Question for the Tax Court
Whether taxpayers had $8,768 of discharge of indebtedness income arising from [the settlement of credit card debt] and whether they may deduct the $2,126 fee they paid to the agency that negotiated that settlement. (1-2).
The taxpayers had $13,084 in credit card debt with Chase Manhattan Bank. (2). Arbitronix, Inc. negotiated a settlement with Chase on behalf of the taxpayer, whereby Chase agreed to accept $4,579 in full satisfaction of petitioner's balance. (2). Arbitronix charged the taxpayer a fee of 25 percent on the $8,505 savings, or $2,126. (3). The taxpayer conceded at trial that they had $8,768 of cancellation of debt (COD) income. (3). The court did not address the discrepancy between the $8,505 savings and the 1099-C that stated $8,768 as the amount of debt canceled. (3 fn. 3).
Quick anecdote if I may. Let's assume the taxpayer is in the 15% marginal tax bracket and also pays 5% state income tax for a combined tax rate of 20%. Their federal and state income tax on the COD income would be $8,768 x 20% = $1,754. Adding this tax bill to the $2,126 fee, the taxpayers $8,505 savings is reduced by $3,880 for a total real savings of $4,625, approximately 53% of the $8,505.
The taxpayers argued that 'this is a case of disputed debt or contested liability.' [And] that the settlement is the 'amount of debt to be recognized for tax purposes' and that the 'excess of the original (disputed) debt over * * * [the settlement] should be disregarded for both accounting and tax purposes.'
The taxpayers also argue that the fee paid to Arbitronix is deductible, not under section 162 or 212, but rather 'part and parcel of the 'income' assessed through I.R.C. sec. 61(a)(12) is the reduction . . . of the amount . . . that does not provide a benefit.'
The taxpayer is wrong.
Tax Court's Opinion
[We find] that the taxpayers have failed to introduced credible evidence that they disputed the debt. (6). The Arbitronix invoice describes the debt forgiven as 'savings' and the letter from Chase confirming the settlement states that if Chase did not receive the $4,579 payment before a certain date, then the 'offer' would no longer be 'valid.' (6). Neither the invoice nor the letter in any way indicates the debt was disputed. (7).
The taxpayers suggest that they received no monetary benefit from the cancellation of debt. . . . We cannot agree with petitioners. Section 61(a)(12) manifestly does not provide for any kind of deduction. (8).
Nothing real earth shattering about this opinion here. Although, the taxpayer's argument to reduce their COD income by the fee paid was interesting. Without doing a lot of research in this area, they probably would have gotten further with a section 212 argument, but still lost. Here is the analysis for the Tax Court in case they face the question in the future. . . free of charge.
Section 212 states, "there shall be allowed a deduction for all ordinary and necessary expenses paid or incurred during the taxable year -- for the production or collection of income." Here, the taxpayers paid an expense that did in fact produce taxable income. The regulations under 1.212-1 do not make a specific exception for the type of fees paid by the taxpayer in this case.
In contrast, section 262 disallows deductions for all expenses that are for personal, living, or family expenses. I think the fee paid to Arbitronix could easily be classified as a personal expense.
Going back the regulations under section 1.212-1(e) we find that "a deduction under section 212 is subject to the restrictions and limitations in part XI (section 261 and following). . . relating to items not deductible. [Further] section 212 does not allow the deduction of expenses which are disallowed by any of the provisions of Subtitle A of the Code, even though such expenses may be paid or incurred for one of the purposes specified in section 212."
In other words, section 262 trumps section 212 via the regulations in section 1.212-1(e). An amount that is otherwise deductible under section 212, will not be deductible if specifically excluded by section 262, or other code provision under Subtitle A of the Code. Confusing enough! Who needs tax reform when I can charge $250 per hour to figure this stuff out, and worse yet I enjoy it!