a. Probable net recovery on collateral in the event of liquidation.

b. The extent to which the lender is unsecured and the probability of recovery as an unsecured creditor after payment of income and other taxes and administrative costs in bankruptcy or other mode of liquidation.

c. The economic cost to the lender of interruption of interest payments in the event of liquidation.

d. The probability that the borrower, after restructuring, will be able to service the resulting debt.

a. The test most frequently relied upon is the "active v. passive" test which emphasizes the extent of the taxpayer's activities in relation to the property. See Ltr. Rul. 8350008, August 23, 1983 (mere rental of real property does not constitute a trade or business under I.R.C. § 1231).

b. A "facts and circumstances" test has been applied by the Tax Court. See John E. Good, 16 T.C. 906 (1952), acq., 1951-2 C.B. 2 (unimproved land rented for pasture used in trade or business because of consistent attempts by taxpayer to rent land). But see Durbin v. Birmingham, 92 F. Supp. 938 (S.D. Iowa 1950) (unimproved land rented to sharecroppers was capital asset where there was no management or control by taxpayer). Compare Susan P. Emery, 17 T.C. 308 (1951) (loss from sale of unimproved realty was capital loss); Ltr. Rul. 8814034, January 11, 1988 (sale of land at loss after Christmas trees died; business had not begun to function). Cf. Edwin R. Curphey, 73 T.C. 766 (1980) (ownership and rental of real property does not, as matter of law, constitute trade or business).

c. For improved real property, the courts have been more likely to find trade or business status. Irving Stratton, T.C. Memo. 1962-218; Charles M. Spindler, T.C. Memo. 1963-202. But see Grier v. United States, 120 F. Supp. 395 (D. Conn. 1954) (single family house rented by taxpayer was not property used in trade or business and did not qualify for ordinary loss treatment).

d. Even though an asset is connected with a trade or business, it may not have been acquired for use in the trade or business. Azar Nut Co., 94 T.C. 455 (1990) aff'd, 931 F.2d 314 (5th Cir. 1991) (loss on house acquired from fired executive).

e. If property is used in a trade or business and is subsequently rented under a passive arrangement, trade or business status may continue for a period of time. See, e.g., Wofac Corp. v. United States, 269 F. Supp. 654 (D. N.J. 1976) (business discontinued because of unprofitability; noncapital asset status not lost immediately).

f. A loss may not be deductible if the loss relates to a personal asset or the property was not acquired with a profit motive. Kenneth Ralph Barger, T.C. Memo. 1990-238 (nominal rent paid by son and family to occupy house purchased by taxpayer).

a. Asset gain or loss from the transfer of the property, measured by the difference between the adjusted income tax basis of the transferred property and the amount received for the property, and would be taxed in accordance with the usual gain-on-sale rules, and

b. Gain or loss from payment of the debt, which is measured by the difference between the unpaid balance of the debt and the amount paid toward discharging the debt, and would be taxed under the usual discharge of indebtedness rules.

a. Asset gain or loss from the transfer of the property, measured by the difference between the adjusted income tax basis of the property and the fair market value of the property, and

b. Gain or loss from payment of the debt measured by the difference between the unpaid balance of the debt and the fair market value of the property.

a. The courts have sometimes agreed, holding that a transfer of property in discharge of debt results in gain from sale rather than in cancellation of indebtedness income. See R. O'Dell & Sons, Inc., 8 T.C. 1165 (1947), aff'd, 169 F.2d 247 (3d Cir. 1948); Carlisle Packing Co., 29 B.T.A. 514 (1933). See also Charles F. Nutter, 7 T. C. 480 (1946), acq., 1946-2 C.B. 4 (no loss allowed).

b. That result has been reached regardless of whether the property transferred was the property securing the debt or other property and regardless of whether the transfer occurred by means of a foreclosure or a voluntary reconveyance. Thus, gain results to the extent the liability discharged exceeds the adjusted income tax basis of the property.

c. Other courts treated the transaction as producing cancellation of indebtedness income rather than all being gain or loss from sale. E.g., Julian S. Danenberg, 73 T.C. 370 (1979), acq., 1980-2 C.B. 3. The transaction is treated as if the transferor had sold the asset for cash equivalent to the amount of the debt and applied the cash to payment of the debt. Peninsula Properties Co., 47 B.T.A. 84 (1942), acq., 1942-2 C.B. 14. Where that was the outcome, the cancellation of indebtedness income was measured by the difference between the fair market value of the transferred property and the liability discharged. This is believed to be the correct result. IRS seems to agree. Ltr. Rul. 8614022, January 2, 1986 (in exchange of property for release of debt exceeding fair market value of property, taxpayer realized capital gain or loss on difference between fair market value and adjusted basis of propery transferred and discharge of indebtedness income to extent debt exceeded fair market value of property transferred). See Vukasovich, Inc. v. Commissioner, 790 F.2d 1409 (9th Cir. 1986).

d. In Commissioner v. Tufts, 461 U.S. 300 (1983), the United States Supreme Court held that the amount realized on the disposition of the property was equal to the unpaid balance of the debt and that there was no cancellation of indebtedness income. Tufts involved nonrecourse debt but the court did not limit the holding to nonrecourse debt.

