While not as certain as death and taxes, small businesses failures are highly probable events. This webpage from the Bureau of Labor Statistics goes into the gnarly.
When a small business fails, that often means it cannot repay loans. A lender will often write off the loan as a bad debt, discharging the borrower from the obligation to repay. That discharge is taxable income to the borrower, unless they qualify for an exclusion. Today’s lesson involves the insolvency exclusion in §108(a). To qualify for that, one has to be (duh) insolvent! Insolvency is tested at the time of the discharge. Section 108(d)(3) defines insolvency as "the excess of liabilities over the fair market value of assets." But nothing in the statutes or regulations defines the term "liabilities."
Katrina E. White v. Commissioner, T.C. Memo. 2023-77 (June 21, 2023) (Judge Paris), teaches a lesson about what types of obligations count as liabilities in determining insolvency for §108(a) purposes. We learn that a liability which is legally enforceable, and due and owing at the time of the discharge, counts even if the lender takes no action to actually collect or enforce the debt. Details below the fold.
Law: Loans Are Not Income, Loan Forgiveness Is
A loan puts money in your pocket. Money that you can use to buy a home, buy a car, start a business. It sure seems like a loan is an accretion to wealth and thus constitutes gross income under §61 and the principles of Commissioner v. Glenshaw Glass, 348 U.S. 426, 431 (1955) (anti-trust damages were income because they were “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”).
Everyone agrees, however, that loan proceeds are not gross income because they are not, actually, an undeniable accession to wealth. Not everyone agrees on why that is so. Some say it is because your obligation to repay burdens your other assets, so the current-year you is not really any richer because of that. Your net worth balance sheet has not changed. United States v. Kirby Lumber, 284 U.S. 1 (1931). Others say it is because the obligation to repay comes from future income. So while the current-year you really is richer, it’s only because you are buying stuff with future dollars; the future-year you will be poorer by the amount of the repayment. Commissioner v. Tufts, 461 U.S. 300 (1984). For a deeper dive into details see Lesson From The Tax Court: The Phantom Of The Tax Code—Discharge Of Indebtedness, TaxProf Blog (Feb. 19, 2018). But basically the first idea is based on the yearly accounting of income while the second idea takes a multi-year transactional view based on the life of the loan and assumes the future repayment nets out to zero increased wealth.
Everyone also agrees that if your obligation to repay is cancelled or discharged, then that constitutes income. Not everyone agrees on what to call this. Some call it Discharge of Indebtedness (DOI). Some call it Cancellation of Debt (COD). Judge Paris mashes those together to call it “cancellation-of-indebtedness.” Op. at 1. LOL. I’ll use DOI, 'cause that what's in the title of §108.
Whatever you call it, the reason DOI constitutes gross income is linked to whatever reason you thought made the loan proceeds not income in the first place. Again, I go into more detail in the Phantom of the Tax Code blog post above. It might be because the discharge frees up those burdened assets and that increases your wealth. I call that the balance-sheet theory. Or it might be because the future-year you won’t have to re-pay which means we need to fix the now erroneous assumption that the loan would be repaid. I call that the error-correction theory.
Section 108(a)(1)(B) follows the balance sheet theory by allowing taxpayers to exclude DOI from gross income when they are insolvent and, further, limiting the exclusion to the amount of the insolvency at the time of the discharge. For example, if a taxpayer is discharged from $10,000 of debt at a time when the taxpayer is insolvent by $6,000, then the taxpayer can exclude $6,000 of the DOI from income but must report the remaining $4,000 as gross income, assuming no other exclusion applies. §108(a)(3).
Determining insolvency is seemingly simple: if the value of your liabilities is more than the value of your assets, you are insolvent! What counts as a liability, however, is not always clear. Courts generally agree that to count as a “liability” in the insolvency calculation, an obligation must actually burden assets. For example, in Merkel v. Commissioner, 109 T.C. 463 (1997), the taxpayers had guaranteed some loans and wanted those guarantees to count as liabilities for purposes of determining insolvency. The Tax Court disagreed, because that obligation was too speculative. See if you spot the balance sheet theory in this explanation the Court gave: “an indiscriminate inclusion of obligations to pay in the... the statutory insolvency calculation...without any consideration of how speculative those obligations may be, would render meaningless any inquiry as to whether assets are freed upon the discharge of indebtedness. Logic dictates that an obligation to pay is a liability under the freeing-of-assets theory only if it can be said with a satisfactory degree of certainty that the obligation offsets assets.” Id. at 476.
Today we learn a lesson on the degree of certainty that must exist for an obligation to count in the insolvency calculation.
The tax year at issue is 2016. That year, Ms. White received DOI of $14,433 and the question was whether she could exclude that under §108(a)(1)(B).
The DOI arose from a failed business. In mid-2015 Ms. White started a body sugaring business in a suburb of Milwaukee, borrowing $15,000 from a local bank. She also entered into a 3-year lease for her business. The lease agreement provided that if she failed to pay her rent on time for two months in a row, “the full amount on the remaining lease would be immediately due in full and had to be paid on the third month.” Op. at 2.
