ISSUES IN CANCELLATION OF DEBT INCOME CASES 1

ISSUES IN CANCELLATION OF DEBT INCOME CASES 1 Introduction Cancellation of indebtedness is a deceptively simple notion: if a taxpayer is relieved of an obligation to repay a debt, the amount of debt relief constitutes gross income. This is simply a recognition that borrowed money is nothing more than tax-deferred income: a borrower must earn money, pay income taxes on it and use the after-tax money to make repayment of the debt. If the borrower fails to do so, the system is out of balance. The taxpayer has received assets (the loan) upon which no income tax has been paid. This is the classic accession to income described in United States v. Kirby Lumber Co., 2 which established the principle of cancellation of debt as constituting an item of gross income. This is today accomplished by Code 61(a)(12), which requires "income from discharge of indebtedness" to be included in gross income. If there is cancellation of debt income (CODI), however, Code 108 may allow all or a portion of it to be excluded from gross income. Although CODI is generally required to be included in gross income, Code 108 permits debtors to exclude it under certain circumstances. Exclusion is permitted: 1. any time debt is discharged in a Title 11 case (meaning any bankruptcy proceeding); 2. to the extent the debtor is insolvent immediately before the debt is canceled; 3. to the extent the debtor can exclude CODI under the qualified farm exception; 4. to the extent CODI can be excluded under the exception for qualified real property business indebtedness; 5. if the CODI is qualified principal residence indebtedness discharged on or after January 1, 2007, and before January 1, 2013. It is here that life for the debtor becomes complicated. There has been much controversy over the years concerning the proper interpretation and application of the provisions of 108, and there are issues yet to be resolved, especially with respect to the insolvency exception. The following materials address some of these. Deductible Debt The Wash Principle In determining how much CODI can be excluded under 108, one modification may be necessary. Section 108 (e)(2) states that, "No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction." This is simply an application of the "wash" principle in that constructive income from cancellation of a deductible debt would also entitled a taxpayer to a constructive deduction for its satisfaction. The most common result of this rule is to exclude interest from CODI. However, the exclusion would also apply to such things as cash basis trade accounts payable. 1. Copyright 2013, Kenneth K. Wright, PO Box 3920, Chesterfield, MO 63006, 314-650-4523, mokkw394@yahoo.com. 2. 284 U.S. 1 (1931). 1

Example 1. Interest. A taxpayer owes the lender $200,000, which the lender forgives. Of this amount, $40,000 represents accrued business interest. For purposes of the 108 exclusion, the $40,000 is ignored and the taxpayer is treated as having $160,000 of CODI. If, on the other hand, the interest is personal interest, it is not deductible, so the COD amount would be $200,000. Example 2. Capitalized interest. Assume in the previous example that the original note was for a principal amount of $140,000. Several years earlier, however, the taxpayer had owed the lender accrued business interest of $20,000 and the lender rewrote the original note to include the accrued interest as principal. Thus, the principal amount of the new note became $160,000, the principal amount canceled in the preceding example. Because a cash basis taxpayer is prohibited from deducting interest under those circumstances, for purposes of 108 the capitalized interest is still considered interest. The principal amount of the note canceled is therefore $140,000 for purposes of determining COD income, not $160,000. Example 3. Trade account payable. A business taxpayer owes a supplier $40,000. The taxpayer has also accrued $4,000 of finance charges on the bill. In exchange for a $30,000 cash payment, the supplier cancels the entire $44,000 debt. The taxpayer is not treated as having any COD income because a payment of the canceled portion of the bill and the finance charge would have entitled the taxpayer to a current income tax deduction. They are therefore ignored. The preceding examples all assume the taxpayer is a cash basis taxpayer. If the taxpayer is an accrual basis taxpayer, the result would be different. An accrual basis taxpayer would generally already have deducted the interest and the supplier's bill. Since the taxpayer would have received the benefit of the income tax deduction already, the failure of the taxpayer to make actual payment would result in the application of the tax benefit doctrine upon cancellation of the obligation. Thus, an accrual basis taxpayer would be required to treat as CODI any amounts canceled for which the taxpayer has taken a previous deduction. The question here is whether the deduction should be any deduction the taxpayer could take at any time are only one deductible in the tax year the corresponding debt is canceled. It appears from the limited authority on this matter to be the latter interpretation. In Brooks v. Commissioner, 3 for example, the taxpayer tried to argue that CODI was excludable under the wash principle because a forgiven loan from his employer was used to purchase investment securities in his employment as a stockbroker. The Tax Court said that even if this had been the case, the taxpayer would not have been entitled to an interest deduction in the year the loan was forgiven because he had no net investment income that year. In a private letter ruling a cash basis taxpayer who nonrecourse debt and accrued interest canceled with respect to rental real estate properties was permitted to exclude the accrued interest under the wash principle because the passive activity limitations of 469 did not apply to limit the taxpayer's ability to take the deduction. 