It is always better, from a billings perspective, to have wealthy clients rather than poor ones. Sometimes, however, more satisfying work can be done for insolvent clients. There are many ways a CPA financial planner can assist such individuals.

Defining Insolvency

Bankruptcy law defines insolvency as the condition wherein current liabilities are greater than current assets. The IRS defines insolvency as when total liabilities exceed total assets. Another, more generally used definition is the inability to pay one’s debts, currently or when due. Regardless of which definition applies to the taxpayer, CPAs can use the following strategies to assist their insolvent clients. Ultimately, a key issue for CPAs is the taxability of the cancelled debt.

Review Assets and Liabilities and Prepare a Statement of Financial Condition

A review of the individual’s assets and liabilities is essential in order to assess the exact state of the finances. The review can indicate whether there are any assets that can be sold or if there is any borrowing power. Items owned in partnership, jointly or with others, should also be identified.

Preparing a statement of financial condition will be necessary if the information will be submitted to a third party, such as the IRS or a bankruptcy court. Some creditors might ask to see a complete statement, but the authors do not recommend submitting anything to them, because they have access to credit reports and will likely know more than even the CPA. If something is omitted from the statement, even inadvertently, the individual will lose credibility and may incur a penalty.

Family Spending and Budgeting

There are many reasons why people fall into debt. Some are beyond an individual’s control, such as medical bills for extreme illnesses not fully covered by insurance. Other people incur debt because of failed business or other loans they guaranteed. Still others lose a job and are unable to find a new one quickly enough, thus paying for necessities with credit. Some, however, end up in debt simply because of irresponsible spending. These individuals need help in readjusting their spending, putting a workable repayment plan in place, and learning to live within their means.

Every sensible spending plan requires a budget. The head of the family must be proactive in the preparation of a realistic budget and committed to following it. The budget must include each item of family expenditures. The sidebar contains a sample worksheet for a family budget.

If the individual has past due taxes, an installment agreement with the IRS may be needed. In such a case, the IRS’s spending guidelines should be compared with the family’s needs.

Pay stubs can be reviewed for the adequacy of take-home pay and withheld taxes. If the withholding is too high, it can be reduced so the added funds can be part of the regular spendable income. If too low, then the taxpayer must decide whether to leave withholding as is and pay the extra tax when filing the return or to adjust it to avoid another mounting debt; the latter is preferred.

Review Assets and Try to Liquidate Debt

The individual’s assets should be reviewed to determine if any can be liquidated to generate cash to reduce high-interest debt. Home equity loans can be considered to pay down credit card debt; the interest on loans up to $100,000 is deductible, and repayment periods can be stretched forward. One possibility is to have the individual borrow additional funds so that the first year’s repayments can be made from the excess borrowing. This might be more costly, taking into account the extra interest on the added borrowing, but it will go a long way toward reducing the pressure on the individual and bringing the level of debt under control.

Retirement accounts are also assets. Some can be used for spending, such as an IRA, and some cannot, such as a 401(k). These accounts should be analyzed for the availability of withdrawals, borrowing capacity, or protection from creditors.

The authors do not believe that borrowing against a 401(k) account is an effective strategy. Instead, taxable IRA withdrawals may be a better source of funds to pay off debts, even considering the penalty assessed. Assuming that withdrawals will carry a 35% tax and penalty charge and current credit card debt is accruing interest at a 25% rate, withdrawing $40,000 from the IRA will provide $26,000 to pay down credit card debt. The credit card interest charges saved over three years will pretty much equal the tax and penalty paid on the IRA withdrawal. Meanwhile, the monthly credit card payments will be eliminated and the credit rating will improve.

If funds are borrowed from an employer retirement plan—which is not an option with all such plans—they have to be repaid with interest out of after-tax take-home pay. It is also worth noting that people with spending problems and high debt may not be disciplined enough to stick to a loan repayment schedule. If an individual is over 59½, however, the penalty will not apply, which may make this a more attractive option.

Both of these strategies are complex. The authors believe, however, that a careful analysis considering all the issues shows the retirement plan withdrawal strategy as the better choice. Regardless of which approach is chosen, the process should assess the whole of the individual’s circumstances and consider all available alternatives.

