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Post Date:  6/24/2015
Last Updated:  6/24/2015

Summary
Cross References
- Johnston, T. C. Memo. 2015-91, May 11, 2015

IRC section 61(a)(12) states that the discharge of indebtedness is includable in gross income. Whether a debt has been discharged depends on the substance of the transaction.

In this case, the taxpayer was offered a job which included a salary, employee benefits, and a loan to the taxpayer for use in another business that he co-founded. The taxpayer agreed to work as an executive for his employer, as well as to work for the corporation that he co-founded. The two positions did not conflict with each other. The taxpayer’s employment agreement with the new employer stated that if he ever left his position, he would have to repay the loan.

Years later, the taxpayer decided he needed to work for the corporation that he co-founded full time due to its rapid growth. Consequently, he resigned his position with his employer. The taxpayer’s resignation triggered his repayment obligation on the loan. But the employer did not demand repayment and no Form 1099-C, Cancellation of Debt, was issued to the taxpayer. About a year later, the taxpayer’s corporation went bankrupt. Three years later, the taxpayer agreed to go back to work for his previous employer. Six years after going back to work, the employer notified the taxpayer that he still needed to pay back the loan from his previous employment agreement. The taxpayer agreed, and proceeded to have payroll deductions from each paycheck to pay back the loan.

The IRS claimed that the only reason the taxpayer (and employer) agreed to start paying back the loan was because the IRS had sent the taxpayer a notice of deficiency determining that he had failed to report cancelation of debt income (COD).

The court noted that the moment it becomes clear that a debt will never have to be paid, that debt must be viewed as having been discharged. The taxpayer argued that the debt was not discharged because he is currently making payments on the loan. The IRS said that the debt was discharged when the employer failed to take collection action after the taxpayer had originally resigned. Such inaction manifests the intention to forgive the loan. The IRS said that the taxpayer did not make a payment on the loan until after the commencement of the IRS audit which determined there was un-reported COD income. In other words, the IRS argued that the taxpayer only sought to repay the loan so that he could avoid paying tax on COD income.

The court disagreed. A reasonable person would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment of the loan costs more economically than paying tax on the debt forgiveness. The court said the taxpayer sought to repay the loan because he understood that it was his obligation to repay it. The IRS audit merely prompted the taxpayer and the employer to address an overlooked matter. The court ruled the loan was not forgiven and consequently, there was no COD income.

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