Roderick E. Carlson and Jeanette S. Carlson v. Commissioner

116 T.C. No. 9UNITED STATES TAX COURT
RODERICK E. CARLSON AND JEANETTE S. CARLSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12068-99. Filed February 23, 2001.
Ps, husband and wife, purchased a fishing vessel
(vessel). They financed that purchase by borrowing
money from a bank. As security for the loan, Ps grant-
ed the bank a mortgage interest in the vessel. Ps
became delinquent in making payments to the bank on the
loan, and the bank foreclosed on the vessel, sold it as
part of that foreclosure, used the proceeds from that
sale to reduce the outstanding principal balance of the
loan, and discharged the remaining balance of the loan.
As a result, Ps realized capital gain of $28,621 and
discharge of indebtedness (DOI) income of $42,142.
Ps excluded the DOI income from their gross income
pursuant to the insolvency exception of sec.
108(a)(1)(B), I.R.C., because they determined that they
were insolvent within the meaning of sec. 108(d)(3),
I.R.C. In making the insolvency calculation prescribed
by sec. 108(d)(3), I.R.C., Ps excluded certain assets
that they claim are exempt from the claims of creditors
under applicable State law. The parties agree that if
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such assets may not be excluded in making that calcula-
tion, Ps were not insolvent within the meaning of sec.
108(d)(3), I.R.C., and may not exclude the DOI income
from gross income pursuant to sec. 108(a)(1)(B), I.R.C.
Held: The word “assets” as used in sec.
108(d)(3), I.R.C., includes assets exempt from the
claims of creditors under applicable State law.
Held, further: Ps are liable for the accuracy-
related penalty under sec. 6662(a), I.R.C., to the
extent stated herein.
Terry P. Draeger, for petitioners.
Kay Hill, for respondent.
OPINION
CHIECHI, Judge: Respondent determined a deficiency in, and
an accuracy-related penalty under section 6662(a)1 on, petition-
ers’ Federal income tax (tax) for 1993 in the amounts of $14,449
and $2,890, respectively.
The issues remaining for decision are:
(1) Are petitioners entitled to exclude from gross income
under section 108(a)(1)(B) discharge of indebtedness (DOI) income
in the amount of $42,142? We hold that they are not.
(2) Are petitioners liable for the accuracy-related penalty
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the year at issue.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
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under section 6662(a)? We hold that they are to the extent
stated herein.
Background
This case was submitted fully stipulated. The facts that
have been stipulated are so found.
Petitioners’ mailing address was in Chignik, Alaska, at the
time the petition was filed.
In 1988, petitioner Roderick E. Carlson, whose occupation
during the year at issue was commercial fisherman, and petitioner
Jeanette S. Carlson purchased the fishing vessel Yantari
(Yantari), a 44-foot seiner made of fiber glass that was built in
1982. They paid $202,451 for that fishing vessel, which included
the engine. Petitioners financed their purchase of the Yantari
by borrowing money (loan) from Seattle First National Bank (bank
or Seattle First). As security for that loan, petitioners
granted to the bank a so-called preferred marine mortgage inter-
est (mortgage) in the Yantari.
During 1992, petitioners became delinquent in making pay-
ments to the bank on the loan. On February 8, 1993, when the
unpaid principal balance of the loan was $137,142, the bank
foreclosed on the Yantari, the Yantari was sold for $95,000 as
part of that foreclosure, the proceeds from that sale were used
to reduce the outstanding principal balance of the loan by
$95,000, and the bank discharged the remaining $42,142 of the
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loan. (For convenience, we shall refer collectively to the
bank’s foreclosure on the Yantari and the concomitant sale of the
Yantari and other events that occurred on February 8, 1993, as
the foreclosure sale.) As a result of the foreclosure sale,
petitioners realized capital gain of $28,621 and DOI income of
$42,142.
Immediately preceding the foreclosure sale on February 8,
1993, petitioners had (1) assets located in the States of Alaska
and Washington which had an aggregate fair market value of
$875,251 and (2) liabilities which totaled $515,930.2 Included
2
Petitioners’ description of petitioners’ liabilities imme-
diately preceding the foreclosure sale on Feb. 8, 1993, and the
amounts thereof stipulated by the parties are:
Description of Amount of
Liability Liability
Seattle First $137,142 (principal)
23,973 (interest)
Washington Mutual 96,280
HFC (2nd Mortgage) 61,546
Seattle First 9,575
Seattle First 4,196
Seattle First 11,456
Seattle First Cr. 4,068
Alaska Airlines 284
Coastal Trans. 5,610
Discover 1,710
Hartig Rhodes 4,447
HFC Visa 804
Medden 1,246
Nordstrom 806
Bon Marche 1,855
Guiness Assoc. 35,100
Security Pacific 4,319
HFC Charge 6,941
Household Finance 2,828
(continued...)
