Cancellation of Indebtedness Income Timing Issues

Joe Dawson

Dawson & Gerbic, LLP

During 1992 the American Bar Association issued its Report of the Section 108 Real Estate and Partnership Task Force, 46 Tax Law 209, ("the Report").  The Report's authors stated that the law concerning the timing of debt cancellation income ("CODI") realization for debtors in bankruptcy was unsettled.  I believe they really meant to say that they found the probable law in that context unsettling.

The Report did not suggest that the law regarding CODI timing for debtors outside of bankruptcy was unclear.  And the Report authors provided no authority or compelling reasons for different treatments of bankruptcy and non-bankruptcy CODI.  I suspect they were concerned by the unstated possibility that parallel treatment might frequently place bankruptcy-related CODI outside of the gross income exclusions of Internal Revenue Code 108(a).  That concern may have been well-founded, because bankruptcy and non-bankruptcy CODI timing rules should logically be the same.

The Report provides a brief list and discussion of a few events, and suggests that in general the earliest of those events should be the trigger for taxable debt discharge.  That list includes: acceptance by a creditor of payment in an amount less than the total owed and in complete satisfaction of the debt; forgiveness by agreement of the parties; cancellation by a creditor's binding act; cancellation by operation of applicable law; and cancellation by order of a court.

As discussed below, the Report's position on CODI triggering events was probably overly simplified.  Each of the Report's suggested triggering events outside of bankruptcy proceedings is supported by existing law, however.

The landmark case in the CODI arena, United States v. Kirby Lumber Co., 284 U.S. 1 (1931), found CODI to be triggered upon a creditor's repurchase of its bonds for less than the amount owed.

CODI was triggered on the effective date of agreements between the debtors and the government in Likens-Foster Honolulu Corp. v. Commissioner, 417 F.2d 285 (10th Cir. 1969). see also Capitol Coal Corp. v. Commissioner, 250 F.2d 361 (2d Cir. 1957), cert. denied, 356 U.S. 936; Exchange Security Bank v. U.S., 492 F.2d 1096 (5th Cir. 1974); TAM 8120014.

Even unilateral actions by a creditor have triggered CODI.  In Salva v. Commissioner, 51 F.3d 1049 (11th Cir. 1995), a creditor's filing of mortgage release documents, which discharged the debtor under state law, created CODI.

Various non-bankruptcy laws can render debts uncollectible, and CODI has normally been found to arise when that occurs.  The running of a general statue of limitations created CODI in cases such as Randolph v. Commissioner, 80 T.C.M. (CCH) 192 (2000) and Schweppe v. Commissioner, 8 T.C. 1224 (1947), aff'd 168 F.2d 284 (9th Cir. 1948).   More limited statutes can have the same effect; for example, in Carl T. Miller Trust v. Commissioner, 76 T.C. 191 (1981), CODI arose when no claim was filed against an estate during the probate statutory claims period.

The Report's list of triggering events could have been much shorter.  Each listed event involves a final and binding determination that a creditor, either voluntarily of by legal compulsion, will be paid less than the amount he is owed.  The Report implies that the law generally requires an event which creates such a binding and final determination.  It's not that simple, however.

A finding of CODI doesn't appear to require identification of a final and binding event.  In fact, there are numerous examples of events which were either not final or not binding, but which were nevertheless judicially deemed to trigger CODI.  The actual test seems to be best stated as a requirement of an identifiable event or events, whether binding on the creditor or not, that make it clear within a reasonable degree of certainty that the debt will not be repaid.  see:  Helvering v. Jane Holding Corp., 109 F.2d 933 (8th Cir. 1940); Cozzi v. Commissioner, 88 T.C. 435 (1987).

Creditors' non-binding internal policies or decisions have triggered CODI when it became clear that no further attempt would be made to collect the obligation. see, for examples: Marcus Estate v. Commissioner, 34 T.C.M. (CCH) 38 (1975);  McIssac v. Commissioner, 57 T.C.M. (CCH) 793 (1989); and Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744 (1994).

