Harold Johnston has worked in the telecommunications industry since 1968 and in 1996 he cofounded Summit Communications, Inc. (Summit) to provide communications-related services to businesses in Hawaii.
In 1998, Johnston was approached by Al Hee, the founder of another communications services provider, Sandwich Isles Communications, Inc. (SIC), to manage SIC's telephone operations.
Johnston was initially hesitant to join SIC as he felt a duty to ensure Summit's financial well-being.
In order to induce Johnston
, Hee offered him (in addition to salary and benefits) a loan of $450,000, with the understanding that if he
accepted the loan, Johnston
would in turn lend the $450,000 to Summit
in order to support its operations.
Johnston and SIC executed an employment agreement in 1998, which allowed Johnston to continue to serve as a director and chief executive officer of Summit, and stated that the SIC loan would become due upon the termination of Johnston's employment with SIC.
Later that year, Johnston
requested an additional $20,000 loan from SIC's parent company, Waimana Enterprises, Inc.
, and passed the funds on to Summit
In 2000, SIC
sold its interest in the original $450,000 loan to Waimana
Shortly after Johnston began his employment with SIC, Summit began to receive sizable contracts from SIC, and in late 2000 it became apparent that Johnston was needed to manage Summit full time because of its rapid growth.
In 2001, with Hee's approval, Johnston resigned his position with SIC.
resignation triggered his
repayment obligations for the SIC loan, SIC and Waimana
did not demand repayment of the SIC loan at that time, nor did either company issue a Form 1099-C, Cancellation of Debt.
In 2001 SIC
received a large loan from the U.S. Department of Agriculture
to finance a project to provide telecommunications service to rural communities in Hawaii.
With the additional financing SIC reduced its reliance on Summit
, which forced Johnston
to reduce expenses, cut salaries, and lay off employees.
Johnston continued to work for Summit until it filed for bankruptcy in 2002, and he went back to work for SIC in 2005.
Hee met with Johnston
in 2011 and notified him that the SIC loan was still due and owing.
arranged to begin making payments on the SIC loan via payroll deductions from his
In 2010, in connection with an audit of SIC's return, the IRS
audited Johnston's return for 2007.
Despite the fact that he
had been insolvent in 2007, Johnston
agreed to an income adjustment of $20,000 related to COD income from the Waimana loan, resulting in a partial assessment of tax due for 2007.
In 2013 IRS
a notice of deficiency determining that he
had failed to report COD income for the SIC
and Waimana loans in 2007.
argued that Johnston
realized COD income in 2007 because SIC and Waimana
failed to take collection action on the $450,000 SIC loan before the period of limitations for collection expired in 2007.
The Tax Court disagreed with the IRS's claim that the SIC loan had been canceled, pointing out that Hee testified that Waimana
considered the SIC loan outstanding and that Johnston
was repaying the SIC loan via payroll deductions of $1,000 per month.
The court also noted that if the SIC loan had been forgiven, Waimana
would have a strong incentive to report the loan as discharged so that it could benefit from a bad debt deduction, and that Johnston
did not receive a Form 1099-C from Waimana
discharging the SIC loan.
took issue with the fact that Johnston
did not make a payment on the SIC loan until after the IRS
2007 return, arguing that Johnston
sought to repay the SIC loan only to escape taxes.
The Tax Court disagreed, noting Johnston
sought to repay the SIC loan because he
understood it was his
obligation to repay it.
additionally argued that Johnston
realized COD income in 2007 from discharge of the $20,000 Waimana loan.
Although Johnston's agreement to this adjustment during the 2010 audit resulted in a partial assessment of tax for 2007, he
disputed this claim at trial.
The court agreed with the IRS
, noting that the fact the Waimana
loan was written off in 2007 demonstrated the intention of Waimana to forgive the loan.
Additionally, the court found no evidence that Johnston
was repaying the loan, or that Waimana
considered the loan outstanding.
However, the court concluded that because Johnston
was insolvent in 2007, and neither the IRS's
nor Johnston's calculations of his
insolvency exceeded the canceled debt, the COD income of $20,000 was excludable from his
income under Code Sec.