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in petitioners’ assets immediately preceding the foreclosure sale
on February 8, 1993, was a so-called Alaska limited entry fishing
permit which had a fair market value of $393,400.3 Petitioners’
Alaska limited entry fishing permit was a purse seine permit for
the commercial fishing of salmon in the Chignik, Alaska fishery
(petitioners’ fishing permit).
Petitioners jointly filed Form 1040, U.S. Individual Income
Tax Return, for 1993 (petitioners’ joint return). In petition-
ers’ joint return, petitioners did not report any gain or loss or
any DOI income as a result of the foreclosure sale of the
2
(...continued)
Washington Mutual 1,039
I.R.S. 28,000
Sea Catch 24,950
ISA 22,755
Tina Carlson 25,000
3
The remaining assets included in petitioners’ total assets
immediately preceding the foreclosure sale on Feb. 8, 1993, and
the respective fair market values thereof stipulated by the
parties were:
Asset Fair Market Value
Cash $ 7,261
Land in Chignik, Alaska 35,000
F/V Yantari 95,000
F/V Little One 1,964
Fish Bldg., Chignik, Alaska 1,500
Residence, Chignik, Alaska 150,000
Residence, Edmonton, Wash. 159,026
1989 Ford Aerostar 15,000
1988 Ford F150 Pickup 10,000
Personal prop., Chignik, Alaska 2,100
Office equip., Chignik, Alaska 2,000
Arabian horse 3,000
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Yantari. However, petitioners attached to that return Form 1099-
A, Acquisition or Abandonment of Secured Property (Form 1099-A),
which the bank issued to petitioners and which showed that, on a
date that is not legible,4 the outstanding principal balance of
the loan secured by the Yantari was $137,142. The following was
written by hand at the bottom of Form 1099-A that was attached to
petitioners’ joint return: “Taxpayer Was Insolvent - No Tax
Consequence” (written statement).
Respondent timely issued to petitioners a notice of defi-
ciency for 1993 (notice). In the notice, respondent determined,
inter alia, to increase petitioners’ income by $42,142 for
“RELIEF OF DEBT” and by $28,629 for “DISPOSITION OF F/V YANTARNI
[sic]”. Respondent also determined in the notice to impose an
accuracy-related penalty under section 6662(a).
Discussion
Petitioners bear the burden of proving that the determina-
tions in the notice are erroneous. See Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). That this case was submit-
ted fully stipulated does not change that burden or the effect of
a failure of proof. See Rule 122(b); Borchers v. Commissioner,
95 T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th Cir. 1991).
4
Although the date on Form 1099-A is illegible, the parties
stipulated that the date for determining discharge of indebted-
ness income is Feb. 8, 1993.
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DOI Income--Section 108
Section 61(a) defines the term “gross income” broadly to
mean all income from whatever source derived, including income
from discharge of indebtedness. See sec. 61(a)(12). Section
108(a) provides certain exceptions to section 61(a)(12). See
Gitlitz v. Commissioner, 531 U.S. __, __, 69 U.S.L.W. 4060, 4062
(Jan. 9, 2001). As pertinent here, section 108(a)(1)(B) (insol-
vency exception) excludes from gross income any amount that
otherwise would be includable in gross income by reason of the
discharge in whole or in part of indebtedness of the taxpayer if
the discharge occurs when the taxpayer is insolvent. The amount
of DOI income excluded under section 108(a)(1)(B) is not to
exceed the amount by which the taxpayer is insolvent. See sec.
108(a)(3). The term “insolvent” is defined in section 108(d)(3)
as follows:
(3) Insolvent.–-For purposes of this section
[108], the term “insolvent” means the excess of liabil-
ities 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.
The parties’ general dispute here is whether, pursuant to
section 108(a)(1)(B), petitioners may exclude from gross income
for the year at issue $42,142 of DOI income resulting from the
foreclosure sale on February 8, 1993. The parties agree that
resolution of that issue depends on whether, immediately before
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that foreclosure sale, petitioners were insolvent within the
meaning of section 108(d)(3). The parties’ specific dispute here
concerns the meaning of the word “assets” as used in section
108(d)(3).
It is petitioners’ position that the word “assets” as used
in section 108(d)(3) does not include assets that are exempt from
the claims of creditors under applicable State law. In support
of that argument, petitioners rely principally on Cole v. Commis-
sioner, 42 B.T.A. 1110 (1940), and Hunt v. Commissioner, T.C.
