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Contingent debt taken into account in determining insolvency.

The Tax Court recently held, in Merkel, 109 TC 463 (1997), that a taxpayer can include a contingent liability in the determination of insolvency for purposes of the insolvency exclusion of Sec. 108 (a) (1) (B), if the taxpayer can prove it is more probable than not that he will be called on to pay the amount claimed. Sec. 108 (a) (1) (B) provides that gross income does not include amounts otherwise includible in income because of the discharge of indebtedness (DOI) if the discharge occurs when the taxpayer is insolvent. Sec. 108(d)(3) defines insolvent as an "excess of liabilities over the fair market value of assets."

The taxpayers in Merkel claimed insolvency for Sec. 108(a) (1) 03) purposes based on a potential obligation to pay as guarantors of debt and as responsible officers potentially obligated on a corporate state sales tax claim. The IRS argued that only fixed and unconditional liabilities can be included in the calculation of insolvency. The Service's reasoning was that there should be symmetry between discharged liabilities included in income and liabilities included in the insolvency test; a discharge of a contingent liability does not cause DOI income. The court disagreed, citing the legislative history of the Bankruptcy Tax Act of 1980 as authority that liabilities should be included in the calculation of insolvency if it is likely that such liabilities will be paid. Otherwise, the court reasoned, the taxpayer would be forced to pay tax instead of his liabilities; this would be contrary to the "fresh start" mandated by law. The Tax Court, however, held that the taxpayers failed to prove that it was more probable than not that they would be called on to pay the contingent liabilities in question.

Merkel alters the long-held view that contingent liabilities are not taken into account for purposes of determining insolvency. The IRS's position is that no authority exists to bring contingent or contested liabilities within the scope of the term "liability" for purposes of determining insolvency (Letter Ruling (TAM) 8348001, citing Consolidated Edison Co., 366 US 380 (1961)).

Other areas of the tax law treat contingent liabilities differently; contingent amounts are not taken into account until fixed and determinable. For example, contingent amounts payable are not included in basis; see Denver and Rio Grande Western R.R. Co., 505 F2d 1266 (Ct. Cl. 1974) (basis in a railroad line did not include payments to be made out of profits derived from transporting products over that line); Albany Car Wheel Co., 40 TC 831 (1963), aff'd per curiam, 333 F2d 653 (2d Cir. 1964) (contingent liability for severance pay could not be added to the purchaser's basis in the business purchased); and Temp. Regs. Sec. 1.338(b)-3T(d) and (e) (basis in a stock purchase treated like an asset purchase). Also, courts have held that the forgiveness of a contingent liability does not give rise to DOI income; see Corporacion de Ventas de Salitre y Yoda de Chile, 130 F2d 141 (2d Cir. 1942), or Hunt, TC Memo 1989-335. In addition, the Tax Court previously held that the release from a guaranty of debt does not create DOI income (Landreth, 50 TC 803 (1968)).

Possible Effects of Merkel

The Merkel decision provides an increased opportunity for taxpayers to exclude DOI income. Taxpayers now have authority for including contingent liabilities in the insolvency determination if they can prove that it is more likely than not they will be called on to pay a contingent liability or a portion thereof. However, the IRS could possibly use the Merkel "more-probable-than-not" standard for liabilities and apply it to liabilities legally unconditional but not likely to be paid. For example, it is the Service's current position that a nonrecourse liability not discharged is included in the calculation of insolvency only to the extent of the value of the property that secures the nonrecourse liability (Rev. Rul. 92-53). The IRS could also use Merkel to force a taxpayer to prove that it is more probable than not that a recourse liability for which the taxpayer is unconditionally obligated will ultimately be paid.

FROM EDWARD A. SAIR, J.D., CPA, MLT, AND PAUL MORTENSON, J.D., CPA, WASHINGTON, DC
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Title Annotation:tax exclusion
Author:Mortenson, Paul
Publication:The Tax Adviser
Geographic Code:1USA
Date:Mar 1, 1999
Words:701
Previous Article:Final regs. on allocating income between U.S. and possessions.
Next Article:IRS finalizes regs. on basis reduction on excluded DOI income.
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