Discharge of Indebtedness Income? Really?

Posted on: February 18, 2012 | By: dunn_access | Civil Tax Controversies, Discharge of Indebtedness Income, Tax Planning

By Stephen J. Dunn

By now many people have received a Form 1099-C, Cancellation of Debt, concerning discharge of indebtedness income allegedly realized by them in 2011. If you received a Form 1099-C, don’t assume that you are taxable on the income alleged in it. There is a good chance you aren’t.

Federal income tax reaches “all income from whatever source derived.” In United States v. Kirby Lumber Co., 284 U.S. 1, 52 S. Ct. 4, 76 L. Ed. 131 (1931), the U.S. Supreme Court first held that gross (taxable) income includes the amount of debt from which a taxpayer is discharged. Kirby Lumber Co. issued bonds, and later bought them back at less than face value. The Supreme Court held that the excess of the bonds’ face value over the price at which the issuer bought them back was gross income realized by the issuer.

The Internal Revenue Code (“IRC”) § 108(a)(1) carves out several exceptions to recognition of discharge of indebtedness income. Gross income does not include discharge of indebtedness income where—

(A) the discharge occurs in a title 11 bankruptcy reorganization case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.

A taxpayer is “insolvent” for purposes of IRC § 108(a)(1)(B) to the extent the total of his indebtedness exceeds the total fair market value of his assets.

Taxpayers commonly avail of the insolvency (IRC § 108(a)(1)(B)) and qualified personal residence (IRC § 108(a)(1)(E)) exceptions to recognition of discharge of indebtedness income.

Another, more pervasive, exception is that the debtor was not discharged of debt, but that the creditor and the debtor compromised a doubtful and contested debt. In the seminal case of N. Sobel v. Commissioner, 40 B.T.A. 1263 (1939), a company bought stock in a bank in 1929, issuing its promissory note in the face amount of $21,700 for the purchase price. In 1930, the Superintendent of Banks of the State of New York closed the bank. The company sued to rescind (cancel) the stock purchase transaction, asserting that the bank had made misrepresentations in selling it the stock. The bank countersued for the full amount of the promissory note. The litigation was settled in 1935 with the company agreeing to pay half the face amount of its promissory note, $10,850. On its 1935 income tax return, the company deducted the $10,850 as a business loss. The Commissioner of Internal Revenue rejected the deduction, claiming that it occurred in a prior year. The Commissioner also attributed $10,850 in discharge of indebtedness income to the company in 1935. The Tax Court held for the company on both issues. As to the $10,850 of compromised debt, the Court held that it was not discharged debt, but a compromise of contested and doubtful debt.

In Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990), David Zarin, of Atlantic City, New Jersey, began gambling at the Resorts International casino in Atlantic City in 1978. His credit limit was originally set at $10,000, but Resorts steadily increased it. In 1979, his credit limit was $200,000, and he lost $2,500,000 at the Resorts craps tables, losses he paid in full.

Responding to allegations of credit abuses, the New Jersey Division of Gaming Enforcement filed with the New Jersey Casino Control Commission a complaint against Resorts. Among the 809 violations of casino regulations alleged in the complaint were 100 pertaining to Zarin. Subsequently, a Casino Control Commissioner issued an Emergency Order, the effect of which was to make further extensions of credit to Zarin illegal.

Nonetheless, Resorts continued to extend Zarin’s credit limit by the use of two different practices: “considered cleared” credit; and “this trip only” credit. Both methods effectively ignored the Emergency Order, and were later found to be illegal.

By January, 1980, Zarin was gambling compulsively and uncontrollably at Resorts, spending as many as sixteen hours a day at the craps table. During April, 1980, Resorts again increased Zarin’s credit line without further inquiries. That same month, Zarin delivered personal checks and counterchecks to Resorts which were returned as having been drawn against insufficient funds. Those dishonored checks totaled $3,435,000. In late April, Resorts cut off Zarin’s credit.

