As readers may recall, we expressed serious reservations about the tax consequences of a program launched by Strike Debt, an Occupy Wall Street working group, to buy distressed consumer debt from debt collectors and forgive it. These concerns have been confirmed by a top tax expert, Lee Sheppard. Sheppard not only describes how the scheme has the potential to harm the borrowers that Strike Debt wants to help, but also points out how their initiative runs afoul of IRS rules for not for profits.*
Sheppard is a heavyweight in her field. Her bio at Forbes states:
Sheppard is one of the most widely read and respected tax commentators in the world. She has been a mainstay of Tax Analysts’ publications for 30 years. Trained as a lawyer, Sheppard specializes in cutting-edge financial issues, such as derivatives and hedge funds, and taxation of multinational corporations. She is frequently asked to speak on tax subjects. She has appeared on television shows such as 60 Minutes and Frontline, as well as in the documentary We’re Not Broke. Tax Analysts, the publisher of Tax Notes and related publications, is a nonprofit publisher that provides the latest and most in-depth tax information worldwide.
While Strike Debt’s plan, called Rolling Jubilee, sounds like a clever way to help debt overburdened consumers, upon inspection it looks more like a gimmick, since Strike Debt concedes it will be able to provide relief only to a small number of people. And in case you hoped that the project was using these purchases as a foundation to publicize the issue of consumer debt slavery, the Rolling Jubilee website proclaims that 100% of the proceeds of its fundraising will be used for debt purchases, which means no money will be spent on PR and lobbying.
As for the tax issues, we’ll recap our concerns, turn to Sheppard’s analysis, and discuss Strike Debt’s response.
Strike Debt’s Tax Problems
Strike Debt has two potential problems with its program. The first is that borrowers it is trying to help be liable for taxes and thus could wind up worse off than if Strike Debt did nothing. The second it that Strike Debt itself may be liable for failing to comply with the requirements of the type of not for profit it has elected to use, a 501 (c)(4). We’ve discussed these issues at much greater length, including extracts of IRS rules and discussions of case law, in two previous posts (see here and here)
The possible problem for borrowers is due to the fact that forgiveness of debt is taxable income to the borrower and the party writing off the debt is required to notify the IRS. Strike Debt cheerily claims that they can treat the forgiveness as a gift. A gift (up to $13,000 per donee per year) is not income to the recipient and if the transfer is indeed a gift, Strike Debt would not be obligated to report the forgiveness of debt to the IRS.
It is important to understand that this is a novel tax position. We discussed earlier at some length why this is grey and the outcome can’t be determined at this juncture. Even though a generous act of buying and writing off debt seems like a gift, intuition and tax law often don’t match.
The IRS’s discussion of gift treatment stresses that “there will not be any gift exception in a commercial context.” Debt buying is a commercial activity, and Strike Debt’s argument that it has no profit motive may not be sufficient to win it gift treatment, particularly in light of other rulings and case law in this area, some of which we cited in past posts.
And Strike Debt can’t get this question sorted out now; the IRS publishes a list every year of issues on which it will not issue a ruling, and whether a particular transfer is a gift is one of them. In addition, the IRS is much less generous in its view of who is a suitable recipient of charity than the public at large might be. People earning middle class incomes are not considered to be a “charitable class”, no matter how much difficulty they are having in paying their bills. Our understanding is that Strike Debt is making no effort to ascertain the income level of individuals whose debt it is buying.
The way Strike Debt is using a not for profit organization looks even dicier. As we noted earlier:
Rolling Jubilee is using a 501 (c)(4), which is a form of tax exempt organization used for “social welfare” purposes, which can include lobbying and political activities as long as they are primarily for the promotion of social welfare. However, the debt buying scheme appears to run afoul of the “private benefit” rule. From the IRS discussion of 501 (c)(4)s:
To qualify for exemption under section 501(c)(4), the organization’s net earnings must be devoted only to charitable, educational, or recreational purposes. In addition, no part of the organization’s net earnings can inure to the benefit of any private shareholder or individual.
