Rev. Rul. 83-60

1983-1 C.B. 39.

                       Internal Revenue Service
                                 Revenue Ruling

           PREMATURE WITHDRAWAL PENALTIES; DISCHARGE OF INDEBTEDNESS

                           Published: March 28, 1983

SECTION 108. - -INCOME FROM DISCHARGE OF INDEBTEDNESS, 26 CFR 1.108(a)-1: Income from discharge of indebtedness

(Also Sections 61, 591; 1.61-12, 1.591-1.)

  Premature withdrawal penalties; discharge of indebtedness. The income from premature withdrawal penalties received by a financial institution is not income from discharge of indebtedness that may be excluded from gross income under section 108 of the Code.

ISSUE

  Is the income from premature withdrawal penalties received by a financial institution income from discharge of indebtedness that may be excluded from gross income under section 108 of the Internal Revenue Code?

FACTS

  The taxpayer is a financial institution that issues savings certificates with terms of maturity varying from 6 months to 10 years.  Federal regulations pertaining to these certificates require a holder to forfeit an amount as a penalty for withdrawal of the funds before the stated term of maturity.  The amount of this premature withdrawal penalty is prescribed by the Depository Institutions Deregulation Committee (DIDC), which was established by the Depository Institutions Deregulation Act of 1980, section 203, 12 U.S.C. section 3502 (1980).  Published at 12 C.F.R. section 1204.103 (1980), the regulation states:

    Where a time deposit with an original maturity of three months or more to one year, or any portion thereof, is paid before maturity, a depositor shall forfeit an amount at least equal to three months of interest earned, or that could have been earned, on the amount withdrawn at the nominal (simple interest) rate being paid on the deposit, regardless of the length of time the funds withdrawn have remained on deposit.  Where a time deposit with an original maturity of less than three months, or any portion thereof, is paid before maturity, a depositor shall forfeit an amount at least equal to the amount of interest that could have been earned on the amount withdrawn at the nominal (simple interest) rate being paid on the deposit had the funds remained on deposit until maturity.  Where a time deposit with an original maturity of more than one year, or any portion thereof, is paid before maturity, a depositor shall forfeit an amount at least equal to six months of interest earned, or that could have been earned, on

the amount withdrawn at the nominal (simple interest) rate being paid on the deposit, regardless of the length of time the funds withdrawn have remained on deposit.

  The regulation provides a premature withdrawal penalty that may cause, in effect, a forfeiture of principal, as well as interest. If the deposited funds are withdrawn before the specified amount of interest is earned, or before it could have been earned, then a portion of the principal must be forfeited to pay the prescribed penalty.

  Under the taxpayer's contracts with its savings certificate holders, interest at a fixed rate is paid or credited to accounts of the holder either monthly or quarterly at the holder's option.  The interest is withdrawable on demand and without penalty.  The taxpayer's contracts also contain the terms of the penalties required by the above DIDC regulation for premature withdrawal. Should a holder incur a premature withdrawal penalty after withdrawing interest earned, a corresponding reduction is made in principal returned to the holder.

  The taxpayer reported on its federal income tax return is income attributable to premature withdrawal penalties as income from the discharge of indebtedness under section 108 of the Code.  Thus, the taxpayer excluded the amount of the penalties from its gross income and elected to reduce under section 1017 the basis of its depreciable property by the amount excluded.

LAW AND ANALYSIS

  Section 61(a) of the Code provides that gross income means gross income from whatever source derived.

  Section 61(a)(12) of the Code provides that gross income includes income from discharge of indebtedness.  Section 1.61-12(a) of the Income Tax Regulations provides that a taxpayer may realize income by the payment of obligations at less than their face value.

  Section 108 of the Code provides that, for transactions occurring on or before December 31, 1980, no amount is included in gross income by reason of the discharge of any indebtedness for which a corporate taxpayer is liable if the taxpayer files a consent to the regulations prescribed under section 1017 relating to the adjustment of basis of property.  Section 108 was amended by the Bankruptcy Tax Act of 1980, Pub.L. No. 96-589, section 2(a), 96th Cong., 2d Sess. (1980).  For transactions occurring after December 31, 1980, section 108(a) now provides that gross income does not include any amount which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness discharged is qualified business indebtedness as defined in section 108(d)(4).  Under section 108(d)(4) qualified business indebtedness is indebtedness that is incurred or assumed by a corporation that makes an election under section 108(d)(4) with respect to the indebtedness.

