Recognition of "debt modification income" following consumer bankruptcy reform.

EXECUTIVE SUMMARY

* Tax advisers and financial consultants should help clients structure settlements in a way that allows them to exclude discharged debt from gross income.

* Sec. 108 provides an income exclusion for debt forgiveness if taxpayers are insolvent or have debt discharged through bankruptcy proceedings.

* Debtors may avoid recognizing debt modification income if the cancelled obligation is not a valid debt or the modification is a purchase-price settlement.

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The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provided incentives for debtors to negotiate settlement of debts, instead of filing for bankruptcy. This article discusses how to structure settlements to exclude discharged debts from gross income.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (1) (BAP '05), is considered a major overhaul of the U.S. bankruptcy system. Unquestionably, fewer debtors are now eligible to file for Chapter 7 liquidation. The financial accountability and other anti-abuse provisions in the BAP '05 evidence Congress's desire to see a significant number of debtors resolve their financial troubles through negotiated settlements. However, whether such settlements become common, as an alternative to bankruptcy, remains to be seen.

The BAP '05 changes provide an incentive to debtors and creditors to negotiate an alternative resolution. If negotiated settlements become significantly popular as an alternative to bankruptcy, tax advisers and other financial consultants will have to help clients structure those settlements in a way that allows them to exclude discharged debt from gross income.

This article analyzes certain BAP '05 provisions that could result in an increase in negotiated settlements and explains how to avoid discharge of indebtedness (DOI) income (1) under the Sec. 108(a)(1)(B) insolvency exclusion, (2) as a contested liability or (3) as a qualifying purchase-price adjustment. Debtors should be fully informed of the debt modification income that will result from negotiated settlements when these exclusions are unavailable.

Basic Reform Provisions

Means Test

The BAP '05 significantly changes the definition of an "abusive filing" Prior to the BAP '05, it was incumbent on creditors or a court to challenge the propriety of a Chapter 7 filing. The BAP '05 no longer requires creditors or a court to show that a petition for relief constitutes a substantial abuse. It merely requires a determination of abuse (2) and sets forth a "means test" that defines an abusive filing. In light of the means test and other anti-abuse provisions discussed below, an increase in the number of negotiated settlements between debtors and creditors is likely. It is not unusual for laws passed for the purpose of achieving a certain goal to have unintended consequences--that may be the case with the BAP '05. In particular, negotiated settlements with creditors could result in the recognition of DOI income and immediate tax liabilities for already financially strapped debtors.

The means test imposed by the BAP '05 begins with a comparison of a debtor's income to the median income in his or her state of residence. (3) Debtors who earn less than their state's median income are eligible to file for Chapter 7 bankruptcy and eliminate most of their debts with little (if any) payments to their creditors. However, insolvent debtors whose incomes significantly exceed the median income for their state are generally ineligible to file for Chapter 7, and must choose between a Chapter 13 bankruptcy (which requires making monthly payments toward a restructured debt-payment plan) or negotiating settlement of debts directly with creditors.

Credit Counseling

BAP '05 Section 106 provides that individuals seeking relief through the bankruptcy system must have received credit counseling from an approved nonprofit budget and credit counseling agency within 180 days prior to filing a bankruptcy petition. Following credit counseling, debtors who do not qualify for bankruptcy will likely enter into negotiated settlements with creditors.

Realizing that negotiating settlements requires motivation on the part of all concerned, the BAP '05 requires a creditor to engage in good-faith negotiations of reasonable repayment schedules for unsecured consumer debt. Creditors that fail to do so run the risk of having a claim for such debt reduced by as much as 20% by the bankruptcy court. (4) The BAP '05 encourages creditors to accept settlement offers that provide for payment of at least 60% of a dischargeable debt over a reasonable period.

Extended Waiting Period

BAP '05 Section 312(1) also extends the period that a debtor who has previously obtained a bankruptcy discharge must wait before being eligible to obtain another, from six years to eight. Thus, debtors who pass the means tests and find themselves in financial trouble, and who have received a bankruptcy discharge within the last eight years, will be ineligible to file for bankruptcy again. The extension will result in an increased number of debtors ineligible to file for Chapter 7 bankruptcy.

