Calculating the value of insolvency.

• Author: Lynch, Michael

In many closely held, privately controlled and family-owned businesses, shareholders and partners are often asked to personally guarantee business debt. Often, this debt is forgiven or partially discharged. According to Sec. 61(a)(12), this discharge of indebtedness (DOI) income must be included in a taxpayer's gross income. Thus, if a creditor forgives a $10,000 debt, the taxpayer will generally have $10,000 of gross income. However, DOI income can be excluded from gross income to the extent a taxpayer is insolvent. To be insolvent, a taxpayer's liabilities must exceed the fair market value (FMV) of his assets. Thus, for example, if a taxpayer with liabilities of $100,000 and assets with an FMV of $94,000 has a $10,000 debt forgiven, that taxpayer would be able to exclude $6,000, leaving DOI income of $4,000. Therefore, a taxpayer with DOI income must adopt a tax strategy to minimize assets and maximize liabilities.

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.

Case Law

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...