ࡱ> ` bjbjss .fffffffzb2b2b2b2l2dzT2>34444444YT[T[T[T[T[T[T$ VhtXZTf:44::Tff44T.=.=.=:f4f4YT.=:YT.=.=mOff%P423 w0njb2:,OeST0TPX<X(%P%P XfES 4u6.=7c8m444TT ="444T::::zzzdzzzzzzffffff   HYPERLINK "http://services.taxanalysts.com/Login" \o "Return to Tax Analysts Web Services Welcome Page"  INCLUDEPICTURE "http://services.taxanalysts.com/www/website.nsf/tax-analysts.gif" \* MERGEFORMATINET   HYPERLINK "http://services.taxanalysts.com/Login" \o "Return to Tax Analysts Web Services Welcome Page"  Tax Notes Todays Today June 10, 2011 California Bar Seeks Definition of 'Liability' in Debt Cancellation Regs  INCLUDEPICTURE "http://services.taxanalysts.com/www/website.nsf/PublishedHeader/$file/summary.gif" \* MERGEFORMATINET  Haleh Naimi of the State Bar of California recommended that Treasury issue guidance defining "liability" in the context of section 108 exclusions of discharged debt income, saying the "more likely than not" standard put forth in a 1999 decision by the Ninth Circuit Court of Appeals leads to "uncertainty and distortions."  INCLUDEPICTURE "http://services.taxanalysts.com/www/website.nsf/PublishedHeader/$file/fulltext.gif" \* MERGEFORMATINET  CALIFORNIA STATE BAR TAXATION SECTION CORPORATE AND PASS-THROUGH ENTITIES COMMITTEE PROPOSED GUIDANCE UNDER CODE SECTION 108(d)(3) This paper was principally prepared by Haleh Naimi, a member of the Corporate and Pass-Through Entities Committee of the California State Bar's Taxation Section.1 The author wishes to thank A. Lavar Taylor of the Law Offices of A. Lavar Taylor for suggesting the topic and for his valuable insights. The author also wishes to thank the referees, Thomas Humphreys of Morrison & Foerster LLP and Milton Hyman of Irell & Manella LLP, for their helpful comments.2 Contact Person: Haleh Naimi, Esq. Advocate Solutions, Inc. 9701 Wilshire Boulevard, Suite 1000 Beverly Hills, CA 90212 (310) 601-7157 hnaimi@advocatesolutions.com EXECUTIVE SUMMARY3 Businesses in the State of California, as well as the rest of the country, have faced the most severe recession in modern economic times. As part of the recovery from the recession, businesses have been retiring debt at discounted rates and creditors have been charging off loans and foreclosing on mortgage obligations at unprecedented levels. These debt cancellations have resulted in sometimes unanticipated tax consequences from cancellation of indebtedness ("COD") income under section 61(a)(12) of the Code. The Code provides for an exclusion of COD income under section 108(a)(1)(B) by an insolvent taxpayer and defines "insolvency" as the excess of the taxpayer's liabilities over the fair market value of the taxpayer's assets immediately before the debt discharge. However, neither the Code nor the Regulations provide guidance on the definition of "liability" for purposes of the insolvency exclusion. As a result, businesses are left with great uncertainty about their tax liability when restructuring their debts outside of a bankruptcy proceeding. In 1999, the Ninth Circuit4 announced a narrow standard upon which to treat contingent liabilities for purposes of the insolvency exclusion. Under this rule, contingent liabilities are included in the insolvency calculation only if the taxpayer can prove it is "more likely than not" that it will be called upon to pay the liability. Based on this standard, both the Service and taxpayers continue to face uncertainty as to whether the factual evidence underlying the contingent liability supports the Ninth Circuit's standard, particularly when there is a close call in judgment about the likelihood that the contingency would eventuate. In addition to this uncertainty, the author believes that the Ninth Circuit's test may result in distortions for taxpayers who are unable to satisfy the preponderance test, but are otherwise insolvent. For instance, taxpayers facing contingent liabilities with a significant likelihood of occurrence would be denied the insolvency exclusion outside of a bankruptcy proceeding and would be required to pay tax on any COD income recognized rather than satisfying their future liabilities. This result would defeat the legislative intent underlying the insolvency exclusion. To address the uncertainty and distortions created by the narrow "more likely than not" test announced in Merkel, this paper recommends that Treasury issue a regulation that would (i) set forth a definition for liability in the context of section 108 of the Code which includes contingent obligations; (ii) provide a standard for fairly valuing contingent obligations for purposes of the insolvency exclusion; (iii) provide evidentiary considerations to guide taxpayers in determining the likelihood that a contingent obligation would become an actual liability; and (iv) require, to the extent contingent liabilities cannot be estimated with reasonable accuracy, that taxpayers estimate the liability and request that the transaction remain open until the actual liability is determined. Once the actual liability amount is determined, taxpayers would file an adjustment form reporting the difference between the estimated and actual amount and adjust the tax upward or downward on any COD income recognized in the earlier tax year. DISCUSSION I. BACKGROUND Businesses in the State of California, as well as the rest of the country, have faced the most severe recession in modern economic times. As part of the recovery from the recession, businesses have been retiring debt at discounted rates and creditors have been charging off loans and foreclosing on mortgage obligations at unprecedented levels.5 These debt cancellations have resulted in sometimes unanticipated tax consequences from cancellation of indebtedness ("COD") income under section 61(a)(12)6 of the Code.7 The Code provides for an exclusion of COD income under