You are here

Cancellation of Indebtedness

30 July, 2015 - 12:13

All of this assumes that taxpayer will indeed repay the full amount of the loan. Consider now what happens when we no longer make this assumption. Taxpayer does not repay the loan, and for whatever reason, no longer owes it.

  • Taxpayer has enjoyed the benefits of an expenditure on consumption without an offsetting (net) reduction to his/her/its store of property rights.
  • Taxpayer no longer commits his/her/its future consumption choices to the repayment of the loan.
  • Should we regard this as an accession to wealth and treat it as gross income? See § 61(a)(12).

Or: perhaps the assets that taxpayer purchased with the borrowed funds and upon which taxpayer relies to repay the loan shrink in value so that taxpayer is no longer able to repay the loan.

  • Should this excuse a failure to repay the loan because such shrinkage can hardly be regarded as an “accession to wealth?”
  • If we deem such a shrinkage not to be an “accession to wealth,” we effectively merge the borrowing transaction and the spending or investing of the loan proceeds into one transaction. Is this appropriate? Or should we account separately for –
    • the borrowing and repayment, and
    • the fate of the enterprise in which taxpayer spends or invests the loan proceeds?

Or: Perhaps taxpayer is able to take advantage of market conditions to satisfy his/her/its obligation by paying less than the amount that he/she/it borrowed.

What answers to these questions does this leading case suggest?

United States v. Kirby Lumber Co., 284 U.S. 1 (1931)

MR. JUSTICE HOLMES delivered the opinion of the court.

In July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for $12,126,800 for which it received their par value. Later in the same year, it purchased in the open market some of the same bonds at less than par, the difference of price being $137,521.30. The question is whether this difference is a taxable gain or income of the plaintiff for the year 1923. By the Revenue Act of (November 23) 1921, c. 136, § 213(a), gross income includes “gains or profits and income derived from any source whatever,” and, by the Treasury Regulations authorized by § 1303, that have been in force through repeated reenactments, “If the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.” Article 545(1)(c) of Regulations 62, under Revenue Act of 1921. [citations to more regulations omitted]. We see no reason why the Regulations should not be accepted as a correct statement of the law.

In Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned the stock of another company that had borrowed money repayable in marks or their equivalent for an enterprise that failed. At the time of payment, the marks had fallen in value, which, so far as it went, was a gain for the defendant in error, and it was contended by the plaintiff in error that the gain was taxable income. But the transaction as a whole was a loss, and the contention was denied. Here, there was no shrinkage of assets, and the taxpayer made a clear gain. As a result of its dealings, it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see nothing to be gained by the discussion of judicial definitions. The defendant in error has realized within the year an accession to income, if we take words in their plain popular meaning, as they should be taken here. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.

Judgment reversed.

Notes and Questions:

1. How does it happen that Kirby Lumber Company could buy back bonds in the open market for less than it obtained when it issued the bond?

2. What is a “shrinkage of assets?” Was the holding in Kerbaugh-Empire wrong? Why (or why not)?

  • Evidently, there was a “shrinkage of assets” in Kerbaugh-Empire, but not in Kirby Lumber.

3. What should we make of the “made available” language of the Court?

  • Suppose that taxpayer is hopelessly insolvent. Let’s say that taxpayer has assets with a fmv of $152,000, but has liabilities of $379,000. Liabilities exceed assets by $227,000. One creditor settles a $110,000 debt for property worth $18,000. Now the taxpayer has assets with a fmv of $134,000 and liabilities of $269,000. Liabilities now exceed assets by $135,000, i.e., $92,000 less than before this settlement. Has this transaction really “made available” $92,000 to taxpayer?
    • No, said the Fifth Circuit in Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5th Cir. 1934):

There is a reduction or extinguishment of liabilities without any increase of assets. There is an absence of such a gain or profit as is required to come within the accepted definition of income. ... The cancellation of the respondent’s past due debt ... did not have the effect of making the respondent’s assets greater than they were before that transaction occurred. Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything he did not have before. Gain or profit is essential to the existence of taxable income. A transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income.

