According to bank records, the taxpayers owed $8,042.10 to CitiFinancial and $2,875 to Chase. (2-3). However, they disputed amounts owed. (2-3). CitiFinancial agreed to settle the debt for $7,500 and Chase agreed to settle the debt for $1,000. (2-3). Both banks issued 1099-C's to the taxpayer for the difference between the settlement amount and the original amount of the debt. (2). The IRS asserts that the taxpayers should recognize cancellation of debt (COD) income for this difference. (1).
Cancellation of Debt Income (3)
Section 61(a)(12) includes in the general definition of gross income "income from discharge of indebtedness". When the amount of a debt is disputed, "a subsequent settlement of the dispute would be treated as the amount of the debt cognizable for tax purposes." Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990) (holding that unenforceable debt is also disputed as to amount, and its settlement does not give rise to cancellation of indebtedness income). There must be evidence of a dispute; a settlement standing alone does not prove that a good-faith dispute existed.
Evidence of Bona Fide Dispute Existed
Here, the taxpayers provided "evidence [that] supports a conclusion that a bona fide dispute existed regarding . . . the debt . . . ." (4). The amount of the taxpayer's debt "that was definite and liquidated" was $7,549.66 and $1,000 for CitiFinancial and Chase respectively. (5). Therefore, the taxpayer does not have cancellation of indebtedness income from Chase. (5). But they do have $49.66 of cancellation of indebtedness income from CitiFinancial. (5).
This case represents a caveat to COD income section of the tax code. But, the dispute must bona fide, and the taxpayer must provide evidence of the dispute. The Zarin case is on of the primary authorities on this topic. In Zarin, a New Jersey casino allowed the taxpayer to run up a huge gambling debt, despite a State law that required the casino to limit the amount of credit extended to a single player. Because the debt was not enforceable by the casino, the taxpayer and the casino settled their $3.5 million debt for $500,000. The Third Circuit held that because the debt was unenforceable it was not liquidated. It concluded the liquidated debt, and the amount of debt relevant for section 61(a)(12), was the $500,000.
This caveat may not help many taxpayers in these trying times because the debts being settled are normally not disputed debts. But in the rare case that disputed debts are settled for less than the disputed amount, tax professionals should consider whether this disputed debt exception is helpful to clients.