Cancellation of debt is taxable if not insolvent
July 9, 2018
Mr. and Mrs. Hamilton got student loans to finance the education of their adult son (Andrew). In 2008 Mr. Hamilton was permanently disabled due to a back injury. In June of 2011 he asked to have the loans discharged (canceled). In 2011 two lenders did cancel loans totaling $158,511.
In 2011 Mr. Hamilton had some "erratic spending behavior" so Mrs. Hamilton took charge of the finances. April 1, 2011, they transferred $323,000 to son Andrew's savings account. Andrew gave Mrs. Hamilton authority and permission to transfer funds from his savings account. In 2011 she transferred money from his (son's) savings account to Mr. and Mrs. Hamilton's checking account and paid most of their household bills on a regular basis.
Mr. and Mrs. Hamilton hired Scott Rasmuson, CPA to prepare their 2011 income tax return. He said they were insolvent and didn't have to include the debt cancellation in taxable income.
They filed their 2011 return on March 14, 2014. It was late. It claimed no income from debt cancellation with form 982 included that indicated their debts were greater than the fair market value of their assets on the dates of debt cancellation. By the way, in 2011, Mr. Hamilton received $308,105 as a nontaxable cash distribution for his 14.4 percent interest in an LLC.
IRS sent a Notice of Deficiency for the 2011 return, charging $44,313 more tax, $12,736 for the failure to file on time penalty and $8,862 for the accuracy-related penalty.
IRS introduced credible evidence relating to the ownership of Andrew's savings account. Since Mrs. Hamilton was transferring funds on a regular basis to pay household bills, the Court found she exercised "dominion and control" over the account. That meant it was counted as an asset to determine if they were insolvent. The court then determined they had much more assets than they reported on their income tax return.
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The Tax Court found Andrew held his savings account as the Hamiltons' "nominee" and the savings account was found to be assets available to the parents. That meant they were not insolvent and the debt cancellation was taxable income.
Their failure to file the return on time was found to be due to willful neglect and not reasonable cause, so that penalty was upheld as IRS assessed.
The 20 percent accuracy-related penalty was canceled by the Court. It was found the IRS had no evidence the immediate supervisor of the auditor personally approved (in writing) that penalty.
Did you hear? "What you are is what you have been. What you will be is what you do now," says Buddha.
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.