To qualify for the insolvency exclusion in §108(a) one has to be insolvent. Section 108(d)(3) defines insolvency as "the excess of liabilities over the fair market value of assets." But nothing in the Code or Regulations defines the term "liabilities." The recent case of Richard Bryan Jackson and Nora Irene Jackson v. Commissioner, T.C. Summ. Op. 2018-43 (Sept. 17, 2018), teaches a lesson about the meaning of that word.
In February, I wrote about Discharge of Indebtedness (DOI) Income. I called it “The Phantom of The Tax Code.” Readers will recall that when a taxpayer obtains a loan, the loan proceeds are not reportable as gross income, but it is not entirely clear why. The most common reason given is that the borrowed funds do not represent a increase in wealth because they are offset by the obligation to repay. I call this the balance sheet theory. The logic of this theory means that when the obligation to repay is discharged or relieved by the creditor, that discharge increases the taxpayer’s wealth to the extent that it frees the taxpayer from the obligation. I go into more detail in my February post.
Section 108(a) reflects this balance sheet theory by allowing taxpayers to exclude DOI from gross income when they are insolvent but limiting the exclusion to the amount of the insolvency at the time of the discharge. For example, if a taxpayer is discharged from $10,000 of debt at a time when the taxpayer is insolvent by $6,000, then the taxpayer can exclude $6,000 of the DOI from income but must report the remaining $4,000 as gross income.
Today’s lesson is about what types of obligations count as liabilities for purposes of determining insolvency. It turns out that not every obligation to pay someone is a liability. To see why, read on!
In 2013 Mr. Jackson had over $11,000 in DOI, apparently from three discharges of credit card debts. He did not report the DOI as income, however, because he believed he was insolvent at the times of each discharge. The IRS disagreed and issued an NOD. Mr. Jackson elected the small case procedure. The case was heard by Judge Guy.
To show his insolvency Mr. Jackson submitted a balance sheet of his assets and liabilities as of the various dates of the 2013 discharges. The balance sheets showed a single liability of roughly $52,000 each time and assets of about $10,000. The parties stipulated that if the $52,000 liability was really a liability, Mr. Jackson could exclude the 2013 DOI.
So let’s take a closer look at that asserted $52,000 liability. It was an obligation to New York State to buy back retirement benefits Mr. Jackson once had and then lost, and then regained. Here are the relevant details.
In 1980 Mr. Jackson started working for the State of New York in 1980 under a retirement plan that obligated him to contribute 3% of his salary until he accrued 10 years of service credit. Mr. Jackson left that job in 1989, before the 10 years was up. NY paid him the accumulated retirement benefits of $11,500.
In 2011 Mr. Jackson again became a New York state employee. In the intervening years NY had changed its retirement benefits and also now made employees contribute 3% of their salary for the duration of their State employment and not just 10 years.
In 2013 Mr. Jackson learned he could, in effect, buy back his eligibility for the old retirement plan benefits. NY told him that if he repaid the $11,500 along with 5% interest computed from 1989 he would be reinstated to his former retirement plan program. That seemed like a good deal. The NY State Retirement Plan sent him a letter explaining the obligation this way:
“Please be advised that your reinstatement includes an obligation to repay to [the retirement plan] the principal and interest due on the contributions returned to you when you separated from state service * * * Pursuant to your agreement with [the retirement plan], mandatory arrears payments in the amount of $245.66 will be withheld each pay period beginning January 2013 and will continue for 228 payroll periods. Should you leave state service prior to full payment of your arrears, * * * [the retirement plan] will reduce your retirement benefit to compensate for the balance due, as provided by * * * [the retirement plan] regulations.”
That obligation to pay $245.66 for the remaining pay periods is where the $52,000 came from.
Well, as (bad) luck would have it, Mr. Jackson’s job was eliminated in 2015 and he retired at that time. He no longer had to pay the $245.66 per month but, since he had not repaid his obligations per the buy-back agreement, NY paid Mr. Jackson only a reduced retirement benefit.
Application of Facts to Law
Judge Guy points out that neither the statute nor the regulations define the word “liability.” But Judge Guy finds some useful precedent. In Merkel v. Commissioner, 109 T.C. 463 (1997), the taxpayers had guaranteed loans and argued that those contingent liabilities should count in determining insolvency for §108 purposes. The Tax Court disagreed. It decided that the §108 insolvency exclusion was based on what the Court called “the freeing-of-assets theory.” That’s what I call the balance sheet theory. Said the Court: “That theory establishes the foundation for understanding the nature of the examination to be afforded to obligations claimed to be liabilities for purposes of the statutory insolvency calculation.” 109 T.C. at 474. Put more succinctly, the relevant question is whether the obligation really burdens assets. The Merkel Court puts it like this: “a taxpayer claiming the benefit of the insolvency exclusion must prove...with respect to any obligation claimed to be a liability, that, as of the calculation date, it is more probable than not that he will be called upon to pay that obligation in the amount claimed.” 109 T.C. at 484.
Applying that rule to Mr. Jackson’s case, Judge Guy decided that the $52,000 obligation was not a liability for §108 purposes. Mr. Jackson’s obligation to pay back the $11,500 plus interest did not really burden his assets. First, “Mr. Jackson’s payments were made to his own account to provide savings for retirement. In practical terms Mr. Jackson was merely moving money from one pocket to another.” Second, Judge Guy found that the obligation was contingent on Mr. Jackson continued employment. Sure, in 2013 he owed the money, but that was only because he was still employed. NY would not make him repay anything if he retired before completing the buy-back payments. It would just reduce his future retirement benefits. So what looked like a $52,000 obligation in 2013 did not burden his assets because---to use the words from Merkel---he would not be “called upon to pay that obligation in the amount claimed.”
Coda: Although Mr. Jackson lost, it is one of those rare cases where the IRS did not even attempt to assert a §6662 negligence penalty against a taxpayer. And that seems right. In 2013 the $52,000 reasonably looked and felt like a true liability because it was actually being paid monthly. From Mr. Jackson’s perspective, he “owed” NY the $11,500 plus interest. Mr. and Mrs. Jackson may have also fully disclosed the relevant facts to a competent professional return preparer. If so, the IRS employee conducting the examination would be unlikely to assert the penalty.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.