Potpourri
==> For some reason, I was thinking about debt forgiveness and how the IRS treats that as taxable income. (In a related point, when Oprah first started giving cars out as prizes, apparently the recipients were upset because they’d get hit with a huge tax bill. So then Oprah had to cover the tax liability too, for her gift of a car to people.)
This came up I’m pretty sure in the wake of the housing bust, where even if a bank forgave somebody’s mortgage debt, the IRS would treat that as taxable income. Libertarians and normal people alike were outraged.
However, notwithstanding that taxation is theft, given the structure, it actually makes sense. Forgiving a debt in terms of the accounting is equivalent to income. (The recipient’s ability to consume without reducing capital goes up the same amount, whether you forgive $10,000 in debt or give the individual $10,000 in cash–at least if you assume the individual could borrow $10k from somebody else, which I agree might be dubious and partly what’s driving the outrage in the Oprah/mortgage examples.)
Anyway, it occurred to me that if the IRS didn’t treat debt forgiveness as income, then a company could hire someone, lend him $100,000 at the beginning of the year, and then just be “nice” and forgive the loan in equal installments each month. The company could still deduct the $100k as a business expense, but the individual wouldn’t have to report it as income, since a loan is not income.
==> I was reading SlateStarCodex and he linked to this previous post from 2014, which I had read at the time, but it was excellent.
Two paradoxes:
1) I had forgiven someone’s debt, and the tax lawyer guy told me you can deduct the current balance *including interest*, but that seemed too good to be true to me — then you can deduct income you never lost but just existed on paper. Is the forgiven interest (counted as) income too? :-O
2) So wait, if you pay someone’s taxes on the gift, isn’t the payment-for-taxes *itself* income? So don’t you have to do some converging sequence thing where it’s like:
$100 gift -> $20 higher tax liability (@20% tax rate)
You pay them $20 to cover it -> $4 higher tax liability
You pay them $4 to cover it -> $0.8 higher…
So really, if you want to give someone gift worth $X, you should have to pay X/(1-t) (where t is their tax rate) in order to cover all the taxes-on-taxes!
Standard accrual accounting works like this: you mow my lawn and charge me $100 but I say, “I can’t pay right now, I’ll pay later”. So the IRS decides you just made $100 income regardless of whether you really got paid; because you already sent me the bill.
A year later I still haven’t paid and you come back and say, “I’m charging you $20 late payment fee!” Now the IRS decides you just made another $20 income.
Suppose I finally pay $120 then the actual cash payment makes no difference to the IRS because they already counted that.
However if your lawn mowing contract stipulated you can charge 20% interest for every year of late payment (indefinitely until paid) then the IRS does NOT count income for infinite future years that haven’t happened yet (even though potentially I might owe you interest at some stage).
The only time your tax lawyer would be correct (by my accounting experience) would be if you had a simple interest contract (i.e. the other guy promised to pay a fixed amount regardless of early or late payment) but I’m not 100% sure simple interest would be legal (YMMV on that one) or he might have been only referring to that portion of the interest that had already come due.
Think about it this way: suppose you pulled out $X in cash and handed that to the other guy, who then handed it right back to you in full payment of the debt, on that day, as per whatever contract you had agreed, and thus totally settled the matter. How big would the $X amount be? That’s what you can claim (and the other guy would see $X as a gift attracting whatever tax might be relevant on the gift).
It’s made more complex in Australia because they frown on business charging interest on debts without a banking license (although it’s a bit of a grey area, but don’t try it) so business offers an EARLY payment discount instead of a LATE payment fee (yeah don’t get me started). Then they nominally get taxed for the full amount but claim back the discount (no really … it’s not interest because we are doing it backwards).
Interesting, thanks!
Tel, most individuals in the USA are on the cash basis for taxes. Very few are on the accrual basis (not so for a lot of corporations). So they would owe taxes only on the amount received during the tax year.
