Is expired or cancelled debt taxable income in the US?

[groman]

Hey Everybody,

I was tossing and turning in bed last night at 3:00am unable to fall asleep when a question popped into my head – debts that expire due to statute of limitations (where applicable) or are settled or canceled by an agreement with the lender are technically some sort of financial gain for the debtor. Is this gain taxable income?

Say I borrow $5000 from Joe’s Bank. Now, I have $5000 extra but I also owe $5000 so my federal taxable income did not change – I didn’t make any money. Now, I decide to go live in the woods, dump the $5K into a savings account, and completely forget about Joe’s Bank. Now, a newbie clerk spills coke on the only computer at Joe’s Bank or whatever and for some reason they never follow up on collecting payments as per the loan agreement. Four years pass (California statute of limitations on debt) and Joe’s Bank still didn’t try to collect and I still didn’t try to pay (Hehe, sneaky me). The minute that statute of limitations expires, Joe’s Bank really loses any legal recourse against me other than pestering me with phone calls and ruining my credit.

So do I suddenly develop $5000 more taxable income for the year the statute of limitations expired? What if instead of statute of limitations expiring the debt was cancelled or settled for less based on a mutual agreement, is the partial amount taxable income? If this is NOT taxable income, what prevents employers from offering very loosely termed interest free “loans” as part of compensation packages that are in reality never meant to be paid back?

Thanks a bunch,

Groman

[brazil84]

Canellation of indebtedness is generally considered to be income.

Cancellation-of-debt income

[groman]

@brazil84

Canellation of indebtedness is generally considered to be income.

Cancellation-of-debt income - Wikipedia

This same article actually answers my other question as well

For example, if the lender cannot legally enforce the debt, then the taxpayer is not liable for that debt and will therefore not have tax consequences

EDIT: NEVERMIND this is wrong “Zarin v. Commisioner”:

but the cited reference "Zarin v. Commisioner" ([Summary here](http://www.timbertax.org/research/caselaw/cc/Z/zarin.htm)) seems to deal with something completely different (although I didn't finish reading it yet).

[drachillix]

@groman

If this is NOT taxable income, what prevents employers from offering very loosely termed interest free “loans” as part of compensation packages that are in reality never meant to be paid back?

Thanks a bunch,

Groman

Shareholders…

[groman]

@drachillix

Shareholders…

I think it’d be a great deal for them. Instead of paying some CEO $500,000K on which they get taxed, loan the CEO $300,000K with no interest and a payment plan that starts in 99 years.

[Gfactor]

@groman

I think it’d be a great deal for them. Instead of paying some CEO $500,000K on which they get taxed, loan the CEO $300,000K with no interest and a payment plan that starts in 99 years.

You’re going to run into applicable federal rate problems there:

IRC section 7872 requires that forgone interest on below-market loans be treated as a transfer from the lender to the borrower. The language does not require that this transfer be treated as interest. If the borrower is an employee, the forgone interest is compensation subject to employment taxes but not federal income tax withholding.

http://www.nysscpa.org/cpajournal/2006/106/essentials/p28.htm

But the authors propose:

Here is what the corporation might consider in order to minimize the joint tax burden of the officer and the company when the shareholder-officer does not meet the performance targets required by IRC section 162(m)(4)(C). To the extent that compensation cannot be deducted for any year, the corporation makes the officer, who should also be a shareholder, an interest-free loan in an amount that allows the officer to maintain the expected annual cash flow. The loans are allowed to accumulate for those years during which performance targets are not met, and these loans are subsequently forgiven. Because the cumulative amount of the loans may be expected to have reached an amount such that forgiveness cannot be mistaken for reasonable compensation, the default position for federal tax purposes would treat the payment as a deemed dividend subject to tax at 15%. The advantages to the parties involved have been explained in earlier sections of this article. There is no marginal tax cost to the corporation, and it escapes the modest payroll taxes due on the compensation of the officer. More important, the officer-shareholder saves in two ways: The officer-shareholder saves 20% because of the tax-favored status of dividends, and the officer-shareholder receives the time-value savings occasioned by the delay in recognizing the income represented by the cash available from the interest-free loans.

[DrDeth]

@brazil84

Canellation of indebtedness is generally considered to be income.

Cancellation-of-debt income - Wikipedia

Yes, but in reality, almost never really is. If you are insolvent, then debt cancellation is not taxable. IRC@108.

From wiki "*Not all COD income must be included in gross income. There are four exceptions[6]:

* If the discharge of indebtedness occurs in a title 11 case
* If the discharge of indebtedness occurs when the taxpayer is insolvent
* If the indebtedness discharged is qualified farm indebtedness
* If the indebtedness discharged is qualified real property business indebtedness*"