Loans and Cancellation of Indebtedness

• Author: William Kratzke
• Pages: 195-254

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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

growth.

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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?

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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.