When debt is forgiven, it is not always given away tax-free. Depending on the situation, you could find yourself having to pay tax on the canceled debt. Having a new debt created to the IRS just as you are being saved from the crushing debt other creditors is less than ideal. Fortunately, there are situations where the canceled debt can be treated as tax-free. Here is a situation where the taxpayer had canceled debt where a portion was non-taxable and the rest had to be included in taxable income.

The taxpayer, Frank, borrowed $80,000 from Cody, his brother’s business partner, to purchase gardening equipment for his gardening business. Frank ran into some rough times and offered to pay back $50,000 of the loan. Cody does not want to disrupt his already tenuous business relationship with Frank’s brother and accepts the $50,000 as full payment of the debt. Below was Frank’s balance sheet before the $50,000 payment:

Assets Adjusted Basis Fair Market Value
Gardening Equipment

Other Business Assets

Cash


Total

$40,000

$115,000

$75,000


$230,000

$50,000

$115,000

$75,000


$240,000

Liabilities (including $80,000 debt) $250,000

First, we look at the original nature of the transaction between Frank and Cody. Was the $80,000 a contractual agreement to repay, an investment in the company, or a gift to Frank? For this situation let’s assume that there is a contractual agreement in place as defined in Treas. Reg. 1.108(I)-0(a)(1), in which case Frank owes Cody $80,000. Another point, was it Frank that entered into the contract, a disregarded entity, or a corporation owned by Frank? Each would have different consequences on the calculations, but since there was no mention of a corporation or disregarded entity, we must assume that Frank, acting as an individual, entered into the agreement and that the balance sheet represents all of Frank’s assets and liabilities.

For repayment of the $80,000 loan, Frank gives Cody $50,000 and nothing else (removing the possibility that product or services were provided as repayment), and in the hope of future benefit (therefore excluding IRC 102 gift exclusion), Cody forgives the remaining $30,000. This creates $30,000 of cancellation of debt that must be included in gross income per IRC 61(a)(12) unless an exclusion is provided by IRC 108(a)(1)(A)-(E).

At the time before the cancellation of debt, the FMV of Frank’s assets were $10,000 less than the total of his liabilities, thereby making him insolvent in the amount $10,000.   IRC 108(a)(1)(B) therefore states that the $10,000 is excludable from income as Frank is insolvent in the amount of $10,000. The remaining $20,000 is included in Frank’s gross income.

Per IRC 108(b)(1), Frank has to reduce a tax attribute for the $10,000 that is excluded from gross income. The reduction would have to go in order of reducing any NOL first, then reduce business tax credits, minimum tax credits, capital loss carryovers, basis in assets, passive activity loss and credit carryovers, and then any foreign tax credit carryovers. Frank does not have any tax attributes other than the basis in his business assets, therefore the business assets must be reduced by the $10,000 of excludable income, in the order prescribed in Treasury Regulation 1.1017-1(a)(1)-(5). Treasury Regulation 1.1017-1(b)(3) limits the basis reduction to the extent that immediately following the debt discharged the total basis in assets exceeds the total liabilities. The taxpayer’s basis in the assets cannot go below the taxpayer’s liabilities. The adjusted basis of Frank’s assets after discharge is $180,000 ($230,000 less the $50,000 payment) and his adjusted liabilities is $170,000 ($250,000 less the $80,000 forgiven), thereby limiting the amount of the basis reduction to $10,000. Unfortunately, this is the same amount that Frank already has to reduce the basis in the gardening equipment; Treasury Regulation 1.1017-1(b)(3) does not provide any benefit in this situation. If Frank’s basis was less than his liabilities, then there would be no further reduction in basis and the cancellation of $10,000 in debt would have no tax consequences.

Treasury Regulation 1.1016-7, before it was removed by Treasury Decision 8787, outlined the method of allocating the basis reduction as a pro-rata reduction across the assets purchased with the debt, then across property securing the debt, then to other property used in the business, and then finally to inventory.   Frank can use the same method as outlined in Treasury Regulation 1.106-7 to reduce the basis of the gardening equipment by $10,000. The reduction in basis does not go into effect until the beginning of the year following the cancellation of debt. Frank will have to reduce the basis in his gardening equipment by $10,000 at the beginning of next year. If Frank were to sell all of the assets before the end of the year, then there would be no basis reduction.

Cancellation of debt can take the form of credit cards, student loans, car loans, business loans, or debt between friends. If you receive a 1099-C for the forgiveness of debts greater than $600, then consult a tax professional to see if you qualify for an exclusion to have that cancellation of debt income removed from your taxable income. For more information, contact Abacus CPAs at www.abacuscpas.com or at 417-823-7171. Better Guidance. Smarter Decisions.

Sam Shafer, CPA