While the BAP '05 is still in its infancy and the effects of the above changes are not yet known, it appears that fewer debtors will be able to avail themselves of protection under the bankruptcy system. The BAP '05 changes could lead to an increased incidence of recognition of debt modification income.

Debt Modification Income

Sec. 61

"Gross income" as defined in Sec. 61(a), is "all income from whatever source derived," and includes "all accessions to wealth, clearly realized and over which the taxpayers have complete dominion." (5) Sec. 61(a)(12) requires taxpayers who have incurred a financial obligation that is later discharged in whole or in part to recognize DOI income to the extent that the obligation is reduced. Taxpayers who are unable to pay their debts, and through negotiated settlements obtain a discharge from all or part of those obligations, realize an accession to wealth; the debt cancellation effects a freeing of assets previously offset by the liability arising from such debt. (6)

Sec. 108

Bankruptcy: Sec. 108(a)(1)(A) excludes from gross income debt forgiveness when the discharge occurs in a "title 11 case." Sec. 108(d)(2) defines a title 11 case as

... a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.

For a debt discharge to qualify for exclusion, the bankruptcy court must explicitly exercise jurisdiction over the discharge of debt; in such cases, a court dealing with related tax issues will generally not second-guess the bankruptcy court's assertion of jurisdiction.

Example 1: J had been a real estate broker for a number of years and established strong relationships with a number of banks. When J decided to open an automobile dealership, those banks lent him $1.5 million for his new venture. J guaranteed the loans. Business was reasonably good, but J began gambling at casinos and suffered large losses. He gambled away the dealership's capital and was unable to remain open. The obligations to the banks went into default. Faced with the demand to pay $1.44 million in delinquent notes, J filed for bankruptcy. He owned sufficient personal property to satisfy the debt. However, after exempting personal property allowed by the laws of his state, J turned $200,000 worth of property over to the trustee in bankruptcy to liquidate and pay to his creditors on a pro-rata basis. The bankruptcy court granted J a discharge from the remaining $1.24 million debt. Because the discharge was obtained through bankruptcy, J was able to exclude the entire $1.24 million from taxable income under Sec. 108. If J had negotiated a similar settlement with the banks under terms resulting in DOI income, much (if not all) of the $1.24 million could be subject to tax.

The Tax Court has generally applied the Sec. 108 exclusion to cases in which the bankruptcy court has exercised jurisdiction. In Gracia, (7) the Tax Court held that the bankruptcy court also explicitly held jurisdiction over a partner in a bankruptcy discharging partnership debt. In Gracia, a partnership sought relief from more than $20 million of debt for which the partners were jointly and severably liable. The partners negotiated a settlement that included an agreed-on contribution payment as part of the bankruptcy plan. Following a contribution of $220,000 to the partnership's bankruptcy estate, the partners were released of "all 'claims or potential claims of all creditors' of the partnership." The bankruptcy court specifically discharged and released the partners from any and all liability arising out of or relating to (1) the partnership, (2) their status as general partners in the partnership and (3) their personal guarantee of partnership debt. Gracia, a partner, was able to exclude $195,120 of discharged debt from gross income. Taxpayers who are able to discharge their debts through the bankruptcy court will still benefit from the exclusion allowed in Sec. 108, despite passage of the BAP '05.

Insolvency: Excluding income arising from debt forgiveness from gross income has historically not been difficult for debtors, as most realize debt discharges through bankruptcy filings. However, Sec. 108 also provides a similar exclusion of income from debt forgiveness for taxpayers whose debts are not discharged through bankruptcy proceedings, but are "insolvent" at the time that their debts are forgiven. Under Sec. 108(d)(3):

.... the term "insolvent" means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.

When the insolvency exception applies, the amount excluded cannot exceed the amount by which the tax-payer is insolvent. Under the "net assets" test, if the debtor is insolvent (i.e., liabilities exceed assets) before and after being discharged from debt, no assets have been freed as a result of the discharge and, thus, no gross income is realized. If after the discharge the debtor is solvent under the net-asset test (i.e., assets exceed liabilities after the discharge), the discharge has freed the debtor's assets from the offset of liabilities; to that extent, some gross income is realized from the discharge. (8) Sec. 108 requires a straightforward showing that a taxpayer's liabilities exceed his or her assets, to be considered insolvent. When debts have not been discharged through bankruptcy, taxpayers must prove insolvency in accordance with Sec. 108.

