Court Opinion

ID: 9492530
Source: CourtListenerOpinion
Date Created: 2023-08-05 14:43:29.255278+00
Date Added: 2024-06-11T17:55:21.324761
License: Public Domain

O’SCANNLAIN, Circuit Judge,
dissenting:
Because the majority interprets 26 U.S.C. § 108(d)(3) in a manner which I believe conflicts with the plain language of the statute, I respectfully dissent.
I
Cancellation of indebtedness is, of course, included in income unless “the discharge occurs where the taxpayer is insolvent,” where “the term ‘insolvent’ means the excess of liabilities over the fair market value of assets.” 26 U.S.C. §§ 61(a)(12), 108(a)(1)(B), 108(d)(3). As I see it, we must decide how to treat contingent liabilities in determining whether a taxpayer’s liabilities exceed his assets.
As the majority recognizes, the term “liability” is a “broad legal term ... including almost every character of hazard or responsibility, absolute, contingent, or likely.” Ante at 848 (quoting Black’s Law Dictionary 914 (6th ed.1990)). Accordingly, the plain language of section 108(d)(3) instructs us to consider all liabilities — absolute and contingent — in determining insolvency, and we are bound to follow the *853plain meaning of the text, see Estate of Cowart v. Nicklos Drilling Co., 505 U.S. 469, 475, 112 S.Ct. 2589, 120 L.Ed.2d 379 (1992); United States v. Providence Journal Co., 485 U.S. 693, 700-01, 108 S.Ct. 1502, 99 L.Ed.2d 785 (1988); Coalition for Economic Equity v. Wilson, 122 F.3d 692, 710 (9th Cir.1997), cert. denied, — U.S. —, 118 S.Ct. 397, 139 L.Ed.2d 310 (1997); United States v. E.C. Invs., Inc., 77 F.3d 327, 330 (9th Cir.1996), barring exceptional circumstances in which the text suggests a scrivener’s error or an absurd result, see United States Nat’l Bank of Oregon v. Independent Ins. Agents of America, Inc., 508 U.S. 439, 462, 113 S.Ct. 2173, 124 L.Ed.2d 402 (1993); Green v. Bock Laundry Mach. Co., 490 U.S. 504, 510-11, 109 S.Ct. 1981, 104 L.Ed.2d 557 (1989); Church of the Holy Trinity v. United States, 143 U.S. 457, 458-59, 12 S.Ct. 511, 36 L.Ed. 226 (1892).
Notwithstanding the express statutory-language, which, to repeat, instructs us to weigh liabilities against assets in determining whether a taxpayer is insolvent, the majority holds that a contingent liability is to be counted as a liability if, and only if, the taxpayer can establish that it was more likely than not that the contingent liability would eventuate. See Ante at 850. Under this all-or-nothing approach, a liability is counted in its entirety if the probability of occurrence exceeds 50 percent and is excluded altogether from the insolvency if the probability is equal to or less than 50 percent.
The majority bases its departure from the plain language on its belief that inclusion of all contingent liabilities would lead to an “absurd result.” Ante at 848. I respectfully disagree and would instead follow the lead of our sister circuits, who, in determining whether someone is insolvent in the bankruptcy context, include all contingent liabilities discounted by the probability of occurrence. See In re Trans World Airlines, Inc., 134 F.3d 188, 197 (3d Cir.1998), cert. denied, — U.S. —, 118 S.Ct. 1843, 140 L.Ed.2d 1093 (1998);1 Covey v. Commercial Nat’l Bank, 960 F.2d 657, 660 (7th Cir.1992); In re Xonics Photochemical, Inc., 841 F.2d 198, 200 (7th Cir.1988); see also FDIC v. Bell, 106 F.3d 258, 264 (8th Cir.1997) (discounting by the probability of occurrence in valuing contingent liabilities); In re Chase & Sanborn Corp., 904 F.2d 588, 594-95 (11th Cir.1990) (same). This methodology values each liability at an amount equal to the liability multiplied by the probability of occurrence. For example, a taxpayer with a definite liability of $200,000 and an additional liability of $1,000,000 which is contingent and which has a 10 percent probability of occurring would have total liabilities of $200,-000 plus $1,000,000 times 10 percent, or $300,000. Accordingly, he would be insolvent if he had less than $300,000 in assets and solvent otherwise.
Despite the majority’s fears, we have seen that our sister circuits have used this methodology to determine insolvency in the bankruptcy context without encountering an “absurd result.” Rather, I suggest it is the majority’s methodology that is problematic. The discounted liability approach better reflects the economic reali*854ties of particular situations. “Discounting a contingent liability by the probability of its occurrence is good economics and therefore good law, for solvency ... is an economic term.” Covey, 960 F.2d at 660.
