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Exempt assets may increase insolvency exclusion.

Under Sec. 61(a)(12), a taxpayer generally must include as gross income any income from discharge of indebtedness. An important exception to this rule is found in Sec. 108(a)(1)(B), which provides that debt discharge income is not included in gross income if the discharge occurs when the taxpayer is insolvent under Sec. 108(d)(3) (i.e., the taxpayer's liabilities exceed the fair market value (FMV) of his assets). Given the relatively large number of distressed business ventures, this exception has taken on increased significance in recent years.

The theory underlying the Sec. 108(a)(1)(B) exception is that there is no accession to wealth if the taxpayer is insolvent both before and after the discharge, since assets have not been "freed" from the claims of creditors. (See, e.g., Kirby Lumber Co., 284 US 1 (1931), and Dallas Transfer & Terminal Warehouse Co., 70 F2d 95 (5th Cir. 1934).)

The IRS has recognized that the insolvency exception is a codification, in part, of the freeing of assets theory. Thus, in Letter Rulings 9125010 and (TAM) 9130005, the IRS ruled that assets exempt from the claims of creditors under applicable state law are not considered in determining whether, and the extent to which, a taxpayer is insolvent. After all, an asset cannot be "freed up" if it was not subject to creditors' claims to begin with. Est. of Marcus, TC Memo 1975-009, and Hunt, TC Memo 1989-335, support this conclusion. Example: Taxpayer T has liabilities of $150 and assets with an FMV of $100, of which $10's worth is not subject to the claims of creditors. A creditor discharges $60 of T's liabilities. Under the rationale of the letter rulings, T may exclude from income the entire $60 forgiveness, since T is insolvent to the extent of $60 ($150 - ($100 - $10)) immediately prior to the discharge.

It is important to emphasize two points. First, for purposes of the Sec. 108(a)(1)(B) insolvency exception, the determination of insolvency is made by excluding only those assets exempt from claims of creditors under state law (and presumably under nonbankruptcy federal law); assets exempt under federal bankruptcy law cannot be excluded, unless sanctioned under state law. Thus, since the laws of various states differ, there is no nationwide uniformity in determining which assets are exempt from creditors' claims. Therefore, taxpayers in identical financial positions but in different states may be subject to different tax treatment.

Second, taxpayers who have their debts discharged in bankruptcy must look to the Sec. 108(a)(1)(A) exclusion rather than to Sec. 108(a)(1)(B), since Sec. 108(a)(2) provides that the bankruptcy exclusion takes precedence.

Although exemptions differ by state, it may be interesting to list some that are generally applicable under Florida law.

* Homestead exemption. * $1,000 personal property exemption. * Certain wages of a head of family. * Proceeds and cash surrender value of certain life insurance policies with respect to the claims of creditors of the insured. * Proceeds of certain annuity contracts. * Certain disability income benefits. * Certain pension and retirement benefits. * Certain interests of a beneficiary in a spendthrift trust. * Assets held by husband and wife as tenants by the entireties, with respect to creditors of one spouse alone.

In addition, under federal (nonbankruptcy) law, Veterans Administration benefits and Social Security benefits are generally not subject to claims of creditors. Presumably, under the freeing of assests rationale, these benefits generally should not be considered in determining whether, and the extent to which, a taxpayer is insolvent.

A person considering filing for bankruptcy should compare carefully those of his assets exempt under the federal bankruptcy law with those exempt under state (and nonbankruptcy federal) law. In particular, a client whose assets are fully or largely exempt under state law may find that, depending on all the facts and circumstances, filing for bankruptcy is not the most appropriate course of action.
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Author:Orbach, Kenneth N.
Publication:The Tax Adviser
Date:Jan 1, 1992
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