The Tax Court issued two opinions on January 16, 2018, where taxpayers got hit by what I call the Phantom of the Tax Code: Discharge of Indebtedness (DOI), also known as Cancellation of Debt (COD). I will first tell you about each case, and then discuss what we can learn about this Phantom.
In John Anthony Glennon v. Commissioner, T.C. Memo. 2018-4, Mr. Glennon got unlucky in Las Vegas, but not in the usual way. He was at the airport and was enticed by the offer of a $59 fly-anywhere ticket to sign up for a Southwest Airlines credit card issued by Chase Bank. Like most of us, he just wanted the enticement and after using it planned to cancel the card. But times got bad and he needed the card to pay living expenses. He fell behind in payments and in 2014 the bank contacted him with an offer to settle the debt. He took the offer, and his payment left him with a balance due of just under $9,686. The bank then cancelled that remaining debt and in 2015 sent him a Form 1099-C. Mr. Glennon did not report the COD income and thanks to its nifty computer matching system, the IRS discovered the resulting deficiency in tax. Mr. Glennon’s main argument before the Court seems to be that “the debt had been resolved by his settlement.” The Court responded: “petitioner did not understand the concept of cancellation of indebtedness income.”
In Michelle Keel v. Commissioner, T.C. Memo. 2018-5, Ms. Keel’s 2015 COD income kicked her over the income limit to receive health insurance premium assistance tax credits. Those credits are given to taxpayers on a monthly basis in the form of direct payments to insurers to help pay for the taxpayer’s health insurance. Their purpose is to help with cash flow problems. In Ms. Keel’s case, she claimed the credit for 2015 and the federal government paid $335 per month to her insurer.
Only taxpayers whose income falls below a ceiling can get the health insurance premium assistance credits. And while taxpayers are allowed to estimate their income for the year, they must reconcile the amount of credits received with their actual income. In 2015 the ceiling for Ms. Keel was $46,680. In 2015 Ms. Keel had wage income of $39,000 and if that were her only income, she would qualify. However, in 2015 the Bank of America discharged some $16,000 of indebtedness. If you add that to the wage income, it took her well above the ceiling. While Ms. Keel properly reported the COD income on her return, she failed to reconcile. The IRS did it for her and Ms. Keel protested the resulting NOD. She asserted in her petition that the COD should not count in computing her eligibility for the premium assistance tax credits. But she failed to otherwise appear or argue the matter. The Tax Court granted Summary Judgement to the IRS.
Each cases teaches us something about the Phantom of the Tax Code: a basic lesson and a more advanced one. Both lessons are below the Fold
The Basic Lesson
The basic lesson is that loans are not income but DOI is income. In the 1954 case of Commissioner v. Glenshaw Glass , 348 U.S. 426 (1955), the Supreme Court famously defined gross income as any “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” When a taxpayer borrows money, that seems to fit within the broad scope of the Glenshaw Glass test. But we all know that when a taxpayer borrows money the taxpayer does not have to report the borrowed funds as gross income
Loans only become income if and when a taxpayer is relieved of the obligation to repay. Two interchangeable terms---Cancellation of Debt (COD) and Discharge of Indebtedness (DOI)--- describe that event. Most taxpayers---including Mr. Glennon apparently---are surprised to learn that COD is gross income. They don’t usually feel wealthier; they just feel less desperate. IRS Publication 4681 helpfully explains both when COD is income and when it may be excluded. But it does not explain the why. So that will be our basic lesson.
Honestly, no one really knows why borrowed funds are not gross income nor why DOI is income. There are two theories: I call them the balance sheet theory and the expectancy theory.
The balance sheet theory says the borrowed funds are not income because the loan creates an immediate offsetting debit on the taxpayer’s balance sheet. The taxpayer is no wealthier because the taxpayer’s assets are burdened by the obligation to repay. Accordingly, when the taxpayer is discharged from debt, those assets are “free up” and that is the accession to wealth needed under the Glenshaw Glass test.
To see the balance sheet theory at work, look at United States v. Kirby Lumber, 284 U.S. 1 (1931). There by buying back its previously issued bonds at a lower price, a company effectively cancelled $137k of its debt. A grumpy Justice Holmes used the balance sheet theory to explain why that was income: “As a result of its dealings, it made available [$137k] assets previously offset by the obligation of bonds now extinct.”
