COD income not includible due to lack of a bona fide debt

A taxpayer established that she never intended to be the primary obligor on the loan.
By Maria M. Pirrone, CPA, LL.M.

The Tax Court held no bona fide debt existed with respect to a taxpayer because she was only a guarantor on a loan that gave rise to purported cancellation-of-debt (COD) income, even though a Form 1099-C, Cancellation of Debt, was issued to her. Therefore, she did not have to include the COD amount in gross income.

Facts: The adult son and daughter-in-law of the petitioner, FloEtta Bullock, operated a business hauling cars across the country. Due to a business emergency in 2007, they sought a loan to purchase a used pickup truck for their business. Bullock, along with her son and daughter-in-law, discussed loan options with a credit union. Although Bullock intended to serve as a co-signer for her son, she unknowingly signed paperwork that made her the primary obligor on the loan. However, the credit union dealt only with the son and daughter-in-law.

The truck was stolen in 2008. The initial insurance policies on the truck covered only a portion of the outstanding balance of the loan. After the credit union was paid by the insurance company, the petitioner's son and daughter-in-law stopped making loan payments. The outstanding balance on the loan, which was $8,164, was discharged.

Bullock did not receive any phone calls or correspondence from the credit union attempting to collect the outstanding balance. Neither did she receive any information regarding the discharge of the loan.

Bullock did receive a Form 1099-C from the credit union indicating that she received COD income of $8,164 for the 2013 tax year. However, she did not report the COD income on her 2013 federal income tax return. On Jan. 19, 2016, the IRS issued a notice of deficiency determining that she had unreported COD income of $8,164. Bullock timely filed a petition with the Tax Court for redetermination and appeared pro se.

Issue: Sec. 61(a) defines gross income for purposes of calculating taxable income as "all income from whatever source derived" and specifically states that "income from discharge of indebtedness" is included within the definition, under Sec. 61(a)(12). The rationale is that discharge of debt accords the debtor an economic benefit equivalent to income. For COD income to exist, a bona fide debt must exist. Whether a transaction constitutes a debt is a factual determination.

Holding: After considering the relevant facts, the Tax Court held that the transaction at issue did not create a bona fide debt of the taxpayer. The court found that when Bullock signed the paperwork, she did not intend to be the primary obligor on the loan. Quoting Dixie Dairies Corp., 74 T.C. 476, 494 (1980), the court stated that the ultimate question regarding the existence of a bona fide debt is: "Was there a genuine intention to create a debt with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?" Further, the court noted that a guaranty creates a contingent liability where a party's obligation to make a payment under the guaranty is contingent upon the primary obligor's failure to pay the debt, citing Mylander, T.C. Memo. 2014-91.

After considering these principles, the Tax Court held that the transaction in this case did not create a bona fide debt. Bullock, with the knowledge of the credit union, operated as a guarantor for her son and daughter-in-law. Additionally, the court held that because she was merely the secondary obligor, her net worth was not increased. Therefore, Bullock did not receive $8,164 in COD income in 2013.

  • Bullock, T.C. Memo. 2017-219

— By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John's University, Queens, N.Y.

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