the substance of the transaction (Cozzi, 88 T.C. 435 (1987)). Additionally, once it becomes clear that a debt will never have to be paid, that debt must be viewed as discharged. When a debt does not have to be repaid is determined by the facts and circumstances relating to the likelihood of payment and subjective intent of the creditor.

Sec. 108(a)(1)(B) provides an exclusion from gross income for amounts discharged if the discharge occurs when the taxpayer is insolvent. The amount excluded cannot exceed the amount by which the taxpayer is insolvent.

The IRS argued that Johnston realized COD income in 2007 from the forgiveness of the SIC loan. It pointed to SIC's and Waimana's failure to take action after the SIC loan became due and before the period of limitation for collection expired. Johnston argued that the SIC loan was not discharged in 2007 because it was still outstanding and he was repaying it monthly. Hee testified that Waimana considered the SIC loan outstanding. Additionally, the IRS argued that Johnston realized COD income in 2007 from the forgiveness of the Waimana loan. Although Johnston had agreed to an audit adjustment related to this loan, in court he disputed this claim. The parties agreed that Johnston qualified for the exclusion under Sec. 108(a)(1)(B) but disagreed as to the insolvency amount.

Holding: The Tax Court held that the SIC loan was still outstanding and therefore was not discharged. Specifically, the court, pointing to prior cases, found that although under some circumstances the expiration of a state limitation period can serve as an identifiable event, it is not conclusive as to when a debt has been discharged. Because Waimana and SIC never treated the SIC loan as canceled or otherwise forgiven, Hee credibly testified that the loan was still outstanding. For that reason and because Johnston was still repaying the loan, the court concluded that Johnston did not have COD from the SIC loan for 2007.

With respect to the Waimana loan, the court determined that Johnston had COD income because there was no evidence that he was repaying the loan or that Waimana considered it outstanding, and Waimana had written off the loan in 2007. However, the Tax Court held that the COD income of $20,000 was excludable from Johnston's income under Sec. 108(a)(1)(B). While the IRS and Johnston disagreed on Johnston's insolvency amount, the court noted that the discrepancies were immaterial, because the insolvency amount calculated by both the IRS and Johnston exceeded the COD income from the Waimana loan of $20,000.

  • Johnston, T.C. Memo. 2015-91

—By Maria M. Pirrone, CPA, LL.M., assistant professor of taxation, St. John's University, New York City.


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