In the case of Johnston v. Commissioner, TC Memo 2015-91, the IRS argued that the taxpayer failed to report cancellation of debt income in 2007, leading to a tax liability.

The question of whether a debt has been cancelled for the purposes of federal tax law depends on the showing that a debt will never be repaid, taking into account any identifiable event that establishes this fact. The Tax Court cited the case of Cozzi v. Commissioner, 88 T.C. 435 to support the above analysis.

In this case the IRS argued that two separate key factors established this very fact:

The creditor failed to take collection action when the loan became due and payable and
The statute of limitations for collecting the debt had expired

The taxpayer argued that, despite those facts (which the taxpayer did not contest), the deb was not truly cancelled—and the Tax Court agreed with the taxpayer in this case given the facts.

So, in light of the facts the Tax Court pointed out, what could still convince the court that the debt had not been cancelled?

First, the creditor testified that the loan is still considered by the creditor to be outstanding. That fact had been communicated to Mr. Johnston.

As well, the creditor also had never filed a Form 1099C reporting the cancellation nor had the creditor claimed a bad debt deduction on its tax return for any year

Finally Mr. Johnston began repaying the loan via payroll deductions at $1,000 per month.

But what about the fact that the statute of limitations had expired? The Tax Court points out that while this is a factor in considering whether a debt had been discharged, it is not an absolute indicator. The Court notes:

Although under some circumstances the expiration of a State limitations period can serve as an identifiable event, it is not conclusive as to when a debt has been discharged. See Bear Mfg. Co. v. United States, 430 F.2d 152 (7th Cir. 1970); Miller Trust v. Commissioner, 76 T.C. 191, 195 (1981) ("State statutes limiting the time within which a creditor may bring an action against a debtor to recover the debt, while of evidentiary value, are not necessarily controlling."). This is because the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor. Cohen v. Commissioner, 77 F.2d 184, 185 (6th Cir. 1935), aff'g 28 B.T.A. 190 (1933); Miller Trust v. Commissioner, 76 T.C. at 195.

The IRS argued, however, that Mr. Johnston did not begin making payments on the loan until after the IRS began its exam. Thus, in the IRS’s view, the repayments were simply “window dressing” to attempt to bolster the taxpayer’s claim that no cancellation of debt had taken place.

The Tax Court found that a rational person would not have begun making significant payments merely to avoid the tax on COD income. As the Court noted “a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against Mr. Johnston's economic interests.”

The Court also found believable Mr. Johnston’s testimony that he had begun repayment because he believed the debt was actually outstanding. The Court also concluded that the IRS exam merely:

… prompted Waimana and Mr. Johnston to address an overlooked matter. Mr. Johnston testified that he believed either that the SIC loan had been wiped out in Summit's bankruptcy or that repayment had been extended. However, in 2011, after respondent's agent notified Mr. Johnston of the examination, Mr. Johnston met with Mr. Hee and they agreed that the terms of the SIC loan were still in effect.

What an adviser needs to pay close attention to here is the importance of the taxpayer being a credible witness in the case. Frankly the Court’s willingness to accept the taxpayer’s interpretation that the exam merely cause “addressing an overlooked manner” is a rather startlingly taxpayer friendly interpretation of the events—and one that is likely to be accepted only if the Court truly finds the taxpayer credible.

As well, the fact that the taxpayer was not merely making token payments or attempting to claim he “planned to pay off the debt eventually” were key factors in this case.

But it does remind us that even an expiration of the statute of limitations on collections does not necessarily mean, if other facts suggest the parties view the debt as due and are acting to insure repayment, that a taxable event has taken place.