DUDLEY B. AND LA DONNA K. MERKEL, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent DAVID A. AND NANCY J. HEPBURN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10031-95, 10032-95
UNITED STATES TAX COURT
December 30, 1997
109 T.C. No. 22
Held: The term “liabilities” in
Ann M. Welhaf, for respondent.
HALPERN, Judge: In these consolidated cases, respondent determined deficiencies in the Federal income tax of petitioners Dudley and La Donna Merkel and David and Nancy Hepburn for their 1991 taxable (calendar) years in the amounts of $115,420 and $116,347, respectively. Both cases involve similar circumstances and require us to determine whether petitioners in the two cases (the Merkels and the Hepburns, respectively) may exclude under
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts, with accompanying exhibits, is incorporated herein by this reference.
At the time the petitions were filed, the Merkels and the Hepburns resided in Scottsdale and Paradise Valley, Arizona, respectively.
Discharge of Indebtedness Income
During 1991, the Merkels and the Hepburns were all partners in a partnership (the partnership) that, on September 1, 1991,
The SLC Indebtedness
Systems Leasing Corp. (SLC) is an Arizona corporation organized in 1979 by petitioners Dudley Merkel and David Hepburn to engage in the computer leasing business. SLC is owned “50/50” by Dudley Merkel and David Hepburn. Dudley Merkel and David Hepburn were officers of SLC during its fiscal years ended February 29, 1992, and February 28, 1993, and received officer compensation for those years as follows:
| FYE 2/29/92 | FYE 2/28/93 | |
|---|---|---|
| Dudley Merkel | $183,202 | $191,150 |
| David Hepburn | 182,824 | 191,151 |
In 1986, SLC incurred an indebtedness to Security Pacific Bank (the indebtedness and the bank, respectively), evidenced by a note (the SLC note). The SLC note was personally guaranteed by each petitioner (collectively, petitioners’ guarantees). As of April 16, 1991, the unpaid balance of the SLC note was in excess of $3,100,000, and SLC was in default of its obligations under the SLC note.
On May 31, 1991, SLC, the bank, and petitioners, as guarantors, entered into an agreement (the agreement) containing the terms and conditions of a structured workout concerning the repayment of the indebtedness to the bank. The agreement, in part, provides as follows:
- SLC is to pay to the bank $1,100,000 (the payoff) on or before August 2, 1991 (the settlement date);
- the bank will release its security interest in the remaining collateral upon payment of the payoff by the settlement date; and
- after the payoff by the settlement date, the bank will refrain from exercising any remedies under the SLC note or petitioners’ guarantees if bankruptcy is not filed by or for SLC or petitioners, among others, voluntarily or involuntarily, within 400 days after the settlement date.
SLC made the payoff by the settlement date, and the bank released its security interests in the remaining collateral of SLC. The other conditions of the agreement were met, and the bank, at the expiration of the 400-day period, released SLC from its liability as maker of the SLC note and petitioners from petitioners’ guarantees.
At no time did the bank make any formal written request or formal written demand for payment from petitioners pursuant to petitioners’ guarantees.
North Carolina‘s Sales and Use Tax
SLC was engaged in the business of leasing computer systems in the State of North Carolina during the relevant period. The North Carolina Department of Revenue (the Department of Revenue) issued a “Notice of Sales and Use Tax Due” (the notice) to SLC dated June 14, 1991. The notice identifies the amount of taxes, penalties, and interest due, a total of $980,511.84, and states that the assessment is final and conclusive. The assessment of sales and use tax identified in the notice was for taxes that were never collected by SLC. After receipt of the notice, SLC‘s recourse was to pay the assessed amount and file a suit for refund or to protest the assessment if the Department of Revenue, in the exercise of its discretion, permitted additional time to file a protest. As of August 31, 1991, SLC had not paid the amount identified as due on the notice, nor had SLC requested time to file a protest.
On October 14, 1991, petitioners engaged an attorney to protest the sales and use tax assessment. The Department of Revenue granted SLC 60 days to file a protest. As a result of that protest, the Department of Revenue abated the assessment against SLC in full.
The Department of Revenue never proposed nor made an assessment against any of petitioners relating to the sales and use tax assessed against SLC.
OPINION
I. Introduction
A. Issue
The issue in these consolidated cases is whether petitioners were insolvent on August 31, 1991 (the measurement date), for purposes of
B. Arguments of the Parties
Respondent argues that the term “liabilities“, as used in
Petitioners argue that the plain meaning of the term “liabilities” in
II. Analysis
A. The Code
(1) In general.--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 of the taxpayer if--
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent * * *
(3) Insolvency exclusion limited to amount of insolvency.--In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.
