When does debt become worthless?

The Ninth Circuit, affirming the Tax Court, recently held that to deduct a nonbusiness bad debt, the debt must be “wholly worthless,” and if the debtor reports cancellation-of-debt (COD) income, the discharged debt is not thereby presumed to be worthless to the creditor.

Facts: From 2007 to 2010, Michael R. Kelly transferred millions of dollars between his business entities, characterizing the transfers as loans. These included transfers by Kelly Capital, a single-member limited liability company owned by Kelly, to First Commercial Corp. (FCC), in which Kelly Capital had a 75% stake, and Greenback Entertainment Inc., which Kelly Capital wholly owned. On Dec. 31, 2010, Kelly canceled many of these purported loans.

On his 2010 Form 1040, U.S. Individual Income Tax Return, Kelly reported $145 million in COD income. He then excluded this amount from his gross income due to personal insolvency.

FCC and Greenback also reported COD income of $21 million and $2 million, respectively. These amounts were also excluded from income due to each company’s claimed insolvency. Excluding these amounts prevented the COD income from passing through to Kelly Capital and its single member, Kelly.

Kelly also reported a short-term capital loss of nearly $87 million due to a nonbusiness bad debt, which included $17.8 million owed by FCC and $2 million owed by Greenback to Kelly Capital. Kelly’s rationale for this was that once a taxpayer’s debt is canceled, it becomes automatically worthless, creating COD income and a bad debt deduction at the same time. The IRS disagreed and issued Kelly deficiency notices.

Kelly filed two petitions with the Tax Court challenging the deficiency notices. The court consolidated the two cases and ruled partly in Kelly’s favor on the issue of whether the transfers were bona fide loans but for the IRS on other issues, including the bad debt deduction (Kelly, T.C. Memo. 2021-76).

Kelly appealed to the Ninth Circuit, which found the following Tax Court findings relevant: (1) transfers to FCC and Greenback before 2008 were bona fide loans, but those made subsequently were not; (2) Kelly did not establish that FCC and Greenback were insolvent, such that their COD income would pass through to him; (3) Kelly failed to establish that the debts owed to him by FCC and Greenback were worthless in 2010, making them nondeductible to him under Sec. 166; and (4) even though Kelly was insolvent at the end of 2010, the COD income from FCC and Greenback could not be excluded from his gross income.

The Tax Court’s determinations had resulted in income tax deficiencies in the amount of $5,334,424 and $10,123 for 2010 and 2011, respectively. The only issue on appeal was the worthlessness of the FCC and Greenback loans at the time of their purported cancellation by Kelly.

Issues: To claim a bad debt deduction, the taxpayer must establish: (1) that the debt is bona fide (Regs. Sec. 1.166-1(c)); (2) the taxpayer has a sufficient adjusted tax basis in the debt to claim the deduction (Sec. 166(b)); and (3) the debt became “wholly worthless within the taxable year” (Regs. Sec. 1.166-5(a)(2)). The Ninth Circuit has held that the burden is on the taxpayer to show worthlessness by establishing sufficient objective facts and that mere belief of worthlessness by the taxpayer is insufficient (Cooper, 877 F.3d 1086, 1094 (9th Cir. 2017)).

Kelly’s main argument was that the Tax Court did not construe “worthless” debt under Sec. 166 the same as “discharged” debt under Sec. 61(a)(11). According to Kelly, a canceled debt becomes “undeniably worthless and beyond any hope of recovery.” Therefore, by allowing FCC and Greenback COD income under Sec. 61(a)(11), the court needed to acknowledge a reciprocal bad debt deduction under Sec. 166 as a matter of law. In rejecting this argument, the Tax Court stated, and the Ninth Circuit agreed, that Kelly could not “create a deduction by recording intercompany debt and then canceling it” (Kelly, T.C. Memo. 2021-76 at *22).

In rejecting Kelly’s argument, the Ninth Circuit held that the Tax Court properly construed Secs. 61, 108, and 166. In determining the meaning of a statute, the Ninth Circuit began by looking at the plain text of the statute, considering its structure, object, and policy. Any undefined statutory term is interpreted “pursuant to its ordinary meaning.”

The court stated that the terms “worthless,” under Sec. 166, and “discharge,” under Sec. 61(a)(11), “are not ‘mere synonyms,'” as Kelly contended. Looking at dictionaries from the period of both statues’ enactment, the court noted that “worthless” was defined as “lacking value or utility” and “discharged” as a “release from repayment obligation” (see, e.g., Discharged, Worthless, Webster’s New International Dictionary 519, 2109 (2d ed. 1934); Worthless, Discharged, Black’s Law Dictionary (4th ed. 1951)). Even if a debt obligation might lack value at the time of discharge, determining lack of value requires examining the objective facts, the court found. Without these objective facts demonstrating worthlessness, any monetary transfer could be categorized as a loan and later canceled to produce an illegitimate tax benefit to the putative creditor, especially if the parties are not dealing at arm’s length. This is the main reason Congress (in the Revenue Act of 1942, P.L. 77-753) enacted an objective test of actual worthlessness, abandoning the subjective-worthlessness test previously used. Therefore, the Ninth Circuit concluded that COD income arising from a debt discharge did not presumptively render the discharged debt worthless to the creditor.

Secs. 61 and 108(a)(1)(B), which address COD income, bear no relation to Sec. 166, the Ninth Circuit found. Both Secs. 61 and 108(a)(1)(B), as the court explained, adopt a “freeing-of-assets theory” where the “discharged debt creates a potential gain,” depending on the taxpayer’s solvency, which does not have a relationship to worthlessness or any “reciprocal effect on the creditor.” The court also posited that Sec. 166 is more akin to a casualty loss deduction. Therefore, according to the court, allowing a discharging creditor a bad debt deduction “would be like allowing an insurance payout to someone who intentionally burned down his own house.” Thus, the Ninth Circuit concluded that, by requiring Kelly to prove worthlessness, the Tax Court properly construed Secs. 61, 108, and 166.

The taxpayer must also prove that the debt is “wholly worthless” (Sec. 166(a)(1)). Under Ninth Circuit precedent, worthlessness is not determined by comparing the face value of the debt to the debtor’s assets. Rather, the relevant benchmark used is zero (L.A. Shipbuilding & Drydock Corp., 289 F.2d 222, 228 (9th Cir. 1961)). Therefore, if any portion of the debt — even a modest fraction — is recoverable, it is not deemed to be worthless.

Kelly conceded that the debts between Kelly Capital and FCC and Greenback were “near[ly] wholly worthless” not wholly worthless. FCC and Greenback had assets during the tax year in which Kelly claimed the deduction, from which the Ninth Circuit deduced that some part of the debt was recoverable. At no point did Kelly provide evidence that the debts were uncollectible. Therefore, the Tax Court had been correct in holding that Kelly failed to prove that FCC and Greenback were insolvent and that Kelly’s subjective determination of the loans’ value on Dec. 31, 2010, was not enough, the Ninth Circuit held.

Holding: The Ninth Circuit held that the Tax Court had properly required Kelly to prove the worthlessness of his discharged debts instead of presuming worthlessness because COD income arose from that discharge. Further, the court did not clearly err in determining that Kelly’s debt was not worthless, given his concession that it was not and his failure to show through objective facts that the debt was worthless.

Kelly, No. 23-70040 (9th Cir. 2025)

— John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, and Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, both at Cornell University. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.