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Discharge of Debt For Insolvent or Bankrupt Debtors

A discharge is the release of a debtor from payment of debts in a bankruptcy proceeding.  A discharge order permanently prohibits creditors of the debtor from taking any form of collection action on discharged debts, including legal action.  Courts discharge debts in bankruptcy proceedings in order to relieve debtors of the requirement to pay off their debts.  A discharge applies only to debts incurred before bankruptcy proceedings.  A Debt which cannot be discharged include certain taxes, child support, alimony, student loan, and court fines.  To be proclaimed bankrupt, one must file a motion requesting to be declared bankrupt with the U.S. Bankruptcy Court.  Bankruptcy is a legally declared inability of an individual or organization to pay their creditors.  Insolvency is a financial term that means one has liabilities or debts in excess of his/her assets.

A bankruptcy discharge varies with the type of case a debtor files.  A bankruptcy discharge releases a debtor from personal liability for certain types of debts.  Once discharged, the debtor is no longer legally required to pay the discharged debts.  However, a valid lien is not avoided by discharge.  A secured creditor may enforce a lien to recover the property secured by the lien.

In the U.S., tax payers may have tax consequences when a debt is discharged.  This is called Cancellation of Debt income (COD).  Gross income includes all income from what ever sources and includes income from the discharge of indebtedness[i].  However, gross income does not include COD income if the debt discharge occurs in a Title 11 case[ii] ;ie., in bankruptcy or to the extent the taxpayer is insolvent[iii].  When a discharge happens in a bankruptcy case or while the debtor is insolvent, the debtor doesn’t have COD income.  Relief from inclusion in gross income is limited to discharge of indebtedness income.  Exemption is available only if a taxpayer is under the jurisdiction of a court in such a case and the discharge is granted by the court or in a court-approved plan[iv].

Although declared insolvent or bankrupt, a debtor must reduce certain tax attributes.  Moreover, when reduction or cancellation of indebtedness is compensation, he/she wouldn’t be eligible for exemption under the Internal Revenue Code[v]. The amount of debt discharge excluded from the debtor’s gross income is up to the amount of his insolvency[vi].  The amount excluded under insolvency exception is applied to reduce;

  • the debtor’s tax attributes [vii];or
  • the debtor’s basis in depreciable assets or in real property held as inventory[viii].

The insolvency amount is determined from assets and liabilities accrued immediately before discharge[ix].  In United States v. Davenport [x], it was observed that “a taxpayer claiming to be insolvent for purposes of 26 USCS § 108(a) (1) (B) and challenging the commissioner’s determination of deficiency must prove by a preponderance of the evidence that he/she will be called upon to pay an obligation claimed to be a liability and that the total amount of liabilities so proved exceed the fair market value of his/her  assets”.  Moreover, assets exempted from the claims of creditors under state law must be taken into account in determining insolvency.

[i] Tabrezi v. Comm’r, T.C. Memo 2006-61 (T.C. 2006); Internal Revenue Code

[ii] 26 USCS § 108(a) (1) (A)

[iii] 26 USCS § 108(a) (1) (B)

[iv] 26 USCS § 108(d) (2)

[v] 26 USCS § 108(a)

[vi] 26 USCS § 108(a)(3)

[vii] 26 USCS § 108(b)

[viii] 26 USCS § 108(b)(5)(a).

[ix] 26 USCS §  108(d)(3)

[x] 412 F. Supp. 2d 1201 (W.D. Okla. 2005)

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