The term “insolvent” is defined in
For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer‘s assets and liabilities immediately before the discharge.
B. Extrinsic Sources
1. Introduction
This Court‘s function in the interpretation of the Code is to construe the statutory language so as to give effect to the intent of Congress. See United States v. American Trucking Associations, 310 U.S. 534, 542 (1940); Fehlhaber v.
In the context of the parties’ dispute, we believe that the term “liabilities” in
2. Legislative History
The insolvency exclusion was added to the Code by the Bankruptcy Tax Act of 1980 (the Bankruptcy Tax Act),
The relevant committee reports (the committee reports) accompanying H.R. 5043, 96th Cong., 2d Sess. (1980), which became the Bankruptcy Tax Act, provide that the proposed insolvency exclusion is intended to insure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy, who is accorded a “fresh start” under the bankruptcy law) is not burdened with an immediate tax liability. See S. Rept. 96-1035, at 10 (1980), 1980-2 C.B. 620, 624; H. Rept. 96-833, at 9 (1980).
The pre-existing law is described as follows:
Under a judicially developed “insolvency exception,” no income arises from discharge of indebtedness if the debtor is insolvent both before and after the transaction;1 and if the transaction leaves the debtor with assets whose value exceeds remaining liabilities, income is realized only to the extent of the excess.2
* * *
S. Rept. 96-1035, supra, 1980-2 C.B. at 623; see H. Rept. 96-833, supra at 7. The proposed insolvency exclusion is described in terms that reflect the preexisting insolvency exception:
The bill provides that if a discharge of indebtedness occurs when the taxpayer is insolvent (but is not in a bankruptcy case), the amount of debt discharge is to be excluded from gross income up to the amount by which the taxpayer is insolvent.16
S. Rept. 96-1035, supra, 1980-2 C.B. at 627; see H. Rept. 96-833, supra at 12.
3. Relevant Cases Cited in the Committee Reports
The Supreme Court in United States v. Kirby Lumber Co., 284 U.S. 1 (1931), established the general rule that a debtor realizes income when discharged of indebtedness (i.e., relieved of indebtedness without full payment of the amount owed). In that case, the taxpayer repurchased some of its own bonds in the open market for $137,5212 less than what it had received upon issuance earlier that same year. Justice Holmes distinguished Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926), the Supreme Court‘s first pronouncement on the subject of income from the discharge of indebtedness, by stating:
the defendant in error [in Kerbaugh-Empire] owned the stock of another company that had borrowed money repayable in marks or their equivalent for an enterprise that failed. At the time of payment the
In Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933), the taxpayer was relieved of an indebtedness with respect to unpaid rent and interest thereon of $107,881 upon conveying to the lessor certain real property of lesser value. The Court of Appeals for the Fifth Circuit held that the transaction did not give rise to taxable income because the taxpayer remained insolvent3 after the discharge of its debt to the lessor and distinguished United States v. Kirby Lumber Co., supra, as follows:
The taxpayer‘s [Kirby Lumber Co.‘s] assets having been increased by the cash received for the bonds, by the repurchase of some of those bonds at less than par the taxpayer, to the extent of the difference between what it received for those bonds and what it paid in repurchasing them, had an asset which had ceased to be offset by any liability, with a result that after that transaction the taxpayer had greater assets than it had before. The decision * * * that the increase in clear assets so brought about constituted taxable income is
In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the taxpayer, pursuant to a “composition settlement“, paid to its creditors $15,473 in consideration of being relieved of the taxpayer‘s indebtedness to those creditors of $104,710. Prior to the composition settlement, the taxpayer was insolvent; after that settlement, the taxpayer had net assets of $39,597. The Board of Tax Appeals (the Board) agreed with the Commissioner
that the rationale of United States v. Kirby Lumber Co., 284 U.S. 1, should apply and that gain is realized to the extent of the value of the assets freed from the claims of creditors * * * The petitioner‘s net assets were increased from zero to $39,596.93 as a result of the cancellation of indebtedness by its creditors, and to that extent it had assets which ceased to be offset by any liability. * * * [Id. at 292.]
