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Student Loan Relief and the Purchase Price Reduction Doctrine

Posted on Dec. 7, 2020
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor with TaxNotes. He formerly worked in the mergers and acquisitions and international tax groups at PwC and at the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP. The views expressed here are his own. He thanks Charles Lincoln for his valuable insights and contributions to this article.

In this article, Willis argues that the common law purchase price reduction doctrine could apply to all government student loan debt relief and many other purchase price adjustments.

Congress and the Trump administration have provided for the cancellation of student loan debt,1 but principal and interest relief, generally or for COVID-19 reasons, could give rise to cancellation of debt income. The government’s replacement of student loan debt with tax debt would be backhanded, and it needn’t be: Government-provided student loan reductions are purchase price adjustments that don’t give rise to tax.

While there are different avenues for relief from tax upon the cancellation of debt, the judicially created purchase price reduction doctrine provides the broadest relief and requires no means testing or other administratively difficult determinations. The fast-approaching December 31 end date for COVID-19-related student loan relief inspired this article’s inquiry into why relieving such debt shouldn’t give rise to taxable income under the general welfare doctrine, but the principles discussed below support offering broad relief from cancellation of debt income in many contexts.

The common law purchase price reduction doctrine is an acknowledgment that the value of the assets or services acquired can’t be equated with the debt, and thus, it is reduced to comport with the correct value and substance of the exchange. It’s an adjustment to observe the value the parties wish to ascribe to property or services, even if determined after the original exchange or by third or unrelated parties that now hold the debt. Some think this broad doctrine has been subsumed by section 108(e)(5), and others have confused it with the contested liability doctrine that applies to a dispute between a debtor/buyer and a creditor/seller regarding the enforceability of all or part of a debt.

A fundamental concept in understanding debt is that borrowing money is a tax-free event because there is no income — the liability offsets the asset and net worth remains the same.2 When the loan amount is reduced, there is generally an accession to wealth. That isn’t the case with a purchase price adjustment, when it is recognized that the cost of an asset — such as a degree — warrants reduction so that its cost aligns with its value. Purchase price adjustments occur all the time for various reasons. It is fully within the government’s purview to reduce the cost of education, through reduced debt and subsidies, in the best interests of the parties and the general welfare. Education has been subsidized by the government for hundreds of years, even though age, gender, and other criteria for such benefits have continually fluctuated.3 But how can it be tax free?

Before we dive in, let’s get practical for a second. Have you ever received a mail-in rebate offer when buying something? You don’t include the check you get in the mail as income on your tax return because it’s a purchase price adjustment.

Did you know the government gives rebates? Below we discuss Rev. Rul. 88-95, 1988-2 C.B. 28, which involves a rebate given through a government program as a third party to help sell cotton to overseas buyers. Like many economic subsidies the government provides, those rebates were intended to help the country. And, yes, governments subsidize education through rebates or their economic equivalents in many ways that are nontaxable, including performance-based academic grants and below-market interest rates.

Now that we’ve gotten our feet wet, it is time for the deep end. I hope you brought your swimsuit.

Governments Broker Education for Their Benefit

The U.S. federal government is a party to more than 90 percent of student loan debt. We can trace the expansion of government funding for education back to the Cold War, when people worried that education in the United States was slipping compared with it in other countries. Concerns about equality expanded in the 1960s when low- and middle-income families often couldn’t qualify for loans without encountering oversized collateral requirements and high interest rates. 

That meant education would continue to be available to only a select few. By helping fund postsecondary education for all citizens and ensuring equal educational opportunity despite differences in wealth, the government intended to improve U.S. competitiveness in the global economy.

Through the Higher Education Act of 1965, the government agreed to help broker the purchase of education to ensure lending to students of all socioeconomic backgrounds and to certify that educational institutions could meet their obligations to provide a valuable education.4 As a generous counterparty, the government was able to ensure low-interest rates on what banks view as high-risk investments. Thus, the resulting loans weren’t arm’s length from the outset: They were always government-sponsored general welfare that subsidized more than 50 million people, including wealthy and poorer students and families.

Does a valuable education only affect home values based on corresponding school districts, or can education move as an intangible asset with the student? One’s education is indeed an asset for relevant tax purposes; as we see in the area of trade secrets, information is protected by various laws, even if that information is found solely in the mind.5 Knowledge is power, including for tax purposes. That logic has been applied to purchase price adjustments to exclude cancellation of debt income for purchases of intangible assets and services.6

Is the government a party to the purchase of education directly as an accreditor and loan provider and indirectly as a guarantor, or is it an unrelated third party that can’t partake in a purchase price adjustment? It certainly is a party to those purchases, and it can indeed be a third party if the borrower suffers from an infirmity or inducement under the IRS’s interpretation found in Rev. Rul. 92-99 that expands beyond a plain reading of section 108(e)(5). (How many people might be an induced by an economy with no jobs for them and a government willing to provide loans for education?) And, yes, the government could be a third party in many other circumstances under the broader common law purchase price reduction doctrine, which has lived on long after the enactment of section 108(e)(5). Of course, not everyone agrees that the common law purchase price reduction doctrine survived the enactment of section 108(e)(5).7

Student Loan Debt Relief

Recent legislation and guidance that suspended loan principal and interest payments have been generous. The Tax Cuts and Jobs Act provided that discharges of student loans through death or permanent disability result in no cancellation of debt income.8 To reduce the economic burdens caused by the pandemic, President Trump issued a series of executive orders that provide relief and instructions for renters, homeowners,9 payroll tax obligations,10 the unemployed,11 and employers. Among those directives is the August 8 “Presidential Memorandum on Continued Student Loan Payment Relief During the COVID-19 Pandemic,” which has the effect of an executive order.12

On March 13 Trump declared a national emergency. The pandemic has created the need for the disaster relief provided in the Robert T. Stafford Disaster Relief and Emergency Assistance Act:13 All 50 states, the District of Columbia, and four territories have been approved for major disaster declarations to assist with needs identified under the nationwide emergency declaration for COVID-19.14 This disaster activates qualified relief payment under section 139, among other things.15 On May 15 the IRS Office of Chief Counsel concluded in INFO 2020-0008 that relief “payments to undergraduate and graduate students” are excludable from gross income under section 139.

Of the 45 million student borrowers in the United States, with a collective student loan debt of more than $1.6 trillion, most are estimated to qualify for student loan debt relief under the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136).16 Section 432(a) of the Higher Education Act of 1965 gives the Secretary of Education broad authority to cancel federal student loan debt.17 The Higher Education Act provides tax relief under the IRC and provides that the “amount of a loan, and interest on a loan, which is canceled under this section shall not be considered income for purposes of title 26.”18 The IRC also excludes from income discharges under “subsection (a) or (d) of section 437 of the Higher Education Act of 1965.”19

The point is that government agencies don’t, and shouldn’t, operate in a vacuum, and that benefits provided by one agency aren’t intended to cause detriments through another agency to those who received the benefits. Unfortunately, it’s unclear whether there is the coordination required to ensure that such unintended consequences don’t occur, and the IRS could argue that without a clear exception, income arises. While the government can give with one hand and take with another, that often stems from a lack of coordination within the government. Treasury is aware of that problem and sometimes provides relief from unintended burdens. Yes, Treasury and the IRS can indeed be taxpayer-friendly to the extent permitted by law.

