When debt is forgiven or partially discharged, Internal Revenue Code §61 requires that the cancellation of debt (COD) be included in the taxpayer's income. Internal Revenue Code §108 allows for the exclusion of COD income to the extent that the taxpayer is insolvent. Insolvency occurs when the fair-market value (FMV) of the taxpayer liabilities exceeds the FMV of the taxpayer assets. While this principle appears deceptively simple, there has been some uncertainty over time as to exactly what assets and liabilities should be included in the insolvency test—particularly with respect to individual taxpayers.

A recent judicial decision and several recent administration rulings provide guidance to taxpayers—and to their valuation advisors—as to (1) what assets and liabilities should be considered in the insolvency test and (2) when they should be considered. This discussion will summarize this recent professional guidance.

Determination of Insolvency

In many closely held and family-owned businesses, the individual business owners are often asked to personally guarantee the business debt. When the business becomes financially distressed, this debt is often partially or entirely discharged. According to §61(a)(12), this COD income must be included in the individual taxpayer's gross income.

For example, if a creditor forgives a $100,000 debt, the taxpayer will generally recognize $100,000 of taxable income. However, COD income can be excluded from gross income to the extent the taxpayer is insolvent. To be insolvent, the taxpayer liabilities must exceed the FMV of the taxpayer assets. Continuing the example, if the taxpayer (1) has liabilities of $400,000 and (2) has assets with an FMV of $360,000, that taxpayer would be able to exclude $40,000 of the discharged debt. Accordingly, the individual taxpayer will recognize only $60,000 of COD income—instead of $100,000 of COD income.

Valuation analysts have identified several uncertainties as to (1) which assets should be excluded, (2) which liabilities should be included and (3) how these assets and liabilities are to be valued. This leads us to the following burning question: Is it possible for a debt guarantor to be let "off the hook" when the debt is forgiven and, at the same time, count that debt as a liability for COD avoidance insolvency purposes?

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Section 108(d)(3) makes clear that for insolvency purposes, the taxpayer liabilities must exceed the (full market value) of the taxpayer assets. However, the Internal Revenue Code does not indicate which assets should be included in the insolvency test.

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Dudley B. Merkel

In Dudley B. Merkel, 192 F.3d 844 (9th Cir. 1999), aff'g. 109 T.C. 463 (1997), the Ninth Circuit decided the question of "When is a liability a liability?" for insolvency purposes. Dudley Merkel and David Hepburn were the two officers and co-owners of Systems Leasing Corp. (SLC), a computer-leasing company. SLC secured a bank loan in 1986. Merkel and Hepburn personally guaranteed the loan. As of April 16, 1991, the unpaid balance of the note was approximately $3.1 million, and SLC was in default. However, 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. The bank agreed (1) to discharge the remaining balance and (2) to release Merkel and Hepburn as personal guarantors. This agreement was reached with the understanding that none of the parties would file for bankruptcy within 400 days after Aug. 2, 1991.

In an unrelated matter, the Internal Revenue Service (IRS) audited Merkel and Hepburn and included $360,000 of COD income from a partnership that they operated with their wives. On their 1991 returns, both couples excluded this COD income, claiming that their liability as guarantors on the SLC note rendered them both insolvent.

The IRS concluded that the personal guarantees were not liabilities for "insolvency" purposes. The IRS argued that the taxpayers were solvent and had to include the COD income as taxable income since their liabilities did not exceed the FMV of their assets.

According to the IRS, only those debts "ripe" and in existence immediately before the discharge of debt could be counted as liabilities. A guarantee is a "remote" liability until the guarantor is actually forced to make a payment, the IRS alleged. The two taxpayers, on the other hand, argued that all liabilities—contingent or not—should be included in the insolvency test.

The issue before the appellate court was whether the individual taxpayers were "insolvent" when the bank forgave the SLC note. The court had to determine 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.

In the court's view, §108(d)(3) does not indicate how likely the occurrence of a contingency must be to count the obligation as a liability, nor does it indicate whether all contingent liabilities are to be considered in the insolvency determination.

The court disagreed with the taxpayer's inclusion of all liabilities in the insolvency test, stating that such a conclusion would lead to absurd results if "remote contingencies" were taken into account. The court concluded that rules that exclude items from income should be narrowly construed.

The court observed that historically, insolvent taxpayers could exclude COD income in order to preserve a debtor's "fresh start" so as not to burden the individual with an immediate tax liability when the debt is forgiven. The court also noted that if a taxpayer had "free" assets that could be used to pay an immediate tax liability, the COD income should be included in gross income—to the extent of the individual's solvency (computed after the debt discharge).

Affirming the tax court's decision, the court ruled that, for purposes of determining insolvency under §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 the liability. The court concluded that Merkel and Hepburn failed to provide 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. They were found to be solvent and the COD was included in their gross income.

Letter Ruling 9932013

Section 108(d)(3) makes clear that for insolvency purposes, the taxpayer liabilities must exceed the FMV of the taxpayer assets. However, the Internal Revenue Code does not indicate which assets should be included in the insolvency test. 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 determination.

On May 4, 1999, the IRS issued Letter Ruling 9932013, revoking Letter Ruling 9125010. In its new ruling, the IRS concluded that judicial decisions since 1940 had allowed the exclusion of these exempt assets, but there was no statutory basis in §108(d)(3) to support this rationale. Therefore, the FMV of all assets must now be counted in the insolvency test.

The IRS applied this rationale in Letter Ruling (TAM) 9935002. In this fact set, an individual taxpayer purchased a residence for $130,000. A few years later, the FMV of the property declined to $100,000, while the outstanding mortgage remained at $122,000. The bank discharged a deficiency of $22,000. The IRS concluded that the taxpayer should recognize $22,000 of COD income.

The taxpayer claimed that he was insolvent and could exclude the COD income from taxable income. This claim was based on the premise that assets exempt from creditors' claims under state law should be excluded from the insolvency formula. However, the IRS concluded that the taxpayer was solvent. The IRS concluded that the assets could no longer be excluded from the insolvency test and that the taxpayer had taxable COD income of $22,000.

Field Service Advice 9932019

In Field Service Advice 9932019, the IRS also addressed the insolvency issue. In the facts of this case, a husband and wife owned real property and personal property (e.g., bank accounts, stock, 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 commercial loan was forgiven.

The husband did not report the resulting COD income on his tax return, believing that his liabilities exceeded the FMV of his assets since 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 determination and concluded that the husband was solvent.

The IRS ruled that any assets held by the husband as tenants by the entirety with his wife must be included in the insolvency test. Otherwise, the IRS reasoned, taxpayers would be motivated to hold most of their assets as tenants by the entirety in order to exclude their COD income.

Summary and Conclusion

Individual business owners who personally guarantee business debt—and their valuation and tax advisors—should become familiar with this recent professional guidance with regard to the insolvency test. In particular, business owners and their advisors should be familiar with the "more-likely-than-not" test of Merkel.

According to the appeals court, if Merkel and Hepburn had provided (1) that a bankruptcy filing was possible and (2) that it was "more likely than not" that they could be called on to pay the loan, their contingent liability would have been classified as a "ripe" liability. Accordingly, Merkel and Hepburn would have been deemed insolvent, and they would not have had to recognize the COD income.