Recognition of "debt modification income" following consumer bankruptcy reform.

• Author: Parker, James O.

EXECUTIVE SUMMARY

* Tax advisers and financial consultants should help clients structure settlements in a way that allows them to exclude discharged debt from gross income.

* Sec. 108 provides an income exclusion for debt forgiveness if taxpayers are insolvent or have debt discharged through bankruptcy proceedings.

* Debtors may avoid recognizing debt modification income if the cancelled obligation is not a valid debt or the modification is a purchase-price settlement.

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The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provided incentives for debtors to negotiate settlement of debts, instead of filing for bankruptcy. This article discusses how to structure settlements to exclude discharged debts from gross income.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (1) (BAP '05), is considered a major overhaul of the U.S. bankruptcy system. Unquestionably, fewer debtors are now eligible to file for Chapter 7 liquidation. The financial accountability and other anti-abuse provisions in the BAP '05 evidence Congress's desire to see a significant number of debtors resolve their financial troubles through negotiated settlements. However, whether such settlements become common, as an alternative to bankruptcy, remains to be seen.

The BAP '05 changes provide an incentive to debtors and creditors to negotiate an alternative resolution. If negotiated settlements become significantly popular as an alternative to bankruptcy, tax advisers and other financial consultants will have to help clients structure those settlements in a way that allows them to exclude discharged debt from gross income.

This article analyzes certain BAP '05 provisions that could result in an increase in negotiated settlements and explains how to avoid discharge of indebtedness (DOI) income (1) under the Sec. 108(a)(1)(B) insolvency exclusion, (2) as a contested liability or (3) as a qualifying purchase-price adjustment. Debtors should be fully informed of the debt modification income that will result from negotiated settlements when these exclusions are unavailable.

Basic Reform Provisions

Means Test

The BAP '05 significantly changes the definition of an "abusive filing" Prior to the BAP '05, it was incumbent on creditors or a court to challenge the propriety of a Chapter 7 filing. The BAP '05 no longer requires creditors or a court to show that a petition for relief constitutes a substantial abuse. It merely requires a determination of abuse (2) and sets forth a "means test" that defines an abusive filing. In light of the means test and other anti-abuse provisions discussed below, an increase in the number of negotiated settlements between debtors and creditors is likely. It is not unusual for laws passed for the purpose of achieving a certain goal to have unintended consequences--that may be the case with the BAP '05. In particular, negotiated settlements with creditors could result in the recognition of DOI income and immediate tax liabilities for already financially strapped debtors.

The means test imposed by the BAP '05 begins with a comparison of a debtor's income to the median income in his or her state of residence. (3) Debtors who earn less than their state's median income are eligible to file for Chapter 7 bankruptcy and eliminate most of their debts with little (if any) payments to their creditors. However, insolvent debtors whose incomes significantly exceed the median income for their state are generally ineligible to file for Chapter 7, and must choose between a Chapter 13 bankruptcy (which requires making monthly payments toward a restructured debt-payment plan) or negotiating settlement of debts directly with creditors.

Credit Counseling

BAP '05 Section 106 provides that individuals seeking relief through the bankruptcy system must have received credit counseling from an approved nonprofit budget and credit counseling agency within 180 days prior to filing a bankruptcy petition. Following credit counseling, debtors who do not qualify for bankruptcy will likely enter into negotiated settlements with creditors.

Realizing that negotiating settlements requires motivation on the part of all concerned, the BAP '05 requires a creditor to engage in good-faith negotiations of reasonable repayment schedules for unsecured consumer debt. Creditors that fail to do so run the risk of having a claim for such debt reduced by as much as 20% by the bankruptcy court. (4) The BAP '05 encourages creditors to accept settlement offers that provide for payment of at least 60% of a dischargeable debt over a reasonable period.

Extended Waiting Period

BAP '05 Section 312(1) also extends the period that a debtor who has previously obtained a bankruptcy discharge must wait before being eligible to obtain another, from six years to eight. Thus, debtors who pass the means tests and find themselves in financial trouble, and who have received a bankruptcy discharge within the last eight years, will be ineligible to file for bankruptcy again. The extension will result in an increased number of debtors ineligible to file for Chapter 7 bankruptcy.

While the BAP '05 is still in its infancy and the effects of the above changes are not yet known, it appears that fewer debtors will be able to avail themselves of protection under the bankruptcy system. The BAP '05 changes could lead to an increased incidence of recognition of debt modification income.

Debt Modification Income

Sec. 61

"Gross income" as defined in Sec. 61(a), is "all income from whatever source derived," and includes "all accessions to wealth, clearly realized and over which the taxpayers have complete dominion." (5) Sec. 61(a)(12) requires taxpayers who have incurred a financial obligation that is later discharged in whole or in part to recognize DOI income to the extent that the obligation is reduced. Taxpayers who are unable to pay their debts, and through negotiated settlements obtain a discharge from all or part of those obligations, realize an accession to wealth; the debt cancellation effects a freeing of assets previously offset by the liability arising from such debt. (6)

Sec. 108

Bankruptcy: Sec. 108(a)(1)(A) excludes from gross income debt forgiveness when the discharge occurs in a "title 11 case." Sec. 108(d)(2) defines a title 11 case as

... a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.

For a debt discharge to qualify for exclusion, the bankruptcy court must explicitly exercise jurisdiction over the discharge of debt; in such cases, a court dealing with related tax issues will generally not second-guess the bankruptcy court's assertion of jurisdiction.

Example 1: J had been a real estate broker for a number of years and established strong relationships with a number of banks. When J decided to open an automobile dealership, those banks lent him $1.5 million for his new venture. J guaranteed the loans. Business was reasonably good, but J began gambling at casinos and suffered large losses. He gambled away the dealership's capital and was unable to remain open. The obligations to the banks went into default. Faced with the demand to pay $1.44 million in delinquent notes, J filed for bankruptcy. He owned sufficient personal...