TAM 1321019: Court order fixed the date of discharge of indebtedness

Plain-English summary

The IRS considered when an S corporation's debt was discharged after a settlement with its creditor. The settlement required payments and a court order dismissing the related claims, and it included a later effective date tied to possible bankruptcy events. The IRS concluded that the discharge occurred when the court entered the agreed order dismissing all claims with prejudice, because that order prevented the creditor from later pursuing more than the compromised amount. The determination addresses the timing of discharge of indebtedness income under IRC § 61 and the effect of excluded discharge income under IRC § 108 for an S corporation.

Ruling snapshot

• Question: When was the taxpayer's indebtedness discharged for federal income tax purposes?
• Outcome: Advice given
• Key authorities: IRC §§ 61, 108, 1366; Gitlitz v. Commissioner, 531 U.S. 206 (2001); Cozzi v. Commissioner, 88 T.C. 435 (1987)

Full text (IRS public release)

                     INTERNAL REVENUE SERVICE
           NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM



                                      Third Party Communication: None
                                      Date of Communication: Not Applicable

Number: 201321019
Release Date: 5/24/2013
Index (UIL) No: 61.22-00
CASE-MIS No: TAM-135686-12
Date: February 12, 2013
Chief, Appeals Office
Dallas, TX

  Taxpayer's Name:                    ----------------------------------
  Taxpayer's Address:                 -------------------------------------------
                                       ------------------------------
  Taxpayer's Identification No:       -----------------
  Year(s) Involved:                   -------
  Date of Conference:                 ----------------------

LEGEND:

Taxpayer = ----------------------------------
Creditor = -------------------------------------
Individual A = --------------------------------
-------------------------
Date 1 = ------------------------
Date 2 = ----------------------
Date 3 = -----------------
Date 4 = --------------------
Date 5 = -----------------
Date 6 = ----------------------------
Date 7 = ----------------------------
Date 8 = ----------------------------
Date 9 = ----------------------------
Date 10 = --------------------------
$a = ------------------
b% = -----
c% = ------
$d = -------------------
TAM-135686-12 2

$e = ------------------
$f = ------------------
$g = ------------------
$h = ------------------
$k = ----------------
Year 1 = -------
Year 2 = -------

ISSUE:

Whether Creditor discharged Taxpayer’s indebtedness on or before October 11, 2001,
resulting in discharge of indebtedness income to Taxpayer at that time.

CONCLUSION:

Creditor discharged Taxpayer’s indebtedness on or before October 11, 2001, resulting
in discharge of indebtedness income to Taxpayer at that time.

FACTS:

Taxpayer’s shareholder relies on Gitlitz v. Commissioner, 531 U.S. 206 (2001), to claim
additional basis in shares of S corporation stock from excluded discharge of
indebtedness income under § 108 of the Internal Revenue Code (Code). The Supreme
Court held in Gitlitz that excluded discharge of indebtedness income may be added to a
shareholder's stock basis. Gitlitz was subsequently overturned prospectively when
Congress amended § 108(d)(7)(A), effective after October 11, 2001.1 Because the
holding in Gitlitz applies to excluded discharge of indebtedness income arising on or
before October 11, 2001, the date when Creditor discharged Taxpayer’s indebtedness
is crucial to the instant case.

On Date 1,2 Taxpayer, an S corporation wholly owned by Individual A, entered into a
Term Loan Agreement with an unrelated third-party lender (Creditor) and executed
several Secured Promissory Notes (Notes) in favor of various Creditor entities, from
which Taxpayer borrowed $a at a stated interest rate of b% per year. The Notes further
provided that, in addition to the b% rate of interest, the loan to Taxpayer would consist
of the conveyance of a “royalty adjustment” sufficient to yield a c% internal rate of return
to Creditor. Additionally, any overdue interest or principal amounts bore interest at c%.

1
Section 108(d)(7) provides, in part:

      (A) Certain provisions applied at corporate level. In the case of an S corporation, subsection (a),
          (b), (c), and (g) shall be applied at the corporate level, including by not taking into account
          under section 1366(a) any amount excluded under subsection (a) of this section.