The definition of insolvency for bankruptcy purposes differs greatly from that under Sec. 108. Under the Bankruptcy Code, an insolvent individual is one whose total liabilities exceed the sum of the fair market value (FMV) of his or her assets, less property that may be exempted in a bankruptcy proceeding under the laws of his or her state. (9)

Example 2: P has $100,000 equity in his personal residence, which has a FMV of $220,000. He also owns household furnishings and personal effects worth $32,000; a truck worth $4,000; $800 in the bank; and stock worth $5,000. In addition to a $120,000 mortgage on his house and a $2,000 loan balance on his truck, P has credit-card debt totaling $110,000. In P 's state of residence, the property exemptions allowed include $100,000 equity in a personal residence; all household furnishings and personal effects, regardless of value; up to $2,000 equity in an automobile; and cash equal to the debtor's earnings for two weeks. P earns $750 a week. Using the criteria in Sec. 108, P's net worth and solvency would be determined as shown in Exhibit 1 on p. 661.

P is dearly solvent under Sec. 108. If he negotiates a settlement with the credit-card companies that allows him to pay half of his outstanding balances, the amount discharged ($55,000) would be taxable DOI income to him. However, under the Bankruptcy Code, P's net worth and solvency would be determined differently, as shown in Exhibit 1.

After excluding exempt property from his assets, P is insolvent. The exemption of certain assets contributes to his insolvency, and if he otherwise qualifies to file bankruptcy and does so, he can avoid DOI income recognition.

Additional Asset Exemptions

BAP '05 exacerbates the difference in the insolvency determination by increasing asset exemptions. Exemptions are extended to include (1) retirement savings, (10) (2) education savings (11) and (3) employee contributions to employee benefit and health insurance plans. (12) Although the BAP '05 standardized the homestead exemption across states with limited exceptions, allowing these additional exemptions will further widen the difference between the calculation of solvency under the Bankruptcy Code versus Sec. 108.

Contingent Liabilities

The Bankruptcy Code and Sec. 108 may require different treatment of contingent liabilities in determining a debtor's net assets. Contingent liabilities are those that may or may not result in the debtor having to pay them. They often arise when an individual guarantees payment of the debt of a related party in the event of default. In Chapter 7 bankruptcy cases, debtors generally include all of their liabilities, with little distinction made between contingent and noncontingent. A discharge of liabilities in a bankruptcy petition generally relieves the debtor of all liabilities.

A taxpayer claiming the benefit of the Sec. 108(a)(1)(B) insolvency exception must prove, as to any obligation claimed to be a liability, that (1) as of the calculation date, it is more probable than not (emphasis added) that he or she will be called on to pay that obligation in the amount claimed; and (2) the total liabilities so proved exceed the FMV of the assets. (13) Under Sec. 108, debtors generally must exclude contingent liabilities in the calculation of "net assets" unless it is more probable than not that they will be called on to pay them.

In Merkel and Hepburn, (14) a consolidated case, Merkel and Hepburn were partners in a computer-leasing business that ran into financial trouble and was unable to pay its debt obligations: a bank note with a balance in excess of $3.1 million and sales and use tax assessed by North Carolina of almost $1 million. Merkel and Hepburn guaranteed the bank loan; as officers of the partnership, they were liable for any sales and use tax that should have been collected by the partnership. The partners negotiated a structured workout for the debt the partnership owed the bank, which resulted in releases for the partnership (as well as the individual partners). The negotiated settlement for the bank debt was substantially less than the balance owed on the note. The partners appealed the sales and use tax assessment and were successful in having it abated. Each of the partners realized $359,721 in income due to debt forgiveness on the bank note, which they reported, but excluded from income under the insolvency exception of Sec. 108(a)(1)(B).The IRS disallowed the exclusion, arguing that the contingent obligations did not meet the definition of "liabilities" under established accounting principles. The partners argued that contingent liabilities resulting from their guarantee of the bank note and the unpaid assessed sales taxes should be included in the insolvency calculation.

