Insolvency and Canceled Debt: Make Sure You Can Prove It!

If you have a debt that gets canceled, the general rule is that you must report the canceled debt as income. For example, if the credit card company forgives $5,000 of credit card debt, you’ll need to report $5,000 of income on your tax return.

Many exceptions apply, such as debt cancellation relating to your primary residence (as in a foreclosure), bankruptcy or insolvency.

This blog post will focus on the insolvency exception.

What is Insolvency?

Insolvency is when the amount of your debt is greater than the amount of your assets, with assets being things such as cash in the bank, or the value of property you own.

Example: you owe $15,000 on a credit card and $100,000 on a mortgage, for a total of $115,000 of debt. Your home is worth $105,000, your car is worth $5,000 and you have $1,000 of cash in the bank, for a total of $111,000 of assets. You are insolvent by $4,000.

Insolvency and Canceled Debt

Canceled debt is not taxable to the extent you are insolvent. Using our example above, let’s say the credit card company cancels all $15,000 of credit card debt. You would report $11,000 of taxable income from this cancellation — $15,000 of canceled debt minus $4,000 insolvency.

Reporting Insolvency

Lenders will typically issue a Form 1099-C to you when they cancel a debt. In order to show that some or all of the canceled debt is not taxable due to insolvency, you’ll need to complete a Form 982 and mark the box that says “Discharge of indebtedness to the extent insolvent.”

And that’s it. Per the instructions to Form 982, no further explanation or attachments are needed.

In practice, though, the IRS often questions claims of insolvency by sending a notice to you several months after you’ve filed your tax return.

Insolvency Worksheet

When I’m helping someone with canceled debt, I have the person fill out the “insolvency worksheet,” which you can find on page 8 of IRS Publication 4681.

In my experience, submitting the insolvency worksheet to the IRS when they ask for proof of insolvency has been sufficient. I’ve never had them come back and ask for additional documentation beyond the worksheet, though they certainly could ask for additional documentation.

In order to further protect yourself, I would recommend keeping copies of bank statements and anything else that can prove the numbers shown on the worksheet.

Caveat: Beware of 401(k)s and IRAs

Money held in retirement accounts counts as an asset. You must include this money on the insolvency worksheet.

I have seen this derail attempts at claiming insolvency before. Clients have been sure, initially off the top of their head, that they were insolvent by thousands of dollars … except they hadn’t accounted for the thousands of dollars held in their 401(k). When they filled out the insolvency worksheet, they realized that they weren’t nearly as insolvent as they thought they were!

Incorporate Your Life? Not So Fast

At a presentation I gave to prospective entrepreneurs earlier this year, one of the participants asked if I had read a book called “Incorporate Your Life.” I said I had not. The participant went on to say that it was a really interesting book on how you could turn personal expenses into tax-deductible expenses.

I tried explaining how non-business expenses can’t ever really be turned into tax-deductible expenses, but I’m not sure the message sank in.

After doing some research, I believe the participant was referring to a book called “Incorporate & Get Rich: How to Cut Taxes 70% & Protect Your Assets Forever!”.

I’ve never read the book so I won’t comment on the contents of the book. Though I think the over-the-top title speaks for itself….

But I will say this: simply having a business entity DOES NOT make everything in your life tax deductible.

Forming a corporation doesn’t magically make your mortgage deductible. Forming a corporation doesn’t make your grocery bill deductible. Forming a corporation doesn’t make the purchase of a big-screen TV for your living room tax deductible.

Legitimate business expenses are tax deductible.

Personal expenses are not tax deductible.

Should you take advantage of every deduction available? Of course! But don’t start a business just to get tax deductions … because that’s not how it works!

There are no magic bullets or tax fairies*.

(*-To give credit where credit is due, my tax blog-o-sphere buddy Joe Kristan is the one who coined the “tax fairy” phrase. I’m green with envy over the fact that I didn’t think of it first!)

Life After DOMA: Audits of Prior-Year Returns

We know that couples in same-sex marriages must file their 2013 federal taxes as a married but they are not required to amend prior-year tax returns where the couple filed as two single people.

How will this concept work with audits of returns within the current statute of limitations (2010-2012)?

The answer is surprisingly straightforward:

  • If the person’s original tax return was filed as a single person, they would be audited as a single person. This assumes that the original return was filed before September 16, 2013. See this blog post for more details.

  • If the person originally filed as single but they then submitted an amended tax return as married after the DOMA ruling, they and their spouse will be audited as a married couple.


Glossary of Tax Terms: FICA

The term “FICA” stands for “Federal Insurance Contributions Act.” FICA taxes fund Social Security and Medicare.

The FICA equation for an employee is: 6.2% of gross wages are withheld from pay for Social Security, and 1.45% for Medicare. The 6.2% is assessed on wages up to the Social Security Wage Base cap for that year; for 2013, that cap is $113,700).

For an employee who makes less than $113,700, they’ll pay 7.65% in FICA taxes (6.2 + 1.45). Additionally, the employer puts in a matching contribution of 7.65%. Total contribution = 15.3% (7.65 + 7.65).

For self-employed taxpayers, FICA taxes are called self-employment tax. Self-employment tax is equal to 15.3% (the self-employed person is considered both employer and employee for FICA tax purposes and so pays 7.65% x 2) . Self-employment tax is accounted for on the self-employed person’s tax return.

For more tax terms, click on the Glossary link at the top of the page.

Having a Side Business in Multi-Level Marketing Doesn’t Make Personal Expenses Deductible

If you sell food products in a multi-level marketing system, can you deduct personal grocery expenses?

I’ve actually had this question posed to me before. The person’s “sponsor” in the MLM system told the taxpayer that the taxpayer could deduct all of their grocery purchases from Wal-Mart, etc. as a “marketing expense” because you have to know what the competitor’s food tastes like. Thus, according to the sponsor, grocery expenses are a necessary business expense.

Of course, the sponsor’s accountant allowed the sponsor to take the deduction.

An additional question came up regarding whether it was okay to deduct all food purchases from the MLM supplier, even if it was consumed by the taxpayer instead of being sold to customers. Again, the logic being that you have to know what the food you’re selling tastes like.

Neither deduction is okay.

Here’s what the IRS Audit Technique Guide on multi-level marketers says (my emphasis added):

(T)he cost of a product that is used by the direct seller is a personal expense, even if that product is occasionally shown to prospective customers.  Some direct sellers erroneously think they can decorate their home with products and deduct the cost as a business expense.  To be deductible under IRC Section 162, the expense must be an ordinary and necessary expense paid or incurred in carrying on a trade or business  (also see Regulation 1.162-3). Under IRC Section 262, no deduction generally is allowed for personal, living, or family expenses.”

In other words, anything that you buy and consume for personal purposes is a non-deductible personal expense. This would include your personal grocery bills and purchases from your supplier that you consume personally.