Tenth Circuit Upholds Denial of Insolvency Exclusion for Discharged Debt Income

(Parker Tax Publishing April 2020)

The Tenth Circuit held that a taxpayer was not entitled to exclude discharged student loan debts of nearly $160,000 from income based on the insolvency exception under Code Sec. 108(a) because, during the same tax year, the taxpayer received a nontaxable partnership distribution worth more than $300,000 which, if included in the calculation of the taxpayer's total assets, would have precluded him from being insolvent. The court rejected the taxpayer's argument that he lacked significant control over those funds because the funds were transferred to his son's bank account. Hamilton v. Comm'r, 2020 PTC 108 (10th Cir. 2020).

Background

Vincent Hamilton borrowed more than $150,000 to pay for his son's medical school education. In 2008, Hamilton suffered a disabling back injury. His wife, Stephanie, who managed the family's finances in the aftermath of his injury, subsequently sought to discharge these student-loan obligations. Her efforts met with success, and the loans were fully discharged in 2011.

That same year, Mr. Hamilton received a nontaxable distribution worth more than $300,000 from a partnership interest in a movie theater business. Mrs. Hamilton transferred these funds plus some additional funds, into a previously-unused savings account held by their son, who provided her with login credentials for the account. Throughout 2011, she withdrew nearly $120,000 of the $320,000 that had been transferred to her son's savings account to finance household expenses.

The Hamiltons did not file a tax return for 2011 until March 2014. Filing jointly, they reported just over $850,000 in liabilities and just under $680,000 in assets. Their return made no mention of the $320,000 that Mrs. Hamilton had moved into the couple's savings account. As a result of this omission, Mr. Hamilton self-identified as insolvent, because his liabilities exceeded his assets by roughly $170,000. The Hamiltons therefore sought to exclude the discharged debt from taxable income under the insolvency exception in Code Sec. 108.

The IRS disallowed the exclusion of the discharged debt, reasoning that Mr. Hamilton was not insolvent because his assets outnumbered his liabilities as a result of the funds in the couple's savings account. The IRS also applied late-filing penalties. The Hamiltons took their case to the Tax Court. The Tax Court agreed with the IRS and found that the funds the couple transferred to their son's bank account were assets of the couple on the basis of the substance over form doctrine. The Tax Court also sustained the late-filing penalties. The Hamiltons appealed to the Tenth Circuit.

Under Code Sec. 61, gross income includes all income from whatever source derived, including income from the discharge of indebtedness. Under Code Sec. 108(a)(1)(B), a narrow exception permits taxpayers to exclude discharged debt from income if the discharge occurs when the taxpayer is insolvent. Code Sec. 108(d)(3) defines insolvency as the excess of the taxpayer's liabilities over the fair market value of his or her assets. Although the Code does not define "assets," the term has been construed by the Tax Court as any resource that gives a taxpayer the ability to pay an immediate tax on income from the cancelled debt. In Frank Lyon Co. v. U.S., 435 U.S. 561 (S. Ct. 1978), the Supreme Court held that the IRS may prioritize substance over form and look to the economic reality of a transaction.

On appeal, the Hamiltons argued that the funds transferred to their son's savings account were not their assets because their son could have changed the login credentials of his bank account so as to lock them out of the account. They also contended that under state law, their son was the owner of the savings account. Alternatively, the Hamiltons asserted that the disputed funds should be treated as separate property owned solely by Mrs. Hamilton. With regard to the penalties, the Hamiltons argued that they had reasonable cause for the late filing of their 2011 return due to being consumed with Mr. Hamilton's care and well-being.

Analysis

The Tenth Circuit affirmed the Tax Court's decision and held that the Tax Court properly applied the substance over form doctrine and properly determined that the Hamiltons exercised effective ongoing control over the disputed funds.

The court found that, before the transfer, the Hamiltons' son used his savings account rarely, if at all. The court saw no evidence indicating that the transfer represented a gift, nor did the Hamiltons' son pay any consideration in exchange for the funds. Moreover, the court noted that the son immediately provided Mrs. Hamilton with login credentials so that she could access the funds whenever she wanted and, during 2011, she withdrew nearly $120,000 to cover living expenses. The Hamiltons' son, by contrast, never withdrew any of the funds. Although the Hamiltons claimed that their son could have changed the login credentials to lock them out of the account, in the court's view it was more significant that he never did so.

The court also rejected the Hamiltons' argument that their son was the sole owner of the account under state law. The court said that such an argument was irrelevant to the substance over form inquiry. In addition, the Hamiltons' assertion that the disputed funds should be treated as Mrs. Hamilton's separate property was rejected because the court reasoned that assets beyond the reach of ordinary creditors may nonetheless constitute assets for tax purposes. The court noted that the vast majority of the disputed funds arose from Mr. Hamilton's partnership distribution, and the funds Mrs. Hamilton withdrew supported both of their living expenses. Therefore, in the court's view, Mr. Hamilton - with Mrs. Hamilton acting as his agent - exercised effective control over the funds.

The court upheld the late-filing penalties because it found that the Hamiltons did not have reasonable cause for filing their return late. The court rejected the couple's contention that their attention was consumed with caring for Mr. Hamilton. The court found no evidence of incapacity beyond Mr. Hamilton's injury and noted that during this same period, Mrs. Hamilton successfully managed the complex task of obtaining the student loan discharge.

For a discussion of the insolvency exclusion, see Parker Tax ¶76,110. For a discussion of the reasonable cause exception for delinquency penalties, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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