The business soured quickly. On January 15, 2016 she received a letter from the Lessor stating that she had breached her lease and now owed the full amount of remaining rent ($21,700). It appears she stopping making loan payments in February 2016. From the business’s Facebook Page it appears that the business formally closed on May 2017, but it seems it had not been active since early 2016.
In November 2016, the lender gave up and wrote off the loan. And the lender sent Ms. White a 1099-C showing discharged debt of $14,433.
The Lessor, however, did not give any indication it was forgiving the unpaid rent. It did not send her a 1099-C. At the same time the Lessor gave no indication it was enforcing the obligation: it made no efforts to collect the unpaid rent. And the opinion is silent on whether the Lessor was able to re-let the property in 2015 at or before the November 2016 loan forgiveness.
Ms. White timely filed her 2016 returns. She did not report any DOI income. On audit, the IRS decided she should have reported the lender’s DOI as income and sent her an NOD. Ms. White disagreed and petitioned the Tax Court.
Lesson: Contractual Obligation Can Be Bona Fide Liability Even If Not Enforced
To support her claim that she was insolvent when the Lender discharged the small business loan, Ms. White gave the Court a table of her assets and a table of her liabilities, “as well as supporting documentation of the listed items.” Op. at 4. The IRS did not dispute her table of assets, which showed a total value of just over $32,000. But it did dispute her table of liabilities. Here’s the table, slightly modified, from p. 4 of the Opinion:
Accrued/Past Due Residential Utilities
$14,433.00 (small business loan)
$21,700.00 (lease breach)
The IRS argued that three of the liabilities should not count towards determining whether Ms. White was insolvent: all $21,700 of the claimed lease liability; $2,300 of the claimed utility liabilities; and $7,800 of the claimed personal debts. Judge Paris addresses only the first liability because once she decided it did count, that amount plus the undisputed liabilities made Ms. White’s insolvency greater than the amount discharged. So the entire DOI could be excluded. Total win for this pro-se taxpayer.
The IRS’s basic argument was that the $21,700 lease liability was not certain enough to count towards the insolvency calculation. The IRS noted that neither party treated the claimed obligation as a real obligation because the Lessor “did not sue or otherwise take action to collect the amount due on the lease and because petitioner did not make any payments toward the amount due.” Op. at 5-6. It was just a paper obligation, not a real one. All form, no substance.
Judge Paris rejects that line of reasoning. Citing to Merkel, Judge Paris says that the issue did not turn on whether the obligation was actively being enforced, but rather on whether the obligation was “legally enforceable at the time the $14,433 small business loan debt was discharged.” Op. at 6. She found that Ms. White had proved it was legally enforceable both by the terms of the lease agreement and the January 2016 letter from the Lessor asserting its right to the $21,700.
Bottom Line: Legally enforceable obligations will count, even if the creditor has not taken action to enforce at the time the other debt is forgiven. Here, if the Lessor had sent Ms. White a note saying basically "oh, nevermind" then not only would the rent obligations likely not count towards the insolvency calculations, but now Ms. White would have additional DOI in that amount!
Coda: Alert readers will note that Ms. White’s victory here sets her up for some potential tax issues in later years. First, basis adjustment. Her exclusion of the $14,422 triggers operation of §108(b) which requires her to reduce various tax attributes. The most likely tax attribute here is basis in her assets. And then she need only reduce basis to the extent that her post-discharge basis exceeds her post-discharge liabilities. §1017. Here, Ms. White’s largest asset listed was “real property” asserdedly worth $28,500. Someone needs to run the numbers at least when she sells that real property.
Second, more DOI! Since the Court accepts the rental obligation of $21,700 as a bona fide debt, then that sets up Ms. White for yet more DOI income in a later year, if and when that debt is discharged. As Judge Paris notes, the DOI does not occur just because someone sends Ms. White a Form 1099-C. Nope, rather “the moment it because clear that a debt will never have to be paid, such debt must be viewed as having been discharged.” Op. at 4, note 2. Query whether it might have been better to concede that the $21,700 was not bona fide debt and take the DOI hit in 2015 rather than take a bigger DOI hit in some later year. But query also whether either of these issues will ever be raised.
Comment: I have my doubts about the bona fide nature of the rental debt. I would like to know whether the Lessor re-possessed the premises, or re-let the premises before the loan discharge, or whether the acceleration clause at least so required. I think for this to be a legal (and hence bona fide) obligation, the acceleration clause needed to ensure that the recoverable rents are reasonably adjusted—to account for time value of money or to account for the Lessor’s mitigation by re-letting—so as to avoid a windfall to the Lessor. Otherwise, the clause might be an unenforceable liquidated penalty clause. That is, of course, a matter of state law. See, e.g., United Leasing & Financial Services, Inc. v. R. F. Optical, Inc., 103 Wis.2d 488 (1981) (holding that, to be valid under Wisconsin law, an rental acceleration clause must discount to present value); Frank Nero Auto Lease, Inc. v. Townsendv, 411 N.E.2d 507 (1979) (not enforcing acceleration clause in a car lease because it did not account for, or require, resale or re-lease of the car upon repossession).
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.
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