Are Early Withdrawal Penalties Income By Reason of Discharge of Indebtedness? United States v. Centennial Savings Bank FSB

For several years, banks argued that discharge of indebtedness income is realized from the receipt of penalties for prematurely withdrawn certificates of deposit (CD). This caused conflicts with the IRS, which claimed that financial institutions should declare early withdrawal penalties non-debt discharge income. The banks tried to defer their tax liability by excluding the debt discharge amounts from gross income and by decreasing the adjusted bases of their depreciable assets in an amount equal to their indebtedness. In United States versus Centennial Savings Bank FSB (1991), the Supreme Court decided that income realized from the receipt of these penalties did not constitute income by reason of discharge of indebtedness. Rather, the Court held that the penalties were immediately recognizable ordinary income. The clarifying test set forth by the Court to determine the existence of discharge of indebtedness income will compel debtors and creditors to reevaluate the structure of their relationships in order to avoid unfavorable tax treatment.