2
All “Dates” are in chronological order, i.e., Date 1 is before Date 2, Date 2 is before Date 3 …
TAM-135686-12 3

During Year 1, Taxpayer's partners experienced financial difficulties that resulted in
Taxpayer defaulting on the required payments to Creditor. Taxpayer then sued the
partners who failed to make payments on their obligations, and Taxpayer received a $d
jury verdict and judgment on Date 2. Because the judgment was a substantial asset of
Taxpayer, Creditor decided to await the outcome of the defendants' appeal before
pursuing Taxpayer's collateral securing the Notes. On Date 3, Taxpayer executed
additional security agreements under the Notes in favor of Creditor.

In Year 2, the appellate court reduced the $d judgment to $e. Of that amount, Creditor
ultimately received $f because the judgment was divided among several parties. The
appellate court suggested that the reduction in the judgment was due in part to
malpractice of Taxpayer's attorneys. Thereafter, Taxpayer brought suit against its
former attorneys. Creditor filed a Plea in Intervention in that litigation and claimed that
Taxpayer owed Creditor principal of $g under the Notes, plus interest, royalties and
other amounts, and asserted a right to recover those amounts from any liability
adjudged to be owed to Taxpayer from its former attorneys.

On Date 4, the court entered an Order dividing the litigation into two phases, the “Main
Phase” and the “Intervention Phase.” The Main Phase referred to the claim asserted by
Taxpayer against its former attorneys. The Intervention Phase referred to the claim
asserted by Creditor against Taxpayer.

During Date 5, Taxpayer, Creditor, and Taxpayer’s former attorneys reached a basis for
settlement of the litigation during mediation. The parties memorialized the basis for
settlement in a Mediation Settlement Agreement, in which the parties agreed to draw up
and execute a formal settlement document. That document, the Confidential Settlement
and Release Agreement (Settlement Agreement), generally became effective on Date 6
(a date on or before October 11, 2001), when the last party executed the Settlement
Agreement.

The Settlement Agreement provided that Creditor would receive a $h payment from
Taxpayer’s former attorneys’ insurers, and approximately $ k then held in a custodial
account, in exchange for Creditor cancelling the indebtedness as of the “Creditor
Payment Date.” On Date 7 (a date on or before October 11, 2001), Creditor received
the final settlement payment pursuant to the terms of the Settlement Agreement. On
Date 8, within seven days after payment as required under the Settlement Agreement,
the parties: (1) filed an Agreed Motion to Dismiss with Prejudice (Motion) and (2)
requested entry of an Order Granting Agreed Motion to Dismiss with Prejudice. The
Motion provided that the litigation would be “dismissed with prejudice as to all claims,
cross-claims or counterclaims brought or that could have been brought” in the litigation.
On Date 9 (a date on or before October 11, 2001), the court entered the Order Granting
Agreed Motion to Dismiss with Prejudice (Court’s Agreed Order). The Court’s Agree
Order provided as follows:
TAM-135686-12 4

  IT IS, THEREFORE, ORDERED that the above numbered and styled cause of
  action is hereby DISMISSED WITH PREJUDICE towards refilling the same as to
  all claims, cross-claims or counterclaims brought or that could have been brought
  herein, including the claims in the intervention phase, with each party bearing its
  own attorney’s fees, costs and expenses.

Creditor included language in the Settlement Agreement that it thought would improve
its position in the event that Taxpayer subsequently filed for bankruptcy protection.
Creditor was concerned that the settlement payments made on behalf of Taxpayer
might be viewed as preferential payments and potentially recoverable by Taxpayer’s
bankruptcy estate. Creditor thought that the “Creditor Effective Date” language in the
Settlement Agreement would alleviate that concern. The Creditor Effective Date, Date
10 (a date after October 11, 2001), was defined as the date five months after Creditor
received payment of all amounts due under the Settlement Agreement if certain events
did not occur within 91 days after payment, in which case the Creditor Effective Date
would be deferred until those events were cured and no claim existed that any
payments to Creditor constituted a preference, fraudulent transfer, or similar
conveyance that could be avoided or otherwise restored or repaid by Creditor under any
bankruptcy, insolvency, or similar law. The events that would have delayed the Creditor
Effective date, if they occurred within that 91 day period, were as follows:

  1) A filing by Taxpayer for protection under bankruptcy or similar laws, an
  admission by Taxpayer in writing of its inability to pay its debts, an assignment by
  Taxpayer for the benefit of creditors, or a consent by Taxpayer to the
  appointment of a receiver of itself or its property,

  2) A filing with respect to Taxpayer of an involuntary petition under bankruptcy or
  similar laws or an order appointing a receiver of its property, or

  3) An assignment by Taxpayer of its claims against Creditor, which likewise were
  to be released under the Settlement Agreement on the Creditor Effective Date.