The majority states that “Congress considered a debtor’s ability to pay an immediate tax on discharge of indebtedness income the ‘controlling factor’ in determining whether the § 108(a)(1)(B) exception applies.” Ante at 850. But the majority’s approach is a less reliable method of measuring a debtor’s ability to pay an immediate tax than is the discounted liabilities methodology, as two examples will illustrate.
Suppose that Taxpayer X has assets of one dollar and a contingent liability of one million dollars with a 50 percent probability of occurrence. Because the liability is not more likely than not to eventuate, the majority would disregard the liability in its entirety and conclude that the taxpayer is solvent. This conclusion makes little sense. Although the contingent liability is not more likely than not to occur, ignoring this liability results in a flawed picture of Taxpayer X’s financial situation. In light of the 50 percent chance that Taxpayer X will incur a million dollar liability, his one dollar of assets does not make him solvent in any sensible interpretation of that term. In terms of what the majority characterizes as the “controlling factor” — whether the debtor has the ability to pay an immediate tax on discharge of indebtedness income— Taxpayer X is not able to pay taxes on cancellation of indebtedness income and thus should be considered insolvent.
By making the question of whether it is more likely than not that the taxpayer will be called upon to pay the liability the touchstone of its analysis, the majority fails to take into account the difference between a 50 percent and a one percent probability of occurrence. What really counts is whether assets exceed discounted liabilities. Taxpayer X’s discounted liability of $500,000 — 50 percent times $1 mil.lion — far exceeds his $1 in assets. Thus, contrary to the conclusion reached under the majority’s methodology, he is insolvent.
In Covey, Judge Easterbrook framed this seemingly esoteric issue in an intuitive light. A taxpayer is solvent if people would be willing to pay to be put into the taxpayer’s situation. If one would have to be paid to assume the taxpayer’s package of assets and liabilities, the taxpayer is insolvent. See Covey, 960 F.2d at 660. Clearly, no one would be willing to pay Taxpayer X — who has only $1 in assets and a 50 percent chance of being hit with a $1 million liability — anything to assume his assets and liabilities. Instead, one would have to be paid to do so, which indicates that Taxpayer X is insolvent. By requiring Taxpayer X to pay tax on cancellation of indebtedness income, the majority undermines the tax code’s policy of providing relief to insolvent taxpayers.
A second example illustrates how the majority’s approach sometimes grants a tax break to solvent taxpayers who should properly be paying taxes. Take the case of Taxpayer Y, who has $900,000 in assets and a $1 million liability with a 51 percent probability of occurrence. The majority would count the liability in its entirety and deem the taxpayer insolvent because the $1,000,000 liability exceeds the $900,000 in assets. Is this person really insolvent? Our sister circuits would say he is not, because his assets ($900,000) exceed his discounted liability ($510,000). In terms of Judge Easterbrook’s question, one would surely be willing to pay a positive sum to acquire $900,000 along with a expected liability of $510,000. Moreover, Taxpayer Y is fully able to pay taxes on discharge' of indebtedness income. Thus, he should not benefit from the insolvency exception.
The problems inherent in the majority’s analysis are made all the more evident by taking this example one step further. Suppose that the same Taxpayer Y pays the fair market rate (say, $600,000) for insurance against the 51 percent chance of *855a $1,000,000 liability occurring, with the insurer agreeing to reimburse Taxpayer Y for his liability if it occurs. Voila! Taxpayer Y — who was originally insolvent under the majority’s analysis — would now be fully solvent in the majority’s view because, after purchasing insurance, he would have $300,000 in assets and no (uninsured) liability. There is, however, no sensible reason to treat Taxpayer Y differently depending on whether he insures against the liability. He is really solvent in both situations, as our sister circuits who use the discounted liabilities methodology would recognize.
Absurd results? In my view, Taxpayers X and Y would indeed have absurd results if the majority’s approach prevails.
II
Conceding that valuing liabilities on a discounted basis makes good economic sense, the majority limits this approach to the bankruptcy context, not the tax context. See Ante at 850-51. It bases this conclusion on the fact that the bankruptcy code defines the term “insolvent” slightly differently from the tax code. Compare 11 U.S.C. § 101(32)(A) (“‘insolvent’ means ... financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of .... ”), with 26 U.S.C. § 108(d)(3) (“For purposes of this section, the term ‘insolvent’ means the excess of liabilities over the fair market value of assets.”). As the majority interprets these two provisions, the phrase “at a fair valuation” in the bankruptcy code modifies both “debts” and “property” whereas the phrase “fair market value” in the tax code modifies only “assets.” From this, the majority reasons that the bankruptcy code requires both debts and property to be valued at a fair market value, whereas the tax code requires only assets to be fairly valued. Taking this reasoning one step further, the majority concludes that the tax code requires liabilities to be valued at other than fair value.
