Is Income from Discharge of Indebtedness Really Income at All? A Proposal for a More Reasoned Analysis

Musselman, James L

I. INTRODUCTION

The income tax concept of income from discharge of indebtedness has generated a substantial amount of analysis, criticism, and controversy since it was first recognized as a potential item of gross income in 1926.1 Numerous commentators have discussed and criticized the opinions and rationale of courts that have recognized the concept, and have suggested various theories and proposals for its application in the particular factual contexts in which it has thus far been treated by the courts.2 No commentator or court has yet proposed or applied a rationale for the inclusion in income of discharge of indebtedness that has been uniformly accepted. As a result, the concept has been inconsistently applied by the courts in the factual contexts so far presented,3 and a danger exists that new cases presenting different facts will result in decisions that lack a logical and meaningful basis for support.4

The determination of whether a taxpayer must include a discharge of indebtedness in gross income requires, as with most other gross income issues, a two-part analysis.5 It must first be determined whether gross income conceptually exists pursuant to an analysis under section 61 of the Internal Revenue Code (Code),6 and applicable case law.7 If this analysis results in a determination that gross income does in fact exist, it must then be determined whether any portion of such amount may be excluded from gross income under section 108 of the Code8 or some other applicable exclusionary section.9 A number of conceptual bases have been adopted by the courts over the years for the non-inclusion of income from discharge of debt in certain factual contexts, which have now been codified in section 108.10 This article focuses entirely on the first part of the analysis under section 61 and applicable case law,11 and will not attempt to address issues involving the current version of section 108 or any other exclusionary section, except where necessary to offer an explanation for the result of certain cases hereinafter discussed.

This article traces the judicial history of the concept of income from discharge of indebtedness, identifying and discussing the opinions and rationale that the courts have so far offered for this concept.12 It then reviews and discusses relevant commentary regarding the theoretical basis and application of the concept.13 Next, the article proposes a more reasoned and logical approach to the determination of when and whether a discharge of indebtedness will result in inclusion in gross income, and the amount of any such inclusion.14 Specifically, the article suggests that the issue of income from discharge of indebtedness is no different from other gross income issues, requiring at the outset an inquiry into whether gross income conceptually exists pursuant to an analysis under section 61 of the Code. That inquiry, as this article proposes, simply requires a determination whether a discharge of indebtedness has resulted in a clearly realized accession to wealth and in what amount. Finally, the article discusses the application of this proposed approach to the factual situations identified in the cases previously discussed15 and to additional hypothetical factual situations yet to appear in reported cases.16

II. JUDICIAL HISTORY OF DISCHARGE OF INDEBTEDNESS

A. Early United States Supreme Court Cases Recognizing Discharge of Indebtedness as a Potential Item of Gross Income

1. Bowers v. Kerbaugh-Empire Co.

The income tax concept of income from discharge of indebtedness was first recognized as a potential item of gross income by the United States Supreme Court in 1926, in the case of Bowers v. Kerbaugh-Empire Co.17 In Kerbaugh-Empire, the taxpayer, between 1911 and 1913, borrowed funds from the Deutsche Bank of Germany (Bank) to finance work being done by its subsidiary.18 The promissory notes evidencing the loans were payable by the taxpayer in German marks or their equivalent in U.S. gold coin.19 The borrowed funds were advanced by the taxpayer to its subsidiary, and were expended by the subsidiary and lost in the operation of its business.20 After the United States entered World War I, the Bank became an alien enemy.21 After the war, the taxpayer finally repaid the loans, with the result that the amounts borrowed exceeded the amounts repaid (measured in U.S. dollars) by $684,456.18.22

The Internal Revenue Service (IRS) determined that such amount was includable in the taxpayer's gross income for the year in which the loans were repaid.23 In response, the taxpayer argued that the borrowed funds had been lost by its subsidiary in the operation of its business, and therefore no gross income derived from the transaction taken as a whole.24 The Kerbaugh-Empire Court, citing Eisner v. Macomber25 for the definition of income subject to the federal income tax, held that "[t]he transaction here in question did not result in gain from capital and labor, or from either of them, or in profit gained through the sale or conversion of capital . . . [because t]he result of the whole transaction was a loss."26 The Court explained its decision as follows:

The contention that the item in question is cash gain disregards the fact that the borrowed money was lost, and that the excess of such loss over income was more than the amount borrowed. When the loans were made and notes given, the assets and liabilities of [the taxpayer] were increased alike. The loss of the money borrowed wiped out the increase of assets, but the liability remained. The assets were further diminished by payment of the debt.27

As a result, while not foreclosing the possibility that income might include a discharge of indebtedness in an appropriate situation, the Court held there was no income under these facts.28

2. United States v. Kirby Lumber Co.

The United States Supreme Court next considered the issue of income from discharge of debt in United States v. Kirby Lumber Co.29 In this case, the taxpayer, a corporation, issued its own bonds in 1923 for which it received their par value.30 Later in the same taxable year, the taxpayer repurchased in the open market a portion of those bonds at a price less than par value.31 As a result, the taxpayer, in essence, borrowed funds from the bond purchasers and repaid an amount less than it borrowed.32 The IRS determined that such amount was includable in the taxpayer's gross income in 1923.33 The Kirby Lumber Court agreed with the IRS and distinguished Kerbaugh-Empire on its facts.34 The Court stated that, in Kerbaugh-Empire, "[t]he transaction as a whole was a loss . . . . Here there was no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made available . . . assets previously offset by the obligation of bonds now extinct."35

B. Lower Courts' Attempts to Distinguish Precedents Established in Early Supreme Court Cases

1. Commissioner v. Rail Joint Co.

One year after the Supreme Court issued its opinion in Kirby Lumber, the Second Circuit Court of Appeals distinguished the Kirby Lumber decision in Commissioner v. Rail Joint Co.36 In Rail Joint, the taxpayer, a corporation, reappraised its assets, thereby adding $3,000,000 to its surplus account, and declared a dividend from its surplus account payable in its own bonds at face value.37 In subsequent years, the taxpayer repurchased a portion of those bonds at a price less than face value.38 The issue in Rail Joint, as in Kirby Lumber, was whether the taxpayer was required to include in income the difference between the par value of the bonds and the lesser amount paid by the taxpayer in repurchasing them.39 In explaining Kirby Lumber, the court stated,

The taxpayer's assets were increased by the cash received for the bonds, and, when the bonds were paid off for less than the sum received, it is clear that the taxpayer obtained a net gain in assets from the transaction. . . . [T]he consideration received for the obligation evidenced by the bond as well as the consideration paid to satisfy that obligation must be looked to in order to determine whether gain or loss is realized when the transaction is closed; i.e., when the bond is retired.40

The court then distinguished this case from Kirby Lumber, stating that

[the Kirby Lumber] decision is not applicable to the facts of the case at bar. In paying dividends to shareholders, the corporation does not buy property from them. Here the [taxpayer] never received any increment to its assets, either at the time the bonds were delivered or at the time they were retired. They were issued against a surplus created by reappraising assets already owned; and no one suggests that in writing up the book value of property which had appreciated the corporation received anything. The bonds were merely a way of distributing a part of such surplus among shareholders. When certain of the bonds were retired at less than par, all that happened was that the corporation retained a part of the surplus that it had expected to distribute, because it paid those shareholders whose bonds were redeemed at a discount, less than it had promised to pay them. Hence it is apparent that the corporation received no asset which it did not possess prior to the opening and closing of the bond transaction, and it is impossible to see wherein it has realized any taxable income.41

2. Bradford v. Commissioner

In 1956, in the case of Bradford v. Commissioner,42 the Sixth Circuit Court of Appeals relied on both Kerbaugh-Empire and Rail Joint as the basis for its decision. In Bradford, the taxpayer's husband borrowed funds from a bank and, for various personal and business reasons, persuaded the bank in 1938 to accept a promissory note executed by his wife as substitute for a portion of his debt to the bank.43 The taxpayer received no consideration for the execution of her note to the bank in the amount of $205,000.44 Subsequently, at the bank's request, the taxpayer executed two notes to replace her original note, one of which was in the principal amount of $100,000.45 Several years later, the taxpayer's husband persuaded a relative to purchase the $100,000 note from the bank for $50,000 in cash, with funds provided to the relative by the taxpayer and her husband.46