4 Interestingly, the ruling based its conclusion on the assumption the taxpayer had elected to treat all rental properties as a single activity, but stated nowhere that the taxpayer had actually made such an election. It appears, therefore, that accrued to cash basis deductions not deductible in the year the debt is canceled because of some limitation, such as passive activities or capital loss limitations, must be treated as CODI for that year. The same principle would appear to require that the extent to which a taxpayer's ability to itemize a deduction, such as application of the two percent miscellaneous itemized deduction threshold, be taken into account. But what if the debt was used to create depreciable basis in an asset? It 3. T.C. Memo. 2012-25. 4. PLR 9251023 (Sept. 18, 1992). 2

would seem reasonable to permit CODI to be excluded under the wash principle in proportion to the depreciation deduction for the current year, but not depreciation attributable to future years. An additional obstacle to exclusion under 108(e)(2) is proving that debt proceeds were used for a deductible purpose. In Brooks, for example, the taxpayer was unable to satisfy the tracing requirements of temporary regulation 108-8T to show that the canceled debt had actually been used to purchase the securities. Of course, whether CODI can be excluded under 108(e)(2) in most cases may not matter for purposes of the insolvency exception, as including the debt as CODI should generate an offsetting liability. Nevertheless, it has made a difference in the two reported cases, although neither case dealt directly with or stated facts relevant to the insolvency exception. It is therefore difficult to determine how the included nondeductible CODI resulted in the deficiencies. Calculating Insolvency Conflicting Theories The insolvency exception is important, because it allows debtors to exclude CODI income even though they are not in a bankruptcy proceeding. Under this exception a debtor is eligible to exclude CODI to the extent the debtor is insolvent immediately before the debt is discharged. This is the day before the debt is discharged, sometimes referred to as "the measurement date." According to Code 108(d)(3), insolvency means, "the excess of liabilities over the fair market value of assets." The valuation of assets is generally determined on the basis of the fair market value standard used for tax purposes. This is a standard of what a willing buyer would pay a willing seller, with neither under a compulsion to buy or sell and with both having full knowledge of all relevant facts. It is the position of the IRS and increasingly that of the Tax Court that all assets of the debtor must be taken into account without regard to any exemptions that might be available under state or bankruptcy law and without regard to whether the debtor actually can obtain possession of the assets, such as pension benefits not eligible for a lump-sum distribution. This would include such things as a personal residence, cash surrender value of life insurance, IRAs, and vested benefits in a qualified plan. This is a straight balance sheet approach. Both the Tax Court and the IRS have stated that the purpose of the insolvency exception, according to its legislative history, is, according to the Tax Court in Merkel, "to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy, was accorded a "fresh start" under the bankruptcy law) is not burdened with an immediate tax liability." 5 Nevertheless, the Tax Court in Merkel expressly rejected the notion of horizontal equity: that bankruptcy principles should determine how the insolvency exception should operate. 6 Instead, it went with the traditional freeing-of-assets theory. Simply stated, this theory says that an insolvent debtor who has debt canceled and who remains insolvent after word has essentially gained nothing and therefore is not taxed on the cancellation. To the extent the cancellation renders the debtor solvent, however, the debtor has the ability to pay a tax liability 5. Merkel v. Commissioner, 109 T.C. 463 (1997), aff'd on a different issue, 192 F.3d 844 (9th Cir. 1999). See, also, Rev. Rul. 92-53, 1992-2 C.B. 48. 6. See, e.g., Carlson v. Commissioner, will 116 T.C. 87 (2001), in which the Tax Court, upholding the position of the IRS, held that assets exempt in bankruptcy must be taken into account in determining insolvency for purposes of the insolvency exception. 3