C. Discussion
1. Origin of the Net Assets Test
The Board‘s approach to a taxpayer in financial distress being discharged of an indebtedness, which approach was crystallized in Lakeland Grocery Co. v. Commissioner, supra, has been called, among other things, the “net assets” test.4 That
2. Codification of the Net Assets Test
The net assets test has been criticized, particularly for employing an improper criterion in the definition of income.6 Congress, however, codified the net assets test in
3. The Freeing-of-Assets Theory and the Statutory Insolvency Calculation
From our examination of the statutory language, the legislative history, and the relevant cases cited in the committee reports, we conclude that the analytical framework of the insolvency exclusion and its related provisions is based on the freeing-of-assets theory. That theory establishes the foundation for understanding the nature of the examination to be afforded to obligations claimed to be liabilities for purposes of the statutory insolvency calculation.
It should also be noted that the freeing-of-assets theory, much like its descendant the net assets test, has been criticized:
A particularly troublesome legacy of * * * [the passage in Kirby Lumber that the transaction “made available $137,521.30 assets previously offset by the obligation of bonds now extinct“] 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
(continued...)
Ability to pay an immediate tax (i.e., the statutory notion of insolvency) is a question of fact and, although Congress has specifically instructed us that (in determining ability to pay) assets are to be valued at fair market value, see
Although we have concluded that the analytical framework of the insolvency exclusion and its related provisions is based on the freeing-of-assets theory, we note that the committee reports indicate that Congress intended to achieve a measure of horizontal equity in enacting
To preserve the debtor‘s “fresh start” after bankruptcy, the bill provides that no income is recognized by reason of debt discharge in bankruptcy, so that a debtor coming out of bankruptcy (or an insolvent debtor outside bankruptcy) is not burdened with an immediate tax liability. * * * [Emphasis added.]
S. Rept. 96-1035, at 10 (1980), 1980-2 C.B. 620, 624; H. Rept. 96-833, at 9 (1980). That expression of legislative purpose may suggest that, in making an examination of obligations claimed to be liabilities for purposes of the statutory insolvency calculation, Congress intended an examination that is dependent on the treatment of such obligations in the bankruptcy context. See supra note 5; see also infra sec. II.C.7. (petitioners’ “likelihood of occurrence” test). The broad reach of the insolvency exclusion, however, indicates that Congress recognized the significant differences between a debtor coming out of bankruptcy and an insolvent debtor outside of bankruptcy and realized that different avenues of excluding income from
Title 11 of the United States Code (the Bankruptcy Code) offers bankruptcy relief for various types of debtors. 1 Collier on Bankruptcy, par. 1.03, at 1-21 (15th ed. Revised 1996). Chapter 7 of the Bankruptcy Code governs liquidation of a debtor, colloquially known as “straight bankruptcy“, and provides the mechanism for “the collection, liquidation, and distribution of the property of the debtor“, culminating in the discharge of the debtor. 6 Collier on Bankruptcy, par. 700.01, at 700-1 (15th ed. Revised 1996). Being thus relieved of his debts, the debtor coming out of bankruptcy is accorded a fresh start. To preserve that fresh start, the debtor pursuant to the bankruptcy exclusion is not burdened with an immediate tax liability on account of income from the discharge in bankruptcy of indebtedness.
For the insolvent debtor outside of bankruptcy, until (and unless) all of his debts are settled or discharged, he is not in the identical fresh start position as the debtor coming out of bankruptcy.
5. Respondent‘s Plain Meaning Argument
Respondent argues that the term “liabilities” in
FASB establishes and improves standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial statements. Kay & Searfoss, Handbook of Accounting and Auditing 46-8 (2d ed. 1989). Respondent directs our attention to FASB Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FASB Statement No. 5). By FASB Statement No. 5, FASB establishes standards of financial accounting and reporting for “loss contingencies“, which term is defined to mean, in general, a situation of possible loss that will be resolved in the future, see FASB Statement No. 5, par. 1. The likelihood of a loss can range from “probable” to “remote“. Id. at par. 3. The estimated loss associated with a liability must be accrued by a charge to income (which would result in a balance sheet liability) if both (1) information indicates that it is probable that the liability has been incurred and (2) the amount of the loss can be reasonably estimated. Id. at par. 8.13
In Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968), we rejected the Commissioner‘s suggestion that any person who guarantees the payment of a loan realizes income when the principal debtor makes payments on the loan. We distinguished the situation of a guarantor, who “obtains nothing except perhaps a taxable consideration for his promise“, from that of a debtor, “who as a result of the original loan obtains a nontaxable increase in assets“, and who, if relieved of the obligation to repay the loan, enjoys an increase in net worth that “may be properly taxable. United States v. Kirby Lumber, Co., 284 U.S. 1 (1931).” Id. at 813. This Court stated: “[W]here the guarantor is relieved of his contingent liability, either because of payment by the debtor to the creditor or because of a release given him by the creditor, no previously untaxed accretion in assets thereby results in an increase in net worth.” Id.