  Section 1.591-1(b) of the regulations provides that if a domestic building and loan association (or certain other thrift institutions) accepts deposits subject to fines, penalties, forfeitures, or other withdrawal fees, it may deduct under section 591 of the Code the total amount credited as interest on these deposits notwithstanding that as a customary condition of withdrawal the association has the right, under by-law, contract, or otherwise, to retain or recover a portion of the total amount invested in or credited as earnings on these deposits as a fine, penalty, forfeiture, or other withdrawal fee.  In any tax year in which this right is exercised, the retained or recovered amounts are includible in the gross income of the association.  See also Rev. Rul. 76- 308, 1976-2 C.B. 133, amplifying Rev. Rul. 71-63, 1971-1 C.B. 143 (accrual of interest by banks).

  In Rev. Rul. 73-511, 1973-2 C.B. 402, the Service ruled that financial institutions must report on information return Form 1099-INT, U.S. Information Return for Recipients of Interest Income, and Form 1096, U.S. Annual Information Return, the full amount of interest paid or credited to a depositor even though, in effect, a portion is forfeited because of a premature withdrawal penalty.  The ruling states that there is no statutory provision for the use of any type of netting rule since the interest paid or credited and the forfeiture incurred represent two separate transactions and are taxable as such.  The only relationship between the interest and the forfeiture penalty is the fact that the penalty is calculated by reference to a given amount of interest.  The ruling also provides that an individual depositor who itemizes deductions may generally deduct any premature withdrawal penalty as a loss under section 165 of the Code.

  In response to the above revenue ruling, section 62(12) of the Code was enacted to permit individual taxpayers who do not itemize deductions to subtract from gross income the deductions allowed by section 165 to the extent that these losses include amounts forfeited as a penalty for premature withdrawal of funds from a time savings account, certificate of deposit, or similar class of deposit.

  Not every indebtedness that is cancelled results in gross income being realized by the debtor "by reason of" cancellation of indebtedness within the meaning of section 108 of the Code.  If a cancellation of indebtedness is simply the medium for payment of some other form of income, section 108 does not apply.  For example, if an employee owes his employer $100 and renders $100 worth of services to the employer in return for cancellation of the debt, the employee has received personal services income, rather than income from cancellation of indebtedness within the meaning of section 108.  In such a case, the full amount of the indebtedness is satisfied by the performance of services having a value equal to the debt.  Since the debt cancellation is only the medium of paying the personal services income, section 108 is inapplicable.  See Spartan Petroleum Co. v. United States, 437 F.Supp. 733 (D.S.C. 1977). Accord, S.Rept. No. 1035, 96th Cong., 2d Sess. 8 n. 6 (1980) (Bankruptcy Tax Act of 1980 amendments to section 108).  See also section 1.1017-1(b)(5) of the regulations (no reduction of basis of property is allowed under sections 108 and 1017 to the extent of the value of property transferred to a creditor in connection with a debt cancellation).

  In the present situation, a depositor's liability for the penalty arises from his contract with the taxpayer which contains the terms of the penalty required by the DIDC regulation.  Under the contract and the regulation, amounts forfeited by a depositor are in the nature of agreed-upon fees or liquidated damages intended both as consideration for the early withdrawal privilege, and as compensation to the taxpayer for loss of the use of the deposited funds for the full term of the certificate.  A depositor arranges to pay the penalty by authorizing the taxpayer to collect the penalty out of funds on deposit with the taxpayer.  In effect, when a premature withdrawal occurs, the financial institution returns the full principal amount of the deposit to the depositor, and the depositor pays an amount equal to the penalty back to the financial institution.

  If the penalty were paid to the taxpayer by means other than an offset to amounts deposited (such as by a cash side payment, by performance of services, or by transfer of other valuable consideration), the taxpayer would be in receipt of gross income under section 61 of the Code, and this income would not be income from discharge of indebtedness described in section 61(a)(12).  When the penalty is paid by means of an offset against funds on deposit, the nature of the taxpayer's income remains unchanged.  This income is not considered to be income arising "by reason of" discharge of indebtedness within the meaning of sections 61(a)(12) or 108 merely because the means of payment is a reduction in the amount of a debt owed by the taxpayer.

  That a depositor is allowed to deduct withdrawal penalties under section 165 of the Code (relating to losses), rather than under sections 162 or 212 (relating to certain expenses paid or incurred), does not require a conclusion that a forfeiture suffered upon a premature withdrawal of a certificate may not be characterized as "payment" of a penalty to the taxpayer.  In numerous cases, a deduction under section 165 has been allowed for losses sustained as a result of actual cash payments.  See Yerkie v. Commissioner, 67 T.C. 388 (1976);  Rev. Rul. 79-322, 1979-2 C.B. 76;  Rev. Rul. 67-48, 1967-1 C.B. 50.

HOLDING

  The income from premature withdrawal penalties received by a financial institution is not income from discharge of indebtedness that may be excluded from gross income under section 108 of the Code.

Rev. Rul. 83-60, 1983-1 C.B. 39.