In Rev. Proc. 2015-57, 2015-51 IRB 863, Treasury excluded from income all student loans that were discharged even though “most” would have qualified for an exception to cancellation of debt income generally includable under section 61(a)(11). While the basis for that broad exclusion is unclear, it was likely a policy decision to address the fraudulent circumstances leading to the issuance of the debt that led to debtors facing hardships.20 It’s unclear how the IRS determined the relative importance of experiencing hardship compared with being subject to fraud and whether both of those circumstances must be present.

Another policy ground on which Treasury likely based its decision was administrability. From an administrative standpoint, it would be better to solve the cancellation of indebtedness issues in one fair action rather than dealing with 50,000 separate actions.21 That may be especially true if the federal government had a role in certifying the institutions that are capable of providing an education deserving of access to federal loan programs.

Presidential Memorandum on Student Loan Debt

The August 8 memorandum directed the education secretary to extend student loan relief until December 31, 2020.22 The memorandum provides on “March 20, 2020, my Administration took action to provide immediate relief to tens of millions of student loan borrowers during the pandemic caused by COVID-19 by both suspending loan payments and temporarily setting rates to 0 percent.” One week after the administration eliminated student loan payments and interest, Trump signed the CARES Act, which provided similar but broader relief.

The March 20 release from Education Secretary Betsy Devos enshrines the Department of Education’s first action to “suspend their payments for at least two months” and eliminate interest for “a period of at least 60 days.”23 The administration explained that a forbearance could be granted to “any borrower with a federally held loan who requests one.” It also acknowledged that “some borrowers may want to continue making payments, like those seeking Public Service Loan Forgiveness.” That treatment should be distinguished from the kind provided under the CARES Act, which treated loan payments as paid for purposes of determining whether compliance with loan forgiveness programs was met.24

Senate Minority Leader Charles E. Schumer, D-N.Y., recognized the importance of the memorandum and continuing student loan forgiveness in a September 22 Senate resolution:

Whereas President Donald J. Trump’s Memorandum on Continued Student Loan Payment Relief During the COVID-19 Pandemic, issued August 8, 2020, will expire on December 31, 2020, causing tens of millions of Federal student loan borrowers to enter repayment on New Year’s Day of 2021, including recent graduates facing one of the toughest job markets in recent history.

The memorandum’s student loan debt relief ends December 31, a rapidly approaching end date that makes the unclear tax consequences more pressing. The TCJA enacted a section for cancellation of debt income under section 108 for death, seemingly reinforcing the need for such laws.25 While such disaster relief may be excluded from income under section 139(b)(4), discussed below, the causal relationship between disaster relief and student loan debtors who aren’t facing hardship raises concerns.

Broad student loan debt relief has gone beyond providing assistance in hardship situations under the administration’s orders, but general welfare principles can target larger needs, including needs that, by being addressed, would benefit the country. Freeing up funds allows for more spending by student loan debtors, which could aid an economic recovery. Bailouts have been designed to prevent larger economic devastation by providing relief to groups, such as the auto industry, that affect many other industries. Student loan debt hurts many industries as well as individuals, including those with unmet health needs targeted for tax relief under section 108(f)’s student loan forgiveness provisions.

President-elect Joe Biden will be inaugurated on January 20, 2021. With 20 days between the expiration of the memorandum’s relief for student loan debt and Biden’s inauguration, there will be unclear tax consequences during that time.

Prior Tax Guidance Is Unclear

Rev. Proc. 2015-57 addressed the taxability of discharged debt of students who attended Corinthian Colleges, for-profit schools that went defunct, diminishing the value of the graduates’ degrees.26 Rev. Proc. 2015-57 provided that the discharge of federal student loan indebtedness would be excluded from income as a general rule.

The revenue procedure provided no legal basis for not taxing discharged student loan debt.27 Did it have to? The federal government didn’t think so, and I agree because the diminished value of their degrees thwarted the students’ ability to get what they originally bargained for. The most reasonable way to measure that change — its ultimate cost determined in accordance with the purchase price adjustment that resulted from the reduction in the debt — is by factoring in the consideration paid for the education.

Rev. Proc. 2015-57 indicated that “most borrowers” with discharged student loans could exclude the discharged amount from income. The purpose of the revenue procedure is to state that the IRS “will not assert that certain taxpayers, whose Federal student loans are discharged under the Department of Education’s ‘Defense to Repayment’ discharge process, must recognize gross income as a result of this discharge process.”28 In other words, the IRS left it up to the Department of Education, even though some of its discharges may have had no clear exception from income.

Rev. Proc. 2015-57 provided that:

The Treasury Department and the IRS believe that most borrowers whose Corinthian student loans are discharged under the Defense to Repayment discharge process would be able to exclude from gross income all or substantially all of the discharged amounts based on fraudulent misrepresentations made by the colleges to the students, the insolvency exclusion, or another tax law authority.”29 [Emphasis added.]

Students were promised X in exchange for Y but received Z; Z is less valuable than X, and Y was reduced accordingly, so the adjustment produced no income. The government can make that call about the value of X, especially as a direct or indirect party to the original agreement. But a purchase price adjustment can be made for nearly any reason the parties agree on. Would a student contest a reduction in the cost of education? No. Thus, a unilateral action by the government to reduce student loan debt is all that’s needed to execute a purchase price adjustment.

The policy behind this revenue procedure is akin to the policy behind contract law’s equitable remedy of rescission, which allows one of the contracting parties to cancel the contract. The parties are allowed to unwind the contract and return to the pre-contract situation.30

Cancellation of Debt Income

The Supreme Court held in Kirby Lumber that the reduction of indebtedness for less than the amount due is income to the debtor for federal tax purposes.31 That case is often a tax student’s introduction to section 61(a)(11)’s income from discharge of indebtedness. The IRS has found that interest reduction costs borne by the government are income to the debtor.32 Even payments from the government to the lender are deemed to be paid to the lender first.33 The IRS made sure to distinguish that determination from interest reductions that are implemented for general welfare purposes, which has particular relevance in light of the global pandemic.34

Interest is compensation for the use or forbearance of money.35 An interest rate reduction could cause a change in yield to maturity, a deemed debt modification, and thus a deemed debt-for-debt exchange. But you need no significant modification to incur cancellation of debt income for unpaid interest. In short, accrued and unpaid student interest generally becomes principal, that is, debt that students are obligated to pay.

Cancellation of debt income that is realized while the debtor is insolvent, as defined by section 108(d)(3), is excluded from income to the extent of the debtor’s insolvency.36 Section 108(d)(3) defines insolvency as the excess of the debtor’s liabilities over the FMV of the debtor’s assets. How easy would it be for student loan holders and the IRS to make this determination in the current economy? In Rev. Proc. 2015-57, the government-determined policy cut against students undergoing the burdensome determination of valuing one’s assets, and the current environment would seem to only increase the importance of this and similar policies.

The FMV of property is the price at which it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. If one is buying an education, what if that person were misled about the price? What if the purchased education is a lemon that offers no or little value, as in the Corinthian case? What if a national disaster diminished the value of degrees and their historic ability to increase earning potential? Must the value of an education reflect its cost? Is the cost of an education already subsidized by the Department of Education? Can a government adjust its subsidies even if the value of an education hasn’t decreased?

