If the IRS Accepts an Offer in Compromise, Is the Amount Forgiven Taxable?
If the IRS accepts an offer in compromise for a tax debt, is the amount forgiven taxable?
That is an excellent question that our clients ask us from time to time.
When Is Forgiven Debt Taxable?
And the question makes sense because in general, under Internal Revenue Code Section 108, income from the discharge of indebtedness — i.e., debt forgiveness — is taxable unless it meets one of these exclusions:
- The discharge occurred pursuant to a bankruptcy.
- The discharge occurred when the taxpayer was insolvent.
- The discharge is from qualified farm indebtedness — basically, if the discharged debt is a mortgage on a form.
- The discharge is from qualified real property business indebtedness — basically, if the discharged debt is a mortgage on a piece of property the taxpayer used in their business.
- The discharge is from qualified principal residence indebtedness — basically, if the discharged debt is a mortgage on the taxpayer’s primary residence.
And looking at that list of exclusions above, you may conclude that the discharge of an IRS tax debt in an offer in compromise would be taxable for solvent taxpayers because it doesn’t fit into any of those exclusions — it’s not a bankruptcy, the taxpayer’s not insolvent (they could be — but let’s assume they aren’t), and it’s tax debt, not mortgage debt.
So Is Tax Debt Forgiven in an Offer in Compromise Taxable?
So, since the forgiveness of tax debt in an offer in compromise isn’t specifically mentioned in the list of exclusions in IRC Section 108, the question remains: “Is tax debt forgiven in an offer in compromise taxable?”
Eagle Asbestos Packing Co. v. United States
To answer this question, we have to start with a Court of Claims case from 1965 — Eagle Asbestos Packing Co. v. United States.
In this case, a corporation owed $424,367.52 to the federal government for tax years 1943, 1944, and 1945, broken down as follows:
- Tax liability of $356,237.15
- Accrued interest of $68,130.37
The corporation deducted this interest amount of $68,130.37 across the years 1948 and 1949.
In 1949, the corporation submitted an offer in compromise to the Bureau of Internal Revenue (that’s what the IRS was called back then), and in 1951, the federal government agreed to compromise the corporation’s $424,367.52 liability — including the underlying tax as well as the interest — for $314,377.91.
In 1959, a revenue agent from the Bureau of Internal Revenue audited the corporation and determined that it should have included the amount of the $68,130.37 as income.
The corporation lost the audit, they paid the tax, and now they’re suing the federal government in the Court of Claims for a refund because the corporation doesn’t believe that it should be taxed on that $68,130.37 of interest that was settled out in the offer in compromise.
And what did the Court of Claims rules? The Court of Claims ruled in favor of the corporation.
Here’s what the Court said:
“The effect of the compromise settlement itself and the intentions of the parties in entering into it was to extinguish all tax liabilities included in the items making up the compromise…For the above reasons, we hold that plaintiff, being an accrual basis taxpayer, properly deducted the accrued interest of $68,130.37 in 1948 and that no part thereof can be considered to be income in the year 1951.”
The Court of Claims basically said, “Look, when the government accepted that offer in compromise, it was the intention and everybody’s understanding that all tax liabilities connected with that offer in compromise were to be extinguished by the offer amount and that the taxpayer — the corporation in this case — shouldn’t have to pay some additional tax on account of the offer in compromise.”
Now let’s fast forward almost 40 years to 1997 when the Ogden IRS Branch asked the Salt Lake City Associate District Council a number of questions, including this one:
“Should the IRS issue Forms 1099-C when cancelling tax debt of individuals discharged in a bankruptcy case or as a result of an offer in compromise under § 7122?”
Salt Lake City Associate District Council didn’t know the answer, so they posed this question among others to the Assistant Chief Counsel Office in Washington, DC, and the Assistant Chief Counsel Office produced Significant Service Center Advice (SCA) 1998-039 in response.
And here’s what that document says about this issue:
“Cancellation of debt by IRS. Cancellation of a tax debt by means of an offer in compromise does not give rise to discharge of indebtedness income…The court in Eagle Asbestos concluded that a compromise of the interest portion of a tax debt did not give rise to income from the discharge of indebtedness because “[t]he effect of the compromise settlement itself and the intentions of the parties in entering into it was to extinguish all tax liabilities included in the items making up the compromise.” Such an intent could not be fulfilled if taxable income arose from the agreement. This rationale applies equally to cancellation of a tax debt itself, as well as interest on a tax debt. Therefore, no Form 1099-C is required to be issued. However, we note that if the IRS cancels a debt that is not a tax debt, the amount cancelled is includible in discharge of indebtedness income and a Form 1099-C should be issued.”
So there you have it — from the IRS’s own mouth, tax debt cancelled by an offer in compromise is not taxable.