Disregarded entity

Was he, personally, responsible for card payments, or only the LLC? (I've never heard of the latter, even for billion dollar corporations.)

Was he insolvent (prior to the debt cancellation/reduction)?

Wasn't the credit-card also issued that way?

Seth

Whether he was personally liable for the debt depends upon state law and/or whether he personally guaranteed the debt.

For federal income tax purposes, it's a difference without a meaning in any event. If the COD is income to the LLC, it passes through to your client.

That's true if the LLC is taxed as a proprietorship. But if OP has elected to have it taxed as a corporation, tax would be paid at the entity level and not pass through to the client.

The original post says "I have a client who has a sole-proprietor LLC".

Is that a legal term of art? I thought it just meant it was a single member LLC. And even a single member LLC can be taxed as a corporation.

Another way to look at this, perhaps, is that even if it is an LLC taxed as a proprietorship, if the credit card was taken out in the name of the LLC, for which the LLC was responsible and not the individual, it would be, in effect, non-recourse debt as far as he's concerned.

To me it sounded like an LLC that files a Schedule C as that's what sole proprietorship's file. It might be a faulty assumption.

Here is additional information that makes it more confusing. The business bank loan was originally against his LLC EIN, but the bank converted it to a credit card debt under his SSN without his permission. He did file an 1120S as an S- Corp for the previous year, but got a letter from the IRS that he did not submit the required Form 2355 for S-Corp election therefore they rejected his

I can't imagine that would make a difference.

I think you mean form 2553. That is the S-corporation election when you already have a corporation or have elected to be taxed as one. As a result that doesn't resolve the issue either, since it implies that he elected to be taxed as a corporation, but you have not indicated whether he actually did.

That doesn't follow from what you've said so far.

If the original paperwork didn't make him personally responsible for the loan, it would. (A few years ago I wouldn't have imagined that could happen, but having seen how irresponsible banks can be, I'd certainly consider that it might be the case.) It would be fraud on the bank's part (also not unusual nowadays).

The issue here is, if a debt for which you are not legally responsible is cancelled, is there CoD income? I would tend to believe there isn't.

Seth

I'd love to know HOW they did this, especially without his signature.

The bank may argue that they simply corrected a correctable error in the paperwork. Many of sign documents authorizing this as part of an application process. It's very common when we buy cars or houses and such so I can imagine how he may have signed something similar when he got the loan. If that's the case I'd argue that the bank changed it from correct to incorrect.

The problem here is that the argument will cost money to make - he'll need to retain an attorney to fight that fight.

Interesting, especially since you're allowed to make the election on how a SMLLC is to be taxed on the first filed tax return. If the first return he filed for his SMLLC was an 1120S then I'd argue to the IRS that the election was effectively made when he filed that first tax return. On the other hand, if he filed as a Schedule C the first time, then filed an 1120S the IRS is correct. I'd need more info to make a decision on this.

This may be your best method of effectively and efficiently dealing with the issue. Assume the debt personally, then declare insolvency and avoid paying tax on it.

BUT BEWARE - using insolvency, or bankruptcy, to avert taxation of CoD income requires that you reduce the tax attributes of his other assets. Even if he's insolvent, or bankruptcy, he likely still has other assets so you'll need to consider the future implications of adjusting the tax attributes of those assets.

You may find it worthwhile to pursue a more aggressive posture.

Good luck, Gene E. Utterback, EA, RFC, ABA