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What is cancellation of debt income?

We all understand that if I give someone ten dollars, that’s income — they received cold hard cash. It is a little harder to understand, but if you borrow money, you still receive cash, but it is not income. Why not? Because you have to pay it back.

What happens then if you borrow money and can’t pay it all back? In that event, the portion your lender writes off is considered cancellation of debt (COD) income. Let’s assume you borrowed $1,000 from the bank, but could only repay $500. The IRS will see that as COD income in the amount of $500.00. There are some exceptions and exclusions to this general rule, but for our purposes it is accurate.

I Settled with the SBA. Will I owe the IRS now?

When you settle with the SBA, the obligation is subsequently forgiven, at least in part. So, COD income should follow. Based on our explanation above, it certainly makes sense, except that is not what happens with guarantors.

The IRS generally agrees that a guarantor (whether or not the primary obligor has defaulted and the guarantor has become liable for the indebtedness) does not realize COD income on release of a liability. The United States Tax Court in Whitmer v. Commissioner* held that a guarantor did not realize COD income when the lender released the primary obligor from the debt obligation.

If you think about it, the decision makes sense. For starters, established COD income law does not compel imputation of COD income to a guarantor from a discharge of debt. Second, the forgiveness of the debt did not increase the taxpayer’s net worth, so why should they realize income? Still not clear? Let’s go back to our original example.

If a borrower takes out a bank loan for $1,000 and pays back only $500.00, then he is “better off” by $500.00 because the borrower received the cash and did not have to repay it, but the guarantor on that loan is not better off. The guarantor received nothing; this is the gist of the Whitmer decision.

The Bottom Line

If the IRS comes calling, contact your attorney or CPA and ask him about the Whitemer case.

*Whitmer v. Commissioner, 71 T.C.M. (CCH) 2213 (1996)