Problem: Joe owes Willy $5,000 from an old gambling debt. Joe knows that there is no way he can repay the debt in the near future. He asks Joe if he will take a $25,000 life insurance policy that has a cash surrender value of $4,200 and release him from the debt. Willy agrees to take the insurance policy and cancels Joe's debt. Willy makes only one premium payment on the insurance policy of $50 when Joe is killed in an auto accident. Willy collects the $25,000.
Explain all the tax consequences of these events for both Joe and Willy.