He Began to Cry

My dental hygienist recently brought her father to consult with me to discuss filing bankruptcy. We will call him Steve. Steve had approximately $75,000.00 of credit card debt. He had retired from the State of North Carolina, at age 58, after working as a school teacher for thirty years. He had health issues that prevented him from working more than a part-time job. His wife did not work due to health reasons and had no income. He was supporting himself and his wife on his $3,500.00 State pension and $750.00 of take-home pay from his part-time job. He had accumulated $50,000.00 in the State’s optional 401-K plan. He and his wife had $50,000.00 equity in their jointly-owned residence.

In an effort to eliminate his debt, he engaged in a strategy he got from the internet, in which he quit paying on the cards for several months, and then over several months negotiated settlements. He ultimately settled all $75,000.00 of the debt for $40,000.00, saving himself $35,000.00. He obtained the funds to settle the debt by taking $40,000.00 in early withdrawals from his 401-K plan, leaving him with $10,000.00 in the plan. The plan did not withhold any funds from the distribution for taxes. So, Steve had depleted his savings, but felt good about getting rid of his debt.

Then the other shoe dropped. Steve got 1099-C’s from his creditors for total income of $35,000.00 for the cancellation of indebtedness. He got a 1099 from the 401-K plan for the $40,000.00 distribution. The CPA who prepared Steve’s tax return advised him that he had to report the $75,000.00 of income on his tax return, and that he had to pay $4,000.00 early withdrawal tax (10%) on the $40,000.00 401K withdrawal. Steve owed $25,000.00 in combined taxes to the IRS and NCDOR. After obtaining an extension, he filed the tax returns on October 15 without enclosing any payments. He then came to see me.

Was the accountant correct in telling Steve that the $35,000.00 in cancelled debt is included in his income? He was. Section 61(a) of the Internal Revenue Code (“IRC”) broadly defines a taxpayer’s gross income to include income from the discharge of indebtedness. Another provision, §108(a) of the IRC provides certain exceptions to the inclusion of discharged or cancelled debt in the taxpayer’s gross income. Taxpayers report an exception on IRS Form 982. The exception to which bankruptcy lawyers are most familiar is Section 108(a)(1)(A), which excludes from gross income debt cancelled by a bankruptcy discharge. Another exception is Section 108(a)(1)(B), which excludes from income discharged debt to the extent the taxpayer is insolvent. Section 108(d)(3) defines insolvent as “an excess of liabilities over the fair market value of assets… immediately before the discharge.” A landmark United States Tax Court case construing the insolvency exception is Carlson v. Commission of Internal Revenue, 116 T.C. 87 (2001). In that case, the taxpayers owned an Alaskan fishing permit which was exempt from creditors under Alaskan law. If the value of the permit was included in their assets in calculating the taxpayers’ solvency, they were solvent. If excluded, they were insolvent. The taxpayers argued the exempt fishing permit should not be included in the solvency calculation. Utilizing a “plain meaning” statutory construction analysis, the Tax Court held that assets included all assets, whether exempt or not. [See the final paragraph of this blog for additional case law on the insolvency issue.]

Steve asked me several questions. He first asked whether his accountant was correct. Based on the analysis set out above, I replied that he was. He asked me whether he could discharge the tax debt in a bankruptcy. In summary, I told him that he could discharge all the tax debt only if he waited until October 16, 2021 to file, but that he could discharge the penalties, including the $4,000.00 early withdrawal tax, in a chapter 13 without waiting. See In re Cespedes, 393, B.R. 403 (E.D.N.C. 2008). He finally asked me whether he could have discharged the credit card debt in a bankruptcy, and whether he would have lost any of his 401-K, pension, or other assets. I told him that he could have discharged the debt while retaining all his assets. He would still have $50,000.00 in his 401-K, be completely out of debt, and not have a $25,000.00 tax bill. He began to cry, saying, “I’m screwed for trying to do the right thing.” My reply was that I don’t opine on right and wrong, but that it is clear that his own financial interests would have been better served by filing bankruptcy, and that he should have educated himself about that option before embarking upon his debt settlement campaign.

The moral of this story is that people in financial stress should consult with a bankruptcy attorney to make an informed decision whether to file a bankruptcy or engage in some other strategy to eliminate debt.

The Lure of Debt Settlements

What explains the failure of people like Steve to explore bankruptcy as an option? For many individuals who need debt relief, the concept of filing bankruptcy is horrifying. They seem to equate it with having a “B” stamped on their foreheads more humiliating than Hester Prynne’s “Scarlet A”. This aversion to filing bankruptcy explains the numerous debt settlement entities advertising on television, radio and the internet. One strategy of these entities is to emphasize that they offer an alternative to filing bankruptcy. Some of these entities offer transparent, honest, and straight-forward settlement assistance, but, in my opinion, too many improperly trade on debtors’ fears of bankruptcy to entice them into debt settlement arrangements that are less effective and more expensive than bankruptcy. Furthermore, these entities may be violating NC criminal law.

North Carolina has a criminal “Debt Adjusting” law, N.C.G.S. §§14-423 to 426, that renders the practice of many of these debt settlement companies a Class 2 Misdemeanor. A trade practice that violates the criminal law is, in my opinion, a per se unfair and deceptive trade practice that allows the trebling of damages. Debtors’ attorneys are in the best position to uncover these violations and should schedule the potential recovery as an asset on the debtor’s petition and claim any recovery exempt as being compensation for personal injury. Whether exempt or not, by scheduling the claim for compensation from the offending debt adjuster, the claim will be abandoned back to the debtor pursuant to 11 U.S.C. §554(c), if the chapter 7 trustee does not administer the asset.

More on Insolvency Issue

For those attorneys who desire to proceed deeper into the weeds on the insolvency issue, the taxpayer bears the burden of proving insolvency. Reed v. Commissioner of Internal Revenue, T.C. Summ. Op. 2017-30 (2017). As to the retirement accounts, whether the value of the account is included as an asset depends upon whether the taxpayer has access to the funds in the account. If he does, then the account is included in the asset calculation. If not, then it is excluded. In the recent case of Schieber v. Commissioner of Revenue, T.C. Memo. 2017-32 (2017), the taxpayer was receiving monthly distributions from a defined benefit pension plan. He could not convert his interest in the pension into a lump sum cash amount, assign the interest, borrow against the interest, or borrow from the plan. The IRS contended that the value of the pension should be included as an asset in the insolvency calculation. The taxpayer argued otherwise. In holding that the pension should not be included in the taxpayer’s assets, the Tax Court stated that the test set out in Carlson, 116 T.C. at 104–105, was whether the asset gives the taxpayer the ability to pay an “immediate tax on income” from the cancelled debt. Since the taxpayer’s interest in the pension could not be used to immediately pay the income tax on the cancelled-debt income, his interest in the pension plan was not an asset within the meaning of Section 108(d)(3) of IRC. The court distinguished its holding in Shepherd v. Commissioner, T.C. Memo. 2012-212, in which the taxpayer had the right to borrow from the pension plan, and consequently included the amount that he could borrow as an asset under Section 108(d)(3).

January 30, 2019/by Bankruptcy