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Archive for October 10th, 2012

Guillermo Arguello worked for Guggenheim Investments, a conglomerate of entities of uncertain purpose. Mr. Guggenheim struck up a business relationship with another corporation, Netrostar, that was intended to be symbiotic: Guggenheim Investments would share customer lists and provide financing, while Netrostar would provide web development work to the Guggenheim entities.

Times got tough at Netrostar, and Arguello, who performed some small bookkeeping services for the company, was asked to help bail it out.

First, Arguello spent $24,000 on a used Alfa Romeo that was needed — for some odd reason — to keep Netrostar alive, and sold it to the company in exchange for a note.

In addition, Arguello cosigned Netrostar credit card debt in excess of $35,000.

At the end of 2007, Arguello was still owed $21,000 on the Alfa Romeo note, and he was justifiably getting antsy with his precarious position as creditor of a dying corporation. As a result, Mr. Guggenheim worked up an agreement by which Netrostar would pay Arguello an additional $2,000 towards the note, and then Arguello would “forgive” the remaining $19,000 balance in exchange for his release as cosigner of the credit card debt.

On his 2007 tax return, Arguello claimed a worthless debt deduction of $19,000. The IRS promptly denied the debt, arguing that it had not become worthless during 2007.

Relevant Law

Under Section 166, a taxpayer is entitled to a deduction for a debt, business or nonbusiness, that becomes wholly or partially worthless during the taxable year. There is no standard test for determining worthlessness; whether and when a ebt becomes worthless depends on all the facts and circumstances.[i] In general, the year of worthlessness must be established by identifiable events constituting reasonable grounds for abandoning any hope of recovery.[ii]

The Tax Court concluded that Arguello’s receivable from Netrostar did not become worthless during 2007, primarily because the debt was not forgiven due to Netrostar’s inability to pay, but rather in exchange for getting Arguello off the hook for this co-signed credit card debt:

We cannot assume, and do not find, that as of the close of 2007, Netrostar’s financial condition, although shaky, prompted petitioner to relinquish his rights to collect the balance on the note. The evidence shows, and we find, that the debt was extinguished not so much on account of Netrostar’s ability or inability to pay, but rather pursuant to an arrangement that allowed petitioner to avoid potential liabilities in connection with the credit card accounts.

The court summarized its decision thusly:  “A debt is not worthless where the creditor for considerations satisfactory to himself voluntarily releases a solvent debtor from liability.”

The takeaway lesson, of course, is that in today’s economy, where debts are being forgiven left and right, when you are on the creditor side there is a distinction between a debt becoming uncollectible and simply forgiving the debt in exchange for some form of noncash consideration. Under the tax law, the debtor must establish that the debt has become wholly or partially worthless in order to secure a bad debt deduction.


[i] Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950).

[ii] See Crown v. Commissioner, 77 T.C. 582, 598 (1981).

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Like me, Richard Cohen is a CPA who hails from the Garden State. Unlike me, Richard Cohen just lost millions of dollars at the hands of an apathetic IRS.

Cohen’s wife served as an executrix for an estate which held uncashed dividend checks from a public corporation. Due to some shenanigans, Cohen started to suspect that the corporation was retaining the proceeds from these uncashed dividend checks without including the amounts in taxable income.

In pursuit of hard evidence, Cohen requested information from the State comptroller under the Freedom of Information Law, and also reviewed allegations in pleadings from a civil case against the corporation. Cohen’s findings only buoyed his belief that the corporation was up to no good; with the amount of improperly retained unclaimed assets possibly reaching into the hundreds of millions.

At that point, Cohen filed a whistleblower claim with the IRS on Form 211, Application for Award for Original Information. As you may or may not know, Section 7623 provides that an individual who provides information that leads the IRS to pursue an administrative or judicial action against a taxpayer is entitled to receive an award equal to a percentage of the tax dollars collected by the IRS. [Ed note: pick the right taxpayer, and you can get paid $100 million, even if you’re a convicted criminal].

Despite the fact that Cohen felt the IRS had a strong case against the corporation, a mere two weeks after he filed his application he was notified by the IRS that no action was commenced and no tax dollars recovered from the corporation; thus, Cohen was not entitled to an award.

Understandably frustrated, Cohen sued the IRS, presenting the Tax Court with an issue of first impression: Could the court force the IRS to pursue a case against the corporation, so that Cohen would be eligible for a future whistleblower award?

Interpreting the statute literally, the Tax Court held against Cohen and declined to compel the IRS to reopen the whistleblower case. In reaching its decision, the court noted that Section 7623 requires a condition precedent to the issuance of a whistleblower award: the IRS must first commence an administrative or judicial action against the accused taxpayer, and tax dollars must ultimately be collected.

In this case, because the IRS did not see fit to pursue the corporation for its alleged unclaimed assets, no award could be given. Equally as important, the Tax Court established a precedent for future whistleblower decision by concluding that it lacked the authority to direct the IRS to pursue a case; rather, it’s jurisdiction was limited to determining whether an award should be given after a case has been pursued and tax revenue collected.

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