The Settlement Agreement further stated:

  [A]ny release … which is effective as of the [Creditor] Payment Date shall be
  “null, void and of no force or effect ab initio as of the [Creditor] Payment Date if
  prior to the [Creditor] Effective Date any of the payments to the [Creditor] … shall
  have been ordered by a court of competent jurisdiction in connection with a
  bankruptcy or insolvency proceeding of [Taxpayer] to be avoided, rescinded, set
  aside or otherwise recovered, restored or repaid by recipient to [Taxpayer] or
  their respective bankruptcy estate(s) under any bankruptcy, insolvency or similar
  law.

In the instant case, none of these events occurred.
TAM-135686-12 5

In short, the facts of the instant case reveal several possible dates when Creditor might
be viewed as having discharged Taxpayer’s indebtedness. These possible dates
include the following:

  1) On Date 6 (a date on or before October 11, 2001), when Taxpayer, Creditor
     and other parties executed the Settlement Agreement,

  2) On Date 7 (a date on or before October 11, 2001), when Creditor received a
  payment of $h from the custodial account and a payment of $k from Taxpayer’s
  former attorneys’ insurer,

  3) On Date 9 (a date on or before October 11, 2001), when Court’s Agreed Order
  was entered, or

  4) On Date 10 (a date after October 11, 2001), when the Creditor Effective Date
  was met because certain events did not occur.

Taxpayer argues in the alternative. First, the execution of the Settlement Agreement on
Date 6 created a binding obligation on Taxpayer to compromise and settle the debt, and
the execution constituted an “identifiable event” for purposes of determining when a
discharge of indebtedness occurred. Second, the discharged occurred on Date 7, when
all obligations under the Settlement Agreement were fully performed, including
Creditor’s receipt of the settlement payment. Third, the discharge occurred on Date 9,
when the Court’s Agreed Order was entered.

The Service argues that Taxpayer must first meet the Creditor Effective Date provision
and that as a result of Taxpayer meeting that provision on Date 10 (a date after October
11, 2001), discharge of indebtedness occurred at that time.

Although Taxpayer and Appeals do not agree on the exact amount of discharge of
indebtedness income, the parties agree that Taxpayer’s indebtedness owed to Creditor
exceeded the payments that Creditor received under the Settlement Agreement.

LAW AND ANALYSIS:

Section 61(a)(12) of the Code provides that gross income includes income from the
discharge of indebtedness.

In United States v. Kirby Lumber Co., 284 U.S. 1 (1931), a corporation repurchased its
bonds for an amount less than their par value. The Court held that this resulted in an
accession to wealth because, to the extent of the difference, the corporation’s assets
had been released from a liability.
TAM-135686-12 6

In general, if a taxpayer repays its debt for less than the amount due, income from the
discharge of indebtedness arises. If actual repayment on a debt is not made, income
from discharge of indebtedness arises when it becomes clear that the debt will not be
paid. Addressing when a discharge occurs that results in discharge of indebtedness
income, the Tax Court stated in Cozzi v. Commissioner, 88 T.C. 435, 445 (1987):

  The moment it becomes clear that a debt will never have to be paid, such
  debt must be viewed as having been discharged. The test for determining
  such moment requires a practical assessment of the facts and
  circumstances relating to the likelihood of payment. Brountas v.
  Commissioner, 74 T.C. 1062, 1074 (1980), supplemental opinion to 73
  T.C. 491 (1979), vacated and remanded on other grounds 692 F.2d 152
  (1st Cir. 1982), affd. in part and revd. in part on other grounds sub nom.
  CRC Corp. v. Commissioner, 693 F.2d 281 (3d Cir. 1982); see Bickerstaff
  v. Commissioner, 128 F.2d 366, 367 (5th Cir. 1942); Kent Homes Inc. v.
  Commissioner, 55 T.C. 820, 828-831 (1971), revd. on other grounds 455
  F.2d 316 (10th Cir. 1972); Cotton v. Commissioner, 25 B.T.A. 1158
  (1932). Any "identifiable event" which fixes the loss with certainty may be
  taken into consideration. United States v. S.S. White Dental Mfg. Co., 274
  U.S. 398 (1927).

Thus, the inquiry in the instant case is when did it become clear that Taxpayer would
never have to pay the indebtedness. For the reasons explained below, Date 9 is when
the discharge of indebtedness occurred, and the entry of the Court’s Agreed Order is
the “identifiable event” that fixes Creditor’s loss with certainty.

