Tax professionals frequently encounter complex scenarios involving intra-entity transfers and debt cancellations. A recent Ninth Circuit decision, Kelly v. Commissioner, No. 23-70040 (9th Cir. 2025), provides critical clarification on the distinct legal standards for claiming a nonbusiness bad-debt deduction under 26 U.S.C. § 166 and recognizing cancellation-of-debt (COD) income under 26 U.S.C. § 61(a)(11) and § 108. This opinion underscores the principle that a debt’s discharge does not automatically render it "wholly worthless" for deduction purposes, rejecting a taxpayer’s attempt to create a simultaneous deduction upon debt cancellation.

Factual Background of the Case

The case centered on Michael R. Kelly, the petitioner-appellant, who, between 2007 and 2010, transferred millions of dollars among his business entities, characterizing these transfers as loans. These entities included Kelly Capital (a single-member LLC), First Commercial Corporation ("FCC," in which Kelly had a 75% stake), and Greenback Entertainment, Inc. (wholly owned by Kelly). On December 31, 2010, Kelly cancelled many of these purported loans.

On his 2010 income tax return, Kelly reported $145 million of COD income, which he excluded due to his claimed personal insolvency. Simultaneously, FCC and Greenback reported $21 million and $2 million in COD income, respectively, also excluding it due to their own asserted insolvency. Critically, Kelly also reported a short-term capital loss of nearly $87 million due to a nonbusiness bad debt write-off. This deduction included $17.8 million owed by FCC and $2 million owed by Greenback to Kelly Capital. Kelly’s underlying assertion was that a cancelled debt automatically becomes worthless, thereby generating both COD income for the debtor and a worthless-debt deduction for the creditor simultaneously. The Internal Revenue Service ("IRS") disagreed and disallowed the deduction.

Kelly challenged the IRS’s deficiency notices in Tax Court. Following a trial, the Tax Court ruled that: (1) transfers to FCC and Greenback before 2008 were bona fide loans, but those in and after 2008 were not; (2) Kelly had not established the insolvency of FCC and Greenback, implying their COD income would flow through to him; and (3) Kelly failed to establish that the debts owed to him by FCC and Greenback were wholly worthless in 2010, thus precluding a deduction under 26 U.S.C. § 166. The Tax Court’s determinations resulted in income-tax deficiencies exceeding $5 million for 2010. Kelly appealed only the Tax Court’s findings regarding the worthlessness of the FCC and Greenback loans.

Taxpayer’s Asserted Grounds for Relief

Kelly’s core argument on appeal was that the Tax Court erred by failing to construe "worthless" debt under 26 U.S.C. § 166 as equivalent to "discharged" debt under 26 U.S.C. § 61(a)(11). He contended that once a debt is cancelled, it becomes "undeniably worthless and beyond any hope of recovery". From this premise, Kelly argued that the recognition of COD income by FCC and Greenback under § 61(a)(11) necessitated a reciprocal worthless-debt deduction under § 166 as a matter of law for him as the creditor. He essentially sought to establish a presumptive worthlessness of the debt solely due to its cancellation.

Court’s Analysis of Governing Law

The Ninth Circuit, reviewing the Tax Court’s factual determinations for clear error and conclusions of law de novo (Cooper v. Comm’r, 877 F.3d 1086, 1090 (9th Cir. 2017)), provided a detailed analysis of the relevant statutory provisions.

The court reiterated that to claim a nonbusiness bad-debt deduction under 26 U.S.C. § 166, a taxpayer must establish three elements:

The debt is bona fide (26 C.F.R. § 1.166-1(c)).
The taxpayer has an adjusted-tax basis in the debt sufficient to claim the deduction (26 U.S.C. § 166(b)).
The debt became "wholly worthless within the taxable year" (26 U.S.C. § 166(a)(1); 26 C.F.R. § 1.166-5(a)(2)).

