According to the Internal Revenue Code, the discharge of indebtedness must be included in a taxpayer's gross income.
[1] There are exceptions to this rule, however, so a careful examination of one's COD income is important to determine any potential tax consequences.
[2] The standard definition of income is found in a United States Supreme Court case entitled Commissioner v. Glenshaw Glass Co.[3] The Court defined income as 1) accession to wealth; 2) that is clearly realized; and 3) over which the taxpayer has complete dominion.
This is because there is "symmetry" of assets and liabilities on both side: the borrower's increased wealth when the loan is taken out is offset by an obligation to repay that same amount.
Likewise, the lender's loss of wealth by lending out that money is offset by the borrower's promise to pay back the entire amount.
The taxpayer now has a greater ability to pay taxes and this is shown by including the amount of canceled debt in gross income.
One exception to the requirement to file 1099-C is when a student loan has been discharged due to the death or permanent disability of the borrower under provisions of the Tax Cuts and Jobs Act of 2017.
Ordinarily, retiring bonds for less than the issue price would result in taxable canceled debt.
However, in holding that there was no COD for Rail Joint, the court noted that, unlike in a normal issuance of corporate debt for cash consideration, the original issuance of these bonds as dividends did not increase the capital of the corporation and did not create burdened assets to be later freed by the cancellation.
Rail Joint is nonetheless good law, and has been expanded to encompass other situations where the taxpayer received nothing of value in exchange for the debt, such as when a guarantor of a loan who did not enjoy the benefit of the loan settles it for less than the face amount.
That this difference between the adjusted basis of the property and the amount of the debt is simple gain rather than COD has potential upsides and downsides.
[22] If one of the two requirements are met, then the taxpayer must show that they fall under one of the five exclusions in order to avoid tax consequences on the COD Income.
The farm indebtedness provision, on the other hand, represents a political decision to subsidize farmers by offering a tax benefit.
Prior to the enactment of the Tax Cuts and Jobs Act of 2017, there were several lobbying efforts[23] to amend 108(f)(1) for those who get total and permanent disability discharges, since under Department of Education rules, such borrowers are subject to a three-year post-discharge review period during which their incomes from employment cannot exceed the poverty line.
§ 49(a)(1)(D)(iv)[29] There are additional rules as well regarding the total amount excludable, which cannot exceed the sum of tax attributes and business and investment assets.
[37] In the case of excluding COD income from gross income, that policy prevents creating a new tax burden on insolvent and bankrupt taxpayers, who are likely in a situation where they financially need that benefit, and who would likely be difficult or impossible to collect from.
Then, after filing a bankruptcy to wipe out the debt, they could use the NOL carryforward for up to twenty years or until it was exhausted.
[42] Furthermore, on March 9, 2002, President Bush signed the Job Creation and Worker Assistance Act of 2002.
This act prohibited shareholders from increasing basis for their portions of the S corporation's excluded cancellation-of-debt income, for discharges of indebtedness after October 11, 2001.
This effectively overturned the January 9, 2001, U.S. Supreme Court decision to allow such increases in basis in Gilitz v. Commissioner, 531 U.S. 206 (2001).