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.