Although Zarin indicated that he would repay those obligations, Resorts sued Zarin in New Jersey state court in November, 1980, to collect the $3,435,000. Zarin denied liability on grounds that Resort’s claim was unenforceable under New Jersey regulations intended to protect compulsive gamblers. In September, 1981, Resorts and Zarin settled their dispute by Zarin paying Resorts a total of $500,000.

The Internal Revenue Service audited Zarin’s 1980 Federal income tax return, and determined that Zarin realized $2,935,000 of cancellation of indebtedness income. Zarin petitioned the Tax Court, and it upheld the IRS. The U.S. Court of Appeals for the Third Circuit reversed, holding that Resorts did not discharge Zarin of debt, but that it compromised a doubtful and contested debt with him.

In Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999), real estate agent Layne Presslar and his wife bought a 2,500-acre ranch near Cloudcroft, New Mexico from a debtor-in-possession in a chapter 11 bankruptcy proceeding. Moncor Bank, which held the mortgage on the property, provided financing for the $1,000,000 purchase price. The promissory note required the Preslars to make fourteen annual payments of $66,667 each with interest at 12 percent per annum.

The Preslars planned to sell 160 of the acres in one- and two-acre lots for development, and to allow residents to use the remaining 2,340 acres for hunting and fishing. As lots were sold, the Preslars assigned the contracts to Moncor Bank, which credited the balance due on the promissory note for 95 percent of the amount due on each contract, though nothing was said about this practice in the Preslars’ documents with Moncor Bank.

Moncor Bank failed, and the FDIC, its successor-in-interest, refused to accept assignments of sales contracts from the Preslars as payments on the promissory note. The FDIC demanded payment of the promissory note according to its terms. The Preslars failed to comply, and the FDIC sued them. The case was eventually settled by the Preslars paying the FDIC $350,000. The Commissioner of Internal Revenue determined that the Preslars had realized $449,473 in discharge of indebtedness income—the excess of the $1,000,000 face value of the promissory note over the $550,537 total which the Preslars had paid on it. The Preslars petitioned the U.S. Tax Court for review of this determination. The Tax Court held for the Commissioner. Finding the Preslars’ claim against the FDIC vague and “unliquidated,” the U.S. Court of Appeals for the Tenth Circuit affirmed.

Though the Preslars’ claim was perhaps not well articulated nor asserted, it was colorable and undoubtedly influenced the Preslars’ settlement with the FDIC for substantially less than the balance due on their promissory note. Preslar thus seems wrongly decided.

Estate of Smith v. Commissioner, 198 F.3d 515 (5th Cir. 1999), involved Exxon Corporation’s Hawkins Field Unit (“HFU”) in Wood County, Texas. During the early years of the HFU’s operation, the federal government regulated the price of domestic crude oil. In 1978, the Department of Energy (“DOE”) sued Exxon (the “DOE Litigation”) in the United States District Court for the District of Columbia (“DDC”), claiming that Exxon had misclassified the oil produced from the HFU and thus had overcharged its customers, in contravention of the federal price regulations. Exxon continued to pay the HFU interest owners royalties based on the price that the DOE had challenged as excessive, but in 1980 Exxon began withholding a portion of royalties to offset its potential future liability from the DOE Litigation. Adele Smith was one of those owners.

That same year, a group of the royalty owners sued Exxon (the “Jarvis Christian Litigation”) in federal district court in Texas, asserting that Exxon was required to pay them the full amount of their royalties. Early in 1981, Ms. Smith intervened as a plaintiff in the Jarvis Christian Litigation.

Three years later, in the DOE Litigation, the DDC held that Exxon had violated the Federal price-control regulations. The court determined that Exxon was liable, in restitution, for over $895 million. In February of 1986 — following affirmance of the DDC’s judgment, and shortly after the Supreme Court denied certiorari — Exxon paid the judgment, which, including both pre- and post-judgment interest, totaled approximately $2.1 billion.