resulting from including the debt cancellation in gross income. Yet, in discussing the freeing-of-assets theory, the Merkel court went on to say that, Congress' indicated purpose of not burdening an insolvent debtor outside of bankruptcy with an immediate tax liability... together with the operation of the insolvency exclusion and its limitation under section 108(a)(3) [the insolvency exception], in accordance with the statutory insolvency calculation, suggest that Congress intended to make a debtor's ability to pay an immediate tax on income from discharge of indebtedness the controlling factor in determining whether a tax burden is imposed. Indeed, if a debtor has the ability to pay an immediate tax, in the sense that assets of the debtor exceed liabilities that he will be called upon to pay (and not in the sense that the debtor simply has assets on hand), the concern of imposing an unfair or unwarranted immediate tax burden vanishes. [Original italics; footnote omitted.] Retirement Plan Assets There have been numerous articles criticizing the strict balance sheet approach of the freeing-ofassets theory and the fact that debtors who may on paper appear to be solvent remain unable to pay tax liabilities attributable to CODI. In particular, the inclusion of qualified plan assets can create an inescapable catch 22 for debtors. The IRS has included in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), a generally excellent worksheet for individuals to use to calculate insolvency. Line 28 requires the listing as an asset of an interest in retirement accounts, such as IRAs and 401(k) plans. Line 29 requires the listing of an interest in a pension plan. There is no explanation of why these assets should be listed for or how they are to be valued, although the IRS has somewhat address this in a service center advice. In valuing retirement assets, any assets the debtor can obtain as of the measurement date (date of insolvency determination), such as an IRA or a lump-sum distribution from a qualified plan, should be valued based upon the account balance that day. The IRS has stated in a service center advice that the fair market value of vested benefits under a defined contribution plan is simply the value of the individual's account or accounts under the plan. 7 In the case of a defined benefit plan, if the individual is receiving benefits from the plan in the form of an annuity as of the measurement date, the fair market value is the actuarial present value of the payments that are to be made on or after the measurement date. The IRS suggests in the service center advice that this be determined using the mortality tables found in the estate tax regulations. If the individual is not receiving benefits, the value should be the greater of (1) the actuarial present value of the accrued benefit payable at the plan's normal retirement age or (2) the amount of any single-sum distribution that the individual could receive under the plan on the measurement date. Without going into detail, it may be stated as a general principle that ERISA prohibits participants in a qualified plan from accessing or using their plan benefits prior to retirement age. A plan that fails to satisfy these so-called anti-alienation requirements will lose its qualification. Some plans, such as 401(k) plans, do permit plan loans and, in certain hardship cases (not including tax payments), distributions. IRAs, of course, are fully accessible by their owners. The issue in the Merkel case was whether contingent liabilities in the form of guarantees could be treated as liabilities in calculating insolvency. The Tax Court, affirmed on this issue by the Ninth Circuit, held that a contingent liability cannot be treated as a liability under the insolvency exception unless the 7. SCA 1998-039 (Apr. 1, 1998). 4

debtor can establish by a preponderance of the evidence that he or she will be called upon to pay the obligation. A "preponderance of the evidence" means that it is more likely than not to occur. Yet, in so holding, the Ninth Circuit said that, "We also agree, based on Congress' purpose of not burdening an insolvent debtor with an immediate tax liability, that Congress considered a debtor's ability to pay an immediate tax on discharge of indebtedness income the 'controlling factor' in determining whether the 108(a)(1)(B) [insolvency] exception applies." There is only one case that has addressed the issue of an interest in a qualified plan as an asset under the insolvency exception. In Shepherd v. Commissioner 8 the taxpayer was found not to be insolvent because he failed to introduce satisfactory evidence as to the value of his principal residence, beach house, or pension as of the measurement date. The court had already determined that failure to introduce evidence of the value of the residences prohibited use of the insolvency exception when it addressed the pension plan. The court further stated it was addressing the pension issue only because the parties had discussed the issue extensively during the trial. The taxpayer was employed by a township in New Jersey and contributed to the Public Employees Retirement System (PERS). He had previously borrowed the maximum allowable amount from PERS and was making monthly repayments. The IRS and the taxpayer disagreed on whether the pension had to be included as an asset in determining insolvency. The court stated that the fact that the interest in the pension was exempt from creditors under state law does not permit it, solely on that basis, to be excluded as an asset in determining insolvency. The court then went on to address the taxpayer's loan from PERS and concluded that, based on the taxpayer's monthly loan repayments and continued contributions, the taxpayer had an ability to take out additional amounts as a loan and that this constituted an asset for purposes of the insolvency exception. In a footnote the court stated that, "Therefore, it is unnecessary for us to decide whether Mr. Shepherd's entire pension constitutes an asset under sec. 108(d)(3) [defining insolvency]." This apparently contradictory reasoning can probably be attributed to the fact that the court had already concluded that the insolvency exception wasn't