Memo. 1989-335. According to petitioners, petitioners’ fishing
permit, which had a fair market value of $393,400 immediately
preceding the foreclosure sale on February 8, 1993, is an asset
exempt from the claims of creditors under the law of the State of
Alaska.5 Petitioners maintain that, pursuant to Cole and Hunt,
5
Petitioners also contend that certain other assets, i.e.,
petitioners’ principal residence, petitioners’ household goods
and wearing apparel, petitioners’ tools of the trade, and peti-
tioners’ motor vehicle (collectively, petitioners’ other assets),
are assets exempt from the claims of creditors under applicable
State law to the extent of $54,000, $3,000, $2,800, and $3,000,
respectively. According to petitioners, those assets also are
not to be included in petitioners’ assets in performing the
calculation set forth in sec. 108(d)(3) for determining whether
petitioners are insolvent (insolvency calculation). Assuming
arguendo that we were to hold that the word “assets” as used in
sec. 108(d)(3) does not include assets that are exempt from the
claims of creditors under applicable State law and that petition-
ers’ fishing permit is an asset that is exempt from the claims of
creditors under the law of the State of Alaska, petitioners would
be insolvent within the meaning of sec. 108(d)(3) without regard
to whether a total of $62,800 of petitioners’ other assets that
petitioners claim are exempt from the claims of creditors under
(continued...)
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petitioners’ fishing permit should be excluded in performing the
insolvency calculation under section 108(d)(3). If the Court
were to sustain petitioners’ position, the parties agree that
petitioners would be insolvent within the meaning of section
108(d)(3) and that the insolvency exception of section
108(a)(1)(B) would exclude from their gross income for the year
at issue $42,142 of DOI income resulting from the foreclosure
sale on February 8, 1993.
Respondent counters that Cole v. Commissioner, supra, and
Hunt v. Commissioner, supra, on which petitioners rely do not
apply in the instant case. According to respondent, the plain
meaning of the word “assets”, as well as the legislative history
of section 108(a)(1)(B), rejects the narrow definition of that
word which petitioners proffer. Respondent argues in the alter-
native that even if the Court were to sustain petitioners’
5
(...continued)
applicable State law are to be excluded in the insolvency calcu-
lation under that section. Conversely, assuming arguendo that we
were to hold that the word “assets” as used in sec. 108(d)(3)
does not include assets that are exempt from the claims of
creditors under applicable State law and that a total of $62,800
of petitioners’ other assets are exempt from the claims of
creditors under applicable State law, petitioners would not be
insolvent within the meaning of sec. 108(d)(3) unless petition-
ers’ fishing permit were exempt from the claims of creditors
under applicable State law and were to be excluded in performing
the insolvency calculation under that section. Consequently, we
shall address petitioners’ argument regarding the meaning of the
word “assets” as used in sec. 108(d)(3) in the context solely of
petitioners’ fishing permit, and not in the context of petition-
ers’ other assets, all of which they claim are exempt from the
claims of creditors under applicable State law.
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position as to the meaning of the word “assets” as used in
section 108(d)(3), petitioners have failed to show that petition-
ers’ fishing permit is in all instances exempt from the claims of
creditors under the law of the State of Alaska.
Our function in interpreting the Code is to construe it in a
way that will give effect to the intent of Congress. See Merkel
v. Commissioner, 109 T.C. 463, 468 (1997), affd. 192 F.3d 844(9th Cir. 1999). Our starting point in resolving the parties’
dispute over the meaning of the word “assets” as used in section
108(d)(3) is the plain meaning of the language used by Congress.
See American Tobacco Co. v. Patterson, 456 U.S. 63, 68 (1982);
Merkel v. Commissioner, 192 F.3d 844, 848 (9th Cir. 1999), affg.
109 T.C. 463 (1997). Where, as is the case here, the statute
does not define the word,6 we generally interpret it by using its
ordinary and common meaning. See Merkel v. Commissioner, 192
F.3d at 848 (quoting United States v. Iverson, 162 F.3d 1015,
1022 (9th Cir. 1998)). If the ordinary and common meaning of the
statutory language in question supports only one construction,
6
When Congress defined the term “insolvent” in sec.
108(d)(3) to mean the excess of liabilities over the fair market
value of assets, it did not provide in sec. 108 a definition of
the word “assets” (or the word “liabilities”, see Merkel v.
Commissioner, 109 T.C. 463, 468 (1997), affd. 192 F.3d 844 (9th
Cir. 1999)). Nor does the Code contain any generally applicable
definition of the word “assets” (or the word “liabilities”, see
id.). The regulations promulgated under sec. 108 do not elabo-
rate on the definition of the term “insolvency” in sec. 108(d)(3)
and do not define the word “assets” (or the word “liabilities”,
see id.) used in that definition.
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that statutory language is unambiguous. See id. (quoting Cali-
fornia v. Montrose Chem. Corp., 104 F.3d 1507, 1514 (9th Cir.
1997)). However, where the ordinary and common meaning of the
statutory language supports more than one interpretation, the
statutory language is ambiguous, and we may consult legislative
history to assist us in interpreting the language in question.
See Merkel v. Commissioner, 109 T.C. at 468-469. We are to
construe exclusions from income, like section 108(a)(1)(B),
narrowly in favor of taxation. See Merkel v. Commissioner, 192
F.3d at 848 (citing United States v. Centennial Sav. Bank FSB,
499 U.S. 573, 583 (1991); Harbor Bancorp & Subsidiaries v.
Commissioner, 115 F.3d 722, 732 (9th Cir. 1997)).