Forgiving someone’s debt could be a violation of the private benefit rule.
Sheppard’s “Occupy Wall Street’s Santa Problem” Article
Sheppard confirms that Strike Debt’s tax position is risky. From her article in Forbes:
Ironically, the very aspect of the Rolling Jubilee project that is most charming to its proponents and the public—forgiving the debt of a lucky few—makes it problematic from a tax perspective. First, the tax law says that debt forgiveness by a creditor is income to the debtor in the amount of the principal forgiven.
There are some specific exceptions to this rule, such as the one recently enacted for forgiveness of residential mortgage debt, which expires at the end of this year (section 108(a)(1)(E)). Congress did not create an exception for gifts by creditors. Exceptions to cancellation of indebtedness income are narrowly construed—taxpayers don’t get to create their own exceptions by popular will.
Oh, but it’s a gift! Rolling Jubilee appears to be working on the premise that a creditor acting in an economically irrational way and wrapping forgiveness letters up in a bow establishes donative intent.
A gift would absolve the debtor from debt cancellation income. Gifts are excluded from income (section 102). But there is a presumption that a creditor will act like a creditor. When Rolling Jubilee purchases debt, it is stepping into the shoes of the creditor. So the organization has the burden of proving that debt forgiveness is a gift.
Sheppard also confirms our concerns about the IRS not seeing middle class borrowers as a charitable class, and raises more flags about Strike Debt’s use of a 501 (c)(4):
Section 501(c)(4) social welfare organizations are required to be operated exclusively for the promotion of social welfare. Giving big gifts of debt forgiveness to a few people is not consistent with the purpose of the exemption. It is not enough that the organization be operated as a nonprofit.
A social welfare organization must be operated to benefit a community, not a select group of individuals. Credit counseling services can qualify because they hold themselves open to all debtors needing assistance (Rev. Rul. 65-299).
Certainly overindebted middle class Americans constitute a broad class of people. But this class is not a charitable one and this group is not a community.
The Rolling Jubilee Fund by its own admission can only forgive the debts of a few. Its purpose is more symbolic than substantive in clearing out the huge backlog of debt—as one proponent noted, to start a conversation about debt.
Section 501(c)(4)(B) explicitly prohibits monetary benefits to any private shareholder or individual. It refers to “net earnings.” The net earnings of a debt purchaser would be the difference between the purchase price of the debts and the collectible amount. If Rolling Jubilee forgives one person’s debt, it has transferred its potential earnings on that item of debt to a private individual.
In other words, Houston, we have a problem.
Strike Debt’s Sort of Response
After we had published our concerns, we were told Strike Debt would issue a rebuttal. We’re not aware of any such discussion having been released. The closest we’ve seen is some remarks in a Village Voice article last week which announced that Strike Debt had mailed its first debt forgiveness letters. The article mentions that the initiative had spent $5,000 buying $100,000 of medical debt owed by 44 individuals. That means the average amount of indebtedness was $2,273. The good news is that if any of these individuals were to have the debt relief characterized as income, we aren’t talking about large tax liabilities (although if the people receiving relief are indeed in financial difficulty, even a few hundred dollars of extra taxes owed could be burdensome). The bad news is this is also not much in the way of debt relief.
Here is are the remarks from the unnamed advisor to Strike Debt on tax issues:
“I’m a little mystified by the critiques based on the tax implications,” says the tax lawyer who has been advising Strike Debt. (The lawyer works in the tax department at a top international law firm — her employer knows she is advising Strike Debt, but doesn’t want its name attached to the project.)
The tax lawyer dismisses the concern that the Rolling Jubilee is engaged in commercial activity: “It doesn’t make a great deal of sense to me,” she said. “When Habitat for Humanity is helping people build houses, someone still has to buy the lumber. It doesn’t change their tax status. The critical thing is that this is a not-for-profit organization, and it’s not engaged in trying to make money.”
