Taxpayer Had to Include COD Income in Year Lender's Time to File a Claim Expired

(Parker Tax Publishing September 2023)

The Tax Court held that the owner of a single-member limited liability company treated as a disregarded entity for federal income tax purposes had cancellation of indebtedness (COD) income arising from the discharge of the unpaid balance of a small business line of credit in the year that the lender's time to bring a claim for recovery of the loan under state law expired, rather than the year the taxpayer claimed he abandoned the business. The court also found that the taxpayer could not treat the COD income as capital gain since he and the lender never agreed that the business would surrender the property that secured the line of credit in exchange for the lender's cancellation of the debt. Jacobowitz v. Comm'r, T.C. Memo. 2023-107.

Background

Steven Jacobowitz was the sole member of an entity named Sagasolutions.com (Sagasolutions), a single-member limited liability company he established in 2003. Sagasolutions ceased to exist in approximately May 2008. During its existence it designed and delivered technical solutions in the areas of customer service, sales, and marketing. Additionally, during its existence it was a disregarded entity for federal income tax purposes; it never filed Form 8832, Entity Classification Election, with the IRS to be classified otherwise. The last year for which Sagasolutions' income (or loss) was reported to the IRS was 2009.

In 2006, Sagasolutions secured a $25,000 small business line of credit with Connecticut-based Newtown Savings Bank (Newtown). In connection with this line of credit Jacobowitz executed on Sagasolutions' behalf a promissory note and a security agreement. The promissory note set forth the terms of the line of credit, including the interest rate, the minimum advance amount, the monthly principal repayment amount and date, the amounts for finance charges and other fees, and that the line of credit would be linked as overdraft protection to Jacobowitz's personal checking account, also at Newtown. The security agreement set forth in pertinent part what property of Sagasolutions was pledged as security for the repayment of the line of credit and under what circumstances Sagasolutions would be in default of its payment or other obligations with respect to the line of credit.

Sagasolutions took advances from, and made payments to, the line of credit numerous times from January 2006 to September 2010. The first advance, of $7,000, was on January 24, 2006, and the last, of $625, was on April 5, 2010. When Sagasolutions' last principal payment of $52 was made on September 27, 2010, the outstanding principal balance for the line of credit was $24,948. Newtown sent Sagasolutions and the IRS a Form 1099-C, Cancellation of Debt, for 2016. This form indicated that as of December 30, 2016, Newtown had discharged the outstanding principal balance and accrued interest, which totaled $34,964, after the September 27, 2010, payment owed on the line of credit. The form also indicated that the reason for the discharge was "Statute of limitations or expiration of deficiency period." On his 2016 federal income tax return. Jacobowitz did not report the COD income totaling $34,964.

Following an examination, the IRS determined that the outstanding principal balance and accrued interest owed on the line of credit that Newtown discharged, totaling $34,964, was taxable cancellation of debt (COD) income to Jacobowitz. A 2019 notice of deficiency reflected this determination. Jacobowitz disagreed, and took his case to the Tax Court.

Jacobowitz argued that under Connecticut law, his individual assets could not be reached to satisfy any outstanding line of credit balance of Sagasolutions because he did not personally guarantee Sagasolutions' line of credit with Newtown. Jacobowitz also contended that Sagasolutions' debt was discharged before 2016. He claimed that (1) the property used to secure the line of credit was abandoned in 2008 and (2) Sagasolutions' last payment to the line of credit was in 2008. In addition, Jacobowitz contended that any COD income that may be attributable to him should be characterized as capital gain. Lastly, Jacobowitz contended that because the line of credit was a business loan and the interest paid with respect thereto would have been a deductible business expense, the portion of the COD income that is interest ($10,016) was excludable from his gross income under Code Sec. 108(e)(2), which provides that no income will be realized from the discharge of debt to the extent that payment of the liability would have given rise to a deduction.

Analysis

The Tax Court sustained the IRS's determination that Jacobowitz had $34,964 of taxable cancellation of debt (COD) income in 2016.

The court found that although state law governs the legal relationships that are established when an entity is formed, federal law governs whether an entity is taxed, or disregarded, as a corporation. Looking to the check-the-box regulations in Reg. Sec. 301.7701-3, the court noted that a domestic entity that is not a corporation and has a single owner is disregarded as an entity separate from its owner unless the owner elects otherwise. Absent such an election, the entity is treated as a sole proprietorship or branch of its owner, and any items of income or loss generated by the entity are attributable to and reported by the entity's owner. The court also noted that under Reg. Sec. 1.108-9(a)(3) the insolvency exclusion of Code Sec. 108(a)(1)(B) applies to the discharged indebtedness of a disregarded entity at the ownership level, i.e., the insolvency exclusion applies to the discharged indebtedness of a disregarded entity only to the extent the owner of the disregarded entity is insolvent. The court observed that this regulation would be superfluous if, as Jacobowitz contended, there is no recognition of income from the discharge of debt for the disregarded entity. Noting that Sagasolutions never Form 8832 to be treated as a corporation, it was treated as a disregarded entity, and Jacobowitz as its sole member had to report any income or loss attributable to Sagasolutions.

Turning to the issue of the timing of the debt cancellation, the court found that under Cozzi v. Comm'r, 88 T.C. 435 (1987), a debt is deemed discharged (and COD income is generated) the moment it becomes clear that the debt will never have to be repaid. The court also observed that Reg. Sec. 1.6050P-1(b)(2) provides an exclusive list of seven "identifiable events" which constitute a discharge of debt for canceled debt information reporting purposes. The third of the seven "identifiable events" is a cancellation or extinguishment of debt upon the expiration of the statute of limitations for collection of an indebtedness, or upon the expiration of the statutory period for filing a claim or commencing a deficiency judgment proceeding. The court found that Sagasolutions defaulted on its line of credit sometime in 2010, and at the latest in October 2010 after a final principal payment of $52 was made in September 2010. Under Connecticut law, Newtown had to bring an action within six years of when the action accrued - sometime in 2016. The court reasoned that when the six-year period for bringing a claim expired, an identifiable event occurred and it triggered Newtown's obligation to under Code Sec. 6050P to issue a Form 1099-C, which Newtown did. The court therefore concluded that 2016 was therefore the correct year of the discharge of Sagasolutions' debt.

The court rejected Jacobowitz's contention that any COD income attributable to him should be characterized as capital gain. The court found that Sagasolutions and Newtown never agreed that Sagasolutions would surrender or abandon the property that secured the line of credit in exchange for Newtown's canceling the debt, and Jacobowitz did not show that the resulting COD income was from the exchange of a capital asset as defined in Code Sec. 1221. The court also found that Jacobowitz offered no evidence that the interest which accrued after the last principal payment would have been an ordinary and necessary business expense. Instead, the court said the record unmistakably showed that Sagasolutions stopped doing business in 2008 and that 2009 was the last years Sagasolutions' income (or loss) was reported to the IRS - before the interest started accruing in 2010. Accordingly, the total amount of the cancelled debt was COD income to Jacobowitz for 2016.

For a discussion of cancellation of indebtedness income and determining the year of discharge, see Parker Tax ¶72,310.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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