Insolvency test includes exempt assets.

• Author: Packard, Pamela
• Position: IRS rule; discharge of indebtedness

Under Sec. 61(a)(12), gross income includes income from discharge of indebtedness (DOI). However, Sec. 108(a)(1)(B) excludes DOI income from gross income if the discharge occurs when a taxpayer is insolvent. Sec. 108(d)(3) defines "insolvent" as the excess of liabilities over the assets' fair market value (FMV) (immediately before the discharge). In Carlson, 116 TC No. 9 (2001), the Tax Court held that the term "assets" used in Sec. 108(d)(3) includes assets exempt from creditors' claims under state law.

In 1988, taxpayers purchased a vessel. They borrowed money for the purchase from Seattle First National Bank and granted the bank a preferred marine mortgage interest in the boat. In 1992, the couple became delinquent on loan payments and, in 1993, the bank foreclosed. The boat was sold and the proceeds applied to the loan's outstanding principal balance. The bank discharged the remaining $42,142, apparently prohibited under Alaskan law from seizing the taxpayers' fishing permit (which had a $393,400 FMV) to satisfy the loan's deficiency.

The couple did not report this $42,142 DOI income. The bank filed Form 1099-A, Acquisition or Abandonment of Secured Property, with the Service and sent a copy to the taxpayers, who attached it to their 1992 joint return with the following notation: "Taxpayer Was Insolvent--No Tax Consequence."

The IRS issued a deficiency, notice including the DOI in the taxpayers' income and imposed an accuracy-related penalty. The couple argued that assets (as used in Sec. 108(d)(3)) excludes assets (such as their fishing permit) exempt from creditors' claims under state law. The parties agreed that, if the court sustained the couple's position, they would be insolvent within the meaning of Sec. 108(d)(3) and could exclude the $42,142 DOI income.

The Tax Court first concluded that the statute and Sec. 108 regulations do not define "asset," and that its common meaning supported more than one construction. It then reviewed Sec. 108's legislative history and noted that, under a judicially developed "insolvency exception," no income arises from DOI if the debtor is insolvent both before and after the transaction. If the transaction leaves the debtor with assets whose value exceeds remaining liabilities, income is realized only to the extent of the excess value.

The court then addressed the taxpayer's argument that Cole, 42 BTA 1110 (1940), controlled...