Develop a Restructuring Plan and Negotiate Debt Settlements

Getting debt under control involves reducing current spending, paying down debt, reducing interest rates and principal repayments, convincing creditors to stretch out repayments or settle for lesser amounts, or possibly securing a loan or bonus from the individual’s employer. Attacking a client’s overwhelming debt is a serious undertaking requiring a carefully developed plan.

It has become more and more common for creditors to accept offers for reduced payments. If the collection is turned over to an agency, it is often easier to settle, since many of them are paid primarily on a percentage of the amounts collected, and they are given benchmarks of how low they could go when the account is turned over to them. CPAs can be very effective in this, because they have higher levels of trust and credibility in the marketplace and understand debt repayments and cash flow better.

Discuss the Different Types of Bankruptcy

There are three types of bankruptcy for which an individual can file. While attorneys should be consulted on all matters and used to prepare the actual filing, CPAs can advise individuals generally on the rules, explain the financial aspects, and help develop an exit plan.

Filing under Chapter 7 of the federal Bankruptcy Code is the most common. In a Chapter 7, the individual will generally walk away with no prefiling liabilities (with some exceptions) but also no assets (with some exceptions). Note that Chapter 7 does not specifically discharge secured liabilities, such as an auto loan or home mortgage, as the creditor can generally rely on the collateral; for this reason, a careful examination of debtor obligations is critical. In circumstances where the value of the collateral is less than the secured obligation, there may be an opportunity to address the shortfall in the Chapter 7 process. In order to file under Chapter 7, the individual debtor must pass a means test, which is designed to prevent high-income earners from taking advantage of Chapter 7. The means test evaluates income and expenses and the amount, if any, of excess income. If there is sufficient excess income, the individual must file under Chapter 13.


Aside from failing a Chapter 7 means test, a Chapter 13 petition is also filed in instances where the debtor wishes to freeze a foreclosure proceeding with a secured creditor while retaining the asset, to protect codebtors on consumer obligations from collection actions while the bankruptcy plan is in place, to discharge obligations that cannot be discharged under Chapter 7, or to remain in control of assets due to regular income. Under Chapter 13, the debtor enters into a plan to make creditor payments, usually over a five-year period. Use of Chapter 13 is subject to limitations on the amount of the secured and unsecured debt.

Individuals can occasionally file under Chapter 11 (i.e., corporate bankruptcy), but this is unusual and not covered here.

Assets that can be retained under Chapter 7 include qualified pension assets and IRAs (up to a designated limitation), a residence or homestead, and certain personal property. Exemption amounts vary by state, and there is also a federal set of exemptions. Debts that cannot be discharged are secured debts, college loans, child support payments, and certain taxes and penalties. For people with business assets, the process can become more complicated. Taxes that are not more than three years old and most penalties, regardless of when assessed, cannot be discharged. Assets transferred by a debtor prior to filing a petition or because of the intended filing may have to be repaid to the appointed trustee for distribution to creditors. The time limits vary, based on circumstances.

Tax Advice for Reporting Cancelled Debt

Tax issues always ensue when debt is cancelled. In general, cancellation of debt under a bankruptcy proceeding does not result in taxable income, as it might without the bankruptcy filing. Furthermore, if debts are cancelled outside of a bankruptcy and the client was insolvent before and immediately afterwards, income does not have to be recognized. If the client receives a 1099-C from the debtor, it should be reported, but an entry should also be made on line 21 recording the amount not recognizable from the 1099-C. It is possible that the full amount is excludible; in this case, both the amount of the debt and the excludible amount will appear together, zeroing themselves out on line 21. Both amounts should then be entered on a supporting schedule included with the return. Any calculations of insolvency should be made carefully and retained in case of audit.

Other Issues

Insolvent clients usually have poor credit scores and credit ratings, and should not expect to obtain new credit. Additionally, widespread delinquency can cause issuers of current credit cards to reevaluate the individual’s ability to pay future balances. Regardless, the authors recommend that individuals keep current with at least one credit card for the convenience of certain purchases. All payment for that card should be made on time.

There are many opportunities where CPA financial planners can assist clients. In all cases, it is important to be sensitive to clients’ situations and look for openings to suggest assistance.

Sidney Kess, JD, LLM, CPA is of counsel to Kostelanetz & Fink. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Board.
Edward Mendlowitz, CPA/PFS, ABV is partner at WithumSmith+Brown, PC. He is also the author of a twice-weekly blog posted at