Respondent relies heavily on Landreth for the proposition that petitioners are precluded “from using their status as guarantors to render themselves insolvent within the meaning of
The Landreth Court reasoned that “[p]ayment by the principal debtor does not increase the guarantor‘s net worth; it merely prevents it, pro tanto, from being decreased.” Landreth v. Commissioner, 50 T.C. at * * * [813]. This rationale is sound for several reasons. The guarantor did not receive the tax-free accretion in wealth upon payment of the loan funds, but rather the principal obligor did. When the principal obligor makes payments pursuant to the loan, there is
no liability to the guarantor that is being reduced by such payments which would increase the guarantor‘s net worth. This is so because the guarantee did not represent a liability to the guarantor in the first instance, it merely represented the possibility of a liability in the future upon the occurrence or nonoccurrence of some future event. * * * the guarantees were not a liability to petitioners within the meaning of
I.R.C. § 108 for purposes of income or the insolvency exception to that income. To hold otherwise would result in an inconsistent application of this statute. If discharge of the contingent liability does not give rise to discharge income pursuant toI.R.C. § 108 , Congress could not have intended for taxpayers to use that very same debt to render themselves insolvent under that section. [Fn. ref. omitted; emphasis added.]
We believe that respondent misreads Landreth v. Commissioner, supra. The touchstone of this Court‘s analysis in Landreth is the absence of any “previously untaxed accretion in assets” that, by reason of the guarantor‘s being relieved of the contingent liability, “results in an increase in net worth“, id. at 813, and not the absence of a liability, the reduction of which increases the guarantor‘s net worth. Indeed, the cases relied on by this Court in Landreth, Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir. 1932), affg. 22 B.T.A. 1277 (1931); Fashion Park, Inc. v. Commissioner, 21 T.C. 600 (1954), specifically rejected the rationale that respondent now suggests is the basis of this Court‘s decision in Landreth. See Commissioner v. Rail Joint Co., supra at 752 (“But it is not universally true that by discharging a liability for less than its face the debtor necessarily receives a taxable gain.“);
Respondent‘s argument, in any event, reveals a more fundamental misconception regarding the insolvency exclusion and its related provisions. Without any justification in the Code or in the legislative history of section 108, respondent assumes that the insolvency exclusion and
As Congress enacted the insolvency exclusion, it eliminated the net assets test as a judicially created exception to the general rule of income from the discharge of indebtedness. See
Essentially, the insolvency exclusion defers to
7. Petitioners’ “Likelihood of Occurrence” Test
As an alternative to the argument that the full amount of both petitioners’ guarantees and the State tax exposure should be
In Covey v. Commercial Natl. Bank, supra at 660, the Court of Appeals for the Seventh Circuit stated that “[t]o decide whether a firm is insolvent within the meaning of
To allow debtors to avoid an immediate tax liability by virtue of a contingent liability that the debtor will not likely be called upon to pay, a consequence of the likelihood of occurrence test advanced by petitioners, would undermine the
In conclusion, a taxpayer claiming the benefit of the insolvency exclusion must prove (1) with respect to any obligation claimed to be a liability, that, as of the calculation date, it is more probable than not that he will be called upon to pay that obligation in the amount claimed and (2) that the total liabilities so proved exceed the fair market value of his assets.
D. Application
1. Petitioners’ Burden of Proof
As stated in section I.A., supra, the parties have stipulated that the exposure of each of the Merkels and the Hepburns pursuant to petitioners’ guarantees and the State tax exposure was $1 million and $490,000, respectively, and inclusion of the amount of their exposure under either obligation would make each of them insolvent to the extent of the full amount of the discharge of indebtedness income to each. Petitioners bear the burden of proof, Rule 142(a), but have proposed no findings of fact with respect to the other liabilities or the fair market value of the assets of either the Merkels or the Hepburns as of the measurement date. Thus, we must conclude that petitioners intend to prove that they (each of the Merkels and the Hepburns) were insolvent by showing that the amount of the liability under either, both, or the sum of petitioners’ guarantees and the State tax exposure was at least $490,000. If it were any less, we have
2. Petitioners’ Guarantees
The measurement date (the date on which petitioners must prove their insolvency) is August 31, 1991. By that date, SLC had defaulted on the SLC note, which petitioners had guaranteed, and petitioners and the bank had entered into the agreement. Under the agreement, among other things, if SLC and petitioners (and certain others) avoided bankruptcy for 400 days after the settlement date (August 2, 1991), petitioners would be released from their guarantees without having to make any payment to the bank. The 400-day period ended September 5, 1992.
