Whether the taxpayer is insolvent is a vital consideration in determining if debt forgiveness results in income to the taxpayer. However, the code, IRS, and the courts have not provided an adequate definition of the term, and there is confusion as to what assets and liabilities are to be included in its determination. A recent IRS ruling helps, but it is not the final answer.

What items must be included in a taxpayer's gross income? Gross income is generally defined by exception. For example, IRC Sec. 61 requires that "except as otherwise provided . . . gross income means all income from whatever source derived." IRC Sec. 61 also provides a list of specific items that must be included in gross income. One such item specifically included by IRC Sec. 61(a) (12) is the discharge of indebtedness.

A discharge of indebtedness occurs when a lender agrees to accept less than face value for a debt. The taxpayer/borrower has income because his net worth has increased as a result of this transaction. The amount that must be included in gross income as discharge of indebtedness income is the difference between the amount of debt outstanding and the fair market value of the property used to satisfy the debt. This amount is treated as ordinary income. In addition, a taxpayer may have capital gain income if the taxpayer uses appreciated property to satisfy the debt. The amount of the capital gain will be the excess of the fair market value of the property used to extinguish the debt over the taxpayer's basis in that property.

IRC Sec. 108 provides two exceptions to the general rule. The first exception, contained in IRC Sec. 108 (a)(1)(A), excludes discharge of indebtedness from gross income if the taxpayer has declared bankruptcy under Title 11.

The second exception, provided in IRC Sec. 108(a) (1) (B), aids those taxpayers that are technically insolvent before the discharge from indebtedness but have not declared bankruptcy. Taxpayers that have declared bankruptcy can be easily identified. However, determining whether a taxpayer meets the definition of insolvency under IRC Sec. 108(d) (3) is a more difficult proposition.

The Basics as Set Forth in the Code

IRC Sec. 108(a)(1)(B), which provides that "gross income does not include any amount which would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent," was modified by The Bankruptcy Act of 1980. Although that provision of the IRC may exclude from gross income the gain from a discharge of indebtedness for taxpayers that are insolvent, IRC Sec. 108(a) (3) limits the excludable portion to the amount by which the taxpayer is insolvent. For example, if a taxpayer owns assets with a fair market value of $50,000 and has liabilities of $75,000, only $25,000 (the amount by which he is insolvent) can be excluded if the liabilities were discharged. Therefore, the calculation of insolvency becomes very important.

Little direction is given by the IRC on how to calculate the amount by which a taxpayer is insolvent. Insolvency is defined as the excess of liabilities over the fair market value of assets. The calculation of insolvency must be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge. Problems have arisen in the calculation of insolvency because there is no indication as to which assets and liabilities must be included in the insolvency calculation. In addition, no guidance was given in this area by the Congressional committee reports on The Bankruptcy Act of 1980. The only guidance comes from court cases that established the judicial insolvency exception prior to The Bankruptcy Act. The question also has been addressed recently in several revenue rulings. Generally, the case or ruling has examined the inclusion of either assets or liabilities but not both at the same time. Therefore, this discussion will address which assets must be included first and then look at the treatment of liabilities.

Which Assets to Include

United States v. Kirby Lumber Co. |284 U.S. 1(1931) is the first case in the evolution of the insolvency exception. In Kirby Lumber, the taxpayer issued bonds which were later retired at less than par value. The Supreme Court ruled the difference between the par value and the amount paid to retire the debt must be included in gross income. The Court reasoned the taxpayer had realized an actual increase in assets by this amount. This decision developed the "fleeing of assets" doctrine, which says that income is realized when a debt is discharged for less than the full amount only if assets were freed from the claims of creditors. Since the taxpayer had the use of additional assets in Kirby Lumber it had to recognize income.

The Court in Kirby Lumber did not address the question of taxpayer insolvency. This issue was first raised in Dallas Transfer and Terminal Warehouse Co. vs. Commissioner |70 F. 2nd 95 (5th Cir. 1934). In Dallas, the taxpayer was released from its indebtedness to its lessor by conveying a piece of real estate. However, the value of the real estate was less than the total debt. Before the transfer the taxpayer had a deficit of $226,470. Though the release from the debt on its lease reduced this deficit, the taxpayer was still insolvent after the transfer. The taxpayer was insolvent both before and after the debt was discharged. Thus, the Court determined that no income was realized because no assets had been freed from the claims of creditors. It further ruled that "taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything he did not have before. Gain or profit is essential to the existence of taxable income." Therefore, since the taxpayer remained insolvent after the discharge it did not realize a gain or profit.