a. The amount realized is the full amount of the nonrecourse liabilities which are discharged as a result of the transfer of the property. Allan v. Commissioner, 856 F.2d 1169 (8th Cir. 1988), aff'g, 86 T.C. 655 (1987) (advances for interest added to nonrecourse mortgage principal were part of debt obligation); Clarence Williams, T.C. Memo. 1990-266 (partnership defaulted on nonrecourse mortgage and HUD foreclosed).

b. The debtor realizes no cancellation of indebtedness income. See 2925 Briarpark, Ltd., T.C. Memo. 1997-298 (income from discharge of nonrecourse loans treated as gain and not discharge of indebtedness income).

a. A borrower must enter into a shared appreciation agreement for all write-downs involving real estate as collateral. 7 C.F.R. § 1951.909(e)(5).

b. The IRS position is that if a write-down occurs and no shared appreciation agreement is entered into, the write-down by FmHA results in cancellation of indebtedness for federal income tax purposes. I.R.S. Letter, Appendix B.

c. In those instances in which FmHA requires a shared appreciation agreement, IRS has taken the position that the indebtedness is nonetheless considered discharged for federal income tax purposes to the extent of the write-down. I.R.S. Letter, Appendix B. The shared appreciation agreement is not considered a substitute debt and is considered too contingent to preclude discharge of indebtedness from occurring. This outcome seems questionable and is likely to be challenged by debtors.

a. The debtor is required to execute a recapture agreement and to agree to pay in full the difference between the net recovery value of the property and the fair market value of the property (as of the date of the agreement) if within two years the property is conveyed for an amount greater than the net recovery value.

b. The IRS position is that the transaction constitutes a prepayment of the loan with discharge of indebtedness occurring to the extent of the difference between the outstanding loan balance and the buyout amount. I.R.S. Letter, Appendix B, p. 6. The IRS position is that the obligation to pay under the recapture agreement is so contingent that it cannot serve as substitute indebtedness for the FmHA debt in excess of the buyout amount. Therefore, a debtor realizes discharge of indebtedness income to the extent the "old" FmHA debt balance exceeds the buyout amount even though a recapture agreement is executed. Again, this outcome seems questionable.

a. The loss includes the original investment plus any other payments made (including any deficiency payments).

b. The loss is available whether the property was given up through foreclosure, forfeiture or voluntary transfer.

a. For capital assets, the taxpayer has a capital loss.

b. If the property was used in the business, a net loss would be ordinary.

c. A loss on the residence, and losses on other personal assets, would not be deductible.

a. The equivalent of a sale up to the fair market value of the property, or

b. Cancellation of indebtedness.

a. If no objections to discharge are sustained, in Chapter 7 bankruptcy 60 days after the meeting of creditors at which the debtor appears and is examined under oath. Bkrpcy. Rule 4004(a), (c).

b. Under Chapter 11 bankruptcy upon confirmation of a plan of reorganization as to debts arising before confirmation with some exceptions. 11 U.S.C. § 1141.

c. Under Chapter 12 bankruptcy "as soon as practicable" after completion of payments under the plan. 11 U.S.C. § 1228(a).

d. For Chapter 13 bankruptcy, upon completion of payments under the plan. 11 U.S.C. § 1328(a).

e. In a foreclosure action, discharge of indebtedness occurs when all appeals of the action have been exhausted. See Thomas A. Ryan, T.C. Memo. 1988-12, aff'd, 873 F.2d 194 (8th Cir. 1989) (accrual basis limited partners realized income from discharge of indebtedness in taxable year appeal of foreclosure action completed and not year of foreclosure sale).

f. In the cancellation of a loan in exchange for a cash payment, discharge occurs in the year the costs are paid. Shannon v. Commissioner, T.C. Memo. 1993-554. See Benjamin Rivera, T.C. Memo. 1993-609 (cancelled indebtedness was income in year settlement agreement executed and payments made, not in following year when recorded).

g. In general, there must be an identifying event or forgiveness on the part of creditors to give rise to discharge of indebtedness income. Michael Friedman, T.C. Memo. 1998-196 (filing of involuntary bankruptcy petition not sufficient).

a. A spouse,

b. Children and grandchildren,

c. Parents,

d. Spouses of children and grandchildren,

e. An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by the individual,

f. Two corporations which are members of the same controlled group,

g. A grantor and a fiduciary of any trust,

h. A fiduciary of a trust and a fiduciary of another trust if the same person is a grantor of both trusts,

i. A fiduciary of a trust and a beneficiary of such trust,

j. A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts,

k. A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust,

l. A person and a Section 501 charitable organization which is controlled, directly or indirectly, by such person,

m. A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation and more than 50 percent of the capital or profits interest in the partnership,

n. An S corporation and another S corporation if the persons own more than 50 percent in value of the outstanding stock of each corporation,

o. An S corporation and a C corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation,

p. A partnership and a partner owning, directly or indirectly, more than 50 percent of the capital or profits interest in the partnership, or

q. Two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital or profits interest.

a. This rule also applies to transactions in which the holder of the outstanding indebtedness becomes related to the debtor if the holder is treated as having acquired the indebtedness in anticipation of becoming related to the debtor.

b. Steps taken to avoid related-party status may be disregarded if necessary to prevent taxpayer avoidance of realization of discharge of indebtedness income. Rev. Rul. 91-47, 1991-2 C.B. 16 (third party's formation of corporation with subsequent sale of stock to debtor disregarded because no business purpose served).

a. The taxpayer must report as gain (or loss) the difference between the income tax basis in the property and the amount of the foreclosure sale proceeds. Cox v. Commissioner, 68 F.3d 128 (5th Cir. 1995).

