Chapter 4: Loans and Cancellation of Indebtedness

➔ (gross income)

EQUALS (adjusted gross income (AGI))

MINUS (standard deduction or itemized deductions)

MINUS (personal exemptions)

EQUALS (taxable income)

Compute income tax liability from tables in § 1 (indexed for inflation)

MINUS (credits against tax)
I. Tax Consequences of Borrowing Money

The Tax Code and Economic Growth: A taxpayer’s opportunity to invest borrowed funds prior to the time that he/she/it has paid income tax on the income necessary to invest an equivalent amount has tremendous growth implications for the nation’s economy. Imagine how much more slowly the economy would grow if borrowed funds were subject to income tax immediately upon receipt. No doubt, there would still be markets for credit, but the higher cost of borrowing would mean that there would be less borrowing – and slower growth.
In this chapter, we take up various tax consequences of borrowing money. The fact that a taxpayer has borrowed money means that he/she/it has more money to spend. However, it also means that he/she/it has incurred an obligation to repay. One precisely offsets the other. Hence, there are no tax consequences to taking out a loan. Furthermore, taxpayer is entitled to spend this addition to his/her/its “store of property rights” on investment or consumption – and we treat such a taxpayer the same as we would if he/she/it had made such a purchase or investment with after-tax income. There is no income tax upon taking funds from the taxpayer’s “store of property rights” (minus) and spending them (plus), as such removal and spending precisely offset. Moreover, taxpayer’s expenditure entitles him/her/it to basis in whatever asset he/she/it may have purchased.
This does not mean that taxpayer is entitled to income that is not subject to income tax. Consider how taxpayer will meet his/her/its obligation to repay the loan. Taxpayer will have to earn income that is subject to income tax to repay the loan – perhaps by working at a job, paying income tax on wages, and using what remains after payment of taxes to pay down the loan. By taking out a loan, taxpayer has in fact exercised certain future consumption choices: he/she/it has committed future taxable consumption choices to the repayment of that loan. Consistent with the principle that borrowing money is not income to the taxpayer is the rule that repayment of loan principal is not deductible.

II. Cancellation of Indebtedness

All of this assumes that taxpayer will indeed repay the full amount of the loan. Consider now what happens when we no longer make this assumption. Taxpayer does not repay the loan, and for whatever reason, no longer owes it.

•Taxpayer has enjoyed the benefits of an expenditure on consumption without an offsetting (net) reduction to his/her/its store of property rights.

•Taxpayer no longer commits his/her/its future consumption choices to the repayment of the loan.

•Should we regard this as an accession to wealth and treat it as gross income? See § 61(a)(12).
Or: perhaps the assets that taxpayer purchased with the borrowed funds and upon which taxpayer relies to repay the loan shrink in value so that taxpayer is no longer able to repay the loan.

•Should this excuse a failure to repay the loan because such shrinkage can hardly be regarded as an “accession to wealth?”

•If we deem such a shrinkage not to be an “accession to wealth,” we effectively merge the borrowing transaction and the spending or investing of the loan proceeds into one transaction. Is this appropriate? Or should we account separately for –

•the borrowing and repayment, and

•the fate of the enterprise in which taxpayer spends or invests the loan proceeds?
Or: Perhaps taxpayer is able to take advantage of market conditions to satisfy his/her/its obligation by paying less than the amount that he/she/it borrowed.
What answers to these questions does this leading case suggest?