Bearing in mind the foregoing principles of statutory
construction, we shall consider initially respondent’s contention
that the plain meaning of the word “assets” supports only one
construction of that word as used in section 108(d)(3). As
pertinent here, the common and ordinary meaning of the word
“assets” set forth in Merriam-Webster’s Collegiate Dictionary 69
(10th ed. 1996) is:
1 pl a : the property of a deceased person subject by
law to the payment of his or her debts and legacies b :
the entire property of a person, association, corpora-
tion, or estate applicable or subject to the payment of
debts * * * 3 * * * b pl : the items on a balance sheet
showing the book value of property owned
The first and second dictionary definitions of the word “assets”
quoted above appear to exclude from that definition assets exempt
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from the claims of creditors under applicable State law. That is
because under applicable State law such assets generally are not
subject to the payment of debts. However, the third dictionary
definition of the word “assets” quoted above seems to include
assets exempt from the claims of creditors under applicable State
law. That is because such assets are items appearing on a
balance sheet showing the value of property owned. See Account-
ing and Fin. Reporting for Personal Fin. Statements, Statement of
Position 82-1 (AICPA 1982). We conclude that the common and
ordinary meaning of the word “assets” as reflected in the dictio-
nary definition of that word does not support only one construc-
tion. We next turn to pertinent legislative history for guidance
in interpreting what Congress intended by its use of the word
“assets” in the definition of the term “insolvent” in section
108(d)(3).
Congress enacted section 108(a)(1)(B) and related provisions
(i.e., section 108(a)(3), (d)(3), and (e)(1)) into the Code in
1980 as part of the Bankruptcy Tax Act of 1980, Pub. L. 96-589,
sec. 2(a), 94 Stat. 3389 (1980 Bankruptcy Tax Act). The stated
purpose of the 1980 Bankruptcy Tax Act was to “accommodate
bankruptcy policy and tax policy.” S. Rept. 96-1035 at 9-10
(1980), 1980-2 C.B. 620, 624. Such an accommodation was neces-
sary after Congress made significant changes to the Federal
bankruptcy laws in 1978 by passing the Bankruptcy Reform Act of
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1978, Pub. L. 95-598, 92 Stat. 2549 (1978 Bankruptcy Reform Act),
which enacted title 11 into the United States Code (title 11).
In passing the 1980 Bankruptcy Tax Act, Congress “intended to
complete the process of revising and updating Federal bankruptcy
laws by providing rules governing the tax aspects of bankruptcy
and related tax issues.” Staff of Joint Comm. on Taxation,
Description of H.R. 5043 (Bankruptcy Tax Act of 1980) as Passed
by the House, at 3 (J. Comm. Print 1980). Both the Senate and
House reports accompanying H.R. 5043, 96th Cong., 2d Sess. (1980)
(H.R. 5043), which became the 1980 Bankruptcy Tax Act, indicate
that the proposed insolvency exception in section 108(a)(1)(B)
was intended to ensure that an insolvent debtor outside of
bankruptcy (like a debtor coming out of bankruptcy who is ac-
corded a “fresh start” under the Federal bankruptcy laws) is not
to be burdened with an immediate tax liability. See S. Rept. 96-
1035, supra, 1980-2 C.B. at 624; H. Rept. 96-833, at 9 (1980).
The committee reports accompanying H.R. 5043 describe in
pertinent part the tax law governing DOI income that was extant
at the time Congress passed the 1980 Bankruptcy Tax Act, as
follows:
Under present law, income is realized when indebt-
edness is forgiven or in other ways cancelled (sec.
61(a)(12) of the Internal Revenue Code). For example,
if a corporation has issued a $1,000 bond at par which
it later repurchases for only $900, thereby increasing
its net worth by $100, the corporation realizes $100 of
income in the year of repurchase (United States v.
Kirby Lumber Co., 284 U.S. 1 (1931)).
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There are several exceptions to the general rule
of income realization. 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 * * *
1
Treas. Regs. § 1[.]61-12(b)(1); Dallas Transfer &
Terminal Warehouse Co. v. Comm’r, 70 F.2d 95 (5th Cir.
1934).
2
Lakeland Grocery Co., 36 B.T.A. 289 (1937).
S. Rept. 96-1035, supra, 1980-2 C.B. at 623; see H. Rept. 96-833,
supra at 7.
