Insolvency test includes exempt assets.

Under Sec. 61(a)(12), gross income includes income from discharge of indebtedness (DOI). However, Sec. 108(a)(1)(B) excludes DOI income from gross income if the discharge occurs when a taxpayer is insolvent. Sec. 108(d)(3) defines "insolvent" as the excess of liabilities over the assets' fair market value (FMV) (immediately before the discharge). In Carlson, 116 TC No. 9 (2001), the Tax Court held that the term "assets" used in Sec. 108(d)(3) includes assets exempt from creditors' claims under state law.

In 1988, taxpayers purchased a vessel. They borrowed money for the purchase from Seattle First National Bank and granted the bank a preferred marine mortgage interest in the boat. In 1992, the couple became delinquent on loan payments and, in 1993, the bank foreclosed. The boat was sold and the proceeds applied to the loan's outstanding principal balance. The bank discharged the remaining $42,142, apparently prohibited under Alaskan law from seizing the taxpayers' fishing permit (which had a $393,400 FMV) to satisfy the loan's deficiency.

The couple did not report this $42,142 DOI income. The bank filed Form 1099-A, Acquisition or Abandonment of Secured Property, with the Service and sent a copy to the taxpayers, who attached it to their 1992 joint return with the following notation: "Taxpayer Was Insolvent--No Tax Consequence."

The IRS issued a deficiency, notice including the DOI in the taxpayers' income and imposed an accuracy-related penalty. The couple argued that assets (as used in Sec. 108(d)(3)) excludes assets (such as their fishing permit) exempt from creditors' claims under state law. The parties agreed that, if the court sustained the couple's position, they would be insolvent within the meaning of Sec. 108(d)(3) and could exclude the $42,142 DOI income.

The Tax Court first concluded that the statute and Sec. 108 regulations do not define "asset," and that its common meaning supported more than one construction. It then reviewed Sec. 108's legislative history and noted that, under a judicially developed "insolvency exception," no income arises from DOI if the debtor is insolvent both before and after the transaction. If the transaction leaves the debtor with assets whose value exceeds remaining liabilities, income is realized only to the extent of the excess value.

The court then addressed the taxpayer's argument that Cole, 42 BTA 1110 (1940), controlled the issue of whether assets exempt from creditors' claims should be considered for Sec. 108 purposes. The Board of Tax Appeals (BTA) had applied the freeing-of-assets theory of Kirby Lumber Co., 284 US 1 (1931), and Lakeland Grocery Co., 36 BTA 289 (1937), to determine whether the taxpayer became solvent through cancellation of certain notes. In Cole, whether the taxpayer became solvent depended on whether the taxpayer's equity in life insurance policies was includible in assets. The BTA concluded that the equity in these policies was not includible in assets "freed from creditors' claims," because those policies were never subject to creditors' claims to begin with. Hence, the taxpayer was taxable only on gain in the amount of assets actually freed from creditors' claims.

In rejecting Cole's rationale, the Carlson court noted that, in Merkel, 109 TC 463 (1997), aff'd, 192 F3d 844 (9th Cir. 1999), it had held that Sec. 108(a)(1)(B)'s insolvency exclusion eliminated the judicially created net assets test as an exception to the general rule of DOI income.

The court also pointed out that property exempt from creditors' claims was excluded in determining insolvency under the Bankruptcy Reform Act of 1978. Therefore, the court concluded that if Congress had intended to exclude exempt assets from a taxpayer's assets in determining whether the taxpayer is insolvent for Sec. 108 purposes, Congress would have so stated in Sec. 108(d)(3).

Thus, the IRS's determination that included the DOI income in the taxpayers' gross income was sustained. However, the Service conceded that an accuracy-related penalty should not be imposed on that portion of the underpayment, because the couple adequately disclosed such income.

FROM STUART R. JOSEPHS, CPA, TAX ASSISTANCE PRACTICE (TAP), SAN DIEGO, CA