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LITERALISM CARRIES THE DAY FOR TAXPAYERS IN FOUR DEBT FORGIVENESS CASES

June 22, 2004

Sometimes the tax law means just what it says.

Debt forgiveness is taxable to the forgiven debtor under general tax principles. Courts found ways to overcome these general principles over the years, particularly for taxpayers who were bankrupt or insolvent. Congress has gradually replaced the case law with a statutory scheme to govern when debt cancellation is taxable.

One of the most important exclusions for cancellation of debt (COD) from income is found in Code Sec. 108(a)(1)(A), which excludes from income debt cancellation when "the discharge occurs in a title 11 case..." Title 11 is the federal bankruptcy code.

Four Tax Court cases issued today show that...

...IT DOESN'T HAVE TO BE YOUR BANKRUPTCY!

In 1988 Northcliff Associates, a Maryland general partnership, filed for Chapter 11 protection while it attempted to reorganize its debts. This had to be scary for general partner Chester L. Price, who was on the hook for, in round numbers, $1,850,000 in partnership debt.

The bankruptcy trustee negotiated a deal with Mr. Price and the other general partners. In exchange for cash payments, the creditors forgave the partners their liability for partnership debt. Mr. Price bought out his liability for $25,000.

BANKRUPTCY, OR JUST INSOLVENCY?

The partners didnt report their debt forgiveness on their tax returns on the grounds that the discharge occurred "in a title 11 case." The IRS disagreed on the grounds that it was the partnership's bankruptcy case, not the partners'. The IRS said that the partners could exclude the debt forgiveness only to the extent it rendeded them solvent, as provided by Code Sec. 108(a)(1)(B). This would have given Mr. Price $456,864 of taxable income.

The Tax Court sided with the partners:

   For purposes of section 108, a “title 11 case”
   is defined as “a case under title 11 of the 
   United States Code (relating to bankruptcy),
   but only if the taxpayer is under the 
   jurisdiction of the court in such case and 
   the discharge of indebtedness is granted by
   the court or is pursuant to a plan approved 
   by the court.” Sec. 108(d)(2).

   The partnership’s chapter 11 bankruptcy was 
   a case under title 11 of the United States 
   Code. See 11 U.S.C. ch. 11 (2000). 
   Pursuant to its December 19, 1995, order, 
   the bankruptcy court discharged and released
   petitioner from all liability to the trustee, the
   bank, and all other creditors that might have
   claims arising from or relating to the 
   partnership, petitioner’s status as a general
   partner in the partnership, and the April 9, 
   1985, personal guaranty agreement. In the 
   same order, the bankruptcy court explicitly 
   asserted its jurisdiction over petitioner for
   this purpose. Giving due regard to principles 
   of judicial comity, we discern no reason to 
   second-guess the bankruptcy court’s 
   assertion of jurisdiction over petitioner in the
   partnership’s chapter 11 bankruptcy case.

In other words, as long as your debt is forgiven in a Title 11 case, it doesn't have to be your Title 11 case to qualify for the exclusion, according to the Tax Court. The Court reached the same result in four cases released today involving the partnership.

It will be interesting to see whether the IRS chooses to appeal the cases. In Gitlitz v. Commissioner, another case involving taxation of debt forgiveness, the Supreme Court took the statute literally to arrive at an odd result with the effect of giving bonus deductions to taxpayers with debt forgiveness income. The Court said it wasn't their job to fix Congressional drafting errors. Congress later rewrote the statute. There is no evidence the courts have abandoned what one might call an Amelia Bedelia approach to statutory construction.

Links:

Chester L. Price, T.C. Memo. 2004-149.

Jose Gracia and Nancy Gracia, T.C. Memo. 2004-147

Ralph J. and Joan B. Mirarchi, T.C. Memo. 2004-148

Estate of Jose Martinez, Deceased, Patrick G. Martinez, Personal Representative, T.C. Memo. 2004-150

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