Furthermore, the lawyer says, recipients don’t have to be poor to receive tax-free debt forgiveness. “This is focused on medical debt,” she says, “and people with health problems can be categorized as distressed. You don’t need to show that they’re impoverished.”
Note the logic is a bit circular: we are organized as a not-for-profit, ergo since we are not trying to make money, of course what we are doing is charitable. That doesn’t wash. Using the same reasoning, you could create a hospital that did plastic surgery for celebrities and claim it was a valid not for profit because it was not engaged in trying to make money because it has set its fees to cover all its costs and not have anything left over, and would send patients refund checks if it did. The IRS has specific notions of what constitutes charity and what constitutes social welfare. Rolling Jubilee’s activities need to conform to them. It does not appear that they do.
Specifically, the unnamed lawyer does not engage the “debt buying as commercial activity” argument. When borrowers get in distress and seek a resolution with their lender, they negotiate a restructuring or writedown. The loan remains with the original lender. I challenge Strike Debt to find previous instances of parties other than financial institutions, investors and debt collectors buying consumer debt. This is not at all analogous to housing, which is a basic human need and families, communities, and charities have a long history of providing assistance to the less fortunate in this arena.
The attorney argues that the borrowers in question are proper recipients of charity because the debt is medical debt and the borrowers are having health problems and therefore distressed. “Distressed” in the IRS’s eyes is distinct from poor (although the two often overlap) and distressed individuals are also valid candidates for charity. However, the IRS has a disquisition on its regulations and case law in this area. And it’s hard to see that the Strike Debt medical debt notion fits:
The term “distressed” generally is not equated with “poor.” The former term is used in revenue rulings dealing with emergency situations and with the elderly.
There is no mention of medical emergencies in the subsequent discussion. Furthermore, the typical amount of debt for which Strike Debt is seeking relief is not consistent with a health emergency (such as an accident or unexpected surgery) where the amounts charged would typically be much larger, or with a chronic health problem. You can rack up $1000-$3000 easily seeing a specialist and getting some tests and still get a clean or not all that bad bill of health, or in diagnosing and treating a not-serious ailment. Furthermore, as we discussed at some length in early posts, these debts may be junk debts: discharged in bankruptcy, disputed, past the statute of limitations, which would again mean that the borrower may not be under any kind of financial stress now. The failure of Strike Debt to ascertain the circumstances of the individuals whose debt is it forgiving increases the odds that it will have trouble if the IRS takes interest.
Now there may be other ways for Strike Debt to achieve its ends without running this level of tax risk for borrowers and itself. Bankruptcy attorney masaccio suggested one earlier this month:
[If the debtor has defenses to the indebtedness] Rolling Jubilee and the debtor can enter into a settlement agreement in which both sides release each other from all claims. In that situation, there is no debt forgiveness. Instead, each side gives consideration to the other to avoid litigation and serious loss. The situation can be improved if the debtor provides a statement of assets and liabilities and a budget showing that collection of the amount owed is highly unlikely. It is further improved if the debtor pays something towards the debt. That money can be used by Rolling Jubilee to offset the expenses of reaching out and settling, or even to buy more debt.
So far, Strike Debt has chosen to ignore the issues we’ve raised. Sheppard’s article confirms that the risks Strike Debt is running is real. The onus is on them to substantiate their reasoning, or better yet, revise their approach, since their statements so far are unpersuasive.
What is most distressing is that Strike Debt seems unconcerned about the idea that they could wind up hurting the people they profess they want to help to make a political point, and that they’ve put them at risk without getting their consent. We don’t need that from Occupy Wall Street. We have already have two parties for that sort of thing.
* Strike Debt is using a 501 (c)(4) and correctly tells donors that their contributions are not tax deductible, so any IRS action would not affect people who have donated to the program. However, losing its tax exempt designation would expose the program, Rolling Jubilee, to taxation.