available and that at a minimum the taxpayer's ability to borrow from the plan constituted an additional asset weighing against his insolvency. Inclusion of an asset a debtor is prohibited by law from accessing simply ignores the recognized and often stated Congressional policy of not burdening an insolvent taxpayer outside of bankruptcy with an immediate tax liability based on CODI to the extent the taxpayer lacks assets to pay that liability. Even the Merkel case can be viewed as supporting such an exclusion based upon its requirement for certainty as of the measurement date. At a minimum such benefits should be excluded because they are not accessible by the debtor because of applicable law and not because of any action taken by the debtor. Such an exclusion relies on the principle of ability to pay and not bankruptcy or state exemptions. Granted, there is no protection to the extent a debtor could obtain a current lump-sum distribution or perhaps borrow from a plan. The exclusion does, however, seem to comport more with the reasoning in the cases than an exempt asset's argument. Liabilities should be determined using principles of accrual accounting for cash basis taxpayers. This means, for example, that such things as accrued interest, real estate, and payroll taxes as of the day before the debt is canceled should be treated as liabilities. The insolvency worksheet described below at the end of this section uses this approach. If the taxpayer is subject to a contingent liability, such as acting as guarantor of someone else's note, the contingent liability cannot be treated as a liability under the insolvency exception unless the debtor can establish by a preponderance of the evidence that he or she 8. T.C. Memo. 2012-212. 5

will be called upon to pay the obligation. A "preponderance of the evidence" means that it is more likely than not to occur. 9 Liabilities as of the day before the debt is canceled should also include the canceled debt itself as well as any accrued interest, late fees, penalties, and administrative costs that are included in the COD. This does not apply, however, to any debt that is not treated as CODI because it would be deductible by the debtor if paid. 10 Example 1. A debtor receives a 1099-C showing cancellation of $50,000 of principal indebtedness. As of the day before the cancellation of debt, there was $5,000 of accrued interest on the indebtedness which would be deductible if the debtor paid it. The $50,000 can be taken into account as a liability, but the $5,000 of accrued interest cannot be. Example 2. Assume in the preceding example that the 1099-C is for $55,000, and includes the $5,000 of interest. The interest can be taken into account as a liability in calculating insolvency. In Revenue Ruling 92-53 11 the IRS addressed the issue of the amount by which a nonrecourse debt which exceeds the fair market value of the property securing the debt should be taken into account in determining insolvency. The IRS analysis involved three different situations. Those situations and the analysis are reproduced below. Situation 1. In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. The note was secured by an office building valued in excess of $1,000,000 that A acquired from B with the proceeds of the note. A was not personally liable on the note. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note's principal amount to $825,000. The modified note bore adequate stated interest within the meaning of section 1274(c)(2) of the Code. At the time of the modification, A's only other assets had an aggregate fair market value of $100,000, and A was personally liable to D on other indebtedness in the amount of $50,000. In this situation, $175,000 of A's $200,000 excess nonrecourse debt is discharged and, therefore, that portion of the excess nonrecourse debt is taken into account in determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. Thus, A has liabilities of $1,025,000, consisting of the full $50,000 amount for which A is personally liable, plus the portion of the nonrecourse debt equal to the sum of the $800,000 fair market value of the property securing the nonrecourse debt and the $175,000 of excess nonrecourse debt that is discharged. Because A's $1,025,000 of liabilities exceed the $900,000 fair market value of A's assets ($800,000 + $100,000) by $125,000 immediately before the indebtedness is discharged, A is insolvent to the extent of $125,000. Accordingly, pursuant to section 108(a)(1)(B) and (a)(3), A must include only $50,000 of the $175,000 of discharged indebtedness ($175,000 - $125,000) in income under section 61(a)(12). Situation 2. The facts are the same as Situation 1, except that D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A's recourse indebtedness of $50,000, and C did not reduce A's nonrecourse note. 9. Merkel v. Commissioner, 192 F.3d 844 (9th Cir. 1999). 10. Lawinger v. Commissioner, 103 T.C. 428 (1994), footnote 4. 11. 1992-2 C.B. 48, distinguishing Rev. Rul. 91-31, note 6 supra. 6