b. Consideration should be given to filing bankruptcy before expiration of the right to redeem if significant income tax liability is involved. But that is not always successful. Evert E. Berglund, T.C. Memo. 1995-536 (taxpayers had to recognize gain from foreclosure sale of farmland).

a. If the borrower is personally liable for repayment of the debt, the Form 1099-A is to state the fair market value of the property at the time the interest is acquired. Temp. Treas. Reg. § 1.6050J-1T (Q&A 26).

b. The requirement does not apply to a loan secured by tangible personal property which is not held for investment and which is not used in a trade or business. I.R.C. § 6050J(b).

c. The reporting requirement applies to governmental units without regard to the trade or business requirement. I.R.C. § 6050J(d).

d. The reporting requirements apply to acquisitions of property and abandonments of property after December 31, 1984. Tax Reform Act of 1984, Pub. L. 98-369, Sec. 148(d).

a. Debt is considered discharged and reporting is required only if the following events occur —

b. The discharged debt is reported on Form 1099-C, Cancellation of Debt. When IRS receives Form 1099-C for a taxpayer with joint and several liability on an indebtedness, the full amount of indebtedness is not treated as income to each separate taxpayer. SCA 1998-039. Guarantors and sureties are not required under Treas. Reg. § 1.6050)-1(d)(7) to report discharges of the guaranteed indebtedness because they are not themselves debtors. Id.

c. A guarantor is not considered a debtor for purposes of the reporting requirements. Treas. Reg. § 1.6050P-1(b)(7). That is the case whether or not there has been a default and demand for payment made on the guarantor. Id.

d. The regulations are effective for discharges of debt after December 21, 1996. Treas. Reg. § 1.6050P-1(h). Until that time, Temp. Treas. Reg. § 1.6050P-1 continues to apply. In addition, the interim relief from penalties applies. Notice 94-73, 1994-2 C.B. 553.

a. This rule does not apply in a bankruptcy case or to the extent the debtor is insolvent. I.R.C. § 108(e)(10)(B).

b. The stock-for-debt exception, in an exchange of preferred stock for indebtedness, applies only to the extent of the redemption price and liquidation preference of the preferred stock. Rev. Rul. 90-87, 1990-2 C.B. 32.

a. For purposes of determining the amount of cancellation of indebtedness income on issuance of a new corporate debt instrument in satisfaction of an old debt, the debtor is treated as having satisfied the old debt with the amount of money equal to the issue price of the new debt.

b. The legislation also repeals the stock-for-debt exception (except in certain de minimis cases) for bankruptcy cases and insolvent debtors for taxpayers issuing disqualified stock in exchange for debt. Disqualified stock is any stock with a stated redemption price and that either has a fixed redemption date, is callable by the issuer or is puttable by the holder. RRA 1990, Sec. 11325(a), amending I.R.C. § 108(e).

c. In general, the provision is effective for debt instruments issued or stock transferred after October 9, 1990, in satisfaction of debt. RRA 1990, Sec. 11325(c).

a. But this exception does not apply to the issuance of nominal or token shares or to transfers to an unsecured creditor in a workout where the ratio of the value of the stock received to the indebtedness cancelled or exchanged in the workout is less than 50 percent of a similar ratio calculated for all unsecured creditors participating in the workout. I.R.C. § 108(e)(8).

b. What is nominal or token is subject to a facts and circumstances test with regulations focusing on the following factors as indicative that the stock exchanged for indebtedness would not be nominal or token —

c. If common stock is issued for outstanding unsecured indebtedness in a bankruptcy case or insolvency workout, the issuance is not treated as nominal or token if the ratio of issued stock to total outstanding stock is 15 percent or less. Rev. Proc. 94-26, 1994-1 C.B. 612.

a. A bankrupt or insolvent corporation may exclude from income all or a portion of cancellation of indebtedness income created by the transfer of its stock by reducing tax attributes.

b. The amendments do not apply to stock transfers in satisfaction of any indebtedness if the transfer is in a bankruptcy case filed on or before December 31, 1993. RRA, § 13226(a)(3)(B).

a. The nonrecognition rules of I.R.C. § 108(b) operate only at the S corporation level and do not result in any pass-through to the shareholders or increase of stock basis. Mel T. Nelson, 110 T.C. 114 (1998); Ltr. Rul. 9423003, February 28, 1994; Ltr. Rul. 9541006, July 5, 1995. See Michael Friedman, T.C. Memo. 1998-196 (dictum). Instead, the corporation reduces its tax attributes by the amount of discharge of indebtedness income after effecting any pass through of corporation income, loss or deduction to the shareholders. Ltr. Rul. 9541001, November 30, 1994.

b. An S corporation, in applying I.R.C. § 108(b)(2), does not reduce net operating losses carried forward from a period when it was a C corporation. Id.

c. Debt discharge income in an S corporation increases the shareholders’ bases in their stock, enabling the shareholder to deduct their distribution shares of S corporation losses. Philip D. Winn, T.C. Memo. 1997-286 (without basis increases, shareholders’ losses would have been suspended).

d. Extensions of time can be granted to make an election to exclude income from discharge of indebtedness from gross income. Ltr. Rul. 9738033, June 23, 1997 (taxpayer acted reasonably and in good faith and granting of relief did not prejudice government’s interest).

