Indebtedness has been a central focus of Parts I and II of this series, and it will continue to be a key concept in future posts as we explore in further detail the COD Income exceptions and discuss potential tax consequences resulting from modifications of indebtedness. In order to fully grasp the concepts discussed throughout this series, a baseline understanding of what the term “indebtedness” means is necessary. This Part III seeks to provide a brief introduction to the history of indebtedness in the tax law and serve as a guide to understanding what constitutes indebtedness.
The History of Indebtedness in the Tax Law
The concept of indebtedness, or debt, and related issues concerning taxation of various aspects of indebtedness have been plaguing courts for decades. Indebtedness has been a prominent component of the United States economy for quite some time and only appears to be growing in significance of late, as the economic downturn caused by Covid-19 has caused renewed focus on all aspects of indebtedness.
Over many decades, the tax law has sought to address indebtedness in various contexts—from the issuance and repayment of indebtedness to the forgiveness and modification of the terms of indebtedness. And while the courts, Treasury, and the Internal Revenue Service (“IRS”) have worked to parse out the rules governing the tax treatment of indebtedness, a related issue has continued to persist—whether indebtedness is truly indebtedness at all.
The tax law has been faced for many years with arguments and questions concerning the characterization of debt in various contexts. This is a result of a number of factors, including the favorable tax treatment of debt in comparison to other characterizations, such as equity, and the ability of taxpayers to arrange their affairs, generally, in whatever manner they see fit, which has resulted in debt instruments with unique terms and characteristics. The difficulties in characterizing indebtedness are further compounded by the fact that the tax law does not provide a fixed definition of indebtedness. Examples of some of the common characterization questions include whether something constitutes debt or equity, a gift or a loan, or is a bona fide debt.
Throughout the years, courts, the Treasury, and the IRS have used a facts and circumstances analysis to classify instruments as debt for federal income tax purposes. For example, courts may consider the label or name of the instrument, advance, or investment; whether there is a promissory note or other formal documentation; reporting treatment; presence or lack of a fixed maturity date; the right to enforce payment upon default; absence or inadequacy of interest; whether there is a reasonable expectation of repayment; whether the parties could have obtained the funds from an arm’s-length source on roughly comparable terms; and the parties’ intent, among other factors, in determining whether an instrument should properly be classified as debt. In addition to these factors, Treasury has also recently issued final Regulations under § 385 of the Internal Revenue Code (the “Code”), which provide for the recharacterization of debt as equity in certain related-party transactions.
Whether an obligation constitutes indebtedness can greatly affect the tax consequences of the parties to the obligation. For example, forgiveness or cancellation of the obligation or a significant modification to the terms governing the obligation could, if the obligation were classified as indebtedness, cause the parties to recognize taxable income.
Defining Indebtedness in the Context of Cancellations and Modifications of Indebtedness
Both the cancellation of indebtedness and significant modifications to the terms of indebtedness can result in cancellation of indebtedness income (“COD Income”). COD Income is includible in a taxpayer’s gross income unless an exception in § 108 of the Code or a congressionally-enacted exception explicitly provides otherwise. This general rule governing COD Income and the exceptions to the general rule are discussed in Parts I and II of this series.
Section 108 of the Code governs the taxation of COD Income, and § 108(d)(1) provides that as the term indebtedness is used in the context of cancellation of indebtedness, “indebtedness of the taxpayer” means any indebtedness (A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property.” Neither § 108 or the current Treasury Regulations promulgated thereunder provide a definition of the term indebtedness.
Case law and now-repealed Treasury Regulations, discussed below, however, provide guidance on the definition of indebtedness. Case law has traditionally defined indebtedness as an unqualified obligation to pay a sum certain along with a fixed percentage of interest payable regardless of the debtor’s income (or lack thereof). Prior to its repeal, Treasury Regulation § 1.108(b)-1(c) similarly defined indebtedness, stating that indebtedness was “an obligation, absolute and not contingent, to pay on demand or within a given time, in cash or another medium, a fixed amount.”
While the specific terms of an obligation may vary, obligations and agreements providing that a taxpayer has an absolute and non-contingent obligation to pay a fixed amount, either on demand or at a fixed date, have traditionally been classified as indebtedness, and identifying these features in the terms of an obligation allows a taxpayer to better understand whether they may be subject to the rules of taxation governing indebtedness. Obligations containing these features of absolute, fixed amounts of payments due on fixed dates and for which a taxpayer is liable or to which a taxpayer’s property is subject would, based on the definitions of indebtedness and § 108(d)(1), be subject to the rules in § 108 governing the cancellation of indebtedness.
Examples of obligations courts have held to be indebtedness for purposes of finding COD Income include credit card debt, mortgages, and obligations to repay disability benefits previously received tax-free to which the taxpayer was not entitled. In cases in which courts have found obligations did not constitute indebtedness resulting in COD Income, the disputed debt doctrine, discussed below, has typically been asserted to contest the classification of the obligation as indebtedness and the COD Income resulting from such classification.
Disputed Debt Doctrine
Whether an obligation is truly indebtedness, with the result of such classification being that a taxpayer would be required to recognize COD Income, is disputed most frequently in the context of COD Income through the use of the disputed debt doctrine.
The disputed debt doctrine is traditionally invoked by taxpayer-debtors arguing that an alleged debt is not, in fact, a bona fide debt for cancellation of indebtedness purposes because the amount of the debt is subject to a bona fide dispute relating to the amount claimed by the creditor as owed. If there is a bona fide dispute as to the amount of the disputed debt, there is not a “sum certain” or “fixed amount” owed on the part of the debtor, as required by the definitions of indebtedness, discussed above. As a result, the settlement and subsequent payment of the disputed debt by the debtor and creditor for a lower amount than alleged as originally owed does not result in COD Income because there was no sum certain or fixed amount until the settlement, at which point the obligation becomes a sum certain and payment of the sum certain would be equal to the settled amount of indebtedness. If, however, the debtor paid an amount less than the settled amount and the creditor subsequently forgave the remaining balance, that would result in COD Income because the debt had become a fixed amount and, therefore, a bona fide debt.
Understanding what obligations constitute indebtedness and the consequences that may stem from cancelling or modifying the terms of such indebtedness are critical to anticipating when debt restructuring and modification may result in adverse tax consequences, preventing unexpected tax liabilities. Future installments of this series will discuss the tax consequences of the modification and restructuring of indebtedness and explore in more detail the exceptions under § 108.
For any questions on this or any other tax-related matter, please feel free to contact Charles Pulman at firstname.lastname@example.org or by phone at (214) 749-2447 and Annie McGinnis at email@example.com or by phone at (214) 749-2412. This blog was written based on the law as in effect on June 15, 2020.