section 108(a)(1)(B)8 by an insolvent taxpayer to the extent of insolvency and defines "insolvency" as the excess of the taxpayer's liabilities over the fair market value of the taxpayer's assets immediately before the debt discharge. However, neither the Code nor the Regulations provide clear guidance on the definition of "liabilities" and the treatment of contingent liabilities for purposes of the insolvency exclusion. Although businesses that file for bankruptcy relief can exclude all COD income, a business that restructures its debt outside of bankruptcy may only exclude COD income to the extent of its insolvency. Taxpayers are, therefore, left with great uncertainty about their tax liability when restructuring their debts outside of bankruptcy. Current law presents a significant problem for businesses engaging in out-of-court workouts, in receivership, or facing foreclosure proceedings since, in the absence of clear guidance on contingent liabilities, they may not be considered insolvent for purposes of section 108. In view of this uncertainty businesses will be more likely to file bankruptcy than to engage in debt restructuring outside of bankruptcy. II. Treatment of Contingent Liabilities Under Merkel In 1999, the Ninth Circuit9 announced a narrow standard upon which to treat contingent liabilities for purposes of the insolvency exclusion. Under this rule, contingent liabilities are included in the insolvency calculation only if the taxpayer can prove it is "more likely than not" that it will be called upon to pay the liability. A. Factual Background Dudley Merkel ("Merkel") and David Hepburn ("Hepburn") were officers and co-owners of Systems Leasing Corp. ("SLC"), a computer leasing company. SLC obtained a bank loan in excess of $3 million, which Merkel and Hepburn personally guaranteed. Several years later, the note remained unpaid and SLC was declared in default, but the bank did not demand payment from Merkel or Hepburn. Instead, the bank, SLC and the guarantors entered into a structured workout agreement wherein SLC agreed to pay the bank $1.1 million by August 2, 1991 and the bank agreed to discharge the remaining balance of the loan and release the Merkel and Hepburn guarantees, as long as none of the parties filed for bankruptcy within 400 days. In addition, Merkel and Hepburn were listed as the officers of SLC and under North Carolina law, the officers were deemed secondarily liable for the sales and use tax of the corporation. As of August 31, 1991, SLC had not paid the assessed sales and use tax. On their tax returns, both Merkel and Hepburn excluded cancellation of indebtedness income from their gross income, claiming that their liability as guarantors on the SLC note rendered them insolvent. The Service argued that the personal guarantee was not a "liability" for "insolvency" purposes. They argued that only liabilities that are ripe and in existence immediately before the discharge could be counted as a liability. The taxpayers argued that all liabilities, including contingent liabilities should be included in the insolvency analysis. The court noted that it was not clear whether Congress intended for all contingent liabilities to be considered in the insolvency analysis. The issue before the Ninth Circuit was whether the taxpayers were "insolvent" when the bank discharged part of the SLC note. The court had to determine whether the guarantee under the provisions of the structured workout agreement was a liability for purposes of the insolvency exclusion. After considering the arguments, the Ninth Circuit affirmed the Tax Court's finding that the taxpayers failed to prove that a bankruptcy event was likely to occur and therefore failed to prove that, as of the August 31, 1991, they would be called upon to pay any amount to the bank.10 In addressing this issue, both the Tax Court and the Ninth Circuit reviewed the legislative history of the insolvency exclusion and the relevant cases cited in the committee reports, beginning with the Supreme Court's decision in United States v. Kirby Lumber Co.11 B. Judicial Insolvency Exclusion -- Net Asset Theory In Kirby Lumber the taxpayer was held to have COD income when it repurchased its own bonds for less than it had received when the bonds were issued. The Court explained that as a result of these dealings, the taxpayer made available assets previously offset by the obligation of the bonds. Following, this decision, the courts quickly carved out an insolvency exclusion to the general rule in Kirby Lumber. In Dallas Transfer & Terminal Warehouse Co.,12 an insolvent taxpayer was relieved on an indebtedness with respect to unpaid rent and interest, but the taxpayer was insolvent both before and after the debt was discharged. The court concluded that the discharge did not have the effect of making the taxpayer's assets greater than before the transaction occurred because the taxpayer had no assets in either situation. These rules were reduced to the "net assets test" announced in Lakeland Grocery Co.13 Under the net assets test, if a debtor remains insolvent after being discharged of indebtedness, no assets have been freed as a result of the discharge since the debtor's assets are still more than offset by post-discharge liabilities. On the other hand, if the debtor is solvent after being discharged of indebtedness, the discharge has freed at least some of the debtor's assets from offsetting liabilities, and gross income is realized from the discharge to the extent of the solvency. In reviewing the cases developed under the judicial insolvency exception, the court did not mention the Conestoga Transp. Co. v. Commissoner decision,14 wherein the Tax Court allowed reserves for claims in measuring insolvency, without discussing the contingent nature of those reserves. C. Legislative