We shall discuss in greater detail the three cases referred
to in the foregoing excerpt of the committee reports accompanying
H.R. 5043. In United States v. Kirby Lumber Co., 284 U.S. 1(1931), the Supreme Court of the United States (Supreme Court)
established the rule that a debtor realizes (and must recognize)
income when discharged of indebtedness, i.e., when relieved of
indebtedness without full payment of the amount owed. In Kirby
Lumber Co., the taxpayer had issued bonds for which it received
par value. In the same year, the taxpayer repurchased some of
those bonds in the open market for less than their par value
issue price. See id. at 2. The Supreme Court held that the
taxpayer must recognize income in an amount (i.e., $137,521.30)
equal to the difference between the issue price and the repur-
chase price of the bonds in question. See id. at 2, 3. In so
holding, the Supreme Court reasoned: “As a result of its [tax-
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payer’s] dealings it made available $137,521.30 [of] assets
previously offset by the obligation of bonds now extinct.” Id.
at 3.
Several years after the Supreme Court decided Kirby Lumber
Co., the U.S. Court of Appeals for the Fifth Circuit distin-
guished that case and established an insolvency exclusion to the
rule that the Supreme Court had announced in that case. See
Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d
95 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933). In Dallas
Transfer & Terminal Warehouse Co., the taxpayer was relieved of
indebtedness as the lessee of certain real property with respect
to unpaid rent and other bills totaling $107,881 when it conveyed
to the lessor of that property certain real property of lesser
value (i.e., $42,507) in which the taxpayer’s equity at the time
of conveyance was $17,507. See id. The Court of Appeals held
that the taxpayer did not realize income as a result of that
transaction. See id. at 96. In so holding, the Court of Appeals
stated:
In effect the transaction was similar to what occurs in
an insolvency or bankruptcy proceeding when, upon a
debtor surrendering, for the benefit of his creditors,
property insufficient in value to pay his debts, he is
discharged from liability for his debts. This does not
result in the debtor acquiring something of exchange-
able value in addition to what he had before. There is
a reduction or extinguishment of liabilities without
any increase of assets. There is an absence of such a
gain or profit as is required to come within the ac-
cepted definition of income. * * * It hardly would be
contended that a discharged insolvent or bankrupt
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receives taxable income in the amount by which his
provable debts exceed the value of his surrendered
assets. * * *
Id. The Court of Appeals distinguished United States v. Kirby
Lumber Co., supra, as follows:
The instant case is substantially different from the
[Kirby Lumber Co.] case * * *. In the last-mentioned
case a corporation issued its bonds at par and in the
same year repurchased some of them at less than par.
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 repur-
chasing 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 [Kirby Lumber Co.] * * * that the
increase in clear assets so brought about constituted
taxable income is not applicable to the facts of the
instant case, as the cancellation of the respondent’s
[Dallas Transfer & Terminal Warehouse Co.’s] past due
debt to its lessor did not have the effect of making
the respondent’s assets greater than they were before
that transaction occurred. * * *
Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra
at 96.
In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289(1937), the Board of Tax Appeals (Board) considered the insol-
vency exclusion established by Dallas Transfer & Terminal Ware-
house Co. v. Commissioner, supra. In Lakeland Grocery Co., the
taxpayer entered into a so-called composition settlement under
which the taxpayer paid its creditors $15,473 in consideration of
being relieved of its indebtedness to those creditors in the
amount of $104,710. Prior to entering into the composition
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settlement, the taxpayer was insolvent. After that settlement,
the taxpayer had net assets of $39,597, which, as noted by the
Board, “were freed from the claims of creditors as a result of
the * * * [discharge of indebtedness].” Lakeland Grocery Co. v.
Commissioner, supra at 291. The Board distinguished Dallas
Transfer & Terminal Warehouse Co. v. Commissioner, supra, from
the facts before it and concluded that the rationale of United
States v. Kirby Lumber Co., 284 U.S. 1 (1931), was applicable to
those facts. See Lakeland Grocery Co. v. Commissioner, supra at
291-292. The Board held that the taxpayer realized gain to the
extent of the value of the assets freed from the claims of its
creditors, i.e., to the extent it had assets (i.e., $39,597)
which ceased to be offset by any liability. See id. at 292.
We recently had occasion in Merkel v. Commissioner, 109 T.C.
463 (1997), to review the three cases (United States v. Kirby
Lumber Co., supra, Dallas Transfer & Terminal Warehouse Co. v.
Commissioner, supra, and Lakeland Grocery Co. v. Commissioner,
supra) to which the committee reports accompanying H.R. 5043
refer and which we discuss above. In Merkel, as here, we had to
determine whether a debtor qualified for the insolvency exception
in section 108(a)(1)(B). However, in order to resolve that issue
in Merkel, we had to determine the meaning of the word “liabili-
ties” as used in the definition of the term “insolvent” in
section 108(d)(3). See Merkel v. Commissioner, supra at 466-467.
- 18 -
We observed in Merkel:
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. That test is based on
the so-called freeing-of-assets theory derived from the
Supreme Court’s statement in Kirby Lumber that the
transaction “made available $137,521.30 assets previ-
ously offset by the obligation of bonds now extinct”.