a. Thus, discharge of indebtedness income is recognized at the partnership level and the I.R.C. § 108 provisions are applied at the partner level. See Estate of Newman v. Commissioner, 934 F.2d 426 (2d Cir. 1991) (insolvency exception to discharge of indebtedness rule applied at partnership level; case arose prior to change in I.R.C. § 108(d)(6)); Murphy v. Commissioner, 98-2 U.S.T.C. ¶ 50,588 (2d Cir. 1998) (partnership released from debt obligation; partners required to take into account their distributive share of gain); James R. Brickman, T.C. Memo. 1998-340 (limited partnership's default on note generated discharge of indebtedness income to partners; married taxpayers required to reduce wife's net operating loss carryover to zero because NOLs were community property). See also Kenneth G. Lind, T.C. Memo. 1993-286 (discharge of indebtedness income realized by partnership; neither partner nor partnership was bankrupt or insolvent); Ltr. Rul. 9815035, January 7, 1998 (partner granted extension of time to file partnership’s election to reduce basis of depreciable property); Ltr. Rul. 9840026, June 30, 1998 (partners entitled to exclude discharge of indebtedness income received by partnership which was qualified real property business indebtedness).

b. The election under I.R.C. § 108(b)(5) for a bankrupt or insolvent taxpayer to reduce the basis of depreciable property before reducing other tax attributes is made by the partners and not by the partnership. I.R.C. § 703(b)(1).

c. Each partner's basis in the partnership is increased by the discharge of indebtedness income allocated to that partner. I.R.C. § 705(a)(1)(A). See Ltr. Rul. 9739002, May 19, 1997 (taxpayer’s share of discharge of indebtedness excludible from income if taxpayer qualified under I.R.C. § 108). This is offset by a decrease in basis (but not below zero) under I.R.C. § 733, resulting from the deemed distribution to the partner under I.R.C. § 752(b) equal to the partner's share of the reduction in partnership liabilities because of the debt discharge. Ltr. Rul. 9739002, May 19, 1997. See Rev. Rul. 92-97, 1992-2 C.B. 124.

d. If a partner is insolvent, no income is recognized from cancellation of indebtedness and so the partner's share of the cancelled debt does not increase the partner's partnership basis. Babin v. Commissioner, 23 F.3d 1032 (6th Cir. 1994) (deemed distribution of money from decrease in partnership liabilities exceeded basis and produced gain).

e. If a partnership issues a partnership interest to a creditor in satisfaction of indebtedness, rules similar to those in I.R.C. § 108(e)(7) (discussed above for corporations) are to be imposed on creditors of the partnership. I.R.C. § 108(e)(7)(F).

a. Earnings and profits apparently are increased to the extent discharge of indebtedness is applied to reduce tax attributes other than basis or is excluded from gross income because tax attributes are exhausted. Id.

b. If the interest of a shareholder is extinguished or terminated in a bankruptcy "or similiar case," and the corporation has a deficit in earnings and profits, the deficit is reduced by the paid-in capital of the corporation allocable to the interests of the shareholders which have been terminated or extinguished. I.R.C. § 312(1)(2).

a. An appeal of a Tax Court decision may also be stayed regardless of which party appeals. Delpit v. Commissioner, 18 F.3d 768 (9th Cir. 1994) (Chapter 11 filing).

b. The bankruptcy court may lift the stay to allow a Tax Court hearing to continue. 11 U.S.C. § 362(d).

a. For purposes of determining the number of years to which a net operating loss or a capital loss may be carried forward, presumably the last taxable year of a taxpayer (whether or not a short taxable year) and the first taxable year of the succeeding taxpayer each constitute a taxable year. Cf. Treas. Reg § 1.172-4(b)(3).

b. The limitations period for tax loss refunds is not tolled while the bankruptcy case is open. I.R.C. § 6511 takes precedence over 11 U.S.C. § 346(i) in determining which statute of limitations to apply. In re Eric T. Page, 94-2 U.S.T.C. ¶ 50,541 (D. Kan. [Bkrpcy.] 1994).

c. Before the enactment of the Bankruptcy Tax Act of 1980, the bankruptcy estate did not succeed to the net operating losses of the debtors. In re Luster, 93-1 U.S.T.C. ¶ 50,009 (7th Cir. 1992) (net operating loss carryforwards were not property of bankruptcy estate).

a. The debtor's unused passive activity loss and unused passive activity credit (determined as of the first day of the debtor's tax year in which the bankruptcy case commences) pass to the bankruptcy estate beginning with its first tax year. Treas. Reg. § 1.1398-1(c). See In re Antonelli, 150 Bkrpcy. Rep. 364 (D. Md. [Bkrpcy.] 1992), aff'd, 92-2 U.S.T.C. ¶ 50,619 (D. Md. 1992) (debtor's pre-petition passive activity losses did not pass to bankruptcy estate before issuance of temporary regulations; court refused to consider passive activity losses as so closely related to net operating losses and capital losses as to be included); In re Rueter, 93-2 U.S.T.C. ¶ 50,642 (N.D. Calif. 1993) (debtors and not bankruptcy estate were sole owners of right to carry forward pre-petition passive activity losses).

b. The debtor's unused disallowed losses under the at-risk rules, determined as of the first day of the debtor's year in which the case commences, pass to the bankruptcy estate beginning with its first tax year. Treas. Reg. § 1.1398-2(c).

