The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 6, January 2003, Panel Publishers, New York, NY.


By Robert W. Wood and Jonathan R. Flora

Wouldn't it be nice if receiving taxable income meant you had some cash in your pocket at the day's end? Alas, going back at least as far as the Supreme Court's decision in U.S. v. Kirby Lumber, 284 U.S. 1 (1931), our federal tax system has included in its notion of income more than mere cash receipts. In Kirby Lumber, as M&A Tax Report readers may recall, a corporation bought back its own bonds for less than their issue price. Despite a cash outlay, the corporation ended up with taxable income.

This concept — commonly known as cancellation of debt, or "COD," income — is rooted in the idea that a discharge of debt frees up a taxpayer's assets. Cash may be king today, but the concept of COD income is firmly embedded in the Internal Revenue Code. It appears both in the definition of gross income (§61(a)(12)), and in a more qualified form, in section 108. The latter provision includes a number of helpful exceptions, particularly for insolvent taxpayers.

COD income typically arises when a creditor opts to cancel outstanding indebtedness. On the one hand, the debtor is lucky to be skirting his legal obligation to the creditor. On the other, the debtor is nevertheless obligated to the IRS for income tax on the COD income arising from the discharged debt.

Matching (or not matching) 1099s with Income

There is another, less theoretical side to income found near the back of the Code — the information reporting rules. Many of these reporting rules lack the austere history of their substantive counterparts, and the correlation between determining income and reporting income is often a rough one. There also is an internal tension between substantive theory and the reporting rules, since the IRS wants a payor to report anything that looks or smells like income, while the Code and judicial decisions are often more sensitive to facts and theory, and are less black and white.

In some cases, the zeal for reporting anything resembling income results in rules that require double reporting of a single item of income. Section 6045(f), for example, requires anyone who pays fees to an attorney to report the payment, even if the services were rendered to someone else, and even if the payment will be reported by the client under section 6041.

The reporting rules for COD income are a particularly poor fit with substantive income tax theory. This lack of fit (coupled with the underlying inclination that the IRS has to want the reporting rules to over-report rather than under-report income) results in some fairly blatant inequities. The poor fit and resulting inequities are illustrated by a recent Significant Service Center Advice issued by the Chief Counsel's office. SCA 200235030.

COD Income vs. Reporting COD Income

Under the reporting rules, a creditor who cancels debt (of $600 or more) is generally required to issue a Form 1099-C, Cancellation of Debt. The ostensible purpose of a 1099-C — as its name implies — is to report COD income to those "payees" not lucky enough to have income in the form of cash receipts. The triggering events for Issuing a 1099-C include a variety of enumerated circumstances.

The one such circumstance on which we will focus is when a creditor has not received a payment during a 36 month testing period. Reg. §1.6050P-1(b)(2)(H). (A testing period is basically 36 months plus any time the creditor was barred from enforcing the debt, such as through bankruptcy.) The problem with this particular COD reporting rule is that its trigger is not the same as — and is in fact much broader than — the definition of COD income. COD income is defined by an "identifiable event." Cozze v. Comr., 88 T.C. 435, 445 (1987). COD income requires the termination of a legally enforceable obligation, and it depends on the substance of the transaction as determined by the facts and circumstances of each case. Id.; Miller Trust v. Comr., 76 T.C. 191, 195 (1981).

Triggering events for COD income can include a formal settlement agreement, Exchange Security Bank v. United States, 345 F. Supp. 486 (N.D. Ala. 1972), aff'd 492 F.2d 1096 (5th Cir. 1974); Rivera v. Commissioner, T.C. Memo. 1993-609; the abandonment of security, Cozzi, 88 T.C. 435; Carlins v. Commissioner, T.C. Memo. 1988-79; a unilateral discharge by a creditor, Waterhouse v. Commissioner, T.C. Memo. 1994-467; and the entry of an item on the corporate books, Schneller v. Commissioner, T.C. Memo. 1996-62, aff'd without published opinion 129 F.3d 1265 (6th Cir. 1997).

Hold On Just a Minute...

Take a step back to look more carefully at what can trigger genuine COD income. Notice anything? In order to have actual COD income, there is not a single reference to the expiration of a 36 month period. That trigger is only applicable to reporting rules. As a result, it is theoretically possible that a creditor will be required to issue a Form 1099-C that purports to show "COD income" even though there has not been any COD income.

Actually, strike "theoretically." In fact, it is darn likely that a creditor will be obligated to issue a Form 1099-C where there is no true discharge. Talk about over-reporting. It's one thing for a debtor to pay income tax on COD income. It is quite another for a debtor to pay income tax for COD income when there hasn't been any income at all. Zounds!

