Taxability of Discharged Debts: Advantages and Consequences of Bankruptcy

The Internal Revenue Code ("I.R.C." or the "Code") broadly defines gross income as "all income from whatever source derived, including . . . [i]ncome from discharge of indebtedness" I.R.C. § 61(a)(12). Although the I.R.C. does not define "discharge," this has long been understood to include the taxpayer's release from a monetary obligation such as debt forgiveness or by way of a discharge in a bankruptcy case.  

The Internal Revenue Code contains a very specific and generous provision excluding discharge of indebtedness income from gross income if certain conditions are met: "Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if (A) the discharge occurs in a title 11 [i.e., a bankruptcy] case [or] (B) the discharge occurs when the taxpayer is insolvent . . ." I.R.C. § 108(a)(1). It's important to note that the bankruptcy discharge exclusion is a blanket provision that takes precedence over the other enumerated exclusions per § 108(a)(2)(A) and that the insolvency exclusion (but not the bankruptcy exclusion) is limited to "the amount by which the taxpayer is insolvent" (§ 108(a)(3)). In addition, it should be noted that the Code defines "insolvent" in terms of "the excess of liabilities over the fair market value of assets" (§ 108(d)(3)) rather than, as insolvency is sometimes defined, in terms of cash flow (inability of a person to pay obligations as they become due). Thus, a debtor who, through access to credit facilities or otherwise, is current on all outstanding obligations, may nonetheless be insolvent for purposes of the insolvency exclusion promulgated by the Code. A corollary to these rules is that, in some cases, bankruptcy will provide an insolvent—within the meaning of § 108(d)(3)—​debtor a greater gross income exclusion than is available outside of bankruptcy, if such a debtor receives a bankruptcy discharge greater than the amount by which the debtor is insolvent. This is possible in part because the Bankruptcy Code permits debtors to exempt certain assets that could otherwise be used to satisfy the claims of creditors. 

What this means for debtors or prospective debtors in bankruptcy is that bankruptcy provides a way to discharge debts without negative tax consequences: in short, it provides debtors a meaningful fresh start without impairing their post-petition condition with tax burdens arising from discharged obligations.