Crucially, the burden of proof for worthlessness rests squarely on the taxpayer, requiring the establishment of "sufficient objective facts," as "mere belief of worthlessness is insufficient" (Cooper, 877 F.3d at 1094 (quoting Aston v. Comm’r, 109 T.C. 400, 415 (1997))). The court emphasized that the standard for worthlessness is "zero," meaning that if any portion of the debt is recoverable, even a "modest fraction," it is not considered wholly worthless (L.A. Shipbuilding & Drydock Corp. v. United States, 289 F.2d 222, 228 (9th Cir. 1961); Cooper, 877 F.3d at 1094; Buchanan v. United States, 87 F.3d 197, 198–199 (7th Cir. 1996)). Worthlessness can be proven if any legal action to collect the debt would be "entirely unsuccessful" (Cooper, 877 F.3d at 1094 (quoting Dustin v. Comm’r, 467 F.2d 47, 48 (9th Cir. 1972)); 26 C.F.R. § 1.166-2(b)).

The court firmly rejected Kelly’s assertion that "worthless" in § 166 and "discharge" in § 61(a)(11) are "mere synonyms". Citing dictionary definitions from the time of the statutes’ enactment, "worthless" was defined as lacking value or utility, while "discharged" meant a release from repayment obligation. The panel concluded that while a debt might lack value at the time of discharge, debt discharge does not, as a matter of law, eliminate the debt’s prior objective value and render it worthless.

The court further elucidated that without an objective test for worthlessness, "any monetary transfer could be categorized as a loan and later cancelled to produce an illegitimate tax benefit to the putative creditor". This risk is particularly pronounced in non-arm’s length transactions where the creditor stands to benefit from the cancellation (Roth Steel Tub Co. v. Comm’r, 620 F.2d 1176, 1182 (6th Cir. 1980); Buchanan, 87 F.3d at 199). Congress, the court noted, specifically enacted an objective test for actual worthlessness to prevent such abuse (Whipple v. Comm’r, 373 U.S. 193, 200 (1963); Redman v. Comm’r, 155 F.2d 319, 320 (1st Cir. 1946)).

Regarding COD income, the court explained that both § 61 and § 108(a)(1)(B) operate under the "freeing-of-assets theory," where discharged debt generates a potential gain dependent on the taxpayer’s solvency (Merkel v. Comm’r, 192 F.3d 844, 849 (9th Cir. 1999)). This theory, the court emphasized, has no relation to worthlessness and no reciprocal effect on the creditor. The court analogized allowing a discharging creditor to claim a worthless-debt deduction to an insurance payout for intentionally burning one’s own house, highlighting the absurdity of the claim.

Application of Law to Facts and Conclusion

The Ninth Circuit affirmed that the Tax Court properly construed 26 U.S.C. §§ 61, 108, and 166 in rejecting Kelly’s argument. The panel was not persuaded by Kelly’s contention that a debt discharge automatically renders it worthless as a matter of law.

Furthermore, the Tax Court did not commit clear error in determining that Kelly’s debt was not worthless. Kelly himself conceded that the debts were not "wholly worthless," describing them instead as "near[ly] wholly worthless". The evidence presented to the Tax Court supported this concession, demonstrating that FCC and Greenback possessed assets during the tax year, indicating that at least some portion of the debt was recoverable (Bodzy v. Comm’r, 321 F.2d 331, 335 (5th Cir. 1963)). Kelly also failed to provide objective proof that the debts were uncollectible. This failure aligned with the Tax Court’s unchallenged finding that Kelly had not proven the insolvency of the two entities. Ultimately, Kelly’s subjective determination that the loans became wholly worthless by year-end was insufficient to meet the objective standard required by § 166.

In conclusion, the Ninth Circuit affirmed the Tax Court’s decision. The court unequivocally held that the Tax Court did not err by requiring Kelly to prove the worthlessness of his discharged debts and by declining to presume worthlessness simply because COD income arose from that discharge. This case serves as a crucial reminder for tax professionals that the standards for recognizing COD income and claiming bad debt deductions are distinct and governed by separate statutory requirements, demanding objective proof of worthlessness, especially in related-party transactions.

Prepared with assistance from NotebookLM.