If Silas Barta is using cash accounting then seems very weird to me that he would be claiming ANY unpaid interest on a loan. I dunno how that could work.
Surprisingly enough … the Australian Tax Office already has a Q&A on this specific topic. I’m presuming (without detailed knowledge) that the IRS does it the same way … at least to a first order approximation.
https://community.ato.gov.au/t5/General-tax-questions/Bad-debt-Sole-Trader-Deduction/td-p/323
Out of curiosity I followed the link through to the longer (formal) explanation and found this:
The “capitalized interest” means that somewhere you have written it down on your balance sheet as a capital gain (if you are the lender it’s a gain, if you are the borrower then it’s a cost).
“This came up I’m pretty sure in the wake of the housing bust, where even if a bank forgave somebody’s mortgage debt, the IRS would treat that as taxable income. Libertarians and normal people alike were outraged.”
Wait – were banks forgiving mortgage debt and allowing people to keep the houses. That seems unlikely.
Presumably, they’d be forgiving people who were “underwater” in the sense that they owed more than the house was worth, and presumably only the “underwater” amount would be forgiven. In that case (taxation being theft aside) it makes perfect sense to me that this would be treated as taxable income. You wouldn’t be taxed on the full value of the home, only on the quite literal financial gift you just received, in USD, from a company.
I was audited years ago (They seized my bank account with no notice over $2000. My employer who owed $350K had his drag on for years with no seizures.). I had a job where I had to live on site. In such a case, housing does not count as income (According to tax law). The job being in CA, the agent disagreed assessed the rent I should be paying as income at nearly $3000 a month extra, which exceeded my actual income. This put me greatly in debt (I asked this genius if I still lived with my mom if that would count as income, he said possibly.). The agent’s helpful advice was to get another job which would put me in a higher tax bracket exacerbating the problem; it was like the I Love Lucy episode with the whip cream and cherry coming faster and faster. Fortunately, I was able to see another agent who straightened out the whole mess and took pennies on the dollar for what I owed. My experience has been, ask 5 different agents the same question and get at least 6 different answers.
Wow that sound horrible JimS, sorry to hear about that.
Tis raises the question, if the government forgives a debt, like a student loan, is it income?
And if we follow the Our Father and forgive the trespasses of others against us, do they have to pay a sin tax in heaven?
Dr. Murphy you make everything so complicated. The IRS sees any payment that reduces one’s tax liability as increasing the tax liability of the recipient. This is only common sense. An example would be if I sent a personal check to Tel for $1,000 so that he could go on the Contra-Cruse. Since my tax liability would not change this would be a gift. Tel would not have to declare it. If I wrote him a check from my rental house account and entered it as an expense reducing my rental house tax liability, Tel would then have to declare it as compensation on his US tax return. Obviously Oprah (or else whoever gave her the cars) used the value of the cars as an expense and deducted it from their tax liability, which increased the tax liability for the final possessor of the automobiles. There is no free lunch.
That being said, your bank example leaves much to be desired. Let us say you do a million dollars of work for me this year. I say, “I will pay you $200,000 and lend you $800,000.” Each year for the next four years, I will write off $200,000 of my loan to you. If I paid you in a lump sum your tax liability would be $335,689 at present tax rates. By spreading the compensation over the five years, you will only pay $228,445 in total taxes ($45,689 per year). Either way you will have the total million dollars to spend this year. This is what went on in the Paul Maniford trial. I think it is a clever scheme. But then I understand the principles of depreciation and depletion, which obviously most people don’t. Whether it is better for me to pay you in a lump sum, taking the whole million dollars as an expense this year or spreading my expense over the next four years is solely based on my particular tax circumstance.
One thing to know about debt forgiveness income in the USA. Debt forgiveness income can be excluded to the extent of insolvency. If you have $100,000 in assets and $200,000 in liabilities (including the debt being forgiven) then you are insolvent by $100,000, and may exclude that much in debt forgiveness income.