c. The regulations are generally effective for bankruptcy cases commencing on or after November 9, 1992 and are applicable to cases commencing earlier and terminating after that date if the debtor and estate jointly and irrevocably elect to apply the regulations. Treas. Reg. § 1.1398-1(f)(2)(vi),-2(f)(2)(vi).

a. Investment tax credit.

b. Any recovery exclusion.

c. Any loss carryover.

d. Any foreign tax credit carryover.

e. Any capital loss carryover.

f. Any claim of right.

a. Net operating loss carryovers. See John M. Schaefer, T.C. Memo. 1998-163 (no tax return filed by bankruptcy estate and no documentary evidence of net operating loss; no deduction allowed).

b. Charitable contributions carryover.

c. Any recovery exclusion under I.R.C. § 111 relating to recovery of bad debts, prior taxes and delinquency amounts.

d. The carryover of any credit.

e. Capital loss carryover.

f. The income tax basis, holding period and character of assets in the hands of the bankruptcy estate. I.R.C. § 1398(i).

a. A bankruptcy estate is, of course, subject to the usual rules on the number of years losses and credits can be carried back and forward.

b. The debtor cannot carry back net operating losses for tax years after the bankruptcy petition was filed to tax years before the filing. Again, the same rule applies to investment tax credit and other credits. If a carryback were possible, any refunds would become property of the bankruptcy estate which would interfere with the debtor's fresh start.

c. If the bankruptcy estate incurs a net operating loss, the estate can carry the loss back not only to its own earlier tax years but also to those of the debtor before the tax year in which the bankruptcy case began. I.R.C. § 1398(j)(2). See Ltr. Rul. 8932002, April 19, 1989 (alternative tax net operating loss could be carried back similarly).

d. A trustee in bankruptcy can revoke a debtor's net operating loss carryforward election without approval of IRS even though such elections are irrevocable. In re Russell, 927 F.2d 413 (8th Cir. 1991) (bankruptcy trustee filed amended returns with net operating losses carried back, entitling bankruptcy estate to refund). On remand, the Bankruptcy Court held that the prepetition net operating loss election was not made with intent to defraud creditors. In re Russell, 93-1 U.S.T.C. ¶ 50,309 (W.D. Ark. 1993).

e. A debtor apparently succeeds to passive activity losses of the bankruptcy estate as of the first day of the bankruptcy estate’s taxable year in which the transfer occurs. Ltr. Rul. 9611028, December 14, 1995.

f. For state and local tax purposes, the estate may carry back any loss of the estate to a taxable period of the debtor ending before the order for relief in the same manner as the debtor could have carried back the loss had the loss been incurred by the debtor. 11 U.S.C. § 346(i)(3). However, in determining the number of taxable periods during which the estate may use a loss carryback, the taxable year of the debtor during which the case is commenced is deemed not to have been terminated by commencement of the case. 11 U.S.C. § 346(h). Therefore, for state and local tax purposes, the debtor's short taxable year in which the case was commenced does not count for carryback purposes.

g. For state and local tax purposes, debtors may apparently carry back post bankruptcy losses to pre-bankruptcy years after the close of the bankruptcy case. See 11 U.S.C. § 346(i)(3). This is not possible for federal income tax purposes as noted above.

a. Therefore, income tax liability incurred in a Chapter 12 bankruptcy is the responsibility of the debtor. In re Lindsey, 92-2 U.S.T.C. ¶ 50,400 (W.D. Okla. [Bkrpcy.] 1992) (trustee acted in capacity as standing trustee, not as trustee of separate liquidating trust).

b. This seemingly overrides earlier law recognizing separate entity status in other settings. E.g., Ralph Roger Bergman, T.C. Memo. 1985-256 (individual's bankruptcy estate was separate taxable entity); Rev. Rul. 78-134, 1978-1 C.B. 197 (separate entity for individual bankrupt); Rev. Rul. 72-387, 1972-2 C.B. 632 (same).

c. The estate of a corporation in bankruptcy clearly is not a separate entity for federal income tax purposes. Treas. Reg. § 1.641(b)-2(b).

d. Before the Bankruptcy Tax Act of 1980 became effective, the estate of a bankrupt partnership was considered to be a separate taxable entity. Rev. Rul. 68-48, 1968-1 C.B. 301 (separate entity created for bankrupt partnership treated as estate).

e. Before enactment of the Bankruptcy Tax Act, even with separate entity status, the transfer of the bankrupt's assets to the trustee in bankruptcy was not a taxable event and the basis carried over to the trustee. Rev. Rul. 78-134, 1978-1 C.B. 197.

a. For individuals filing under Chapters 7 or 11, administrative expenses are deductible. I.R.C. § 1398(h)(1). However, there is no deduction for administrative expenses for which there is no legal obligation to pay. Claude T. Allen, T.C. Memo. 1990-651 (legal expenses written off by law firm beause of conflict of interest).

b. There was authority, before enactment of the Bankruptcy Tax Act, that the expenses of the bankruptcy estate were deductible under I.R.C. § 212. Rev. Rul. 68-48, 1968-1 C.B. 301, 302 ("usual costs of administration, including the referee's compensation, statutory compensation for the trustee and for the bankrupt's attorney, the trustee's bond premium…"). See Ralph Roger Bergman, T.C. Memo. 1985-256 (deductions for real estate taxes, interest and legal fees available to bankruptcy estate, not debtor); Herbert E. Cox, T.C. Memo. 1981-552 (bankrupts allowed to deduct portion of attorney's fee representing portion of debts that were business debts); Maurice Artstein, T.C. Memo. 1970-220 (portion of attorney's fee for filing bankruptcy petition not deductible in voluntary petition to liquidate in bankruptcy because not sufficiently related to trade or business and not deductible as expense in connection with transaction entered into for profit).

