## Facts

- A domestic corporation operated as a wholesale distributor and bought goods under two supply contracts with an unrelated seller.
- The seller shipped some goods but then refused to ship the remaining quantities required by the contracts.
- The corporation owed the seller 1,000x dollars for goods already shipped but refused to pay after the seller’s nonperformance.
- The seller sued in U.S. district court to collect the 1,000x; the corporation counterclaimed for breach of contract seeking lost-profit damages.
- The parties settled: the corporation paid 500x of the 1,000x payable, and the seller forgave the remaining 500x in exchange for the corporation’s release of its counterclaim.
- On its 1982 return, the corporation treated the 500x as discharge-of-indebtedness (COD) income under I.R.C. § 61(a)(12), excluded it under § 108 as qualified business indebtedness, and reduced asset basis under § 1017.

## Issues

1. Whether a seller’s forgiveness of part of a buyer’s trade debt, given in exchange for the buyer’s release of a breach-of-contract counterclaim, is COD income under I.R.C. § 61(a)(12).
2. If the forgiven amount is COD income, whether it may be excluded under I.R.C. § 108 and trigger basis reduction under I.R.C. § 1017.

## Decision

- The forgiven 500x was not COD income under § 61(a)(12).
- The 500x was treated as consideration paid by the seller to settle and obtain release of the corporation’s breach-of-contract counterclaim.
- Because the amount was not COD income, § 108 and the related § 1017 basis-reduction rules did not apply.

## Legal Principles

- A reduction or cancellation of a liability can produce gross income, but characterization depends on the substance of the transaction and what the cancellation is given for.
- When debt cancellation functions as the medium of payment for property, services, or settlement of claims, the tax consequences follow the underlying transaction rather than § 61(a)(12) COD rules.
- A creditor’s partial forgiveness of a debt provided as bargained-for consideration for the debtor’s release of claims is treated as settlement proceeds (amount realized on the disposition/settlement of the claim), not COD income.
- Section 108 exclusions apply only to income that is COD income; if the amount is not COD income, there is no § 108 exclusion and no § 1017 basis reduction.

## Conclusion

Where a creditor forgives part of a debtor’s obligation in exchange for the debtor’s release of a breach-of-contract counterclaim, the forgiven amount is treated as settlement consideration rather than discharge-of-indebtedness income, making § 108 and § 1017 inapplicable.


Rev. Rul. 84-176, 1984-2 C.B. 34 (1984)