Tax Effects Of Compromising A Disputed Debt

Section 108 and section 61(a)(12) of  the Internal Revenue Code set forth “the general rule that gross income includes income from the discharge of indebtedness.” I.R.C. § 108(e)(1). Even if the debt was a non-recourse obligation, if there exists collateral in association with its discharge, the amount of the non-recourse debt is taxable upon discharge, if liquidated, at face value. I.R.C. § 108(d)(1). In this instance, the basis or FMV or the property is of no consequence. See, e.g., IRS publication 468, Chapter 2.

However, where there exists a dispute concerning the validity of the debt ab initio, its taxability as imputed income upon discharge remains at issue. Further, if and when the obligation is settled through negotiation or accord the amount of the settlement is deemed to be the amount taxable if thereafter written off. N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939).

Generally, of course, a settlement will result in payment on compromised terms, whereupon there will be no imputation of taxable income. United States v. Hall, 307 F.2d 238 (10th Cir. 1962). In these instances, the amount originally claimed over and above the compromised amount is not taxable. Id. (See also, Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990). So, for example, even where a debt is incurred unlawfully, such as an illegal gambling debt, its discharge, compromise, negotiation, or settlement may fix the amount actually owed. At that point, an accord and satisfaction thereof will negate any otherwise taxable event. Zarin, 916 F.2d at 116.