Opinion ID: 2971554
Heading Depth: 3
Heading Rank: 1

Heading: The realization of income

Text: Gross income is “all income from whatever source derived.” I.R.C. § 61(a). The Supreme Court has held that included within this definition of income is money coming from a third party in payment of a debt owed by the taxpayer. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929) (“The discharge by a third person of an obligation to [the taxpayer] is equivalent to receipt by the person taxed.”). As this court has noted, “[u]nder the income tax law the payment of a legal obligation of a taxpayer constitutes taxable income.” Guarantee Title & Trust Co. v. Commissioner, 313 F.2d 225, 228 (6th Cir. 1963). None of the parties dispute the principle that when a third party pays the debt of the taxpayer, the taxpayer has realized income. But the agreement ends there. Mas One submits that, first, Midland “was not some unrelated party, but was connected to the Partnership in its partnership capacity.” Because Midland is not an unrelated party, Mas One argues, “the payment cannot constitute forgiveness of debt income to the Partnership.” But this argument is unsupported, both legally and factually. Mas One cannot point to a single authority for the proposition that, by virtue of an ambiguous “relationship,” Old Colony does not apply. To the contrary, many cases have held that an indebtedness paid by a third party to satisfy a taxpayer’s obligation is realized income to the taxpayer notwithstanding a close relationship between the two. See, e.g., Diedrich v. Commissioner, 457 U.S. 191 (1982) (finding the realization of income to the parents when their children agreed to pay the gift tax on a bequest made by the parents); Tenn. Secs., Inc. v. Commissioner, 674 F.2d 570 (6th Cir. 1982) (finding the realization of income to the parent corporation when its subsidiary paid the balance on a loan owed by the parent). Midland, moreover, was a legally independent party at the time of the payment to Huntington. It had terminated its relationship with Mas One the day before the payment was made as part of a deliberately planned series of transactions. One of Mas One’s lawyers admitted that “[i]t was my understanding that both the closing of the Midland-Huntington loan payoff transaction and the closing of the . . . purchase of the Clearwater Tower were to occur after the closing of the [partnership] restructuring.” Despite the principle that the “substance of the transaction will govern, rather than its form,” Treas. Reg. § 1.721-1(a), the reasoned steps taken by the parties to legally separate before the payment was made No. 03-4188 Mas One Limited Partnership v. USA Page 4 cannot be ignored. The Supreme Court has repeatedly recognized that although “a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.” Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (internal citations omitted). In the present case, we see no reason to disregard the very specific timeline established by the parties. Mas One next argues that Midland “was obligated to pay the debt in its partnership capacity and pursuant to the Debt Service Guaranty Agreement.” This argument, if true, would be persuasive, because Old Colony is applicable only where there is a “discharge by a third person of an obligation to [the taxpayer.]” Old Colony Trust Co., 279 U.S. at 729 (emphasis added). If Midland had the obligation, and not Mas One, to pay the principal of the Huntington loan, then Old Colony and its progeny would not control the tax treatment in this case. The facts, however, belie Mas One’s argument. Midland was under no obligation to make the $8.3 million payment to Huntington. The two guaranty agreements, which were the only provisions binding Midland with regard to the loan, limited the company’s obligations to making the monthly interest payments and the $2.5 million substantial-completion principal payment. Both of these payments, moreover, were due only in the event that Mas One failed to make those payments itself. Nothing in the original promissory note or the two guaranty agreements obligated Midland to pay the entire principal balance of the loan. To the contrary, the promissory note is clear in that the obligation to pay the loan balance upon maturity belonged solely to Mas One. Mas One, however, argues that Midland’s obligation to pay the loan balance should be inferred from the payment itself. “[N]o person or organization, particularly not a sophisticated insurance company, is going to make a payment in the very substantial amount of $8.3M unless it believes it is obligated to do so.” We find this argument unconvincing. The negotiations surrounding Midland’s abandonment of the Clearwater Tower project were complex, and we have no need to explore the cost-benefit analyses performed by each party. Suffice it to say that Midland had other options and considerations, but chose to pay Mas One’s obligation quickly in order to relieve itself of the Debt Service Guaranty by the end of the calendar year in question. The fact that it was not legally obligated to do so means that Old Colony is applicable. Mas One further argues that the Debt Service Guaranty, which obligated Midland to make monthly interest payments indefinitely, was tantamount to a guarantee by Midland of the total loan balance. But this analysis ignores the fact that the Generals, the entity that had unlimited liability for Mas One’s obligations, was the group that in effect guaranteed the repayment of the loan. Had Midland not paid the principal balance when it did, the responsibility for paying the balance would have fallen to the individual members of the Generals. We thus conclude that Midland’s obligation was not equivalent to a guarantee to pay the loan balance. In sum, Mas One was the only party contractually bound to pay the principal balance on the Clearwater Tower laon, and it was freed from this obligation when Midland made the $8.3 million payment as a means to terminate its Debt Service Guaranty. This payment therefore constituted ordinary income to Mas One under the tax-law principle enunciated in Old Colony.