The Tax Court, agreeing with the IRS, held that $50,000 was includable in the taxpayer's gross income from discharge of indebtedness in the year the $100,000 note was purchased from the bank.47 The court acknowledged that, under a mechanical application of Kirby Lumber, "it is obvious that when $100,000 of the [taxpayer's] indebtedness was discharged for $50,000 . . . , she realized a balance sheet improvement of $50,000 which would be taxable as ordinary income under the rule of the Kirby Lumber Co. case."48

However, the Sixth Circuit then immediately distinguished Kirby Lumber on its facts, holding that "by any realistic standard the [taxpayer] never realized any income at all from the transaction in issue."49 The court reasoned that "[h]ad [the taxpayer] paid $50,000 in 1938 to discharge $100,000 of her husband's indebtedness, the Commissioner could hardly contend that she thereby realized income. Yet the net effect of what she did do was precisely the same."50 The Bradford court, although relying on Kerbaugh-Empire for support for its decision, acknowledged that Kerbaugh-Empire had been referred to as "'a frequently criticized and not easily understood decision.'"51 Yet, as the Bradford court continued, "[c]ourts have not hesitated in appropriate circumstances to look behind the cancellation of indebtedness in a given calendar year, and in doing so to evaluate in its entirety the transaction out of which the cancellation arose."52 In comparing this case to Rail Joint, the Bradford court stated,

Stripped of superficial distinctions, . . . Rail Joint . . . is identical in principle with the present case. In that case, as in this, the taxpayer received nothing of value when the indebtedness was assumed. Although the indebtedness was discharged at less than its face value, the taxpayer was in fact poorer by virtue of the entire transaction.53

3. Zarin v. Commissioner and N. Sobel, Inc. v. Commissioner

Aside from cases where Kirby Lumber had direct application and cases like Rail Joint and Bradford where Kirby Lumber was factually distinguished, the judicial landscape regarding discharge of indebtedness as income remained relatively quiet until 1990, the year the Third Circuit Court of Appeals issued its controversial opinion in Zarin v. Commissioner.54 David Zarin (Zarin) was a professional engineer who developed a nasty gambling habit.55 He resided in Atlantic City, New Jersey and applied for and received a credit line from Resorts International Hotel (Resorts) to enable him to gamble on credit at its casino.56 Zarin's gambling activities at Resorts became substantial enough to qualify him as a "valued gaming patron" and to become known as an extravagant "high roller."57 By December 1979, Zarin had incurred cumulative gambling losses at Resorts in the amount of $2,500,000, all of which he repaid in full.58 In October 1979, as a result of various allegations of credit abuses, many of which were related to Zarin, the New Jersey Division of Gaming Enforcement filed a complaint against Resorts with the New Jersey Casino Control Commission, resulting in the issuance of an Emergency Order, the effect of which was to make further extensions of credit to Zarin illegal.59

Notwithstanding the issuance of the Emergency Order, Resorts continued to allow Zarin to gamble on credit,60 and "[b]y January, 1980, Zarin was gambling compulsively and uncontrollably at Resorts, spending as many as sixteen hours a day at the craps table."61 By April 1980, Zarin owed Resorts a total of $3,435,000.62 Resorts filed an action against Zarin in New Jersey state court to collect the $3,435,000, and Zarin defended the action, by denying any liability for the debt on the basis that it was unenforceable under New Jersey law.63 Ultimately, Zarin and Resorts settled the lawsuit in 1981 by Zarin paying Resorts $500,000 in cash.64 The IRS concluded that Zarin must include $2,935,000 in gross income in 1981 from the discharge of his indebtedness to Resorts, representing the difference between the $3,435,000 debt to Resorts and the $500,000 Zarin paid to Resorts to settle the lawsuit.65

The Third Circuit held that Zarin was not required to include any amount in gross income from discharge of indebtedness, and gave two bases for its decision.66 The court's first rationale, which relied on the definition of "indebtedness" set forth in section 108(d)(1) of the Code, was most surely incorrect.67 As accurately pointed out in Judge Stapleton's dissenting opinion, the majority opinion was incorrect because section 108(d)(1) expressly defines the term "indebtedness" for purposes of section 108, dealing with the exclusion of income from the discharge of indebtedness, and not for the purposes of section 61 of the Code, dealing with the determination of whether anything is includable in income in the first place.68

The court's second rationale, that Zarin's transaction with Resorts should properly be analyzed under the "contested liability doctrine,"69 has resulted in much commentary. The Zarin court explained the doctrine as follows:

Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes. Thus, if a taxpayer took out a loan for $10,000, refused in good faith to pay the full $10,000 back, and then reached an agreement with the lender that he would pay back only $7,000 in full satisfaction of the debt, the transaction would be treated as if the initial loan was $7,000. When the taxpayer tenders the $7,000 payment, he will have been deemed to have paid the full amount of the initially disputed debt. Accordingly, there is no tax consequence to the taxpayer upon payment.70

In N. Sobel, Inc. v. Commissioner, the case in which the contested liability doctrine was first recognized, the taxpayer purchased 100 units of stock directly from the corporate issuer, the Bank of the United States (Bank), executing a promissory note for the purchase price in the amount of $21,700.71 The following year, the taxpayer brought suit against Bank, requesting rescission of the purchase contract and the loan on the ground that Bank made the loan in violation of law and failed to perform certain promises made in connection with the transaction.72 The lawsuit was ultimately settled by the taxpayer paying $10,850 to Bank.73 The IRS determined, inter alia, that the taxpayer must include $10,850 in gross income from the discharge of its indebtedness to Bank, representing the difference between the $21,700 debt to Bank and the $10,850 that the taxpayer paid to Bank to settle the lawsuit.74 The Board of Tax Appeals, precursor to the Tax Court, held that the taxpayer was not required to include any income from the discharge of indebtedness because there was a legitimate question as to the existence and amount of the taxpayer's liability to Bank, and such question was not resolved until settlement of the lawsuit, which the court determined from the record was bona fide.75 The court held that the taxpayer's liability to Bank was definitely fixed at $10,850 when the lawsuit was settled.76 Thus, the taxpayer had no income from the discharge of indebtedness because it effectively paid Bank the exact amount of its liability to Bank.77

The Zarin court, in comparing Zarin's situation to the situation in Sobel, stated that

[t]here is little difference between the present case and Sobel. Zarin incurred a $3,435,000 debt while gambling at Resorts, but in court, disputed liability on the basis of unenforceability. A settlement of $500,000 was eventually agreed upon. It follows from Sobel that the settlement served only to fix the amount of debt. No income was realized or recognized. When Zarin paid the $500,000, any tax consequence dissolved.78

However, the IRS in Zarin, citing the Tax Court's decision in Colonial Savings Ass'n v. Commissioner,79 argued that the contested liability doctrine was inapplicable, because the doctrine applied only in cases involving an unliquidated debt, meaning "a debt for which the amount cannot be determined."80 The IRS argued that "Zarin contested his liability based on the unenforceability of the entire debt, and did not dispute the amount of the debt . . . [and thus his] debt was liquidated, therefore barring the application of Sobel and the contested liability doctrine."81 The court rejected the IRS's argument, holding that

[w]hen a debt is unenforceable, it follows that the amount of the debt, and not just the liability thereon, is in dispute. Although a debt may be unenforceable, there still could be some value attached to its worth. This is especially so with regards to gambling debts . . . [where] the debt is frequently incurred to acquire gambling chips, and not money. Although casinos attach a dollar value to each chip, that value, unlike money's, is not beyond dispute, particularly given the illegality of gambling debts in the first place. This proposition is supported by the facts of the present case. Resorts gave Zarin $3.4 million dollars of chips in exchange for markers evidencing Zarin's debt. If indeed the only issue was the enforceability of the entire debt, there would have been no settlement. Zarin would have owed all or nothing. Instead, the parties attached a value to the debt considerably lower than its face value. In other words, the parties agreed that given the circumstances surrounding Zarin's gambling spree, the chips he acquired might not have been worth $3.4 million dollars, but were worth something. Such a debt cannot be called liquidated, since its exact amount was not fixed until settlement.82