With respect, I cannot agree with the majority’s analysis. Upon closer inspection, the purported differences between 11 U.S.C. § 101(82)(A) and 26 U.S.C. § 108(d)(3) collapse, and it becomes clear that, contrary to the majority’s contention, the fair value modifier in the bankruptcy code applies only to the asset side of the ledger. The placement of the phrase “at a fair valuation” directly after the word “property” in 11 U.S.C. § 101(32)(A) indicates that, as is the case with 26 U.S.C. § 108(d)(3), the fair value modifier is limited to “property” (i.e., assets); only by stretching is it possible to read this modifier to cover “debts” as well as “property.” To the extent that the phrasing of the statute leaves room for reasonable disagreement over issues of grammar, it is insightful to examine 11 U.S.C. § 1(19), the prior statute from which 11 U.S.C. § 101(32)(A) was adopted, which provided:
A person shall be deemed insolvent within the provisions of this title whenever the aggregate of his property, exclusive of any property which he may have conveyed, transferred, concealed, removed, or permitted to be concealed or removed, with intent to defraud, hinder, or delay his creditors, shall not at fair valuation be sufficient in amount to pay his debts.
11 U.S.C. § 1(19) (1966). It was clear from the placement of the phrase “at fair valuation” within section 1(19) that this modifier applied only to assets, and not to debts. Although the Bankruptcy Code of 1978 replaced section 1(19) with section 101(32), the new definition was adopted from section 1(19) with the only difference being which property is excluded. See S. Rep. 95-989, at 25 (1978), reprinted in 1978 U.S.C.C.A.N 5787, 5811 (“The definition of ‘insolvent’ in paragraph (26) is adopted from section 1(19) of current law. An entity is insolvent if its debts are greater than its assets, at a fair valuation, exclusive of property exempted or fraudulently transferred. It is the traditional bankruptcy balance sheet test of insolvency.... *856The difference in this definition from that in current law is in the exclusion of exempt property for all purposes in the definition of insolvent.”).
The conclusion that the “fair valuation” modifier in 11 U.S.C. § 101(32)(A) applies only to assets — -just like the “fair market” modifier in 26 U.S.C. § 108(d)(3) applies only to assets — is bolstered by 11 U.S.C. § 101(32)(B), which defines the term “insolvent” as it applies to partnerships: “ ‘insolvent’ means.... with reference to a partnership, financial condition such that the sum of such partnership’s debts is greater than the aggregate of, at a fair valuation [the partnership’s assets and the sum of each general partner’s nonpartnership net assets].” 11 U.S.C. § 101(32)(B). Again, it is clear from the phrasing that “at a fair valuation” modifies only assets, and there is no reason to think that Congress intended to define insolvency differently in the partnership context (covered by subsection B) than in other contexts (covered by subsection A). Thus, the majority’s interpretation of 11 U.S.C. § 101(32)(A) is untenable in light of subsection (B) and former section 1(19), as the Third Circuit has expressly concluded. See Trans World Airlines, 134 F.3d at 196-97.
Thus, we see that the term “insolvent” is defined similarly under bankruptcy law and under tax law. In both contexts, Congress instructed us to include liabilities in determining insolvency, but did not expressly delineate how to value liabilities. As other circuits have concluded, the fact that Congress expressly provided that assets are to be fairly valued but did not so provide with respect to liabilities does not mean that liabilities must be un fairly valued. See, e.g., Covey, 960 F.2d at 660. Instead, as even the majority appears to agree, the discounting approach outlined in Part I “is good economics and therefore good law, for solvency ... is an economic term.” Id.
Ill
Consistent with the decisions of our sister circuits and in adherence to the plain statutory language, I would reverse and remand for a proper determination of whether Appellants’ assets exceeded their discounted liabilities.

. Contrary to the majority’s assertions, Trans World. Airlines does not stand for the proposition either that contingent liabilities are not to be counted in determining insolvency or that contingent liabilities are not to be discounted by probability of occurrence. That court stated quite clearly: "We agree with the bankruptcy court that it is proper to consider contingent liabilities when evaluating the insolvency of a corporation pursuant to 11 U.S.C. § 101(32)(A).” Id. (citing Mellon Bank, N.A. v. Official Comm. of Unsecured Creditors (In re R.M.L., Inc.), 92 F.3d 139, 156 (3d Cir.1996); In re Xonics Photochemical, Inc., 841 F.2d 198, 200 (7th Cir.1988); Syracuse Engineering Co. v. Haight, 97 F.2d 573, 576 (2d Cir.1938)). In each of the three cited cases — Mellon Bank, Xonics Photochemicals, and Syracuse Engineering — assets and liabilities were valued on a discounted basis. Thus, Trans World Airlines, read in conjunction with the Third Circuit's opinion in Mellon Bank, makes clear that the Third Circuit values contingent liabilities discounted by the probability of occurrence in determining insolvency.