Tax Court Includes Exempt Assets in 108 Insolvency Test

or both individuals and corporations, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… Revenue Code §61(a)(12)</a> provides
that gross income includes income from the cancellation of debt (COD). However,
§108(a)(1)(B) excludes the recognition of COD income if the discharge of
indebtedness occurs when a taxpayer is insolvent. Section 108(d)(3) defines
"insolvent" as the excess of liabilities over the fair market value (FMV) immediately
before the debt discharge.

</p><p>In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 116 T.C. No. 9 (2001)</a>, the U.S. Tax Court held that
the term "assets" used in §108(d)(3) includes assets that are exempt from
creditors' claims under state law. The <i>Carlson</i> case provides valuable guidance to
valuation analysts and other bankruptcy professionals. Individuals and corporations that
seek bankruptcy protection often negotiate some discharge of indebtedness with their
creditors. In addition, the §108 insolvency test related to the exclusion of COD
income is an important income tax benefit to these taxpayers.

</p><h3>The Facts of the Case</h3>

<p>In 1988, Mr. and Mrs. Carlson purchased a boat. They borrowed the money for
the purchase from Seattle First National Bank. To secure the loan, the Carlsons
granted the bank a preferred marine mortgage interest in the boat. In 1992, the
Carlsons became delinquent on their loan payments. In 1993, the bank foreclosed
on the loan.

</p><p>The boat was sold, and the sale proceeds were applied by the bank to the loan's
outstanding principal balance. The bank discharged the remaining $42,142
outstanding principal on the loan. As an important side note, the bank was
prohibited under state (Alaska) law from seizing the taxpayers' fishing permit (which
had a FMV of $393,400) in order to satisfy the loan's deficiency.

</p><p>The Carlsons did not report this $42,142 COD income on their federal income
tax return. The bank filed Form 1099-A, Acquisition or Abandonment of Secured
Property, with the Internal Revenue Service (IRS). The bank also sent a copy of
Form 1099-A to the Carlsons. The Carlsons attached it to their 1992 joint
income tax return with the following notation: "Taxpayer was insolvent—no tax
consequence."

</p><p>The IRS issued a deficiency notice including the COD in the taxpayers' income. The
IRS also imposed an accuracy-related tax penalty. The Carlsons argued that the term
"assets" (as used in §108(d)(3)) excludes assets (such as their fishing permit)
exempt from a creditor's claim under state law.

</p><p>Before the trial, the IRS and the Carlsons agreed that if the court sustained
the taxpayers' position, the taxpayers would be insolvent within the meaning of
§108(d)(3), and that if the Carlsons were insolvent, they could exclude the
$42,142 COD income from their gross income.

</p><blockquote><blockquote>

<hr>
<big><center><i>
Section 108 (and the associated regulations)
determine what portion of the related COD
income is excluded from gross income, based on
the taxpayer's insolvency at the time of the
discharge.
</i></center></big>
<hr>
</blockquote></blockquote>

<h3>The Tax Court's Decision</h3>

<p>The tax court first concluded that the §108 statute and the corresponding regulations
do not define "asset." The court noted that the word's common meaning could support more
than one definition. The court then reviewed the §108 legislative history. The court
noted that, under a judicially developed "insolvency exception," no income arises from
COD if the debtor is insolvent both (1) before and (2) after the COD
transaction. If the transaction leaves the debtor with assets the value of which exceeds
his/her remaining liabilities, then income is realized only to the extent of that excess
value.

</p><p>The court then addressed the taxpayer's legal argument that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 42 B.T.A.
1110 (1940)</a>, controlled the issue of whether assets exempt from creditors' claims
should be considered for §108 purposes. The Board of Tax Appeals (BTA) had
applied the freeing-of-assets theory of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… Lumber Co.,</i> 284 U.S. 1
(1931)</a>, and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… Grocery Co.,</i> 36 B.T.A. 289 (1937)</a>, to
conclude whether a taxpayer became solvent through cancellation of certain notes. In

<i>Cole,</i> whether the taxpayer became solvent depended on whether the taxpayer's equity in
life insurance policies was includable in his assets. The BTA concluded that the equity
in these policies was not includable in assets "freed from creditors' claims." The BTA
reached this conclusion because those insurance policies were never subject to a creditor's
claims to begin with. Therefore, the taxpayer was taxable only on the gain in the
amount of assets actually freed from a creditor's claims.

</p><p>In rejecting the <i>Cole</i> rationale, the tax court noted that in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 109
T.C. 463 (1997)</a>, <i>aff'd.,</i> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… F.3d 844 (9th Cir. 1999)</a>,
it had previously ruled that the §108(a) (1)(B) insolvency exclusion eliminated
the judicially created net assets test as an exception to the general rule of COD
income.

</p><p>The tax court also noted that property exempt from creditors' claims was excluded
in determining insolvency under the Bankruptcy Reform Act of 1978. Therefore, the
court concluded that if Congress had intended to exclude exempt assets from a
taxpayer's "assets" in determining insolvency for §108 purposes, then Congress would
have so stated in §108(d)(3).

</p><h3>Summary and Conclusion</h3>

<p>The IRS's determination that included the COD income in the taxpayers' gross income
was sustained by the U.S. Tax Court. However, the IRS conceded that an
accuracy-related penalty should not be imposed on that portion of the tax underpayment
because the Carlsons had adequately disclosed such income on their timely filed federal
income tax return.

</p><p>The <i>Carlson</i> case is important to valuation analysts and to other professionals who
practice in the bankruptcy arena. Individuals (and corporations) seeking bankruptcy
protection often negotiate some discharge of indebtedness with their creditors. Section
108 (and the associated regulations) determine what portion of the related COD
income is excluded from gross income, based on the taxpayer's insolvency at the time
of the discharge. The <i>Carlson</i> decision provides professional guidance as to what assets
are included in "assets" (such as assets that are exempt from creditors' claims under
state law, according to <i>Carlson</i>) for purposes of the §108 insolvency test.

</p><hr>