Cancellation-of-indebtedness Income and Transactional Accounting
More than three-quarters of a century after the Supreme Court’s decision in United States v. Kirby Lumber established that the cancellation of a debt produces taxable income, there is still uncertainty - both in the courts and among commentators - concerning the rationale for the taxation of cancellation-of-debt (COD) income. Is the taxation of COD income based on the simple fact that the cancellation of a debt improves the taxpayer’s balance sheet, thus increasing the taxpayer’s net worth in the year of cancellation? Or is it based on a multi-year perspective, in which inclusion of the cancelled debt in income is necessary because the overall transaction - consisting of the creation of the debt in one year and the cancellation of it in another - produces an economic gain for the taxpayer? The choice between the rationales is crucial in a significant number of cases involving no-benefit debts. In a no-benefit debt cancellation situation, the taxpayer received nothing of value when the debt was created. This article examines the theoretical underpinnings of the taxation of COD income, and concludes that the whole-transaction analysis should be recognized as the only rationale for the taxation of COD income, with the result that COD income should not follow from the cancellation of a no benefit debt. The article also analyzes nine fact patterns in which a taxpayer at least arguably received nothing of value when the debt was incurred, so that the cancellation of the debt should not produce COD income. The consideration of one of these categories - cancellations of obligations to pay accrued nondeductible interest - is particularly timely, because of the prospect that hundreds of thousands, or even millions, of taxpayers may soon be relieved of obligations to pay accrued credit card interest. Another of these categories - the cancellation of gambling debts - involves one of the most controversial, and most commented-on, tax cases of recent decades.