Court Reluctantly Agrees to Rule on Question Parties Asked, Finding Employee Had to Include Forgiven Interest in Income

The Tax Court gave us a decision in the case of Brooks v. Commissioner, TC Memo 2012-25, though the Court clearly believes it was asked the wrong question by the parties.  The question the Court answered involved whether a taxpayer who had principal and interest forgiven on a loan by his employer could, under the facts of the case, avoid the inclusion of cancellation of indebtedness income on the interest portion of the debt that was forgiven.

The problem the Court found was that it wasn’t really sure there had really been a loan to begin with, thus whether there was either principal or interest that could be forgiven in the year in question.  The taxpayer upon beginning employment with the employer (a stock brokerage firm) had received $500,000 cash.  The employer and taxpayer had a note written up making the amount a loan that was due in five years and had a stated interest rate.  If the taxpayer was still employed with the employer at the end of the five years, the employer agreed to forgive the balance of the loan.  If he left before then, he still would only need to repay a prorata portion of the loan.

While the parties had stipulated that the amount was a loan and that Mr. Brooks had $500,000 of cancellation of debt income in year five, the Court believed that this transaction likely should not have been recognized as a loan for tax purposes.  The Court found the facts of this case virtually identical to those found in the case of Winter v. Commissioner, T.C. Memo. 2010-287.

Since the reason for the “loan” was to induce Mr. Brooks to provide services and the repayment obligation was conditional, the Court believed the proper treatment was to have treated the $500,000 as income in the year it was received.  Mr. Brooks had unrestricted use of the funds and only a contingent obligation to repay, so under the claim of right doctrine he should have included the entire balance in income.

As the Court pointed out, that would create a problem for the IRS because they were litigating the wrong year (the one five years after the taxable event).  And, as well, without the “loan” there also would be no forgiveness of interest (which was the issue the parties were disputing).

But the parties had stipulated that the $500,000 principal was taxable income.  The court noted:

There are limits to what parties can stipulate, and pure statements of law that are just plain wrong may well be out of bounds. But we read the stipulation in this case as an agreement that Brooks received at least $506,300–the principal of the loan–as income in 2003. Because neither party has argued that the stipulation on this mixed question of fact and law doesn’t bind us, we deem this issue waived.

The Court noted, in a footnote, that the parties had also ignored the question of, if there had been a real debt that the income should have been recognized each year as a prorata portion of the debt was “earned” but that for the same reason as it was ignoring the question of the reality of the loan, it would ignore that issue as well.

The Court then moved on to decide the issue that, however questionable its relevance should have been in the Court’s view, was the one the parties wanted resolved—could the taxpayer exclude from income the interest forgiven.  The taxpayer argued that he should be able to exclude the interest under the forgone deduction provision of IRC §108(e)(2).  That provisions holds that if an amount forgiven would have given rise to a deduction had it been paid, the debtor does not include that amount as cancellation of debt income.

Mr. Brooks claimed he used the $500,000 to purchase investment assets, arguing that the purpose behind the loan was to give him a “stake to showcase his skills as a stockbroker to produce income for himself and his wife” which would prove useful for his employer who employed him as a stockbroker.  Unfortunately Mr. Brooks produced no records to trace the proceeds as required under IRC §1.163-8T.  Since Mr. Brooks could not trace the debt to such investment assets, the Court ruled that he had not shown the interest would have been investment interest if he had paid it.

Second, the Court also agreed with the IRS that investment interest is only contingently deductible—a taxpayer must have investment income in order to be able to claim a deduction.  For the year in question his return showed net investment income of only $25.  So the Court agreed with the IRS that even if he had been able to trace the funds to investment assets, he could not have excluded the income because the amount would not have been otherwise deductible.

Advertisement