  • Reducing the degree by which taxpayer is insolvent from $227,000 to $135,000 is not sufficient to constitute gross income.  What if the reduction had been from $227,000 to $100.  Where is the line?

4. (note 3 continued) In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289, 291-92 (1937), taxpayer was insolvent and had filed a petition for voluntary bankruptcy. Taxpayer’s creditors wrote off $104,000 of debt in exchange for payments totaling $15,000 in order to keep taxpayer from further pursuing relief through a bankruptcy proceeding. After this exchange, the value of taxpayer’s assets exceeded its liabilities by $40,000. Taxpayer’s net assets were increased from zero to $39,596.93 as a result of the cancellation of indebtedness by its creditors, and to that extent it had assets which ceased to be offset by any liability. ... The cancellation of [taxpayer’s] debts had the effect of making its assets greater than they were before that transaction occurred. It is true that ‘gain’ or ‘profit’ is essential to the existence of taxable ‘income’ ... and we believe that ‘gain’, as commonly understood, was realized here when [taxpayer], who was hopelessly insolvent, received by the action of its creditors an increment to its assets clear and free of any claims of the creditors. ... We conclude that the assets freed to the [taxpayer] by the composition of creditors had an exchange value. Under such facts ..., [taxpayer] realized taxable gain ...

5. The “making available assets” language meant – practically uniformly among lower courts – that an insolvent debtor realized gross income from cancellation of indebtedness only to the extent that such cancellation made the debtor solvent. In fact, some courts held that the cancellation of debt of an insolvent debtor was not “income” under the Sixteenth Amendment. See Ann K. Wooster, Application of the 16th Amendment to U.S. Constitution – Taxation of Specific Types of Income, 46 A.L.R. Fed. 2d 301 (2010) § 12 (debt forgiveness income).

6. Back to Kerbaugh-Empire: A loan is a transaction. Taxpayer may use loan proceeds in another transaction. Logically, the loan and the spending or investment of proceeds are two different transactions that taxpayer should have to account for separately. In the absence of any statutory provision governing exclusion of cancellation of indebtedness income, the Code essentially required the Commissioner prior to 1954 to kick a taxpayer when he/she/it was down. We see what happened. Dallas Transfer and Lakeland Grocery focused on taxpayer’s insolvency to exclude at least some coi income from taxpayer’s gross income. The holding in Kerbaugh-Empire seemed to permit a court to focus on the success of the enterprise in which taxpayer invested loan proceeds to determine whether taxpayer had to include cancellation of indebtedness in his/her/its gross income.

  • Section 108 changes this, but § 108 does not convert business losses into excludable cancellation of indebtedness income.
  • Review the holding and rationale of United States v. Gehl, 50 F.3d 12, 1995 WL 115589 (8th Cir.), cert. denied, 516 U.S. 899 (1995), in chapter 3 of the text, supra.

7. In 1954, Congress added §§ 61(a)(12), 108, and 1017 to the Code. 1 Read §§ 61(a)(12), 108(a)(1)(A and B), 108(d)(1 through 3). Do you see the influence of cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery – as well as of cases holding that the meaning of “income” in the 16th Amendment does not encompass discharge of indebtedness (doi) when taxpayer does not thereby become solvent? See also Reg. § 1.61-12(b)(1) (adopted in 1957).

  • Section 108(e)(1) provides that there is no insolvency exception from the general rule that gross income includes income from discharge of indebtedness other than what § 108 provides.
  • When the other provisions of § 108 apply, § 108 appears to “preempt the field” – much as §§ 119 and 132 preempt their respective fields. See Boris I. Bittker, Martin J. McMahon, Jr., & Lawrence A. Zelenak, supra at 4-21 to 4-22.

8. Read § 108(b). What is a “tax attribute?”

  • The Code does not define the phrase. We surmise its meaning by reading § 108(b).
  • Section 108(b) lists tax consequences of various transactions that might reduce taxpayer’s tax liability in the future. The list includes: net operating loss, general business credit, minimum tax credit, capital loss carryover, basis reduction, passive activity loss and credit carryovers, and foreign tax credit carryovers.
  • What is the effect of § 108(b) on the holdings of cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery? Define the “exclusion” from gross income that § 108 provides a taxpayer who is in bankruptcy or insolvent.

