or both individuals and corporations, Internal Revenue Code §61(a)(12) provides that gross income includes income from the cancellation of debt (COD). However, §108(a)(1)(B) excludes the recognition of COD income if the discharge of indebtedness occurs when a taxpayer is insolvent. Section 108(d)(3) defines "insolvent" as the excess of liabilities over the fair market value (FMV) immediately before the debt discharge.

In Carlson, 116 T.C. No. 9 (2001), the U.S. Tax Court held that the term "assets" used in §108(d)(3) includes assets that are exempt from creditors' claims under state law. The Carlson case provides valuable guidance to valuation analysts and other bankruptcy professionals. Individuals and corporations that seek bankruptcy protection often negotiate some discharge of indebtedness with their creditors. In addition, the §108 insolvency test related to the exclusion of COD income is an important income tax benefit to these taxpayers.

The Facts of the Case

In 1988, Mr. and Mrs. Carlson purchased a boat. They borrowed the money for the purchase from Seattle First National Bank. To secure the loan, the Carlsons granted the bank a preferred marine mortgage interest in the boat. In 1992, the Carlsons became delinquent on their loan payments. In 1993, the bank foreclosed on the loan.

The boat was sold, and the sale proceeds were applied by the bank to the loan's outstanding principal balance. The bank discharged the remaining $42,142 outstanding principal on the loan. As an important side note, the bank was prohibited under state (Alaska) law from seizing the taxpayers' fishing permit (which had a FMV of $393,400) in order to satisfy the loan's deficiency.

The Carlsons did not report this $42,142 COD income on their federal income tax return. The bank filed Form 1099-A, Acquisition or Abandonment of Secured Property, with the Internal Revenue Service (IRS). The bank also sent a copy of Form 1099-A to the Carlsons. The Carlsons attached it to their 1992 joint income tax return with the following notation: "Taxpayer was insolvent—no tax consequence."

The IRS issued a deficiency notice including the COD in the taxpayers' income. The IRS also imposed an accuracy-related tax penalty. The Carlsons argued that the term "assets" (as used in §108(d)(3)) excludes assets (such as their fishing permit) exempt from a creditor's claim under state law.

Before the trial, the IRS and the Carlsons agreed that if the court sustained the taxpayers' position, the taxpayers would be insolvent within the meaning of §108(d)(3), and that if the Carlsons were insolvent, they could exclude the $42,142 COD income from their gross income.

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Section 108 (and the associated regulations) determine what portion of the related COD income is excluded from gross income, based on the taxpayer's insolvency at the time of the discharge.

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The Tax Court's Decision

The tax court first concluded that the §108 statute and the corresponding regulations do not define "asset." The court noted that the word's common meaning could support more than one definition. The court then reviewed the §108 legislative history. The court noted that, under a judicially developed "insolvency exception," no income arises from COD if the debtor is insolvent both (1) before and (2) after the COD transaction. If the transaction leaves the debtor with assets the value of which exceeds his/her remaining liabilities, then income is realized only to the extent of that excess value.

The court then addressed the taxpayer's legal argument that Cole, 42 B.T.A. 1110 (1940), controlled the issue of whether assets exempt from creditors' claims should be considered for §108 purposes. The Board of Tax Appeals (BTA) had applied the freeing-of-assets theory of Kirby Lumber Co., 284 U.S. 1 (1931), and Lakeland Grocery Co., 36 B.T.A. 289 (1937), to conclude whether a taxpayer became solvent through cancellation of certain notes. In Cole, whether the taxpayer became solvent depended on whether the taxpayer's equity in life insurance policies was includable in his assets. The BTA concluded that the equity in these policies was not includable in assets "freed from creditors' claims." The BTA reached this conclusion because those insurance policies were never subject to a creditor's claims to begin with. Therefore, the taxpayer was taxable only on the gain in the amount of assets actually freed from a creditor's claims.

In rejecting the Cole rationale, the tax court noted that in Merkel, 109 T.C. 463 (1997), aff'd., 192 F.3d 844 (9th Cir. 1999), it had previously ruled that the §108(a) (1)(B) insolvency exclusion eliminated the judicially created net assets test as an exception to the general rule of COD income.

The tax court also noted that property exempt from creditors' claims was excluded in determining insolvency under the Bankruptcy Reform Act of 1978. Therefore, the court concluded that if Congress had intended to exclude exempt assets from a taxpayer's "assets" in determining insolvency for §108 purposes, then Congress would have so stated in §108(d)(3).

Summary and Conclusion

The IRS's determination that included the COD income in the taxpayers' gross income was sustained by the U.S. Tax Court. However, the IRS conceded that an accuracy-related penalty should not be imposed on that portion of the tax underpayment because the Carlsons had adequately disclosed such income on their timely filed federal income tax return.

The Carlson case is important to valuation analysts and to other professionals who practice in the bankruptcy arena. Individuals (and corporations) seeking bankruptcy protection often negotiate some discharge of indebtedness with their creditors. Section 108 (and the associated regulations) determine what portion of the related COD income is excluded from gross income, based on the taxpayer's insolvency at the time of the discharge. The Carlson decision provides professional guidance as to what assets are included in "assets" (such as assets that are exempt from creditors' claims under state law, according to Carlson) for purposes of the §108 insolvency test.

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