4. Preslar v. Commissioner

In 1999, the Tenth Circuit Court of Appeals, in the case of Preslar v. Commissioner,83 criticized Zarin's application of the contested liability doctrine. Preslar involved a fairly complex fact situation in which the taxpayers, after extensive negotiations, acquired a 2,500 acre ranch in New Mexico.84 The corporate seller (Seller) was a debtor-in-possession in a Chapter 11 bankruptcy proceeding, and the property was subject to three mortgage liens.85 The most junior lien was held by Moncor Bank (Moncor), which took the lead in assisting in the negotiations between Seller and the taxpayers for the purpose of avoiding foreclosure and salvaging as much of its interest as possible.86 The taxpayers purchased the ranch for one million dollars, and Moncor provided the financing.87 The taxpayers executed a one million dollar promissory note to Moncor, $760,000 of which was used by Moncor to satisfy the two senior mortgages.88 The promissory note was secured by a mortgage on the ranch, which then became the only mortgage with respect to the property.89 The promissory note was payable in fourteen annual installments of equal amounts.90 The taxpayers intended to develop the property by subdividing 160 acres, selling lots for cabins or vacation homes, and permitting the lot owners to hunt and engage in other outdoor recreational activities on the remaining 2,340 acres.91 The taxpayers were permitted by Moncor to make payments on the promissory note by assigning installment sales contracts of lot purchasers to Moncor at a discount.92 This repayment arrangement was first evidenced by a letter from a Moncor representative to the taxpayers dated approximately ten months after the purchase of the property; there was no reference to such arrangement in the loan documents executed by the taxpayers and Moncor.93

Two years after the purchase of the property by the taxpayers, Moncor "was declared insolvent and the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver."94 The FDIC refused to accept any further assignments of installment sales contracts as payments on the promissory notes, and the taxpayers filed an action against the FDIC for breach of contract.95 That action was settled when the taxpayers paid $350,000 to the FDIC in full satisfaction of the promissory note and the FDIC released the mortgage lien on the property.96 At that time, the unpaid balance on the promissory note was $799,463; the obligation was thus reduced by virtue of the settlement by $449,463 ($799,463 minus $350,000).97 The IRS determined that the taxpayers must include the $449,463 debt reduction in gross income.98 The taxpayers challenged the IRS's determination in the United States Tax Court.99

Applying the contested liability doctrine, the Tax Court held for the taxpayers.100 The court

held the [taxpayers'] unusual payment arrangement with Moncor . . . caused their liability for the full $1 million loan to be brought into question. The court determined the true amount of the [taxpayers'] indebtedness was not firmly established until they settled with the FDIC; thus, no discharge-of-indebtedness income could have accrued to the [taxpayers] as a result of the settlement.101

On appeal, the Tenth Circuit rejected the Tax Court's application of the contested liability doctrine, and in the process, although unnecessarily, criticized Zarin's application of it as well.102 In its criticism of Zarin, the court stated,

The problem with the Third Circuit's holding [in Zarin] is it treats liquidated and unliquidated debts alike. The whole theory behind requiring that the amount of a debt be disputed before the contested liability exception can be triggered is that only in the context of disputed debts is the Internal Revenue Service (IRS) unaware of the exact consideration initially exchanged in a transaction. The mere fact that a taxpayer challenges the enforceability of a debt in good faith does not necessarily mean he or she is shielded from discharge-of-indebtedness income upon resolution of the dispute. To implicate the contested liability doctrine, the original amount of the debt must be unliquidated. A total denial of liability is not a dispute touching upon the amount of the underlying debt.103

The taxpayers argued that the amount of their debt to Moncor was doubtful because, due to the unusual payment arrangement with regard to the promissory note, the one million dollar "purchase price had been inflated and did not reflect the fair market value of the ranch."104 The Tax Court accepted this argument and held that when the FDIC refused to honor the payment arrangement "'a legitimate dispute arose regarding the nature and amount of [the taxpayers'] liability on the Bank loan.'"105 The Tax Court reasoned, "Only after [the taxpayers] and the FDIC settled their subsequent lawsuit . . . was the amount of liability on the loan finally established."106 The appellate court, however, rejected that argument holding that the evidence presented at trial did not establish a legitimate dispute as to the amount of the taxpayers' obligation to Moncor.107 As a result, the appellate court in Preslar determined the obligation remained liquidated at all times.108

III. COMMENTATORS' REACTIONS TO TREATING DISCHARGE OF INDEBTEDNESS AS A POTENTIAL ITEM OF GROSS INCOME

The decisions in Kerbaugh-Empire and Kirby Lumber have produced a substantial amount of confusion for quite some time, and are often criticized. As stated in a major article published in 1978:

Kirby Lumber carried forward from Kerbaugh-Empire the theory that the taxability of a debt discharge depends on the profitability of the "transaction as a whole," requiring consideration not merely of whether the taxpayer borrowed more than it repaid but also of whether the use of the borrowed funds was profitable. It is usually impossible to make this latter determination . . . . Even where funds can be traced to a particular project, the attribution is artificial . . . [and thus] misleading . . . . A second source of confusion in Kirby Lumber was the Court's assertion that the transaction "made available . . . assets previously offset by the [obligation to repay]." . . . A particularly troublesome legacy of [that] passage has been the tendency of some courts to read Kirby Lumber as holding that it is the freeing of assets on the cancellation of indebtedness, rather than the cancellation itself, that creates a taxable gain. Such reasoning misses the point. Income results from the discharge of indebtedness because the taxpayer received (and excluded from income) funds that he is no longer required to pay back, not because assets are freed of offsetting liabilities on the balance sheet. . . . In a tortuous series of later decisions, . . . the courts have held that the nature of the obligation, the mode of discharge, the creditor's objective in agreeing to the settlement, the absence of prior tax benefits, and the debtor's financial condition may, in particular circumstances, shield the taxpayer from the result reached in Kirby Lumber.109

The confusion engendered by Kerbaugh-Empire and Kirby Lumber took a turn for the worse with the Third Circuit's opinion in Zarin, resulting in a plethora of articles, both supporting and criticizing either the result reached by the court or its analysis used to reach such result, or both.110 The most thoughtful and analytical of these was published by Professor Shaviro,111 followed by an article by Professor Dodge expressing general agreement with Professor Shaviro, and further sharpening his analysis in several important respects.112

Professor Shaviro described Zarin as "a perplexing and difficult case, both theoretically and under existing tax law,"113 and asserted that "Zarin is a case without a right answer."114 Despite his assertion that Zarin is a case without a right answer, Professor Shaviro came close to offering a very satisfactory explanation of Zarin from both a theoretical and practical perspective.115 In the section of his article dealing with what he referred to as statutory issues, Professor Shaviro first cited the article by Professor Bittker and Barton Thompson,116 for the proposition that

[i]ncome results from the discharge of indebtedness because the taxpayer received (and excluded from income) funds that he is no longer required to pay back, not because assets are freed of off-setting liabilities on the balance sheet. Debtors who ultimately pay back less than they received enjoy a financial benefit whether the funds are invested successfully, lost in a business venture, spent for food and clothing, or given to a charity.117

Professor Shaviro then argued

the government's argument that Zarin had $3 million of cancellation of indebtedness income compellingly followed from its assertion that he received $3.5 million of value in the form of gambling chips. The problem was simply whether this assertion was correct. The cancellation of indebtedness issue properly turned on the value of Zarin's consumption . . . . Zarin should not have been taxed if in 1980 he received $500,000 of value in exchange for what ultimately turned out to be $500,000 of liability. By contrast, the government was right if the value of what he received was $3.5 million.118

