Taxpayer Properly Excluded Cancelled Debt from Income Due to Insolvency

(Parker Tax Publishing July 2023)

The Tax Court held that a taxpayer was entitled to exclude cancellation of indebtedness income resulting from the discharge of a small business loan because she was insolvent immediately before the discharge of the loan under Code Sec. 108(a)(1)(B). The court rejected the IRS's contention that the taxpayer's debts did not exceed her liabilities because a debt resulting from the taxpayer's breach of lease on commercial real estate was not bona fide. To the contrary, the court found that the lease agreement was a legally enforceable arm's length transaction under which the entire amount remaining on the lease became immediately due upon the breach, even though the landlord did not sue or otherwise take action to collect the amount due. White v. Comm'r, T.C. Memo. 2023-77.

Background

During 2015 Katrina White owned and operated Professional Body Sugaring, LLC, in Menomonee Falls, Wisconsin. On June 17, 2015, White signed a promissory note to First Bank Financial Centre for a small business loan of $15,000. White's business struggled and brought in little revenue. Between July 11, 2015, and February 3, 2016, White made five payments on the loan totaling $661. Following the February 3 payment, White failed to make any further payments toward the loan, and on November 23, 2016, the bank charged the loan off its books. First Bank Financial Centre issued White a Form 1099 - C, Cancellation of Debt, reporting discharge of debt totaling $14,433.

On April 20, 2015, White had entered into a three-year lease with Leap Properties, LLC, for office space for her business beginning June 1, 2015, and terminating May 31, 2018. The lease included an acceleration clause stating that, if rent was late for more than two months, the full amount on the remaining lease would be immediately due in full and had to be paid on the third month. White breached her lease with Leap Properties, LLC, on January 15, 2016.

In November 2015 White received $8,000 from her family, purportedly as a loan, to help with her struggling business. White did not enter into a written loan agreement or set a repayment schedule, and it was unclear whether any interest was charged. White had made two payments of $100 each toward the loan at the time her small business loan debt was discharged.

On her 2016 federal income tax return, White reported as her only income for the year wage income of $29,140. She did not report the discharge of indebtedness on her return. The IRS determined that the discharge of indebtedness represented gross income to White. The IRS issued a notice of deficiency, and White took her case to the Tax Court.

Code Sec. 61(a) defines gross income as "all income from whatever source derived" including income from discharge of indebtedness. Code Sec. 108(a) provides certain exceptions under which discharge-of-indebtedness income is excluded from income. One such exception arises under Code Sec. 108(a)(1)(B) where the taxpayer is insolvent immediately before the discharge. Under Code Sec. 108(d)(3), insolvent means that the taxpayer's liabilities exceed the fair market value of her assets. The amount of the exclusion is limited to the amount by which the taxpayer is insolvent, i.e., the amount by which the taxpayer's liabilities exceed the fair market value of her assets. In Merkel v. Comm'r, 109 T.C. 463 (1997), the Tax Court held that a taxpayer claiming the benefit of the insolvency exception must prove (1) with respect to any obligation claimed to be a liability, that, as of the calculation date, it is more probably than not that she will be called upon to pay that obligation in the amount claimed and (2) that the total liabilities so proved exceed the fair market value of her assets.

To prove that she was insolvent at the time her small business loan was discharged, White provided an insolvency worksheet that showed her assets and liabilities at the time of the discharge, along with supporting documentations. According to her worksheet, White's assets totaled $32,059 while her liabilities came to $61,936. White included in her liabilities $21,700 for the lease breach acceleration debt, $7,800 for the family loan, and $2,500 for unpaid utility bills. The IRS argued that White failed to adequately substantiate that the family loan, the lease breach acceleration debt, or the utility bills were bona fide debts. With respect to the lease breach acceleration debt, the IRS argued that the debt was not bona fide because Leap Properties, LLC, did not sue or otherwise take action to collect the amount due on the lease and because White did not make any payments toward the amount due.

Analysis

The Tax Court held that the discharge of White's indebtedness of $14,433 was excluded from gross income under Code Sec. 108(a)(1)(B).

The court disagreed with the IRS's argument that White's lease breach acceleration debt was not bona fide. The court noted that White provided a copy of the lease agreement, as well as a letter from Leap Properties, LLC, stating that she breached the lease on January 15, 2016. The court found that under the terms of the lease, the entire amount remaining on the lease would become immediately due. The lease agreement between White and Leap Properties, LLC, was in the court's view an arm's-length transaction for a multiyear lease on commercial real estate, and the obligation to pay was legally enforceable at the time the $14,433 small business loan debt was discharged.

According to the court the fact that Leap Properties, LLC, did not sue White to collect the debt did not in and of itself mean, as the IRS suggested, that it was not a bona fide debt. The court found that the IRS cited no authority for the requirement that, to determine insolvency under Code Sec. 108(a)(1)(B), a creditor must bring legal action or the taxpayer's liabilities must be brought to judgment.

Thus, taking into account the $21,700 liability for breach of the lease, the court determined that White's liabilities totaled $51,636 while the value of her assets totaled $32,059. The court excluded the amount of White's family loan and utility bills from her liabilities because she met the standard for insolvency with the including of the liability for breach of lease and the court therefore did not need to consider the IRS's arguments with respect to those items. Finding that White's liabilities exceeded the value of her assets by $19,576, the court concluded that White was insolvent at the time the small business loan was discharged, and the court discharge-of-indebtedness income was excluded.

For a discussion of the insolvency exception to discharge of indebtedness income, see Parker Tax ¶76,110.

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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