Intent Underlying Section 108(a)(1)(B) The legislative history of the Bankruptcy Tax Act of 1980 (the "Bankruptcy Tax Act") provides that the Bankruptcy Tax Act is a codification of the judicially developed insolvency exclusion. The relevant committee reports accompanying H.R. 5043, 96th Cong., 2d Sess. (1980), which became the Bankruptcy Tax Act, provide that the proposed insolvency exclusion was intended to insure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy, who is accorded a "fresh start" under the bankruptcy law) is not burdened with an immediate tax liability.15 Based on this legislative history, it is clear that Congress intended to afford the taxpayer with the same equitable policy of a "fresh start" from insolvency whether the taxpayer was in or outside of a bankruptcy proceeding. The Senate report indicates that aside from its acceptance of the net assets theory, Congress had a dual bankruptcy and tax purpose in enacting section 108(a)(1)(B).16 III. SUBSTANTIAL NEED FOR GUIDANCE On the facts of Merkel, it is understandable why the court held that the liabilities should not be included in the insolvency calculation since their likelihood of occurrence was remote. However, the court used the Merkel facts to announce a general standard for the treatment of contingent liabilities under section 108, which has resulted in significant uncertainty for both taxpayers and the Service. Taxpayers are faced with uncertainty about the tax costs of restructuring their obligations outside of bankruptcy, which presents a situation contrary to the Congressional intent underlying the insolvency exclusion. This current uncertainty may encourage businesses to restructure their debts under the bankruptcy court's jurisdiction when they would not otherwise do so, solely to avoid a potential tax liability from COD income. In addition, the Ninth Circuit's test may result in distortions for taxpayers who are unable to satisfy the preponderance test, but are otherwise insolvent. A taxpayer obligated on a contingent liability with a forty-nine (49%) percent probability of occurrence would be denied the exclusion under the current Merkel test and would have to pay an immediate tax on any gross income realized from its debt restructuring. The following example illustrates this distortion in applying the Merkel standard: Example: Taxpayer X has the following assets and liabilities in Year 1 -- Assets Liabilities _______________________________________________________________________ $1,000 (cash) $100,000 (promissory note) $50,000 (stocks) $100,000 (accounts payable) $150,000 (retirement plan) $900,000 (contingent liability) ________ __________ $201,000 $1,100,000 Assume Taxpayer X cannot provide evidence in Year 1 that the $900,000 contingent liability has a more than fifty (50%) percent probability of occurring (but can prove it has a forty-nine (49%) percent chance of occurring). Under the Merkel test, Taxpayer X will be deemed solvent and obligated to pay tax on any COD income recognized under section 61(a)(12) of the Code.17 In Year 2, Taxpayer X has the following remaining assets and liabilities: Assets Liabilities ________________________________________________________________________ $1,000 (cash) $0 (promissory note) $15,000 (stocks) $100,000 (accounts payable) $150,000 (retirement plan) $900,000 (contingent liability) ________ _________ $166,000 $1,000,000 Assume Taxpayer X's promissory note in the sum of $100,000 was cancelled in Year 1. As a result, Taxpayer X realized COD income equal to the entire amount of the debt. Assuming a tax rate of thirty-five (35%) percent, Taxpayer X was obligated to pay $35,000 on the COD income recognized, which was paid by liquidating $35,000 in stocks. Taxpayer X does not have new evidence or information to raise the likelihood of the contingent liability occurring to more than fifty (50%) percent. Therefore, under the Merkel test, the entire $900,000 in contingent liability is omitted from the insolvency calculation and the taxpayer is again considered solvent in Year 2. If Taxpayer X restructures the $100,000 in accounts payable obligations, he will again be obligated to pay tax on the COD income recognized under section 61(a)(12) of the Code. As illustrated by the above example, the distortion under Merkel arises because Taxpayer X faces a potentially significant liability but is unable to satisfy the burden of proof when the COD income is recognized.18 If a taxpayer's insolvency hinges on the inclusion of contingent liabilities, it must be prepared to present credible evidence of its obligations which satisfy the more likely than not test. Although the Merkel test may be perceived as favorable to the taxpayer facing financial hardship because the entire contingent liability is included among the liabilities without discounting for the risk or time value of money, it is a difficult standard to meet with respect to most projected liabilities. The cases following the Merkel decision, demonstrate the uncertainty and how difficult it is for most taxpayers to satisfy this evidentiary standard with respect to their contingent liabilities.19 Under the Merkel test, most contingent liabilities with a significant likelihood of occurrence are eliminated entirely from the insolvency calculation and, therefore, may overstate a taxpayer's net worth. As a consequence, the narrow Merkel test places great financial hardship on taxpayers already facing insolvency and defeats the legislative intent underlying the insolvency exclusion. The uncertainty and lack of guidance in measuring insolvency have been noted by several other commentators.20 IV. TREATMENT OF CONTINGENT LIABILITIES UNDER TAX AND BANKRUPTCY LAW A. Contingent Liabilities Under Tax Law The Code does not provide a uniform definition for the term "liability." Section 