As will be discussed in my proposal,119 Professor Shaviro would have offered a very satisfactory solution to Zarin if he had stopped there instead of focusing on the value Zarin received from Resorts rather than the value of his consumption, although the two values may very well be the same.120 Professor Dodge, describing Professor Shaviro's article as "a penetrating critique of the various opinions handed down in Zarin,"121 first made the important point that Zarin did not borrow cash from the casino, but instead gambled on the house's credit.122 Zarin thereby incurred a liability to the casino, but not a loan resulting from borrowed funds.123 Professor Dodge then concluded that "one cannot simply assume that Zarin received $3.4 million in money or money's worth from the gambling transactions because $3.4 million was the face amount of the liability."124 From that conclusion, he suggested a very simple possible explanation for Zarin, that "as a cash method taxpayer, [he] only suffered nondeductible gambling losses in 1981 to the extent of $500,000, the amount of the cash settlement."125 He supported this suggestion by asserting that Zarin can be viewed as having "made a 'bargain purchase' of $3.4 million of 'consumption' for $500,000,"126 and that "arm's-length bargain purchases are not treated as creating gross income."127 That result, while appealing, ignores the possibility that Zarin engaged in a taxable event in which he received something of value from Resorts in excess of what he paid.128 The facts in Zarin require that issue to at least be addressed.129 However, merely acknowledging that the value of what Zarin received from Resorts might have been something less than $3.4 million was an important point;130 and, if Zarin engaged in a potential taxable event with Resorts, exploring the extent of such value requires a traditional gross income analysis under section 61 of the Code, as will be discussed in my proposal.131

Professor Shaviro's article was criticized in an article published by Professor Johnson,132 arguing that the result in Zarin can be easily explained, in that "[t]he 1981 forgiveness of [Zarin's] markers was a recovery of an expense for which Zarin had no prior tax benefit. Zarin has no income under the exclusionary, protaxpayer branch of the tax benefit rule."133 Professor Johnson described the rule as follows:

Under the exclusionary or pro-taxpayer branch of the tax benefit rule, a taxpayer may exclude the recovery of an expenditure from income, where the expenditure gave the taxpayer no prior tax benefit. The taxpayer may be viewed as, in effect, having a basis in the expenditure, which the taxpayer may use to shelter the recovery from tax, provided the expenditure did not previously generate a tax savings. The tax benefit rule is a part of our tax accounting rules which require us to look at transactions as a whole rather than as fragments segregated by separate tax years.134

Professor Johnson argued that Zarin's gambling losses in 1979 and 1980 were nondeductible in those years, and thus Zarin received no tax benefit from having incurred them.135 The forgiveness of Zarin's markers was simply a recovery of those nondeductible losses, and thus is excluded from Zarin's gross income under the rule because the forgiveness of the markers and the gambling losses were all part of the same transaction, albeit occurring in different years, and Zarin received no tax benefit from the losses.136 Professor Johnson conceded that "[i]t might . . . be argued that the rule applies only to [allowable] deductions which produced no tax benefit, not [disallowed] deductions, such as [Zarin's] gambling losses . . . ."137 However, he went on to argue that "gambling losses are [deducted], . . . provided the taxpayer has gambling gains for the year."138 He concluded his argument by stating that

[t]he fact that gambling losses can be deducted only against gambling gains is exactly the kind of problem at which the exclusionary branch of the tax benefit rule is aimed: to allow netting of gains against prior losses in exactly those cases where the taxpayer did not have income in the right prior year to offset those losses.139

It would be difficult to conceive of a situation where Professor Johnson's argument might be analytically correct with respect to gambling gains received in a subsequent year from gambling losses, where the losses and the gains are part of the same transaction, and thus the gains could be considered to be a recovery of the losses under section 111 of the Code.140 Certainly, however, Zarin would not be one of these situations. The most important point missed by Professor Johnson in his argument is that the forgiveness of Zarin's markers does not constitute gambling winnings.141 Thus, even if Resorts forgave Zarin's markers in the same years he suffered his gambling losses, in turn making any potential for application of the tax benefit rule unnecessary, Zarin would still not be allowed to deduct his gambling losses against any potential income resulting from such forgiveness.142 If Zarin has income from the forgiveness of his markers, it is because he has income from discharge of indebtedness, not from gambling.143 Thus, Professor Johnson's argument cannot possibly be correct; the tax benefit rule simply has no application in a case like Zarin.144

IV. PROPOSAL

The factual situations so far presented by the reported cases dealing with the issue of income from discharge of indebtedness have resulted in a variety of theories and results, none of which have been uniformly accepted by courts or commentators.145 I believe that the courts in both Kerbaugh-Empire and Kirby Lumber applied an improper analysis in dealing with this issue.146 As a result, courts subsequently dealing with the issue of income from discharge of indebtedness in different factual settings have had to give deference to those precedents in trying to reach a rational decision.147 In doing so, some of those courts have apparently reached what they believed to be an equitable result based upon the facts presented. Then, in an effort to keep from directly departing from the holdings and reasoning in the United States Supreme Court cases of Kerbaugh-Empire and Kirby Lumber, those courts seized upon any precedent or idea they could find to rationalize their equitable result.148 Understandably, this has resulted in the confusing patchwork of theories and rationales for decisions discussed in this article.149

Under my proposal, the issue of inclusion of income from discharge of indebtedness is no different than other gross income issues, requiring a two part analysis.150 The first inquiry is whether gross income conceptually exists pursuant to an analysis under section 61 of the Code.151 The Supreme Court case providing the precedent governing the concept of gross income at the time Kerbaugh-Empire and Kirby Lumber were decided was Eisner v. Macomber,152 a precedent that is now clearly outdated. The Supreme Court's 1955 decision in Commissioner v. Glenshaw Glass Co.153 is now the most often-cited case defining gross income.154 In Glenshaw Glass, the Court, stating that Eisner v. Macomber "was not meant to provide a touchstone to all future gross income questions,"155 held that "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion," were includable in the taxpayer's gross income.156

Thus, I propose when a taxpayer has received a discharge of indebtedness, it must simply be determined whether such discharge resulted in a clearly realized accession to the taxpayer's wealth, and in what amount.157 Under my proposal, the amount of any such accession to wealth is determined by the value of anything the taxpayer received as a result of any such discharge of indebtedness, as with any other gross income issue.158 When determining the value received from the discharge of indebtedness, it is necessary to evaluate the transaction that initially created the indebtedness since any value the taxpayer received from a discharge of indebtedness would have been received at that time.159 Notably, the value received by the taxpayer at the time of the transaction initially creating the indebtedness would not have been included in the taxpayer's gross income at that time because the receipt of such value coincided with the creation of the indebtedness by the taxpayer, thus resulting in no accession to the taxpayer's wealth.160

In most cases, determination of the value received by the taxpayer in a transaction creating an indebtedness is simple.161 The most basic example is borrowing cash.162 If a taxpayer borrows $10,000 from a bank in cash, and the debt is subsequently discharged by the bank, the taxpayer would clearly have $10,000 of gross income from discharge of indebtedness. No one would argue with the conclusion that the taxpayer received $10,000 of value when he borrowed that amount from the bank because he received $10,000 in cash.

Another simple example is incurring indebtedness by purchasing property. If a taxpayer agrees to buy a car on credit for $10,000, and is subsequently discharged from his obligation to pay that amount, everyone would agree with the conclusion that the taxpayer received $10,000 of value when he received the car. In that case, the taxpayer did not receive cash, but the law presumes that, in ordinary arm's length purchases of property, the value of the property received by the taxpayer is equal to the amount the taxpayer paid or agreed to pay for it.164

Cases in which indebtedness is incurred for something other than cash or property can be much more difficult to analyze, depending on the facts and circumstances involved. 165 The most common example of this situation occurs when a taxpayer incurs debt for services.166 Suppose a taxpayer agrees to pay an accountant $1,000 to prepare his tax return. After preparing and filing the return, the taxpayer is discharged from the $1,000 obligation. The question presented in this situation is whether the taxpayer incurs $1,000 of income from the discharge of indebtedness. A very good argument could be made that he should be treated the same as the taxpayer who was discharged from his $10,000 debt incurred by purchasing the car. Assuming the agreement for preparation of the taxpayer's tax return for $1,000 was at arm's length, the law should presume that the value of the services received by the taxpayer is equal to the amount the taxpayer agreed to pay for them.167 There can, however, be many variations on these facts, some of which would rebut any such presumption and require an evaluation of whether the taxpayer received value equal to what he agreed to pay.168 I believe that Zarin is one such case.169 If the taxpayer, in a case with appropriate facts, can show that he received value in a lesser amount than the debt incurred, he should not have income from the discharge of such debt in excess of the value received.170