* * * The net assets test is a corollary of the princi-
ple in Dallas Transfer that an insolvent debtor does
not realize income when discharged of indebtedness.
Under the net assets test, if the debtor remains insol-
vent (liabilities exceed assets) after being discharged
of indebtedness, no assets have been freed as a result
of the discharge since the debtor’s assets are still
more than offset by his postdischarge liabilities, and,
thus, no gross income is realized; if the debtor is
solvent (assets exceed liabilities) after being dis-
charged, then the discharge has freed the debtor’s
assets from the offset of his liabilities to that
extent, and, thus, gross income is realized from the
discharge. In essence, the net assets test is simply
an examination of the debtor’s net worth after he is
discharged of indebtedness–-an increase in net worth
gives rise to income, but a decrease in negative net
worth does not.
Id. at 472-473; fn. ref. omitted.
We explained in Merkel that Congress
codified the net assets test in section 108(a)(1)(B),
(a)(3), and (d)(3) as a means of determining an exclu-
sion from gross income of an item of income derived
from the discharge of indebtedness. Aside from the
parallel descriptions in the committee reports of the
preexisting law and of the proposed insolvency exclu-
sion, * * * that codification is apparent from the
statutory insolvency calculation coupled with the
insolvency exclusion limitation provided in section
108(a)(3), which together share the same underlying
analytical framework as the net assets test. That
framework requires an examination of the debtor’s
assets and liabilities for the purpose of determining
whether the debtor’s net worth turns positive (assets
- 19 -
exceed liabilities), i.e., whether assets are freed, as
a result of the debtor’s being discharged of indebted-
ness.
* * * * * * *
From our examination of the statutory language,
the legislative history, and the relevant cases cited
in the committee reports, we conclude that the analyti-
cal framework of the insolvency exclusion and its
related provisions [in section 108] is based on the
freeing-of-assets theory. * * *
A solvent debtor is capable of meeting his finan-
cial obligations because his assets equal or exceed his
liabilities. That excess (if any) is not increased
when an obligation that offsets assets is paid in full
because the reduction in liabilities is equal to the
reduction in assets. If the reduction in liabilities
exceeds the reduction in assets, then, under the
freeing-of-assets theory, the solvent debtor has real-
ized a gain to the extent of that excess. * * * Pursu-
ant to the freeing-of-assets theory, a debtor does not
realize income when discharged of a particular indebt-
edness, however, if his postdischarge liabilities equal
or exceed his postdischarge assets (if any); i.e.,
under the net assets test, the debtor’s liabilities
equal or exceed his assets after the discharge (or, the
statutory insolvency calculation shows that the debtor
is insolvent by an amount greater than or equal to the
discharge of indebtedness income * * *
Id. at 473-475; fn. ref. omitted.
With the foregoing in mind, we shall now consider petition-
ers’ argument that we follow Cole v. Commissioner, 42 B.T.A. 1110(1940), in defining the word “assets” as used in the definition
of the term “insolvent” in section 108(d)(3).7 In Cole, the
7
Petitioners also urge us to follow Hunt v. Commissioner,
T.C. Memo. 1989-335. Petitioners argue that we previously held
in Hunt that, for purposes of sec. 108(a)(1)(B), the word “as-
sets” in sec. 108(d)(3) does not include assets exempt from the
(continued...)
- 20 -
Board began its analysis by acknowledging that under Lakeland
Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the taxpayer,
a resident of New York, would realize income upon the discharge
of his indebtedness “to the extent of the excess of total assets
over total liabilities immediately after * * * [discharge].”
Cole v. Commissioner, supra at 1112. In determining whether
there was such an excess, the Board stated:
In determining the amount in [sic] which peti-
tioner’s net assets were increased as a result of the
cancellation of petitioner’s indebtedness by his credi-
tor, i.e., the amount of petitioner’s assets which
ceased to be offset by claims of creditors, there
should be, and has been, omitted from the value of
petitioner’s assets the value of his equity in ten life
insurance policies. * * *
7
(...continued)
claims of creditors under applicable State law. We reject that
argument and petitioners’ characterization of Hunt as a case
decided under sec. 108(a)(1)(B). Hunt involved tax year 1980.
The insolvency exception in sec. 108(a)(1)(B) that was enacted
into the Code as part of the 1980 Bankruptcy Tax Act became
effective for transactions occurring after Dec. 31, 1980. See
1980 Bankruptcy Tax Act, Pub. L. 96-589, sec. 7(a)(1), 94 Stat.
3411. Although in certain circumstances Congress made available
to debtors in bankruptcy cases or similar judicial proceedings an
election to substitute Sept. 30, 1979, as the effective date of
the 1980 Bankruptcy Tax Act, see id. at sec. 7(f)(1), there is no
indication in Hunt that the taxpayers involved there made such an
election, see Hunt v. Commissioner, supra. Our discussion in
Hunt of sec. 108 as amended by the 1980 Bankruptcy Tax Act
(amended sec. 108) is dictum and appears in Hunt after we re-
solved the issue presented to us with respect to DOI income under
the tax law that was extant prior to the passage of the 1980
Bankruptcy Tax Act. See Hunt v. Commissioner, supra. In this
connection, it is noteworthy that we began our discussion of
amended sec. 108 in Hunt by stating: “Furthermore, the correct-
ness of our result is reinforced by the language of [amended]
section 108.” Id.