The first case to address which assets must be included in the insolvency calculation was Marcus Estate v. Commissioner (T.C. Memo 1975-9). In Marcus, the taxpayer died indebted to a corporation for funds the corporation had advanced to him and for expenditures made by the corporation on his behalf. Even though these advances were not evidenced by promissory notes, the Court found the amounts represented an obligation of the decedent. The Court also determined that a forgiveness of indebtedness occurred at the taxpayer's death since the executors of the estate had no intention of satisfying this debt and the corporation's management had no intentions of trying to enforce it. Therefore, the estate must report income unless it meets one of the exceptions provided in IRC Sec. 108.

To determine the amount of income the estate must include, the Court first considered whether the estate was insolvent. This required a decision about which assets and liabilities are includable in the calculation. The Tax court decided that assets exempt from creditor claims did not have to be included in the taxpayer's calculation of insolvency. This decision was based on the "freeing of assets" doctrine developed in Kirby Lumber. The court rationalized that if income is only realized to the extent assets are freed from creditor claims, only assets subject to creditor claims should be included when determining insolvency. This position is beneficial to taxpayers, because it reduces the asset base and thereby increases the potential of meeting the insolvency test. Increasing the extent to which a taxpayer is insolvent reduces the amount of taxable income.

The 1975 Marcus decision was reached before IRC Sec. 108 was amended. The asset question also has been addressed several times since IRC Sec. 108 was modified in 1980. One such case, Hunt v. Commissioner (T.C. Memo 1989-335) examined the difference between assets exempt from creditors under state law and those exempt under bankruptcy laws. The Tax Court followed Marcus Estate in this case by excluding assets exempt from creditors under state law. However, the Court rejected the idea assets exempt from creditor claims under bankruptcy laws also should be excluded from the calculation.

The Court said Congress anticipated different treatment for taxpayers who had filed for bankruptcy under Title 11 and those taxpayers who were merely insolvent. Their intention was codified in the two separate exceptions under IRC Sec. 108 described earlier. Therefore, the definition of insolvency is irrelevant to bankruptcy cases. As such, only assets excluded from creditor claims under state law can be excluded from the determination of insolvency under IRC Sec. 108(a) (1) (B). By disallowing the exclusion of assets exempt from creditor claims solely due to bankruptcy laws, the Court reduced the extent of the taxpayer's insolvency and in turn, increased the amount includable in gross income.

The Hunt decision was recently upheld in PLR 9130005. In this ruling, the taxpayer's personal residence was foreclosed under a non-judicial foreclosure proceeding. At the time of foreclosure, the residence was worth $100,000 and the mortgage balance on the residence was $122,000. Under the laws of the taxpayer's state, the creditor cannot collect from the debtor a deficiency that results from a nonjudicial foreclosure. In this instance, the creditor may claim only the assets collateralizing the debt. Therefore, the taxpayer has discharge of indebtedness income to the extent of the difference between the fair market value of his personal residence and the face amount of the outstanding debt. This amount must be included in gross income unless the taxpayer meets one of the exceptions under IRC Sec. 108.

The IRS used the rules set forth in Hunt and concluded that all assets exempt from creditor claims under state law could be excluded in the determination of insolvency under IRC Sec. 108(d) (3). However, because the taxpayer had not filed for bankruptcy, the taxpayer could not exclude assets exempt from creditor claims under bankruptcy laws.

Applying the Theory to the Facts

Although the private letter ruling establishes values for the mortgage debt and the home, it does not provide any amount for the income to be recognized or the extent of insolvency. However, an attempt to apply the theory to the known facts results in a very interesting conclusion.

Under state law, the creditor was precluded from collecting any asset other than the residence. Since all of the taxpayer's other assets are free from claims, none of the assets should be used to measure the insolvency. The result is the taxpayer is insolvent for the full amount of the debt in excess of the residence's value and would have no recognized income from discharge of the debt.