The Tax Court concluded that to include contingent liabilities in determining the taxpayers' insolvency, they had to show that it was more likely than not that they would be required to pay the liability, which they failed to do. Neither was insolvent for Sec. 108(a) (1)(B) purposes. The Tax Court had the advantage of hindsight, enabling it to determine with certainty whether or not the debtors were compelled to pay their contingent liabilities. Generally, a court will be able to use hindsight when determining insolvency in such cases. Had Merkel and Hepburn been held personally liable on the two obligations--the payment demanded by the bank and North Carolina--each of them would have been considered insolvent under Sec. 108(a)(1)(B).

Avoiding Debt Modification Income

Taxpayers who negotiate a discharge of some or all of a debt may avoid DOI income, even if not insolvent for purposes of excluding their cancelled debt under Sec. 108(a)(1)(B).To the extent that a taxpayer can show that a cancelled obligation was not a valid debt, or that the cancellation was a purchase-price adjustment, he or she can avoid recognizing debt modification income for the amount justified. Debtors who finance purchases directly with sellers will be in the best position to avail themselves of the exclusions allowed under the contested-liability and purchase-price-adjustment doctrines.

Contested-Liability/Disputed-Debt Exception

The contested-liability (or disputed-debt) exception rests on the premise that if a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of that dispute is "treated as the amount of debt cognizable for tax purposes." (15) To exclude income from debt reduction on grounds that the original debt was not valid, the taxpayer must prove that there was a bona fide dispute over the legitimacy of the original debt. A mere assertion on the taxpayer's part that the debt is questionable is not enough.

Example 3: M Co. sold a used bulldozer to A for $25,000. M financed $22,000 of the purchase price. Soon after A acquired the bulldozer, it stopped working. A was advised by a mechanic that the engine was so badly worn, it needed to either be replaced or completely reworked. The cost to repair or replace the engine would be $10,000. M's salesman had told A that the engine in the bulldozer had just been rebuilt and, because of this deception, A refused to make further payment. This resulted in an agreement between A and M to reduce A's debt by $10,000, the cost of the repair. A will not recognize income from the debt reduction, because there was a bona fide dispute over the bulldozer's value and the debt reduction was a legitimate good-faith settlement of that dispute.

For the disputed-debt exception to apply, negotiations must be with the seller of goods or services, rather than with a third-party lender. In Preslar, (16) the taxpayer borrowed funds to buy property and excluded subsequent negotiated reductions in his loan principal on the grounds that they were adjustments to the sales price. The Tax Court ruled in the taxpayer's favor on the issue, but the Tenth Circuit reversed, because the lender was not the seller of the property, but had merely financed the transaction, and there was no dispute over the validity of the loan. However, the court did make it clear that taxpayers can exclude debt cancelled in settlement of a bona fide dispute over the debt's validity. It summed up the "contested liability/ disputed debt exception" as follows:

The "contested liability," or as it is occasionally known, "disputed debt" doctrine, rests on the premise that if a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of that dispute is "treated as the amount of debt cognizable for tax purposes." In other words, the "excess of the original debt over the amount determined to have been due" may be disregarded in calculating gross income.

Following the contested-liability doctrine in Preslar, there are a number of situations in which solvent taxpayers may be permitted to exclude DOI income. Taxpayers who buy goods on credit and negotiate reductions in their obligations due to misrepresentations concerning those goods should be able to employ the contested-liability doctrine. Taxpayers who buy businesses using seller financing and negotiate a debt reduction when they discover that they were deceived about the enterprise's past profits, may also be able to exclude negotiated purchase-price adjustments under the contested-liability doctrine.

Still another exclusion of DOI income may be available to debtors who negotiate settlements with creditors that may have jeopardized their rights of recovery due to noncompliance with certain legal procedures.