IRS to the Rescue!

This blatant inequity was one of the factors prompting SCA 200235030. In its infinite sense of justice and fair play, the IRS took a stab at resolving the dilemma with the following rule:

[I]f the particular facts and circumstances presented demonstrate that it was not clear in the year for which the Form 1099-C was issued that the amounts would never be repaid, then the taxpayer did not realize cancellation of indebtedness income in that year and is entitled to a refund. . . . Payment of the entire liability in a later year would support a conclusion that the original amount reported should not have been included in income. The proper amount that should have been included if the taxpayer later partially paid the liability would depend on the particular facts in question. Accordingly, the taxpayer may file an amended return if the period of limitations for filing a claim for refund is open. SCA 200235030.

Let's see how this works. Take a debtor — we'll call him Randy — who obtained a consumer loan of $50,000 from CreditCo. Due to company downsizing, Randy is laid off from a dotcom in Silicon Valley. Despite his efforts to keep his finances in order, Randy finds that he cannot make any payments to CreditCo for 37 months.

Randy's failure to pay during a 36 month period triggers the reporting obligations for Form 1099-C. CreditCo dutifully issues a Form 1099-C to Randy for $50,000, and Randy dutifully reports the COD income (following the IRS instructions in Publication 17, "Your Federal Income Tax," which require a taxpayer to report as income amounts reported on Form 1099-C.)

Meanwhile, CreditCo continues to hold Randy legally responsible for repaying the entire debt. It even sends out automated reminders from time to time. As a result of this continuing legal obligation, Randy doesn't have COD income under sections 61 and 108. Instead, there is only an obligation for CreditCo to issue a Form 1099-C under the reporting rules.

Lo and behold, four years go by and Randy's luck turns for the better. An old friend is hired as the CEO of a struggling telecom company, and the friend hires Randy as a VP. The company pays Randy a lucrative salary and a hefty signing bonus, which provides Randy with more than enough cash (the type of income we like) to pay off CreditCo's debt. Randy — who has been sleeping poorly because of his outstanding debt — decides to immediately pay down the entire debt, and any potential for COD income evaporates into thin air.

Under the substantive tax laws, Randy does not have, nor did he ever have, any COD income. But under the reporting rules, Randy was required to report COD income because of the Form 1099-C CreditCo properly issued to him.

And Justice For All?

Let's return to the IRS's guidance in SCA 200235030. The quoted statement applies to 1099-Cs which are issued at a time when it is unclear "that the amounts owed would never be repaid." This, of course, is Randy's situation. The solution? The IRS concedes there is no COD income in that year for substantive tax purposes, and so it states: "the taxpayer did not realize cancellation of indebtedness income in that year and is entitled to a refund."

A refund. Of course, this is one approach to solve an over-reporting problem. Another (perhaps more accurate) approach would have been for Randy to not report COD income because he didn't have any. But the IRS opted for the former, and so Randy is left with paying taxes on income he didn't have and a refund claim.

Does it matter to Randy that he's left only with a refund claim? You bet, because here is the rub. According to the SCA, "the taxpayer [who was required to report income he never had] may file an amended return if the period of limitations for filing a claim for refund is open."

As you can imagine, Randy is perplexed and he is unhappy. He has dutifully followed IRS instructions for reporting income, and he has satisfied his legal (and moral) obligation of paying off his outstanding debt. (He also learned from his tax advisor that obtaining and repaying loans does not result in any income.)

Although the IRS has handed him a right to file an amended return, this right is of no value to Randy because the limitations period on a refund claim expired. By following the IRS rules to a "t," Randy has paid taxes on $50,000 of COD "income" when there was never any income at all. He has no way to correct this error. Well, Randy might investigate the mitigation provisions of the Code (someone always mentions mitigation when the statute is closed), but they are unlikely to be any help.


The IRS clearly has good reason to ensure that payments are reported. However, when it comes to a non-cash "payment" that results in COD income, it seems the reporting rules should track the substantive definition of COD income. Fee, there's a novel concept. Otherwise (as was the case with Randy) taxpayers may be forced to report "income" they never had. And once it is clear there is no income, it may not be possible to recover the taxes that should never have been paid in the first place.

COD Income, Reporting, and Injustice (Or, How the IRS Makes You Pay Taxes On Income You Don't Have), by Robert W. Wood and Jonathan R. Flora, Vol. 11, No. 6, The M&A Tax Report (January 2003), p. 1.