The Insolvency Exclusion to Cancellation of Debt (COD) Income; The Effect of Exempt Assets Under the Carlson Rule (Part 2 of 2)
Guest Writer - Mike Cook, Winstead PC
2nd in a series of 2 postings
(Part 1: The Insolvency Exclusion to Cancellation of Debt (COD) Income;
The Effect of Exempt Assets Under the Carlson Rule)
The Court, having determined that the use of “assets” was ambiguous, pointed out that “[t]he stated purpose of the 1980 Bankruptcy Tax Act was to ‘accommodate bankruptcy policy and tax policy.’” Both Senate and House reports indicate that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy who is accorded a ‘fresh start’ under Federal bankruptcy laws) is not to be burdened with an immediate tax liability.
The Tax Court, however, concluded that although an asset of a debtor may be exempt from the claims of creditors under applicable law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. By implication, therefore, the same Congress that decided that it was in the public interest that exempt assets be removed from the reach of creditors so that debtors could obtain a fresh start intended, nevertheless, to impose an income tax on the value of those assets in the event that a taxpayer negotiated a debt settlement with creditors outside of bankruptcy. In effect, the Carlson Court concluded that Congress intended to impose a penalty on taxpayers that handled their financial problems without resorting to the bankruptcy court.
Under the Carlson rule, an individual with substantial exempt assets pays a high penalty for not filing bankruptcy. The opposite viewpoint, however, is that the reason the Tax Court has sided with the government is because the cases from the late 1980s showed the gross disparity in tax treatment that could occur from the differences in exempt assets allowed from state to state. In Texas, a person with substantial exempt assets could successfully take an insolvency position under the old law. It should be noted that only the Tax Court has addressed the issue, and if the economic conditions currently being experienced produce the same quantity of workouts from commercial debt (COD from residential loans is currently excluded from gross income) as occurred in the 1980s, the issue of whether exempt assets should be excluded from the insolvency calculation will surely reach several courts of appeal.
