Measuring insolvency under sec. 108.

• Author: Sullivan, Catherine Mary

A hot topic for some taxpayers in the past few years has been cancellation of debt (COD) income and how to exclude it from taxable income. Bankruptcy and insolvency are the two main circumstances available for excluding COD income. While determining if a taxpayer is bankrupt is straightforward (the debt is discharged in a Title 11 case), determining whether a taxpayer is insolvent can be tricky.

Sec. 108(a)(1)(B) provides for the exclusion of COD income if the debt discharge occurs when the taxpayer is insolvent. Sec. 108(d)(3) defines insolvency of the taxpayer as the excess of liabilities over the fair market value (FMV) of assets determined immediately before the discharge of debt. The excluded income is limited to the amount by which a taxpayer is insolvent, as stated in Sec. 108(a)(3). For example, if the taxpayer has COD income of $500,000 and the excess of liabilities over assets immediately before the discharge is $450,000, the taxpayer includes $50,000 of COD income in his or her gross income.

Four criteria to determine when calculating insolvency are:

* The taxpayer;

* The measurement date;

* The assets; and

* The liabilities.

The Taxpayer

Identification of the taxpayer in the case of unmarried individuals, C corporations, and S corporations is straightforward. The IRS has issued guidance for identifying the taxpayer for other types of entities and for married couples. Sec. 108(d) (6) provides that Sec. 108 is applied at the partner level; therefore, a partnership is not the taxpayer. Prop. Regs. Sec. 1.108-9 provides that the owner of disregarded entities and grantor trusts is the taxpayer.

Married individuals are considered two taxpayers for purposes of the exclusion. It is important to consult an attorney when one or both spouses have COD income. State law for community property vs. non--community property needs to be considered, along with tax filing status and IRS guidance. The measurement of separately titled and jointly titled assets is discussed later. This is an overview of the types of taxpayers; specific information regarding each type of taxpayer is beyond the scope of this item.

Measurement Date

The taxpayer determines insolvency immediately before the discharge of the debt. This has been interpreted as the day before the date of the discharge (see, e.g., Merkel, 109 T.C. 463 (1997)). In cases of multiple instances of forgiveness of debt, the measurement date is determined separately for each instance, unless the...