By the terms of petitioners’ guarantees, petitioners’ obligations to pay the SLC note were unconditional. Moreover, we assume those obligations became fixed on April 16, 1991, when SLC was in default on the SLC note. Nevertheless, on the measurement date, those fixed obligations had been replaced by obligations that were dependent on certain conditions and, thus, were contingent obligations.
To address the likelihood of certain of those conditions, petitioners propose the following finding of fact (to which respondent objects):
42. During the continuing efforts by SLC and the Petitioners to work with creditors, there was a
continuing challenge as to whether acceptable workout arrangements could be made with these creditors. By the end of the summer of 1991 at about the time of the * * * discharge of indebtedness there was a real possibility that SLC and/or the guarantors would file for bankruptcy protection or that creditors would file for them. * * * [Emphasis added.]
Petitioners support that proposed finding of fact with the testimony of Robert Kennedy, an attorney who represented SLC in a general business capacity and who represented David Hepburn and Dudley Merkel in connection with certain guarantees of obligations of SLC. Based, in part, on his memory that SLC, David Hepburn, and Dudley Merkel owed a substantial amount (“I think it was $800,000“), he testified that there was “a real possibility that they could file bankruptcy at that time [by the end of the summer of 1991]“. Petitioners also point to the testimony of David Hepburn, who testified that, by the end of the summer of 1991, the possibility of bankruptcy for SLC or petitioners was not “insignificant“. Petitioners imply that the State tax assessment was a significant factor giving rise to the possibility of bankruptcy.
The uncertain variable on the measurement date was the probability of a bankruptcy event; the bankruptcy of either SLC or petitioners (or certain others) was a condition precedent to any demand for payment by the bank. None of the petitioners, however, provided sufficient details of their personal financial situations from which we could draw a conclusion as to the likelihood on the measurement date of a bankruptcy event.
3. State Tax Exposure
The State tax assessment became final on June 14, 1991, in the amount of $980,511.84. As in effect and in relevant part,
(b) Each responsible corporate officer is personally and individually liable for all of the following:
(1) All sales and use taxes collected by a corporation upon taxable transactions of the corporation.
(2) All sales and use taxes due upon taxable transactions of the corporation but upon which the corporation failed to collect the tax, but only if the responsible officer knew, or in the exercise of reasonable care should have known, that the tax was not being collected.
* * * * * * *
The liability of the responsible corporate officer is satisfied upon timely remittance of the tax to the Secretary by the corporation. If the tax remains unpaid by the corporation after it is due and payable, the Secretary may assess the tax against, and collect the tax from, any responsible corporate officer in accordance with the procedures in this Article for assessing and collecting tax from a taxpayer. As used in this section, the term “responsible corporate officer” includes the president and the treasurer of the corporation and any other officers assigned the duty of filing tax returns and remitting taxes to the Secretary on behalf of the corporation. * * * [
N.C. Gen. Stat. sec. 105-253(b) (1991).]
North Carolina law also provides procedures for assessing and collecting tax from a taxpayer.
The Department of Revenue never proposed nor made an assessment against any of petitioners relating to the State tax assessment. Petitioners have failed to prove that any assessment was ever likely to be made against Dudley Merkel and David Hepburn. Therefore, we have no basis to find that, as of the measurement date, the State tax exposure represented an obligation to pay that would result in petitioners’ being called upon to pay any amount on account thereof.
III. Conclusion
Petitioners have failed to prove that they would be called upon to pay any amount with respect to either petitioners’ guarantees or the State tax exposure, and, thus, neither
Decisions will be entered for respondent.
Notes
Bittker & Thompson, supra at 1165. That criticism, however, does not apply to a statutory exclusion from income that simply employs the freeing-of-assets theory to achieve objectives other than a definition of income. See infra sec. II.C.6.
FASB Emerging Issues Task Force, Issue Summary No. 85-20 (emphasis added).It is accepted current practice that a guarantor does not report on its balance sheet a liability for the obligation under guarantee; typically, however, there is disclosure of guarantees in footnotes. If it is determined “probable” that the guarantor will have to perform under the guarantee agreement (i.e., pay the lender on behalf of the borrower), an accrual for such amounts should be established by the guarantor in accordance with the principles of FASB Statement 5, “Accounting for Contingencies.”