Section 108(f) excludes the forgiveness of a limited type of student loan. The agreed-upon discharge must be for students who work for a specified period in specialized professions for some types of employers. Generally, the loans must have been made by governmental entities, schools, and other organizations, such as a section 501(c)(3) nonprofit under a program to encourage students to serve in professions or areas with unmet needs. This provision is narrowly targeted and certainly couldn’t address the tax liabilities resulting from the plethora of differently situated students that could benefit from student loan relief.

Section 108(e)(5)

Should the federal government as student loan lender — and guarantor, accreditor of postsecondary education, deferrer, canceler, forgiver, and discharger — be the collector of possibly more than one third of cancellation of debt income in tax debt caused by its own actions? Or should the federal government view its role in eliminating loan principal or interest, which both give rise to income, as allowing the debt reduction and thus price reduction to qualify as a tax-free purchase price adjustment?

Under section 108(e)(5), cancellation of debt income isn’t recognized when a seller of property reduces the payment obligation of the purchaser.37 Rather, it’s treated as a reduction of the purchase price. It would appear a government could adjust a debt reduction for the debt it is owed, including any resulting tax liabilities.

Section 108(e)(5) was enacted “to eliminate disagreements between the Internal Revenue Service and the debtor as to whether, in a particular case to which the provision applies, the debt reductions should be treated as discharge income or a true price adjustment.”38 The conditions required for a reduction in the amount of a debt to be treated as a purchase price adjustment under section 108(e)(5) are: (1) The debt must be that of a purchaser of property to the seller that arose out of the purchase of such property; (2) the taxpayer must be solvent and not in bankruptcy when the debt reduction occurs; and (3) except for section 108(e)(5), the debt reduction otherwise would have resulted in discharge of indebtedness income.39

In the context of federal student debt, is the federal government a party to the transaction? Does it need to be? Some case law and IRS guidance on the section 108(e)(5) purchase price adjustment exception appear to reach the conclusion only the original buyer and seller may partake in the loan reduction, but other guidance indicates that this isn’t the case unless there is some infirmity that relates back to the acquisition of the property. Here, the infirmity is the possibility of a valuable degree, often given a premium based on accreditation criteria established by the Department of Education as well as a lesser premium for state-only accreditation.40 But why look only to section 108(e)(5)?

Confusion Over the Contested Liability Doctrine

The purchase price adjustment principle is found in section 108(e)(5). Of course, the purchase price adjustment concept was also used in the law underlying the partial codification of the broader common law doctrine. However, because this body of law generally involves a reduction in debt that could be viewed as giving rise to income, I prefer the term purchase price reduction. It has been called the purchase price reduction doctrine and exception along with many other variants, including the “exception for reductions in purchase price.” Treasury has continued to allow reductions in purchase price well outside the plain language of section 108(e)(5) to be tax free, a general tax principal, but it has also confused the common law doctrine with the narrower contested liability doctrine and section 108(e)(5), which was never meant to displace it.

The contested liability doctrine provides that when there is a “legitimate dispute between a creditor and a debtor concerning the existence of a liability, and a compromise between the parties is reached, no discharge of indebtedness income will arise as to the contested and unpaid portion of the original liability.”41 The contested liability doctrine focuses on the legal existence or proper amount of a liability and shouldn’t be confused with the common law purchase price reduction doctrine. The contested liability doctrine has been confused by courts and the IRS, most notably in Rev. Rul. 92-99 and Preslar.42

In Preslar the taxpayers purchased a ranch using a $1 million loan from a bank. Under the terms of the loan, however, written installment contracts for the sale of subdivided ranch lots were assigned to the bank upon sale, and 95 percent of the stated purchase price was credited to the principal of the loan, regardless of what amounts were ultimately collected. The loan was compromised after only $550,540 was paid and the IRS determined that the taxpayer had discharge of indebtedness income. The court provided that a taxpayer generally could adjust the basis by taking into account a debt reduction of the property rather than recognize a gain under section 108(e)(5). However, the Tenth Circuit held that the Preslars weren’t entitled to treat the FDIC settlement as a purchase-price reduction under section 108(e)(5) because that provision “applies only to direct agreements between a purchaser and seller.” The court cited the legislative history that seems to support the proposition that a purchase price adjustment may occur only if there is a direct agreement and that it doesn’t apply “if the debt has been transferred by the seller to a third party (whether or not related to the seller), or if the property has been transferred by the buyer to a third party (whether or not related to the buyer).”43 This stems from the contested liability doctrine; it appears the court failed to examine the legislative history in its entirety and should have paid more attention to the judge providing the minority opinion, who acknowledged the common law purchase price reduction doctrine.

The court recognized an exception for third parties when there is an infirmity, which seems to make little sense when applying section 108(e)(5); infirmity and third-party availability is appropriate, however, when applying the common law contested liability doctrine or purchase price reduction doctrine. But the purchase price reduction doctrine applies to third-party adjustments, infirmity or not. Debts get transferred all the time, and the courts have recognized this doesn’t prevent purchase price adjustments. The Preslar court discussed the contested liability (or disputed debt) doctrine but moved on as if it no longer exists.44 However, a slew of cases cite the contested liability doctrine.45 But it is the purchase price reduction doctrine that the court confused.

In Preslar, dissenting Judge David M. Ebel placed weight on the importance of Sherman, saying that “in reaching its holding that the taxpayers did not realize discharge of indebtedness income, Sherman did not discuss the contested liability doctrine, but rather relied on the purchase-price reduction doctrine.”46 (Emphasis added.) The contested liability doctrine addresses circumstances in which the liability itself is contested because it was fraudulently obtained, for example, and cannot be respected. As the court explained, “Although the majority cites Commissioner v. Sherman, 135 F.2d 68 (6th Cir. 1943), nowhere in the case does the Sixth Circuit state or imply the [infirmity] limitation suggested by the majority.” But the purchase price reduction doctrine lives on.

The Purchase Price Reduction Doctrine

The Bankruptcy Tax Act of 198047 added section 108(e)(5) to the code, which didn’t replace the purchase price reduction doctrine. Footnote 26 in the Senate report provides that a “purchase price adjustment (whether or not described in new section 108(e)(5) of the Code, as added by this bill) continues to constitute an adjustment,” confirming the purchase price adjustment exception continues to apply, and other authorities agree.48 Further, unlike other provisions of the Bankruptcy Act of 1980, for which the underlying congressional reports provide that the “effect of these provisions of the bill would be to overturn” common law, there is no indication that section 108(e)(5) was intended to overturn the common law purchase price reduction doctrine.49

The IRS understands that “a court might recognize a common law (nonstatutory) reduction in purchase price exception” because the agency believes it’s unclear “to what extent the common law exception has survived the enactment of section 108.”50 And while at times the IRS has been uncertain, this has not always been the case. In one field service advice dated October 17, 1995, the corporate division of the IRS chief counsel's office explained that the “judicial exception appears to have survived enactment of the statutory exception. Rev. Rul. 92-99, 1992-2 C.B. 35.” And while this is indeed the proper interpretation of this revenue ruling, it’s clear that the common law doctrine has survived because of the legislative history and plain wording of the narrow statute applicable only to purchase money debt adjusted by the original buyer and seller.

