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Recognition of “Debt Modification Income” Following Consumer Bankruptcy Reform The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provided incentives for debtors to negotiate settlement of debts, instead of filing for bankruptcy. This article discusses how to structure settlements to exclude discharged debts from gross income. James Parker, J.D., M.L.T.
Claire Y. Nash, Ph.D.,
CPA For more information about this article, contact Dr. Nash at cnash@cbu.edu. Executive Summary
The Bankruptcy Abuse Prevention and Consumer Protection Act of 20051 (BAP ’05), is considered a major overhaul of the U.S. bankruptcy system. Unquestionably, fewer debtors are now eligible to file for Chapter 7 liquidation. The financial accountability and other anti-abuse provisions in the BAP ’05 evidence Congress’s desire to see a significant number of debtors resolve their financial troubles through negotiated settlements. However, whether such settlements become common, as an alternative to bankruptcy, remains to be seen. The BAP ’05 changes provide an incentive to debtors and creditors to negotiate an alternative resolution. If negotiated settlements become significantly popular as an alternative to bankruptcy, tax advisers and other financial consultants will have to help clients structure those settlements in a way that allows them to exclude discharged debt from gross income. This article analyzes certain BAP ’05 provisions that could result in an increase in negotiated settlements and explains how to avoid discharge of indebtedness (DOI) income (1) under the Sec. 108(a)(1)(B) insolvency exclusion, (2) as a contested liability or (3) as a qualifying purchase-price adjustment. Debtors should be fully informed of the debt modification income that will result from negotiated settlements when these exclusions are unavailable.
Basic Reform Provisions Means Test The BAP ’05 significantly changes the definition of an “abusive filing.” Prior to the BAP ’05, it was incumbent on creditors or a court to challenge the propriety of a Chapter 7 filing. The BAP ’05 no longer requires creditors or a court to show that a petition for relief constitutes a substantial abuse. It merely requires a determination of abuse2 and sets forth a “means test” that defines an abusive filing. In light of the means test and other anti-abuse provisions discussed below, an increase in the number of negotiated settlements between debtors and creditors is likely. It is not unusual for laws passed for the purpose of achieving a certain goal to have unintended consequences—that may be the case with the BAP ’05. In particular, negotiated settlements with creditors could result in the recognition of DOI income and immediate tax liabilities for already financially strapped debtors. The means test imposed by the BAP ’05 begins with a comparison of a debtor’s income to the median income in his or her state of residence.3 Debtors who earn less than their state’s median income are eligible to file for Chapter 7 bankruptcy and eliminate most of their debts with little (if any) payments to their creditors. However, insolvent debtors whose incomes significantly exceed the median income for their state are generally ineligible to file for Chapter 7, and must choose between a Chapter 13 bankruptcy (which requires making monthly payments toward a restructured debt-payment plan) or negotiating settlement of debts directly with creditors.
Credit Counseling BAP ’05 Section 106 provides that individuals seeking relief through the bankruptcy system must have received credit counseling from an approved nonprofit budget and credit counseling agency within 180 days prior to filing a bankruptcy petition. Following credit counseling, debtors who do not qualify for bankruptcy will likely enter into negotiated settlements with creditors. Realizing that negotiating settlements requires motivation on the part of all concerned, the BAP ’05 requires a creditor to engage in good-faith negotiations of reasonable repayment schedules for unsecured consumer debt. Creditors that fail to do so run the risk of having a claim for such debt reduced by as much as 20% by the bankruptcy court.4 The BAP ’05 encourages creditors to accept settlement offers that provide for payment of at least 60% of a dischargeable debt over a reasonable period.
Extended Waiting Period BAP ’05 Section 312(l) also extends the period that a debtor who has previously obtained a bankruptcy discharge must wait before being eligible to obtain another, from six years to eight. Thus, debtors who pass the means tests and find themselves in financial trouble, and who have received a bankruptcy discharge within the last eight years, will be ineligible to file for bankruptcy again. The extension will result in an increased number of debtors ineligible to file for Chapter 7 bankruptcy. While the BAP ’05 is still in its infancy and the effects of the above changes are not yet known, it appears that fewer debtors will be able to avail themselves of protection under the bankruptcy system. The BAP ’05 changes could lead to an increased incidence of recognition of debt modification in-come.
