Insolvency is the condition of having more liabilities (debt), than total assets which might be available to pay them, even if the assets were mortgaged or sold. In other words, you owe more than you can pay. A bankruptcy court can determine that you cannot pay all your debts and “discharge” (canceled the debt) for some of them. This means the party that is owed money is out of luck.
As it has become more common to experience debt relief in these challenging times, there are important elements to remember. Debt relief is usually taxable if not relieved through bankruptcy proceedings. But, canceled debt is not included in income to the extent that you are insolvent immediately before the cancellation. You are insolvent if all of your liabilities exceed the fair market value of all of your assets. Because of the difficulty in determining insolvency, the IRS has developed a comprehensive insolvency worksheet. It can be found in the newly revised edition of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). The result can then be used to determine whether and to what extent your canceled debts are excluded from gross income.
If you own a business and you need advice about your insolvency, contact a small business accountant to help analysis your situation.