Notable differences between section 108(e)(5) and the judicially created purchase price reduction doctrine are that the insolvency and purchase money debt limitations don’t apply under the common law exception. Thus, insolvent debtors can qualify under the judicial exception, and parties other than the original buyer and purchaser may partake in the purchase price adjustment. While a decline in value has been associated with the purchase price reduction doctrine, those who reduce the purchase price make that determination, which has included third parties (that is, not the original buyer or seller) including in cases with no infirmity.

In INFO 2010-0141 the IRS responded to Sen. Bill Nelson, D-Fla., who inquired about the tax treatment of cancelled student loans that were used to attend a vocational school that had closed. The loans were sold to an unaffiliated third party. Students and cosigners filed suit in various jurisdictions across the country. In their complaints, the plaintiffs alleged fraud as well as violations of state and federal consumer protection acts; they sought to “rescind the contracts.” The IRS explained that in third-party lender cases, it may treat a debt reduction as a purchase price adjustment under section 108(e)(5) to the extent that the debt reduction by the third-party lender is based on an infirmity that clearly “relates back” to the original sale (for example, the seller’s inducement of a higher purchase price by misrepresentation of a material fact or by fraud). Tax exceptions for infirmity and inducements can provide tax relief, but those section 108(e)(5) exceptions to the direct and original party limitation also shouldn’t be confused with the doctrine at issue.

Rev. Rul. 92-99, 1992-2 C.B. 35, provides that third-party purchase price adjustments under section 108(e)(5) are limited to instances in which there is an infirmity in the original transaction. But it also implicitly indicates the common law purchase price reduction doctrine wasn’t replaced by section 108(e)(5) when enacted in 1980. The IRS stated that it:

will not follow Commissioner v. Sherman, 135 F.2d 68 (6th Cir. 1943), involving a third-party lender, to the extent that it relied on Kerbaugh-Empire to permit a purchase price adjustment. The Service will, however, treat a debt reduction in third-party lender cases as a purchase price adjustment to the extent that the debt reduction by the third-party lender is based on an infirmity that clearly relates back to the original sale (e.g., the seller’s inducement of a higher purchase price by misrepresentation of a material fact or by fraud). Cf. Commissioner v. Sherman, 135 F.2d at 70. No other debt reduction [under section 108(e)(5)] by a third-party lender will be treated as a purchase price adjustment. [Emphasis added.]

The IRS was conflating the contested liability doctrine with the purchase price reduction doctrine, which doesn’t require an infirmity that causes the obligation to be legally unenforceable. That confusion was exacerbated by the Preslar majority. Note that the IRS stated that it won’t follow Sherman,51 involving a third-party lender, to the extent that it relied on Kerbaugh-Empire52 to permit a purchase price adjustment. Kerbaugh-Empire had a relatively narrow scope. We must understand those two cases to see that the purchase-price reduction doctrine lives on outside section 108(e)(5).

In Kerbaugh-Empire, a corporation borrowed German marks from 1911 to 1913 to finance construction contracts being performed by a subsidiary, then lost money on the underlying transaction from 1913 to 1918, and finally repaid the loan in 1921 with marks that had depreciated in value. The Supreme Court held that the difference between the purchase price of the marks and the repayment amount wasn’t income in 1921, the tax year at issue; rather, it was a reduction of the loss on the underlying transaction and was therefore not taxable. In reaching its decision, the Court gave controlling weight to the substance rather than the form of the transaction.

The principles of this case have been narrowed, as indicated by Rev. Rul. 92-99. In Colonial Savings, the Tax Court stated:

Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926), which was founded on the major premise that debt cancellation did not, in the constitutional sense, generate income was overruled or modified by United States v. Kirby Lumber Co., 284 U.S. 1 (1931), rev’g. 71 Ct. Cl. 290, 44 F.2d 885 (1930). With respect to borrowing and repayment in the same foreign currency, the vitality of its holding is said to have been lost. National-Standard Co. v. Commissioner, 80 T.C. 551, 568 (1983) (Tannenwald, J., dissenting), aff’d, 749 F.2d 369 (6th Cir. 1984). To the extent that the overall effect of the transaction produces a loss to the debtor, Kerbaugh-Empire retains some vitality. See Vukasovich, Inc. v. Commissioner, T.C. Memo. 1984-611, on appeal (9th Cir., Apr. 30, 1985).53

In Rev. Rul. 92-99, the IRS stated that it “generally will not follow cases permitting a purchase price adjustment by third-party lenders, such as Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940), and Allen v. Courts, 127 F.2d 127 (5th Cir. 1942).” (Emphasis added.) The IRS went on to provide that agreement to reduce a debt between a purchaser and a third-party lender isn’t a true adjustment of the purchase price paid for the property “because the seller has received the entire purchase price from the purchaser and is not a party to the debt reduction agreement.” Good thing they included the word “generally.”

Interestingly, while the IRS focused on section 108(e)(5) and the decision to interpret the plain wording of the statute when an infirmity exists, third party adjustments to what is no longer purchase money debt can only occur by relying on the pre-1980 judicial doctrine authorities, which, like Allen, Hirsch, and Sherman allow for third-party debt reductions, although those cases weren’t focused on the infirmities associated with the contested liability doctrine. Ultimately, an infirmity is one example of proof that the creditor chooses to recognize to allow the cancellation of debt to comport with the purchase price they are accepting. And so there has been overlapping confusion with these principles.54

In Sherman,55 a husband purchased property using a mortgage. The property later passed through his estate to his beneficiaries and the mortgage was transferred, so both the original buyer and the seller were not the owner/debtor and creditor when the debt was reduced. Still the court concluded that “regardless of whether the minds of the parties met upon the exact nature of the transaction, the effect was that the decedent and his wife acquired unencumbered title to property for a price less than the original amount bargained.” It went on to provide that the “final payment of cash and certificates of claim completed the transaction and, viewing it as a whole, there was no gain, since the property at that time was worth less than the unpaid amount of the mortgage. The effect of the whole transaction was a reduction in the purchase price of the property.” (Emphasis added.)

In Hirsch,56 the taxpayer purchased real estate in 1928 for $29,000: $10,000 in cash and the assumption of a $19,000 mortgage. The Great Depression caused the purchased property to depreciate in value to $8,000 in 1936, when the unpaid principal owed to the mortgagee was $15,000. The taxpayer paid $8,000 to the mortgagee, which was accepted in complete satisfaction of the outstanding mortgage debt. The court held that the discount received by the taxpayer wasn’t income and construed the transaction to be a reduction of the purchase price paid (from $29,000 to $22,000) because the taxpayer received nothing of exchangeable value on the cancellation of indebtedness. The court reached this conclusion even though the original mortgage was refinanced with another borrower shortly after the purchase.57

The 1988 case Sutphin distinguished Sherman because the “significant fact common to both Sherman and Hirsch was that, for various reasons, the value of the property was below the unpaid principal amount of the mortgage.”58 That is why the court dissent in Preslar referred to the doctrine as the purchase price reduction doctrine.

