12.1.2 Existence of a Debt

Debt cancellation income is income from the discharge of a debt. To evaluate the potential tax liability, first determine whether there was a “debt”.

If there is a dispute as to whether the taxpayer owed the debt, a compromise may not give rise to a discharge of a “debt.” Furthermore, a creditor may not need to report debts that are cancelled by operation of law.1  A settlement or “forgiveness” of a disputed or unenforceable debt does not result in income to the taxpayer.2  In Zarin v. Commissioner, no taxable income resulted from the settlement because the amount of the discharged debt was void ab initio due to the underlying illegality or fraud.3  Refinancing of a debt may also provide an exception to debt cancellation income.4

To win a Zarin argument, there must be evidence of a dispute as to the amount or enforceability of the debt. A settlement alone does not prove that a good faith dispute existed.5  The taxpayer has the burden of proof.6  If the taxpayer raises a reasonable dispute as to the amount of debt cancellation income on the Form 1099-C, the IRS must produce reasonable and probative information as to the amount of debt cancellation income and can’t rely on the Form 1099-C.7

To avoid tax consequences to the debtor, the settlement should include an agreement by the parties that the settlement agreement reflects settlement of disputed claims, that it does not represent a discharge of indebtedness for purposes of I.R.C. § 61(a)(12), and that the lender will not report the transaction as resulting in income to the debtor to any taxing authority. Lenders rarely agree to the last of these conditions, but that disagreement does not make the debt cancellation taxable income.

What are the tax consequences if the taxpayer successfully rescinds a transaction pursuant to the Truth-in-Lending Act or another consumer protection law? The IRS will argue that the difference between the loan principal and the amount paid by the taxpayer for rescission is debt cancellation income.8  The taxpayer can argue that there was no debt cancellation income under Zarin because the debt was disputed. This may be a successful argument, at least to the extent the taxpayer did not deduct interest in prior tax returns.

However, if the taxpayer took deductions for interest paid on this debt in prior tax years, the IRS will argue that recovery of the same is taxable income under the tax benefit rule. In Schlifke v. Commissioner, the Tax Court ruled that there was income from a rescission under the tax benefit rule to the extent that the taxpayer had taken deductions for interest on the rescinded mortgage.9

• 1See, e.g., IRS Chief Counsel Adv. Mem. 201112008 (Mar. 11, 2011) (principal reduction in negotiated settlement of unfair lending practices case); IRS Priv. Ltr. Rul. 2008-02-012 (Jan. 11, 2008).
• 2See, e.g., Zarin v. Comm’r, 916 F.2d 110, 115 (3d Cir. 1990).
• 3Id.; see also Estate of Smith v. Comm’r, 198 F.3d 515 (5th Cir. 1999) (unliquidated claim for contribution or restitution is not a “debt” that creates debt cancellation income).
• 4See Zappo v. Comm’r, 81 T.C. 77, 85–86 (1983).
• 5McCormick v. Comm’r, T.C. Memo 2009-239.
• 6Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997).
• 7McCormick, T.C. Memo 2009-239.
• 8See Schlifke v. Comm’r, T.C. Memo 1991-19.
• 9Id.