9. Reduction of tax attributes and reductions of basis: Section 1017 and Reg. § 1.1017-1 provide some rather technical rules governing reductions in tax attributes and bases. Tax attributes reduce a taxpayer’s tax liability at some future time. Does it matter how far into the future the reduction occurs?

  • The consequence of reducing a tax attribute is that taxpayer’s future tax liability will not decrease.
  • To the extent that a taxpayer has tax attributes, § 108 does not in fact exclude doi income from taxpayer’s gross income, but instead defers the effect of its recognition to the day that a tax attribute would have reduced taxpayer’s tax liability.
  • The temporal sequence in which reductions of tax attributes occur might be the same as the temporal sequence in which a typical taxpayer would derive a tax benefit from the particular tax attribute. If that is true, then the Code minimizes the length of time taxpayer benefits from not immediately recognizing doi income.

Basis represents investment that is not subject to income tax. We have encountered in passing the concept of depreciation. Consider it to be a deduction that reflects the partial consumption of a productive asset that taxpayer uses to generate gross income. Because there is partial consumption of the productive asset, depreciation allowances must reduce taxpayer’s basis in the asset. A depreciation allowance represents the taxpayer’s “de-investment” in the asset. Some productive assets are not subject to depreciation because taxpayer does not actually consume them in generating gross income. Land is an obvious example. A reduction in the basis of property can affect taxpayer’s tax liability on two occasions: (1) a lower basis shortens the period over which taxpayer may claim depreciation deductions; (2) a lower basis increases the gain taxpayer realizes upon sale of the asset. Consider the likely timing effect(s) of reducing the basis of particular pieces of a taxpayer’s productive assets.

  • What policies do you see implicit in § 1017(b)(4)(A)?
  • What policies do you see implicit in § 108(b)(5)/Reg. § 1.1017-1(c and e)?
  • What policies do you see implicit in Reg. § 1.1017-1(a)?

10. Consider:

  • 10a. Taxpayer owns real property, fmv = $100,000, ab = $135,000. This is all of taxpayer’s property. Taxpayer also has no other assets, not even cash. Taxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of § 108? By how much?
  • 10b. Taxpayer owns real property, fmv = $135,000, ab = $100,000. This is all of taxpayer’s property. Taxpayer also has no other assets, not even cash. Taxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of § 108? By how much?
  • 10c. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is all of taxpayer’s property, except that taxpayer also has $5000 of cash. Taxpayer’s real property is subject to a debt of $110,000 that he owes to creditor. Taxpayer did not purchase the property from creditor. Taxpayer was having difficulty making payments, so creditor agreed to reduce taxpayer’s debt to $95,000. How much doi income must taxpayer include in his gross income under §§ 61(a)(12)/108?
  • 10d. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is all of Taxpayer’s property, except that Taxpayer has $20,000 of cash. Taxpayer’s real property is subject to a debt of $150,000 that she owes to creditor. Taxpayer did not purchase the property from creditor. Taxpayer was having difficulty making payments. Creditor agreed to reduce taxpayer’s debt from $150,000 to $130,000 in exchange for an immediate cash payment of $10,000. Taxpayer agreed and made the payment. How much doi income must taxpayer include in her gross income under §§ 61/108?
  • 10e. Same facts as 10d, except that taxpayer has filed for bankruptcy. The creditor makes the same arrangement with taxpayer. How much doi income must taxpayer include in her gross income under §§ 61/108? [Disregard the effect of such a payment on the bankruptcy proceeding.]

11. The reduction is made to the basis of any property held by the taxpayer at the beginning of the tax year following the tax year in which the debt discharge occurs (§ 1017(a)).

  • Taxpayer need not reduce (“spend”) her/his/its tax attributes on the discharge of indebtedness but rather may use them to reduce tax liability for the year.
  • Then taxpayer may also reduce basis.