Forgiveness of indebtedness – does this create taxable income, or is there an insolvency exception to IRS taxation?
Individuals facing financial difficulties often hear rumors from creditors and other sources that if their debts are “charged off” or otherwise “forgiven” by their creditors, the individual will receive an IRS Form from their creditor at the end of the taxable year that shifts the tax liability for the forgiven debt to the individual. Creditors and debt collectors excitedly cite to the Internal Revenue Code in support of their argument: 26 U.S.C. § 61(a)(12) states: “General definition.–Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: … Income from discharge of indebtedness.” This “discharge of indebtedness” in lay terms simply means the writing off or forgiveness of outstanding debt. Thus, the general rule supports the creditors and may create tax liability.
However, creditors fail to inform you that there are major exceptions to the general rule that debt forgiveness is taxable income. Two major exceptions to this general rule are 1) if the debt is forgiven while the individual is in a bankruptcy case; and 2) if the debt is forgiven when the individual is insolvent. See 26 U.S.C. § 108(a) (1) (A) and (B), (“Exclusion from gross income.–… In general.–Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if– (A) the discharge occurs in a [bankruptcy] case, [or] (B) the discharge occurs when the taxpayer is insolvent.”) As is readily seen from the fact that there is one exception for those in bankruptcy and a separate exception for “insolvency”, an individual does not necessarily have to be in bankruptcy to be insolvent. Bankruptcy is simply a safe-harbor that creates a bright-line rule.
Yet, it is important to know that those desiring to raise the insolvency defense may have a fight on their hands. Insolvency is determined on a case-by-case basis and must be assessed as of the time the debt is forgiven. Therefore, if an individual is considered “solvent” at the time the debt was forgiven and that individual later becomes insolvent, the debt forgiveness is considered taxable income for which the individual will be liable. Unfortunately, any such taxes are probably not dischargeable in a subsequent bankruptcy. Before you attempt to negotiate with creditors or seek debt reduction/forgiveness, it would be well worth your while to seek the advice of a competent attorney. (Special thanks to Phoenix attorney J. Tyler Martin and his Phoenix colleagues for drafting and analysis used in this blog entry.)
Merry tax-free discharging!