IRS Proposes to Eliminate 36-Month Nonpayment Rule Triggering COD Income Reporting The IRS has issued proposed regulations that would eliminate the use of a 36-month nonpayment testing period as an identifiable event that triggers cancellation of debt (COD) income. The 36-month rule has created confusion and does not increase tax compliance, the IRS concluded. CCH Take Away. "This is a good thing, and I applaud the IRS," Thomas Callahan, partner and tax practice leader, Thompson Hine LLP, Cleveland, told CCH. "How can you take an arbitrary 36-month period? Just because you get a 1099, that doesn’t mean you have cancellation of indebtedness income. I can envision all kinds of whipsaw situations: people having to report income, or the government losing revenue. This rule shouldn’t have been in the regulations in the first place," Callahan said. Background Code Sec. 61(a)(12) includes COD income in gross income, unless an exception applies under Code Sec. 108, such as bankruptcy, insolvency, or other circumstances. Code Sec. 6050P, enacted in 1993, requires reporting of COD income to encourage taxpayer compliance and to enhance IRS enforcement of the rules. The reporting requirement applies generally to applicable entities. Originally, it applied to financial entities, such as financial institutions and credit unions. The reporting requirement was expanded to include any executive, judicial, or legislative agency, and any organization with a significant trade or business of lending money. In 2008, the IRS exempted the latter entities from the 36-month rule. Identifiable events Regulations adopted in 1996 rejected the use of a facts and circumstances test to determine whether debt had been discharged. Instead, the regulations required reporting on the occurrence of an identifiable event specified in the regulations, whether or not an actual discharge had occurred. The regulations identified seven events, including: a judicial discharge; an agreement between the creditor and debtor; the expiration of a collection statute of limitations; a defined policy of the creditor to discontinue collection activity and discharge the debt; and other specific occurrences that result from an actual discharge of debt. The regulations included an eighth event—the expiration of a 36-month nonpayment testing period. The 36-month rule was added because of concerns that a facts and circumstances approach would not be clear. After 36 months, a rebuttable presumption arises that an identifiable event has occurred, but this may be rebutted by engaging in significant collection activity. However, a creditor’s failure to rebut the presumption did not indicate that it had discharged the debt. New regulations The IRS stated that taxpayers remained confused about the 36-month rule and whether a creditor’s reporting (on Form 1099-C, Cancellation of Debt) represented COD that the debtor must include in gross income. In Notice 2012-65, the IRS asked whether it should remove or modify the 36-month rule. The IRS received 10 comments, all of which favored eliminating or modifying the rule. The IRS now has proposed to eliminate the rule, effective when it publishes final regulations. The IRS further noted that information reporting should coincide with the actual discharge of debt. Because of reporting under the 36-month rule, a debtor may believe he or she has taxable income even though the creditor has not discharged the debt and continues to try to collect it. Issuing a Form 1099-C may also lead the IRS to initiate reporting and collection actions even though the debt has not been discharged. In addition, if the creditor reports a discharge based on the 36-month rule, the regulations do not require any further reporting when the debt is actually discharged. This treatment hampers the IRS’s ability to collect taxes on the COD income, the agency observed.