The Insolvency Exclusion to Cancellation of Debt (COD) Income; The Effect of Exempt Assets Under the Carlson Rule (Part 1 of 2)
Guest Writer - Mike Cook, Winstead PC
Part 1 of 2
During the current economic crisis, debtors will be negotiating workouts with lenders and if the debtors successfully obtain debt relief, they will also be seeking tax relief from the taxation of COD income. The ability to use the broadest exclusion from COD income, the insolvency exclusion, has been severely restricted in recent years. The relief from taxation of COD income by reason of insolvency of a taxpayer has a common law history, but it was codified in 1980 as Section 108(a)(1)(B) of the Internal Revenue Code. The legislative history of the Bankruptcy Tax Act of 1980 made it clear that a purpose of the statutory insolvency exclusion was to put insolvent taxpayers on the same footing as those who filed bankruptcy, which also excludes COD income from taxation. But recently the Tax Court has penalized taxpayers for not filing bankruptcy; the insolvency exclusion does not now produce the same tax results as does bankruptcy. So are debtors better off filing bankruptcy than entering into a debt settlement with lenders?
When an individual files bankruptcy and is relieved of personal liability, the debtor comes out of bankruptcy with his/her exempt assets and there is no taxation of the relief of liability because COD is not income pursuant to Section 108(a)(1)(A). In the late 1980s, when the banking and real estate industries collapsed in the southwest United States, taxpayers relied on old case law to the effect that their exempt assets were not included in the insolvency calculation. The IRS seemed to back away from its initial litigating position and agreed with the taxpayers’ exempt asset position, but in the 1990s the IRS put taxpayers on notice that its position was that the insolvency calculation should be calculated without inclusion of the exempt assets. The Tax Court subsequently addressed the issue in Carlson v Commissioner, 116 T.C. 87 (2001) and it adopted the IRS’ position.
The Carlson Court noted with some frustration that Congress did not define the word “insolvency” or “assets” as used in Section 108(a)(1)(B) and turned to several dictionaries to find the meaning of “asset.” The court noted three definitions: (i) the property of a deceased person subject by law to the payment of his or her debts and legacies; (ii) the entire property of a person, association, corporation, or estate applicable or subject to the payment of debts; and (iii) the items on a balance sheet showing the book value of property owned. The first two definitions support an exclusion of exempt assets while the third definition supports an inclusion.
