Insolvency Worksheet

Anna Chumakova

Expert Contributor
Last Updated: December 9, 2021

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Getting all or portion of your back taxes pardoned can help you or your business start afresh. To take advantage of debt cancellation, it is important to follow all the requirements and have the right information about your options. Learn what debt cancellation entails, what steps to take right after, and how an insolvency worksheet can help you avoid falling back into owing to the IRS again.

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1 Canceled Debt as Income

2 The Insolvency Exception

3 Insolvency Worksheet

4 What Counts as Assets

5 Reporting and Calculating Insolvency

Canceled Debt as Income

When a debt (such as a credit card or a loan) gets canceled, the debtor must report the canceled debt as income. Numerous exceptions exist that may allow the debtor to exclude the canceled debt from their income, such as if there is a foreclosure on the debtor’s primary residence or bankruptcy. Another common exception, especially for businesses, is the insolvency exception. Let’s find out what it means and how you could use it help lower your overall owed amount.

The Insolvency Exception

Insolvency refers to the situation when the total amount of owed is greater than the total amount of assets. Canceled financial obligations are not taxable to the extent the debtor is insolvent. In other words, if the debtor’s total liabilities are greater than the total assets, the debtor is considered to be insolvent and can reduce the amount of canceled amount reported as income by the amount of insolvency. For better understanding, let’s work through the following example.

Let say your assets consist of your home (which is worth $200,000), your car (worth $8,000), and $2,000 cash in your bank account. At the same time, your liabilities consist of $220,000 in mortgage loan and $10,000 in credit card debt. Under these facts, your total assets would be $210,000 ($200,000 + $8,000 + $2,000) and your total liabilities would be $230,000 ($220,000 + $10,000). As a result, you would be insolvent by $20,000 ($230,000 – $210,000).

Now, imagine that your credit card company cancels all your debt ($10,000 total). Normally, you would need to report the canceled debt as income, which would be taxable. However, because you are insolvent by $20,000, the insolvency exception applies in this case and none of the canceled debt needs to be reported as income. As a result, none of it is taxable.

Insolvency Worksheet

You can determine the degree of your individual or business insolvency by filling out the insolvency worksheet. In the worksheet, you will list all your assets and liabilities. Be careful to only list assets you acquired before the day of debt cancellation. For the values of assets and liabilities, you must use the values they had on the debt cancellation day. The insolvency exception will apply if your liabilities’ fair market value is greater than the fair market value of the assets. If in the worksheet’s total you end up with either a zero or negative number, this will indicate you or your business is insolvent.

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What Counts as Assets

When filling out the insolvency worksheet, debtors must record all their assets. To make sure your numbers are right, let’s clarify what assets are and which of them you can include in the worksheet for maximum benefit. Assets are either long-term or short-term.

Short-term assets are comprised of undeposited checks, petty cash, and funds in your bank accounts. They also include marketable securities, such as stocks, bonds, and mutual funds. Another item under short-term assets is annuity contracts, such as cash value a business owner might have in a whole life policy for business protection. Finally, and most overlooked, short-term assets also include IRA accounts paid by the company, Keoghs, and 401(k) accounts.
Long-term assets are composed of real estate as well as real property the business owns. This could be land, office buildings, or structures. Long-term assets would also encompass the company’s vehicles, tools, large equipment, furniture, machinery, computers, and computer-support equipment. Interests and investments in other organizations are also part of long-term assets. These could take the form of partnership interests in a general or limited partnership or membership interests in a limited liability company.

Reporting and Calculating Insolvency

When a debt is canceled, the lender will typically issue Form 1099-C to the debtor. In order to show that the insolvency exception applies and some or all of the canceled debt is not taxable due to insolvency, the debtor needs to complete Form 982 and mark the box that says, “Discharge of indebtedness to the extent insolvent.” Typically, no further explanation is necessary.

In reality, however, the Internal Revenue Service (IRS) often questions assertions of insolvency and would send the debtor a notice several months after the debtor filed a tax return. One way to respond to the IRS looking for proof of insolvency is by filling out the insolvency worksheet, which can be found on Page 8 of IRS Publication 4681. Submitting the insolvency worksheet to the IRS, while not required, can go a long way in proving insolvency.

In filling out the insolvency worksheet, make sure to list all the assets and liabilities, including some that you might not consider at first glance, such as money in your 401(k). Consider the help of a qualified debt professional in going through the list of all your assets and figuring out which ones you can include in your worksheet. You should also keep copies of bank statements and any other documents that can prove the numbers shown on the worksheet.

An insolvency worksheet is a useful tool and an integral part of a debt cancellation process. Not only can it help you lower your overall debt, but it is also an important document in your communication with the IRS. Make sure to fill out and file it right away to find out whether you are insolvent, to get even more back tax assistance, and to make your debt cancellation last.

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Anna Chumakova

Expert Contributor
Last Updated: December 9, 2021

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