In this situation no portion of the excess nonrecourse debt is discharged. Instead, $10,000 of A's recourse debt is discharged. Therefore, the excess nonrecourse debt is not taken into account in determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. As a result, A is solvent immediately before the discharge because its $850,000 of liabilities ($800,000 + $50,000) do not exceed the $900,000 fair market value of its assets ($800,000 + $100,000). Accordingly, A must include the entire $10,000 of discharged indebtedness in income under section 61(a)(12). Situation 3. The facts are the same as Situation 1, except that pursuant to a prearranged work-out plan D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A's recourse indebtedness of $50,000, and shortly thereafter C reduced the principal amount of A's nonrecourse note to $825,000. In this situation, pursuant to the prearranged work-out plan, $10,000 of A's recourse debt is discharged, and shortly thereafter $175,000 of A's nonrecourse debt is discharged. Because of the prearranged plan, the discharges are viewed as occurring simultaneously, but solely for purposes of determining whether, and to what extent, A is insolvent within the meaning of section 108(d)(3) of the Code. As a result, A must include only $60,000 of the total of $185,000 of discharged indebtedness in income under section 61(a)(12). The $60,000 is comprised of (1) the $50,000 discharge of indebtedness income as determined with respect to the nonrecourse debt in Situation 1, and (2) the $10,000 discharge of indebtedness income as determined with respect to the recourse debt in Situation 2. A worksheet for calculating insolvency can be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Does Abandonment Convert Recourse to Nonrecourse Debt? An individual borrowed money secured by a mortgage on a farm. On February 28, 1986, the individual filed Chapter 7 bankruptcy. Because the mortgage on the farm exceeded its fair market value, the trustee abandoned the farm to the debtor on May 1, 1986. The individual was granted a discharge on August 1, 1986, including a discharge on the debt secured by the mortgage. The individual subsequently received on January 31, 1989, a ruling from the IRS concerning, among others, the tax consequences of an impending foreclosure on the farm. The ruling stated that, at the time it was issued, the individual continued in possession of the farm and that some farming operations continued. In its ruling the IRS stated that the individual's personal obligation to make repayment of the loan was discharged in bankruptcy. To the extent the debt was secured by a lien on the property, however, the debt survived, but now constituted nonrecourse debt. Citing Tufts, 12 the IRS ruled that the individual would realize gain on the foreclosure to the extent the mortgage exceeded the individual's basis in the farm. 13 If the letter ruling is a correct statement of the law, debtors are placed in an even more precarious position with respect to abandoned property if a disposition of the property is taxable to the debtor rather than to the estate. If trustees routinely abandon property in which liabilities exceed fair market value, it is also likely that liabilities exceed the debtor's basis in the property. The debtor will therefore be required to 12 Commissioner v. Tufts, 461 U.S. 300 (1983). 13 PLR 8918016 (Jan. 31, 1989). 7

recognize gain in all such cases (other than property eligible for the principal residence exclusion under 121). If the debt were instead treated as recourse, the gain would be computed with reference to the lesser of the property's fair market value or the discharged debt. Any discharged debt in excess of the fair market value would be cancellation of debt (COD) income and excludable. The practical effect under the letter ruling is to deny the debtor tax relief from discharge of a portion of the debt in the bankruptcy case by recharacterization as an amount realized on the sale of property rather than COD. Had the property then disposed of prior to filing bankruptcy, the debt would have been recourse and the COD portion potentially excludable under 108. Unfortunately, too many debtors in bankruptcy are poorly advised and, once in bankruptcy, have very little choice in how matters are handled. The issue of recharacterization of recourse debt as nonrecourse is also an issue for taxpayers in states with anti-deficiency statutes. An analysis of the tax consequences of foreclosures and voluntary conveyances under those statutes certainly seems to validate the IRS position in the 1989 letter ruling. Effect of Anti-Deficiency Statutes Several states have various forms of anti-deficiency statutes. 14 Anti-deficiency statutes bar or limit the ability of a lender to obtain a deficiency judgment against a borrower if the value of property securing an indebtedness is insufficient to satisfy the debt. In a bar state, a lender is prohibited from pursuing any deficiency judgment against the borrower, usually with respect to purchase-money indebtedness only. In Arizona, for example, a lender is barred from pursuing a deficiency against a borrower with respect to purchase money indebtedness on a personal residence. Some states, such as California, are single-action states. 15 A lender has a choice of foreclosing property under a power-of-sale provision in the mortgage or deed of trust or of foregoing the security interest and suing on the entire debt. The question is whether anti-deficiency statutes caused debt to be treated as nonrecourse for federal tax purposes. Although there are two court cases involving foreclosures of properties under the California antideficiency statute, the opinions have simply stated without analysis that the debt was nonrecourse. 16 there is, however, a Chief Counsel Advice analyzing the California anti-deficiency statute in some detail. 