Sometimes I like to bring up issues occurring strictly in the USA and take a peek at how the US tax rules would shake out if foreigners were involved in the transactions. It always makes for a much more complicated analysis.
Here is one for today! Let’s look at the juicy story of Justice Clarence Thomas. I know there are quite a few out there, but today’s focus is on the forgiven loan used by the good Justice to purchase a Prevost Marathon RV.
The New York Times thought it had a great scoop recently: Justice Clarence Thomas never paid back a lot (if any) of the principal (over USD 267K) on a loan he got from a wealthy friend to buy Justice Thomas’s ultra-luxury RV, a Prevost Marathon motor coach. The well-to-do lender, Anthony Welters, was a friend and forgave the debt after Thomas had paid him only interest for a few years. Although Times investigative reporter, Jo Becker, provided readers with some juicy tidbits, the article fell somewhat short on the tax analysis of the transaction. Understandable! US tax issues are notoriously complex.
Forgiven Loans and Cancellation of Debt Income
It seems that according to the article, Justice Thomas would have taxable income from the cancellation of the debt. Indeed, the tax laws do provide that when debt is canceled, forgiven, or discharged for less than the amount owed, the borrower must report the amount canceled or forgiven as income for tax purposes. This is known in the trade as “income from the discharge of indebtedness” or “cancellation of debt income”.
That is not the end of the story, however. There is another tax rule that says gifts are not items of income. So, if the friend cancelled the debt strictly out of disinterested generosity and affection for Justice Thomas, this cancellation would be a gift and would not be income to Justice Thomas for tax purposes. On the other hand, if the motive of the lender is not out of such affection, and something is expected in return, then forgiving the debt is not a gift at all. This means Justice Thomas would have a hefty tax bill to pay. (I will leave aside the explosive ethical issues we have here. It has been reported repeatedly that Justice Thomas has failed to disclose receipt from uber-rich benefactors such things as luxury vacations, private jet and yacht travel, expensive tickets to sports and other events, as well as other lavish benefits).
Was forgiving the debt a gift? In examining such issues generally, the US Internal Revenue Service (IRS) looks closely to see if the gift is bona fide or whether it might be some kind of disguised compensation or other taxable item. While the term “gift” is not defined in the US tax law, the US Supreme Court case of Commissioner v. Duberstein 363 US 278 (1960) holds that in determining a gift for US federal income tax purposes (note, the test is different for gift tax purposes), the critical consideration is the transferor’s intention.
So, what US tax issues might be implicated if we had a loan of funds from a foreign person to a US person, and the debt later forgiven, by the foreign lender?
Foreign Lender / US Debtor: Income and Withholding Tax
A true loan will bear interest at a market rate (and if it does not, the IRS, in its taxpayer friendly fashion, will impute a market interest rate). When interest income is paid by a US borrower to a foreign lender, that interest can be treated as from “US sources”. If it is, the interest income would taxable by the United States and the US borrower will have to withhold US tax at a 30% rate (or lower treaty rate) on the payment. This withholding tax can possibly be eliminated due to a certain exception in the tax laws for so-called “portfolio interest”. However, taking advantage of the portfolio interest exception or a lower treaty rate is not automatic and proper paperwork has to be in place. If withholding is required, a failure to do so can result in personal liability to the US borrower for the tax that should have been withheld as well as significant penalties.
My earlier tax blog post covers the US income and withholding tax issues that arise when interest payments are made to a foreign lender by a US borrower. If the borrower is a “US resident” at the time of the payment, the interest will be treated as derived from US sources, and thus subject to withholding.
Who is a US resident for purposes of these rules gets tricky, What if the borrower is a green card holder but living outside the US? What if he or she holds US status simply by virtue of making an election to be treated as a US person only to file a joint tax return with the US spouse? Full details at my blog post.
Foreign Lender / US Debtor: Forgiving the Debt – Taxable Income? A Gift?
If the loan is forgiven, cancellation of indebtedness income arises (unless it is in the nature of a gift). If the forgiven loan is not in the nature of a gift and involves foreign currency, further tax complexity comes into play with foreign currency gains and losses. Income from the discharge of indebtedness when the debt is denominated in a foreign currency is discussed at my post here.
If the debt is forgiven strictly out of generosity and affection, and therefore, a gift no income will arise to the borrower when the debt is cancelled. So, if forgiving the debt is to be treated as a “gift” by the foreign lender do any tax issues arise for the lender or the US borrower? Of course they do!
These include the possibility of the lender having to pay a US gift tax (yes foreign persons can be liable for US gift taxes on certain gift transfers that occur within the United States) and the borrower having to report to the Internal Revenue Service that he has received a foreign gift. There will be no tax to the borrower on the gift, (unless it is a “purported gift”), but information reporting should not be missed unless the borrower is happy to pay Uncle Sam a penalty of 25% of the value of the gift.
Posted November 2, 2023
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