TAXPAYERS DID NOT HAVE FORGIVENESS OF DEBT INCOME WHERE THEY DID NOT HAVE ABILITY TO PAY FROM THE ASSET IN QUESTION.
In a recent Tax Court case, David and Janet Schieber v. Comm., T.C. Memo. 2017-32, the taxpayers were assessed a $129,509 deficiency and $25,902 in penalties because of the IRS asserting the taxpayers had a sizable debt forgiven (on June 30, 2009 GMAC Mortgage canceled $448,671 of the Schiebers’ debt). Both the taxpayers and IRS recognized that the general rule is that debt forgiveness income is generally taxable. However, if the taxpayer is insolvent at the time of the debt forgiveness, the income is not taxable to the extent of the insolvency. The amount of income excluded under this provision cannot exceed the amount by which the taxpayer is insolvent. Insolvency is defined as the excess of liabilities over the fair market value of assets. The issue often arises as to whether certain assets should be included in this calculation. In the Schiebers’ case, the asset at issue was the balance of Mr. Schieber's California Public Employees’ Retirement System account (the “Plan”). If the value of the Plan was included, the IRS argued that the taxpayers would not be insolvent and the cancellation of debt would be fully taxable.
Mr. Schieber was receiving monthly payments from the Plan. In the event of his death, Mrs. Schieber had a right to receive the monthly payments. Other than the right to receive the monthly payments, the taxpayers could not access the value in the Plan. They could not convert their interest in the Plan to a lump-sum cash amount, could not sell the Plan interest, could not assign the interest, could not borrow against the interest, and could not borrow from the Plan. The IRS argued that the entire principal of the Plan should be considered an asset for purposes of the insolvency calculation.
However, the Tax Court held for the taxpayers by finding that the Schiebers' interest in the Plan is not an asset for the purpose of determining whether the taxpayers were insolvent and the amount of their insolvency.
The IRS argued that as the taxpayers received monthly payments from the Plan, therefore the Plan should be considered an asset. But, the Tax Court relied on a test developed in Carlson v. Comm., 116 T.C. at 104-105. The rule for being considered an asset under this provision is whether the asset gives the taxpayer the ability to pay an "immediate tax on income" from the cancelled debt, not the ability to pay the tax gradually over time. As the taxpayers could not access the undistributed principal, the Plan was considered not to be an asset for insolvency purposes and the taxpayers were found to be insolvent in part. They could therefore exclude income up to the point they became insolvent.
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