How Do You Prove Insolvency to the IRS?

To prove insolvency to the IRS, an insolvency worksheet calculates the amount of cancelled debt income that can be excluded, and Form 982 is used to report it to the IRS. The worksheet does not have to accompany the tax return, according to the IRS.

A taxpayer doesn't have to include cancelled debt in income to the extent that he was insolvent before the cancellation. The insolvency worksheet, available in IRS Publication 4681, is used to list all assets and liabilities immediately before the cancellation of debt. The taxpayer needs records of debt balances and asset values. "It's not impossible, but the more time that passes, it's hard to go back and really prove that you were insolvent," notes The worksheet and supporting documents should be kept in case the IRS asks to see them.