Skeptics will claim that allowing taxpayers to argue, in cases where they have been discharged from indebtedness, that they received little or no value in the transaction in which the debt was created and thus have little or no income from discharge of indebtedness, will encourage spurious claims by taxpayers and further hamper administration of the tax laws. In most cases, however, this argument will simply not be available to taxpayers. This type of argument will only be appropriate in cases where the taxpayer has incurred debt for something other than cash or property, and then only where the facts clearly and objectively give rise to a serious question of whether the taxpayer received value in a lesser amount than the debt incurred.171 Furthermore, valuation issues regarding the proper amount to include in gross income are common-place under the Code,172 and the issue of whether a taxpayer has income from discharge of debt (or the amount of any such income) should not be analyzed any differently in appropriate cases. As in all valuation cases, the taxpayer will have the ultimate burden of proof regarding the value received upon creation of the debt and thus the amount of income that must be included from the discharge of that debt.173

V. APPLICATION OF PROPOSAL

A. Application to Decided Cases

As illustrated below, a simple application of my proposal and the other well-established principles in part IV of this article to the reported cases previously identified and discussed would have resulted in a satisfactory and doctrinally accurate solution in all such cases.

1. Bowers v. Kerbaugh-Empire Co. and United States v. Kirby Lumber Co.

Under my proposal, Kerbaugh-Empire and Kirby Lumber would fall in the category of cases that are very easy to resolve.174 First, in Kerbaugh-Empire, the taxpayer borrowed cash from the Bank, and subsequently repaid the loans in full with a lesser amount of cash than it borrowed.175 Under my proposal and the modern definition of gross income provided by the Court in Glenshaw Glass, the taxpayer clearly received gross income from the discharge of indebtedness equal to the amount borrowed less the amount repaid. 176 This result would hardly be controversial today. The decision and reasoning in Kerbaugh-Empire has often been criticized by courts,177 and commentators, with virtually all commentators now in agreement that Kerbaugh-Empire is no longer good law.178

Second, in Kirby Lumber, the taxpayer, a corporation, "issued its own bonds for . . . which it received their par value," later repurchasing in the open market a portion of those bonds at a price less than par value.179 Although it is not clear from the opinion itself, Professor Bittker and Barton Thompson note that the bonds were not originally issued in exchange for cash, but rather "for the taxpayer's preferred stock with dividends in arrears."180 Thus, if this observation is true, Kirby Lumber can be factually distinguished from Kerbaugh-Empire in that the taxpayer did not effectively borrow cash from the bond purchasers, but instead acquired property in exchange for the issuance of the bonds.181 Assuming that the bonds were not exchanged for cash but were issued in exchange for the taxpayer's preferred stock, the value received by the taxpayer in the transaction creating the taxpayer's indebtedness (the issuance of the bonds) thus equaled the value of the preferred stock.182 As recognized in my proposal, pursuant to well-established legal principles the law presumes that, in ordinary arm's length purchases of property, the value of the property received by the taxpayer is equal to the amount the taxpayer paid or agreed to pay for it.183 In this case, the value of the property received would be the par value of the bonds (in essence, the principal amount of the taxpayer's indebtedness to the bond purchasers). Thus, after applying my proposal to Kirby Lumber, it falls into the category of cases that are easy to resolve.184 The taxpayer is presumed to have received value equal to the par value of the bonds when it issued them, and thus, as the Court held, clearly received income from discharge of indebtedness when it repurchased the bonds at a price less than par.185

2. Commissioner v. Rail Joint

Rail Joint, Bradford, and Zarin are more difficult cases, because they involve indebtedness incurred for something other than cash or property.186 In Rail Joint, the taxpayer, a corporation, appraised its assets, thereby adding $3,000,000 to its surplus account, and declared a dividend from its surplus account payable in its own bonds at face value.187 Subsequently, the taxpayer repurchased a portion of those bonds at a price less than face value.188 This case is factually distinguishable from both Kerbaugh-Empire and Kirby Lumber because the taxpayer neither effectively borrowed cash from its shareholders, who received the bonds as a dividend, nor acquired property in exchange for the bonds.189 Thus, the question presented in Rail Joint is whether the taxpayer received anything of value when it issued the bonds as a dividend to its shareholders and thus created the indebtedness.190

Under my proposal, I would argue that the taxpayer received value equal to the face value of the bonds when it distributed them to its shareholders as a dividend because the taxpayer clearly distributed a dividend to its shareholders, the amount of which was certain.191 That transaction is, in substance, the same as selling the bonds for cash at their face value and distributing the cash as a dividend to the shareholders. If that is what the taxpayer had done, then clearly, under my proposal, the taxpayer would have had income from discharge of indebtedness when it repurchased the bonds at a price less than face value.192 As the United States Supreme Court stated in Commissioner v. Court Holding Co.193 in 1945, "[t]he incidence of taxation depends upon the substance of a transaction."194 Thus, the taxpayer in Rail Joint should be treated the same as the taxpayer in Kerbaugh-Empire; the taxpayer should be treated as if it borrowed cash and then repaid the loan in full with a lesser amount of cash than it borrowed,195 thus allowing Rail Joint to join Kerbaugh-Empire in the category of cases that are easily resolved.196

3. Bradford v. Commissioner

In Bradford, the taxpayer executed a promissory note as substitute for a portion of her husband's debt to a bank.197 Her husband had incurred the debt by borrowing funds from the bank, and the taxpayer received no consideration for the execution of her note to the bank.198 Subsequently, the taxpayer executed two notes to replace her original note, and then (in essence) repaid one of those notes in full for an amount less than its principal amount.199 The issue in this case, as in Rail Joint, was whether the taxpayer received anything of value when she created her indebtedness to the bank by executing her original promissory note.200 Under the facts, she clearly acquired no cash or property, or for that matter any other consideration, by executing the note.201

Under my proposal, this case should be analyzed in the same manner as Rail Joint; the taxpayer received value equal to the principal amount of her original promissory note to the bank when she executed it.202 The taxpayer clearly made a gift to her husband, the amount of which was certain, by substituting her promissory note for his debt to the bank.203 That transaction is in substance the same as borrowing cash, and using the funds to pay her husband's debt to the bank.204 If that is what the taxpayer had done, pursuant to my proposal she clearly would have had income from discharge of indebtedness when she repaid the loan in full for an amount less than its principal amount.205 Thus, under the reasoning discussed above with respect to Rail Joint,206 the taxpayer in Bradford should be treated the same as the taxpayers in Rail Joint and Kerbaugh-Empire; the taxpayer should be treated as if she borrowed cash and then repaid the loan in full with a lesser amount of cash than she borrowed.207 That reasoning would then allow Bradford to join both Kerbaugh-Empire and Rail Joint in the category of cases that are easily resolved.208

4. Zarin v. Commissioner and N. Sobel, Inc. v. Commissioner

In Zarin, as discussed earlier, the taxpayer gambled on credit at a casino.209 By December 1979, Zarin had incurred cumulative gambling losses at Resorts in the amount of $2,500,000, all of which he paid to Resorts in full.210 In October 1979, as a result of various allegations of credit abuses, many of which related to Zarin, the New Jersey Division of Gaming Enforcement filed a complaint against Resorts with the New Jersey Casino Control Commission, resulting in the issuance of an Emergency Order, the effect of which was to make further extensions of credit to Zarin illegal.211 Notwithstanding the issuance of the Emergency Order, Resorts continued to allow Zarin to gamble on credit.212 By April 1980, Zarin owed Resorts a total of $3,435,000.213 Resorts filed an action against Zarin in New Jersey state court to collect the $3,435,000, and Zarin defended that action, denying any liability for the debt on the basis that it was unenforceable under New Jersey law.214 Ultimately, Zarin and Resorts settled the lawsuit in 1981 by Zarin paying to Resorts $500,000 in cash.215 Once again, as in Bradford and Rail Joint, the issue in Zarin was whether the taxpayer received anything of value when he created the $3,435,000 indebtedness to Resorts by gambling on credit.216 This is a much more difficult question to answer in Zarin than in any of the previously reported cases dealing with the issue of income from discharge of debt.

