Tax Research Memo Format: Insolvency And Cancellation Of Debt

Background

In 2017 Jan Witherspoon, one of the sales representative for Mac Pharmaceutical Company, was sent of Black Hawk, Colorado with an objective of setting up an office of the company in Colorado. Due to the official purpose of setting up an office at Black Hawk in Colorado, Jan was required to spend number of months at the Black Hawk. Jan who has always fancied herself as an excellent blackjack player spends considerable amount of her non-official time in gambling at the casino of Black Hawk facility.

Jan even applied for a loan of $25,000 to the hotel for gambling and it was approved as she received the line of credit for $25,000. She used to receive gambling chips for the line of credit. She used to sign a negotiable instrument every time she used to receive gambling chips from the hotel payable at the hotel. The negotiable instruments was drawn on the personal bank account of Jan. These drafts were held for 45 days by the hotel before Jan used to pay the hotel with personal cheques.

By the beginning of 2017, Jan has started gambling heavily in the casino with the casino increasing the debt limits of Jan to $120,000 from $25,000. Due to heavy losses in gambling by the end of October, 2017, Jan’s debt to the hotel stood at $285,000. The cheques written by Jan to pay off the debts to the hotel started returning from banks due to insufficient funds in the personal bank account of Jan. With the objective recovering the debt from Jan, the hotel filed a suit in the State Court.

Meanwhile at the beginning of 2018 Jan and the hotel negotiated an agreement that required Jan to make 5 monthly payment of $25,000 each in full discharge of the debt amount of $285,000. Jan paid the 5 monthly payments of $25,000 as per the agreement.

Jan in addition to the above debt also owed the First State Bank $230,000. After failing to make repayment of the above loan Jan transferred her investment property worth ,000 and common stock value of $55,000 with basis of 48,000 and $74,000 respectively. She also paid a cash of $8,000 with the Bank forgiving the balance debt subsequent to the above payments. The amount of assets and liabilities Jan were $220,000 and $410,000 respectively.

Issues:

• Will the amount of debt cancelled by the casino be considered for computation of taxable income of Jan and tax implications of the amount of debt cancelled by casino subsequent to the negotiations between Jan and the casino, (285,000 – 120,000) = $165,000 in the hands of Jan Witherspoon.   
• Will the amount of loan waived by the casino be considered for computation of taxable income of Jan and the tax implications of amount of loan waived by the First State Bank subsequent to the negotiation between the bank and Jan?  

Conclusion:

• No, the balance of debt cancelled by the Casino will not be considered for computation of taxable income of Jan and No liability of tax will arise to Jan subsequent to the debt cancellation by Casino. No, the balance of loan waived by the bank will not be considered for computation of taxable income of Jan.  
• The balance of loan waived by the bank would not be considered for determination of tax liability of Jan and no resultant tax liability would arise subsequent to such waiver of loan by the bank.  

Discussion:

• As per section 61 (a), all income received from whatever source is considered for computation of gross income. Apart all income also the debt cancellation shall be included in case of individuals as well as for companies to calculate taxable income. However, certain exception to the rule include the exemption of such debt cancellation for computation of taxable income of an individual or company which is insolvent. An individual is said to be insolvent if his total liabilities far exceeds his total assets as on a given date.

As per the decision in Jones v. Cendant Mortg. Corp. (In re Jones), 396 B.R. 638, cancellation of debt is equated with realization of taxable income. As per § 61(a) (12), discharge of indebtedness is a term that can be interchanged with cancellation of debt. Thus, cancellation of debt is to be equated with realization of taxable income. However, in case the individual is insolvent then the question of taxable income as well as tax liability does not arise (Miguens, 2015). A person shall be considered to be insolvent when the amount of liabilities of such person is far in excess of the amount of assets of such person as on a particular date. In this case prior to the negotiation between Casino and Jane the total amount of liabilities of Jan was $410,000 is far more than total assets of Jan of $220,000. Thu, Jan is an insolvent person hence, no taxable income and tax liability would arise of Jan subsequent to the cancellation of debt by the casino (Vizcarrondo Jr & Wilson, 2013).

In Hill v. Comm’r, T.C. Memo2009-101 (T.C. 2009), it was established that waiver of loan is also discharge of indebtedness to an individual or person. Such discharge amount is similar to the amount of taxable income realized by the individual as per § 61(a) (12). However, the circumstances of each case has to be considered before determining whether taxable income has realized to an individual or a person based on the circumstances of each cases (Club, 2016). Jan being insolvent even before entering into a negotiation with the First State Bank would ensure there is no taxable income realized subsequent to the waiver of loan. Hence, there would also be no resultant tax liability to Jan for such waiver as she is insolvent with total liabilities of $410,000 as opposed to total assets of $220,000 (Bailey, 2010).  

Hence, from the above it can be concluded that cancellation of debt by the Casino as well as waiver of loan by the First State Bank would not be considered as taxable income of Jan as she was insolvent at the time of such cancellation of debt and waiver of loan.   

References:

Bailey, R. L. (2010). Challenges and Opportunities for the Tax Professional Guiding Closely-Held Entities: 2009 & 2010 Regulatory and Judicial Developments Impacting Fourth Circuit Tax Practitioners. Campbell L. Rev., 33, 39.

Club, P. C. (2016). Written materials for: The Non-Dischargeability of Student Loan Debt–. Florida Law Review, 68, 141.

Miguens, H. J. (2015). The liability of corporate officers and directors in the united states: procedural aspects. Díkaion Revista de Fundamentación Jurídica, 24(1), 86-116.

Vizcarrondo Jr, P., & Wilson, B. R. (2013). Liabilities under the federal securities laws.