Our legal system allows people to move on from past obligations under certain circumstances. For example, people can discharge debts through bankruptcy, creditors have a limited amount of time to sue for unpaid debts, and even the IRS allows a fresh start for unpaid taxes.
These laws strike a balance between allowing those who are owed or due something sufficient time to recover or recop their investment or outlay and the ability of the other party to move on. The length of the time limit is often a point of contention with those who are on the owing or liable side, as they often want a shorter time limit.
The recent Jacobowitz v. Commissioner, T.C. Memo. 2023-107, case provides an opportunity to consider this balance in the context of canceled debt income. The case addresses whether a taxpayer has to pay income taxes in the current year for a loan that was taken out more than ten years prior and has not been paid for several years.
Facts & Procedural History
The taxpayer was the sole member of an LLC that was established in 2003 and ceased operations in 2008. The LLC was disregarded for federal income tax purposes so its income and expenses were reported on the taxpayer’s individual income tax returns.
In 2006, the LLC obtained a $25,000 small business line of credit from a bank. The taxpayer, acting on behalf of the LLC, executed a promissory note and a security agreement for the credit line. The promissory note detailed terms such as interest rates, minimum advances, monthly repayments, fees, and linked the line of credit to the taxpayer’s personal checking account for overdraft protection. The security agreement outlined pledged assets and conditions for default.
Between 2006 and 2010, the LLC made multiple advances and payments on the line of credit. The initial advance was $7,000 in 2006, and the final advance was $625 in 2010. The last principal payment of $52 was made in 2010, leaving an outstanding principal balance of $24,948.
In 2016, the LLC received a Form 1099-C, Cancellation of Debt, from the bank. The form indicated that the bank had discharged the outstanding principal balance and accrued interest of $34,964 on December 30, 2016. The reason cited for the discharge was the “statute of limitations or expiration of deficiency period.”
When the taxpayer filed his 2016 federal income tax return, he did not report the canceled debt (“COD”) income of $34,964 arising from the discharged debt. The IRS audited the return and, in 2019, determined that the discharged amount of $34,964 constituted taxable COD income. Litigation in the U.S. Tax Court commenced.
About COD Income
We have previously addressed COD income, such as using rebates to avoid COD income, and provide this summary for background.
Cancellation of debt income is an income tax concept. Our income tax system starts with the concept of gross income. Gross income is anything that is an increase in one’s net worth. When a liability or debt is discharged or forgiven, the taxpayer has an increase in their net worth. This increase is the cancellation of debt income. Our tax laws impose a tax on this income.
The cancellation of debt income rules set out a number of exceptions. One exception is for debts discharged when the taxpayer is insolvent:
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(B) the discharge occurs when the taxpayer is insolvent,
It goes on to define the term “indebtedness of the taxpayer:”
For purposes of this section, the term “indebtedness of the taxpayer” means any indebtedness—
(A) for which the taxpayer is liable, or
(B) subject to which the taxpayer holds property.
It also defines what “insolvent” means:
For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.
Thus, the taxpayer can avoid cancellation of debt income if their liabilities exceed their assets immediately before the debt is discharged or forgiven. As we have previously addressed, future payments akin to pensions are not assets for purposes of this determination.
How COD Income is Reported
We haven’t previously addressed how COD income is reported. Those who discharge or forgive certain debts owed to them in excess of $600 are required to file a Form 1099C with the IRS. The regulation notes that penalties can apply if a party fails to file a Form 1099-C.
Treasury Regulation § 1.6050P-1 sets out the specifics for how and when to file a Form 1099-C with the IRS. As can be expected, the regulation explains what information must be included in Form 1099-C is specified, including details such as the debtor’s name, address, and taxpayer identification number (TIN), the date of the identifiable event, the discharged indebtedness amount, indication of bankruptcy, and any other relevant data as required by the form’s instructions.
The regulation says that Form 1099C must be submitted to the IRS by February 28 (or March 31 if filed electronically) of the subsequent year following the occurrence of the identifiable event.