a. Mutuality is present only if the claims and debts are mutual, involving the same parties, in the same right or capacity, and of the same kind or quality. See In re Whitman, 38 Bkrpcy. Rep. 395, 397 (D. N.D. [Bkrpcy.] 1984).

b. Mutuality is lacking where a post-petition liability is owed to a trustee or debtor in possession because they differ from the pre-petition debtor. In re Braniff Airways, Inc., 42 Bkrpcy. Rep. 443, 449-450 (N.D. Tex. [Bkrpcy.] 1984).

c. If debtors incur a pre-petition tax liability to the United States, and the United States incurs a post-petition liability to the debtors, such as with a government farm program, a set-off is permissible. In re Schons, 54 Bkrpcy. Rep. 665 (W.D. Wash. [Bkrpcy.] 1985) (Milk Diversion Program payments from U. S. Department of Agriculture). See In re B & P Enterprises, Inc., 67 Bkrpcy. Rep. 179 (W.D. Tenn. 1986) (refund of personal income tax offset against corporate taxes and penalties for which taxpayers were responsible parties); In re IML Freight, Inc., 65 Bkrpcy. Rep. 788 (D. Utah [Bkrpcy.] 1986) (IRS allowed setoff of income tax penalties against shipping charges owed by United States to debtor).

a. The amount of gain or loss is the difference between the basis of the installment obligation at the time of disposition and either the amount realized in a sale or the fair market value of the obligation at the time it is disposed of other than by sale. I.R.C. § 453B(a). The rules for determining taxable gain on disposition of an installment obligation are different depending upon how the disposition occurs.

b. For a discussion of the consequences of pledging an installment obligation, see Part Five.

c. Disposition of a contract to children in exchange for annuity payments constitutes a taxable disposition. Harold W. Smith, 56 T.C. 263 (1971).

d. In a disposition by gift, the donee's income tax basis presumably would be the fair market value of the obligation inasmuch as the donor's basis would be increased by virtue of the taxable disposition.

e. A tax-free exchange to a corporation or partnership does not trigger taxability of installment obligations transferred. See Treas. Reg. § 1.453-9(c)(2).

f. Assignment of a note by a nominee to a beneficial owner does not trigger recognition of gain. Irving Snyder, 66 T.C. 785 (1976), acq., 1976-2 C.B. 3.

g. Death of the seller—

h. Cancellation of an installment obligation is treated as a disposition of the obligation by the holder. I.R.C. § 453B(f).

i. All depreciation recapture on installment sales of real or personal property is taxed to the seller in the year of sale. This is the outcome even if no principal payments are received. This is a change applicable to installment sales entered into after June 6, 1984, except for contracts binding on March 22, 1984.

j. Exchange of the property securing the installment obligation for another property without otherwise changing the terms of the obligation is not a disposition. Ltr. Rul. 8848054, September 7, 1988 (substitution of new property as security for installment obligation secured by property sold under threat of condemnation not disposition of installment obligation).

a. Similarly, an agreement reducing payments, allocating all payments to interest and deferring principal payments (and some interest) for two years is not a disposition. Ltr. Rul. 8606052, November 15, 1985 (warning about using test rate of interest when payments resume). See Rhombar Co., 47 T.C. 75 (1966), acq., 1967-1 C.B. 2 (no constructive receipt on deferral of scheduled payments); Ltr. Rul. 9506018, November 7, 1994 (postponing principal payments was not disposition of note).

b. The substitution of a mortgage contract, in an amount equal to the unpaid balance of the purchase price, payable on the same terms and conditions of payment as the balance under the installment obligation, results only in a change in the type of security and does not constitute a satisfaction or disposition of the installment obligation. Rev. Rul. 55-5, 1955-1 C.B. 331. See Rev. Rul. 82-122, 1982-1 C.B. 80 (substitution of new obligor and change in rate of interest not considered disposition); Rev. Rul. 75-457, 1975-2 C.B. 196 (substitution of obligors, deeds of trust and promissory notes not disposition where no change in terms or conditions of original deeds and notes); Rev. Rul. 74-157, 1974-1 C.B. 115 (substitution of two promissory notes and two deeds of trust for existing promissory note and deed of trust was not disposition). See also Ltr. Rul. 9238005, June 8, 1982 (mere change in collateral securing sale did not affect installment reporting).

a. The gain or loss is measured by the difference between the fair market value of the property at the time of repossession and the seller's income tax basis in the obligation satisfied by receipt of the property.

b. The seller's basis under deferred payment sales is higher, however, with deferred payment sales because the buyer's obligations or evidences of indebtedness are included at fair market value in determining the amount realized at the time of sale.