17 One of the issues in the CCA was the effect of the California anti-deficiency statutes on COD for federal tax purposes. The IRS examined the California statutes dealing with recovery of deficiency judgments following sales of property to satisfy indebtedness secured by a mortgage or deed of trust on the property. It found that the anti-deficiency statutes do not limit the liability of the borrower for the full amount of the indebtedness, but rather limit the remedy of the lender. Furthermore, lenders are not precluded from seeking a deficiency judgment following foreclosure in the case of non-purchase money debt. The CCA then went on to state: 14 One list, based on non-definitive Internet research, identifies these as Alaska, Arizona, California, Minnesota, Montana, North Dakota, Oregon, and Washington. Other sources also include Connecticut, Florida, Idaho, North Carolina, Texas, and Utah, and exclude Montana and Oregon. No representation is made by the author concerning the technical accuracy of discussions of the various state laws. 15 One Internet list identifies single-action states as California, Idaho, Montana, Nevada, New York, and Utah. 16 See, e.g., Freeland v. Commissioner, 74 T.C. 970 (1980) (whether we conveyance of property subject and nonrecourse debt was an abandonment ordinary loss or a sale or exchange with capital loss); Catalano v. Commissioner, T.C. Memo. 2000-82, aff'd, 279 F.3d 682 (9th Cir. 2002) (whether lifting the automatic stay constituted effective abandonment). 17 CCA 003372 (Nov. 15, 1994). See, also, a discussion of the California anti-deficiency statute in GCM 35627 (Jan. 16, 1974). 8

Accordingly, our conclusion respecting residential mortgage foreclosures in California (and similar states) is that, assuming recourse notes are executed in connection with the mortgage instruments, and unless the creditor is prohibited from pursuing the deficiency through another remedy, (such as suit upon the note itself, or judicial foreclosure) such debts are recourse and are not rendered nonrecourse by reason of the anti-deficiency statutes. Under the election of a power of sale under the mortgage instrument, we believe a discharge of recourse debt by operation of law occurs. At that time, the borrower is released of personal liability on the indebtedness secured by the mortgage. [Footnote omitted.] It would appear, therefore, that a foreclosure in a bar state would be treated for income tax purposes as a transfer of property subject to nonrecourse indebtedness because the debt is nonrecourse from the very beginning. In an election state, on the other hand, recourse debt is converted to nonrecourse debt, not because of negotiation between borrower and lender, but because of the unilateral choice by the lender of which remedy to pursue. Could such an analysis be used in abandonment cases? There is certainly a superficial similarity. Assuming that is originally recourse, its conversion to nonrecourse is not by negotiation, but is based on the election of a third party, the bankruptcy trustee, to abandoned the property. Unfortunately, on the lender's perspective there is no choice. Because the personal liability of the debtor will be discharged in bankruptcy, the lender's only recourse is against the property. Abandonment would therefore seem in substance to be more can to the result in a bar state. The IRS position therefore seems to be justified. Joint Debtors The instructions for form 1099-C state that, in the case of multiple debtors, a 1099-C must be issued to each debtor who is jointly and severally liable on a debt of $10,000 or more incurred after 1994. Multiple debtors are presumed to be jointly and severally liable for a debt if there is no clear and convincing evidence to the contrary. If it can be shown the joint and several liability does not exist, a 1099-C is required for each debtor for canceled debt of $600 or more. For debts incurred before 1995 and for debts of less than $10,000 incurred after 1994, a 1099-C must be filed only for the primary or firstnamed debtor. If the lender knows or has reason to know that the multiple debtors were husband and wife who were living at the same address when the debt was incurred, and the lender has no information that the circumstances have changed, the lender is permitted to file only one form 1099-C. Notwithstanding these instructions, it appears from experience that the practice of most lenders when there are multiple debtors is to issue a 1099-C to every debtor who was liable on the debt. The problem, therefore, is how to handle this on the tax returns of the individual debtors. The only guidance that has been found addressing this issue is a service center advice from 1998. 18 In the advice, the IRS discussed the fact that a joint and several obligation creates a legal relationship between the lender and the debtors under which the lender may sue one or more of the debtors separately or may sue them all together at the lender's option. However, a debtor who is required to satisfy more than that debtor's proportionate share of a common liability generally is entitled to seek pro rata contribution from each of the other co-debtors. Exactly how much contribution the debtor is entitled to depends on the facts and circumstances, including whether the co-debtors equally enjoyed the use of the proceeds of the debt. 18. SCA 1998-039 (Apr. 1, 1998). 9

