The issue is how to define “insolvency” to determine if the cancellation of debt is taxable income or not. Code Section 108(d)(3) defines “insolvency” as the “excess of liabilities over the fair market value of assets.”
Mr. and Mrs. Schieber had mortgage debt canceled in 2009. He was retired and received monthly payments from a retirement plan that was a defined benefit plan. If he died, then Mrs. Schieber had a right to receive the monthly payments. But they could not get a lump sum cash payment and they could not sell their right to the monthly payments. They had no way to change from just getting the monthly payments.
IRS said the value of the defined benefit was an asset to determine if the taxpayers were insolvent and if so, how much their debts (liabilities) exceeded the assets. Most retirement plans these days are defined contribution plans. A defined benefit plan is a promise to pay an amount each month until the worker dies or if he selected a reduced monthly benefit until he and his wife both died.
The court disagreed with IRS. It noted the code does not define “asset,” but other tax cases did. The court found the Schiebers could not use their interest in their retirement plan to immediately pay a tax liability. They only had a right to monthly payments. They could not convert to a lump sum payment, they could not sell their interest or borrow against their interest and they could not borrow from the plan.
The fair market value of the asset was not the balance in the retirement plan as IRS said. They only had the ability to pay as they received the monthly payments. So they had very little immediate availability or value from the retirement plan. They then met the insolvency rules and were not taxable on the debt that was canceled.
The determination of what assets they had and what debts they owed was to be determined on the day the debt was canceled. Without the full value of the possible retirement plan benefits, the Schiebers did not have the assets IRS tried to use in the computation of insolvency.
This was a Tax Court Memo Decision. It is a bit of a surprise IRS even took the case to Tax Court.
I guess it shows IRS can make mistakes just like the rest of us.
Did you hear? “Benjamin Franklin may have discovered electricity — but it was the man who invented the meter who made the money,” by Earl Wilson (1907-1987).
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.
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