When is an asset not an asset? Or, more precisely, what is an asset when a specific internal revenue code section doesn’t contain a definition?
Typically, when a lender says you don’t have to repay a loan for which you are personally liable, the “forgiveness” of the debt is treated as taxable income to you. As you might expect, “typically” does not mean “always” and internal revenue code section 108 contains several exclusions from the general rule.
One exclusion is insolvency. Section 108 defines insolvency as the excess of liabilities over the fair market value of assets. However, section 108 does not define the terms “assets” and “liabilities.”
In T.C. Memo 2017-32 (Schieber), the question was whether a taxpayer’s pension should be considered an asset when determining whether the taxpayer was insolvent.
A lender cancelled $448,671 of debt that was secured by property owned by the taxpayer. The taxpayer, a retired police officer, reported only part of the cancelled debt as income on his 2009 federal income tax return. He said he was insolvent because at the time the debt was forgiven, his liabilities exceeded his assets, and the portion he did not report was excludable from his income. He did not include the pension he had been receiving since his retirement in 2005 as part of his assets.
The IRS said the taxpayer was not insolvent at the time the debt was forgiven because the taxpayer had the right to receive monthly payments from the pension. That meant the taxpayer could use the monthly payments to pay liabilities, and the pension should be considered an asset.
The taxpayer says the pension is not an asset because he was entitled only to monthly payments under the pension plan and could not convert his interest in the plan to a lump-sum cash amount, sell the interest, assign the interest, borrow against the interest, or borrow from the plan.
The taxpayer and the IRS agree that if the pension is not considered an asset, the taxpayer was not insolvent at the time of the debt cancellation, and the entire amount of the cancelled debt would be taxable.
Here’s the relevant tax law.
From internal revenue code section 108(d)(3): Provides that a taxpayer is insolvent if, immediately before the cancellation of debt, the taxpayer’s liabilities exceeded the fair market value of the taxpayer’s assets. The word “assets” is not defined by the internal revenue code. In Carlson v. Commissioner, a 2001 tax court case, the court said that an asset exempt from creditors could still be an asset under section 108(d)(3) because even an asset exempt from creditors can give the taxpayer “the ability to pay an immediate tax on income” from the canceled debt.
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For the taxpayer.
The IRS contends the taxpayer’s interest in the pension plan should be considered an asset because the taxpayer can use the monthly payments to pay liabilities. But the test in Carlson v. Commissioner is whether the asset gives the taxpayer the ability to pay an “immediate tax on income” from the canceled debt–not to pay the tax gradually over time.
The taxpayer’s interest in the pension plan cannot be used to immediately pay the income tax on canceled debt income. Therefore, we hold that the taxpayer’s interest in the pension plan is not an asset within the meaning of section 108(d)(3).