Debt Modification Income Sec. 61 “Gross income,” as defined in Sec. 61(a), is “all income from whatever source derived,” and includes “all accessions to wealth, clearly realized and over which the taxpayers have complete dominion.”5 Sec. 61(a)(12) requires taxpayers who have incurred a financial obligation that is later discharged in whole or in part to recognize DOI income to the extent that the obligation is reduced. Taxpayers who are unable to pay their debts, and through negotiated settlements obtain a discharge from all or part of those obligations, realize an accession to wealth; the debt cancellation effects a freeing of assets previously offset by the liability arising from such debt.6
Sec. 108 Bankruptcy: Sec. 108(a)(1)(A) excludes from gross income debt forgiveness when the discharge occurs in a “title 11 case.” Sec. 108(d)(2) defines a title 11 case as
For a debt discharge to qualify for exclusion, the bankruptcy court must explicitly exercise jurisdiction over the discharge of debt; in such cases, a court dealing with related tax issues will generally not second-guess the bankruptcy court’s assertion of jurisdiction.
The Tax Court has generally applied the Sec. 108 exclusion to cases in which the bankruptcy court has exercised jurisdiction. In Gracia,7 the Tax Court held that the bankruptcy court also explicitly held jurisdiction over a partner in a bankruptcy discharging partnership debt. In Gracia, a partnership sought relief from more than $20 million of debt for which the partners were jointly and severably liable. The partners negotiated a settlement that included an agreed-on contribution payment as part of the bankruptcy plan. Following a contribution of $220,000 to the partnership’s bankruptcy estate, the partners were released of “all ‘claims or potential claims of all creditors’ of the partnership.” The bankruptcy court specifically discharged and released the partners from any and all liability arising out of or relating to (1) the partnership, (2) their status as general partners in the partnership and (3) their personal guarantee of partnership debt. Gracia, a partner, was able to exclude $195,120 of discharged debt from gross income. Taxpayers who are able to discharge their debts through the bankruptcy court will still benefit from the exclusion allowed in Sec. 108, despite passage of the BAP ’05. Insolvency: Excluding income arising from debt forgiveness from gross income has historically not been difficult for debtors, as most realize debt discharges through bankruptcy filings. However, Sec. 108 also provides a similar exclusion of income from debt forgiveness for taxpayers whose debts are not discharged through bankruptcy proceedings, but are “insolvent” at the time that their debts are forgiven. Under Sec. 108(d)(3):
When the insolvency exception applies, the amount excluded cannot exceed the amount by which the taxpayer is insolvent. Under the “net assets” test, if the debtor is insolvent (i.e., liabilities exceed assets) before and after being discharged from debt, no assets have been freed as a result of the discharge and, thus, no gross income is realized. If after the discharge the debtor is solvent under the net-asset test (i.e., assets exceed liabilities after the discharge), the discharge has freed the debtor’s assets from the offset of liabilities; to that extent, some gross income is realized from the discharge.8 Sec. 108 requires a straightforward showing that a taxpayer’s liabilities exceed his or her assets, to be considered insolvent. When debts have not been discharged through bankruptcy, taxpayers must prove insolvency in accordance with Sec. 108. The definition of insolvency for bankruptcy purposes differs greatly from that under Sec. 108. Under the Bankruptcy Code, an insolvent individual is one whose total liabilities exceed the sum of the fair market value (FMV) of his or her assets, less property that may be exempted in a bankruptcy proceeding under the laws of his or her state.9
P is clearly solvent under Sec. 108. If he negotiates a settlement with the credit-card companies that allows him to pay half of his outstanding balances, the amount discharged ($55,000) would be taxable DOI income to him. However, under the Bankruptcy Code, P’s net worth and solvency would be determined differently, as shown in Exhibit 1. After excluding exempt property from his assets, P is insolvent. The exemption of certain assets contributes to his insolvency, and if he otherwise qualifies to file bankruptcy and does so, he can avoid DOI income recognition.