358(h)(3) of the Code defines liability in the context of establishing rules for determining basis in corporate transactions, as including "any fixed or contingent obligation to make a payment." Congress enacted section 358(h)(3) to address certain situations where taxpayers attempted to duplicate a loss in corporate stock and to accelerate deductions that would typically only be allowed on the economic performance of these types of obligations. In these transactions, the transferor would transfer property to a corporation in exchange for both stock and the corporation's assumption of certain obligations. The transferors would claim that the obligations were not liabilities within the meaning of section 357(c), and therefore, the obligations did not reduce the basis of the transferor's stock.21 The transferors would then sell the stock and claim a loss. In order to curb the perceived abuse from these transactions, Congress defined liabilities broadly in the Code to include contingent obligations. Congress perceived that taxpayers were attempting to use partnerships to carry out the same types of abuses that section 358(h) was intended to deter and directed the Secretary to prescribe rules to provide similar adjustments to prevent the acceleration or duplication of losses through assumption (or transfer of assets) subject to liabilities in transactions involving partnerships. Accordingly, Regulations 1.752-0 through 1.752-7 were drafted to stem the perceived abuses and designed to reflect the true economics of these transactions. The definition of liability and method of valuation set forth in Treas. Regs. 1.752-1, 1.752-2, and 1.752-7 would provide both taxpayers and the Service with much needed guidance to fairly measure insolvency under section 108 of the Code.22 These regulations provide guidance on valuation of liabilities through the constructive liquidation and assumption of liabilities in a hypothetical, taxable arms'-length transaction which produces fair market valuation of the assets and liabilities. The regulations also identify the appropriate discount rate for determining the liability's present value which can similarly apply to the indebtedness discharge context. In view of Congress' legislative intent to ensure that an insolvent debtor outside of bankruptcy not be burdened with an immediate tax liability, the disparate treatment of contingent liabilities under sections 752 and 108 presents an inequitable disparity in the treatment of insolvent taxpayers under the Code. Application of the liability definition and valuation procedure to section 108 of the Code would reveal the true economics of the transaction by including a fair valuation of taxpayers' significant liabilities. Aside from contingent obligations, there have also been other circumstances in which the Service has allowed taxpayers to estimate their assets and obligations. For instance, healthcare providers have been permitted to estimate gross income in the context of contractual allowances. In this context, the Service has limited the use of such estimates of gross income only where they are determined with reasonable accuracy.23 In order to determine whether the contractual allowance reflected on the taxpayer's return meets the reasonably accurate standard, the taxpayer must provide factual evidence to support its position. The burden of proof rests solely with the taxpayer to demonstrate that the method used is reasonably accurate.24 B. Contingent Liabilities Under Bankruptcy Law As recognized by the Tax Court in Merkel, liabilities within a bankruptcy proceeding are dealt with differently than outside of bankruptcy. In bankruptcy, liabilities are generally liquidated and fixed by the creditors' claims process. As a result, it is generally unnecessary to estimate projected liabilities by the probability of their occurrence during a bankruptcy proceeding.25 However, there are exceptions for certain contingent claims that cannot be readily liquidated and, therefore, require the debtor to assign a reserve for payment of those claims rather than treat them as claims directly against the estate. For instance, in mass tort bankruptcy cases, debtors with knowledge of unknown future claims estimate and discount these contingent liabilities by the likelihood of their occurrence.26 In this circumstance, bankruptcy courts have recognized that all contingencies cannot be resolved during the bankruptcy administration. Therefore, a reserve for liabilities may need to be estimated for accurate administration of claims. As noted by the dissent in Merkel, the discounting of contingent liabilities may also provide an accurate assessment of the liabilities in the context of preference and fraudulent transfer litigation where the debtor's insolvency is analyzed during the period preceding the bankruptcy case. Cases interpreting whether a firm or individual is "insolvent" within the meaning of the Bankruptcy Code, discount liabilities by the probability of their occurrence before determining whether the assets exceed the liabilities.27 It is clear that when a debtor faces uncertainty about the value of its liabilities, bankruptcy courts throughout the country have measured insolvency by allowing the debtor to discount the contingent liability by the probability of its occurrence. This measure of insolvency may provide the most accurate reflection of the debtor's true liabilities, prevents distortions, and reflects good law for solvency analysis. V. PROPOSED GUIDANCE UNDER SECTION 108 To address the uncertainty and distortions created by the narrow "more likely than not" test announced in Merkel, Treasury should consider issuing a regulation that would (i) set forth a definition for liability in the context of section 108 of the Code which includes contingent