This conclusion is fully in keeping with the "freeing of assets" theory of Kirby Lumber. However it is contrary to the economic result in other cases. A good example is Millar (67 TC 656). In this case, the taxpayer surrendered stock in cancellation of debt. The Tax Court held the taxpayer was required to report a gain equal to the amounts of the debt canceled in excess of the value of the property surrendered. The amount reported as a gain is the same amount that the taxpayer would have reported as forgiveness of indebtedness income. However, because the asset surrendered was a capital asset, the income was characterized as capital gain. If this rule is applied to PLR 9130005, the taxpayer would have to report capital gain without regard to any insolvency.

Liabilities to Be Included

The issue that appears to be the most crucial in this area is the classification of the liability between recourse and nonrecourse. If a liability is recourse, it appears the full amount of that liability is included when calculating insolvency. However, the rule for nonrecourse debts is not as clear-cut. Before discussing the effect of nonrecourse debt on insolvency, it is helpful to review the relevant history of nonrecourse debt.

One of the first cases which ruled on the inclusion of forgiveness of indebtedness income due to the discharge of a nonrecourse mortgage was Fulton Gold Corp. v. Commissioner. In this decision, the Court ruled the taxpayer must reduce the basis of the property attached to the nonrecourse debt by the amount that was forgiven instead of recognizing the amount forgiven as income. IRC Sec. 108(c) (5) contains a similar rule, which permits a basis reduction for adjustments made to liabilities incurred to acquire property. It is the IRS's position that these reductions are limited to debt held by the vendor of the property.

In Crane, the Supreme Court ruled nonrecourse debt should be included in both the basis and amount realized on disposition of the property. The Court left unanswered the question of the proper amount realized when the debt exceeded the fair market value of the property. This issue was addressed in Tufts. In Tufts, the taxpayer sold property which was subject to a nonrecourse note that exceeded the value of the property. The sale in question consisted of a third party assuming the existing mortgage. In calculating the gain, Tufts reported the fair market value of the property as the sales price. The Supreme Court ruled the amount realized on the sale equaled the face amount of the note and the fair market value of the property was irrelevant. They justified this ruling by concluding that since a taxpayer treats a nonrecourse debt as true debt upon inception, it must be treated as a true debt when discharged. To allow a taxpayer to limit the amount realized on the sale to the fair market value of the property sold would permit the taxpayer to recognize a tax loss without a corresponding economic loss. The Tufts decision was expanded by Gershkowitz v. Commissioner. In this case, the taxpayer had loans outstanding to a third party which were secured by stock. When the two parties decided to terminate their relationship, the outstanding loans totaled $250,000, while the value of the stock securing the loan was only $2,500. To affect the termination, the taxpayer paid the lender $40,000 in cash. In return, the lender canceled the debt and relinquished its rights to the stock. Relying on Tufts, the Tax Court ruled the taxpayer had relief of indebtedness income of $210,000 (the difference between the face amount of the loan and the amount paid). The fact the taxpayer made a cash payment in Gershkowitz does not change the outcome. Based on these cases the IRS now follows the rule that a taxpayer has forgiveness of indebtedness income when all or part of the liability is discharged even though there has not been a disposition of the collateral.

The court cases have addressed how to treat nonrecourse debt when determining the amount of forgiveness of indebtedness income. A more recent ruling, Rev. Rul. 92-53, addresses the issue of nonrecourse debt when calculating insolvency under IRC Sec. 108(d) (3). Specifically, this ruling sets guidelines for the amount of nonrecourse debt to be included in the insolvency calculation when the outstanding debt exceeds the fair market value of the property that secures the debt.

Preserving a Fresh Start

As is true with assets, the IRC also does not define the term liability as it is used for purposes of calculating insolvency. However, legislative history implies insolvent taxpayers should not be subject to tax on the discharge of indebtedness to preserve the "fresh start," the discharge has allowed. Therefore, the amount by which a nonrecourse debt exceeds the fair market value of the underlying asset should be included as a liability when determining insolvency. The IRS agreed with this position in Rev. Rul. 92-53, but limited the amount of excess nonrecourse debt included as a liability under IRC Sec. 108(d) (3) to the amount of debt that was discharged. In addition, the ruling explains this amount is included in the definition of a liability whether it is the only debt discharged or whether the nonrecourse debt is part of a pre-arranged work-out plan in which both nonrecourse and recourse notes are extinguished.

