Cancellation of Debt - Explained
What is Cancellation of Indebtedness?
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Table of ContentsWhat is Cancellation of Debt (COD)?How Does Cancellation of Debt Work? Negotiating with CreditorsDebt Relief ProgramsBankruptcyAcademic Research on Cancellation of Debt (COD)
What is Cancellation of Debt (COD)?
Cancellation of debt (COD) is an act of relieving a debtor of a debt obligation. It is sometimes referred to as debt forgiveness, when a creditor lets go of debt repayment, thereby relieving the debtor. There are many reasons a cancellation of debt can occur, in most cases, debtors plead with their creditors to forgive their debt. In some cases, debtors file for bankruptcy through a debt relief program so that their debts can be cancelled.
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How Does Cancellation of Debt Work?
Distressed or bankrupt borrowers can negotiate with their creditor for debt cancellation or forgiveness. This provides a relief for the debtors as well as economic support for those that are indigent. Debtors can also file for bankruptcy under a debt relief program to have their debts cancelled. In the United States, cancelled debts are taxed under the taxable income of the creditor. The creditor records cancelled debts, these debts are contained as income on a 1099-C for the debtor.
Negotiating with Creditors
Cancellation of debt by a creditor is not an easy thing to come by. Most creditors are unwilling to cancel debts owed by debtors. Typically, creditors generate income through interest payments on debts and well as the repayment of debts, this is why negotiation for debt cancellation can be a daunting task. Some creditors have debts relief provision in credit contracts while some do not have any provision for cancellation of debts. Credit relief services attract additional fees. Generally, some loans issued by the government can be forgiven, debt forgiveness and debt cancellation are often common in mortgage loans, student loans and some other government programs.
Debt Relief Programs
In the United States, there are debt relief programs that borrowers can access to get their debts cancelled. The National Foundation for Credit Counselors is an organization that helps individuals identify the debt relief program most suitable for them. A common practise in debt relief is that debtors will cease paying to creditors, so that they can be at an advantage of getting debt cancellation. Over the years, debt cancellation or forgiveness has benefited borrowers that became bankrupt or delinquent, thereby unable to make debt repayment. Some debtors also seek the service of debt settlement companies to help them negotiate debt cancellation in exchange for a fee. These companies often request an access to the credit profile of a debtor so as to negotiate for cancellation directly with the creditor.
Bankruptcy is a condition that puts debtors on a favorable pitch or at an advantaged side when it comes to debt cancellation. A bankrupt debtor or a distressed debtor can file for bankruptcy under the debt relief program. This individual can also seek the support of the court or an attorney.
Academic Research on Cancellation of Debt (COD)
- IRS Proposes ScrappingCODNonpayment Testing Period: The Service Says the 36-Month Period for ReportingCancellation-of-DebtIncome Is Ineffective and Prone Schreiber, S. P. (2015). IRS Proposes Scrapping COD Nonpayment Testing Period: The Service Says the 36-Month Period for Reporting Cancellation-of-Debt Income Is Ineffective and Prone to Confusion.Journal of Accountancy,219(1), 68. Because the IRS believes that requiring the filing of Form 1099-C, Cancellation of Debt, at the expiration of a 36-month nonpayment of debt testing period "creates confusion for taxpayers" and does not increase tax compliance, the Service released proposed regulations to eliminate the rule. Under Sec. 6050P and its regulations, cancellation-of-debt (COD) income of $600 or more must be reported on Form 1099-C when any of eight identifiable events occur. Seven of these events are specific instances that actually result in a discharge of debt, such as an agreement between the creditor and the debtor. The eighth, the expiration of the nonpayment testing period, does not actually result from a discharge and may be difficult to determine. The nonpayment testing period is a 36-month period during which a creditor has not received any payments from the debtor, which creates a presumption that the loan was discharged, thus triggering the Form 1099-C filing requirement. The creditor can rebut this presumption by showing significant, bona fide collection activity or other facts and circumstances that indicate the debt has not been discharged. The nonpayment testing period was added to the regulations in 1996 in response to creditors' concerns that the prior facts-and-circumstances test for determining when an identifiable event had occurred was not sufficiently clear to allow them to determine when reporting was required.
- Taxadjusted discount rates with investor taxes and riskydebt Cooper, I. A., & Nyborg, K. G. (2008). Taxadjusted discount rates with investor taxes and risky debt.Financial Management,37(2), 365-379. This paper derives a taxadjusted discount rate formula with a constant proportion leverage policy, investor taxes, and risky debt. The result depends on an assumption about the treatment of tax losses in default. We identify the assumption that justifies the textbook approach of discounting interest tax shields at the cost of debt. We contrast this with an alternative assumption that leads to theSick (1990)result that these should be discounted at the riskless rate. These two approaches represent polar cases. Each generates its results by using a different simplifying assumption, and we explain what determines the correct treatment in practice. We also discuss implementation of the valuation procedure using the capital asset pricing model.
- Valuation effects of taxes ondebt cancellation Krause, M., & Lahmann, A. (2017). Valuation effects of taxes on debt cancellation.The Quarterly Review of Economics and Finance,65, 346-354. Standard models on firm valuation regard a simplified default setting, often not revealing relevant implicit assumptions. In this paper, we analyze the impact of risky debt and of taxes on a cancellation of indebtedness (COD) on tax savings. For the case of a taxation of a COD, we explicitly show that the risky components in the pricing equation of tax savings cancel out so that the tax shield pricing is similar to the case of risk-free tax savings. Furthermore, assuming no tax on a COD, we show the standard textbook equations for the tax shield, the tax-adjusted discount rates and WACC subject to risky debt to be generally valid only for a pro-rata loss distribution between interest and principal payments. Using standard equations for the case of no taxes on a COD in case of a non-proportional loss distribution can lead to substantial misvaluations, which we illustrate with an example.
- A Field Guide toCancellation of DebtIncome, McMahon, M. J., & Simmons, D. L. (2010). A Field Guide to Cancellation of Debt Income.The Tax Lawyer,63(2), 415-470.
- Cancellation of Debt and Other Incidental Items of Income: Puritan Tax Rules in the US, Beck, R. C. (2004). Cancellation of Debt and Other Incidental Items of Income: Puritan Tax Rules in the US.NYL Sch. L. Rev.,49, 695.
- Assessing S CorporationCancellation of DebtIncome on Shareholders' Income and Basis in the S Corporation's Stock: Gitlitz v. Commissioner, Bell, J. F. (2000).
- Assessing S Corporation Cancellation of Debt Income on Shareholders' Income and Basis in the S Corporation's Stock: Gitlitz v. Commissioner.Tax Law.,54, 671.
- Cancellation of debt as a gift, Schnee, E. J. (1999). Cancellation of debt as a gift.Journal of Accountancy,188(1), 83.
- Income on cancellation of debt, Gordon, A. I., Fischer, S. N., Keiser, L., & Kramer, H. (1979). Income on cancellation of debt.The CPA Journal (pre-1986),49(000002), 55.