obligations; (ii) provide a standard for fairly valuing contingent obligations for purposes of the insolvency exclusion; (iii) provide evidentiary considerations to guide taxpayers in determining the likelihood that a contingent obligation would become an actual liability; and (iv) require, to the extent contingent liabilities cannot be estimated with reasonable accuracy, that taxpayers estimate the liability and request that the transaction remain open until the actual liability amount is determined. Once the actual liability amount is determined, taxpayers would file an adjustment form reporting the difference between the estimated and actual amount and adjust the tax upward or downward on any COD income recognized in the earlier tax year. Contingent obligations for which estimates can be provided with reasonable accuracy should be subject to closed transaction treatment under the author's proposed guidance. Taxpayers would estimate the probability of the contingent liability based on all the evidence and information available to them immediately before the discharge of indebtedness in order to fairly measure insolvency. By contrast, contingent obligations for which taxpayers cannot provide estimates with reasonable accuracy should be subject to open transaction treatment. In view of the omission of remote contingent liabilities from the insolvency calculation, this provision should apply in very limited and unusual circumstances. To the extent, the open transaction approach is required, taxpayers would be obligated to file an adjustment form reporting the difference between their estimate and the actual liability amount. This treatment would remove the uncertainty associated with projecting liability values and would curb potential abuse of the insolvency exclusion. A. Valuation of Contingent Liabilities 1. Definitions The regulations should clearly define the term "liability" for purposes of the insolvency exclusion to provide taxpayers and the Service with certainty about the scope of liabilities. The author proposes the following definitions which mirror the definitions set forth in Regulation 1.752-1(a)(4) and 1.752-2(b)(4): Liability defined. (i) In general, an obligation is a liability for purposes of section 108 and the regulations thereunder, only if, when, and to the extent that incurring the obligation -- (A) creates or increases the basis of any of the obligor's assets (including cash); (B) gives rise to an immediate deduction to the obligor; or (C) gives rise to an expense that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital. (ii) Obligation. For purposes of section 108, an obligation is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contractual obligations, severance and pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, and futures contracts.28 Contingent obligations. A payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. 2. Liability Valuation The value of the liability should represent the amount of deduction the taxpayer could take with respect to the liability if the taxpayer disposed of all of its assets, paid an unrelated person to assume all of its liabilities in a hypothetical fully taxable arm's-length transaction. In order to reach this valuation of liabilities the taxpayer would discount the liability by the probability of its occurrence. The discount rate would be estimated based upon all the facts and circumstances surrounding the contingent liability. This valuation method is similar to the method set forth in Treas. Reg. 1.752-7 and produces a fair valuation of the taxpayer's liabilities. This discounting rule represents a broadly accepted method of valuation of contingent liabilities under both tax and bankruptcy law.29 Valuation of contingent obligations would depend upon whether the liability can be accurately estimated. Obligations which are fixed in amount are identified in the author's proposed guidance as liquidated contingent liabilities. For example, liabilities arising under personal guarantees or contractual warranties would involve fixed or known amounts and are referred to as liquidated contingent liabilities. Although the amount is fixed, the taxpayer's obligation may still be contingent upon a future or multiple future events before he is called upon to pay on the obligation. Under the author's proposed valuation standard, these contingent liability amounts would be discounted by a risk factor that the taxpayer would estimate. In situations where the contingent liability amount is unknown, or has not been liquidated to a fixed amount, such as lawsuits and governmental actions, the author has identified these as unliquidated contingent liabilities. Since the amount is uncertain, the taxpayer would be required to estimate the liability amount based upon all the information available to the taxpayer. The likelihood of the contingency occurring would be reflected in the estimated liability amount and that amount may require discounting by an appropriate interest rate to reflect the time value of money as well. Given the complexity in evaluating and estimating the likelihood of contingencies and the uncertainties which stem from this procedure, Treasury should provide guidance as to the evidentiary requirements needed to value the liability amount. This additional guidance might mitigate some evidentiary disputes and provide both the Service and taxpayers with greater certainty as to the evidentiary requirements for the insolvency calculation. B. Evidentiary Considerations In order to mitigate evidentiary disputes, it is recommended that the regulations provide rebuttable presumptions with respect to contingent obligations where there is a significant likelihood that the taxpayer's liability estimates are credible and accurate. Each party would have the opportunity to rebut the evidence submitted and the taxpayer would still bear the burden of proof. 