The general rule is that discharge of indebtedness produces ordinary income – known as cancellation of debt income (CODI). I.R.C. § 61(a)(12). However, there are exceptions to the general rule. One of those exceptions concerns a debtor that is “insolvent” but not in bankruptcy. An insolvent debtor that’s not in bankruptcy doesn’t have CODI to report. But how is insolvency to be measured? In 2017, the U.S. Tax Court clarified the issue. Unfortunately, just recently the IRS voiced its disagreement with the Tax Court’s 2017 opinion.
The definition of “insolvency” for purposes of the exclusion from income of CODI – that is the topic of today’s post by Farm-Legal Expert Roger A. McEowen.
In General
An important part of debt resolution is the income tax consequences to the debtor. Actually, there are two major categories of income tax consequences--(1) gain or loss if property is transferred to the lender in satisfaction of indebtedness and (2) possible CODI to the extent debt discharged exceeds the fair market value of property given up by the debtor.
Recourse debt. The handling of discharge of indebtedness income depends upon whether the debt was recourse or nonrecourse. With recourse debt, the collateral stands as security on the loan. If the collateral is insufficient, the debtor is personally liable on the obligation and the debtor’s non-exempt assets are reachable to satisfy any deficiency. The bulk of farm and ranch debt is recourse debt.
For recourse debt, when property is given up by the debtor, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. First, there is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. The difference between fair market value and the income tax basis is gain or loss. There is no relief from gain--even if the taxpayer is insolvent. This is the end of the first step in the process--treated as a hypothetical sale on the debt being discharged. Second, if the indebtedness exceeds the property’s fair market value, the difference is discharge of indebtedness income.
Nonrecourse debt. For nonrecourse debt, the collateral stands as security on the obligation. But if the collateral is worth less than the balance on the debt, the debtor does not bear personal liability on the obligation. Therefore, the creditor must look solely to the collateral in the event of default. Very little farm and ranch debt is nonrecourse, except perhaps for some installment land contracts and commodity loans from the Commodity Credit Corporation to the extent that the debtor may pay off the loan with a sufficient amount of an eligible commodity having a price support value equal to the outstanding value of the loan (or less than the value of the loan in the case of a “marketing assistance loan”).
Handling nonrecourse debt involves a simpler one-step process. See, e.g., Comr. v. Tufts, 461 U.S. 300 (1983). Fair market value is ignored, and the entire difference between the income tax basis of any property involved (and transferred to the creditor) and the amount of debt discharged is gain (or loss). There is no CODI.
Exceptions
There are several relief provisions that a debtor may be able to use to avoid the general rule that CODI constitutes income.
Bankruptcy. A debtor in bankruptcy does not report CODI as income. I.R.C. §108(a)(1)(A). However, the debtor must reduce tax attributes (including operating losses and investment tax credits carried forward) and reduce the income tax basis of their property. Losses are reduced dollar for dollar; credits are reduced one dollar for three dollars (one dollar of credit offsets three dollars of CODI). To preserve net operating losses and tax credit carryovers, a debtor may elect to reduce the basis of depreciable property before reducing other tax attributes.
Real property business debt. Taxpayers other than C corporations can elect to exclude from gross income amounts realized from the discharge of “qualified real property business indebtedness.” I.R.C. §108(a)(1)(D). Instead, the income tax basis of the property is reduced.
Note: The provision does not apply to farm indebtedness.
Solvent farmers. For all debtors other than farmers, once solvency is reached there is CODI. For solvent farm debtors, however, the discharge of indebtedness arising from an agreement between a person engaged in the trade or business of farming and a “qualified person” to discharge “qualified farm indebtedness” is eligible for special treatment. I.R.C. §108(a)(1(C). A special procedure for reducing tax attributes and reducing the basis of property is available to the debtor.
A “qualified person” is someone who is “actively and regularly engaged in the business of lending money and who is not somehow related to or connected with the debtor.” “Qualified farm indebtedness” means indebtedness incurred directly in connection with the operation by the taxpayer of the trade or business of farming and 50 percent or more of the average annual gross receipts of the taxpayer for the three proceeding taxable years (in the aggregate) must be attributable to the trade or business of farming. In many instances, the presence of off farm income can make qualifying for the solvent farm debtor rule difficult. Also, a cash rent landlord is likely to be deemed to not be engaged in the trade or business of farming such that discharge of indebtedness is not discharge of qualified farm indebtedness. See, e.g., Lawinger v. Comr., 103 T.C. 428 (1994).
If the requirements are met, a solvent farm debtor first reduces tax attributes in the following order:
- Net operating loss of the taxable year and any carryover losses to that year.
- General business credits (including investment tax credits carried over to that year).
- Minimum tax credit
- Capital losses for the year and capital losses carried over to that year.
- Passive activity loss and credit carryovers.
