Is Debt Forgiveness from an IRS Offer in Compromise or Bankruptcy a Taxable Event?

Is Debt Forgiveness from an IRS Offer in Compromise or Bankruptcy a Taxable Event?

No. The IRS issued guidance in 1998 specifically advising taxpayers that the cancellation of IRS debt arising from an Offer in Compromise or bankruptcy does not count as imputed income to the taxpayer and the taxpayer does not get a 1099-COD.

The IRS's Offer in Compromise program was established in 1992. In 1995, many tax experts were questioning whether or not the debt forgiveness program would result in the circular "taxes on taxes" problem: The idea that the taxpayers would be responsible for new taxes on the original taxes they could not pay. (See the article here.) In general, there is an exception to COD (Cancellation of Debt) income where the taxpayer was insolvent at the time of the forgiveness. However, you need to affirmatively claim the exception and preserve evidence if you want to be protected in the event of an audit.

In 1998, the IRS answered the question with a simple "no." In the IRS's Chief Counsel Memorandum dated April 1, 1998, SVA 1998-039 (released 12/4/1998), the IRS's attorneys advised as follows:

Should the IRS issue Forms 1099-C when cancelling tax debt of individuals discharged in a bankruptcy case or as a result of an offer in compromise under § 7122?

Cancellation of debt by IRS. Cancellation of a tax debt by means of an offer in compromise does not give rise to discharge of indebtedness income. Eagle Asbestos & Packing Co. v. United States, 348 F.2d 528 (Ct. Cl. 1965). The court in Eagle Asbestos concluded that a compromise of the interest portion of a tax debt did not give rise to income from the discharge of indebtedness because "[t]he effect of the compromise settlement itself and the intentions of the parties in entering into it was to extinguish all tax liabilities included in the items making up the to cancellation of a tax debt itself, as well as interest on a tax debt. Therefore, no Form 1099-C is required to be issued. However, we note that if the IRS cancels a debt that is not a tax debt, the amount cancelled is includible in discharge of indebtedness income and a Form 1099-C should be issued.

With respect to tax debts of individuals discharged in bankruptcy, regulations under § 1.6050P-1(d)(1)(i) state: "Reporting is required under this section in the case of a discharge of indebtedness in bankruptcy only if the creditor knows from information included in the reporting entity's books and records pertaining to the indebtedness that the debt was incurred for business or investment purposes ... ". Further, § 1.6050P-1(d)(1)(ii) states: "Indebtedness is considered incurred for business purposes if it is incurred in connection with the conduct of any trade or business other than the trade or business of performing services as an employee. Indebtedness is considered incurred for investment purposes if it is incurred to purchase property held for investment, as defined in section 163(d)(5)." An indebtedness arising as a result of nonpayment of an individual income tax liability is not incurred for business or investment purposes. See § 1.163-9T(b)(2)(i)(A) and Miller v. United States, 65 F.3d 687 (8th Cir. 1995). But see Redlark v. Commissioner, 106 T.C. 31 (1996). Therefore, a cancellation of such an indebtedness in bankruptcy would not give rise to a reporting requirement under § 1.6050P-1(d)(1)(i).

Thus, there is no risk of taxes on taxes from an Offer in Compromise or bankruptcy discharge of IRS taxes.

Posted on 6/23/2021 by Daniel Layton.