1. Liquidated Contingent Liabilities Certain liquidated debts, such as personal guarantees, are fixed in amount, but contingent upon default by the original obligor. In this circumstance, once the taxpayer presents evidence of default by the original obligor, a rebuttable presumption in favor of including the entire liability should be available to the parties in order to reduce litigation uncertainty and expense. The Service may rebut the presumption with evidence that the taxpayer was able to seek contribution or indemnity in whole or in part from the original obligor or third party to ensure accurate compliance. Such information would generally be reported as a contingent asset on the taxpayer's financial statements and would, therefore not present a burden on the government. 2. Unliquidated Contingent Liabilities Unliquidated liabilities such as lawsuits and governmental actions may be contingent upon multiple future events before the actual liability amount is determined. A taxpayer may self-insure against these unliquidated but anticipated contingent liabilities through reserves reported on its financial statements. By reporting the reserves on its financial statements, the taxpayer has determined, based upon all the information available at the time, that the liability is probable for financial accounting purposes. Taxpayers would have little incentive to report misleading information on their financial statements, which are made available to their creditors and investors; therefore, such disclosures would be reasonably accurate. To the extent there is evidence to the contrary, either party could present evidence to rebut the presumption. Unlike the Merkel test which permits a taxpayer to include one hundred (100%) percent of the contingent liability if there is more than a fifty (50%) percent probability that the taxpayer would be called upon to pay on the obligation, the liability as measured by the reserve may represent a more accurate dollar amount for the insolvency analysis. This standard of valuation would also be more consistent with the net asset theory as well as the equitable principles underlying the insolvency exclusion. 3. Remote Contingent Liabilities Under the author's suggested regulation, taxpayers may not include remote contingent liabilities among their liabilities for purposes of the insolvency calculation. Indeed, the burden of estimating the discount rate and liability amount will be outweighed by the need to include such remote liabilities. Accordingly, the author's proposed guidance suggests omitting remote contingent liabilities from the insolvency calculation. 4. Evidentiary Factors The author suggests that the following factors be included in the regulations for guidance to support the estimates used to value contingent liabilities:30 Have contingent liabilities been documented on financial statements or footnotes to balance sheets? Does state or federal statutory law apply to the contingent liability? What state and federal case law, Attorney General Opinions, legal writings, and articles exist that are applicable to the contingent liabilities? Has the taxpayer prepared a chronological factual statement of activities relating to the liabilities? Has the taxpayer interviewed or retained an expert to assess risk? Did the taxpayer prepare a range of potential liabilities in dollar damages and other damages? If potential or actual litigation is pending, what is the posture of the case (i.e., suit threatened, filed, discovery, motions, etc.)? What acts constitute the offending conduct? What is the history, nature, and extent of the offending conduct? What are the relative bargaining positions of the parties? What defenses are available? What has been the prior success or failure in defending or settling similar actions in the jurisdictions where litigation is likely? What volume of litigation is anticipated? What is the present nature and extent of any governmental investigations? What has been the nature and extent of media coverage of the contingent liabilities? What "damage control" measures have been taken (to counter or answer media releases)? What is the relative experience and ability of plaintiff versus defense counsel? What is the anticipated cost of defense? Is there any basis for an award of attorneys' fees if governmental or private parties prevail? What is the nature and extent of possible insurance coverage? Has anyone affiliated with the company been contacted by any governmental agency regarding any contingent liability? If any affiliated person was contacted, what was the nature and extent of the contact? Have the names of affiliated or formerly affiliated persons who have spoken to or who have been interviewed or named by the media or by representatives of governmental agencies been obtained? If so, have any of them been contacted or interviewed by representatives of the company? Have any of the company's business records been subpoenaed or otherwise turned over to governmental or investigative agencies? C. Adjustment For Taxes Due In order to discourage potential abuse, the guidance might provide that taxpayers who claimed an insolvency exclusion under section 108 of the Code, but were unable to estimate a contingent obligation with reasonable accuracy, submit an estimate of their contingent obligation for purposes of the insolvency calculation and file an adjustment form when the actual liability amount is determined. Taxpayers would then report the difference between the estimated and actual amount and adjust the tax upward or downward on any COD income recognized in the earlier tax year. In this respect, the discharge of indebtedness transaction would be partly open and partly closed. The transaction would be closed