- Foreign tax credits
Again, losses reduce CODI dollar for dollar. One dollar of credits reduces three dollars of CODI.
After the reduction of tax attributes, solvent farm debtors reduce the income tax basis of property used in a trade or business or held for the production of income in the following order:
- Depreciable property.
- Land used or held for use in the trade or business of farming.
- Other qualified property.
Note: An election can be made to reduce the basis of depreciable property first, before reducing the tax attributes. This may help to preserve the tax attributes for later use.
If, after tax attributes and property basis is reduced, discharge of indebtedness remains, the remainder is income.
Purchase price adjustment. For solvent taxpayers who are not in bankruptcy, any negotiated reduction in the selling price of assets does not have to be reported as discharge of indebtedness income. I.R.C. §108(e)(5). To be eligible, the debt reduction must involve the original buyer and the original seller.
Insolvent debtors. Debtors who are insolvent but not in bankruptcy likewise do not have CODI. I.R.C. §108(a)(1)(B). But, again, insolvent debtors must reduce tax attributes and reduce the income tax basis of property. It is handled much like debtors in bankruptcy make the calculations. However, the amount of income from discharge of indebtedness that can be excluded from income is limited to the extent of the debtor’s insolvency. If the amount of debt discharged exceeds the amount of the insolvency, income is triggered as to the excess. Thus, for the rule of insolvent taxpayers to apply, the taxpayer must be insolvent both before and after the transfer of property and transfer of indebtedness.
Determining Insolvency
The determination of the taxpayer’s solvency is made immediately before the discharge of indebtedness. “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets. Both tangible and intangible assets are included in the calculation. Likewise, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not. The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency.
Historically, the courts have held that property exempt from creditors under state law is not included in the insolvency calculation. However, the IRS ruled in mid-1999 that property exempt from creditors under state law is included in the insolvency calculation. Priv. Ltr. Rul. 9932013 (May 4, 1999), revoking Priv. Ltr. Rul. 9125010 (Mar. 10, 1991); Tech. Adv. Memo. 9935002 (May 3, 1999). In 2001, in Carlson v. Comr., 116 T.C. 87 (2001), the Tax agreed with the IRS position. The Tax Court held that a commercial fishing license was an “asset” because the license could be used, in combination with other assets, to immediately pay the income tax on canceled-debt income.
Recent Tax Court clarification. In Schieber v. Comr., T.C. Memo. 2017-32, the petitioner retired from a police force in 2005 and began receiving monthly distributions from his pension plan. The plan withheld federal income tax from the payments. The plan specified that the petitioner could not convert his interest in the plan into a lump-sum cash amount, assign the interest, sell the interest, borrow against the interest, or borrow from the plan. Upon the petitioner’s death, his surviving wife would receive payments for her life. In 2009, GMAC canceled approximately $450,000 of the petitioner’s mortgage debt that was secured by some of the petitioner’s non-residential real estate. The petitioner was not in bankruptcy in 2009. The canceled debt included $30,076 of interest. The petitioner excluded the forgiven interest from income because he had not deducted it on his Form 1040. See I.R.C. §108(e)(2). That provision specifies that “no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.”
While the IRS conceded this point concerning the interest exclusion, the IRS claimed that the petitioner’s interest in the principal amount of $418,596 that was canceled should be included in income. The petitioner claimed that the pension plan should not be considered an asset for purposes of the insolvency computation of I.R.C. §108(d)(3). Under that provision a taxpayer may exclude canceled debt from income to the extent of the taxpayer’s insolvency, defined as the extent to which the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets.
I.R.C. §108(d)(3) does not define the term “assets.” As noted above, in Carlson v. Comr., 116 T.C. 87 (2001), the full Tax Court determined that the value of an exempt asset could be included in the insolvency calculation if it gives the taxpayer “the ability to pay an immediate tax on income” from the canceled debt. In Schieber, the petitioner claimed that he couldn’t access the pension funds by its terms. The IRS did not challenge that point, instead claiming that the point was irrelevant. Instead, the IRS claimed that the petitioner’s right to receive monthly payments caused the plan to be considered an “asset.” The Tax Court disagreed, clarifying that its prior decision in Carlson only extended to assets that gave the taxpayer the “ability to pay an immediate tax on income” from the canceled debt, not the ability to pay the tax gradually over time.
Just recently, the IRS announced its disagreement with the Tax Court’s opinion in Schieber. A.O.D. 2021-1, IRB 2021-15.
Conclusion
The Tax Court’s Schieber decision provided clarity concerning the definition of “assets” for purposes of the insolvency calculation of I.R.C. § 108(d)(3). If an asset doesn’t provide the debtor with the ability to pay an immediate tax on income, the asset’s value is excluded from the insolvency computation. Schieber cites back to the full Tax Court opinion in Carlson for its rationale. Unfortunately, the IRS audit and litigation position appears to be unchanged.