Example 4

Personal property was sold on June 1, 1982 for $50,000, with a $10,000 cash down payment and a note from the purchaser in the face amount of $40,000 with interest at eight percent. The $40,000 note in 1982 had a discounted fair market value of $38,000. The seller's income tax basis in the property was $30,000 at the time of sale. The purchaser's obligation called for 10 annual payments of $4,000 each beginning July 1, 1983. On August 15, 1985, the seller repossessed the property because of failure by the purchaser to make the payment due July 1, 1985. At the date of repossession, the property had a fair market value of $36,000.

a. A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors. See In re Farrington, 111 Bkrpcy. Rep. 342 (N.D. Okla. [Bkrpcy.] 1990) aff'd, 91-1 U.S.T.C. ¶ 50,115 (N.D. Okla. 1991) (debtor in bankruptcy entitled to business bad debt deduction for advances to corporation of which taxpayer was 49 percent shareholder and Section 1244 loss treatment had no effect on bad debt deduction; debtor's activities more extensive than those of most shareholders); Litwin v. United States, 91-1 U.S.T.C. ¶ 50,229 (D. Kan. 1991), aff'd, 983 F.2d 997 (president's dominant motive for making loans, guarantees and advances to corporation was to protect existing business and further business interest in remaining employed; Price v. Commissioner, 98-1 U.S.T.C. ¶ 50,432 (7^th Cir. 1998) (advances to corporation were capital contributions, not bona fide loans; bad debt deduction denied); In re A.J. Healey, 98-2 U.S.T.C. ¶ 50,836 (N.D. Ga. [Bkrpcy.] 1998) (same); Estate of Blazzard, T.C. Memo. 1991-296(no business bad debt deduction for trust fund portion of unpaid employment taxes of bankrupt closely held corporation in which taxpayer had interest); Edgar H. Gleason, Jr., T.C. Memo. 1991-418 (debt was bona fide business debt arising from debtor-creditor relationship involving products sold to retail service station owner); Robert H. Lagoy, T.C. Memo. 1992-213(loans made to retain client in accounting business gave rise to business bad debt deduction); Jerry C. Baldwin, T.C. Memo. 1993-433 (primary motive to secure salary, a motive proximately related to trade or business); Robert A. Read, T.C. Memo. 1997-262 (general partner as guarantor of bank loan to partnership denied bad debt deduction for payment of loan; no proof right of subrogation became worthless during tax year at issue); Nathan Boatner, T.C. Memo. 1997-379 (no business bad debt deduction for advances to wholly-owned S corporation; repayment of advances depended upon success of corporation); Robert R. Plante, T.C. Memo. 1997-386 (business bad debt deduction denied for cash advances to closely-held corporation); Melvyn L. Bell, T.C. Memo. 1998-136 (business bad debt deduction denied for partially worthless advances to corporations); In re Curry, 96-2 U.S.T.C. ¶ 50,529 (W.D. Va. [Bkrpcy.] 1996) (advances to corporation were investment, not to protect employment). See also Bank of Kirksville v. United States, 943 F. Supp. 1191 (W.D. Mo. 1996) (abuse of discretion by IRS in denying bad debt deduction claimed by local bank from loan charge-offs in 1980s).

b. A corporation's bad debts are always considered business bad debts. See Stemm v. United States, 98-2 U.S.T.C. ¶ 50,636 (11^th Cir. 1998) (not deductible bad debt because not wholly worthless).

a. Taxpayers on the cash method of accounting may not claim a bad debt deduction for payments not yet received or which they cannot collect. See Treas. Reg. § 1.166-1(e).

b. Accrual method taxpayers may take a bad debt deduction for amounts owed if previously reported into income.

a. However, if the creditor purchases the collateral for less than the fair market value of the collateral, the creditor realizes gain or loss to the extent of the difference between the amount of the obligation of the debtor applied to the purchase or bid price of the property and the property's fair market value. Treas. Reg. § 1.166-6(b).

a. Guarantees entered into after 1975 —

b. Guarantees entered into before 1976

a. A description of the debt.

b. The name of the debtor.

c. The business or family relationship between the creditor and debtor, if any.

d. The date the debt became due.

e. Efforts made to collect the debt.

f. Basis upon which the decision was made that the debt was worthless.

a. Form 1120 or Form 1120-S in the case of a corporation.

b. Form 1065 for partnership bad debts.

c. Form 1040 for bad debts in relation to a trade or business as an employee.

d. Schedule F, Form 1040 for bad debts from carrying on the business of farming as a sole proprietor.

e. Schedule C, Form 1040 for bad debts from carrying on a trade or business other than farming as a sole proprietor.

a. Column (a)— enter "Bad Debt".

b. Column (b)— enter "Worthless".

c. Column (c)— enter the date the debt became worthless.

d. Column (d)—leave blank.

e. Column (e)— enter the amount of the debt that is worthless.

f. Column (f)— enter the deductible amount in parenthesis to show that it is a loss item.

a. Damages under the Age Discrimination in Employment Act (ADEA) are not excludible. The U.S. Supreme Court reviewed a Fifth Circuit Court of Appeals decision in Commissioner v. Schleier (Unpub. Op. in T.C. and Court of Appeals) which had excluded an ADEA award from gross income. See Jones v. Commissioner, 97-1 U.S.T.C. ¶ 50,402 (10th Cir. 1997) (damages includible in income).

b. Damages from employment discrimination are not excludible. United States v. Stubblefield, 94-2 U.S.T.C. ¶ 50,515 (S.D. Tex. 1994). Compare Alex M. Foster, T.C. Memo. 1996-26, aff’d, 97-2 U.S.T.C. ¶ 50,687 (9^th Cir. 1997), cert. denied, 10/5/98 (payments in settlement of employment dispute not excludible; settlement agreement lacked language that payments were on account of personal injuries).