Example 4: S, a boat dealer, sold a boat to R for $40,000 and financed $30,000 of the sales price. S transferred the $30,000 note to a bank for cash and personally guaranteed it in the event of default. R defaulted on the loan. The bank repossessed the boat under the terms of the security agreement and sold it at auction for $20,000. Although state law required the bank to give notice to all liable parties prior to the sale, no such notice was given to S. The bank sought payment from S for the $10,000 difference between the note balance and the auction proceeds. S informed the bank that she was not given proper notice and disputed the bank's claim. Because proper notice had not been given, the bank settled its claim against S for $2,000. The bank's failure to give S proper notice of the impending boat sale jeopardized its right to recover $10,000 from her. There should be no recognition of DOI income by S, because the reduction was of a disputed debt.

The contested-liability doctrine could also be applied when a taxpayer is discharged from debt when the creditor has no legal right to extend the debt. In Zarin, (17) a gambler was discharged from debt created when a casino extended him credit in defiance of an emergency order issued by the New Jersey Casino Control Commission. Although the taxpayer negotiated a settlement with the casino to pay part of what he owed, the emergency order made extension of the credit illegal and recovery of the debt unenforceable. The court held that because the taxpayer was not liable for the debt he allegedly owed the casino, the Code's cancellation-of-debt provisions did not apply.

There are a number of situations to which the contested-liability doctrine might apply. Its applicability should be considered whenever there is a bona fide dispute over the validity of a debt.

Purchase-Price Adjustments

Taxpayers who can show that their debt modifications are a "purchase price adjustment" can avoid DOI income. As with disputed debts, avoidance under this exception is not usually available when debt-reduction negotiations are with third-party lenders. Sec. 108(e)(5) provides:

If--

(A) the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced,

(B) such reduction does not occur--

(i) in a title 11 case, or

(ii) when the purchaser is insolvent, and

(C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness, then such reduction shall be treated as a purchase price adjustment.

Generally, consumer creditholders are considered third-party debtholders, financiers of initial retail transactions. Sec. 108(e)(5) applies only to direct agreements between a purchaser and seller. According to Rev. Rul. 92-99, (18) if a debt has been transferred by the seller to a third party, or the property has been transferred by the buyer to a third party, the purchase-price reduction exception is generally not available. In Preslar, the court reiterated the rationale articulated in Rev. Rul. 92-99:

An agreement to reduce a debt between a purchaser and a third-party lender is not a true adjustment of the purchase price paid for the property because the seller has received the entire purchase price from the purchaser and is not a party to the debt reduction agreement.

There is a limited "infirmity exception" to the general prohibition against treating debt reductions as purchase-price adjustments in other than direct seller-purchaser transactions. Rev. Rul. 92-99 states that, under this exception, when the seller may have misrepresented a material fact or induced the buyer to purchase through fraud, a negotiated adjustment with the third party based on an infirmity that dearly relates back to the original sale, can be treated as a purchase-price adjustment.

Example 5: X contracted with Y to provide service for all of X's computer equipment at various insurance agencies located throughout the state. Y represented to X that "factory-trained technicians" would service the computers. The cost of the contract was $36,000, payable in 36 monthly installments of $1,000. Y sold the right to receive the monthly payments to C for a lump sum. X made monthly payments directly to C. After only 90 days, X became discontented with Y's service. The technicians sent to service X's computers were merely college students, rather than factory-trained technicians. On several occasions, the students were unable to fix the computer problems, causing X to call other technicians at additional costs. X spoke with C's representative, explained the situation, and suggested that she would void the contract with Y unless the monthly payments were reduced to $500.

C acknowledged that it was experiencing similar problems with other Y customers and agreed to the reduced amount. Even though the negotiated settlement was with a third party (rather than the service provider), the fact that the debt reduction was due to misrepresentation of a material fact, and because C was familiar with Y's business practices, X should be able to use the infirmity exception to avoid DOI income recognition.

Other Timing and Recognition Issues

Ordering of Modification Agreements

While a taxpayer who has negotiated settlements of several debts may be insolvent when he or she negotiates his or her earliest settlements, the taxpayer may reach a point at which sufficient debt is eliminated such that he or she is no longer insolvent as he or she negotiates settlements on the remaining obligations. Only debt relief negotiated when the taxpayer was insolvent will qualify for exclusion from gross income under Sec. 108(a)(1)(B). Each negotiated settlement is viewed as a separate event and is subjected to its own solvency test. As mentioned earlier, under the net-asset test, the taxpayer must be insolvent before and after a DOI to avoid income recognition. If the debtor is solvent under the net-asset test after the discharge, income is recognized to the extent that the discharge has freed assets from the offset of his or her liabilities. Taxpayers who face this potential problem would be wise to structure the order of their negotiated settlements such that the last debt settlement is large enough to qualify the taxpayer for the income exclusion under Sec. 108(d)(3).

