Opinion ID: 778136
Heading Depth: 2
Heading Rank: 1

Heading: The Discharge-of-Indebtedness Income

Text: 13 Section 61(a) of the Internal Revenue Code provides that gross income includes all income from whatever source derived, including income from discharge of indebtedness. 26 U.S.C. § 61(a)(12). This treatment of discharge-of-indebtedness income parallels the Code's treatment of loans: a taxpayer does not include borrowed funds in gross income, even though such funds increase assets, because the taxpayer has a corresponding liability to repay the loans. The justification for taxing discharge-of-indebtedness income is that the elimination of the liability (the obligation to repay the funds previously borrowed) makes available to the taxpayer assets that were previously offset by liabilities. See United States v. Kirby Lumber Co., 284 U.S. 1, 3, 52 S.Ct. 4, 76 L.Ed. 131 (1931). 14 However, the Code provides exceptions to this general rule. Section 108(a)(1) states: 15 Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness to the taxpayer if—(A) the discharge occurs in a title 11 case, (B) the discharge occurs when the taxpayer is insolvent, or (C) the indebtedness discharged is qualified farm indebtedness. 16 26 U.S.C. § 108(a)(1). For purposes of subsection (B), the insolvency exception, `insolvent' means the excess of liabilities over the fair market value of assets. Id. § 108(d)(3). [A]n insolvent debtor realizes income just to the extent his assets exceed his liabilities after the cancellation. Commissioner v. Tufts, 461 U.S. 300, 310 n. 11, 103 S.Ct. 1826, 75 L.Ed.2d 863 (1983). This exception recognizes the fact that an insolvent debtor does not suddenly acquire assets simply because an obligation to pay off loans has been removed. 17 Regarding the discharge-of-indebtedness income, taxpayer argues that the IRS's assessment was arbitrary and capricious and so is not entitled to the presumption of correctness to which IRS assessments usually are entitled, 3 that the Tax Court erred by continuing to rely on the presumption of correctness and by failing to shift the burden of proof to the IRS even after taxpayer presented evidence refuting the accuracy of the assessment, and that taxpayer produced sufficient evidence of his insolvency to qualify for the insolvency exemption to discharge-of-indebtedness income. The IRS counters that it did present evidence of discharge-of-indebtedness income—the corporate tax returns and the CIS statement—so as to be entitled to the presumption of correctness, and that none of the evidence presented by taxpayer established that he was insolvent at the time that he realized the discharge-of-indebtedness income (when he filed the CIS statement indicating positive net worth and no debt). 18 Focusing on the insolvency exception, the Tax Court found, relying on the CIS, that the exception did not apply. The Court determined that taxpayer had a positive net worth in 1993 of approximately $389,650, with assets comprising $50 in cash and $850,000 in real estate (subject to encumbrances of $460,000) and with his sole liability being $400 in credit card debt. Toberman, 80 T.C.M. (CCH) 81, slip op. at 5 & n. 7. The Court further found that taxpayer's contention that, despite his statement on the CIS, he was indeed insolvent by at least two to three million dollars was vague and conclusory and that taxpayer has failed to provide any details... as to ... the specific liabilities he claims to have owed. Id. at 15. Moreover, the Court concluded that the CIS actually understated taxpayer's assets because it did not include his ownership interest in Fantastic Foods and the $457,072 debt that Fantastic Foods owed to him. Id. 19 Mr. Toberman contends that it was improper for the Court to disregard his and his accountant's uncontradicted testimony regarding his insolvency. Moreover, he argues that he did in fact introduce specific liabilities into evidence, namely actual judgments showing that he owed millions of dollars. Tax Court Exhibits 25-P, 26-P, 29-P, 33-P, 34-P, and 35-P. He also testified as to millions of dollars of additional judgments against him. Finally, he contends that Fantastic Foods was itself insolvent and lacked any obvious means to repay him for its debt and, therefore, that his ownership interests in the equity and debt of the company had little or no market value. See 26 U.S.C. § 108(a)(1)(B) (noting that, for purposes of insolvency exception, assets are judged at fair market value). 20 We find taxpayer's arguments persuasive. Although the Tax Court stated that taxpayer failed to provide evidence of specific liabilities, the Court also noted that the record contains notices of judgment against petitioner. Toberman, 80 T.C.M. (CCH) 81, slip op. at 13. The Court referred specifically to a Federal District Court order, dated Sept. 22, 1992, entering judgment of $832,806 against petitioner[]. Id. at 13 n. 11. Moreover, the parties stipulated that various trial court exhibits, presented by taxpayer, were true and correct copies of judgments entered against Mr. Toberman. Joint Appendix 22-23. These judgments were entered on the following dates in the following amounts: September 23, 1992, $835,772.37; June 22, 1992, $969,063.00 (not paid as of January 26, 1995); May 8, 1992, $206,064.04; September 11, 1991, $1,205,600.34; August 9, 1991, $408,528.65. These judgments alone total $3,625,028.40, far greater than the taxpayer's net worth as determined by the Court, $389,650, even considering the loan from Fantastic Foods, $457,072, and a reasonable ownership interest in the company. 21 In response, the IRS contends that, [w]ith the exception of one of the judgments, [footnote 16] there is no evidence that they were extant and enforceable in [March] 1993. Footnote 16 states: Ex. 25-P, a judgment in the amount of $969,063, includes as an attachment a writ of execution issued on January 26, 1995. Commissioner's Brief 29 & n. 16. Thus, even were we not to consider the four judgments that the IRS contends were somehow satisfied by March 1993, the one judgment that the IRS admits was extant in March 1993, by itself, is greater than the fair market value of taxpayer's assets at that time. Moreover, it is not reasonable to conclude, in the absence of any evidence, that the judgments had been satisfied in the one to two year period prior to discharge of taxpayer's debt. Therefore, we hold that the Court's determination that taxpayer was not insolvent at the time of the discharge of his debt to his Subchapter S corporations was clear error. It is our definite and firm conviction that taxpayer met the insolvency exception to discharge-of-indebtedness income. The Tax Court's demand for explicit proof that recent judgments remained unsatisfied, was, in the circumstances of this case, wholly unreasonable.