CODI has also been found to occur at the time that the collateral supporting non-recourse debt became worthless and was abandoned, even though the underlying obligation was not formally cancelled.  see: Cozzi v. Commissioner, 88 T.C. 435 (1987); Carlins v. Commissioner, 55 T.C.M. (CCH) 228 (1988).

The creditor's accounting treatment of obligations has been found to demonstrate their cancellation.  In Callan Court Co. v. Commissioner, 24 T.C.M. (CCH) 1419 (1965), CODI was found when the creditor failed to record a receivable as an asset and claimed a bad debt deduction.  The issuance of a Form 1099 information return to the debtor was a significant factor in the McIssac case cited above.  McIssac v. Commissioner, 57 T.C.M. (CCH) 793 (1989).

Perhaps more surprisingly, the debtor's accounting treatment of obligations has also supported CODI treatment in some instances.  see, as examples: Boston Consolidated Gas Co. v. Commissioner, 128 F.2d 473 (1st Cir. 1942); Fidelity-Philadelphia Trust Co. v. Commissioner, 23 T.C. 527 (1954); and Charleston & Western Carolina Railway Co. v. Burnet, 50 F.2d 342 (CA Dist. 1931).  These cases found CODI to arise upon the debtor's write-off of customer deposits and unclaimed wages, even though the liabilities remained outstanding.

If the test for the timing of CODI is the occurrence of identifiable events that make it clear the debt will not be repaid, the reported decisions suggest that there are three situations where testing may sometimes prove difficult.

One potential problem situation does not present true timing issues.  Sometimes events which at least appear to represent cancellation of an obligation do not produce CODI for tax purposes.  The other difficult situations do raise timing issues, however.  Sometimes no one event alone proves or creates debt cancellation; instead, a group of events, occurring over a period of time, is necessary.  And sometimes there are multiple events, at different times, any of which alone would be sufficient to create CODI.

An obligation cannot be the source of CODI if it is not cancelled.  Meyers v. Commissioner, 27 T.C.M. (CCH) 1535, presented an easy case; there was no communication concerning possible cancellation, so there was no cancellation.  Even where there was a plan for debt cancellation, moreover, no cancellation was found in Maros v. Commissioner, 54 T.C.M. (CCH) 1270 (1987), where cancellation was expressly conditioned upon a property transfer which did not occur.

Where there is a reasonable expectation that an outstanding obligation will be repaid, cancellation is unlikely to be found. see, for examples: Alexander v. Commissioner, 61 T.C. 278 (1973), acq., 1974-2 C.B. 1; and Tsakopoulos V. Commissioner, 83 T.C.M. (CCH) 1064.  Adequate security for an obligation should have the same effect. Fuller v. Commissioner, 40 T.C.M. (CCH) 1184 (1980).

Similarly, no CODI can occur in the absence of evidence that a debt existed in the first place.  In Vanguard Recording Society v. Commissioner, 418 F.2d 829 (2d Cir. 1969), accounting entries to eliminate an old, unexplained liability account were not found to create CODI in the absence of evidence that a true debt ever existed.

Zappo v. Commissioner, 81 T.C. 77 (1983) found no CODI from the release of a contingent liability [although this was of little use to Angelo Zappo, who got zapped anyway on a separate claim].  And the Internal Revenue Service has adopted a similar view in connection with settlement of a proposed tax deficiency, since such settlements are intended to eliminate all of the tax liabilities related to the compromised items, including tax consequences of the settlement itself. see discussion at Gordon Henderson & Stuart Goldring, Tax Planning for Troubled Corporations, 404.6 at 106, note 94 (2006 Ed.)

Even if a liability is cancelled, no CODI occurs if the cancelled obligation is not true debt for tax purposes.  The Report makes it clear that CODI should result only if cancelled indebtedness represents amounts which have been somehow received, but which have been excluded from income because of an obligation to repay.  If the creation of an obligation did not result in an untaxed accretion to the debtor's wealth, or an unpaid deduction for income tax purposes, its cancellation theoretically should not result in CODI.