Example 6: O operated a business that failed. When O closed the business, he owed Supplier A $150,000; Supplier B $68,500; and a credit-card company $13,000. He owns $3,000 in stock; $8,000 in household goods and personal effects; an automobile worth $2,000; $2,000 cash; and an unencumbered home worth $150,000. After closing his business, he began a job that paid too much to qualify to file Chapter 7 bankruptcy. O decides to negotiate a settlement with his creditors. He finds a buyer for his home and, after sales commission and closing costs, will receive $141,500. Because this is substantially less than the amount O owes his creditors, he negotiates a settlement with A and B to pay each a fraction of what he owes, in full satisfaction of his obligations. O would retain the balance of his assets, which could still be subject to the claim of the credit-card company. If A and B were to accept O's proposed debt reduction, the order of his settlements would be critical to avoiding DOI income. O's net worth and insolvency before any negotiated settlements are shown in Exhibit 2 at right.

O sells his home and negotiates a 50% settlement with A. He uses $75,000 of the net proceeds to settle his $150,000 debt with A. Immediately following the transaction, O's net worth and insolvency would be as shown in Exhibit 2, under "Following settlement with A."

O would be solvent following the discharge. While no assets are freed, any further negotiated settlements at less than the full amount owed would result in DOI income recognition. However, if O entered into negotiations to settle his smaller debt with B first and subsequently negotiated a settlement with A, the result could be dramatically different, as shown in Exhibit 2, under "After settling with B first." (O negotiates to pay B approximately 78% of the amount owed.) O continues to be insolvent following the settlement with B. There would be no recognition of DOI income from the settlement, because O is insolvent immediately before and after the settlement transaction. O can now negotiate a settlement with A that will allow him to avoid DOI income recognition.

O negotiates to pay A the remaining cash balance of $90,070, approximately 60% of the amount owed. Immediately following the settlement transaction with A, O's net worth and solvency would be as shown in Exhibit 2, under "After settling with A second." Although O is not insolvent following the transaction, no assets were freed as a result. Thus, O would not have to recognize DOI income.

The ordering of debt modification negotiations is generally not an issue for taxpayers whose debts are discharged through bankruptcy; the granted petition discharges all of a debtor's obligations at once.

Timing Income Recognition

Creditors who grant debt reductions are required by law to send Form 1099-C, Cancellation of Debt, to each debtor and to the IRS, stating the amount of the taxpayer's debt reduction. Not all creditors comply with this requirement. Taxpayers who did not receive the required form and failed to report the income attributable to debt forgiveness have argued that, in the absence of a Form 1099-C, they had no DOI income. The Tax Court has routinely rejected this argument and ruled that receipt of a Form 1099-C is not determinative of whether a taxpayer had DOI income. (19) Moreover even when a creditor does send a Form 1099-C, the year specified in the form as the year in which the DOI occurred is not controlling. Rather, debt is deemed cancelled in the year the creditor ceases collection activities. (20)

Conclusion

The BAP '05 imposes a stringent means test that will prevent many debtors from qualifying for bankruptcy protection. Debtors deemed able to repay a significant portion of their debts under the new financial accountability provision of the BAP '05 are likely to enter into debt modifications with creditors. These negotiated settlements could result in taxable income for debtors, accompanied by an immediate unintended tax burden.

Sec. 108 generally requires a tax-payer who discharges debt for an amount less than its face value to recognize taxable income, as the reduction or cancellation of the debt makes available to a taxpayer assets that previously had been offset by the debt obligation. Tax advisers, financial advisers and consultants should familiarize themselves with the eligibility provisions of the BAP '05 and understand the tax consequences of limiting a debtor's eligibility to discharge debts through bankruptcy. Taxpayers who are unable to qualify for bankruptcy protection and not "insolvent" could have significant tax liabilities following debt modifications resulting from negotiated settlements.