The second theory, the expectancy theory, ignores the balance sheet. It says that the borrowed funds are not income because of the temporary nature of the accession to wealth. The loan represents an advance of future income. We expect the taxpayer to repay the loan with that later income. If we require taxpayers to report the loan as income now then we would need to allow a deduction for later repayments to avoid double taxation. Since most loans get repaid, it’s just a heck of a lot simpler to omit reporting the income in the first place and, likewise, ignore the repayment.
An equally famous Supreme Court case shows the expectancy theory at work. In Commissioner v. Tufts, 461 U.S. 300 (1984), the Court was confronted with a taxpayer who sold property subject to a non-recourse loan for less than the loan balance. Since, by definition, a non-recourse loan does not burden the taxpayers assets, the taxpayer argued that he need not treat the COD as part of the amount he realized on disposition of the property. Under the balance sheet theory of why loans are not income that would be a good argument. But the Tufts Court used the expectancy theory to explain why the taxpayer here had not needed to report the initial loan as income: “When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability....The choice and its resultant benefits to the taxpayer are predicated on the assumption that the mortgage will be repaid in full.” Accordingly, the Court said, “when the obligation is cancelled, the [taxpayer] is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent...”
One sees both of these theories at work in the Tax Code as well, in §108. Section 108 allows taxpayers to exclude DOI income under certain circumstances. The balance sheet theory underlies the insolvency exclusion part of §108. Section 108(a) allows an taxpayer who is insolvent at the time of the DOI to exclude that DOI from income up to the amount of the insolvency. There’s your balance sheet theory at work. If no assets are freed up by the DOI, then it counts as income.
Section 108(e)(5) illustrates the expectancy theory. That provisions says that you do not have gross income if the COD results from a debt owed to the seller of property bought by the taxpayer. That is because the law changes the expectation of what was actually lent to the borrower. The forgiven debt is deemed a purchase price adjustment. If I buy a car by paying $1,000 cash and signing a promissory note to the dealership for $9,000, that looks like I bought a car for $10,000 and we expect me to pay back the borrowed $9,000. But if I have paid off $7,000 of the loan and the dealership cancels $2,000 of the debt, then §108(e)(5) reforms the expectations about what I was supposed to repay. It says the purchase price was actually only $8,000 and not $10,000. So I was expected to repay only a $7,000 loan. And I did. Hence, the DOI is not income.
I was actually surprised to learn that certain used car dealerships use a “sell-high-then-repossess” business model. That is, the dealership sells a car and finances the sale on onerous terms, keeping the loan fulling expecting the buyer to default. When the buyer eventually does default, the dealership repossesses the car and resells it. Some dealerships cancel the remaining debt. Others keep trying to collect. The same car may get sold up to eight times. Don’t believe me? Here’s a good article that explains the scam. Here’s an eye-opening blog post from a consumer law attorney that explains a closely-related scam.
The tax side of the scam, however, is that if the dealership forgives the debt, that is not going to be taxable DOI, even if the dealerships sends the taxpayer a Form 1099-C. Instead, the unpaid balance of the loan (as reduced by the valued of the repossessed car) will be a deemed price reduction under §108(e)(5).
Usually both theories lead to the same conclusion. Look at Mr. Glannon. He was, apparently, not insolvent in 2014 when Chase Bank discharged his $9,686 debt. That means that he could use his funds or the equity in his properties for purposes other than paying back Chase Bank. So the cancellation made him wealthier that year under the balance sheet theory. Similarly, there is no reason to doubt that the $9,686 accurately reflects the value of what he borrowed. That is because Chase was a third party lender and was not involved in the various transactions that created the debt. Because we properly expected him to repay that amount and thus did not tax him on the borrowed funds at that time, it became proper to tax him on those borrowed funds when the obligation to repay ceased.
Similarly, both theories are equally bad news for Ms. Keel. While Ms. Keel did not use an attorney and while she only made an assertion in her petition, I think she had a central insight with her assertion that DOI should not count in determining eligibility for insurance premium assistance credits. The insight is that DOI does not reflect actual cash flow. She could not see the income. It was phantom. Whether she had DOI or not, she had the same cash flow problem that the insurance premium assistance credits were designed to alleviate.
