Question

Several years ago, Courtney borrowed $100,000 from the Friendly Local Bank and used it to buy some equipment to start up a business. Courtney's business results have been disappointing and she has not made any principal payments on the loan, but she has paid all of the interest due. Courtney has fallen on hard times and her only asset is the equipment, which is now worth $75,000 and in which she now has an adjusted basis of $50,000. Courtney has no other assets and no other liabilities.

If the bank cancels the debt in exchange for the equipment, what are the income tax consequences to Courtney?
a) Provide a list of the primary authorities on which you relied on.

Answer 1

Courtney will recognize $25,000 of cancellation of debt (COD) income when the bank cancels her debt in exchange for the equipment, which could be excluded under the insolvency exception depending on her financial situation. Primary authorities to consider include IRC Section 108 on exclusions from gross income and Section 61(a)(12) on income inclusion.

Step-by-step explanation:

When Courtney's debt is cancelled in exchange for the equipment, there will be income tax consequences. The cancellation of debt (COD) income is typically taxable and must be reported as income unless specific exclusions apply. In this case, the value of the equipment ($75,000) is less than the debt ($100,000), meaning Courtney will have a COD income of $25,000, which is the difference between the canceled debt and the fair market value of the equipment. However, since she's insolvent (her liabilities exceed her assets), she may be able to exclude some or all of the COD income from her taxable income under the insolvency exclusion provided by the Internal Revenue Code (IRC Section 108(a)(1)(B)).

For tax reporting purposes, the bank would typically issue a Form 1099-C for the canceled debt. It's important to note that the equipment's adjusted basis is also relevant for determining any loss on the disposition of the equipment. However, it may not impact the COD income calculation directly, but if the equipment was used in a trade or business, there could be a separate consideration for loss on the disposition of business property (under IRC Section 1231, for instance).

Primary authorities to refer to for this situation would include the U.S. Internal Revenue Code, specifically Section 108 addressing the exclusion from gross income of discharge of indebtedness, and Section 61(a)(12) defining income from discharge of indebtedness as part of gross income, as well as related Treasury Regulations and IRS guidance documents.