Calculating Insolvency

Taxpayers are required to include COD amounts in income. A taxpayer that is insolvent at the time a debt is cancelled can exclude COD income from gross income. The Internal Revenue Code defines insolvency as the excess of liabilities over the fair market value of assets. A recent case examined this definition.

Dudley Merkel was a general partner in HMH Partnership. Great Western Bank forgave a $1,439,000 nonrecourse debt of the partnership. Merkel had $359,721 of COD income as a result of the forgiveness. Merkel also was a shareholder in System Leasing Corp. (SLC). He personally guaranteed a bank loan to SLC. The corporation defaulted on the loan. The bank forgave $2,000,000 of the loan on the condition that SLC pay $1,100,000 of it and that Merkel refrain from filing for bankruptcy for 400 days.

Merkel included the $2,000,000 guaranteed debt on his list of liabilities as a contingent liability. As a result, he was insolvent and entitled to exclude the $359,721 of COD income. But the IRS said the guaranteed debt was not part of Merkel’s liabilities and he was, in fact, solvent, making the COD income taxable. The Tax Court ruled in the IRS’s favor and Merkel appealed.

Result. For the IRS. In the view of the Ninth Circuit Court of Appeals, the issue was, Should a taxpayer include contingent liabilities when computing insolvency? Since the IRC definition simply says “liabilities” without further explanation, the Ninth Circuit turned to the legislative history. In evaluating that history, it accepted the Tax Court’s initial conclusion that to include all contingent liabilities would create absurd results. The Ninth Circuit said Congress intended only liabilities that would actually offset assets to be included in the computation. Therefore, a taxpayer may include only liabilities he or she more likely than not will have to pay. Since Merkel could not prove it was likely he would have to pay the guarantee (the 400 days passed without his filing for bankruptcy, and the contingency lapsed), he was not insolvent.

There was one dissent. Judge O’Scannlin preferred to follow the wording of the code, which says “liabilities,” thereby implying all liabilities. To prevent the absurd results that troubled the majority and the Tax Court, O’Scannlin said he would follow the bankruptcy law rules, which include all liabilities discounted by the probability of occurrence. This would, in his opinion, provide more reasonable results than the all-or-nothing approach the majority adopted.

In letter rulings 199932013 and 199935002, the IRS concluded that when computing insolvency, a taxpayer must include all assets he or she owns—even those exempt from creditor claims. This revokes PLR 9125010 and TAM 9130005. The increase in includible assets and the omission of contingent liabilities, unless the creditor is more likely than not to require payment, will make it more difficult for taxpayers to exclude COD income. While there is a slight chance other circuit courts will follow the dissenting approach, until then a taxpayer must include all assets and omit contingent liabilities from the insolvency computation.

• Dudley B. Merkel v. Commissioner, 1999 U.S. App. Lexis 22449, 99-2 USTC 50,848 (CA-9).

Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.