Neither the balance sheet theory nor the expectancy theory deals very well with the cash flow issue. Under the former it’s the freeing up of her assets that makes the DOI income. Whether that freeing up is of any practical use for her is not part of the analysis. Similarly, the expectancy theory focuses on what value was received for the loan and tries to accurately allocate the loan transaction between what was purchased and what was borrowed. It taxes now that which was not taxed back then. Only now the money is long gone.
A More Advanced Lesson
While both theories lead to the same conclusion in most cases, in some cases the choice of which theory to follow can make a difference. The classic illustration is the case of Zarin v. Commissioner, 916 F.2d 110 (1990). It’s a sad, breaking-bad kind of tale about a compulsive gambler. For full details, I recommend Ted Seto’s account “Inside Zarin.” Ted was one of Mr. Zarin’s tax lawyers.
The basic facts are these: in 1980 Zarin gambled at the Resorts Casino in Atlantic City. Resorts advanced Zarin about $3.5 million in chips on credit. Zarin could not repay. In 1981 Resorts agreed to accept $500,000 in satisfaction and forgave the rest of the debt. The question was whether that $3 million of DOI was income in 1981.
The Third Circuit thought the DOI was not income, but it was a 2-1 split decision. The majority used the expectancy theory of why DOI was income to explain that the $3.5 million in chips was not really a $3.5 million debt, because of the disputed debt doctrine. That is, the majority explained that the reason Zarin did not have to report income in 1980 was that he was expected to repay Resorts a debt that everyone thought then was worth $3.5 million. But the parties later agreed that they had been mistaken in that expectation and the correct amount that he was expected to repay was $500,000. In other words, while it looked like Zarin had purchased $3.5 million of gambling exhilaration, the parties later agreed he had only purchased $500,000 worth. This is the common law equivalent of §108(e)(5).
The dissenting judge channeled Justice Holmes in using the balance sheet theory. The reason Zarin did not have to report the $3.5 million in 1980 was, he wrote, “solely because he recognized...an offsetting obligation to repay Resorts...” So when that obligation went away “Zarin’s assets were freed of his potential liability for that amount and he recognized gross income in that amount.”
The different theories meant different outcomes.
To me, the expectancy theory is the better legal clothing for the Phantom of the Tax Code. That’s because I see this issue as mostly a timing issue. When you borrow money, that’s when you have the ability to actually use it. Ordinary borrowers are, in effect, borrowing from their future selves. They are pre-spending future income because, generally, they expect to repay from future income. When the DOI happens, that does not increase their true ability to pay.
Consider Mr. Glennon. Assume he had a car he needed to keep his job. Assume he still needs to buy basic living expenses. When Chase forgives his consumer debt I don’t see the idea that it frees up his assets as very helpful. It’s not as if he is suddenly going to sell the car. He needs it. It may make a difference in his ability to acquire more debt, such as getting a title loan on the car or charging up another credit card. But that’s just swapping debt for debt. I don’t think the balance sheet theory is about freeing assets to acquire more debt. I would welcome comments on that because I could well be wrong. It happens.
Consider also Ms. Keel. Her insight about why DOI should not affect her ability to get tax credits that are based on gross income is better supported by the expectancy theory than by the balance sheet theory. Her ability to actually pay the insurance premiums without further borrowing was probably not affected by the DOI of $16,000. The freeing up of assets idea was more theoretical than real.
Whatever theory you, dear reader, think is better, we can all agree that DOI is hard to spot. Congress has tried to make it easier by requiring lenders to send taxpayers Form 1099-C to reflect forgiving debt. That Form, however, has a raft of problems beyond the scope of today's post. If you are interested in further reading on the Form 1099-C issues, look at Caleb Smith's really nice blog post over at Procedurally Taxing last week. It's about one of those problems in relation to student loans. Peter Reilly also had a good explanation of some of the problems in this 2013 post. And the ABA Section on Taxation sent the IRS these comprehensive comments about revising Form 1099-C that you may find useful.