The potential impact of relief of indebtedness income on settlement agreements

Shenwick & Associates is happy to announce that we have just settled another taxi medallion debt with a favorable result for the client. In resolving this case, IRC (Internal Revenue Code) § 108 was raised in the settlement negotiations, and the purpose of this blog post is to discuss IRC § 108, the structure of the settlement agreement and the impact of IRC § 108 on the settlement.

IRC § 108 provides that if an individual or an entity is relieved of indebtedness, then that indebtedness is deemed to be ordinary income to the debtor or taxpayer, and they must report that income on their tax return. There are two exceptions to this rule; first, if the taxpayer/debtor files for bankruptcy protection, then the relief of indebtedness income is not picked up; and second, on a balance sheet basis, if the individual’s liabilities exceed their assets and they are insolvent, then they do not have to pick up the income.

In many of our taxi medallion workouts, we engage in the workout to avoid a personal bankruptcy filing by the taxi medallion owner, so the bankruptcy filing exception to IRC § 108 does not apply.

An example of the application of IRC § 108 will help to explain the above. Let’s assume that an individual owes a financial institution $1,000,000.  The individual is unable to pay the $1,000,000, so the parties enter into a workout (an out of court settlement) in which the individual repays the financial institution $500,000. According to IRC § 108, the taxpayer must pick up the $500,000 differential between what he or she owed and paid as ordinary income. Many clients assume that the $500,000 of differential would be deemed to be capital gains, but it is ordinary income.

The second question raised by clients is how does the IRS find out about this relief of indebtedness income? The answer is that the institution is required to file a Form 1099-C with the IRS reporting the relief of indebtedness income for more than $600 of forgiven debt.

So now let’s look at our recent taxi medallion settlement and how IRC § 108 impacted the settlement. The facts of the case were as follows: a bank was owed $650,000 for a taxi medallion owned by a mini fleet and the loan was guaranteed by an individual. The owner of the mini fleet and guarantor of the taxi medallion loan was not earning enough money from driving or leasing out the medallion to repay the $650,000 and she didn’t want to file for personal bankruptcy. We negotiated with the bank, and the settlement that was ultimately reached was as follows: (1). the mini fleet would surrender the medallion to the bank; (2) the guarantor would pay the bank $150,000 as part of the settlement; and (3) the parties would enter into a settlement agreement with mutual releases to document the settlement.

The bank drafted the settlement agreement, which provided that the bank would file a 1099-C in an amount to be determined for relief of indebtedness income to the guarantor. We raised this issue with the guarantor, who sought advice from her CPA.  Her CPA indicated that they could not give her clear guidance and that this area of the tax law was murky, but that if the 1099-C was issued to the guarantor, she would pick up a significant amount of taxable ordinary income.

1. We indicated that the settlement agreement should be revised to indicate the amount of the release of indebtedness income. The formula is the amount of the medallion loan, less the amount of money paid by the guarantor, less the value of the taxi medallion; in this case, $650,000-$150,000-$200,000=$300,000.
2. The wild card issue here was what was the value of the medallion when it was surrendered? We track the TLC’s monthly medallion transfer reports, and we advised the guarantor as to what we believed the value of the medallion was. We've also noted that many clients have imputed value for medallions for their internal books and records of $200,000 to $225,000.
3. We also advised the client that it would be better to have the relief of indebtedness income reported the corporation instead of the individual guarantor, and that if the corporation elected to convert from a S corporation to a C corporation, the income would be reported as payable by the corporation instead of the individual guarantor.
4. We’re not tax lawyers, but we are familiar with the IRC and James Shenwick has an LLM in Taxation from the NYU School of Law. We will raise potential tax issues in these workouts for clients, which need to be addressed by their tax advisers or CPAs.

The client acknowledged the tax risk and moved ahead with the settlement agreement, but she indicated that she had losses from other assets which she could offset against the taxi medallion relief of indebtedness income and was thrilled to surrender the taxi medallion and compromise the related loan. We were thrilled to be part of another successful taxi medallion workout!  Clients who own “under water” taxi medallions are encouraged to consult with James Shenwick to discuss their optimal strategy with respect to their taxi medallion loans. Jim