when taxpayers are able to estimate contingent liabilities with reasonable accuracy, but open in the limited and unusual circumstance when the contingent liability cannot be estimated with reasonable accuracy. In view of the uncertainty in measuring insolvency with estimates of the taxpayer's liabilities, this approach would resolve the subjectivity associated with estimating certain contingent obligations. VI. CONCLUSION The proposed regulation and additional guidance suggested above regarding the treatment of contingent obligations for purposes of the insolvency exclusion would greatly reduce uncertainty and eliminate the distortions created by the current "more likely than not" rule, thereby furthering the intended equitable purpose of the insolvency exclusion. The proposed guidance will provide both taxpayers and the Service with clear definitions and valuation methods to estimate liabilities for the insolvency exclusion. Moreover, the guidance on evidentiary issues should relieve some of the government's administrative burden in litigating discharge of indebtedness issues. Taxpayers who face true economic insolvency will also be relieved of the obligation to pay tax on COD income when they do not have the assets to satisfy the tax obligation. Taxpayers who would not otherwise file for relief under Title 11 of the United States Code, would be able to restructure their obligations with more certainty of the tax implications through negotiated workouts. FOOTNOTES 1 The comments contained in this paper are the individual views of the author who prepared them, and do not represent the position of the State Bar of California or of the Los Angeles County Bar Association. 2 Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been engaged by a client to participate in this project. 3 The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or an opinion provided by Advocate Solutions, Inc. to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of non-tax and other factors if any action is to be contemplated. The reader should contact his or her tax advisor prior to taking any action based upon this information. Advocate Solutions, Inc. assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. 4 Merkel v. Commissioner, 192 F.3d 844 (9th Cir. 1999). 5 FED. RESERVE STATISTICAL RELEASE: CHARGE-OFF AND DELINQUENCY RATES ON LOANS AND LEASES AT COMMERCIAL BANKS; DELINQUENCY RATES (2010), available at:  HYPERLINK "http://www.federalreserve.gov/releases/chargeoff/delallsa.htm" http://www.federalreserve.gov/releases/chargeoff/delallsa.htm. 6 Section 61(a)(12) defines discharge of indebtedness as gross income. 26 U.S.C. 61(a)(12). 7 Unless indicated otherwise, references to the "Code" are references to the Internal Revenue Code of 1986, as amended, 26 U.S.C. 1 et seq., as in effect during the relevant periods, and references to "Sections" are references to the Code. References to "Regulations," "Regulation Section" or "Treas. Reg. " are references to the Treasury Regulations promulgated under the Code. References to "Bankruptcy Code" are references to the Bankruptcy Code, as amended, 11 U.S.C. 101 et seq., as in effect during the relevant periods. 8 Section 108(a)(1)(B) states that: "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." 9 Merkel v. Commissioner, 192 F.3d 844 (9th Cir. 1999). 10 The taxpayers had breached the workout agreement by failing to disclose that SLC was assessed $980,512 for unpaid sales and use tax by the North Carolina Department of Revenue. However, this argument was not raised before the Tax Court and was, therefore, waived on appeal. Id. at 852, n.10. 11 Kirby Lumber Co., 284 U.S. 1 (1931). 12 Dallas Transfer & Terminal Warehouse Co., 70 F.2d 95 (5th Cir. 1934). 13 Lakeland Grocery Co., 36 BTA 289 (1937). 14 Conestoga Transportation Co., 17 T.C. 506 (1951). 15 See S. Rept. 96-1035, at 10 (1980), 1980-2 C.B. 620, 623; H. Rept. 96-833, at 9 (1980). 16 "The rules of the bill concerning the income tax treatment of debt discharge in bankruptcy are intended to accommodate bankruptcy policy and tax policy. To preserve the debtor's 'fresh start' after bankruptcy, the bill provides that no income is recognized by reason of debt discharge in bankruptcy, so that a debtor coming out of bankruptcy (or an insolvent debtor outside bankruptcy) is not burdened with an immediate tax liability." S.Rep. No. 96-1035, 1980 U.S.C.C.A.N. at 7024. 17 Assets deemed exempt under state law, such as retirement plans, are included among the definition of assets for purposes of the insolvency exclusion. See e.g., Carlson v. Commissioner., 116 T.C. 87 (2001). 18 The Ninth Circuit observed that insolvency is a question of fact and the taxpayer bears the burden of proof by a preponderance of the evidence. See Merkel v. Commissioner, 192 F.3d at 852; n.9 ("With respect to examinations commenced after July 22, 1998, '[i]f, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer . . . the [Commissioner] shall have the burden of proof with respect to such issue.") (citing Internal Revenue Service Restructuring Act of 1998 3001, 26 U.S.C.A. 7491 (1999)). Section 7491 is applicable in situations involving a cooperating individual, small partnership, corporation, or trust where the taxpayer has produced credible evidence. 19 Zimet, Lee G. , Hui, Linda, "Debt Workouts of S Corps." ABA Section of Taxation S Corporation Committee 2009 Joint Fall CLE Meeting, Sept. 25, 2009 ("the 'more probable than not' standard for determining which contingent liability can be taken into account will be very difficult for many taxpayers to meet."); See Hale v. Commissioner, T.C.M (CCH) 345 (2010) (taxpayer failed to carry burden of proving IRS erred in determining income tax deficiency); Miller v. Commissioner, 91 T.C.M. (CCH) 1267 (2006) (contingent liability should be counted if discharge is imminent); Toberman v. Commissioner, 294 F.3d 985 (8th Cir. 2002) (insolvency established through evidence of judgments entered against taxpayer in the year before the discharge); Acuncius v. Commissioner, 83 T.C.M. (CCH) 1122 (2002) (taxpayer did not have recognizable discharge of indebtedness income). 