Additional Asset Exemptions BAP ’05 exacerbates the difference in the insolvency determination by increasing asset exemptions. Exemptions are extended to include (1) retirement savings,10 (2) education savings11 and (3) employee contributions to employee benefit and health insurance plans.12 Although the BAP ’05 standardized the homestead exemption across states with limited exceptions, allowing these additional exemptions will further widen the difference between the calculation of solvency under the Bankruptcy Code versus Sec. 108.
Contingent Liabilities The Bankruptcy Code and Sec. 108 may require different treatment of contingent liabilities in determining a debtor’s net assets. Contingent liabilities are those that may or may not result in the debtor having to pay them. They often arise when an individual guarantees payment of the debt of a related party in the event of default. In Chapter 7 bankruptcy cases, debtors generally include all of their liabilities, with little distinction made between contingent and noncontingent. A discharge of liabilities in a bankruptcy petition generally relieves the debtor of all liabilities. A taxpayer claiming the benefit of the Sec. 108(a)(1)(B) insolvency exception must prove, as to any obligation claimed to be a liability, that (1) as of the calculation date, it is more probable than not (emphasis added) that he or she will be called on to pay that obligation in the amount claimed; and (2) the total liabilities so proved exceed the FMV of the assets.13 Under Sec. 108, debtors generally must exclude contingent liabilities in the calculation of “net assets,” unless it is more probable than not that they will be called on to pay them. In Merkel and Hepburn,14 a consolidated case, Merkel and Hepburn were partners in a computer-leasing business that ran into financial trouble and was unable to pay its debt obligations: a bank note with a balance in excess of $3.1 million and sales and use tax assessed by North Carolina of almost $1 million. Merkel and Hepburn guaranteed the bank loan; as officers of the partnership, they were liable for any sales and use tax that should have been collected by the partnership. The partners negotiated a structured workout for the debt the partnership owed the bank, which resulted in releases for the partnership (as well as the individual partners). The negotiated settlement for the bank debt was substantially less than the balance owed on the note. The partners appealed the sales and use tax assessment and were successful in having it abated. Each of the partners realized $359,721 in income due to debt forgiveness on the bank note, which they reported, but excluded from income under the insolvency exception of Sec. 108(a)(1)(B). The IRS disallowed the exclusion, arguing that the contingent obligations did not meet the definition of “liabilities” under established accounting principles. The partners argued that contingent liabilities resulting from their guarantee of the bank note and the unpaid assessed sales taxes should be included in the insolvency calculation. The Tax Court concluded that to include contingent liabilities in determining the taxpayers’ insolvency, they had to show that it was more likely than not that they would be required to pay the liability, which they failed to do. Neither was insolvent for Sec. 108(a) (1)(B) purposes. The Tax Court had the advantage of hindsight, enabling it to determine with certainty whether or not the debtors were compelled to pay their contingent liabilities. Generally, a court will be able to use hindsight when determining insolvency in such cases. Had Merkel and Hepburn been held personally liable on the two obligations—the payment demanded by the bank and North Carolina—each of them would have been considered insolvent under Sec. 108(a)(1)(B).
Avoiding Debt Modification Income Taxpayers who negotiate a discharge of some or all of a debt may avoid DOI income, even if not insolvent for purposes of excluding their cancelled debt under Sec. 108(a)(1)(B). To the extent that a taxpayer can show that a cancelled obligation was not a valid debt, or that the cancellation was a purchase-price adjustment, he or she can avoid recognizing debt modification income for the amount justified. Debtors who finance purchases directly with sellers will be in the best position to avail themselves of the exclusions allowed under the contested-liability and purchase-price-adjustment doctrines.
Contested-Liability/Disputed-Debt Exception The contested-liability (or disputed-debt) exception rests on the premise that if a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of that dispute is “treated as the amount of debt cognizable for tax purposes.”15 To exclude income from debt reduction on grounds that the original debt was not valid, the taxpayer must prove that there was a bona fide dispute over the legitimacy of the original debt. A mere assertion on the taxpayer’s part that the debt is questionable is not enough.