United States v. Kirby Lumber Co., 284 U.S. 1 (1931)
MR. JUSTICE HOLMES delivered the opinion of the court.
In July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for $12,126,800 for which it received their par value. Later in the same year, it purchased in the open market some of the same bonds at less than par, the difference of price being $137,521.30. The question is whether this difference is a taxable gain or income of the plaintiff for the year 1923. By the Revenue Act of (November 23) 1921, c. 136, § 213(a), gross income includes “gains or profits and income derived from any source whatever,” and, by the Treasury Regulations authorized by § 1303, that have been in force through repeated reenactments, “If the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.” Article 545(1)(c) of Regulations 62, under Revenue Act of 1921. [citations to more regulations omitted]. We see no reason why the Regulations should not be accepted as a correct statement of the law.
In Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned the stock of another company that had borrowed money repayable in marks or their equivalent for an enterprise that failed. At the time of payment, the marks had fallen in value, which, so far as it went, was a gain for the defendant in error, and it was contended by the plaintiff in error that the gain was taxable income. But the transaction as a whole was a loss, and the contention was denied. Here, there was no shrinkage of assets, and the taxpayer made a clear gain. As a result of its dealings, it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see nothing to be gained by the discussion of judicial definitions. The defendant in error has realized within the year an accession to income, if we take words in their plain popular meaning, as they should be taken here. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.
Judgment reversed.
Notes and Questions:
1. How does it happen that Kirby Lumber Company could buy back bonds in the open market for less than it obtained when it issued the bond?
2. What is a “shrinkage of assets?” Was the holding in Kerbaugh-Empire wrong? Why (or why not)?

•Evidently, there was a “shrinkage of assets” in Kerbaugh-Empire, but not in Kirby Lumber.

•No, said the Fifth Circuit in Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5^th Cir. 1934):

•Section 108 changes this, but § 108 does not convert business losses into excludable cancellation of indebtedness income.

•Review the holding and rationale of United States v. Gehl, 50 F.3d 12, 1995 WL 115589 (8^th Cir.), cert. denied, 516 U.S. 899 (1995), in chapter 3 of the text, supra.
7. In 1954, Congress added §§ 61(a)(12), 108, and 1017 to the Code.⁶¹ Read §§ 61(a)(12), 108(a)(1)(A and B), 108(d)(1 through 3). Do you see the influence of cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery – as well as of cases holding that the meaning of “income” in the 16^th Amendment does not encompass discharge of indebtedness (doi) when taxpayer does not thereby become solvent? See also Reg. § 1.61-12(b)(1) (adopted in 1957).

•Section 108(e)(1) provides that there is no insolvency exception from the general rule that gross income includes income from discharge of indebtedness other than what § 108 provides.

•When the other provisions of § 108 apply, § 108 appears to “preempt the field” – much as §§ 119 and 132 preempt their respective fields. See Boris I. Bittker, Martin J. McMahon, Jr., & Lawrence A. Zelenak, supra at 4-21 to 4-22.
8. Read § 108(b). What is a “tax attribute?”

•The Code does not define the phrase. We surmise its meaning by reading § 108(b).

•Section 108(b) lists tax consequences of various transactions that might reduce taxpayer’s tax liability in the future. The list includes: net operating loss, general business credit, minimum tax credit, capital loss carryover, basis reduction, passive activity loss and credit carryovers, and foreign tax credit carryovers.

•What is the effect of § 108(b) on the holdings of cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery? Define the “exclusion” from gross income that § 108 provides a taxpayer who is in bankruptcy or insolvent.

•The consequence of reducing a tax attribute is that taxpayer’s future tax liability will not decrease.

•To the extent that a taxpayer has tax attributes, § 108 does not in fact exclude doi income from taxpayer’s gross income, but instead defers the effect of its recognition to the day that a tax attribute would have reduced taxpayer’s tax liability.

•The temporal sequence in which reductions of tax attributes occur might be the same as the temporal sequence in which a typical taxpayer would derive a tax benefit from the particular tax attribute. If that is true, then the Code minimizes the length of time taxpayer benefits from not immediately recognizing doi income.

•What policies do you see implicit in § 1017(b)(4)(A)?

•What policies do you see implicit in § 108(b)(5)/Reg. § 1.1017-1(c and e)?

•What policies do you see implicit in Reg. § 1.1017-1(a)?

•10a. Taxpayer owns real property, fmv = $100,000, ab = $135,000. This is all of taxpayer’s property. Taxpayer also has no other assets, not even cash. Taxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of § 108? By how much?

•Taxpayer need not reduce (“spend”) her/his/its tax attributes on the discharge of indebtedness but rather may use them to reduce tax liability for the year.

•Then taxpayer may also reduce basis.