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Showing posts with label 108. Show all posts
Showing posts with label 108. Show all posts

Sunday, August 2, 2020

Are You Insolvent Or Not?

There is a case called Hamilton v Commissioner. It was recently decided in the 10th Circuit, and it caught my eye.

Since it went to a Circuit court, you may correctly assume that this case was on appeal.

Frankly, I do not see a win condition for the taxpayer here. It does, however, give us an opportunity to discuss the concept of a tax nominee.

The patriarch of our story – Mr Hamilton – borrowed over $150,000 to send his son to medical school.

Mr Hamilton injured his back in 2008 – and badly.

I presume that translated into loss of income and a difficult time servicing debt.

Mrs Hamilton finally got the student loan discharged in 2011.

A key point is that the student loan belonged to Mr Hamilton – not the son. When the loan was discharged, the tax effect is therefore analyzed at Mr Hamilton’s level, as he was the debtor.

Before the discharge, Mrs Hamilton transferred approximately $300 grand into a rarely used savings account owned by her son. He in turn gave her the username and password so she could access the account. Throughout 2011, for example, she withdrew close to $120,000 from the account.

COMMENT: There you have the issue of a nominee: whose account is it: Mrs Hamilton’s, the son’s, or both? Granted, it the son’s name is on the account, but is he acting as the face man – that is, a nominee – for someone else?

The issue in the case is whether the discharged debt of $150 grand was taxable to the Hamiltons in 2011.

In general, if your recourse debt is discharged, you have taxable income. There are several exceptions, of which one of the better known is bankruptcy. File for bankruptcy and the tax Code allows you to exclude the debt from taxable income.

But … it requires you to file bankruptcy.

There is a similar – but not quite the same – exception that has to do with insolvency. For tax purposes, one is insolvent if one’s debts exceeds one’s assets.

EXAMPLE: You have assets (house, car, savings, etc.) of $400,000. You owe $500,000. You are insolvent to the extent that your debts exceed your assets ($500,000 – 400,000 = $100,000).

Mind you, you are not filing for bankruptcy. I suppose it is possible that you could power through this stretch, cutting back personal expenditures to a minimum and applying everything else to debt. Still, you are technically insolvent.

The tax Code lets you exclude debt forgiveness from taxable income to the extent that you are insolvent.

EXAMPLE: Let’s continue with the above example. Say that $50,000 is forgiven. You are $100,000 insolvent. $50 grand is less than $100 grand, so $50 grand would be excluded under the insolvency exception.

NEXT EXAMPLE: What if $125 grand was forgiven? You could exclude $100 grand and no more. That last $25,000 would be taxable, as you are no longer insolvent.

The insolvency calculation puts a lot of pressure on what to include and what to exclude in the calculation. Do you include a 401(k) account, for example? Do you include someone else’s loan on which you cosigned?

In the Hamilton case, do you include that savings account?

Under state law, the son did own the account. Tax law however will rarely allow itself to be trapped by mere formality. This judicial doctrine is referred as “substance over form,” and it means what it says: tax law will generally look at the players and on-field performance and resist being distracted by the school band and T-shirt cannons.

The Court made short work of this case.

The taxpayers argued, for example, that the son could change the username and password at any time, so it would be a leap to call him an agent or nominee for his parents.

Yep, and a delivery spaceship for intergalactic deep-dish pizza could land on Spaghetti Junction in Atlanta during rush hour.


If you can log-in with impunity and move $120,000 grand, then you have effective control over the bank account. The mother’s name was not on the account, but it may as well have been because the son was his mother’s agent – that is, her nominee.

I have no problem with that. I would have done the same for my mother, without hesitation.

What the Hamiltons could not do, however, was leave-out that bank account when they were counting assets for purposes of the insolvency calculation. It was, after all, around $300 hundred – less than a Bezos but a lot more than a smidgeon.

Did it affect the insolvency calculation?

Of course it did. That is why the case went to Court.

The Hamiltons were not insolvent. They had income from the debt discharge.

They had to try, I guess, but I doubt whether they ever had a win condition.


Sunday, July 17, 2016

Credit Card Debt And Yankee Doodle Dandy

There is a tax doctrine known as the Cohan rule. It is named after the American composer and playwright George M. Cohan, the subject of the movie Yankee Doodle Dandy. While a renown musician, composer and playwright, he was not much of a recordkeeper, and he found himself in front of the Court defending his business expenses against challenge by the IRS. The Court took an extremely friendly stance and allowed him to estimate his deductions.


While the Cohan rule still exists (in some capacity) today, it should be noted that the tax Code has been changed to disallow the next George Cohan any tax deduction for estimated meals, travel and entertainment. Those particular deductions have to be substantiated or no deduction will be allowed, with or without a friendly judge.

I just read a case where (I believe) a variation on the Cohan rule came up.

The case has to do with cancellation of indebtedness income.

Did you know you could be taxed if a credit card company forgives your balance?

The reason is that the tax Code considers an "accession to wealth" to be "income" (with exceptions, of course). Take the conventional definition of wealth as 
... assets owned less debts owed ...
and you can see that the definition has two moving parts. The asset part is easy - your paycheck increases your bank account, if only fleetingly. The liability part in turn is the reason you can borrow money and not have it considered income (assets and liabilities increase by the same amount, so the difference is zero). Have the bank forgive the debt, however, and the difference is no longer zero.

Newman did something odd. He wrote a check on his Wells Fargo account and opened a new account at Bank of America. He withdrew money from the new account. Meanwhile the check on Wells Fargo bounced.

Bank of America wanted its money back. Newman did not have it anymore.

Impasse.

You may know that a bank will issue a Form 1099 (Form 1099-C, specifically) when it cancels a debt. That 1099 informs the IRS about the forgiveness, and it is a heads-up to them to check for that income on your tax return.

            Question: when does the the bank issue the 1099?

In general it will be after 36 months of inactivity. Newman bounced the check in 2008 and received the 1099 in 2011.

Newman left the 1099 off his tax return. The IRS put it back on.

The Court decided Newman had - potentially - income in 2011.

Newman fired back: he did not have income because he was insolvent in 2011, and the tax Code allows one to avoid debt income to the extent one is insolvent.

You and I use another word for "insolvent" in our day-to-day conversation:  bankrupt.

Bankrupt means that you owe more than you are worth. The tax Code has an exception to debt income for bankruptcy, but it only applies if one is in Bankruptcy Court. But what if you are trying to work something out without going to Bankruptcy Court? The Code recognizes this scenario and refers to it as "insolvency."

So Newman had to persuade the Court that he was insolvent.

One would expect him to bring in a banker's box of bank statements, credit card bills, car loan balances and so forth to substantiate his argument.

The Court looked and said:
At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were."
"Testimony?"

What about that banker's box?

Newman ran a Hail Mary play with time expiring on the game clock. While a low-probability play, he connected for a touchdown and the win.

To a tax advisor, however, Newman was decided differently from Shepherd, another Tax Court case from 2012 where the taxpayer needed much more than his testimony to substantiate his insolvency.

Why the difference between the two Court decisions?

With that question you have an insight into the headaches of professional tax practice.