Loans and Cancellation of Indebtedness

AuthorWilliam Kratzke
Chapter 4: Loans and Cancellation of Indebtedness
I. Tax Consequences of
Borrowing Money
In this chapter, we take up various tax
consequences of borrowing money.
The fact that a taxpayer has borrowed
money means that he has more
money to spend. However, it also
means that he has incurred an
obligation to repay the loan. One
precisely offsets the other. Hence,
there are no tax consequences to
taking out a loan. Furthermore,
taxpayer is entitled to spend this
addition to his “store of property
rights” on investment or
consumption – and we treat such
a taxpayer the same as we would
if he had made such a purchase
or investment with after-tax
income. There is no income tax
upon taking funds from the
taxpayer’s “store of property
rights” (minus) and spending
them on consumption (plus), as
such removal and spending
precisely offset. Moreover,
taxpayer’s expenditure entitles
him to basis in whatever asset he
may have purchased.
This does not mean that taxpayer is entitled to income that is not subject to income
tax. Consider how taxpayer will meet his obligation to repay the loan. Taxpayer
will have to acquire money that is subject to income tax – perhaps by working at a
The Tax Formula:
(g ro ss inco m e )
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or
itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from
tables in § 1 (indexed for inflation)
MINUS (credits against tax)
The Tax Code and Economic Growth: A
taxpayer’s opportunity to invest borrowed
funds prior to the time that he has paid
income tax on the income necessary to invest
an equivalent amount has tremendous growth
implications for the nation’s economy.
Imagine how much more slowly the economy
would grow if borrowed funds were subject
to income tax immediately upon receipt.
There would still be markets for credit, but
the higher cost of borrowing would mean that
there would be less borrowing and slower
job in exchange for wages pay income tax on that income, and use what remains
after payment of taxes to repay the loan. By taking out a loan, taxpayer has made a
future consumption choice, i.e., repayment of the loan. Consistent with the
principle that borrowing money is not income to the taxpayer is the rule that
repayment of loan principal is not deductible.
II. Cancellation of Indebtedness
All of this assumes that taxpayer will indeed repay the full amount of the loan.
Consider now what happens when we no longer make this assumption. Taxpayer
does not repay the loan, and for whatever reason, no longer owes it.
•Taxpayer has enjoyed the benefits of an expenditure on consumption
without an offsetting (net) reduction to his store of property rights.
•Taxpayer no longer commits his future consumption choices to repayment
of the loan.
•Should we regard this as an accession to wealth and treat it as gross
income? See § 61(a)(12).
Or: perhaps the assets (e.g., a business venture) that taxpayer purchased with the
borrowed funds and upon which taxpayer relies to repay the loan shrink in value so
that taxpayer is no longer able to repay the loan.
•Should this excuse a failure to repay the loan because such shrinkage can
hardly be regarded as an “accession to wealth?”
•If we deem such a shrinkage not to be an “accession to wealth,” we
effectively merge the borrowing transaction and the spending or investing
of the loan proceeds into one transaction. Is this appropriate? Or should we
account separately for
•the borrowing and repayment, and
•the fate of the enterprise in which taxpayer spends or invests the
loan proceeds?
Or: Perhaps taxpayer is able to take advantage of market conditions to satisfy his
obligation by paying less than the amount that he originally borrowed.
What answers to these questions does this leading case suggest?
United States v. Kirby Lumber Co., 284 U.S. 1 (1931)
MR. JUSTICE HOLMES delivered the opinion of the court.
In July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for
$12,126,800 for which it received their par value. Later in the same year, it
purchased in the open market some of the same bonds at less than par, the difference
of price being $137,521.30. The question is whether this difference is a taxable gain
or income of the plaintiff for the year 1923. By the Revenue Act of (November 23)
1921, c. 136, § 213(a), gross income includes “gains or profits and income derived
from any source whatever,” and, by the Treasury Regulations authorized by § 1303,
that have been in force through repeated reenactments, If the corporation
purchases and retires any of such bonds at a price less than the issuing price or face
value, the excess of the issuing price or face value over the purchase price is gain
or income for the taxable year.” Article 545(1)(c) of Regulations 62, under Revenue
Act of 1921. [citations to more regulations omitted]. We see no reason why the
Regulations should not be accepted as a correct statement of the law.
In Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned
the stock of another company that had borrowed money repayable in marks or their
equivalent for an enterprise that failed. At the time of payment, the marks had fallen
in value, which, so far as it went, was a gain for the defendant in error, and it was
contended by the plaintiff in error that the gain was taxable income. But the
transaction as a whole was a loss, and the contention was denied. Here, there was
no shrinkage of assets, and the taxpayer made a clear gain. As a result of its
dealings, it made available $137,521.30 assets previously offset by the obligation
of bonds now extinct. We see nothing to be gained by the discussion of judicial
definitions. The defendant in error has realized within the year an accession to
income, if we take words in their plain popular meaning, as they should be taken
here. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.
Judgment reversed.

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