The dissenting opinion in Zarin argues that the case should be treated the same as my proposed treatment of Bradford and Rail Joint; that Zarin received value equal to approximately $3.4 million, the principal amount of his indebtedness to Resorts, when he incurred such indebtedness by gambling on credit.217 The dissent argued that Zarin's transaction with Resorts was in substance the same as if Zarin had borrowed cash from the casino and then returned it to the casino by gambling.218 If this assertion in the dissent is correct, then, pursuant to my proposal, he clearly would have had income from discharge of indebtedness when he repaid the loan in full for an amount less than its principal amount, pursuant to the principles discussed above.219 However, the dissent's argument is incorrect. The argument works in Bradford and Rail Joint because the taxpayers in those cases were incurring indebtedness, the amount of which was certain (the promissory note in Bradford and the bonds in Rail Joint), for the purpose of making transfers conveying a monetary benefit to the transferees (the gift in Bradford and the dividend in Rail Joint), resulting in those taxpayers receiving the satisfaction of having made those transfers in the amount of such indebtedness.220 Thus, those taxpayers can be substantively treated as having borrowed cash to effectuate those transfers in those amounts.221 By contrast, Zarin simply gambled at the casino on credit, and thereby incurred indebtedness to Resorts.222 Zarin never transferred anything to anyone.223 Zarin is best viewed as a situation where the taxpayer incurred debt for services (the opportunity to gamble in the casino).224

The court in Zarin actually addressed, in its application of the contested liability doctrine, the issue of whether the taxpayer received anything of value when he created the $3,435,000 indebtedness to Resorts by gambling on credit, stating that gambling debts are

frequently incurred to acquire gambling chips, and not money. Although casinos attach a dollar value to each chip, that value, unlike money's, is not beyond dispute, particularly given the illegality of gambling debts in the first place. . . . [In this case,] the parties attached a value to the debt considerably lower than its face value. In other words, the parties agreed that given the circumstances surrounding Zarin's gambling spree, the chips he acquired might not have been worth $3.4 million, but were worth something.225

Some commentators have suggested that Zarin received no value from becoming indebted to Resorts by gambling at the casino because suffering gambling losses, at least in the magnitude suffered by Zarin, could not possibly be of any value to anyone.226 That argument uses a subjective definition of value, which is a wholly improper measure of value under the Code.227 Determining whether Zarin received any value in his dealings with Resorts and, if so, how much value, requires an objective evaluation of Zarin's entire transaction with Resorts, taking into account all the facts and circumstances involved.228

Several important factors present in Zarin affect a determination of the amount of value received by Zarin in his dealings with Resorts. First, during the entire time period that Zarin was incurring his $3,435,000 debt to Resorts, he was "gambling compulsively and uncontrollably at Resorts, spending as many as sixteen hours a day at the craps table."229 Zarin apparently had a gambling addiction during this time, and Resorts was clearly taking advantage of the situation, even going so far as committing 100 violations of New Jersey casino regulations to keep Zarin at the tables and losing money.230 Second, Zarin had developed a special relationship with Resorts more than one year prior to the time when he began incurring the $3,435,000 debt, entitling him to special services and privileges.231 Third, Resorts' violations of New Jersey casino regulations pertaining to Zarin resulted in the issuance of an Emergency Order, effectively making Resorts' extensions of credit to Zarin illegal to the full extent of the $3,435,000 debt.232

As discussed above, an arm's length agreement to incur a debt in exchange for services should normally result in a legal presumption that the value of the services received by the taxpayer is equal to the amount the taxpayer agreed to pay for them.233 However, that presumption should be rebutted in cases presenting facts that clearly and objectively give rise to a serious question of whether the taxpayer received value in a lesser amount than the debt incurred.234 I believe that Zarin is an example of a case presenting such facts based on the factors set out above, and should be evaluated accordingly.235 Those factors, viewed together, present a situation requiring an objective evaluation of whether the taxpayer received value equal to what he agreed to pay, and could lead to a determination by a fact-finder in an appropriate proceeding that the value received by Zarin in his dealings with Resorts was an amount less than his $3,435,000 debt to Resorts.236

The foregoing analysis is consistent with any other situation involving the issue of whether a taxpayer has received a clearly realized accession to wealth, and in what amount.237 As discussed earlier, the amount of any such accession to wealth is determined by the value of anything the taxpayer receives, taking into account all the facts and circumstances involved.238 For example, suppose that, instead of gambling on credit at Resorts, Zarin had won a contest entitling him to place bets at a casino aggregating $1,000,000. The value of that prize is a clearly realized accession to the taxpayer's wealth and must be included in gross income.239 No one would argue (except maybe the IRS) that such value would automatically be assumed to be $1,000,000. In fact, a very good argument could be made that an objective evaluation of the taxable event would yield a value substantially less than $1,000,000. Very few taxpayers would place bets aggregating $1,000,000 in a casino unless they won such a contest, and a strong likelihood exists that after the bets are placed the taxpayer will end up with an amount of money substantially less than $1,000,000 because the odds are significantly in favor of the casino. Perhaps the value of that prize should be the amount of money the taxpayer wins by placing the bets. In any event, as discussed earlier, the taxpayer will have the ultimate burden of proof regarding the value of the prize, and thus the amount that must be included in gross income as a result of winning it.20

The court in Zarin did in fact decide that Zarin was not required to include any amount in gross income from discharge of indebtedness.241 The court gave two rationales for its decision, the first of which incorrectly relied on section 108(d)(1) of the Code, as discussed in part II of this article.242 The second rationale for the court's decision, based on the contested liability doctrine, was likely unfounded as well.243 The court cited Sobel as "the seminal 'contested liability' case," and based its reasoning almost entirely on that decision.244 The United States Board of Tax Appeals decided Sobel in 1939, and cited Kirby Lumber as the sole authority for its decision that the taxpayer was not required to include any income from the discharge of indebtedness, stating simply that the discharge of the taxpayer's indebtedness "was not the occasion for the freeing of assets."245 As discussed in part III of this article, the freeing of assets theory for the justification for inclusion of income from discharge of indebtedness has been largely discredited.246 As aptly stated by Professor Bittker and Barton Thompson, "[i]ncome results from the discharge of indebtedness because the taxpayer received (and excluded from income) funds that he is no longer required to pay back, not because assets are freed of offsetting liabilities on the balance sheet."247

Under my proposal, disputing a liability, whether in good faith or not, would have no relevance in determining whether a taxpayer has gross income when the liability is discharged in whole or in part.248 My proposal focuses solely on the question of whether the taxpayer received anything of value when the liability was incurred.249 The freeing of assets theory focuses entirely on the question of whether the taxpayer was obligated for a liability that was discharged.250 The contested liability doctrine is a necessary corollary to the freeing of assets theory, to allow for a determination of the actual amount of the taxpayer's liability in appropriate cases, so that the amount of discharge (and thus the amount of income from such discharge) can be determined.251 It is only because of the unnecessary rigidity of the freeing of assets theory that the contested liability doctrine has come into existence.252 The contested liability doctrine itself has even been applied in an overly rigid fashion, as will be discussed below in the application of my proposal to Preslar.253 My proposal would eliminate any need for the existence of the contested liability doctrine.

