Exempt assets may increase insolvency exclusion.

• Author: Malloy, Lori

Under Sec. 61(a)(12), a taxpayer generally must include as gross income any income from discharge of indebtedness. An important exception to this rule is found in Sec. 108(a)(1)(B), which provides that debt discharge income is not included in gross income if the discharge occurs when the taxpayer is insolvent under Sec. 108(d)(3) (i.e., the taxpayer's liabilities exceed the fair market value (FMV) of his assets). Given the relatively large number of distressed business ventures, this exception has taken on increased significance in recent years.

The theory underlying the Sec. 108(a)(1)(B) exception is that there is no accession to wealth if the taxpayer is insolvent both before and after the discharge, since assets have not been "freed" from the claims of creditors. (See, e.g., Kirby Lumber Co., 284 US 1 (1931), and Dallas Transfer & Terminal Warehouse Co., 70 F2d 95 (5th Cir. 1934).)

The IRS has recognized that the insolvency exception is a codification, in part, of the freeing of assets theory. Thus, in Letter Rulings 9125010 and (TAM) 9130005, the IRS ruled that assets exempt from the claims of creditors under applicable state law are not considered in determining whether, and the extent to which, a taxpayer is insolvent. After all, an asset cannot be "freed up" if it was not subject to creditors' claims to begin with. Est. of Marcus, TC Memo 1975-009, and Hunt, TC Memo 1989-335, support this conclusion. Example: Taxpayer T has liabilities of $150 and assets with an FMV of $100, of which $10's worth is not subject to the claims of creditors. A creditor discharges $60 of T's liabilities. Under the rationale of the letter rulings, T may exclude from income the entire $60 forgiveness, since T is insolvent to the extent of $60 ($150 - ($100 - $10)) immediately prior to the discharge.

It is important to emphasize two points. First, for purposes of the Sec. 108(a)(1)(B) insolvency exception, the determination of insolvency is made by excluding only those assets exempt from claims of creditors under state law (and presumably under nonbankruptcy federal law); assets exempt under federal bankruptcy law cannot be excluded, unless sanctioned under state law. Thus, since the laws of various states differ, there...