ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – CANCELLATION OF DEBT MAY BRING YOU GRIEF – INCOME TAXES
By Robert S. Schriebman
Section 61(a) of the Internal Revenue Code is one of the first laws learned when one studies the income tax law. It is the fundamental bedrock of federal taxation. The Code section defines what is considered taxable income. Subsection 12 of 61(a) states that gross income means income from whatever source derived including income from the discharge of indebtedness. Most of us think of income from our paychecks, interest, dividends, and gambling. Rarely, however, does anyone stop to think about cancellation of debt income. If you borrow money from a friend or relative, for the purpose of paying tuition, buying a vehicle, or furnishing your home, and the debt is forgiven or written off, you probably have hidden cancellation of debt income. Your net worth suddenly increases and this increase is the reason why Congress makes you pay income tax on the amount cancelled. I will refer to this cancellation of debt as “COD.”
Sometimes there are laws that exempt COD income from being taxed. For example, if you are granted an offer in compromise, the taxes you originally owed are forgiven. You only pay the amount of the accepted offer. The reason you are not taxed is due to a corresponding statute. The EDD and the FTB also have offer in compromise programs that exempt the cancellation of the original liability from being subject to income tax.
What happens when a mortgage debt is cancelled? What happens when real property goes into foreclosure? On the face of it, this too is COD income, but there are special provisions in the law that exempt these situations from generating taxable COD income. The provisions are found in Section 108 of the IRC and California equivalent. But things are rarely that clear or simple. The recent US Tax Court decision in Weiderman is an illustration of just how tricky mortgage-related debt cancellation is. This article will discuss the Weiderman case, COD income, and the interplay of IRC § 108. Weiderman v. Commissioner , US Tax Court, CCH Dec. 61,722(M), T.C. Memo. 2020-109 T.C.M., (Jul. 15, 2020)
The Weiderman Case and Debt Cancellation
Jennifer Weiderman worked as an executive vice president of product and marketing with Stride Rite Corp. She and her husband lived in Massachusetts. K-Swiss, located in Southern California, sought her out and made her an offer she could not refuse. Part of the offer was a hefty $25,000 per month salary together with the payment of all moving expenses and an interest-free loan of $500,000 to help her purchase a home in Agoura Hills. She was hired in 2006, but was terminated in December 2008. Part of her agreement with K-Swiss called for the repayment of the $500,000 loan upon termination. After some negotiations, K-Swiss agreed to cancel $220,000 of the loan. This was the first cancellation; there were two more cancellations. The second cancellation was $35,000, and the third was an additional $30,000. In order to protect its position, K-Swiss recorded a deed of trust secured on the Agoura Hills home, but after the home was purchased and before the $30,000 was cancelled; just prior to its sale by Jennifer. K-Swiss sent Jennifer a 1099-MISC Form for $255,000 in 2009 and $30,000 in 2010. A copy of the Form was sent to the IRS as required by law.
The IRS conducted an audit of the Weidermans. Part of the audit taxed the cancellation of indebtedness as income to Jennifer and her husband. Jennifer cried “foul,” and protested the audit assessment on the grounds that the cancellation was not taxable income. Jennifer argued that when K-Swiss secured the remaining balance of the debt on her property, the cancellation of the final $30,000 forgiven was exempt under the law (IRC § 108). The US Tax Court disagreed.
A taxpayer’s gross income tax exposure is governed by IRC § 61(a). The taxpayer’s net worth is increased by the amount of the cancellation. This has been the law since 1931. United States v. Kirby Lumber Co., 284 US 1,2 (1931). The amount of COD income includible in gross income is the value of the cancelled debt less any amount paid in satisfaction of that debt. Income is recognized i.e., required to be reported on the tax return, in the year in which the debt is cancelled. Montgomery v. Commissioner, 65 T.C. 511 (1975). Exemptions are set forth in IRC § 108. Section 108(a)(1)(E) provides that gross income does not include amounts which would be includible as COD income if “the indebtedness discharged as qualified principal residence indebtedness.” The term “qualified principal residence indebtedness” is defined as acquisition indebtedness.
Acquisition indebtedness is any indebtedness which is (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer and (2) secured by that residence. The promissory note did not provide that the indebtedness was secured by the Agoura Hills property. The $500,000 loan was an unsecured debt. When K-Swiss eventually recorded a mortgage against the property before it was sold, that debt was not incurred in acquiring, constructing, or substantially improving the Agoura Hills property. The final $30,000 cancelled was COD taxable income. This is all very tricky, but the judge was right.
The Weiderman case is an example of how a loan must touch and concern real property before its cancellation is exempt from taxation. Of course, it is cheaper to pay the income tax, both IRS and FTB, on the income generated from COD, than it is to have paid the amount of the cancelled debt. I wrote this article because I am concerned about the various governmental programs offered in this pandemic that provide loans for such things as payroll, and other business-related expenses, there are provisions that these loans may be forgiven by the federal and state governments. All these loans are unsecured and are not recorded as mortgages on real estate. The cancellation of debt may generate COD income. In my next life, I will try to work for K-Swiss.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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