If you have a right to receive $1 in the future, is that right an asset? Our tax laws would generally say that it is.
What if you cannot assign the right to receive the $1 and you cannot accelerate the payment? At what point is the right to receive the $1 not an asset currently?
The court addresses this question in Schieber v. Comm’r, T.C. Memo. 2017-32 in the context of cancellation of debt (“COD”) income. The IRS recently issued an Action on Decision noting that it does not agree with the court’s holding in the case.
Facts & Procedural History
The taxpayer-husband retired from the Bakersfield Police Department. He had started receiving payments from the California Public Employees’ Retirement System (CalPERS) defined benefit pension plan.
The taxpayers had a mortgage on the real estate they owned. In 2009, the mortgage company wrote off a portion of the taxpayers’ mortgage.
At the time the mortgage was written off, the taxpayers assets were valued at just under $1 million. Their debt, including the mortgage, was just over $1 million.
If the CalPERS defined benefit pension plan counted as an asset, it would increase the total value of the taxpayers’ assets to an amount in excess of their liabilities.
The taxpayers filed their tax return reporting that they were insolvent. This resulted in no tax imposed on the cancellation of debt.
About Cancellation of Debt Income
Cancellation of debt income is an income tax concept. Our income tax system starts with the concept of gross income. Gross income is anything that is an increase to one’s net worth. When a liability or debt is discharged or forgiven, the taxpayer has an increase in their net worth. This increase is the cancellation of debt income. Our tax laws impose a tax on this income.
The cancellation of debt income rules set out a number of exceptions. One exception is for debts discharged when the taxpayer is insolvent:
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—
(B) the discharge occurs when the taxpayer is insolvent,
It goes on to define what the term “indebtedess of the taxpayer:”
For purposes of this section, the term “indebtedness of the taxpayer” means any indebtedness—
(A) for which the taxpayer is liable, or
(B) subject to which the taxpayer holds property.
It also defines what “insolvent” means:
For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.
Thus, the taxpayer can avoid cancellation of debt income if their liabilities exceed their assets immediately before the debt is discharged or forgiven.
Is a Pension Plan an Asset?
The IRS argued that the taxpayers were not insolvent when their mortgage debt was discharged. The IRS argument was based on the husband’s pension plan was an asset that is to be counted when evaluating whether the taxpayers were insolvent. The IRS noted that the right to receive monthly payments causes the interest in the plan to be considered an asset.
The U.S. Tax Court did not buy the IRS’s argument. The court noted that:
the Schiebers’ interest in the pension plan entitles them only to monthly payments; the interest cannot be converted to a lump-sum cash amount; the interest cannot be sold; the interest cannot be assigned; the interest cannot be borrowed against; and the Schiebers cannot borrow from the plan.
The court reasoned that the taxpayers could not use the plan payments to immediately pay their taxes, given that they did not have the ability to access anything other than the monthly payments that they were entitled to receive.
Based on this, the court concluded that the pension was not an asset for purposes of the cancellation of debt rules.
Future Payments are Not Assets
The IRS action on decision indicates that the IRS does not agree with the court’s holding. It disagrees with the cases the court cited in reaching its conclusion.
The IRS Action on Decision does not address the real issue.
From the taxpayers perspective, the insolvency exception is an equitable provision. It carries out the general fresh-start policies that are found in our tax and bankruptcy laws. The insolvency rules are to be viewed at the time the debt is discharged. The tax rules say that this is the time for making these decisions. The income they may or may not receive in the future should not be considered.
From the IRS’s perspective, the taxpayers had a stable source of significant income that could be used to pay their taxes. Just because they could not immediately use the funds to pay their taxes does not mean that taxes should not apply. Presumably, the IRS would prefer there to be a tax imposed and, if need be, the taxpayers pay the tax over time via an installment agreement.
The other concern the IRS may have is that it is not clear whether this decision can be applied to other income streams. Is this a tax planning opportunity? For example, it would seem that the same reasoning would apply to annuity payments. It might even apply to a carefully worded promissory note. If that is the case, crafty taxpayers may try to structure their affairs so that they can avoid the cancellation of debt income. Those who have debts cancelled should consider how this case applies to their circumstances.