The position that only the discharged portion of the nonrecourse debt is included stems from the IRS's position that excess nonrecourse debt which is not discharged does not affect on the taxpayer's ability to pay taxes from the discharge of another debt. Therefore, they ruled that nonrecourse debt which was not discharged should not be included in the definition of liability under IRC Sec. 108(d) (3). This decision is important because a taxpayer may be deemed to be insolvent concerning the discharge of nonrecourse debt. If the debt to be discharged, however, is a recourse debt, the same taxpayer may be solvent because all of that person's assets are subject to claims and therefore included in the solvency computation. Therefore, the nature of the debt may be crucial to the decision of which debts need to be renegotiated.

The ruling illustrated this conclusion with the following examples.

Example 1: Assume that the taxpayer owns two assets, a building with a fair market value of $800,000 and a second asset with a fair market value of $100,000. The taxpayer has two debts, a $1,000,000 nonrecourse debt secured by the building and a $50,000 of recourse debt. In the first situation the creditor agrees to a reduction of $175,000 in the nonrecourse debt, bringing it to $825,000. In calculating insolvency the taxpayer's liabilities include the $50,000 recourse debt, the $800,000 nonrecourse (to extent of value) and the $175,000 nonrecourse debt forgiven, totaling $1,025,000. The assets total $900,000. Therefore the taxpayer is insolvent in the amount of $125,000. Since the forgiveness exceeds the insolvency by $50,000, the taxpayer reports $50,000 income.

Example 2: The taxpayer transfers $40,000 of other assets in settlement of the $50,000 recourse liability. None of the nonrecourse liabilities were reduced: therefore, the total liabilities for insolvency are $850,000 ($800,000 value of the nonrecourse asset plus the $50,000 recourse debt). The total assets are $900,000. Since the taxpayer is solvent, he must report $10,000 of income.

Example 3: The nonrecourse liability is reduced by $175,000 as in the first example and the $40,000 asset is accepted in settlement of the $50,000 recourse debt as part of a work-out plan. The total liabilities are $1,025,000 and the assets are $900,000. Therefore, of the $185,000 of debt reduction, $60,000 is reported as income.

The examples clearly illustrate the ruling. However, the ruling is incomplete. There is no mention of Millar or PLR 9130005. Therefore, there is no way to know why the $50,000 of other assets in excess of recourse debt was used to compute insolvency when it is not available to satisfy the nonrecourse debt. As previously indicated the question needs to be resolved.

A question that now appears resolved involves partnership debt. Under IRC Sec. 108(d) (6) and Gershkowitz, it is now settled that insolvency is measured at the partner level and not the partnership level. This is not as detrimental as it might first appear because the flow through of the income will increase the partner's basis in his interest in the partnership and thereby reduce future gain on disposition. In fact, it can be argued that this basis increase should occur even if the income is non-taxable because of a partner level insolvency.

Guidance Needed From IRS

The correct interpretation of Millar and PLR 913005 is unsettled. It may be that a taxpayer who is insolvent for accounting purposes but solvent under IRS rules and regulations would be better off letting the creditor foreclose on the property securing a non-recourse debt rather than negotiating a debt reduction. The foreclosure would generate a capital gain, whereas the cancellation of indebtedness income would be ordinary income. If this is true, it could be a reversal of some recent planning ideas.

It would also be helpful if the IRS were to state its position discussing both the asset and liability side of the insolvency question at the same time. The statement should include when an exchange or foreclosure will be treated as a sale of the property. In addition, the theoretical justification of the conclusion should be fully discussed. Only then will the taxpayer be able to correctly report the reduction in liabilities.

Edward J. Schnee, PhD, CPA, is professor of accounting and director of the Masters of Tax Accounting program at the University of Alabama.

Hughlene A. Burton, CPA, is a doctoral student in accounting at the University of Alabama.