The regulation explains what counts as “identifiable events,” which serve as triggers for when there is a discharge of indebtedness. These rules apply even if the actual debt discharge has not taken place yet. These identifiable events encompass various scenarios.
Identifiable Events for COD Income
The following situations are “identifiable events” under Treasury Regulation § 1.6050P-1:
- Discharge of Indebtedness in Bankruptcy (Title 11):
- Occurs when a debtor’s indebtedness is discharged as a result of bankruptcy proceedings under Title 11 of the United States Code.
- Cancellation or Extinguishment in Legal Proceedings:
- A discharge of indebtedness resulting from a cancellation or extinguishment that renders the debt unenforceable.
- Pertains to situations such as receivership, foreclosure, or similar legal proceedings in federal or State courts.
- Election of Foreclosure Remedies by Creditor:
- Relates to the cancellation or extinguishment of indebtedness when a creditor chooses foreclosure remedies.
- The creditor’s right to pursue debt collection is legally extinguished or barred by this action.
- Cancellation in Probate or Similar Proceeding:
- Encompasses the cancellation or extinguishment of indebtedness due to a probate or comparable legal proceeding.
- Renders the debt unenforceable in specific situations involving the decedent’s estate or related matters.
- Discharge under Agreement for Less Consideration:
- Occurs when an applicable entity and a debtor agree to discharge indebtedness at an amount less than the full consideration.
- Represents a negotiated settlement of the debt between the parties.
- Discharge by Creditor Decision or Defined Policy:
- Involves a discharge of indebtedness as a result of a creditor’s decision or application of a defined policy.
- The creditor may choose to halt collection activity and discharge the debt as per an established practice or policy.
- Statute of Limitations Expiration and Judicial Affirmation:
- If the statute of limitations for debt collection expires, an identifiable event is recognized only if a debtor’s affirmative statute of limitations defense is upheld in a final judgment or judicial decision. The event occurs when the appeal period for the judgment or decision concludes.
- Alternatively, upon the expiration of a statutory period for filing a claim or commencing a deficiency judgment proceeding.
Most identifiable events are under # 7 as creditors often wait until the very last time period before they notify debtors that they are discharging the debt.
The Statute of Limitations
Federal law looks to state law, generally, to determine what the statute of limitations is for a debt.
For example, in Texas, the statute of limitations for debts is four years, as outlined in Sec. 16.004 of the Texas Civil Practice and Remedies Code. This means that legal action must be initiated within four years from the day the cause of action accrues.
In Texas, for certain types of debts, the statute of limitations is typically calculated from the later of two key dates: the date when the last payment was made or the date when the debtor defaulted by not making a payment. The statute of limitations begins to run from the later of these two dates.
For example, let’s say a debtor makes a partial payment on a debt and then stops making payments. The statute of limitations for that debt would generally start running from the date of the last payment. If the debtor defaults by missing a payment after that, the statute of limitations would be calculated from the date of that missed payment. This “later of” rule helps ensure that the statute of limitations takes into account the most recent relevant event, whether it’s the last payment made or the date of default.
In the present case, the taxpayer was in Connecticut. It appears that Connecticut has similar laws as Texas–except the 4-year period is 6 years in Connecticut. The court in this case noted that the last payment was made by the taxpayer in October 2010. Thus, the statute of limitations expired in 2016. The court noted that this was the appropriate year for the creditor to file Form 1099-C.
The court’s decision, in this case, shows how one can end up owing income taxes in the current year for a loan that was taken out more than ten years prior. The court confirmed that the creditor can file Form 1099-C in the year in which the statute of limitations expires.
However, the decision does not address all of the issues surrounding the timing of the filing of Form 1099-C. For example, the court case does not address whether the taxpayer’s COD income incurred for the entity creates tax basis in the LLC interest as a contribution to the LLC and whehter the taxpayer can now take a worthless loss deduction for the LLC interest. It also does not address a situation where the creditor filed the Form 1099C in the wrong year.