In 1988, Exxon sued the HFU royalty owners, seeking to recoup a portion of the $2.1 billion judgment. In its complaint, Exxon alleged that it was entitled to contribution from the royalty owners under alternative legal theories, including federal common law, federal statutory law, and several state common law causes of action. In that suit, which was consolidated with the Jarvis Christian Litigation, the royalty owners vigorously defended against Exxon’s claim. They argued that Exxon’s complaint failed to state a cause of action under either federal common law or federal statutory law; and, alternatively, that if Exxon had stated a claim, the royalty owners were not liable to Exxon because (1) Exxon was equitably estopped — by the wrongful nature of its own conduct — from recovering in restitution, and (2) Exxon had not actually suffered a loss despite having paid the judgment.

In August 1989, the district court that was adjudicating the Jarvis Christian Litigation ruled that Exxon had “an implied cause of action [against the HFU royalty owners, including the Ms. Smith] under federal common law for reimbursement.”

In January 1990, the royalty owners, including Ms. Smith, moved for summary judgment. The main thrust of the motion was that Exxon had reaped profits far exceeding the judgment that it had paid in the DOE litigation, both as the largest royalty owner in the HFU and as unit operator. According to the royalty owners’ motion, the established tenets of the law of restitution prevent Exxon from recouping a sum exceeding the losses that it had suffered; and, contended the royalty owners, as Exxon had suffered no losses, its potential recovery was nil.

Ms. Smith died on November 16, 1990. At the time of her death, the royalty owners’ Motion for Summary Judgment was still pending. Exxon subsequently filed its own motion for summary judgment, and in February 1991 — after Ms. Smith’s death but before the filing of her estate tax return— the district court granted summary judgment in favor of Exxon. The court referred the calculation of damages to a special master. Exxon claimed that it was owed a total of $2.48 million by the Ms. Smith’s Estate. In March 1992, Ms. Smith’s Estate paid Exxon $681,840 to settle the case.

Ms. Smith’s Estate deducted the full amount of the Exxon claim, $2.48 million, as an administrative claim on her federal estate tax return. The Internal Revenue Service contested this deduction, asserting that it should be limited to the $681,840 actually paid by the Estate to settle it. The IRS also issued a “protective” notice of deficiency—asserting that, if the Estate was allowed the full $2.48 million for the Exxon claim, then the difference between the $2.48 million claim and the $681,840 actually paid to settle it was discharge of indebtedness income.

The Tax Court held that the Estate’s administrative deduction for the Exxon claim was limited to the $681,840 actually paid to settle it. This mooted the IRS’ discharge of indebtedness income theory.

Reversing, the U.S. Court of Appeals for the Fifth Circuit allowed the Estate a $2.48 million administrative deduction based upon facts existing at the date of Ms. Smith’s death. The Court of Appeals also rejected the IRS’ discharge of indebtedness argument. The Court found that it needn’t choose between the broad view of the Third Circuit in Zarin or the narrow view of the Tenth Circuit in Preslar “[f]or here both the amount and the enforceability of the debt were contested vigorously by the Estate.”

The Supreme Court may need to resolve the apparent conflict among the circuits on the contested liability doctrine.

How to Deal with an Errant Form 1099

A taxpayer who receives an errant Form 1099, of whatever suffix (Forms 1099 “-MISC” and “-C” being the most common), must deal with it. The issuer of the Form 1099 files a copy of it with the IRS, along with a Form 1096 signed under oath swearing that the facts set forth in the Form 1099 are true. The taxpayer should prepare a statement explaining why the income alleged on the Form 1099 is not taxable to the taxpayer, and attach the statement to his or her income tax return before filing it with the IRS. I have prepared many such statements, and the IRS has not challenged any of them. Of course it would be better if the errant Form 1099 were not issued in the first place.

If the taxpayer does not report the income alleged on the Form 1099 on his income tax return, nor attach a statement to the return satisfactorily explaining why the purported income is not taxable to him, the IRS can initiate a proceeding to assess the income alleged on the Form 1099 against the taxpayer. In such a proceeding, the taxpayer can contest the proposed assessment in the IRS Appeals Office and thence in U.S. Tax Court. If the assessment becomes final without contest, the taxpayer can challenge the assessment in a refund action in U.S. District Court. Litigation is, or course, very expensive. The taxpayer’s best alternative is to attach a statement to his income tax return explaining why the income alleged on the Form 1099 is not taxable to him.