Tax advisers knowledgeable about the BAP '05's changes will be able to advise clients of the tax provisions that allow them to avoid recognizing income from discharged debt. These include negotiating reductions in debt based on a bona fide dispute, challenging a debt's validity and identifying purchase-price adjustments. Taxpayers must be properly advised as to the order in which they should negotiate settlement of several different debts, to avoid income recognition from the freeing of assets. Even when there are no applicable exceptions available, it is incumbent on tax advisers to inform clients of the income tax consequences of debt modification agreements. Negotiated debt settlements could potentially result in large unanticipated tax liabilities for debtors.

For more information about this article, contact Dr. Nash at [e-mail]

(1) P.L. 109-8.

(2) BAP '05 Section 102(a)(2)(B)(i)(III).

(3) BAP '05 Section 102(a)(2)(C).

(4) BAP '05 Section 201(a).

(5) See Glenshaw Glass Co., 348 US 426 (1955).

(6) Kirby Lumber Co., 284 US 1 (1931).

(7) Jose Gracia, TC Memo 2004-147.

(8) Dudley B. Merkel and David A. Hepburn, 109 TC 463 (1997).

(9) See 11 USC Section 101(32).

(10) See BAP '05 Section 224.

(11) See BAP '05 Section 225.

(12) See BAP '05 Section 323.

(13) Merkel and Hepburn, note 8 supra.

(14) Id.

(15) David Zarin, 916 F2d 110 (3d Cir. 1990).

(16) Layne E. Preslar, 167 F3d 1323 (10th Cir. 1999), rev'g TC Memo 1996-543.

(17) Zarin, note 15 supra.

(18) Rev. Rul. 92-99, 1992-2 CB 35.

(19) See, e.g., Gregory Paul, TC Summ. Op. 2002-149.

(20) See Judith M. De Shon, TC Summ. Op. 2005-117.

James Parker, J.D., M.L.T.

Professor of Business Law

School of Business

Christian Brothers University

Memphis, TN

Claire Y. Nash, Ph.D., CPA

Associate Professor of Accountancy

School of Business

Christian Brothers University

Memphis, TN

Exhibit 1: Computation of net' worth and
insolvency for Example 2

Under Sec. 108

Assets:

Cash                               $800
Stock                             5,000
Personal residence              220,000
Household furnishings            32,000
Truck                             4,000
Total                          $261,800

Liabilities:

Credit-card debt               $110,000
Truck loan                        2,000
Home mortgage                   120,000

Net worth                        29,800
Total                          $261,800

Under the Bankruptcy Code

Non-exempt assets:

Stock                            $5,000
Value of truck                    2,000

Total                            $7,000

Liabilities:

Credit-card debt               $110,000
Truck loan                        2,000
Home mortgage                   120,000
Net worth                     (225,000)
Total                            $7,000

Exhibit 2: Net worth and solvency for Example 6
(multiple settlements)

Before settlements
Assets:

Cash                              $2,000
Stock                              3,000
Personal residence               150,000
Household furnishings              8,000
Automobile                         2,000
Total                           $165,000

Liabilities:

Supplier A                      $150,000
Supplier B                        68,500
Credit-card debt                  13,000

Net worth                       (66,500)
Total                           $165,000

Following settlement with A
Assets:
Cash                             $68,500
Stock                              3,000
Household furnishings              8,000
Automobile                         2,000

Total                            $81,500

Liabilities:
Supplier B                       $68,500
Credit-card debt                  13,000

Net worth                           -0-
Total                            $81,500

After settling with B first
Assets:
Cash                             $90,070
Stock                              3,000
Household furnishings              8,000
Automobile                         2,000

Total                           $103,070

Liabilities:
Supplier A                      $150,000
Credit-card debt                  13,000

Net worth                       (59,930)
Total                           $103,070

After settling with A second

Assets:
Cash                                  $0
Stock                              3,000
Household furnishings              8,000
Automobile                         2,000
Total                            $13,000

Liabilities:
Credit-card debt                 $13,000

Net worth                           -0-
Total                            $13,000