That having been said, my proposal would achieve results similar to the application of the freeing of assets theory in many of the cases in which the contested liability doctrine might be properly applied, as is evident from the application of my proposal to Zarin.254 However, that would probably not be true in Sobel, in which the taxpayer, just prior to the 1929 stock market crash, purchased 100 units of stock directly from Bank, the corporate issuer, executing a promissory note for the purchase price in the amount of $21,700.255 The following year, the taxpayer brought suit against Bank, requesting rescission of the purchase contract and the loan on the ground that Bank made the loan in violation of law and failed to perform certain promises made in connection with the transaction.256 The lawsuit was ultimately settled by the taxpayer paying $10,850 to Bank.257

Under my proposal, the issue is whether the taxpayer received anything of value when it created the $21,700 indebtedness to Bank by executing the promissory note.258 This is clearly a case involving the incurring of debt by purchasing property.259 As discussed above, the law presumes that, in ordinary arm's length purchases of property, the value of the property received by the taxpayer is equal to the amount the taxpayer paid or agreed to pay for it.260 The arguments made by the taxpayer in its lawsuit against Bank contesting its obligation under the promissory note, even if true, would not necessarily affect the value of the stock at the time it was purchased by the taxpayer, and would probably not rebut the presumption that the value of the stock was equal to the taxpayer's obligation to Bank.261 Thus, the taxpayer would probably have $10,850 of gross income from discharge of indebtedness when it fully satisfied its $21,700 promissory note to Bank for $10,850 in cash, contrary to the result reached in Sobel from applying the contested liability doctrine.262 Under current law, however, any income from discharge of indebtedness resulting from the settlement of the taxpayer's dispute with Bank should be excludable from gross income as a purchase price adjustment under section 108(e)(5) of the Code.263 In any event, although results similar to my proposal might be achieved in many cases by application of the contested liability doctrine, the contested liability doctrine and the freeing of assets theory are based on a largely discredited theory of inclusion of gross income, are too rigid and difficult to apply, and have the potential of producing inequitable results.264

5. Preslar v. Commissioner

In Preslar, as discussed earlier, the taxpayers, after extensive negotiations, acquired a 2500 acre ranch in New Mexico.265 Seller was a debtor-in-possession in a Chapter 11 bankruptcy proceeding, and the property was subject to three mortgage liens.266 The most junior lien was held by Moncor, which took the lead in assisting in the negotiations between Seller and the taxpayers, for the purpose of avoiding foreclosure and salvaging as much of its interest as possible.267 The taxpayers purchased the ranch for one million dollars, and Moncor provided the financing.268 The taxpayers executed a one million dollar promissory note to Moncor, $760,000 of which was used by Moncor to satisfy the two senior mortgages.269 The promissory note was secured by a mortgage on the ranch, which then became the only mortgage with respect to the property.270 The promissory note was payable in fourteen annual installments of equal amounts.271 The taxpayers intended to develop the property by subdividing 160 acres and selling lots for cabins or vacation homes, and permitting the lot owners to hunt and engage in other outdoor recreational activities on the remaining 2,340 acres.272 The taxpayers were permitted by Moncor to make payments on the promissory note by assigning installment sales contracts of lot purchasers to Moncor at a discount.273 This repayment arrangement was first evidenced in writing in a letter from a Moncor representative to the taxpayers dated approximately ten months after the purchase of the property; there was no reference to such arrangement in the loan documents executed by the taxpayers and Moncor.274

Two years after the purchase of the property by the taxpayers, Moncor was declared insolvent and the FDIC was appointed as receiver.275 The FDIC refused to accept any further assignments of installment sales contracts as payments on the promissory notes, and the taxpayers filed an action against the FDIC for breach of contract.276 That action was settled by the payment of $350,000 by the taxpayers to the FDIC in full satisfaction of the promissory note, and release by the FDIC of the mortgage lien on the property.277 At that time, the unpaid balance on the promissory note was $799,463; the obligation was thus reduced by virtue of the settlement by $449,463 ($799,463 minus $350,000).278 Again, the issue is whether the taxpayers received anything of value when they created the one million dollar indebtedness to Moncor by executing the promissory note.279

As in Sobel, this is clearly a case involving the incurring of debt by purchasing property and, as discussed above, the law presumes that, in ordinary arm's length purchases of property, the value of the property received by the taxpayer is equal to the amount the taxpayer paid or agreed to pay for it.280 Is Preslar like Zarin, where the presumption should be rebutted because it presents facts that clearly and objectively give rise to a serious question of whether the taxpayer received value in a lesser amount than the debt incurred?281 I do not believe that it is. The taxpayers asserted that the value of the property at the time they purchased it was less than its one million dollar purchase price, contending that the purchase price had been inflated in exchange for Moncor's assent to the unusual repayment arrangement, allowing the taxpayers to make payments on the promissory note by assigning installment sales contracts of lot purchasers to Moncor at a discount.282 They argued that "their acquiescence in the $1 million purchase price hinged on their being able to satisfy the debt through assignment of installment contracts."283 The court determined that there was no evidence presented at trial, other than the self-serving testimony of one of the taxpayers with regard to intent, to support that argument.284

However, even if the taxpayers could have proven that assertion to be true, they would merely have explained why they agreed to the one million dollar purchase price for the property; they apparently determined that the value of the deal to them was equal to what they were agreeing to pay, looking at the transaction as a whole.285 Preslar is an ordinary case presenting no special facts giving rise to rebuttal of the presumption that they received value in the amount they agreed to pay.286 Thus, when the taxpayers fully settled their remaining obligation to Moncor in the amount of $799,463 by a payment of $350,000 in cash, they received income from discharge of indebtedness of $449,463.287

Preslar provides a good example of the confusion produced by the contested liability doctrine, and why that doctrine, along with the freeing of assets theory, should be fully and finally discarded. As discussed in part II of this article, the court in Preslar criticized Zarin's application of the contested liability doctrine, distinguishing disputes over the amount of a debt from disputes simply denying liability for the entire debt.288 The court maintained that only where a good faith dispute arises over the amount of a debt (i.e., the debt is unliquidated) will the contested liability doctrine be applicable.289 The court criticized application of the contested liability doctrine in Zarin because Zarin denied liability for the entire debt.290 That distinction makes no sense conceptually. In fact, the taxpayer in Sobel, on which support for the contested liability doctrine rests, denied liability for the entire debt.291 As discussed above, the contested liability doctrine was originally developed as a corollary to the freeing of assets theory, to allow for a determination of the actual amount of the taxpayer's liability in appropriate cases, so that the amount of discharge (and thus the amount of income from such discharge) can be determined.292

If the doctrine truly does not apply in cases where the taxpayer is denying liability for the entire debt, then many fact situations could arise that would produce absurd results. For example, a taxpayer who enters into a contract for services, and denies liability for his entire obligation under the contract because the other party performed the services in a manner that caused damages to the taxpayer in excess of the contract price, would be treated differently for tax purposes than a taxpayer who renegotiates the contract price after the services are provided because they were provided in a shoddy manner. In both of those cases, the issue should be whether and in what amount value was received by the taxpayer when he incurred the obligation for the services.293 Assuming that the taxpayer's dispute over the contract price is objectively justified under the facts,294 the taxpayer should have no income from discharge of indebtedness if he ends up paying less than he originally agreed to pay, whether that amount ends up being something or nothing. Whether the taxpayer is denying liability for his entire obligation under the contract, or is instead disputing only the amount of such liability, should have no relevance whatsoever.295

B. Application to Other Factual Situations

There are an infinite number of possible fact patterns raising the issue of income from discharge of indebtedness that the reported cases have not addressed, but I will focus on two broad categories of them here. Both involve situations where an obligation is imposed on the taxpayer involuntarily. The first such category involves obligations imposed on taxpayers by governments such as federal and state tax liabilities.296 The second category involves judgments obtained against taxpayers through the litigation process.297 What happens in the unlikely event those types of obligations are forgiven, or in the more likely event the taxpayer's liability for such obligations is terminated because of the expiration of a statute of limitations for the collection of such obligations?298 Application of the freeing of assets theory would result in income from the discharge of indebtedness in every such situation (subject to, however, application of the contested liability doctrine in cases where the taxpayer has a good faith dispute over the amount of the obligation).299 That result is unacceptable, at least from a conceptual perspective, in many of these situations. Application of my proposal would allow for a more analytical and thoughtful approach to these factual situations, and would correspondingly produce more acceptable results.300

1. Tax Liabilities

Assume a taxpayer prepares his federal income tax return for the year and discovers he has an unpaid tax liability of $50,000. The taxpayer files his return but fails to pay the liability and, for whatever reason, the statute of limitations for collecting such liability expires.301 Under the freeing of assets theory, the taxpayer would have $50,000 of gross income from discharge of indebtedness.302 Is that a conceptually acceptable result? Once again, my proposal would focus on whether the taxpayer received anything of value when the obligation was created.303 Tax obligations are imposed on taxpayers by operation of law, and it is tempting to argue that we get nothing of value in exchange for paying them. Taxes are levied and collected, however, for the purpose of providing governmental services, and all taxpayers receive some level of benefit as a result.304 While no one would argue that the value of governmental services received directly correlates to the amount of tax liability imposed on any individual taxpayer, it makes good policy to presume that the value received is equal to the obligation imposed, and thus force gross income from discharge of indebtedness on taxpayers to the extent they are relieved of their obligations to pay their tax liabilities.305 That result seems conceptually appropriate and is probably not controversial.306