Expansive Purchase Price Reductions

Of course, the government has been able to assert the purchase price reduction doctrine when it desires, even if called another name or no basis is cited at all. Rev. Rul. 88-95, 1988-2 C.B. 28, addressed a payment under the Food Security Act of 1985, which authorized payments available for upland cotton produced in the United States. The payments were “designed to reduce the price of domestic upland cotton to the prevailing world market price, and thus to encourage the export of cotton and cotton-based products.” The IRS explained that “generally price rebates received by a taxpayer are not includible in gross income, but instead are treated as a reduction in purchase price, where such rebates do not represent an accession to the taxpayer’s wealth.” (Emphasis added.)

Because the payments were made to compensate the taxpayer for a decline in the value, “the inventory protection payments do not represent an accession to the taxpayer’s wealth.” Yes, this is the rebate ruling I mentioned in the introduction.

Rev. Rul. 73-559, 1973-2 C.B. 299, addressed market discount and price differential payments made by Ginnie Mae to Fannie Mae for acquisition of mortgages. The ruling explained that the “President of the United States, by letter dated August 6, 1971, authorized two new special assistance programs to support the market for FHA-insured and VA-guaranteed mortgages” in which the Government National Mortgage Association (GNMA) “will issue commitments to acquire mortgages from approved mortgage originators (including banks, savings and loan associations, and mortgage companies).”

The payments were designed to reduce the costs of the mortgages. The IRS “held that the basis of the mortgages acquired by [the Federal National Mortgage Association (FNMA)], whether directly from GNMA or from mortgage originators pursuant to commitments assigned by GNMA, is the amount paid therefor by FNMA less the amount, if any, of the payments received from GNMA in recovery of the ‘market discount’ or ‘price differential’ sustained by FNMA upon the acquisition of such mortgages.” The IRS concluded that the market discount and price differential payments aren’t includable in gross income.

In Rev. Rul. 85-30, 1985-1 C.B. 20, the IRS concluded that refunds of a federal manufacturers excise tax received by a taxpayer regarding floor stocks on hand when that the tax was repealed were held not to be includable in gross income, but instead resulted in a purchase price reduction. The IRS explained that “in the instant situation, a retail tire dealer, to the extent the tires (for which the refund was received) have not been expensed through cost of goods sold under the taxpayer’s LIFO cost assumption, has had no accession to wealth that is includible in gross income, but merely has had its purchase price reduced by virtue of the statutorily-authorized reimbursement.” (Emphasis added.) This authorization came from the Highway Revenue Act of 1984, P.L. 97-424.

In Freedom Newspapers,59 a payment made by a party other than the seller, but intimately tied to the purchase agreement, to induce the purchase of property was held to be a purchase price reduction. The broker promised to pay $100,000 to a purchaser of newspapers if the broker failed to sell one of the purchased newspapers within one year. The sale failed to occur, and the $100,000 was paid to the purchaser. In finding that the payment constituted a reduction to the price of the purchased newspapers, even though the agreement to pay the $100,000 was separate from the purchase agreement, the court stated, “It is obvious that the agreement with [the broker] was intended to and succeeded in inducing petitioner’s purchase of the Jackson County Floridan.”

Even though it was made several years after the purchase of the Floridan, the payment related back to the original purchase and thus resulted in a purchase price adjustment. The court went on to say, “In the alternative, we believe petitioner’s position is supportable under the doctrine established by the Supreme Court in Arrowsmith v. Commissioner, 344 U.S. 6 (1952).”

Regarding student loan debt, the goal could be to help debtors recover from the hardships of an economic recession or for the country’s general welfare to allow them to participate in normal economic activities as opposed to repaying government debt.60 In all instances, taxpayers are being subsidized to prevent undue hardships or minimize economic costs and allow for normal spending, which could help the general welfare. While I cannot say what policies advance a government’s agenda and supports the general welfare, the subsidies that have received tax-free treatment relate to a broad array of policies, including education. The historical contested liability doctrine and the broader purchase price reduction doctrine are similar to the relation-back doctrine: Using the same logic, they look to a transaction as a whole and adjust tax consequences accordingly.

Purchase Price Adjustments That Relate Back

A purchase price adjustment relates back to a prior arrangement and adjusts it accordingly. Relation-back principles found in contracts and debt law are known in the tax context as the Arrowsmith doctrine, which connects a later transaction to a prior transaction to provide for consistent tax treatment.61 Courts generally cite Arrowsmith for the principle that two transactions, one occurring after the other, and each integrally related, should be treated as parts of the same transaction, so that the later event should relate back and be given the same effect and treatment as the prior event. This relation-back doctrine is premised on the idea that the tax consequences should be the same as they would be if the prior and the subsequent transactions had occurred at the same time. The Arrowsmith doctrine is commonly used to distinguish capital and ordinary income treatment.

In Arrowsmith, two shareholders liquidated their corporation and divided the proceeds equally. They reported capital gain. Four years later, a judgment was rendered against the liquidated corporation and one of the shareholders. The shareholders each paid one-half of the judgment as transferees of the assets of the old corporation and deducted their payments as ordinary losses. The commissioner determined that the loss claimed by the stockholders was part of the corporate liquidation and classified the loss as capital. The Supreme Court agreed with the commissioner, stating that “their liability as transferees was not based on any ordinary business transaction of theirs apart from the liquidation proceeding.” This resulted in an adjustment for the cost of capital, basis, and capital gain resulting from the liquidation. The liability created an adjustment that related back to the liquidation. The stockholders, in effect, were required to return a portion of the assets received in the liquidation.

Relation-back principles can apply to debts and obligations in various contexts. In Rev. Rul. 83-73, 1983-1 C.B. 84, the IRS treated indemnity payments relating back to a prior transaction as if they had been contributions to capital of a corporate transferor that were made by its shareholders immediately before a merger. In LTR 200743003, the IRS ruled that a selling group’s payment of litigation expenses on behalf of a target corporation was contribution to capital of the target by the group immediately before a taxable sale.

The Supreme Court applied Arrowsmith in Skelly Oil.62 In that case, the taxpayer had overcharged customers for natural gas for several years. When the taxpayer refunded the overcharges, it deducted the full amounts even though deletion allowances were claimed for a portion. The Court determined that the taxpayer was entitled to deduct the amounts that didn’t already offset income.

The Tax Court applied the Arrowsmith doctrine to a renegotiation of a prior sale in Wener.63 In that case the taxpayers were partners in a partnership and conveyed their partnership interests to other partners, receiving a cash down payment and an agreement to receive the remainder of the purchase price over three installments. In the year after the sale, a pressing need for funds motivated the taxpayers to negotiate a settlement of the remaining installment obligations. The taxpayers settled for an immediate cash payment that was less than the amount remaining under the installment agreement and treated the difference as an ordinary loss. The court rejected the taxpayer’s argument that the sale and the settlement were two separate transactions. The Tax Court stated, “Prior to the dates the remainder of the purchase price was to become due, there was a renegotiation, adjustment, or revamping of the sale itself both as to price and the terms of payment. [There was] a renegotiation and revision of the unexecuted provisions of the sales contract itself and the substitution of new provisions therefor.”

