Tax Legal Services · Primary-source case analysis

Kelly v. Commissioner: Cancelling a Debt Did Not Prove It Was Wholly Worthless

By Aneeta Mishra and Timothy Chan

Published April 20, 2026

Kelly separates the tax consequences of discharging an obligation from the creditor’s burden to prove that a bona fide debt became wholly worthless in the claimed year.

Related entities recorded large loans and cancellations

The taxpayer transferred millions among controlled entities, later cancelled purported loans, reported cancellation-of-debt income subject to insolvency exclusions, and claimed nearly $87 million as a nonbusiness bad-debt loss.

Discharge and worthlessness are different concepts

Section 61 addresses income arising from discharge, while section 166 requires proof of a bona fide debt, adjusted basis, and whole worthlessness during the taxable year. A creditor’s voluntary cancellation does not establish that nothing could have been collected.

Objective value remained the factual question

A debt is not wholly worthless if even a modest fraction is recoverable. The taxpayer conceded the debts were not objectively worthless and did not establish uncollectibility, so the Tax Court did not clearly err.

Disposition

The Ninth Circuit affirmed the deficiencies. Coordinated reporting by related entities could not substitute for evidence satisfying each statutory element of the claimed deduction.

Key takeaways

• Document the bona fide nature and basis of every related-party debt.
• Prove objective worthlessness in the specific deduction year.
• Do not equate voluntary cancellation with uncollectibility.
• Analyze the creditor’s deduction separately from the debtor’s COD income.