2. Judgments

In most situations where a judgment is obtained against a taxpayer, and either the judgment creditor forgives all or some amount of the judgment or the judgment is extinguished by the running of a statute of limitations, the issue of whether the taxpayer has income from discharge of indebtedness can be easily analyzed under the principles discussed in parts II and III of this article.307 For example, if suit is brought against a taxpayer because he defaulted on payment of an obligation of some kind, the forgiveness or extinguishment of any judgment consequently obtained against the taxpayer can be properly analyzed by applying the freeing of assets theory and the contested liability doctrine to the underlying obligation.308 In contrast, what if a judgment is obtained against a taxpayer in a tort action based upon his negligent or intentional conduct, and the judgment is subsequently forgiven or extinguished in whole or in part? Does the taxpayer have income from discharge of indebtedness? Under the freeing of assets theory, the answer would be yes in most cases, but in many of those cases that answer would produce a conceptually unsatisfactory result.309 Under my proposal, it would be difficult in most of these cases to determine how the taxpayer could have received anything of value at any point in time, and thus, there would be nothing to include in income.310

There are at least three situations in which the issue of extinguishment, either in whole or in part, of a tort judgment would commonly arise. First, assume a judgment is obtained against a taxpayer in any kind of tort action, and the taxpayer advises the plaintiff of his intention to appeal. The plaintiff, either out of concern for whether his judgment will be upheld on appeal or simply to get his money immediately, negotiates a settlement of the judgment with the taxpayer for an amount less than the judgment. Clearly, the taxpayer was relieved of a portion of his liability as a result of the settlement. Does he have income from discharge of indebtedness?

Under both my proposal and the freeing of assets theory (coupled with the contested liability doctrine), the answer should be no.311 Under my proposal, the taxpayer received nothing of value at any point.312 He committed an action, which gave the plaintiff the right to sue him resulting in a judgment against him, and he paid money to the plaintiff in the amount of the settlement.313 Under the freeing of assets theory, the settlement would free assets of the taxpayer in the amount of the judgment that he was not required to pay because of the settlement.314 Yet, it would seem that the contested liability doctrine would easily apply here to negate any income the taxpayer may have from discharge of indebtedness.315 The litigation clearly establishes the existence of a good faith contest of the liability, and the judgment did not finally end the matter because of the taxpayer's right to appeal. Thus, when the contest was finally ended by the settlement of the judgment, the settlement amount would be treated as the amount of the liability, which the taxpayer paid.316

The second situation in which this issue would commonly arise is one where a judgment is obtained against the taxpayer in any kind of tort action, and the taxpayer allows the time to expire for filing an appeal. The taxpayer has only exempt assets, however, and the judgment is never collected by the plaintiff. There are statutes of limitations in most, if not all, jurisdictions for the collection of a judgment, so at some point the statute will expire and the judgment will be extinguished. Does the taxpayer have income from discharge of indebtedness upon the expiration of the statute? Under the freeing of assets theory, the answer would be yes in every such case.317 Once a judgment is entered against the taxpayer and the time for appeal has expired, the taxpayer can no longer, in good faith, contest his liability for the judgment.318 But conceptually this makes no sense. At no point did the taxpayer receive anything of value that could be taxed.319 He simply was sued and lost. It may be that he lacked the finances to hire a lawyer and defend the lawsuit, and had a default judgment entered against him. Under my proposal, as in the first situation, he would have no income, which, is a conceptually more satisfactory result.320

Some may disagree on this point. It may be that, from a policy perspective, not all torts should be treated equally. Perhaps intentional torts should be treated differently from other torts, or at least those torts that result in physical harm or damage to property, so that extinguishment of liability for judgments related to those torts would always result in income from the discharge of indebtedness.321 This, however, would seem to be a matter for Congress to take up as it did in the Bankruptcy Code, in denying a discharge in bankruptcy for debts incurred by "willful and malicious injury by the debtor to another entity or to the property of another entity."322 Conceptually, under section 61 of the Code323 as it now exists, I would argue that there should be no income from discharge of indebtedness in this situation.

The third situation in which this issue could arise (probably less commonly than in the first two) is similar to the second situation, except that, instead of the expiration of a statute of limitations for collection of the judgment, the plaintiff simply forgives all or part of the judgment, and no money is paid to the plaintiff by the taxpayer. This situation would seem unlikely to occur except in situations where the taxpayer has only exempt assets and is thus judgment proof, and the plaintiff receives some non-financial consideration for such forgiveness.324 Analysis of the income from discharge of indebtedness issue should be no different than in the second situation above, and should produce the same results for the same reasons.325 However, now there is a bargained-for exchange between the taxpayer and the plaintiff. To the extent the taxpayer received value in exchange for the non-financial consideration provided to the plaintiff, he should have income.326 An argument could be made that no value is received when a taxpayer who is judgment proof receives forgiveness of a judgment against him, but it would seem that there would be some value attached to the cancellation of the judgment, even when the taxpayer had no plans to ever pay any of it (e.g., his credit report is freed of the existence of the judgment).327 In any event, any such income should not be treated as income from the discharge of indebtedness.

VI. CONCLUSION

The issue of whether a taxpayer has received income from discharge of indebtedness has been a controversial one almost as long as there has been a federal income tax. The United States Supreme Court fumbled this issue badly in Kerbaugh-Empire and Kirby Lumber, applying an improper analysis in dealing with this issue from the beginning.328 Subsequent courts addressing the issue in different factual settings have had to give deference to those precedents in trying to reach a rational decision in those subsequent cases, resulting in the confusing patchwork of theories and rationales for decisions.329 This article traces the judicial history of the concept of income from discharge of indebtedness, identifying and discussing the opinions and rationale that the courts have so far offered for this concept;330 reviews and discusses relevant commentary regarding the theoretical basis and application of the concept;331 proposes a more reasoned and logical approach to the determination of when and whether a discharge of indebtedness will result in inclusion in gross income, and the amount of any such inclusion;332 and applies this proposed approach to the factual situations identified in the cases previously discussed,333 and to additional hypothetical factual situations which have not yet been identified in the reported cases.334

Specifically, this article proposes that the issue of inclusion of income from discharge of indebtedness requires the same two part analysis as any other gross income issue.335 The first inquiry is whether gross income conceptually exists pursuant to an analysis under section 61 of the Code.336 Thus, when a taxpayer has received a discharge of indebtedness, it must simply be determined whether such discharge has resulted in a clearly realized accession to the taxpayer's wealth, and in what amount.337 The amount of any such accession to wealth is determined by the value of anything the taxpayer received in the transaction which initially created the indebtedness, which value would not have been included in the taxpayer's gross income at that time because the receipt of such value coincided with the creation of the indebtedness by the taxpayer, thus resulting in no accession to the taxpayer's wealth.338 The application of this proposal to the reported cases indentified and discussed above results in a satisfactory and doctrinally accurate solution in all such cases, as well as other instances raising the issue of income from discharge of indebtedness that the reported cases have not addressed.339

JAMES L. MUSSELMAN*

* James L. Musselman is a Professor of Law at South Texas College of Law in Houston, Texas. He has been on the faculty at South Texas since 1987, and served as Associate Dean from 1990 to 1998. Professor Musselman received a B.S. in Accounting from Illinois State University in 1973 and a J.D., magna cum laude, from Brigham Young University in 1979, where he served as Editor of the Brigham Young University Law Review and was a J. Reuben Clark Scholar. Before joining the faculty at South Texas, Professor Musselman engaged in the private practice of law with firms in Denver, Colorado, and Phoenix, Arizona. His teaching and scholarship focus on the areas of Federal Income Tax, Bankruptcy, and Commercial Law.

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