Regardless of how much time has passed between an acquisition and an adjustment, a reduction in purchase price generally results in a reduction in basis.64 Of course, if no basis resulted from a purchase, then no basis concerns arise from a price reduction. Arrowsmith authorities have indicated that the motivation for the purchase price adjustment can be irrelevant to properly determining the characterization, or substance, of a transaction and the total consideration paid.65

General Welfare Exclusion

The preamble to the Constitution provides that one of its purposes is to promote the general welfare. And Congress is granted taxing power under the taxing and spending clause of Article I, section 8: “The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States.” While serving in 1791 as the first Treasury secretary, Alexander Hamilton described what was meant by the term “general welfare”:

The phrase is as comprehensive as any that could have been used, because it was not fit that the constitutional authority of the Union to appropriate its revenues should have been restricted within narrower limits than the “general welfare,” and because this necessarily embraces a vast variety of particulars, which are susceptible neither of specification nor of definition. It is, therefore, of necessity, left to the discretion of the National Legislature to pronounce upon the objects which concern the general welfare, and for which, under that description, an appropriation of money is requisite and proper. And there seems to be no room for a doubt that whatever concerns the general interests of learning, of agriculture, of manufactures, and of commerce, are within the sphere of the national councils, as far as regards an application of money. The only qualification of the generality of the phrase in question, which seems to be admissible, is this: That the object to which an appropriation of money is to be made be general, and not local: its operation extending in fact or by possibility throughout the Union, and not being confined to a particular spot.66 [Emphasis added.]

Our government has long understood that “the ability to fund an education is critical to the general welfare and prosperity of the United States, and the continuation of the tax-payer funded student loan program is essential to affording all individuals an opportunity to obtain an education to provide for a better future.”67

Section 139(a) provides that gross income shall not include any amount received by an individual as a qualified disaster relief payment. Section 139(b)(4) defines “qualified disaster relief payment” as any amount paid to or for the benefit of an individual if that amount is paid by a federal, state, local government, or agency or instrumentality thereof, in connection with a qualified disaster to promote the general welfare, but only to the extent that any expense compensated by that payment isn’t otherwise compensated for by insurance or otherwise.68 Section 139(c)(4) provides that regarding this general welfare exception, a qualified disaster means a disaster that is determined by an applicable federal, state, or local authority (as determined by the secretary) to warrant assistance from the federal, state, local government or agency, or any instrumentality thereof.69

Yes, a government agency can determine if amounts “paid” by a government, which would include amounts it is owed even if circular, are excluded from gross income to promote general welfare.70

Notice 2012-75, 2012-51 IRB 715, recognizes that a sovereign government must be able to determine for itself what is best for the general welfare of its people. It also recognizes that need can be determined by that government and can look to an entire group of people based on their understanding of what is needed to promote the general welfare. The notice provides the IRS will “conclusively presume that the individual need requirement is met for each tribal member, spouse, or dependent receiving a benefit under the housing programs, educational programs, elder and disabled programs, other qualifying assistance programs, and cultural and religious programs.”

Rev. Proc. 2014-35, 2014-26 IRB 1110, expands on the notice by clarifying that educational assistance includes “tuition payments for students (including but not limited to allowances for room and board on or off campus for the student, spouse, domestic partner, and dependents) to attend preschool, school, college or university, online school, educational seminars, vocational education, technical education, adult education, continuing education, or alternative education.”

Conclusion

While tax laws aren’t always generous to students, they certainly can be. The purchase price reduction doctrine, distinct from the contested liability doctrine and section 108(e)(5), should protect many students from incurring a tax liability owed to the same government that just helped reduce their student debt. The concerns regarding original parties and insolvency are nonexistent for the common law purchase price reduction doctrine. An infirmity to a legal obligation is unnecessary for a creditor to agree to reduce debt, whether it is the original lender or a third party. The purchase price reduction doctrine can be used to promote the general welfare and ultimately provide a sound, reasonable basis for the tax-free treatment of cancellation of debt income for all students released from debt by the government.

FOOTNOTES

2 Commissioner v. Tufts, 461 U.S. 300 (1983) (“When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.”).

3 Jurgen Herbst, The Once and Future School: Three Hundred and Fifty Years of American Secondary Education (1996).

4 Higher Education Act of 1965, P.L. 103-208.

5 See, e.g., Pelican Bay Forest Products Inc. v. Western Timber Products Inc., 297 Or. App. 417, 443 P.3d 651 (2019), rev. denied, 365 Or. 721, 453 P.3d 544 (2019) (finding value and legal rights attach to a memorized trade secret). This is the logical result. An oral agreement can create or destroy valuable legal rights and modify tax consequences. See Benjamin M. Willis, “Taking Stock of Voting Rights,” Tax Notes Federal, Nov. 25, 2019, p. 1309; and reg. section 1.957-1(c), Example 7 (treating a U.S. owner of 45 percent of a foreign corporation’s stock as owning 90 percent of the corporation’s voting power for controlled foreign corporation classification purposes based on an oral agreement authorizing the U.S. owner to direct the votes attributable to the stock held by a 45 percent foreign owner).

6 See Zarin v. Commissioner, 92 T.C. 1084 (1989), rev’d on other grounds, 916 F.2d 110 (3d Cir. 1990) (concluding that the purchase price adjustment doctrine covers intangible property and tangible property based on the plain meaning of property); see also ILM 200039037 (citing Alan Gunn, “Another Look at the Zarin Case,” Tax Notes, Feb. 25, 1991, p. 893: “Although the purchase price discount authorities our research uncovered deal mostly with adjustments to the purchase price of property, the theory is likewise applicable to the purchase of services.”); and INFO 2010-0141 (providing “the agreement to purchase educational services, and any discharge of indebtedness income could be excludable from gross income under section 108(e)(5)”).

7 Many cite a case we’ll discuss below for this view, which we’ll dispel. For a recent example, see Walter D. Schwidetzky’s, “Partnership Debt Workouts During a Pandemic,” Tax Notes Federal, Oct. 12, 2020, p. 259 (“Before the enactment of section 108, there were judicially crafted exceptions. For the most part, these have gone the way of the dodo bird, and section 108 is typically seen as providing the exclusive exceptions to COD income inclusion. See Gitlitz v. Commissioner, 531 U.S. 206, 215 (2001) (stating that section 108 provides exclusive insolvency exception); and Preslar, 167 F.3d at 1332-1333 (section 108(e)(5) provides exclusive purchase price reduction exception).”).

8 This applies to discharges of indebtedness after December 31, 2017, and before January 1, 2026, under section 108(f)(5).

11 Office of the President, “Presidential Memorandum on Authorizing the Other Needs Assistance Program for Major Disaster Declarations Related to Coronavirus Disease 2019” (Aug. 8, 2020). (“As of April 18, 2020, I have declared that a major disaster exists in all States and territories as a result of the virus, and have authorized Emergency Protective Measures (Category B) pursuant to section 403 of the Stafford Act (42 U.S.C. 5170b) for each. To provide financial assistance for the needs of those who have lost employment as a result of the pandemic, I am directing up to $44 billion from the DRF at the statutorily mandated 75 percent Federal cost share be made available for lost wages assistance to eligible claimants, to supplement State expenditures in providing these payments.”).

