Calculating Insolvency: A Technical Minefield for Taxpayers

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Calculating Insolvency: A Technical Minefield for Taxpayers

Wednesday, January 23, 2019

Taxpayers who receive 1099-C forms informing them of debts that have been cancelled and reported to the IRS face the challenge of calculating the value of their assets and liabilities at a time immediately before the debt was cancelled. This requires taxpayers to not only gather financial information from many financial institutions, but also try to calculate fair market values of their property. An issue that most taxpayers do not often consider is whether debts that they list as a liability qualify as a liability for insolvency purposes. Additionally, taxpayers who don’t receive the forms from the creditor and first learn of the cancelled debt after receiving a notice from the IRS, face a much larger burden as they must now gather financial information, often from years ago, and face higher scrutiny on the assets and liabilities they include in their calculation.

Our LITC recently had the opportunity to represent otherwise Pro Se petitioners during this year’s Albany Trial calendar. The clients received a statutory notice from the IRS Automated Underreporter Unit (AUR) proposing to increase their income based on unreported cancellation of debt income. Three credit card companies had cancelled debt on their own. Predictably, all three 1099-C forms were mailed to an outdated address, hence the taxpayer was unaware that any of the debt had been cancelled and that cancellation of debt should be included on his return. After petitioning the U.S. Tax Court, the taxpayer attempted to exclude this income by claiming insolvency. One of the largest debts in his liability column, and the only disputed issue in this case, was the balance of an agreement owed to his New York State pension.

The taxpayer had returned to employment with the State of New York after an absence of many years. When reentering the Civil Service, rather than being returned to his previous retirement tier, he was instead placed in the less advantageous retirement tier that was then available to all new State employees enrolling for the first time. This tier required a perpetual contribution of 3% by the employee towards their retirement plan, rather than capping contributions at 10 years as his original tier had done. The taxpayer was later informed that he could opt into his previous and more beneficial tier. In order to opt in and be relieved of this ongoing expense, he was required to agree to repay the funds that were originally distributed from his retirement account, plus the interest that would have accrued. The agreement contained a contingency that the repayment would cease if and when his employment was terminated.

At the time immediately preceding the cancellation of debt events, the outstanding amount owed by the taxpayer to the New York State Local Employee Retirement System (NYSLRS) was over $50,000. If this amount was a liability under section 108 of the I.R.C., the taxpayer would have been considered insolvent and all cancellation of debt income would have been excluded. Neither section 108 of the I.R.C nor the regulations related to the provision define the term “liabilities”. Chief Counsel objected to allowing this liability to be considered in the insolvency equation, and Judge Guy ultimately agreed. In this case, Judge Guy took issue with three peculiarities of the agreement between the taxpayer and NYSLRS.

The agreement resulted in an immediate and ongoing benefit to the taxpayer;
The calculation for insolvency would be distorted if the agreement would be considered a liability, without regard to the taxpayer’s increased future benefit; and
The payments were contingent on the taxpayer’s continued state employment

I agree that the agreement the taxpayer entered into was financially sound and did substitute a debt for an ongoing expense. However, I believe that the reclassification of the taxpayer’s retirement contributions should not affect the legal reality that an ongoing expense has been extinguished and a new liability created.

I also agree that allowing including the balance owed on this agreement would distort the net asset analysis; however, I do not believe it does so improperly. The insolvency exclusion serves to determine the accession to wealth at the time of an identifiable event. When determining the value of assets and liabilities in a snapshot of time, there can be many distortions. Here, the taxpayer’s agreement resulted in a balance that was owed to NYSLRS. Correspondingly, his interest in a future defined benefit pension was increasing. However, due to the structure of this pension, any contributions to the pension would not result in a corresponding increase in the value of the asset. In Schieber v. Commissioner, TC Memo 2017-32, the court determined that a State pension that did not allow the beneficiary to “convert their interest in the plan to a lump-sum amount, sell the interest, assign the interest, borrow against the interest, or borrow from the plan,” was not available to pay income tax that resulted from cancellation of debt and was therefore not an asset within the meaning of section 108(d)(3). The difference between this taxpayer’s pension and the Schiebers’ was that the NYSLRS pension would allow the taxpayer to borrow against their interest. However, since a loan would result in a corresponding liability, I do not believe this difference would matter.

The most difficult hurdle in this case was whether this agreement resulted in a bona-fide debt or whether the debt was illusory, overly contingent, or non-recourse. The agreement required that the agreed upon repayment amount be drawn from taxpayer’s bi-weekly paycheck. While the agreement was irrevocable and the consequences for non-payment of the periodic payments did exist, the agreement did not include an event that could trigger an acceleration of the amount owed.

While the contingency of the debt alone did not doom this agreement; the totality of the circumstances resulted in a determination that this obligation should not be considered for the purposes of I.R.C. section 108.

While this is a small tax court case and does not have precedential value, it highlights some of the hurdles a taxpayer may have a duty to overcome. In this case, the taxpayer worked diligently with IRS chief counsel to ascertain his liabilities and assets at the time of the debt cancellation. Several days before trial, the taxpayer believed that the sole issue remaining in this case was the correct valuation of the pension as an asset. Taxpayers who claim insolvency may be required to prove, not only the correct value of assets and liabilities at the time immediately before the cancellation of debt, but also that the liabilities qualify as liabilities for insolvency purposes.

I expect insolvency cases to become more frequent, particularly as student loan debtors begin to experience debt forgiveness that has not been statutorily excluded from cancellation of debt income.