When Is Cancellation of Debt Income Not Income?

Floetta Bullock wanted to help her son and daughter-in-law purchase a truck for their small business, so she agreed to co-sign a loan with the local credit union.  However, she didn’t notice that she actually signed as the primary obligor.  Neither did her family members notice.  And, lastly, neither did the credit union since “the credit union dealt only with the…son and daughter-in-law, who made the payments on the loan.”

A year later, the truck was stolen.  The insurance proceeds were paid to the credit union (they held a collateral loan).  The son and daughter-in-law stopped making payments.  Unfortunately, the insurance proceeds came up short and there was still an outstanding loan balance of $8,164.

The credit union did not chase after anyone for the loan balance.  They wrote it off.  However, they now discovered that Mom was not just a co-signer, she was the primary obligor.  So, they issued her a 1099-C and reported cancellation of debt income for the $8,164 balance due!

Mom wasn’t about to report COD income, so she omitted it from her tax return.  The IRS, of course, didn’t miss this unreported income and they nailed Mom for tax, interest and penalties.

Mom went to Tax Court.  What hope did she have?  She signed the note; she received the tax form.  Ah, but see IRC Sec. 7491(a), which shifts the burden of proof onto the IRS when a taxpayer produces credible evidence.  So, if Mom has a valid argument, “This case is decided on the preponderance of the evidence and is not affected by the burden of proof…”

Now, consider what the Court said regarding the reason for taxing COD income [citing Friedman v. Comm., 216 F. 3d 537,545 (6th Cir., 2000)] “the discharge of a debt below the face value of the debt accords the debtor  an economic benefit equivalent to income.”

However, “The guarantor of a contingent liability generally does not recognize income upon discharge of a debt.”  “Such a discharge creates no previously untaxed accretion in assets that would result in an increase in net worth.”  See Landreth v. Comm., 50 TC 803, 812-813 (1968).  What the Court here is saying is that the loan proceeds were not paid to the guarantor, so the guarantor was not enriched (increase in net worth), therefore, there is no income attributed to the guarantor if the debt is less than fully paid.

So, the Court looked to what happened and determined that Mrs. Bullock did not intend to be the primary obligor.  She was not treated as such by the lender; they looked to the son and daughter-in-law; had no communication with Mom; and, never looked to Mom to repay the debt.  “The intent of the parties, in turn, may be reflected by their subsequent acts.”  See Monon R. R. v. Comm.,  55 TC 345, 357 (1970).  “Without an intention for petitioner (Bullock) to repay the debt, there was no bona fide primary obligation between petitioner and the credit union.”

The Court held that Mrs. Bullock was not taxable on the COD income.  The case did not mention if son and daughter-in-law were taxable (although they did not receive a    1099-C).  See Floetta Bullock V. Comm., TC Memo 2017-219 (11/6/17).