Most bankruptcy attorneys have settled claims or debts being asserted against our clients. We try to get the best settlement, which is usually the least amount for our client to pay. Clients appreciate that. They want to save money.

But, when the same client later gets an income tax bill (1099) for the amount of debt forgiven, we may have some explaining to do.

Clients facing financial distress probably will not think about income tax planning. Their focus is on the debt and the havoc it wreaks on their personal lives. They may, on their own or with the help of counsel or other financial advisors, liquidate assets to pay debts, negotiate debt settlements, or proceed with bankruptcy. Any of these actions could result in income tax liabilities that might have been avoided with proper planning.

Two Transactions that Trigger Tax Consequences

Two ​types of transactions commonly trigger income tax consequences for our clients.

A transfer of assets may trigger recognition of gain or loss. So, when assets are liquidated to fund settlements, the capital gain must be considered.

Cancellation of debt may or may not result in recognition of income, depending on the timing and the debtor's circumstances. Debt forgiveness is generally treated as ordinary income. IRC ​§ 61(a)(12) provides that gross income includes, "income from discharge of indebtedness." The original loan or extension of credit was not reported as income because the borrower had an obligation to repay the loan or credit extended. Thus, the borrower had realized no increase in wealth.

CODI

If a loan is forgiven or the balance settled for less than the amount owed, the borrower does have an increase in wealth. This increase in wealth is generally reported as cancellation of debt income (CODI). And it is taxed at ordinary rates.

CODI is generally the difference between the principal balance owed and the amount paid in settlement. It can also include interest if the interest is not otherwise deductible. If property is repossessed and sold, the fair market the value of the property is treated as the settlement amount paid.

Guarantors Excluded

The U.S. Supreme Court in U.S. v. Kirby Lumber Co.​, ​284 U.S. 1 (1941), held that the elimination of liability resulted in an increase in the taxpayer's net worth.

The same is not the case for a guarantor. In Landreth v. Commissioner (1968), the tax court held that a guarantor does not realize CODI due to the underlying debt being paid nor if they are relieved of their contingent liability.

The reasoning is that guarantors do not have their overall wealth increased by relief of debt, as did the debtor, but are simply preventing the decrease of wealth. This is true even if the guaranty has been reduced to a judgment. In Whitmer v. Commissioner (1992), T.C. Memo. 1996-83: "[C]ommissions and loan proceeds that were the subject of the debt went to Midwest, and they did not go into the petitioner's pocket."

Exceptions to CODI

IRC § 108​ allows several exceptions to the recognition of CODI as gross income:

• Bankruptcy – IRC § 108(a)(1)(A). Discharge must be received.

• Insolvency – lRC § 108(a)(1)(B). Liabilities must exceed asset value immediately before and after the cancellation of debt. IRC § 108(d)(3). In making this calculation, all assets are counted, including those that may be exempt from the claims of creditors. Carson v. Commissioner, 116 P.C. 87 (2001). This exclusion applies only to the extent of the insolvency.
  
  The determination of insolvency is based on the taxpayer's liabilities and assets immediately before the discharge of debt. IRC § 108(d)(3). The taxpayer has the burden of proof. IRC Rule 142(a). Traci v. Commissioner, T.C. Memo. 1992-708; Bressi v. Commissioner, T.C. Memo. 1991-651, affd. 989 F.2d 486 (3rd Cir. 1993). The taxpayer must prove by a preponderance of the evidence that he or she will be called upon (as of the date of cancellation of the debt) to pay an obligation claimed to be a liability and that the total amount of liabilities exceeds the fair market value of his or her assets. Merkel v. Commissioner, 192 F.3d 844, 850 (9th Cir. 1999), affd. 109 T.C. 463, 468 (1997). Tabrezi v. Commissioner, T.C. Memo. 2006-61.

• Qualified Principal Residence lndebtedness – lRC § 108(a)(1 )(E). There is no exclusion for income as qualified principal residence indebtedness unless the debt cancellation is subject to an arrangement that was entered into and evidenced in writing before Jan. 1, 2026. Any other applicable exclusions may still be applied.

• Expenses Deductible if Paid – IRC § 108(e)(2). Expenses for which the debtor could claim a tax deduction will not result in CODI. This is because the deduction would kick in if the debt had been paid. If the lender forgives the obligation or the tax-deductible interest, the cancelled debt is not reported as income.

• Installment Purchases – IRC § 108(e)(5). If the debt is owed by the original buyer to the original seller, cancellation of any unpaid portion of that debt is not reported as income. Rather, the purchase price is adjusted. The seller therefore has less gain to report, and the buyer has a lower basis in the asset purchased.

• Qualified Farm lndebtedness – lRC § 108(a)(1)(C). To qualify as a farmer, at least 50% of the debtor's aggregate gross receipts for the three years prior to debt cancellation must have been attributable to farming. The debt must be owed to an unrelated lender and have been incurred directly in the farming operation.

• Qualified Real Property Debt – IRC§ 108(a)(1)(D). Such debt generally must be incurred for the acquisition of real property used in a trade or business and must be secured by that real property. There are limitations in this exception. Discharge of certain indebtedness due to Midwestern disasters.

• Certain businesses repurchasing their own debt.

An Example

Client, aged 55, makes $97,000 per year, and owes $150,000 on ten credit cards. You settle each of them for $0.60 on the dollar, or a total of $90,000. Your fees and costs are $1,000 per account, or a total of $10,000. Client withdraws $100,000 to fund this settlement.

Client saved $50,000, right?

No. $60,000 forgiven will be CODI and taxed at ordinary income rates. This additional income will move our taxpayer client from the 22% bracket to 24%, so the additional tax on the $97,000 income will be $1,940. The tax on the $60,000 CODI will be $14,400. The client will also incur the 10% additional tax for early withdrawal from the IRA, or another $10,000.

The Wisconsin income tax will be 5.3%, or $5,300. The total cost to the client, then, is:

• $90,000— paid in settlement

• $10,000 – attorney fees and costs

• $31,640 – taxes

• $131,640 – total

The client still saved money, but not nearly as much.

If the client had filed bankruptcy, there would not have been any tax on the CODI, as the debt discharged in bankruptcy is not subject to recognition as income. The client would have paid approximately $4,000 in legal fees and costs. This assumes that the client would qualify and not lose assets in that proceeding.

I tell my clients that they probably want to settle at the least net cost. Least net cost is the combined total of the amounts paid in settlement, the cost and attorney fees in reaching that settlement, and the taxes which must be paid as a result of the settlement. All three are important factors and need to be considered, as well as the other options available.

This article was originally published on the State Bar of Wisconsin’s Solo/Small Firm & General Practice Blog of the Solo/Small Firm & General Practice Section. Visit the State Bar sections or the Solo/Small Firm & General Practice Section webpages to learn more about the benefits of section membership.