Ninth Circuit: Discharge of Debt Does Not Presumptively Render It Worthless

(Parker Tax Publishing June 2025)

A panel of the Ninth Circuit affirmed the Tax Court and held that a taxpayer who cancelled millions of dollars of purported loans between business entities he owned, and reported cancellation of debt income to the debtor entities, was not presumptively entitled to claim a corresponding worthless debt deduction by the creditor entities. The panel was not persuaded by the taxpayer's argument that "worthless" debt under Code Sec. 166 is the same as "discharged" debt under Code Sec. 61(a)(11) such that a debt discharge eliminates the debt's prior objective value and renders it worthless as a matter of law. Kelly v. Comm'r, 2025 PTC 207 (9th Cir. 2025).

Background

Between 2007 and 2010, Michael Kelly transferred millions of dollars between his business entities, characterizing them as loans. These included transfers by Kelly Capital, Kelly's single-member LLC, to First Commercial Corporation (FCC), in which Kelly had a 75 percent stake, and Greenback Entertainment, Inc., which Kelly wholly owned. On December 31, 2010, Kelly cancelled many of these purported loans.

The cancellation affected Kelly's 2010 income-tax return. Kelly reported $145 million of COD income but excluded it due to his personal insolvency. FCC and Greenback reported cancellation of indebtedness (COD) income of $21 million and $2 million, respectively, but excluded it due to their own claimed insolvency, preventing the income from flowing to Kelly. Kelly also reported a short-term capital loss of nearly $87 million due to a nonbusiness "bad debt write off," including $17.8 million owed by FCC and $2 million owed by Greenback to Kelly Capital. Kelly reasoned that a cancelled debt automatically becomes worthless, creating COD income and a worthless-debt deduction simultaneously. The IRS did not agree and issued Kelly deficiency notices.

Kelly challenged the resulting deficiency notices in the Tax Court. In Kelly v. Comm'r, T.C. Memo. 2021-76, the Tax Court ruled mostly - but not entirely - in Kelly's favor. The Tax Court found that (1) transfers to FCC and Greenback before 2008 were bona fide loans but those in and after 2008 were not; (2) Kelly had not established FCC and Greenback were insolvent, such that their COD income would flow through to him; (3) Kelly failed to establish the debts owed to him by FCC and Greenback were worthless in 2010 and could therefore not be deducted from Kelly's income under Code Sec. 166; and (4) although Kelly was insolvent at the end of 2010, the COD income from FCC and Greenback could not be excluded from his income. The Tax Court's determinations resulted in income tax deficiencies of $5,334,424 and $10,123 for 2010 and 2011, respectively. Kelly appealed the Tax Court's determinations of the FCC and Greenback loans' worthlessness to the Ninth Circuit.

Under Code Sec. 61(a)(11), a debt of a taxpayer that is discharged by the creditor generally must be included in the gross income of the taxpayer. Code Sec. 108(a)(1) provides exceptions to the general rule for discharge of indebtedness income for discharges in bankruptcy, when the taxpayer is insolvent, and for discharges of qualified principal residence indebtedness, among other exceptions. To claim a nonbusiness bad debt deduction under Code Sec. 166, a taxpayer must establish: (1) the debt is bona fide; (2) the taxpayer as sufficient basis in the debt to claim the deduction; and (3) the debt became "wholly worthless within the taxable year" under Reg. Sec. 1.166-5(a)(2).

Kelly argued the Tax Court erred by not construing "worthless" debt under Code Sec. 166 the same as "discharged" debt under Code Sec. 61(a)(11). Under Kelly's theory, a cancelled debt becomes "undeniably worthless and beyond any hope of recovery." Thus, he argued, by allowing FCC and Greenback COD income under Code Sec. 61(a)(11), the Tax Cour had to acknowledge a reciprocal worthless-debt deduction under Code Sec. 166 as a matter of law. The Tax Court rejected this argument, stating that Kelly "cannot create a deduction by recording intracompany debt and then canceling it."

Analysis

A panel of the Ninth Circuit agreed with the Tax Court, finding that the Tax Court properly construed Code Secs. 61, 108, and Code Sec. 166 to reject Kelly's argument.

Analyzing the plain text of the relevant statutes, the panel found that the terms "worthless" in Code Sec. 166 and "discharge" in Code Sec. 61(a)(11) are not "mere synonyms" as Kelly suggested. The panel observed that dictionaries from the time of both statutes' enactment define "worthless" as lacking value or utility, and "discharged," in this context, as a release from repayment obligation. The panel reasoned that, although a debt obligation might lack value at the time of discharge, determining lack of value requires examining the objective facts. The debt discharge does not, as a matter of law, eliminate the debt's prior objective value and render it worthless. The panel noted that without objective evidence demonstrating worthlessness, any monetary transfer could be categorized as a loan and later cancelled to produce an illegitimate tax benefit to the putative creditor. Consequently, COD income to the debtor arising from debt discharge does not presumptively render the discharged debt worthless to the creditor.

Moreover, the panel found that neither Code Sec. 61 nor Code Sec. 108(a)(1)(B), both of which address COD income, have any relation to Code Sec. 166 and the worthlessness determination. Both adopt the freeing-of-assets theory, whereby discharged debt creates a potential gain - depending on the taxpayer's solvency - which has neither a relation to worthlessness nor any reciprocal effect on the creditor. In contrast, the panel found that the Code Sec. 166 worthless-debt deduction is closer to a casualty loss. Allowing a discharging creditor to claim a worthless-debt deduction, the panel reasoned, would be like "allowing an insurance payout to someone who intentionally burned down his own house."

The panel further held that the Tax Court did not commit clear error when it determined Kelly's debt was not worthless after noting that Kelly conceded the debts were not "wholly worthless," referring to them instead as "nearly wholly worthless." The evidence before the Tax Court, the panel found, supported the concession because it showed that FCC and Greenback had assets during that tax year, making some part of the debt recoverable. And, in the panel's view, Kelly failed to show the debts were uncollectible. According to the panel, this comported with the Tax Court's finding that Kelly failed to prove the two entities were insolvent, which finding Kelly did not dispute on appeal. The panel said that Kelly's subjective determination that the loans had value on January 1, 2010, and became wholly worthless by December 31, 2010, was not enough.

For a discussion of the general rules for discharge-of-indebtedness income, see Parker Tax ¶72,301. For a discussion of the worthless debt deduction, see Parker Tax ¶98,401.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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