What Is Insolvency?

Insolvency Explained in Less Than 4 Minutes

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Insolvency describes a situation in which debtors are unable to pay what they owe to creditors. Both individuals and businesses can be deemed insolvent if not able to pay their debts. 

Different things can cause a person or business entity to become insolvent. And there are varied ways of dealing with it as well, including working out payment arrangements with creditors or, in the worst-case scenario, filing for bankruptcy

Knowing what insolvency means, and what impact it can have financially, matters, especially if you have personal debts or run a business. 

Definition and Examples of Insolvency

Insolvency refers to situations in which a debtor can't repay the debts he or she owes. For example, a business may become insolvent if it's unable to keep up loan payments or money owed to vendor invoices. 

The IRS offers another definition of insolvency:

"A taxpayer is insolvent when his or her total liabilities exceed his or her total assets." 

The IRS uses this insolvency definition when determining whether canceled debts should be included as income on your taxes. So, say you owe $100,000 in credit card debt, but you have a negative net worth. Using the IRS definition, you'd likely be considered insolvent. 

You're not required to include forgiven debts in your taxable income to the extent that you're insolvent.

How Insolvency Works

Insolvency isn't a process, per se. Instead, there are different factors that can lead a person, business, or other entity to become insolvent. 

Here's an example. Perhaps you decide you want to start a food truck business. You get a $100,000 startup loan to purchase a truck, equipment, supplies, and other essentials. 

The initial plan is to use your savings to make loan payments until the business starts making money. But a year into it, you're still not turning a profit and you can no longer make payments on the loan, nor can you pay the other bills required to keep the business running. At that point, the business could be deemed insolvent. 

Legally speaking, there are some federal laws that define insolvency. Under the Uniform Commercial Code, for example, a business is considered insolvent if:

  • It's generally ceased to pay debts in the ordinary course of business, other than as a result of a bona fide dispute
  • It's unable to pay debts as they become due
  • It fits the definition of insolvency under federal bankruptcy law

Insolvency is a financial state, while bankruptcy is a legal proceeding that allows debtors to reach a resolution with creditors. 

In addition to businesses or individuals, governments also can become insolvent. The Greek debt crisis is one example of a government system that faced insolvency in recent years. The crisis was triggered by the country’s inability to make payments on debts owed to the European Union. Thanks to a restructuring of loan agreements, default, which would have threatened the financial stability of the entire eurozone, was avoided. 

Types of Insolvency

There are different ways to measure insolvency. First, balance-sheet insolvency looks at whether assets are greater than liabilities. If you have more debts than assets, then you're generally insolvent according to the balance-sheet rule. 

This type of insolvency can be used in bankruptcy proceedings to determine whether a person or business has assets that could be liquidated and used to pay creditors. The court uses fair-market value to determine what assets are worth. 

Cash-flow insolvency tests your ability to pay the debts you owe. This is also referred to as "ability to pay." This test looks forward to consider whether a person or business is likely to have enough liquidity in the future to pay their obligations. 

It's important to know that a business or a person may meet one insolvency test definition but not another. For example, going back to the food truck business example, it's possible that you could have more debts than assets, making you balance-sheet insolvent. But if you're still able to pay current bills, you may not be considered cash-flow insolvent.

In a Chapter 7 bankruptcy, debts are discharged, or eliminated, while Chapter 11 and Chapter 13 bankruptcy filings allow debts to be restructured and paid back over time. 

Key Takeaways

  • Insolvency is a term used to describe a situation in which a person or business is unable to pay their debts.
  • The IRS offers a distinct definition of insolvency for determining when forgiven debts are taxable. 
  • Becoming insolvent can happen for a variety of reasons, including poor business management and financial situations that are beyond your control. 
  • There are different types of insolvency tests that can be used to measure a person’s or business's financial state. 
  • Insolvency can be a precursor to a bankruptcy filing, though they're two separate things.