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Showing posts with label insolvent. Show all posts
Showing posts with label insolvent. Show all posts

Monday, July 17, 2023

Income And Cancellation of Bank Debt

 

There is a basic presumption in the tax Code that any accession to “wealth” is income. It isn’t much of a leap for the tax Code to then say that all income is taxable unless otherwise excluded.

Let’s next look at “wealth.” I propose a working definition as follows:

          Assets (A) = Liabilities (L) + Wealth (W)

A little algebra shows the following:

          A – L = W

Here is spiff on the above: do you have wealth if your liabilities go down?

Let’s look at the Katrina White case.

Katrina started a business in 2015. She took out a business loan for $15,000. She leased space for her business, signing a three-year lease.

The business did not work out. The family lent her $8 grand, but there was no way to save it. She had repaid the bank less than a grand when her remaining debt of $14,433 was discharged. The bank sent her a 1099, of course, as all American life events can apparently be reduced to a 1099.

Katrina never made a payment on the lease. Since rent was late for more than two months, the entire lease became due and payable. That fiasco totaled $21,700.

 She filed her return.

The IRS said she left out income of $14,433.

How?

Let’s go through it.

Katrina said that her wealth (that is, A – L = W) was as follows when the business failed:                 

Real property

28,500

Personal property

3,560

32,060

Student loans

5,294

Utilities

961

Utilities, estimated

2,500

Furniture loan

1,120

Judgements

8,128

Bank loan

14,433

Lease breach

21,700

Family loan

7,800

61,936

Net wealth

(29,876)

The IRS wasn’t buying this. They argued that:

·      The estimated utilities were a no go.

·      The family loan wasn’t really a “loan.”

·      While we are at it, the lease breach wasn’t really a loan, as the landlord had no intention of enforcing the debt.

The IRS math was as follows:

Real property

28,500

Personal property

3,560

32,060

Student loans

5,294

Utilities

961

Furniture loan

1,120

Judgements

8,128

Bank loan

14,433

29,936

Net wealth

2,124

The matter went to Tax Court.

The Court pointed out the obvious: Katrina signed a valid and binding lease contract. Perhaps the landlord decided that there was nothing there to pursue, but it cannot be argued that she had an enforceable debt.

The Court saw the following:

Real property

28,500

Personal property

3,560

32,060

Student loans

5,294

Utilities

961

Furniture loan

1,120

Judgements

8,128

Bank loan

14,433

Lease breach

21,700

51,636

Net wealth

(19,576)

Let’s recap our numbers:

Wealth per Katrina was          ($29,876)

Wealth per the IRS was              $2,124

Wealth per the Court was        ($19,576)

Remember what we said at the beginning, that all income is taxable unless there is an exception?  Well, there is an exception for cancellation of debt. Several, in fact, but today we are concerned with only one: insolvency. The Code says that one does not have income to the extent that one is insolvent.

What is insolvency?

Go back to the formula: A – L = W.

To the extent that “W” is negative, one is insolvent. Another way of saying it is that one has more debts than assets.

So, who showed negative “W”?

Well, Katrina did. So did the Court.

Katrina was insolvent. That was an exception to cancellation of indebtedness income. Katrina did not have taxable income. The IRS lost.

Our case this time was Katrina White v Commissioner, T.C. Memo 2023.-77.

Sunday, December 20, 2020

Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

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.


Friday, June 19, 2015

A Representative’s Tax Proposal for Credit Card Debt Forgivenesss



I am reading that Representative Scott Peters (D-CA) has proposed a change to the tax Code allowing forgiveness of credit card balances to be nontaxable.

I have two questions for you:

First, what is it with politicians from California?


Second, did you know that credit card forgiveness was taxable?

The tax Code is based on the concept of an increase in net wealth. The concept is simple, although it causes difficulty in application. Let’s look at the following example:
           
Monday morning you have to your name


400
Tuesday the credit card company forgave


125
Friday you got paid




1,000
You put gas in your car



(60)
You bought lunch all week



(40)
Friday afternoon you have to your name


1,425

You went from being worth $400 to being worth $1,425. Does that mean that you have $1,025 of income to report to the tax man? No, but you are thinking along the correct lines. Not every addition in our example is taxable, and not every subtraction is deductible. Let’s look at each.


  •  $125 of your credit card balance was forgiven.

Code section 108 addresses the taxability when somebody forgives your debt. There are five subcategories:

·        108(a)(1)(A) applies in bankruptcy
·        108(a)(1)(B) applies if you are insolvent
·        108(a)(1)(C) applies to farm debt
·        108(a)(1)(D) applies to certain business debt
·        108(a)(1)(E) applies to your mortgage

I am not seeing an exception for credit cards, so for the time being it looks like the $125 will be income. I am assuming that you are not insolvent (meaning that you owe more than you are worth) or in bankruptcy (which sometimes follows owing more than you are worth).

  • Your paycheck

That one is obvious. We should be thankful the government does not just decide to have all paychecks sent to them, allowing them to decide how much to return to us.

  •  Buying gas and a week’s worth of lunches

Code section 262 disallows tax deductions for personal, living and family expenses. Granted, another Code section may override and allow a deduction for specific expenses (such as medical), but in general one cannot deduct groceries, utilities, rent and similar day-to-day-living expenses.

I would say that you have taxable income of $125 plus $1,000 = $1,125.

The credit card is a subset of “forgiveness of indebtedness” taxation. The seminal case is Kirby Lumber, which was decided by the Supreme Court back in 1931. Kirby Lumber had previously issued bonds of over $12 million. They later bought back the bonds for $137,000 less. The question before the Court was whether that $137,000 represented taxable income. It does seem a bit odd that someone can have income just from transacting in debt, but if you think of it as accession to wealth the tax reasoning becomes clearer. At the end of the day Kirby Lumber was worth $137,000 more (as it had less net debt), and the government wanted its cut.

Back to Representative Sun-Dance-Whispered-By-Hidden-Shadow, or whatever he is called back in his native land.

He is proposing that forgiveness of credit cards be excluded from income.

However, the most that a person could exclude from lifetime income is capped at $2,500.

Say that you excluded $1,000 in 2014. Under his proposal, the most you could exclude – over the rest of your life – is another $1,500. You cannot exclude more than $2,500 over your lifetime.

My first thought is that $2,500 is not enough to move the needle, if someone really got into credit card and personal debt problems. I have known and heard of people who have run up a mortgage-level balance on their credit cards.

My second thought is whether this is a wise use of the public purse. Congress provided a mortgage interest deduction because it wanted to increase home ownership. It provided a charitable deduction to promote societal benevolence and reduce strain on the public safety net. What is Congress saying by providing an exclusion for not repaying credit card debt?

And you can see how bad tax law happens. There is no theory of wealth creation, case precedence or administrative practicality at play with this proposal. An elected bludger panders, laws are passed without being read and the tax system (both the IRS and advisors) is left to making sense out of nonsense.