Take-Away: Discharge of indebtedness income often comes as a surprise to the debtor. It comes as an even bigger surprise to a single member LLC owner who was never obligated to repay the loan that was subsequently discharged.

Background: Income from the discharge of indebtedness occurs where any amount of debt is forgiven and is no longer an obligation of the taxpayer. [IRC 108; IRC 61(a)(12); Revenue Ruling 2012-14.] The only exception is forgiven debt that was qualified in home indebtedness, i.e. a mortgage, but only through 2025. No one really knows why the discharge of indebtedness results in taxable income. But that is what the Tax Code provides There are two basic theories for this inclusion in income: (i) balance sheet theory; and (ii) expectancy theory. The balance sheet theory states that borrowed funds are not income because the loan creates an immediate offsetting debit on the individual’s balance sheet. The individual is no wealthier because the individual’s assets are burdened by the obligation to repay the debt. Thus, when the individual is discharged from debt, those ‘burdened’ assets are ‘freed up’ and that results in the accession to wealth. United States v. Kirby Lumber, 284 U.S.1 (1931). The expectancy theory is that the borrowed funds are not income because we just expect that they will be repaid over time, so what looks like income is just imaginary. Yet when the debt is forgiven that expectation disappears and the forgiven amount of unpaid debt becomes real, not imaginary, income. Commissioner v. Tufts, 461 U.S. 300 (1984.) Most courts use the balance sheet theory to conclude that the forgiveness of debt is taxable income to the debtor.

Disregarded LLC Election: Under 1996 Regulations, an LLC is given the power to choose how to be taxed by the federal government. [Regulations 301.7701-1 through 301.7701-3, for the check-the-box rules.] A single-member LLC  can thus choose to be recognized as a separate taxable entity or it can choose to be totally disregarded. Often the single owner/member will choose to be disregarded. Disregarded status of the LLC means that all business activity is the owner’s activity and the LLC owner/member  reports all activity on his/her Schedule C. There is no separate entity taxation when the LLC is disregarded , even though it is a separate legal entity under state law. The primary benefit of the LLC’s disregarded status is a reduced income tax burden and reduced compliance burden.

A recent Tax Court decision applied the discharge of indebtedness rules to a single member limited liability company (LLC) with a not-so-surprising result that the sole member of the LLC was treated as receiving discharge of indebtedness income.

Steven Jacobowitz v. Commissioner, Tax Court Memo 2023-107 (August 16, 2023)

Facts: Steve was the sole owner of an LLC that had taken out a small business loan. Under state law, Steven had no obligation to repay the loan; it was the LLC’s obligation, not Steve’s. Eight years later, the lender discharged the LLC from its obligation to repay after the LLC ceased to exist. The details follow-  Steve owned and operated a single member LLC called Sagasolutions that was established in 2003. The LLC was a disregarded entity. In 2006 the LLC obtained a $25,000 small business line-of-credit loan from a lender. On behalf of the LLC Steve signed the promissory note and  security agreement. Apparently the LLC ceased in May, 2008, but there was a bit of confusion as to the exact date it was terminated, and how it was terminated. The LLC took advances from and made payments to the line-of-credit on several occasions between 2006 and 2010. The last principal payment on the line-of-credit was made in 2010. In 2016 the lender wrote off the debt because the state’s statute of limitations had run on collecting the debt. The lender sent both Sagasolutions and the IRS Form 1099-C (Cancellation of Debt) for $35,000. In 2016, Steve’s Form 1040 reported gross income of $709,000 from his employment at IBM, but Steve did not report any of the $35,000 of the forgiveness of debt as part of his gross income. The IRS audited Steve’s return and concluded that he should have included the $35,000 in his taxable income for 2016. Steve disagreed and he took  the dispute to the Tax Court.

Tax Court:  The Tax Court found Steve had to report the LLC’s discharge of indebtedness as part of his 2016 income.

LLC Not Separate Entity: Steve argued that under state law, neither he nor any of his personal assets were burdened by the loan made to the LLC. Thus, because the discharge of indebtedness did not free up any of Steve’s personal assets he personally could not have any discharge of indebtedness income. Moreover, by the time that the discharge of indebtedness occurred in 2016, the LLC had long since been terminated, so none of its assets were freed up by the discharge either. The Tax Court judge found Steve’s argument to be “ill conceived.” She observed that Steve’s argument assumed that the LLC was a different taxable entity than Steve. It was not. “Although state law governs the legal relationships that are established when an entity is formed, federal tax governs whether an entity is taxed, or disregarded, as a corporation.” In short, the loan to the LLC was, for federal tax law purposes, a loan to Steve at the time that it was made. Therefore, the discharge of the LLC from its obligation to repay the line-of-credit was also a discharge of Steve’s obligation. “Sagasolutions is treated as a disregarded entity for federal tax purposes, and petitioner, as its sole member, is required to report on his federal income tax return any income (or loss) attributable to Sagasolutions.”

LLC Insolvency: The insolvency of the LLC did not matter. That is because it is disregarded. If Steve had been insolvent in 2016 then he might be able to invoke IRC 108, but when he had reported income in excess of $700,00 from his employment,  it is highly unlikely that he was insolvent at the time of the discharge of indebtedness by the lender.

In sum, the lender’s discharge of a disregarded LLC’s debt results in income to the LLC owner, even though neither the owner nor the owner’s personal assets were ‘on the hook’ to repay the loan and the discharge occurred long after Steve’s LLC went defunct.

Conclusion: While state law might very well shield a single member LLC owner from the LLC’s obligations and debts, it cannot shield that member from the discharge of indebtedness tax consequences if that debt is later discharged when the LLC elected to be a disregarded entity.