Because of the right of contribution that co-debtors have on a joint and several liability, the service center advice concluded that discharge of all of the co-debtors by a lender of the full amount of the joint and several obligation should not be treated as income to each of the co-debtors in the full amount of the discharged debt. Instead, an appropriate allocation of the CODI should be made among the co-debtors based on all the facts and circumstances. There are two problems with co-debtors who have joint and several liability. The first is determining the proportionate share of CODI allocable to each. For example, one of the co-debtors may have been the only one to have benefited from the debt, which would cause the entire debt forgiveness to be allocated to that debtor. The second is convincing the IRS that the entire amount of CODI should not be included on the tax return and for each of the co-debtors. Unless the lender, in the description of the debt at box 4 of the form 1099-C identifies the debt somehow as involving joint and several liability or co-debtors, there appears to be no way for the IRS to know of this fact. The author has encountered situations in which husband and wife, who were joint debtors on a single debt and satisfy the requirements for issuance of a single 1099-C, were each issued a separate form 1099-C for the full amount of the canceled debt. The result was an effective doubling of the CODI. The lenders in these cases refused to issue corrective 1099s. The only way to convince the IRS of the mistake was to obtain copies of the original loan documents. If that is not possible, a credit report, when combined with identical 1099-Cs issued to each of the two spouses might very well show that there was only one loan. The same approach should be used for non-spouse co-debtors. Unless one knows or has reason to know that fewer than all of the co-debtors benefited from the canceled debt, it seems reasonable, based on the service center advice, to treat each individual co-debtor as being liable only for his or her proportionate share of the debt. This would be the amount of the debt divided by the number of co-debtors. Guarantors The guarantor of the debt did not receive the debt proceeds and to therefore has had no accession to wealth. If the borrower defaults and the guarantor is called upon to perform under the guarantee, the borrower will be treated as having CODI to the extent of the guarantor's performance. 19 In fact, the regulations for reporting COD on a 1099-C specifically state that, solely for reporting purposes, a guarantor is not a debtor. This applies whether or not there has been a default and demand for payment made upon the guarantor. 20 Thus, the release of a guarantor prior to the borrower's default clearly is not CODI to the guarantor. There is, however, an information letter written by the IRS in which it is stated that the IRS generally has taken the position that CODI must be recognized the extent debt has been canceled, notwithstanding that nothing of value was received when personal liability notes were executed. 21 In the letter the guarantors had issued personal liability deficiency notes to a lender in exchange for original notes issued by their controlled entities for whom they were guarantors and then were subsequently released from the deficiency notes. The information letter then went on to conclude, however, that, because the guarantors would have a claim against the borrower to the extent the guarantors paid the debt, they would also be entitled to 19. Warbus v. Commissioner, 110 T.C. 279 (1998). 20. Treas. Reg. 1.36050P-1(d)(7). 21. Info. Ltr 2002-0024 (March 29, 2002. 10

a bad debt deduction or capital loss if they were unable to obtain reimbursement from the borrower for the payments. According to the IRS, this qualified for the wash rule under 108(e)(2). Post-Cancellation Payments A creditor is required to issue a Form 1099-C upon the occurrence of an identifiable event. One of the identifiable events is the expiration of the non-payment testing period. The regulations describe the non-payment testing period as a 36-month period during which time the creditor has not received any payment on the indebtedness. 22 If the testing period expires without payment by the debtor, a rebuttable presumption arises that an identifiable event has occurred, and the creditor should issue a Form 1099-C. The presumption may be rebutted by the creditor, and the creditor is not required to issue a Form 1099-C, if the creditor, or a third party on its behalf, engaged in significant bona fide collection activity at any time during the 12-month period ending at the close of the calendar year. The presumption also may be rebutted by the creditor if the facts and circumstances existing as of January 31 of the calendar year following the expiration of the non-payment testing period indicate that the indebtedness has not been discharged. There has been considerable controversy concerning the non-payment testing period. Issuance of the 1099-C does not mean that the creditor has abandoned the debt or that it is unenforceable under state law. Rather, it is an artificial event chosen by the IRS as a basis for reporting. It is not uncommon, in fact, for debtors to make payments on debts in a year or years following issuance of a 1099-C based solely on the non-payment testing period. If the debtor was unable to exclude all of the CODI and, as a result, paid tax on it, a subsequent payment on the debt reduces the amount of CODI that should have been reported as income. Unfortunately, a situation like this creates a trap for the debtor, as illustrated in a significant service center advice. 