Calculating the value of insolvency.
The IRS has spent a great deal of time analyzing this topic. Which assets can be excluded? Which liabilities can be included? How are the items valued? Is it possible for a guarantor to be let "off the hook" when a debt is forgiven and avoid DOI income, and, at the same time, count the debt as a liability for insolvency purposes? A recent decision, a letter ruling, a technical advice memorandum and a field service advice memorandum now give practitioners some guidance in dealing with the above questions.
In Dudley B. Merkel, 192 F3d 844 (9th Cir. 1999), aff'g 109 TC 463 (1997), the Ninth Circuit had to decide the issue of "when is a liability a liability" for insolvency purposes. Dudley Merkel and David Hepburn were the officers and co-owners of Systems Leasing Corp. (SLC), a computer leasing company. SLC secured a bank loan in 1986, which Merkel and Hepburn personally guaranteed. As of April 16, 1991, the unpaid balance of the note approximated $3.1 million and SLC was in default. The bank did not demand payment from Merkel and Hepburn. On May 31, 1991, SLC, the bank and the guarantor shareholders entered into a structured workout agreement. SLC agreed to pay the bank $1.1 million by August, and the bank agreed to discharge the remaining balance and release Merkel's and Hepburn's personal guarantees, as long as none of the parties filed for bankruptcy within 400 days after Aug. 2, 1991.
In an unrelated matter, the Service charged Merkel and Hepburn with $360,000 of DOI income from a partnership that they operated with their wives. On their 1991 returns, both couples excluded this DOI income from gross income, claiming that their liability as guarantors on the SLC note rendered them both insolvent.
The IRS argued that the personal guarantee was not a liability for "insolvency" purposes. Therefore, the taxpayers were solvent and had to include the DOI in gross income, because their liabilities did not exceed the FMV of their assets. According to the Service, only those debts "ripe" and in existence immediately before the discharge could be counted as liabilities. A guarantee is a remote liability until the guarantor is actually forced to make a payment. The taxpayers, on the other hand, argued that all liabilities, contingent or not, should be included in the insolvency formula.
The issue before the court on appeal was whether the taxpayers were "insolvent" when the bank forgave SLC's note. The court had to decide if the guaranty on the loan was a liability for insolvency purposes, taking into account the fact that the note was contingent on the occurrence of a bankruptcy filing.
According to the court, Sec. 108(d)(3) does not indicate how likely the occurrence of a contingency must be to count the obligation as a liability. Nor is it clear from the statute whether Congress intended for all contingent liabilities to be considered in the insolvency calculation. The court disagreed with the taxpayer's inclusion of all liabilities in the insolvency formula. Such a rule, according to the court, would lead to absurd results if remote contingencies were taken into account. The court felt that rules that exclude items from income should be construed narrowly The court reasoned that, historically, insolvent taxpayers could exclude DOI income to preserve a debtor's "fresh start," so as not to burden him with an immediate tax liability when a debt is forgiven. On the other hand, the court also stated that if a taxpayer had "free" assets that could be used to pay an immediate tax liability, the DOI income should be included in gross income to the extent of one's solvency (as computed after the discharge).
Affirming the Tax Court, the court held that, for purposes of determining insolvency under Sec. 108(d)(3), a taxpayer must show by a preponderance of the evidence that he will more likely than not be called on to pay a liability. The court found that Merkel and Hepburn failed to prove that a bankruptcy event was likely to occur and, therefore, failed to prove that they would be called on to pay any amount to the bank. Both taxpayers were found to be solvent and the DOI was included in their gross income.
Sec. 108(d)(3) makes clear that, for insolvency purposes, a taxpayer's liabilities must exceed the FMV of his assets. However, the Code does not indicate which assets are included. Prior to 1999, Letter Ruling 9125010 concluded that assets exempt from the reach of creditors under state law (e.g., personal residence and other exempt property) were excluded from the insolvency formula when deciding if DOI income is taxable.
However, on May 4, 1999, the Service issued Letter Ruling 9932013, which revoked Letter Ruling 9125010. In its new ruling, the IRS acknowledged that case law since 1940 has allowed the exclusion of these exempt assets, but there was no statutory basis in Sec. 108(d)(3) to support this rationale. Therefore, the FMV of all assets must now be counted in the insolvency formula.
The Service applied this rule in Letter Ruling (TAM) 9935002. A taxpayer purchased a residence for $130,000. A few years later, the FMV of the property declined to $100,000, but the outstanding mortgage remained at $122,000. The deficiency of $22,000 was discharged and the Service claimed that the taxpayer had $22,000 of taxable DOI income. The taxpayer claimed that he was insolvent and could exclude the DOI income from gross income if assets exempt from creditors' claims under state law could be excluded from the insolvency formula. The IRS concluded that the taxpayer was solvent, because assets could no longer be excluded from the insolvency formula. As a result, the taxpayer had taxable DOI income of $22,000.
In Field Service Advice 9932019, the Service sealed the last leak. A husband and wife owned real and personal property (bank accounts, stocks, bonds and a residence) as tenants by the entirety. The husband took out a commercial loan in his own name. Subsequently, a portion of the loan was cancelled. The husband did not report the resulting DOI income on his tax return, on the grounds that his liabilities exceeded the FMV of his assets if he excluded the assets he owned with his wife as tenants by the entirety.
The IRS included all of the husband's assets in its insolvency calculation and his net worth increased by 800%. The IRS concluded that any assets held by the husband as tenants by the entirety must be included in the insolvency formula. Otherwise, it noted, taxpayers would be motivated to hold most of their assets as tenants by the entirety to exclude their DOI income.
CPAs are familiar with the more-likely-than-not test of Merkel. They have been dealing with this ambiguous test for several years under Financial Accounting Standards Board Statement No. 5, when determining if a contingent liability should be shown on a client's balance sheet.
According to the majority, if Merkel and Hepburn had proved that a bankruptcy filing was possible and it was more likely than not that they could be called on to pay, their contingent debt would have been classified as a liability and they would have been deemed insolvent with no taxable DOI income.
FROM MICHAEL LYNCH, J.D., CPA, MST, BRYANT COLLEGE, SMITHFIELD, RI, AND MARK CONLEY, MST, TRIPLE G SCAFFOLD, NORWELL, MA (NEITHER ASSOCIATED WITH KPMG LLP)
|Printer friendly Cite/link Email Feedback|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2000|
|Previous Article:||Partnership's ownership of residence does not deny sec. 121 exclusion.|
|Next Article:||Tax Court applies sec. 1041 nonrecognition provisions to stock redemption.|