IRS Seeks Broader Insolvency Asset Definition

IRS Seeks Broader Insolvency Asset Definition

The IRS believes the definition of asset under the discharge of debt insolvency exception is more expansive than that set down by the Tax Court. The IRS announced its nonacquiescence in the case of Schieber v. Commissioner. In that case, the Tax Court found the taxpayers' interest in a defined benefit pension plan was not considered an asset in determining whether the taxpayers were insolvent on the date the debt was canceled, and in determining the amount of their insolvency.

Insolvency Exception

Generally, taxpayers must include cancelled debt in income. However, cancellation of debt does not result in gross income to the borrower if the debt discharge occurs when the borrower is bankrupt or insolvent. The term insolvent for this exclusion means the excess of the taxpayer's liabilities over the fair market value of the taxpayer's assets. Whether the taxpayer is insolvent, and the amount of the insolvency, is determined based on the taxpayer's assets and liabilities immediately before the debt discharge.

Is a Pension Plan Interest an Asset?

The issue in this case was whether the taxpayers' interest in the defined benefit pension plan was considered an asset in determining whether they were insolvent on the date the debt was canceled, and the amount of their insolvency.

If the pension plan interest was not considered an asset, the taxpayers' liabilities exceeded their assets by $293,308, and they would be considered insolvent for this amount and entitled to exclude it from cancelled debt income. With the pension plan included, the taxpayers would be taxable on the entire amount of debt discharged ($418,596).

Tax Court looks to prior court rulings and legislative history

The Tax Court noted that the word “assets” is not defined by the Internal Revenue Code. So the court looked to prior decisions citing legislative history to make its determination. In Carlson v. Commissioner, the Tax Court held that an asset exempt from creditors could still be an asset for the Tax Code insolvency exception because even an asset exempt from creditors can give the taxpayer “the ability to pay an immediate tax on income” from the canceled debt.

Comment: The court in Carlson cited Merkel v. Commissioner. In that case, Tax Court took note of Congress' indicated purpose of not burdening an insolvent debtor outside of bankruptcy with an immediate tax liability, the insolvency exclusion and its limitation, as well the statutory insolvency calculation. According Merkel court, these suggested that "Congress intended to make a debtor's ability to pay an immediate tax on income from discharge of indebtedness the controlling factor in determining whether a tax burden is imposed."

In Schieber, the taxpayers had only the right to receive monthly payments from the pension plan. The taxpayers could not access the value in the plan. They could not convert their interest in the plan to a lump-sum cash amount, sell the interest, assign the interest, borrow against the interest, or borrow from the plan. Because the taxpayers' interest in the pension plan could not be used to immediately pay the income tax on cancelled debt income, the Tax Court held that the interest was not an asset within the meaning of the insolvency exception.

IRS: Prior court rulings and legislative history not determinative

In its nonacquiescence, the IRS claimed the Tax Court erred by turning the legislative history and prior court rulings into a into a "threshold test not found in the statute itself." The IRS stated that the right to a stream of payments over a taxpayer's lifetime falls within the plain meaning of the term asset. The IRS further claimed that the Tax Court should have considered the current year's distributions from the pension in the insolvency computation.

So taxpayers can expect the IRS to challenge any exclusion of a defined benefit pension plan interest—whether present or future—and possibly other future interests as well, in determining assets for insolvency purposes.

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