April 2002

Taxpayer Insolvency and Discharge of Indebtedness Income

By Bruce M. Bird

Taxpayers that have borrowed money they cannot repay are faced with the prospect of the resulting discharge of indebtedness (DOI) being included in their gross income. An exception to the inclusion of DOI in gross income is the “insolvency exclusion” rule under IRC section 108(a)(1)(B). For purposes of this exception, a taxpayer’s insolvency, as determined immediately before the discharge of indebtedness, is defined as an excess of liabilities over the fair market value of assets.

Carlson v. Commissioner

In 1988, a commercial fisherman and his wife purchased a fishing boat by borrowing money from a bank. As security for the loan, the debtors granted to the bank a “preferred marine mortgage interest” in the boat itself. Several years later, they became delinquent on their mortgage. In 1993, the bank foreclosed on the mortgage, sold the boat, and used the sale proceeds to reduce the debtors’ unpaid principal loan balance. These proceeds reduced by $95,000 the debtors’ pre-foreclosure loan balance (approximately $137,000). The bank then discharged the debtors’ remaining unpaid loan balance, resulting in a realized capital gain of approximately $29,000 for the debtors. In addition, they received a discharge of indebtedness of approximately $42,000.

When filing their joint return for 1993, the taxpayers did not report any gain or loss or any DOI income from the foreclosure sale. They did, however, attach a Form 1099-A received from the bank. At the bottom of Form 1099-A, they wrote “Taxpayer Was Insolvent—No Tax Consequence.”
After receiving a notice of deficiency from the IRS, the taxpayers filed a petition in Tax Court. In their petition, the taxpayers contended that they satisfied the “insolvency exclusion” rule under IRC Section 108(a)(1)(B), because, immediately preceding the foreclosure sale, their total liabilities exceeded the total fair market value of their assets.

In computing this aggregate fair market value of assets, the taxpayers did not include the value of their Alaska limited entry fishing permit, worth approximately $393,000. This permit, which allowed restricted commercial fishing of salmon in the Chignik fishery, was exempt from the claims of creditors under Alaska law. The taxpayers contended that, under the judicially created net assets doctrine, assets, for purposes of Section 108(d)(3), did not include those assets exempt from creditors under state law.

In Carlson v. Comm’r, the Tax Court noted that, under Section 108(d)(3), insolvent means the excess of liabilities over the fair market value of assets. The taxpayer’s assets and liabilities immediately before the discharge determine whether the taxpayer is insolvent and, if so, the amount of the insolvency.

Dictionary Definition and Statutory Language

The Tax Court examined the plain meaning of “assets,” the legislative history of IRC section 108, and the taxpayer’s analysis of the net assets doctrine. Where the statute in question does not define assets, it is generally interpreted by its ordinary and common meaning. If the ordinary and common meaning of the statutory language in question supports only one construction, the statutory language is unambiguous. However, where its ordinary and common meaning supports more than one construction, the statutory language is ambiguous. Accordingly, legislative history should be consulted to ascertain the true intent of Congress in enacting the code section in question.

The definition of the word “assets” in Merriam-Webster’s Collegiate Dictionary, 10th edition, includes:

The Tax Court noted that although the first and second definitions supported the taxpayers’ position, the third definition did not. Consequently, the Tax Court analyzed the legislative history underlying Section 108(a)(1)(B). Congress enacted this section, and related provisions, in 1980 as part of the Bankruptcy Tax Act. Both the Senate and House reports accompanying the legislation that became the 1980 Bankruptcy Tax Act stated that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy is not to be burdened with an immediate tax liability.

The committee reports accompanying this legislation described the tax law governing DOI income in existence at the time Congress passed the 1980 Tax Act. The committee reports cited Kirby Lumber, Dallas Transfer and Terminal Warehouse, and Lakeland Grocery. In Kirby Lumber, the taxpayer, a corporation, issued bonds at par value. In the same year, the taxpayer repurchased some of those bonds in the open market for less than their par value issuance price. The Supreme Court held that the taxpayer had to recognize income on the repurchased bonds to the extent of the difference between the issuance and repurchase prices.

Several years after the Supreme Court’s decision in Kirby Lumber, the U.S. Court of Appeals for the Fifth Circuit distinguished that case and established an insolvency exclusion to its rule. In Dallas Transfer and Terminal Warehouse, the taxpayer, a corporation, leased real property. The lessee/taxpayer was relieved of its unpaid rent and other bills when it transferred to the lessor other property—of lesser value—that it owned. The Court of Appeals held that the taxpayer did not realize income because of the transaction. In effect, the court held that the exchange did not result in the debtor/taxpayer acquiring something of value in addition to what it had owned before. Unlike Kirby Lumber, where the taxpayer possessed greater assets (which had ceased to be offset by liabilities) after the transaction, in Dallas Transfer, the taxpayer experienced a reduction of liabilities without any increase in assets.

Another decision cited in the committee reports was Lakeland Grocery Co. v. Comm’r, in which the Board of Tax Appeals considered the insolvency exclusion established by the Dallas Transfer decision. In Lakeland Grocery, the taxpayer, an insolvent corporation, entered a so-called composition settlement under which it paid its creditors about 15 cents on the dollar; the taxpayer was left with net assets of approximately $40,000. The Board of Tax Appeals held that the taxpayer realized gain to the extent it had assets that ceased to be offset by any liability because of the DOI under the composition settlement. This ruling is sometimes referred to as the net assets doctrine.

Tax Court Decision

The Tax Court in Carlson noted that the taxpayer relied upon a similar case involving the net assets doctrine to support excluding the taxpayer’s DOI from income. In Cole v. Comm’r, the taxpayer, a resident of New York, owned equity in ten life insurance policies. After acknowledging that the taxpayer would realize DOI income to the extent of the excess of total assets over liabilities (the increase in net assets), the Board of Tax Appeals examined the taxpayer’s assets and liabilities. Under New York law, equity in life insurance policies is free from creditors. As a result, the Board of Tax Appeals held that, in determining the taxpayer’s increase in net assets due to the cancellation of indebtedness, the taxpayer’s net assets should be decreased by those items free from the claims of creditors.

The Tax Court in Carlson rejected the taxpayer’s reliance upon the Cole decision. When Congress enacted the insolvency exception as IRC section 108(a)(1)(B), it also enacted a related provision, section 108(e)(1), which states, “there shall be no insolvency exception from the general rule that gross income includes income from the discharge of indebtedness” except as provided in Section 108(a)(1)(B). As Congress enacted the insolvency exclusion under Section 108(a)(1)(B), it eliminated the judicially created net assets test as an exception to the general rule that DOI is includable in income under Section 61.

The Tax Court further noted that the Supreme Court recently weighed in on this issue in Gitlitz v. Comm’r. As a result, the Tax Court concluded that Section 108(e)(1) precludes the application of Cole—and any other judicially developed insolvency exception—to the general rule of Section 61(a)(12) that gross income includes income from DOI. As a result, although an asset of a debtor may be exempt from creditors under applicable state law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, then the excess will be treated as taxable DOI income.

Bruce M. Bird is a professor in the Richards College of Business at the University of West Georgia, Carrollton.

Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

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