Canceled debt is partially excludable

The Tax Court held that a married couple’s interest in their retirement account was not considered an asset for purposes of the cancellation-of-debt (COD) insolvency test, and thus the taxpayers could exclude a portion of the income from the debt forgiveness. According to the court, the retirement account could not be used to immediately pay any income tax due to the discharged debt and therefore was not an asset for purposes of the test.

Facts: On June 30, 2009, GMAC Mortgage canceled $448,671 of David and Janet Schieber’s debt ($418,596 of principal and $30,076 of interest) secured by real property that was not their principal residence. On that date, their liabilities were $1,218,227, and the fair market value (FMV) of the Schiebers’ assets was $924,919. In addition to those assets, David Schieber was a retiree receiving lifetime monthly payments from a defined benefit pension plan. The pension payments would continue to Janet Schieber after his death, but the couple could not borrow from or against the plan, sell their interest in it, assign it, or receive a lump-sum cash payment in exchange for their interest in it.

The Schiebers had never deducted the canceled interest of $30,076 on previous tax returns; therefore, under Sec. 108(e)(2), they excluded it from income on their 2009 return. Claiming insolvency, the couple also excluded $346,418 of the canceled principal from income and reported the remaining $72,178 as income. The IRS issued a notice of deficiency for tax year 2009 on the basis that the entire $418,596 of canceled principal was income because the Schiebers were solvent at the date of the debt cancellation. The taxpayers petitioned the Tax Court for relief.

Issues: Generally, cancellation of debt results in taxable income. However, Sec. 108 excludes certain debt forgiveness from income including the cancellation of (1) qualified principal residence indebtedness; (2) any debt that, if paid, would have resulted in a tax deduction; and (3) debt forgiven when, and to the extent that, the taxpayer was insolvent. A taxpayer is insolvent if, immediately before the cancellation, the taxpayer’s liabilities exceed the FMV of his or her assets. Although an asset may be protected from the claims of creditors under state law, the protected asset is included in the solvency test calculation if it could be used to immediately pay tax on the income from the canceled debt (Carlson, 116 T.C. 87 (2001)).

The IRS agreed that the forgiven interest of $30,076 was not income, but it argued that the Schiebers’ interest in the pension plan was an asset because they had the right to receive monthly payments under the plan that could be used to pay the tax liability. The Schiebers argued their pension plan interest was not an asset for the insolvency test because it could not be used to immediately pay a tax liability. At trial, they revised their original calculation to take the position that, if the pension interest were excluded from their assets, they would be insolvent by $293,308, and their income would be $125,288 ($418,596 — $293,308). If the pension interest were an asset, they would be solvent, and the entire forgiven debt of $418,596 would be taxable.

Holding: The court agreed with the taxpayers, holding that the pension plan interest was not an asset for the insolvency test because the taxpayers’ only right in the plan was the right to receive monthly payments. Consequently, they had no right in the plan that would provide them with an immediate inflow of cash. According to the court, an asset is included in the insolvency test under the Carlson test if the asset allows the taxpayer to immediately pay the tax on the income from the canceled debt rather than pay the tax gradually over time.

• Schieber, T.C. Memo. 2017-32

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.