In the case of Newman v. Commissioner, TC Memo 2016-125 the Tax Court looked at two questions—did Mr. Newman have cancellation of debt income in 2011 from an overdraft on a bank account he never paid back and, if so, was he insolvent at the time the debt was discharged.
For the first matter (the cancellation of debt issue) the situation began in 2008 as the Tax Court describes:
In July 2008 petitioner opened a checking account at Bank of America. Between July and August petitioner made deposits totaling $8,857.95 into the bank account. Of the total deposits, $8,500 was attributable to a single check drawn from another bank account petitioner maintained at Wells Fargo. Shortly after making the initial deposits petitioner withdrew $8,000 in cash from the Bank of America account. However, the initial $8,500 check petitioner deposited into the Bank of America account did not clear and was later returned to Wells Fargo. This caused the Bank of America account to be overdrawn. Petitioner did not deposit funds in the Bank of America account to correct the negative balance. Consequently, Bank of America closed the account in August 2008.
Bank of America issued a Form 1099C to Mr. Newman in 2011, three years after they had closed the account. Mr. Newman failed to report this as income on his 2011 return and the IRS, not unexpectedly, noticed this failure and sent Mr. Newman a notice asking for additional tax.
One key fact of tax law is that income is taxable only in the year in which it is treated as “received” for tax purposes—so not only does Mr. Newman need to have had debt canceled, but that need to have taken place in 2011.
The Tax Court outlines the test for when a cancellation event has taken place, noting:
A bookkeeping entry by a creditor does not result in COD income. See Kleber v. Commissioner, T.C. Memo. 2011-233, slip op. at 7 (citing Cozzi v. Commissioner, 88 T.C. at 445). The issuance of a Form 1099-C is an identifiable event, but it is not dispositive of an intent to cancel indebtedness. Owens v. Commissioner, T.C. Memo. 2002-253, aff'd in part, rev'd in part, and remanded, 67 F. App'x 253 (5th Cir. 2003). There is a rebuttable presumption that an identifiable event occurred in a calendar year if, during a testing period (generally 36 months) ending at the close of the year, the creditor has received no payments from the debtor. Sec. 1.6050P-1(b)(2)(iv), Income Tax Regs.
The Tax Court, as it has before, turns to the information reporting regulation and uses that as a “rough measure” to determine the date of cancellation. In this case, that 36 month period expired in 2011 which triggers, in the Court’s view, the presumption that this amount is income.
In this case the taxpayer presented no information to overcome that presumption, so the Court found that he had cancellation of debt income.
So the Court moved on to the next question—was Mr. Newman insolvent at the time the debt was canceled? That is important because, under IRC §108(a)(1)(B), cancellation of debt income is not recognized to the extent the taxpayer was insolvent at the date of the discharge.
While the Court had taken a relatively hard line in earlier cases (see the Court’s analysis of insolvency claims in the case of Shepherd v. Commissioner, TC Memo 2012-212 and McAllister v. Commissioner, TC Memo 2013-96), in this case the Court accepted the taxpayers’ claims of insolvency.
As the Court noted:
Petitioner has the burden of proving his claim that he was insolvent. See Rule 142(a). At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were. Therefore, we accept petitioner's claimed amount of insolvency and find that his liabilities at the end of 2011 exceeded his assets by $14,500. We also find that section 108(a)(1)(B) allows petitioner to exclude all $7,875 of COD income from his 2011 gross income because the amount of his insolvency in 2011 exceeded his COD income for 2011.
Of particular interest is that the Court appears to have relied on the testimony of the taxpayer in this case. Advisers facing an agent, armed with the Shepherd case, who demands excessive levels of proof of insolvency will find it helpful to point the agent to this analysis.
The other item of note is that in October of 2014 the IRS issued proposed regulations that would remove the 36 month test from the regulations (REG-136676-13) following a series of cases the IRS lost where the Court applied that provision against the IRS where a lender issued a Form 1099C many years after the fact. The IRS has not moved to finalize those regulations, but if they do it will be interesting to see how the Tax Court’s analysis of “year of cancellation” issues changes—if it does.`