For the disputed-debt exception to apply, negotiations must be with the seller of goods or services, rather than with a third-party lender. In Preslar,16 the taxpayer borrowed funds to buy property and excluded subsequent negotiated reductions in his loan principal on the grounds that they were adjustments to the sales price. The Tax Court ruled in the taxpayer’s favor on the issue, but the Tenth Circuit reversed, because the lender was not the seller of the property, but had merely financed the transaction, and there was no dispute over the validity of the loan. However, the court did make it clear that taxpayers can exclude debt cancelled in settlement of a bona fide dispute over the debt’s validity. It summed up the “contested liability/ disputed debt exception” as follows:
Following the contested-liability doctrine in Preslar, there are a number of situations in which solvent taxpayers may be permitted to exclude DOI income. Taxpayers who buy goods on credit and negotiate reductions in their obligations due to misrepresentations concerning those goods should be able to employ the contested-liability doctrine. Taxpayers who buy businesses using seller financing and negotiate a debt reduction when they discover that they were deceived about the enterprise’s past profits, may also be able to exclude negotiated purchase-price adjustments under the contested-liability doctrine. Still another exclusion of DOI income may be available to debtors who negotiate settlements with creditors that may have jeopardized their rights of recovery due to noncompliance with certain legal procedures.
The contested-liability doctrine could also be applied when a taxpayer is discharged from debt when the creditor has no legal right to extend the debt. In Zarin,17 a gambler was discharged from debt created when a casino extended him credit in defiance of an emergency order issued by the New Jersey Casino Control Commission. Although the taxpayer negotiated a settlement with the casino to pay part of what he owed, the emergency order made extension of the credit illegal and recovery of the debt unenforceable. The court held that because the taxpayer was not liable for the debt he allegedly owed the casino, the Code’s cancellation-of-debt provisions did not apply. There are a number of situations to which the contested-liability doctrine might apply. Its applicability should be considered whenever there is a bona fide dispute over the validity of a debt.
Purchase-Price Adjustments Taxpayers who can show that their debt modifications are a “purchase price adjustment” can avoid DOI in-come. As with disputed debts, avoidance under this exception is not usually available when debt-reduction negotiations are with third-party lenders. Sec. 108(e)(5) provides:
Generally, consumer creditholders are considered third-party debtholders, financiers of initial retail transactions. Sec. 108(e)(5) applies only to direct agreements between a purchaser and seller. According to Rev. Rul. 92-99,18 if a debt has been transferred by the seller to a third party, or the property has been transferred by the buyer to a third party, the purchase-price reduction exception is generally not available. In Preslar, the court reiterated the rationale articulated in Rev. Rul. 92-99:
There is a limited “infirmity exception” to the general prohibition against treating debt reductions as purchase-price adjustments in other than direct seller-purchaser transactions. Rev. Rul. 92-99 states that, under this exception, when the seller may have misrepresented a material fact or induced the buyer to purchase through fraud, a negotiated adjustment with the third party based on an infirmity that clearly relates back to the original sale, can be treated as a purchase-price adjustment.
C acknowledged that it was experiencing similar problems with other Y customers and agreed to the reduced amount. Even though the negotiated settlement was with a third party (rather than the service provider), the fact that the debt reduction was due to misrepresentation of a material fact, and because C was familiar with Y’s business practices, X should be able to use the infirmity exception to avoid DOI income recognition.
