Oftentimes, a debtor is able to negotiate with a creditor to pay off a debt at a discount. The debtor pockets the savings – however its not a total win since the debtor may have to share some of the savings with the IRS. This is because the reduction in the amount due will often be characterized as cancellation of indebtedness income, which is subject to income tax. This harks back to a case that tax people may remember from their school days – U.S. v. Kirby Lumber Co. In that well-known case from 1931, the U.S. Supreme Court held that a taxpayer who purchased back its own bonds at a discount realized income to the extent of the savings since the taxpayer had increased its net wealth in the transaction.
However, not all obligations are treated the same in this area. A recent private letter ruling reminds us that if the debtor’s obligation is contingent only and not fixed, a negotiated prepayment reduction will NOT generate cancellation of indebtedness income. In issuing the favorable ruling, the IRS relied on another old case, Corporacion de Ventas de Salitre y Yoda de Chile v. Comm., 29 AFTR 1074 (CA 2 1942). That case was very similar to Kirby Lumber in that a taxpayer purchased back its own bonds at a discount. However, since the bonds were payable only of future profits, the obligation was contingent. The Second Circuit there held that no cancellation of indebtedness income due to the contingent nature of the obligation.