Under the Internal Revenue Code, discharge or cancellation of indebtedness must be included in the borrower’s gross earnings, as cancellation of debt income. This is more like a liability, provided for in earlier accounting periods, no longer required now, written back or taken as income of the current accounting period.
Discharge or cancellation of indebtedness has tax consequences in the form of either higher taxable income or lower losses.
As a result of the cancellation of the debt or even discharge of indebtedness for a part of the payables, the borrower is financially better off and has greater abilities to pay taxes. This position is reflected by including the amount of discharged or cancelled debt in the borrower’s gross income.
In exceptional cases income arising to the debtor as a result of discharge or cancellation of indebtedness is not included in his gross income. Where the discharge of indebtedness occurs in bankruptcy proceedings or when the taxpayer is insolvent or a qualified farm debtor; the resultant income is not included in the taxpayer’s gross income.
The policy rationale behind such income exclusion is the virtual impossibility to collect tax from insolvent taxpayers. Rather it would be burdensome or oppressive to the insolvent and bankrupt taxpayers to suffer any tax on such income. Moreover, the bankruptcy and insolvency provisions defer tax indefinitely to a time when the taxpayer is in a position to pay. Further, the relief to the farm debtor is a part and parcel of the government policy to subsidize the agricultural sector through such tax benefit or privilege.
Where the parties have a good faith dispute over the amount of debt owed, such income is not included in the gross income of the taxpayer. If there is a purchase price reduction after the buyer and seller have reached an agreement, the revised price is deemed in law to be the original price so that the buyer does not have any income from cancellation of debt.
(More:http://en.wikipedia.org/wiki/Cancellation_of_Debt_(COD)_Income)
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