When a debtor is in financial stress, creditors often forgive or cancel all or a portion of the debt. When that happens, U.S. tax law generally requires the debtor to include the cancelled debt in gross income so it can be taxed. Including the cancelled debt in taxable income presents an obvious challenge, since most taxpayers are discharged from their debt obligations because they can’t afford to repay the loan in the first place, let alone pay additional taxes on it.
However, there are special circumstances and strategies — including strategic pension elections you can make in light of a recently decided court case — that can help insolvent taxpayers exclude at least a portion of the cancelled debt from their gross income and minimize the associated tax liability.
Congress recognized the issue with imposing tax liabilities on cancelled debt. As a result, Internal Revenue Code Section 108 was enacted, which allows taxpayers to exclude discharge of indebtedness income from gross income in certain circumstances.
One of those circumstances is if a discharge occurs when the taxpayer is insolvent. In this circumstance, insolvency is defined as having more liabilities than the fair market value of assets immediately prior to the discharge. The amount that’s allowed to be excluded from gross income is limited to the amount of insolvency.
For example, assume a debtor is discharged of $50,000 of debt. Immediately before the discharge, if the debtor's liabilities are $80,000 and the fair market value of his assets is $45,000, the amount of the discharged debt eligible to be excluded from gross income — and therefore not taxable — is $35,000 ($80,000 less $45,000). The remaining $15,000 of the discharged debt will be included in gross income and will be taxed, unless another exception applies.
However, it’s important to note that “assets,” for purposes of the insolvency exception, are not defined by the tax code. This has created ambiguity when using the exception, as it can be difficult to determine if property is an asset for purposes of the calculation. One point of confusion in particular has been whether or not an interest in a defined benefit pension plan qualifies as an asset. Fortunately, a tax court case decided in 2017 clarifies how to treat an interest in a defined benefit pension plan for purposes of the insolvency exception — and offers important guidance for all taxpayers making elections to their plans.
At issue in Schieber v. Commissioner was whether the Schiebers' interest in a California Public Employees' Retirement System (CalPERS) defined benefit pension plan should be considered an asset when applying the insolvency exception. The government and the Schiebers both agreed that if the interest in the plan was an asset, the Schiebers would not be insolvent.
The Schiebers received monthly payments from the plan but could not convert their interest to a lump-sum cash amount, sell the interest, assign the interest, borrow against the interest or borrow from the plan. As a result, the Court ruled that the Schiebers' interest in the plan was not considered an asset when applying the insolvency exception, and therefore the Schiebers were able to exclude nearly $300,000 of the debt cancellation from their gross income. The Court, relying on precedent from a previous case, came to the decision by applying the “ability to pay an immediate tax on income" standard — reasoning that if the Schiebers couldn’t use the plan to pay an immediate tax, then the plan is not an asset.
The government argued that the Schiebers' interest in the plan should be considered an asset when applying the insolvency exception because the monthly payments could be used to pay the tax liability resulting from the cancellation of debt. The Court explained that the right to receive monthly payments allows a taxpayer to pay a tax liability gradually over time but fails to meet the "immediate" standard of paying off a debt all at once.
The government also cited Shepherd v. Commissioner, in which the Court ruled that the amount a taxpayer could borrow from a defined benefit pension plan is considered an asset when applying the insolvency exception. The Schiebers' situation can be distinguished from Shepherd in that the Schiebers could not borrow from their defined benefit pension plan. It is important to understand this distinction because a change in this fact alone could result in a different conclusion, as the ability to borrow from the plan would satisfy the “immediate” test and cause the defined benefit pension plan to be considered an asset.
The Schieber case provides both clarity and a planning opportunity. In a situation where a discharge of debt is imminent, probable or foreseeable, a taxpayer could realize significant tax savings by electing to receive the benefits of their defined benefit pension plan in monthly payments in lieu of a lump sum distribution. The outcome of this case provides taxpayers and their advisors valuable insight into how carefully these elections should be made.
Contact Michael Boncher or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.