A hot topic for some taxpayers in the past few years has been cancellation of debt (COD) income and how to exclude it from taxable income. Bankruptcy and insolvency are the two main circumstances available for excluding COD income. While determining if a taxpayer is bankrupt is straightforward (the debt is discharged in a Title 11 case), determining whether a taxpayer is insolvent can be tricky.
Sec. 108(a)(1)(B) provides for the exclusion of COD income if the debt discharge occurs when the taxpayer is insolvent. Sec. 108(d)(3) defines insolvency of the taxpayer as the excess of liabilities over the fair market value (FMV) of assets determined immediately before the discharge of debt. The excluded income is limited to the amount by which a taxpayer is insolvent, as stated in Sec. 108(a)(3). For example, if the taxpayer has COD income of $500,000 and the excess of liabilities over assets immediately before the discharge is $450,000, the taxpayer includes $50,000 of COD income in his or her gross income.
Four criteria to determine when calculating insolvency are:
Identification of the taxpayer in the case of unmarried individuals, C corporations, and S corporations is straightforward. The IRS has issued guidance for identifying the taxpayer for other types of entities and for married couples. Sec. 108(d)(6) provides that Sec. 108 is applied at the partner level; therefore, a partnership is not the taxpayer. Prop. Regs. Sec. 1.108-9 provides that the owner of disregarded entities and grantor trusts is the taxpayer.
Married individuals are considered two taxpayers for purposes of the exclusion. It is important to consult an attorney when one or both spouses have COD income. State law for community property vs. non–community property needs to be considered, along with tax filing status and IRS guidance. The measurement of separately titled and jointly titled assets is discussed later. This is an overview of the types of taxpayers; specific information regarding each type of taxpayer is beyond the scope of this item.
The taxpayer determines insolvency immediately before the discharge of the debt. This has been interpreted as the day before the date of the discharge (see, e.g., Merkel , 109 T.C. 463 (1997)). In cases of multiple instances of forgiveness of debt, the measurement date is determined separately for each instance, unless the separate instances of discharge are part of a single prearranged plan (Rev. Rul. 92-53).
The next step requires an examination of the owner/taxpayer’s assets and liabilities. Assets are included at the property’s FMV (not the cost basis). Liabilities consist of all debts of the taxpayer, including the debt being discharged. There has been some debate regarding which assets and liabilities of the taxpayer should go into the insolvency calculation. The IRS provides the following guidelines:
Letter Ruling 8920019 is based on Sec. 6013, as applied in Coerver , 36 T.C. 252 (1961), aff’d, 297 F.2d 837 (3d Cir. 1962), in which the Tax Court stated that a joint return under Sec. 6013 “does not create a new tax personality which would be entitled, in its own right, to deductions not otherwise available to the individual spouses under the pertinent sections of the statute.” The letter ruling further states that “the determination of a taxpayer’s entitlement to the insolvency exclusion under section 108(a)(1)(B) is based on all the assets reachable by the individual taxpayer’s creditors.” The filing of a joint return does not affect whether a spouse’s separate assets are used to determine the taxpayer’s insolvency. This pertains to non–community property states.
Measuring insolvency involves many steps and a few twists. Understanding the four parts—taxpayer, measurement date, assets, and liabilities—assists in determining insolvency, which allows taxpayers to determine whether they can appropriately exclude COD income.
Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or