- 21 -
Id. at 1113. The Board explained in Cole that it excluded the
value of the taxpayer’s equity in certain life insurance policies
from its determination of the value of the taxpayer’s assets
because “Under the applicable law of New York * * * such equity
in insurance was free from claims of creditors.” Id.
We reject petitioners’ argument that we apply Cole in this
case. When Congress enacted the insolvency exception into the
Code as section 108(a)(1)(B), one of the related provisions it
also enacted is section 108(e)(1).8 Section 108(e)(1) provides
that, for purposes of title 26 of the United States Code (i.e.,
the Internal Revenue Code, including section 61(a)(12)), “there
shall be no insolvency exception from the general rule that gross
income includes income from the discharge of indebtedness”
except as provided in section 108(a)(1)(B). As the Supreme Court
8
When Congress “codified the net assets test in section
108(a)(1)(B), (a)(3), and (d)(3),” Merkel v. Commissioner, 109
T.C. at 473, it codified the net assets test developed by Dallas
Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95(5th Cir. 1934), revg. 27 B.T.A. 651 (1933), and Lakeland Grocery
Co. v. Commissioner, 36 B.T.A. 289 (1937). It did not codify the
application of the net assets test by Cole v. Commissioner, 42
B.T.A. 1110 (1940). The committee reports accompanying H.R. 5043
make no reference to and do not describe the holding of Cole,
whereas those reports do refer to and describe the holdings of
Dallas Transfer & Terminal Warehouse Co. and Lakeland Grocery Co.
Nor do those committee reports refer to the two cases that
applied Cole v. Commissioner, supra, which had been decided as of
the time Congress passed the 1980 Bankruptcy Tax Act, i.e., Davis
v. Commissioner, 69 T.C. 814, 833-834 (1978), and Estate of
Marcus v. Commissioner, T.C. Memo. 1975-9. See also Babin v.
Commissioner, T.C. Memo. 1992-673, affd. on other grounds 23 F.3d
1032 (6th Cir. 1994); Hunt v. Commissioner, supra, decided after
Congress passed that Act.
- 22 -
very recently stated, “Section 108(e)[(1)] precludes us from
relying on any understanding of the judicial insolvency exception
that was not codified in §108.” Gitlitz v. Commissioner, 531
U.S. at __, 69 U.S.L.W. at 4063. Even before Gitlitz was de-
cided, we reached a similar conclusion in Merkel v. Commissioner,
109 T.C. 463 (1997). We stated in pertinent part:
As Congress enacted the insolvency exclusion
[section 108(a)(1)(B)], it eliminated the net assets
test as a judicially created exception to the general
rule of income from the discharge of indebtedness. See
sec. 108(e)(1). The fundamental difference between the
insolvency exclusion [in section 108(a)(1)(B)] and the
[judicially developed] net assets test is that the
insolvency exclusion is applicable only if there exists
income from the discharge of indebtedness, whereas the
net assets test engages in the threshold inquiry.
Therefore, unlike the net assets test, the insolvency
exclusion does not necessarily invade the province of
section 61(a)(12).
Essentially, the insolvency exclusion defers to
section 61(a)(12) as to the definition of the term
“gross income”, but represents a policy judgment that
certain of that income should not give rise to an
immediate tax liability. The relevant committee re-
ports intimate that the policy judgment underlying the
insolvency exclusion serves a humanitarian purpose–-to
avoid burdening an insolvent debtor outside of bank-
ruptcy with an immediate tax liability. * * *
Merkel v. Commissioner, supra at 481-482; fn. ref. omitted.
We conclude that section 108(e)(1) precludes in this case
(or in any other case involving the insolvency exception in
section 108(a)(1)(B)) the application of Cole v. Commissioner,
supra, and any other judicially developed insolvency exception to
the general rule of section 61(a)(12) that gross income includes
- 23 -
income from the discharge of indebtedness. See Gitlitz v.
Commissioner, supra at ___, 69 U.S.L.W. at 4063; Merkel v.
Commissioner, supra at 481.
Our conclusion that Cole v. Commissioner, 42 B.T.A. 1110(1940), has no application in the instant case not only carries
out the directive of section 108(e)(1), it also carries out the
intention of Congress in enacting section 108(d)(3) that assets
exempt from the claims of creditors under applicable State law
are not to be excluded in determining the fair market value of a
taxpayer’s assets for purposes of ascertaining whether the
taxpayer is insolvent within the meaning of section 108(d)(3).