Other Timing and Recognition Issues Ordering of Modification Agreements While a taxpayer who has negotiated settlements of several debts may be insolvent when he or she negotiates his or her earliest settlements, the taxpayer may reach a point at which sufficient debt is eliminated such that he or she is no longer insolvent as he or she negotiates settlements on the remaining obligations. Only debt relief negotiated when the taxpayer was insolvent will qualify for exclusion from gross income under Sec. 108(a)(1)(B). Each negotiated settlement is viewed as a separate event and is subjected to its own solvency test. As mentioned earlier, under the net-asset test, the taxpayer must be insolvent before and after a DOI to avoid income recognition. If the debtor is solvent under the net-asset test after the discharge, income is recognized to the extent that the discharge has freed assets from the offset of his or her liabilities. Taxpayers who face this potential problem would be wise to structure the order of their negotiated settlements such that the last debt settlement is large enough to qualify the taxpayer for the income exclusion under Sec. 108(d)(3).
O sells his home and negotiates a 50% settlement with A. He uses $75,000 of the net proceeds to settle his $150,000 debt with A. Immediately following the transaction, O’s net worth and insolvency would be as shown in Exhibit 2, under “Following settlement with A.” O would be solvent following the discharge. While no assets are freed, any further negotiated settlements at less than the full amount owed would result in DOI income recognition. However, if O entered into negotiations to settle his smaller debt with B first and subsequently negotiated a settlement with A, the result could be dramatically different, as shown in Exhibit 2, under “After settling with B first.” (O negotiates to pay B approximately 78% of the amount owed.) O continues to be insolvent following the settlement with B. There would be no recognition of DOI income from the settlement, because O is insolvent immediately before and after the settlement transaction. O can now negotiate a settlement with A that will allow him to avoid DOI income recognition. O negotiates to pay A the remaining cash balance of $90,070, approximately 60% of the amount owed. Immediately following the settlement transaction with A, O’s net worth and solvency would be as shown in Exhibit 2, under “After settling with A second.” Although O is not insolvent following the transaction, no assets were freed as a result. Thus, O would not have to recognize DOI income. The ordering of debt modification negotiations is generally not an issue for taxpayers whose debts are discharged through bankruptcy; the granted petition discharges all of a debtor’s obligations at once.
Timing Income Recognition Creditors who grant debt reductions are required by law to send Form 1099-C, Cancellation of Debt, to each debtor and to the IRS, stating the amount of the taxpayer’s debt reduction. Not all creditors comply with this requirement. Taxpayers who did not receive the required form and failed to report the income attributable to debt forgiveness have argued that, in the absence of a Form 1099-C, they had no DOI income. The Tax Court has routinely rejected this argument and ruled that receipt of a Form 1099-C is not determinative of whether a taxpayer had DOI income.19 Moreover, even when a creditor does send a Form 1099-C, the year specified in the form as the year in which the DOI occurred is not controlling. Rather, debt is deemed cancelled in the year the creditor ceases collection activities.20
Conclusion The BAP ’05 imposes a stringent means test that will prevent many debtors from qualifying for bankruptcy protection. Debtors deemed able to repay a significant portion of their debts under the new financial accountability provision of the BAP ’05 are likely to enter into debt modifications with creditors. These negotiated settlements could result in taxable income for debtors, accompanied by an immediate unintended tax burden. Sec. 108 generally requires a taxpayer who discharges debt for an amount less than its face value to recognize taxable income, as the reduction or cancellation of the debt makes available to a taxpayer assets that previously had been offset by the debt obligation. Tax advisers, financial advisers and consultants should familiarize themselves with the eligibility provisions of the BAP ’05 and understand the tax consequences of limiting a debtor’s eligibility to discharge debts through bankruptcy. Taxpayers who are unable to qualify for bankruptcy protection and not “insolvent” could have significant tax liabilities following debt modifications resulting from negotiated settlements. Tax advisers knowledgeable about the BAP ’05’s changes will be able to advise clients of the tax provisions that allow them to avoid recognizing income from discharged debt. These include negotiating reductions in debt based on a bona fide dispute, challenging a debt’s validity and identifying purchase-price adjustments. Taxpayers must be properly advised as to the order in which they should negotiate settlement of several different debts, to avoid income recognition from the freeing of assets. Even when there are no applicable exceptions available, it is incumbent on tax advisers to inform clients of the income tax consequences of debt modification agreements. Negotiated debt settlements could potentially result in large unanticipated tax liabilities for debtors. |
