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IRS Won't Follow Tax Court's Ruling in Insolvency Exception Case

(Parker Tax Publishing April 2021)

The IRS announced its nonacquiescence to the Tax Court's ruling in Schieber v. Comm'r, T.C. Memo. 2017-32, in which the Tax Court held that a taxpayers' interest in a pension plan was not an asset for purposes of the insolvency exclusion under Code Sec. 108(d)(3) because it could not be converted into a lump-sum cash amount, sold, assigned, or borrowed against. According to the IRS, the Tax Court misinterpreted language from the legislative history of Code Sec. 108. AOD 2021-1.


Under Code Sec. 61(a)(12), income from the discharge of indebtedness generally must be included in the gross income of the taxpayer whose debt is discharged. However, an exception applies under Code Sec. 108(a)(1)(B), which provides that discharge-of-indebtedness income is excludable from gross income when the taxpayer is insolvent. Under Code Sec. 108(d)(3), a taxpayer is insolvent to the extent the taxpayer's liabilities exceed the fair market value of the taxpayer's assets immediately before the debt is discharged.

In Merkel v. Comm'r, 109 T.C. 463 (1997), the Tax Court held that a certain liability was too contingent to be included in the meaning of the term "liability" under Code Sec. 108(d)(3). In Carlson v. Comm'r, 116 T.C. 87 (2001), the court relied on Merkel in holding that an asset exempt from creditors under state law was included in the meaning of the term "asset" under Code Sec. 108(d)(3). Both opinions cited to the underlying legislative history and concluded that the taxpayers' ability to pay an immediate tax on income was relevant in determining whether the liability or asset fell within the meaning of those terms in the statute. The court in each case measured the taxpayers' economic solvency and their ability to pay an immediate tax by considering the reality of the taxpayers' financial situations. In Merkel, that reality was reflected by a determination that it was unlikely the taxpayers would be called upon to pay the obligation. In Carlson, that reality was measured by the court's determination that including exempt assets in determining a taxpayer's solvency more accurately reflects the taxpayer's economic situation.

In Schieber v. Comm'r, T.C. Memo. 2017-32, the Tax Court held that a married couple's interest in a pension plan was not an asset for purposes of the insolvency exclusion because it could not be converted into a lump-sum cash amount, sold, assigned, or borrowed against. In support of its decision, the Tax Court stated that the "test" in Carlson for determining whether something is an asset is whether it gives the taxpayer the ability to pay an immediate tax on income from the cancelled debt - not to pay the tax gradually over time.

AOD 2021-1

In AOD 2021-1, the IRS announced that it will not follow the Tax Court's decision in Schieber in excluding assets from the definition of asset under Cod Sec. 108(d)(3) on the grounds that they cannot be converted into a lump-sum cash amount, sold, assigned or borrowed against. The IRS found that the Tax Court in Schieber erred by taking language from the legislative history of Code Sec. 108 that the court used in interpreting the statute in Merkel and Carlson and turning that language into a threshold test not found in the statute itself.

The IRS reasoned that the language cited by the court in Schieber is merely part of the underlying legislative history that explains why Congress enacted the insolvency exclusion, to provide a fresh start to an insolvent taxpayer and require a reduction of tax attributes under Code Sec. 108(b). The IRS found that the court in Schieber used this legislative history language to hold that something that falls within the plain meaning of the term "asset" (in this case, the right to a stream of payments over a taxpayer's lifetime) is not considered an asset for purposes of Code Sec. 108(d)(3). The IRS stated that, furthermore, the court's holding in Schieber is internally inconsistent because it does not consider even the current year's distributions from a pension in the insolvency computation.

Observation: The IRS noted that in Schieber, the Tax Court concluded that the issue of whether an interest in the pension plan can be converted into a lump-sum cash amount, sold, assigned, or borrowed against was not disputed by the IRS. The IRS stated that it may dispute this premise in future cases.

For a discussion of the insolvency exception, see Parker Tax ¶76,110.

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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