Mr. Dunnigan would discover, in the case of Dunnigan v. Commissioner, TC Memo 2015-190 that merely because your bank and an IRS employee told you there wouldn’t be tax due on a cancellation of debt, that doesn’t mean there actually won’t be tax due.
Mr. Dunnigan had taken out a $50,000 line of credit for his business in 2008. In 2009 Mr. Dunnigan found he was unable to pay off the line of credit, so he negotiated an agreement with the bank where the bank would take $15,628 in full satisfaction of the debt in question.
This line of credit wasn’t the only debt Mr. Dunnigan had failed to repay in 2009. He reported on his Form 1040 for the year cancellation of debt income of $68,360.95 for cancellations of debts from three other entities. But the Form 1099-C from the bank with which he had his credit line had box 5 checked, indicating Mr. Dunnigan was not liable for the repayment of the remaining debt.
Mr. Dunnigan did not include that amount as taxable on his Form 1040. He did include a copy of the Form 1099-C with return on which was written the following note:
PLEASE NOTE; SWIFT FINANCIAL INDICATED TO ME THAT I AM NOT LIABLE FOR REPAYMENT OF CANCELLED DEBT. I HAD EXPLAINED TO THEM THAT I HAVE A SERIOUS CANCER PROBLEM, AND THAT IM [sic] 76 YEARS OLD. THUS, THEY MARKED BOX 5 'NO'. THE LOCAL IRS OFFICE SUGGESTED I EXPLAIN THE SITUATION AT TIME OF FILING, AND FELT IT WOULD LIKELY COME UNDER 'HARDSHIP' RULES FOR APPROVAL.
Mr. Dunnigan clearly believed he was not liable for tax on this amount for two separate reasons:
● The bank did not require that he repay the balance of the loan (and the Form 1099 noted that)
● The IRS office had told him that due to his situation (serious cancer problems) he would likely come under “hardship” rules for approval
Unfortunately, neither of those reasons allowed Mr. Dunnigan to leave the cancellation of this debt out of his income for 2015.
Not being held liable for repaying a debt does not mean there is no cancellation of debt income. As the Court explained:
He first argues that Swift did not hold him personally liable for the repayment of the debt and it indicated this result on box 5 of Form 1099-C. Cancellation of debt income, however, may be realized without a taxpayer's personal liability for a debt. See, e.g. , Gershkowitz v. Commissioner , 88 T.C. 984, 1006 (1987) (determining that taxpayers realized cancellation of debt income where a creditor discharged their nonrecourse loans in exchange for cash settlements). Moreover, petitioner did not establish that he had no obligation to repay the borrowed funds. Swift's credit agreement with petitioner and Dunnigan Appraisal provided that he was individually and severally liable for repayment of the credit line, in direct opposition to the box 5 indication.
The advice from the IRS office and bank regarding hardship relief also did not help Mr. Dunnigan. As the Court noted:
Petitioner also alleges that Swift and Internal Revenue Service (IRS) employees told him that "hardship" rules could apply in his case. However, he does not point to any legal authority that addresses a "hardship" exception to the taxability of discharge of indebtedness income. While there are exceptions to the recognition of such income, they do not appear to help petitioner's case. See, e.g. , sec. 108(a) (excluding discharge of indebtedness from gross income in certain cases involving, inter alia, bankruptcy and insolvency); id. subsec. (e)(2) (same as to lost deductions); id. subsec. (f) (same as to certain student loan discharges);Landreth v. Commissioner , 50 T.C. 803 (1968) (creating a judicial exception that a guarantor does not realize discharge of indebtedness income upon the release of a contingent liability). The closest exceptions appear to be bankruptcy or insolvency, but the record does not show that petitioner was either bankrupt or insolvent in 2009.
But shouldn’t he be excused since he relied on that advice from the lender and the IRS office even if it wasn’t correct? Unfortunately, that answer is no as the Court pointed out:
Petitioner's reliance on alleged statements of Swift and IRS employees is also unpersuasive. A trial before the Court is a proceeding de novo, and our redetermination of a taxpayer's tax liability is based on the merits and not on any matters occurring before the notice of deficiency was sent. Greenberg's Express, Inc. v. Commissioner , 62 T.C. 324, 327-328 (1974). Additionally, administrative guidance by the IRS is not binding on the Government, nor can it change the plain meaning of tax statutes. See Miller v. Commissioner , 114 T.C. 184, 195 (2000) (addressing specifically IRS publications), aff'd sub nom. Lovejoy v. Commissioner , 293 F.3d 1208 (10th Cir. 2002).
In the end the Court agreed that Mr. Dunnigan had suffered hardships (in addition to the cancer, he and his wife had separated during 2009) but that there’s no relief from cancellation of debt due to hardship provided for in the Internal Revenue Code.
While we can’t be sure, it seems most likely that the IRS office was referring more to the possibility that Mr. Dunnigan would be able to get relief from collections due to his hardships. However, as is often true when people who aren’t regularly dealing with the tax system get advice, Mr. Dunnigan either did not pick up that nuance that was in the advice, or the IRS employee simply assumed that the taxpayer would understand that it meant the IRS would likely “take it easy” in collections, not that they would simply allow the income to be treated as nontaxable.