It is clear that the Settlement Agreement provides for Creditor to receive a payment
from Taxpayer’s former attorneys’ insurers in exchange for Creditor’s cancellation of
Taxpayer’s indebtedness. Taxpayer first argues that the execution of the Settlement
Agreement on Date 6 created a binding obligation to compromise and settle the debt.
Thus, the execution constituted an “identifiable event” for purposes of determining when
a discharge of indebtedness occurred. See Cozzi v. Commissioner, supra. However,
the courts are in agreement that if the settlement agreement is contingent upon future
events, those events or conditions must first be met. In the present situation, the mere
execution of the Settlement Agreement does not fulfill all of Taxpayer’s obligations,
including payment, under the Settlement Agreement. See, Walker v. Commissioner, 88
F.2d 170 (5th Cir. 1937), affg. White v. Commissioner, 34 B.T.A. 424 (1936), (an
agreement to cancel a debt in the future is not sufficient to discharge the indebtedness
immediately if the cancellation is contingent upon future events).

Taxpayer’s next argument provides that, in general, if a taxpayer repays its debt for less
than the amount due, income from the discharge of indebtedness arises at the time the
debt is satisfied. Thus, Taxpayer argues that on Date 7, when the final payment is
received, it becomes clear that a debt will never have to be paid and that payment is the
TAM-135686-12 7

“identifiable event” that results in discharge of indebtedness income. See Cozzi v.
Commissioner, supra. In the present situation, the Settlement Agreement requires that
the parties file the Motion and request entry of the Court’s Agreed Order after payment
is received. Thus, all conditions in the Settlement Agreement were not met when
payment was received. See, Walker v. Commissioner, supra.

The Service presents a reasonable argument that the Creditor Effective Date provision
created a condition that must have been met before a discharge of indebtedness could
have occurred. Under this approach, the discharge of indebtedness would have
occurred on Date 10 (a date after October 11, 2001). As explained above, if Taxpayer
filed for bankruptcy protection and the settlement payment was viewed as a preferential
payment and recovered by Taxpayer’s bankruptcy estate, the Settlement Agreement
would be rendered “null, void and of no force or effect.” If this occurred, Creditor could
have continued with the litigation to pursue collection of the entire indebtedness owed,
including amounts in excess of the compromised amount negotiated under the
Settlement Agreement. If the litigation had continued, it would not be clear that the debt
would never have to be paid. See Cozzi v. Commissioner, supra. Also see, Walker v.
Commissioner, supra.

However, we conclude that Taxpayer has the better argument that the discharge of
indebtedness occurred on Date 9, when the Court’s Agreed Order was entered. On
Date 9, the Court’s Agreed Order dismissed with prejudice all “claims cross-claims or
counterclaims brought or that could have been brought herein, including the claims in
the intervention phase …” At this point in time, neither Taxpayer nor Creditor could ever
again sue for claims arising out of the same cause of action. If Taxpayer had violated
the terms of the Settlement Agreement, which it did not, Creditor’s only recourse would
have been to sue to enforce the terms of the Settlement Agreement. Creditor could not
have sued to recover any amount in excess of the compromised amount negotiated
under the Settlement Agreement. Thus, the entry of the Court’s Agreed Order locked
the parties into the compromised amount negotiated, and received, under the terms of
the Settlement Agreement.

The Creditor Effective Date provision simply had no effect on the finality of the Court’s
Agreed Order terminating all of Creditor’s rights to seek additional amounts owed on the
indebtedness. In addition, if Taxpayer’s bankruptcy estate had recovered Taxpayer’s
payment to Creditor, the Creditor Effective Date would have given Creditor no rights
greater than the rights available to any creditor under general bankruptcy law. Further,
the faint possibility of such an event occurring would be highly remote and would not
affect when a discharge occurs for federal tax purposes. See Milenbach v.
Commissioner, 318 F.3d 924, 936 (9th Cir. 2003), (repayment of indebtedness need not
have become absolutely impossible before it is considered discharged for federal
income tax purposes, … and slim possibility that debt may still be enforced does not
prevent it from being treated as discharged).
TAM-135686-12 8

Accordingly, based on the facts and circumstances presented, the discharge of
indebtedness occurred on Date 9. The entry of the Court’s Agreed Order is the
identifiable event that makes it clear that Taxpayer’s indebtedness would never have to
be paid.