20 See e.g., Lipton and Golub, "Taxation Meets Bizarro World: Passthroughs and Debt Workouts," ALI-ABA Continuing Legal Education (November 4-6, 2010) (more likely than not test is not an economically rational way to look at contingent liabilities and is inconsistent with approach taken by IRS in Reg. 1.752-7); Lipton, "Murky Test for Insolvency in Merkel Continues to Cause Problems," 91 J. Tax'n, 372 (Dec. 1999) (suggested taking contingent liabilities into account only if there is a substantial likelihood that such liability will be asserted against the taxpayer.); Raby & Raby, "Measuring Assets and Liabilities for DOI purposes," 85 Tax Notes 77 (1999); Blumenreich, Richard "Troubled Projects, Workouts and Debt Restructurings" (2008); William & Mary Annual Tax Conference. Paper 50; available at:  HYPERLINK "http://scholarship.law.wm.edu/tax/50" http://scholarship.law.wm.edu/tax/50; Abahoonie & Lee, "Measuring Insolvency for Sec. 108 Purposes: Suggested Valuation Guidelines," 26 Tax Adviser 618 (1995) (advocating discounted cash flow methodology to determine insolvency of business). 21 See section 357(c)(3) of the Code (exclusion of a transfer of a liability by a controlling shareholder to a corporation, the payment of which gives rise to a deduction, from the determination of the amount of liabilities assumed, except when the incurrence of the liability results in the creation of, or increase in, the basis of any property). 22 "Liability defined -- (i) In general. An obligation is a liability for purposes of section 752 and the regulations thereunder (Sec. 1.752-1 liability), only if, when, and to the extent that incurring the obligation -- (A) creates or increases the basis of any of the obligor's assets (including cash); (B) Gives rise to an immediate deduction to the obligor; or (C) Gives rise to an expense that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital. (ii) Obligation. For purposes of this paragraph and Sec. 1.752-7, an obligation is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps." See Treas. Reg. 1.752-1(a)(4). 23 See e.g., TAM 200619020 (Service allowed the use of estimates to the extent the use of estimates results in gross income determined with "reasonable accuracy."). 24 See John Risacher, Industry Director Directive on Contractual Allowance Issues in the Healthcare Industry , September 10, 2007 available at  HYPERLINK "http://www.irs.gov/businesses/article/0,,id=174275,00.html" http://www.irs.gov/businesses/article/0,,id=174275,00.html (LMSB-04-0807-056). 25 See Merkel v. Commissioner, 109 T.C. 463, 478 (1997), affd. 192 F.3d 844 (9th Cir. 1999) ("When Congress codified the net assets test . . ., the insolvency exclusion was made available to all insolvent debtors outside of bankruptcy. The necessary consequence of that choice is that the nature of the examination of obligations claimed to be liabilities for purposes of the statutory insolvency calculation depended on an analytical framework based on the freeing-of-assets theory and not on the treatment of such obligations in some analogous context, e.g., 'debt' in the bankruptcy context. . . . In addition, adherence to bankruptcy procedures and policies, for example, the estimation of contingent or unliquidated debt pursuant to Bankruptcy Code section 502(c)(1) would unnecessarily and unjustifiably import unrelated considerations into the statutory insolvency calculation."). 26 See e.g., Owens Corning/Fiberboard Asbestos Personal Injury Trust Distribution Procedures established in In re Owens Corning, et al. Case No. 00-03837. 27 See e.g., In the Matter of Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988); Covey v. Commercial National Bank, 960 F.2d 657, 660 (7th Cir. 1992) ("Discounting a contingent liability by the probability of its occurrence is good economics and therefore good law, for solvency."). 28 This Paper will not address the treatment of contingent obligations involving derivative financial instruments, but the author recognizes that guidance is required with respect to the treatment of these instruments as well. 29 See e.g. In the Matter of Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988); In re W.R. Grace & Co., et al., 281 B.R. 852 (Bankr. D. Del. 2002); Merkel v. Commissioner, 109 T.C. 463, 478 (1997), affd. 192 F.3d 844 (9th Cir. 1999) ("the treatment of contingent liabilities under GAAP is consistent with the examination required of obligations claimed to be liabilities for purposes of the statutory insolvency calculation. . . . "). 30 See Benjamin S. Seigel, "Some Risk Management Considerations for Lenders," The RMA Journal, September 2005 (listing the risk factors attendant to litigation and governmental action). END OF FOOTNOTES Tax Analysts Information CodeSections:Section 108 -- Discharge of Indebtedness Section 61(a)(12) -- Debt Cancellation Section 358 -- Basis to Distributees Section 357 -- Assumed Liabilities Jurisdiction:United States SubjectArea:Bankruptcy and insolvency Author:Naimi, Haleh InstitutionalAuthor:State Bar of California; Taxation Section; Corporate and Pass-Through Entities Committee CrossReference:For Merkel v. Commissioner, 192 F.3d 844 (9th Cir. 1999), see Doc 1999-30468 or 1999 TNT 182-7  HYPERLINK "http://services.taxanalysts.com/taxbase/archive/tnt1999.nsf/86255f19006ce90385255b580068db3a/ba09dc1cef5d656885256a4100085ce4?OpenDocument"  INCLUDEPICTURE "http://services.taxanalysts.com/icons/doclink.gif" \* MERGEFORMATINET . 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