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Long Delay in Loan Enforcement Didn't Establish Taxpayer had Cancellation of Debt Income.

(Parker Tax Publishing May 23, 2015)

The Tax Court held that although the creditor waited ten years to enforce collection of an outstanding loan, the taxpayer-debtor did not receive cancellation of debt (COD) income. Additionally, cancellation of debt income from a forgiven loan was excludable under the Code Sec. 108 insolvency exception. Johnston v. Comm'r, T.C. Memo. 2015-91.


Harold Johnston has worked in the telecommunications industry since 1968 and in 1996 he cofounded Summit Communications, Inc. (Summit) to provide communications-related services to businesses in Hawaii.

In 1998, Johnston was approached by Al Hee, the founder of another communications services provider, Sandwich Isles Communications, Inc. (SIC), to manage SIC's telephone operations. Johnston was initially hesitant to join SIC as he felt a duty to ensure Summit's financial well-being. In order to induce Johnston, Hee offered him (in addition to salary and benefits) a loan of $450,000, with the understanding that if he accepted the loan, Johnston would in turn lend the $450,000 to Summit in order to support its operations.

Johnston and SIC executed an employment agreement in 1998, which allowed Johnston to continue to serve as a director and chief executive officer of Summit, and stated that the SIC loan would become due upon the termination of Johnston's employment with SIC. Later that year, Johnston requested an additional $20,000 loan from SIC's parent company, Waimana Enterprises, Inc., and passed the funds on to Summit. In 2000, SIC sold its interest in the original $450,000 loan to Waimana.

Shortly after Johnston began his employment with SIC, Summit began to receive sizable contracts from SIC, and in late 2000 it became apparent that Johnston was needed to manage Summit full time because of its rapid growth. In 2001, with Hee's approval, Johnston resigned his position with SIC. Although his resignation triggered his repayment obligations for the SIC loan, SIC and Waimana did not demand repayment of the SIC loan at that time, nor did either company issue a Form 1099-C, Cancellation of Debt.

In 2001 SIC received a large loan from the U.S. Department of Agriculture to finance a project to provide telecommunications service to rural communities in Hawaii. With the additional financing SIC reduced its reliance on Summit, which forced Johnston to reduce expenses, cut salaries, and lay off employees. Johnston continued to work for Summit until it filed for bankruptcy in 2002, and he went back to work for SIC in 2005.

Hee met with Johnston in 2011 and notified him that the SIC loan was still due and owing. The Waimana loan had been written off in 2007, and was not discussed. Johnston arranged to begin making payments on the SIC loan via payroll deductions from his SIC paycheck.

In 2010, in connection with an audit of SIC's return, the IRS audited Johnston's return for 2007. Despite the fact that he had been insolvent in 2007, Johnston agreed to an income adjustment of $20,000 related to COD income from the Waimana loan, resulting in a partial assessment of tax due for 2007. In 2013 IRS sent Johnston a notice of deficiency determining that he had failed to report COD income for the SIC and Waimana loans in 2007.

$450,000 SIC Loan

A debt of a taxpayer that is discharged by the creditor generally must be included in the gross income of the taxpayer. Thus, gross income generally includes cancellation of debt (COD) income (Code Sec. 61(a)(12); Reg. Sec. 1.61-12(a)).

The IRS argued that Johnston realized COD income in 2007 because SIC and Waimana failed to take collection action on the $450,000 SIC loan before the period of limitations for collection expired in 2007. The Tax Court noted, however, that the expiration of the period of limitations generally does not cancel a debt, but simply provides a defense for the debtor in an action by the creditor, citing Miller Trust v. Comm'r, 76 T.C. 191 (1981).

The Tax Court disagreed with the IRS's claim that the SIC loan had been canceled, pointing out that Hee testified that Waimana considered the SIC loan outstanding and that Johnston was repaying the SIC loan via payroll deductions of $1,000 per month. The court also noted that if the SIC loan had been forgiven, Waimana would have a strong incentive to report the loan as discharged so that it could benefit from a bad debt deduction, and that Johnston did not receive a Form 1099-C from Waimana discharging the SIC loan.

The IRS took issue with the fact that Johnston did not make a payment on the SIC loan until after the IRS examined his 2007 return, arguing that Johnston sought to repay the SIC loan only to escape taxes. The Tax Court disagreed, noting Johnston sought to repay the SIC loan because he understood it was his obligation to repay it. Additionally, the court noted a reasonable person would not agree to pay an unenforceable debt to save a fraction of that debt on taxes.

$20,000 Waimana Loan

Code Sec. 108(a)(1)(B) excludes COD income from gross income if the discharge occurs when the taxpayer is insolvent. The amount of income excluded cannot exceed the amount by which the taxpayer is insolvent (Code Sec. 108(a)(3)).

The IRS additionally argued that Johnston realized COD income in 2007 from discharge of the $20,000 Waimana loan. Although Johnston's agreement to this adjustment during the 2010 audit resulted in a partial assessment of tax for 2007, he disputed this claim at trial. The court agreed with the IRS, noting that the fact the Waimana loan was written off in 2007 demonstrated the intention of Waimana to forgive the loan. Additionally, the court found no evidence that Johnston was repaying the loan, or that Waimana considered the loan outstanding.

However, the court concluded that because Johnston was insolvent in 2007, and neither the IRS's nor Johnston's calculations of his insolvency exceeded the canceled debt, the COD income of $20,000 was excludable from his income under Code Sec. 108(a)(1)(B).

Despite the delay in enforcing the SIC loan, because Johnston and Hee understood that it was still due and owing and he was repaying the loan through payroll deductions, the Tax Court held Johnston did not have COD income in 2007 from the SIC loan. Additionally, although the Waimana loan was forgiven in 2007, the court held that COD income was excludable due to Johnston's insolvency that year.

For a discussion of COD income, see Parker Tax ¶72,300. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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