12 Office of the President, “Memorandum on Continued Student Loan Payment Relief During the COVID-19 Pandemic” (Aug. 8, 2020). The Supreme Court has held that there is no difference between a presidential executive order and a presidential memorandum or other proclamation or directive in Wolsey v. Chapman, 101 U.S. 755 (1879). Chief Justice Waite of the Supreme Court wrote “A proclamation by the President, reserving lands from sale, is his official public announcement of an order to that effect. No particular form of such an announcement is necessary. It is sufficient if it has such publicity as accomplishes the end to be attained . . . an order sent out from the appropriate executive department in the regular course of business is the legal equivalent of the President’s own order to the same effect.” See also Jessica M. Stricklin, “The Most Dangerous Directive: The Rise of Presidential Memoranda in the Twenty-First Century as a Legislative Shortcut,” 88 Tul. L. Rev. 397 (2013).

13 Stafford Act, as amended (May 2019).

14 Federal Emergency Management Agency list of COVID-19 disaster declarations.

15 One IRS FAQ clearly states: “Section 139(c)(2) of the Code provides that for purposes of section 139 of the Code, the term ‘qualified disaster’ includes a disaster determined by the President to warrant assistance by the Federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, 42 U.S.C. 5121-5207. The President has made such a disaster determination for all 50 states, the District of Columbia, and all U.S. Territories.”

16 Jaleesa Bustamante, “Student Loan Debt Statistics,” Educationdate.org (Apr. 12, 2020) (“35 million of these borrowers may qualify for student debt relief under the CARES Act of 2020” and “44.7 million student borrowers are in debt by an average of $37,584 each.”); see also Zack Friedman, “Student Loan Debt Statistics in 2020: A Record $1.6 Trillion,” Forbes, Feb. 3, 2020.

17 20 U.S.C. section 1082(a)(4) and (6) generally allow the secretary to modify the “rate of interest, time of payment of any installment of principal and interest or any portion thereof, or any other provision of any note” and “release any right, title, claim, lien, or demand,” respectively.

18 20 U.S.C. section 1087ee(a)(5). Other exceptions to discharge student loans may be found under 20 U.S.C. section 1087(c)(4) (FFEL); 20 U.S.C. section 1087dd(g)(4) (Federal Perkins Loan); 20 U.S.C. section 1087e(a)(1) (Federal Direct Loan); and 34 C.F.R. section 682.209(g).

20 Cf. The reasoning in Rev. Proc. 2015-57 “might apply to millions of others, but it would still only apply to a fraction of debtors and not to any debtors facing hardship who were not subject to fraud.” Luke Herrine, “The Law and Political Economy of a Student Debt Jubilee,” 68 Buff. L. Rev. 281 (2020).

21 Rev. Proc. 2015-57 (“ED has estimated that over 50,000 Corinthian borrowers may be eligible for discharges under this program.”).

22 Presidential memorandum, supra note 9.

23 The announcement “Delivering on President Trump’s Promise, Secretary DeVos Suspends Federal Student Loan Payments, Waives Interest During National Emergency” (Mar. 20, 2020), also quotes DeVos: “I commend President Trump for his quick action on this issue, and I hope it provides meaningful help and peace of mind to those in need.”

24 Office of Management and Budget, “Fiscal Year 2019: An American Budget” (2019) (“the Budget eliminates the Public Service Loan Forgiveness program”).

25 Section 108 was amended by section 11031(a)(5) of the TCJA based on the provisions in the Higher Education Act.

26 Rev. Proc. 2015-57, 2015-51 IRB 863.

27 See, e.g., Rev. Proc. 2015-57; Rev. Proc. 2017-24, 2017-7 IRB 916; Rev. Proc. 2018-39, 2018-34 IRB 319. In January, the IRS clarified that a safe harbor exists for taxpayers who receive closed school discharges in Rev. Proc. 2020-11, 2020-6 IRB 406.

28 Rev. Proc. 2015-57. See also Rev. Proc. 2018-39, and Rev. Proc. 2017-24.

29 See also Bruce M. Bird, Michael E. Hopper, and Mohamed Mehanaoui, “IRS Guidance Regarding the Taxability of Certain Discharges of Federal Student Loan Debt,” 124 J. Tax’n 36 (2016).

30 See Rockefeller v. Socialist Workers Party, 400 U.S. 1201, vacated, 400 U.S. 806 (1970). “Section 4 of the Sherman Act, 15 U.S.C. s 4, and s 15 of the Clayton Act, 15 U.S.C. s 25, empower ‘the Attorney General, to institute proceedings in equity to prevent and restrain . . . violations’ of the antitrust laws. The relief which can be afforded under these statutes is not limited to the restoration of the status quo ante.” Ford Motor Co. v. United States, 405 U.S. 562 (1972).

31 United States v. Kirby Lumber Co., 284 U.S. 1 (1931).

32 Rev. Rul. 76-75, 1976-1 C.B. 14.

34 Rev. Rul. 75-271, 1975-2 C.B. 23 (“Mortgage assistance payments that are in substance interest subsidies paid under section 235 of the National Housing Act for the benefit of cash basis calendar year taxpayers are in the nature of general welfare and not includible in their gross income.”).

35 Deputy v. Du Pont, 308 U.S. 488 (1940); Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974); United States v. Midland-Ross Corp., 381 U.S. 54 (1965).

36 Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937).

37 Regarding the plain language of the statute, “the legislative history of sec. 108(e)(5) provides that that section applies only when the debt of a purchaser of property to the seller of such property, which arose out of the purchase of such property, is reduced. See S. Rept. 96-1035 at 16 (1980), 1980-2 C.B. 620, 628.” O’Malley v. Commissioner, T.C. Memo. 2007-79.

38 S. Rept. 96-1035.

39 Juister v. Commissioner, T.C. Memo. 1987-292, aff’d without published opinion, 875 F.2d 864 (6th Cir. 1989) (failing to look at the legislative history that indicates the judicial doctrine applies outside the limits of section 108(e)(5), which itself indicates no displacement of the common law purchase price reduction doctrine). Section 108(e)(5) provides in its entirety: “If — (A) the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced, (B) such reduction does not occur — (i) in a title 11 case, or (ii) when the purchaser is insolvent, and (C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness, then such reduction shall be treated as a purchase price adjustment.”

41 Mertens, Law of Federal Income Taxation 42, at section 11.19 (1996) (citing Zarin, 916 F.2d 110; N. Sobel Inc., 40 B.T.A. 1263 (1939)); Prelsar v. Commissioner, 167 F.3d 1323, 1333 (10th Cir. 1999).

42 Preslar, 167 F.3d 1323.

43 S. Rep. No. 96-1035, at 16 (1980), reprinted in 1980 USCCAN 7017, 7031; see also H. Rep. No. 96-833; and JCS-25-80.

44 Richard M. Lipton, “New Decision Casts a Shadow on the Contested Liability Exception to COD Income,” 90 J. Tax’n 261.

45 See, e.g., Estate of Smith v. Commissioner, 198 F.3d 515 (1999) (“Our conclusion that there can be no discharge-of-indebtedness income is supported by the so-called ‘contested liability’ doctrine.”).