23 It appears the only recourse the debtor has is to file an amended return for the year the CODI was reported assuming the statute of limitations for refund is still open. Nor, in the case of consumer debt, does the IRS believe that 1341 (restoration of amounts previously included under claim of right) is applicable. That provision, supported by authority, is not itself authorize a deduction; it merely sets out the methodology for determining a taxpayer's deduction or a reduction in tax liability for the year of repayment. There must, however, be a separate provision of the Internal Revenue Code that permits the deduction. Because payments of personal loans are generally not deductible, the advice concludes, no deduction and therefore no relief is available under 1341. Things can become even more complicated if there has been reduction of tax attributes under 108(b). In response to the farm crisis in the 1980s, the FmHA (Farmers Home Administration) was authorized under the Agricultural Credit Act of 1987 to enter into various agreements with delinquent farmers. Several options were available, depending upon the FmHA's analysis of a particular farmer's situation, but the final result involved some degree of debt cancellation, sale of assets, or both. In addition, farmers whose loans were written down to net recovery value (what the FmHA thought it could get under a worst case scenario fire sale of the collateral) and refinanced by the FmHA were required to enter into a shared appreciation agreement (SAA) pursuant to which certain additional payments could be required to be made to the FmHA in the future. 22. Treas. Reg. 1.6050P-1(b)(2)(iv). The IRS has requested comments to help it determined whether the non-payment testing period rule should be modified or eliminated. Notice 2012-65, 2012-52 I.R.B. 773. 23. SCA 200235030 (Aug. 30, 2002. 11

Under the SAA, the farmer agreed to pay to the FmHA 75% of any appreciation in the value of the land securing the restructured loan if the land was sold, the loan repaid, or the farmer ceased farming within four years from the restructuring. The recapture was reduced to 50% of appreciation from the fourth through the tenth year. At the end of the tenth year, the farmer was required to pay the 50% of appreciation in any event. The amount recaptured under the SAA could not, however, exceed the amount of debt originally written down. The FmHA administered the SAA by creating an account receivable equal to the amount of debt written down. At such time that payment is made under the SAA, the account is credited with the payment. Any excess of the receivable over the amount paid under the SAA was then credited as a cancellation of debt. Example. In 1989, a farmer owed $300,000 to the FmHA. the debt was written down to $150,000 of net recovery value, resulting in a debt write-down of $150,000. The farmer entered into an SAA with respect to the $150,000. The FmHA then created a $150,000 receivable from the farmer. In 1999, the tenth anniversary of the SAA, the farmer's land has appreciated in value by $100,000. The farmer is therefore required to pay the FSA $50,000, half the appreciation. The $50,000 is credited against the $150,000 receivable, and the remaining $100,000 is treated by the FSA as cancellation of debt. When the FmHA began its debt restructuring in 1989, the issue presented by the SAA and the recapture agreement was when the determination should be made of the amount of COD income the farmer would have for federal income tax purposes. Should it be in the year the debt was initially written down, or in the year a final determination is made of any recapture amount that has to be paid? In a letter dated May 22, 1989, from the Chief Counsel of the IRS to the FmHA, the Chief Counsel concluded that the debt restructuring would be a closed transaction in the year of the initial write-down. Thus, a debtor who entered into a debt restructuring with the FmHA in 1989 and signed an SAA was required to determine the COD consequences in 1989 and reduce tax attributes in that year to the extent required. To the extent a farmer subsequently had to make payment under an SAA, the Chief Counsel concluded that the farmer should, at that time, take a 162 business expense deduction to the extent CODI had been included in gross income, then reestablish tax attributes in reverse order of their original reduction first under the qualified farm indebtedness exclusion, then under the insolvency exclusion. In short, restoration was every bit as complicated as the original exclusion. What was not addressed in the letter remains unanswered, is how many more years a restored NOL would be permitted to be carried over or how a restoration of depreciable basis should be handled. The fairest approach would be to treat the tax attributes as if they had simply been suspended for that period of time and to continue with whatever remaining NOL carryover period was applicable to the NOLs when they were reduced or to continue depreciating the basis of the asset in the same manner as would have been done had there been no basis reduction. Unfortunately, the service center advice discussed previously in this section takes the position that a subsequent payment effectively undoes the CODI in the original year to the extent of the payment. The effect of that would therefore seem to be that the limitation on NOL carryovers continues to run and that property should continue being depreciated all 10 years after the fact. Thus, for any year in which the statute of limitations on refund has expired, a farmer who reduced tax attributes might find himself or herself unable to amend. In that case, presumably, 1341 should be available to provide some possible relief. 12