Contingent debt taken into account in determining insolvency.

• Author: Sair, Edward A.
• Position: Tax exclusion

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...