46 Preslar, 167 F.3d 1323 (Ebel stated that the contested liability doctrine was misinterpreted: “Thus, contrary to the majority’s view, the contested liability doctrine is not limited to instances where the taxpayer specifically disputes only the amount of the debt and the original amount was unliquidated. Indeed, the facts of N. Sobel, the seminal contested liability case, belie the majority’s position. There, the taxpayer corporation issued a $21,700 note to pay for 100 shares of a bank’s stock.” See N. Sobel, 40 B.T.A. at 1264. When the note became due, the corporation refused to pay, disputing not the amount of the note but the validity of the note itself “on the ground that the bank made the loan in violation of law and failed to carry out promises to guarantee the [corporation] against loss.” Id. The corporation and the bank settled the dispute for $10,850. The Board of Tax Appeals found no discharge of indebtedness income, even though the corporation didn’t dispute the amount of the debt and even though the original amount was liquidated (at $21,700). Id. at 1265. The board held that the amount of the corporation’s liability was “not actual and present” until the corporation’s later compromise agreement with the bank. Id. at 1265. Given N. Sobel, I believe that the majority is mistakenly narrow in its view that the contested liability doctrine applies only when the original amount of a debt is disputed and unliquidated.). See also N. Sobel, 40 B.T.A. 1263.

47 P L. 96-589 (1980).

48 Baxter Dunaway, “Law of Distressed Real Estate,” section 47:24 (2020) (“Section 108(e)(5) was intended only to provide a safe harbor regarding purchase price adjustments and not to provide the exclusive circumstance under which this special exception is available. As a result, the common law exception to COD continues to be available to taxpayers who do not neatly fit into the statutory exception.”).

49 Specifically, the underlying congressional reports provide: “The effect of these provisions of the bill would be to overturn the decision in Stackhouse v. United States, 441 F.2d 465 (5th Cir. 1971).” See S. Rep. No. 96-1035, at 16 (1980); H. Rep. No. 96-833; and JCS 25-80. Under post-1980 law, section 108 generally applies at the partner level, not the partnership level. See section 108(d)(6). Read as a whole, the 1980 decision by Congress to overturn some common law principles and not others further supports the continued vitality of common law doctrines that were not explicitly eliminated.

50 1998 IRS NSAR 5368, 1998 WL 1993104 (Nov. 2, 1998).

51 Commissioner v. Sherman, 135 F.2d 68 (6th Cir. 1943).

52 Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926).

53 Colonial Savings Association v. Commissioner, 85 T.C. 855 (1985), aff’d sub nom. (7th Cir. 1988). See also Theodore P. Seto, “The Function of the Discharge of Indebtedness Doctrine: Complete Accounting in the Federal Income Tax System,” 51 Tax L. Rev. 199 (1996) (“the reason for the uncertain status of the nonstatutory purchase price adjustment exception is that the line of cases establishing the exception was founded on Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926). Doubts about the continued validity of that case have led to assertions that the nonstatutory exception itself is invalid. . . . The narrowest holding — that no income was recognized on the facts presented — has been legislatively overruled. IRC section 998.”).

54 See also Linda S. Weindruch and David J. Brown, “Scope of Purchase Price Exception to COD Income Questioned in New Ruling,” 74 J. Tax’n 302 (May 1991) (“The judicially created purchase price adjustment exception to the discharge of indebtedness rules has been applied in a much less rigid manner than Section 108(e)(5).”).

55 Sherman, 135 F.2d 68.

56 Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940).

57 Similarly, in Helvering v. A.L. Killian Co., 128 F.2d 433, 434 (8th Cir. 1942), the court concluded that the “transaction in question here was not a mere cancellation of indebtedness, but was a reduction in the purchase price of property brought about by shrinkage in the value of the property and the consequent decrease in the assets of the taxpayer.” The court went onto explain: “This case is in all respects like Hirsch v. Commissioner . . . viewed as a whole, the transaction involved was in its essence a reduction in the purchase price of the property, the cancellation of indebtedness being an incident in the real agreement between the parties.” See also Gehring Publishing Co. Inc. v. Commissioner, 1 T.C. 345 (1942) (“we hold that the net result of the settlement in 1937 was in substance a reduction of the purchase price of the Hotel World Publishing Co. stock from $40,000 to $33,800, and thereafter Ahrens’ cost basis of the stock was $33,800 instead of $40,000”).

58 Sutphin v. United States, 14 Cl. Ct. 545, 550 (1988).

59 Freedom Newspapers Inc. v. Commissioner, T.C. Memo. 1977-429.

60 See also Rev. Rul. 91-36, 1991-2 C.B. 17. Here, the IRS addressed whether a reduction in an energy bill of a customer who participates in an energy conservation program was taxable income. Under the program “energy efficient products or equipment may be acquired from the utility company or from parties unrelated to the utility company” by the customer and the “utility company reflects the price reduction for a customer who participates in the utility’s energy conservation programs on the customer’s monthly electric bill.” The IRS concluded that the reduced purchase price was not “includible in the customer’s gross income under section 61 of the Code.” The IRS’s acknowledgement that a utility company could subsidize purchase price reductions relating to energy efficient products sold by unrelated parties helps clarify the definition of income consistent with the purchase price reduction authorities.

61 Arrowsmith v. Commissioner, 344 U.S. 6 (1952).

62 United States v. Skelly Oil Co., 394 U.S. 678 (1969).

63 Wener v. Commissioner, 24 T.C. 529 (1955), aff’d, 242 F.2d 938 (9th Cir. 1957).

64 Kingfisher Systems Inc. v. United States, 145 Fed. Cl. 22 (2019) (explaining, in the context of a section 108(e)(5) purchase price adjustment, that the “normal tax treatment when there is a purchase price reduction after the close of the year in which an asset is acquired . . . is simply to reduce the basis of the asset.”).

65 Kimbell v. United States, 490 F.2d 203 (5th Cir. 1974) (“The taxpayer argues that Arrowsmith is distinguishable because the payments there were made against a legal liability existing prior to final liquidation and the Arrowsmith taxpayers did not make the payments to protect their business reputations. . . Taxpayer’s subjective motivation for making a settlement payment is irrelevant to the determination of its deductibility. It is the origin and character of the claim against the taxpayer that controls the characterization of settlement expenses for federal tax purposes.”).

66 Hamilton, “Report on Manufacturers” (Dec. 5, 1791); see also Henry St. George Tucker, “The General Welfare,” 8 Va. L. Rev. 167-180 (Jan. 1922).

67 In re Mason, 456 B.R. 245 (Bankr. N.D. W.Va. 2011).

68 Joint Committee on Taxation, “Technical Explanation of the ‘Victims of Terrorism Tax Relief Act of 2001,’ as Passed by the House and the Senate on December 20, 2001,” JCX-93-01 (Dec. 21, 2001). “The exception has been held to exclude from income payments made under legislatively provided social benefit programs for the promotion of the general welfare.”

69 Rev. Rul. 2019-19, 2019-36 IRB 674; Rev. Rul. 57-102, 1957-1 C.B. 26; Rev. Rul. 76-144, 1976-1 C.B. 17; Rev. Rul. 77-77, 1977-1 C.B. 11; Rev. Rul. 98-19, 1998-1 C.B. 840; Rev. Rul. 2003-12, 2003-1 C.B. 283; Rev. Rul. 2005-46, 2005-2 C.B. 120.

70 Jasper L. Cummings, Jr., “The General Welfare Exclusion,” Tax Notes Federal, Oct. 19, 2020, p. 441.

END FOOTNOTES

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