Based on this rationale, cancellation of guarantee obligations has been excluded from CODI. see, for examples: Hunt v. Commissioner, 59 T.C.M. (CCH) 635 (1990) and Landreth v. Commissioner, 50 T.C. 803 (1968).  And in Gordon Henderson & Stuart Goldring, Tax Planning for Troubled Corporations, 404.1 at 89-90 (2006 Ed.), the authors suggest that the same treatment is appropriate for the cancellation of nondeductible interest and for the settlement of a disputed claim for less than the amount originally claimed.

Even the modification or cancellation of items that are true debt for tax purposes sometimes avoids classification as CODI.  Where there is a gratuitous debt discharge, either by gift or by a testamentary disposition, the debtor reports no income.  see T.A.M. 9240003 (June 17, 1992).  And no CODI occurs when a liability is paid with depreciated currency, Philip Morris, Inc. v. Commissioner, 104 T.C. 61 (1995), aff'd, 71 F.3d 1040 (2d Cir. 1995), cert denied, 517 U.S. 1220 (1996),or converted into a less valuable security, U.S. v. Centennial Savings Bank FSB, 499 U.S. 573 (1991), according to its original terms.

And a taxpayer incurs CODI only if his own liability on an obligation is cancelled.  For example, cancellation of partnership debt creates no CODI for partners who remain liable. see F.S.A. 20028019.

As mentioned above, judicial decisions have sometimes based their debt cancellation determination on a combination of a series of events and of multiple factors spanning an extended time frame. see, for example  B. M. Marcus Estate v. Commissioner, 34 T.C.M. (CCH) 38, where the court based its determination of debt cancellation in the year of the decedent's death on the general intentions of the executors not to pay and of the creditor not to enforce its obligation.

Presumably, if existence of each relevant event and factor is considered necessary, but only the complete combination is considered sufficient to create debt cancellation, then CODI occurs when the last piece falls into place.  Determination of that point in time may be difficult in practice, but the concept isn't conceptually difficult.

Unfortunately, however, some perplexing conceptual issues can arise when multiple events, any of which might be independently sufficient to create CODI, occur at different times.

Some of the most confusing issues result from necessity to choose between the dates of an agreement to perform an act and the dates of other events.  But before that analysis can even begin, it's necessary to determine precisely what the agreement date is.

Some subsequent events clearly do not control the identification of the date of events.  For example, in Rivera v. Commissioner, 66 T.C.M. (CCH) 1682 (1993), the court made it clear that the date of recording in a creditor's accounting records is merely a ministerial act, and does not identify the date of the recorded transaction itself.

On the other hand, if a subsequent event is an integral and necessary part of an agreement, then no agreement exists until that event occurs.  The most obvious example of this situation is a debt cancellation included in a contractual agreement where the entire agreement has a later effective date.  No agreement exists until that effective date.

Other subsequent events may also be necessary conditions precedent to an agreement's existence for CODI purposes.  For example, in Exchange Security Bank v. U.S., 492 F.2d 1096, (5th Cir. 1974), the court concluded that an agreed-upon litigation settlement had no effect until necessary judicial approval was obtained.

Once the date of an agreement is determined, there are numerous other types of events which may require consideration in selecting the date that CODI is incurred.

One of the most common fact patterns of this sort is an agreement conditioning a future cancellation of debt on required future payments or transfers from the debtor to the creditor.  The courts, and more recently the Internal Revenue Service, have held that such a contingent agreement results in no CODI until the required payments are made.  see: Connell Bros. Co. Ltd., B.T.A. Mem. Dec. (P-H) 40,055 (1940); Walker v. Commissioner, 88 F.2d 170 (5th Cir. 1937); Shannon v. Commissioner, 66 T.C.M. (CCH) 1418 (1993); Rivera v. Commissioner, 66 T.C.M. (CCH) 1682 (1993); P.L.R. 9551036; Lowry v. Commissioner, 82 T.C.M. (CCH) 499 (2001).

