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Forgiveness of Debt as Taxable Income and the Insolvency Exception

A concept under federal tax laws that seems to baffle a lot of people is Cancellation of Debt income (“COD Income”). Under IRC §61(a)(12), when you have debt cancelled by a creditor there is resulting taxable income. For example, if you have $5,000 of credit card debt and negotiate a non-bankruptcy work out to pay only $2,000 of the debt, you have $3,000 of potential taxable income ($5,000 original debt, less $2,000 actually paid = $3,000 of COD income).

There are, however, various situations listed in IRC §108(a) in which COD income is not taxable. Debt discharged in Bankruptcy does not create taxable income; debt secured by a principal residence, which is discharged prior to January 1, 2013, is not taxable income; debt discharged when the taxpayer is insolvent is not taxable income; and there are a few other technical situations in which the discharge of debt does not create taxable income.

The exception for discharge of indebtedness when the taxpayer is insolvent seems fairly straightforward. If the taxpayer’s debts exceed the value of the taxpayer’s assets, the taxpayer is insolvent. Of course, there are situations in which the value of the taxpayer’s assets is difficult to determine (privately held business interests, art, etc.), but another aspect of “insolvency” that is not 100% clear is whether assets which would not be available to creditors in a Bankruptcy proceeding are included in the calculation of insolvency for purposes of IRC §108(a). Most notably, are ERISA pension funds included in a taxpayer’s assets for determining solvency?

Earlier this week, the United States Tax Court touched on this issue in the case of Shepherd v. Commissioner (T.C. Memo 2012-212). Unfortunately, the Court seems to have somewhat sidestepped this issue in Shepherd and ruled only that the portion of the taxpayer’s pension which could be withdrawn as a loan was an asset for purposes of insolvency under IRC §108, while specifically refusing (in footnote 7) to make a ruling on whether the entire value of the pension constitutes an asset under IRC §108.

Despite the Court’s refusal to address the issue of whether ERISA exempt assets should be included in the calculation of solvency for COD income purposes, it is clear from the Shepherd case that the IRS position remains that these assets are to be included in the calculation. As such, taxpayers should consider the possibility of IRS challenge to the exclusion of COD from taxable income, based on insolvency, where there are pension (or other creditor protected assets) which may change the analysis. The threat of this tax outcome may also alter the analysis of whether a non-bankruptcy workout is preferential to filing for Bankruptcy, as debts discharged in Bankruptcy are clearly exempt from taxable income, and ERISA assets will generally remain safe from the taxpayer’s creditors in a Bankruptcy proceeding.