Preslar v. Commissioner: Debt-Discharge Income and its Rationale

I. INTRODUCTION How taxpayers determine the amount of money on which they must pay taxes is an uneasy question because this amount, gross income, has never been conclusively defined. Neither the Internal Revenue Code ("I.R.C." or "Code") nor the courts have ever exactly defined the concept,1 largely because the inquiry into what constitutes gross income involves numerous conceptual uncertainties. One of these uncertainties revolves around "[i]ncome from discharge of indebtedness."2 The general notion of debt-discharge income (that a taxpayer recognizes a benefit and, therefore, must recognize income when a debt is forgiven because the taxpayer will not have to repay the debt) is relatively uncontroversial. However, there is considerable difficulty surrounding both the actual reasoning behind the rule and, more specifically, an exception to the rule that allows noninclusion if the original amount of the debt is uncertain. In the case of Preslar v. Commissioner, the Tenth Circuit examined this "disputed debt" exception in depth and came to a conclusion directly at odds with preexisting Third Circuit authority.3 This Note analyzes these opposing conclusions and ultimately suggests that this split arises because the two circuits interpret the underlying logic of debt discharge income differently. Part II more thoroughly introduces the concept of debt-discharge income and examines the disputed debt exception to the general rule. Part III examines the facts of the Preslar case and summarizes the Tenth Circuit's reasoning. Part IV analyzes the court's reasoning in the context of how the rationale for debt-discharge income should affect the disputed debt exception and critiques the Tenth Circuit's application of the exception to the facts of the Preslar case. Finally, Part V concludes that the Preslar court correctly analyzed the concepts of debt-discharge income and the disputed debt exception but incorrectly applied those concepts to the facts of the Preslar case. II. BACKGROUND A. Gross Income When Great Britain first considered the adoption of an income tax, economists differed as to what amount should constitute a tax base.4 Based on the ideal that people should be taxed according to their standard of living, some favored taxing personal consumption.5 Others thought that people should be taxed according to their ability to pay and favored taxing wealth.6 For a variety of reasons, an income tax was seen as a good way to attain both of these goals.7 Still, "income" had to be defined. The "Schanz-Haig-Simons" theory attempts to do this.8 Although the theory does not explicitly appear anywhere in the I.RC., this concept roughly describes the tax system's view of gross income.9 In essence, it asserts that "an individual's income for a given period (usually a year) equals any net increase in her wealth (or minus any net decrease in her wealth) plus the market value of her consumption during the year."10 Though the concepts of consumption and wealth change may seem easily comprehensible, both can be quite difficult to accurately ascertain. For example, consumption literally means any type of satisfaction, whether psychological or material; under this strict interpretation, a taxpayer's gross income should include both tangible and intangible benefits including, for instance, the enjoyment he receives from listening to birds sing.ll Clearly, the Internal Revenue Service ("IRS") could not feasibly administer this interpretation. Instead, the IRS has chosen to value consumption objectively by only assessing a tax on the amount the taxpayer initially pays for consumption.12 This practice helps, in large part, to simplify the tax system, and the conceptual tax base may again seem simple to compute. However, taxpayers engage in so many varied transactions that deciding whether a particular transaction is consumption or an increase in wealth or neither is very difficult. The Supreme Court touched upon these difficulties in Commissioner v. …