Value of CalPERS Pension Not Included in Calculation of Insolvency

The general rule is that income from the cancellation of debt is included in a taxpayer’s gross income. [IRC §61(a)(12)]  However, IRC §108 provides various exclusions from income for cancellation of debt if certain requirements are met.  One of those exclusions, found at IRC §108(a)(1)(B), provides for excluding from income cancellation of debt to the extent the taxpayer is insolvent at the time the debt is discharged.

The taxpayers in the case of Schieber v. Commissioner, TC Memo 2017-32 argued that they were insolvent at the time GMAC Mortgage had cancelled debt of $448,671.  The debt was secured by a piece of property (the Stockdale Highway property) that was not the taxpayer’s principal residence. 

They excluded $30,076 of that amount, representing accrued interest on the debt, because they had never claimed a deduction for that interest.  They argued that this was excludable under §108(e)(2), which provides no income is realized from cancellation of debt “to the extent that payment of the liability would have given rise to a deduction.”[1]

The Schieders computed that they were insolvent at the time of the discharge by $346,418, so they also excluded that amount from income.  So, in the end, they reported as taxable $72,178 of the amount discharged.

The IRS argued that their calculation of their solvency was in error, because they had included no amount for the value of the defined benefit pension being paid by CalPERS they were receiving payments from.  The taxpayers had a joint and survivor annuity being paid to them of over $5,000 per month when the debt was discharged, which had increased (based on annual cost of living adjustments) to over $5,700 by May 2015.

While the Schiebers were receiving the payments, they did not have the right to convert their interest into a lump-sum amount, assign their interest, sell the interest, borrow against the interest or borrow directly from the CalPERS plan.

The taxpayers had conceded that if they were required to include their interest in the pension plan in the calculation of insolvency that they were not insolvent the entire $418,596 should have been included in income.  They did concede at trial to a revaluation of some other figures in their calculation of insolvency, so if the pension was not included in the calculation of insolvency they would be insolvent to the extent of $293,308 immediately prior to the discharge and able to exclude that amount.

Thus, the only issue before the Court was whether or not the pension had to be included in this calculation.

The Court first looked at prior case law to determine how insolvency had been defined and noted:

Section 108(d)(3) provides that a taxpayer is insolvent if, immediately before the cancellation of debt, the taxpayer’s liabilities exceeded the fair market value of the taxpayer’s assets. The word “assets” is not defined by the Internal Revenue Code. Carlson v. Commissioner, 116 T.C. 87, 93 & n.6 (2001). In Carlson v. Commissioner, 116 T.C. at 104-105, we held that an asset exempt from creditors could still be an asset under section 108(d)(3) because even an asset exempt from creditors can give the taxpayer “the ability to pay an immediate tax on income” from the canceled debt.

The taxpayer argued that they shouldn’t have to include the value of the defined benefit plan interest in income because of the restrictions on accessing those funds in their case.  They argued:

…[T]he Schiebers contend that they could not use their interest in the pension plan to immediately pay a tax liability because they were entitled only to monthly payments under the plan and could not convert their interest in the plan to a lump-sum cash amount, sell the interest, assign the interest, borrow against the interest, or borrow from the plan.

The IRS argued that this is wholly irrelevant with regard to whether it must be valued and treated as an asset for purposes of the insolvency calculation.  The IRS:

…argues that the Schiebers’ right to receive monthly payments causes their interest in the plan to be considered an asset. In its view, the lack of any other rights does not matter.

However, the Court adopts the Carlson test literally by focusing on the tax deferral nature of the Section 108 exclusion.  Taxpayers are required to reduce the basis of asset they hold (at least to some extent) when the insolvency exclusion applies, resulting in, in most cases, simply delaying when the tax will be paid, either through reduced depreciation deductions over time, larger gains when the assets are disposed of or reduced losses at disposition.

The Court therefore states:

But the test in Carlson v. Commissioner, 116 T.C. at 104-105, is whether the asset gives the taxpayer the ability to pay an “immediate tax on income” from the canceled debt—not to pay the tax gradually over time. In Carlson, we held that a commercial fishing license could be an asset because the license could be used, in combination with other assets, to immediately pay the income tax on canceled-debt income. Id. By contrast, the Schiebers’ interest in the pension plan cannot be used to immediately pay the income tax on canceled- debt income. Therefore, we hold that the Schiebers’ interest in the pension plan is not an asset within the meaning of section 108(d)(3).

Interestingly, this view of the pension rights (the ability to make them taxable immediately) seems at odds with the position the Court took in the 2012 case of Shepherd v. Commissioner, TC Memo 2012-212 where the Court forced inclusion as an asset the amount at least equal to the value the taxpayer could have borrowed from the plan.  Although clearly that amount would have been available to pay the debt, it would not have given the taxpayer the “right to pay an immediate tax on income” which was the standard used in this case.  However, in that case Mr. Shepherd had not produced evidence with regard to how much he could have valued, so the Court pointed out in a footnote that it wasn’t taking the position that was the value of the asset—rather, it held that since he had failed to establish the value of that asset, along with others involved in the calculation of insolvency, he had not carried his burden.

[1] The opinion does not comment on the question of how a deduction would have been allowed had they paid this debt.  All we know for sure is that the property wasn’t their principal residence and it does not appear that the IRS challenged the taxpayers on this part of their exclusion at trial.