c. Amounts received in settlement of an ERISA action are not excludible inasmuch as ERISA does not provide a tort-like remedy. Hemelt v. United States, 122 F.3d 204 (4^th Cir. 1997) (ERISA relief only equitable in nature); Mayberry v. United States, 98-2 U.S.T.C. ¶ 50,632 (8^th Cir. 1998) (same). See Mertens v. Hewitt Associates, 508 U.S. 248 (1993) (only equitable relief under ERISA). But see Dotson v. United States, 95-1 U.S.T.C. ¶ 50,258 (S.D. Tex. 1995), rev'd, 87 F.3d 682 (5th Cir. 1996).

d. As the regulations point out, non-taxable damages include "an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution". Treas. Reg. § 1.104-1(c). See Boyett Coffee Co. v. United States, 775 F. Supp. 1007 (W.D. Tex. 1991) (settlement proceeds not excludible from income as personal injury damages; taxpayer failed to present credible evidence of "tort-type" injury for loss of business reputation). See also Veronica A. Taylor, T.C. Memo. 1995-442 (settlement payment by former employee in breach of contract suit includible in gross income); Gary A. Simko, T.C. Memo. 1997-9 (same); Julius R. Phillips, T.C. Memo. 1997-336 (lump sum payment upon termination of employment deemed severance pay and not excludible even though age discrimination alleged); William Roger Thorpe, T.C. Memo. 1997-342 (same); Neil D. Lubart, T.C. Memo. 1997-343 (same); Joseph J. Gajda, T.C. Memo. 1997-345 (same); Joyce M. Hamm, T.C. Memo. 1997-358 (same). Compare Greer v. United States, 98-2 U.S.T.C. ¶ 50,821 (E.D. Ky. 1998) (severance benefits received in excess of standard severance package excludable; excess payments attributable to potential wrongful discharge claimed); Banks v. United States, 94-2 U.S.T.C. ¶ 50,630 (W.D. Wash. 1994) (claim of employee against union for breach of duty of fair representation was tort-like and excludible from gross income); George Knevelbaard, T.C. Memo. 1997-330 (payments received by dairy farmers from bonds in settlement of lawsuit against dairy professor and distributor for default on contractual obligation to pay for delivered milk excludible as based on tort or tort-type rights; settlement proceeds paid on account of emotional harm to farmers).

e. However, interest on damages for personal injury or sickness is not excludible. Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996) (prejudgment interest on damages from explosion caused by gas leak); Rice v. United States, 834 F. Supp. 1241 (E.D. Calif. 1993) (punitive damages also taxable income although regular damages excludible). See R. S. Kovacs, 100 T.C. 124 (1993), aff'd Unpub. Op. (6th Cir. 6/6/94) (statutorily-imposed interest). See also Delaney v. Commissioner, 99 F.3d 20 (1st Cir. 1996) (39 percent of settlement in negligence action apportioned to prejudgment interest which was taxable); Rozpad v. Commissioner, 98-2 U.S.T.C. ¶ 50,672 (1^st Cir. 1998) (pre-judgment interest in medical malpractice settlement taxable); Michael J. Woods, T.C. Memo. 1998-435 (same); Joseph M. Perry, T.C. Memo. 1998-433 (prejudgment interest taxable); Manuel J. Serpa, Jr., T.C. Memo. 1998-453 (same).

f. Validity of settlement agreements—

g. Punitive damages appear to be includible in gross income. Commissioner v. Miller, 914 F.2d 586 (4th Cir. 1990); Reese v. United States, 24 F.3d 228 (Fed. Cir. 1994); Hawkins v. United States, 30 F.3d 1077 (9th Cir. 1994); Moore v. Commissioner, 53 F.3d 712 (5th Cir. 1995); Rice v. United States, 834 F. Supp. 1241 (E.D. Calif. 1993). See Wesson v. United States, 48 F.3d 894 (5th Cir. 1995) (punitive damages for bad faith action against insurance company not excludible). Robinson v. Commissioner, 70 F.3d 34 (5th Cir. 1995) (punitive damages obtained from bank for failure to release lien not excludible); Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996) (prejudgment interest on damages from explosion caused by gas leak); Willa Mae Barlow Davis, T.C. Memo. 1998-248 (punitive damages in civil suit for refusal to cancel report contract taxable). But see Horton v. Commissioner, 100 T.C. 93 (1993), aff'd, 33 F.3d 625 (6th Cir. 1994). Horton v. Commissioner, supra, will no longer be followed by the Tax Court. Hughes A. Bagley, 105 T.C. 396 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997) (part of settlement agreement involving tortious interference with employment, libel and invasion of privacy consisted of settlement of corporation’s liability for punitive damages and was includible in income). The U.S. Supreme Court has held that a punitive damages award for death from toxic shock syndrome was not excludible from gross income. O’Gilvie v. United States, 117 S. Ct. 452 (Sup. Ct. 1996) (damages not received "on account of" personal injury).

h. In 1996, Congress specified that the exclusion for personal injury or "tort-like" damages does not apply to punitive damages or to damages not attributable to physical injury or physical sickness. Pub. L. 104-188, Sec. 1605(a), amending I.R.C. § 104(a)(2), effective for payments received after August 21,1996. See Rev. Rul. 96-65, 1996-2 C.B. 6 (back pay includible in gross income is subject to FICA, FUTA, and RRTA).

i. Settlement proceeds allocable to a mental distress claim are excludible from gross income. E. Pauline Barnes, T.C. Memo. 1997-25.