Insolvency Definition & Meaning

What Is Insolvency?

Insolvency is a financial state where a person can’t meet their liabilities. Insolvency can refer to either cash flow insolvency or balance sheet insolvency:

• Cash flow insolvent: Your income is less than your regular bills. 

• Balance sheet insolvent: Your total debt is more than the value of your assets.

How you deal with insolvency depends on the type. Here’s how each type of insolvency works.

Cash flow insolvency

Cash flow insolvency happens when you don't have the income to pay your bills by the due date every month. You’re cash flow insolvent in any situation where your monthly bills are more than your earnings.

You could also be cash flow insolvent if you have a large emergency expense that you can’t pay in full. In this situation, you may need to prioritize certain bills over others or set up a payment plan for some of your expenses.

To determine if you’re cash flow insolvent, add up the total of your monthly bills. Subtract the amount of your bills from your monthly income. For example, if your bills come to $4,000 per month and you make $3,500 per month, you’d be considered cash flow insolvent by $500. 

Balance sheet insolvency

Balance sheet insolvency occurs when the total amount of debt you owe is more than the value of your assets. Some examples of debts and assets to include:

To determine if you’re balance sheet insolvent, add up the current balances on all your debts and the fair market value on everything you own. Subtract your total debt from the combined value of your assets. For example, if you have $25,000 in debt and $15,000 in assets, then you’re balance sheet insolvent by $10,000.

Key Aspects of Insolvency

Insolvency can be temporary, and it’s not always a serious issue. If you’re between jobs, you could be cash flow insolvent while you’re without an income. But if you have plenty of money in your emergency fund, you could rely on that savings until you find work.

Balance sheet insolvency also may not always be serious, especially for young adults. If you pay for college with student loans, you may have more debt than assets when you get out of school. This is fairly common and not necessarily a cause for alarm.

In some cases, insolvency can be a sign of trouble. If you regularly can’t pay your necessary expenses, or if you have more debt than you can realistically expect to pay back, then you probably need to make some financial changes.

Insolvency also comes into play if you settle debt for less than what you owe. The IRS normally considers forgiven debt to be taxable income. If a creditor forgives $10,000 in debt, then you’d add $10,000 to your taxable income for the year. But if you’re balance sheet insolvent, you can usually avoid taxes on forgiven debt.

Every situation is different, and we’re not tax advisors. Please contact a tax professional to discuss potential tax implications of forgiven debt and whether insolvency rules may apply to you.

Real-Life Example: How the IRS Determines Insolvency

The IRS only recognizes balance sheet insolvency. You can check if you qualify using the IRS sample insolvency determination worksheet online. You’re generally allowed to exclude forgiven debt from your taxable income up to the amount you’re insolvent.

For example, imagine you’re insolvent by $30,000. If you had $20,000 in debt forgiven, you could likely report your insolvency to the IRS and avoid paying income taxes on the entire $20,000.

On the other hand, if you had $50,000 in debt forgiven, you could exclude up to $30,000 from your taxable income. You couldn’t exclude the entire $50,000, because that’s more than your insolvency.

To request an exclusion from the IRS, file Form 982 with your tax return for the year you had the debt forgiven.