Chapter 2.09 of the text deals with foreclosures and debt relief; it also shows you how to compute the insolvent taxpayer exclusion. After conducting some research, we have concluded that the method used in determining the amount by which a taxpayer is insolvent is not correct. In the original text material, students are instructed to reduce a taxpayer’s assets by the bankruptcy exclusions when determining the amount by which the taxpayer is insolvent.
This is incorrect; the assets should NOT be reduced by the state bankruptcy exclusions.
Tax Court rulings that previously had held that assets exempt from creditors' claims are not taken into account in determining whether a taxpayer is insolvent. According to the Code, the term "insolvent" means the excess of liabilities over the fair market value of assets, determined on the basis of a taxpayer's assets and liabilities immediately before the discharge (Code Section 108(d)(3)). Further research indicates the Tax Court’s current position, with which the IRS agrees, is that a taxpayer's assets for this purpose include assets that are exempt from creditors' claims under the applicable state law (Carlson v. Commissioner, 116 T.C. 87 (2001)).
The Tax Court reasoned in Carlson that Congress decided to, and did, adopt a different definition of the term "insolvent" in section 108(d)(3) for purposes of section 108. Unlike the definition of the term "insolvent" in section 101(26) of the 1978 Bankruptcy Act, 11 U.S.C. sec. 101(26) (Supp. II, 1978), which Congress adopted for purposes of the Federal bankruptcy laws, the definition of that term which Congress adopted for purposes of section 108 does not specifically exclude assets of a debtor that are exempt from the claims of creditors under applicable State law or any other title 11 exempt property in determining whether the debtor is insolvent. The Court concludes that the decision of Congress not to define the term "insolvent" in section 108(d)(3) to exclude specifically such exempt assets in determining whether a debtor is insolvent for purposes of section 108 was intentional. It is the Court’s opinion that Congress did not intend to exclude assets exempt from the claims of creditors under applicable State law from a taxpayer's assets for purposes of determining whether the taxpayer is insolvent within the meaning of section 108(d)(3). If Congress had intended to exclude such exempt assets from a taxpayer's assets in determining whether the taxpayer is insolvent for purposes of section 108, Congress would have so stated in section 108(d)(3). It did not.
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