CODI recognition is only delayed if there is truly a contingent element to the required payment stream.  If the future payments are by agreed-to automatic set-offs of mutual obligations, as in U.S. v. Ingalls, 399 F.2d 143, (5th Cir. 1968), or if the debt cancellation actually occurs at the time the agreement is entered into, rather than at the completion of the stated payment term, as in Seay v. Commissioner, 33 T.C.M. (CCH) 1406, CODI occurs at the agreement date.

And, of course, there is no CODI if the agreement provides for payment in full, with no debt cancellation element.  see Republic Supply Co. v. Commissioner, 66 T.C. 446 (1976).

Foreclosure transactions can also present analytical difficulties in some cases.  A foreclosure may result in CODI, but only if recourse debt is truly cancelled.  Sometimes there are deficiency judgments.  To the extent that unpaid recourse liability remains after the foreclosed property disposition, no CODI should occur due solely to the fact of foreclosure.  see Aizawa v. Commissioner, 99 T.C. 197 (1992).  Presumably, however, an independent analysis of the remaining liability's collectibility would be required.

And foreclosures are sometimes not final events.  Debtors frequently have a right to redeem the foreclosed property for a period of time.  Where such a right exists, the existing authorities delay CODI recognition until the redemption right is extinguished or waived by the debtor. see, as examples:  Derby Realty Corp. v. Commissioner, 35 B.T.A. 335 (1937), acq. 1938-1 C.B. 9; Commissioner v. Peterman, 118 F.2d 973 (9th Cir. 1941); R. O'Dell & Sons Co. v. Commissioner, 169 F.2d 247 (3d Cir. 1948); Rev. Rul 70-63, 1970-1 C.B. 36.

Foreclosures are not the only type of apparently conclusive events which are not truly final. For example, judicial decisions are normally subject to appeal.  In Exchange Security Bank v. U.S., 492 F.2d 1096 (5th Cir. 1974), the court found that a debtor's defense of a debt cancellation order appeal did not cause delay of debt cancellation past the date of the initial order.

Another common example of a supposedly final determination which is actually reversible is the expiration a statute of limitations on the collection of debts.  Limitation statutes frequently provide only an affirmative defense against collection efforts, and even supposedly cancelled debts are sometimes subject to reaffirmation.

For these reasons, several judicial decisions have delayed debt cancellation past the expiration of limitations statutes when subsequent events suggested a continuing intent on the debtor's part to pay.  see, for examples:  Bear Mfg. Co. v. Commissioner, 430 F2d 152 (7th Cir. 1970), where unpaid liabilities remained on the debtor's accounting records for three years past the limitation statute expiration date, and Standifer Construction Corp. v. Commissioner, 30 B.T.A. 184 (1934), where unpaid wages were deemed cancelled only when corporate dissolution began, rather than in earlier years when limitation statutes expired.

Limitation statute expirations are not the only type of event where accounting treatment can govern timing.  As mentioned above, various judicial decisions have relied upon accounting write-offs of debt to find debt cancellation for CODI purposes even though debts still technically existed.  In each of those cases, however, it appears that the courts relied upon the rationale supporting the creditor's accounting, rather than the accounting entries themselves.  The write-offs were made because the debts were determined to be uncollectible; they didn't cause it.

Furthermore, limitation statute expirations are not the only type of event where otherwise cancelled debts may be subject to reaffirmation.  No CODI occurred in Milenbach v. Commissioner, 106 T.C. 184 (1996), aff'd 318 F.3d 924 (9th Cir. 2003), where a creditor's failure to fund an escrow account, which relieved a debtor from its obligation to pay, was waived by the debtor for business reasons.

But, again, waivers or reaffirmation agreements will delay CODI only if a true liability is created.  In Jelle v. Commissioner, 116 T.C. 63 (2001), the debtor's agreement to reinstate a cancelled debt to a mortgage creditor, but only if the security property was sold within ten years, did not delay CODI.  The agreement had no certain amount, bore no interest, and had no definite payment schedule; any repayment essentially remained at the debtor's discretion.

Debt reaffirmation frequently occurs in the context of bankruptcy proceedings.  Actually, all of the conflicts between possible COD dates discussed above do.  There are definitions, events and statutory rules peculiar to bankruptcy proceedings that superficially appear to create unique CODI timing issues.  However, as suggested above, the analysis and resolution of those issues should logically be the same in both bankruptcy and non-bankruptcy contexts.

Just as in non-bankruptcy situations, CODI in the bankruptcy context should occur when an identifiable event creates reasonable certainty that a debt will not be repaid.  Certain types of events, including binding court orders, satisfy that requirement.  Both Chapter 7 and Chapter 11 of the Bankruptcy Code ("the Code") provide for binding court orders discharging debts in some cases.  Logically, such court orders should result in CODI.  And they do, subject to many of the same caveats discussed above in connection with non-bankruptcy CODI determinations.

The only likely timing issue concerning a court order which expressly discharges a debt is the effective date of the order.  In C. Richard McQueen & Jack F. Williams, Tax Aspects of Bankruptcy Law and Practice, 23:12 at 23-13 (Third Ed.), the authors state that such an order under Code sec. 747 of the Code usually occurs at the end of a case under Chapter 7.  They state that the court normally uses Official Bankruptcy Form No. 18, which provides that the debtor is released from all dischargeable debts.  Therefore, the issuance of Form 18 should trigger CODI.

The situation is more complicated in bankruptcy cases under Chapter 11.  Sec. 1141(d) of the Code provides that the confirmation of a plan of reorganization may provide debt discharge.  At least one income-tax related judicial decision appears to have taken the Bankruptcy Code literally.  In Benton v. Commissioner, 122 T.C. 353 (2004), the Tax Court held that in Chapter 11, the termination date of an individual's bankruptcy  estate for purposes of Internal Revenue Code sec. 1398 is the date the plan is confirmed.

Of course, the Benton decision is not semantically correct.  The Sixth Circuit reached the correct answer in an unpublished opinion, see In re Linsenmeyer, 2003 TNT 226-49 (6th Cir. 2003).  In that decision the court apparently recognized that, just as discussed above in connection with non-bankruptcy situations, the significant date was the effective date of the confirmation order.

In fact, the Linsenmeyer position is mandated by the actual language of Bankruptcy Code 1141(d)(1).  Discharge occurs upon plan confirmation "Except as otherwise provided in this subsection, in the plan, or in the order confirming the plan..."  A stated effective date later than the plan confirmation date clearly falls within that exception.

The Code sec. 1141(d) debt discharge provision is subject to other exceptions and limitations as well.  Code sec. 1141(d)(5) delays debt discharge until either all payments required by a confirmed plan of reorganization are made, or the court orders an earlier discharge.  Again, however, the rationale of the non-bankruptcy decisions discussed above should resolve any CODI timing questions.
In the normal individual bankruptcy case, no modification will occur to the original debt unless, and until, the required payments are made.  The debt isn't cancelled at the date of plan confirmation, so there should be no CODI at that date.  And if the court orders an earlier debt discharge, the non-bankruptcy rules covering intervening final court orders should appropriately apply to accelerate CODI recognition.

Bankruptcy Code secs. 1141(d)(3) and 727(a) go still farther; those Code provisions deny debt discharge entirely in certain cases.  But, again, the non-bankruptcy rules provide guidance for determination of CODI timing.  When non-binding events, facts and circumstances make it clear that there will be no further attempts at debt collection, CODI should be deemed to occur.

And, finally, non-bankruptcy CODI concepts should also serve to resolve choices between other  possible triggering events in a bankruptcy context.  The Report recognizes that a creditor can accelerate a debtor's CODI recognition by entering into a binding agreement to reduce debt during the pendency of a bankruptcy case.  But, as discussed above in the non-bankruptcy arena, an agreed settlement can have no effect until any necessary judicial approval is obtained.  So, any agreement that is contingent by its terms upon an order of the bankruptcy court can not create CODI before such an order is issued.  Until that point in time, the agreement should not be effective for any purpose.

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