Congress’ intention is disclosed by an examination of section
108(d)(3) together with the 1978 Bankruptcy Reform Act and its
legislative history and the 1980 Bankruptcy Tax Act and its
legislative history. One of the stated policies of the 1978
Bankruptcy Reform Act was “to provide a fresh start”, S. Rept.
95-989, at 6 (1978), for debtors coming out of bankruptcy. The
principal mechanism adopted by Congress in the 1978 Bankruptcy
Reform Act for providing such a “fresh start” in the Federal
bankruptcy laws is through the discharge of debts.9 See id. at
98.
9
The discharge-of-debt provisions of the 1978 Bankruptcy
Reform Act, Pub. L. 95-598, sec. 727, 92 Stat. 2609, are de-
scribed in the accompanying Senate report as “the heart of the
fresh start provisions of the bankruptcy law”. S. Rept. 95-989,
at 7, 98 (1978).
- 24 -
Congress also adopted another method in the 1978 Bankruptcy
Reform Act for providing a “fresh start” to debtors coming out of
bankruptcy, namely, allowing debtors in bankruptcy to retain
after bankruptcy certain property classified as exempt property
for purposes of title 11 (title 11 exempt property), which
includes property exempt from the claims of creditors under
applicable State law. See 1978 Bankruptcy Reform Act, Pub. L.
95-598, sec. 522(b)(2)(A), 92 Stat. 2549, 2586, 11 U.S.C. sec.
522(b)(2)(A) (Supp. II, 1978);10 see also S. Rept. 95-989, supra
at 6. The role of title 11 exempt property in the Federal
bankruptcy laws is evidenced by, for example, the definition of
the term “insolvent” for purposes of title 11 that Congress
adopted in section 101(26) of the 1978 Bankruptcy Reform Act, 92
10
Although there have been amendments to 11 U.S.C. sec.
522(b) as originally enacted that were in effect for the year at
issue, those amendments are not material to a resolution of the
issue presented here under sec. 108. See 11 U.S.C. sec. 522(b)
(1994).
- 25 -
Stat. 2553, 11 U.S.C. sec. 101(26) (Supp. II, 1978).11 In deter
11
Sec. 101(26) of the 1978 Bankruptcy Reform Act provides:
(26) “insolvent” means--
(A) with reference to an entity other than a
partnership, financial condition such that the sum of
such entity’s debts is greater than all of such en-
tity’s property, at a fair valuation, exclusive of–-
(i) property transferred, concealed, or re-
moved with intent to hinder, delay, or defraud
such entity’s creditors; and
(ii) property that may be exempted from prop-
erty of the [bankruptcy] estate under section 522
of this title; * * *
1978 Bankruptcy Reform Act, sec. 101(26), 92 Stat. 2549, 11
U.S.C. sec. 101(26) (Supp. II, 1978). Although there have been
amendments to sec. 101(26) of title 11 as originally enacted that
were in effect for the year at issue, those amendments are not
material to a resolution of the issue presented here under sec.
108. See 11 U.S.C. sec. 101(32) (1994).
Sec. 522(b) of the 1978 Bankruptcy Reform Act, 92 Stat.
2586, 11 U.S.C. sec. 522(b) (Supp. II, 1978), which allows a
debtor in bankruptcy to exclude exempt title 11 property from
property of the debtor’s bankruptcy estate, provides:
(b) Notwithstanding section 541 of this title, an
individual debtor may exempt from property of the
[bankruptcy] estate either–-
(1) property that is specified under subsec-
tion (d) of this section, unless the State law
that is applicable to the debtor under paragraph
(2)(A) of this subsection specifically does not so
authorize; or, in the alternative,
(2)(A) any property that is exempt under
Federal law, other than subsection (d) of this
section, or State or local law that is applicable
on the date of the filing of the petition at the
place in which the debtor’s domicile has been
(continued...)
- 26 -
mining whether a debtor in bankruptcy is insolvent for purposes
of title 11, the debtor’s title 11 exempt property, which in-
cludes property exempt from the claims of creditors under appli-
cable State law, is excluded from the property he otherwise owns.
See 1978 Bankruptcy Reform Act, sec. 101(26), 11 U.S.C. sec.
101(26) (Supp. II, 1978).
When it passed the 1980 Bankruptcy Tax Act, Congress was
aware of the role that it had decided to give title 11 exempt
property in the 1978 Bankruptcy Reform Act. In particular, when
Congress enacted into the Code the insolvency exception in
section 108(a)(1)(B) and the definition of “insolvent” in section
108(d)(3), it knew that it had decided to, and did, define the
term “insolvent” in section 101(26) of the 1978 Bankruptcy Reform
Act, 11 U.S.C. sec. 101(26) (Supp. II, 1978), to exclude specifi-
11
(...continued)
located for the 180 days immediately preceding the
date of the filing of the petition, or for a lon-
ger portion of such 180-day period than in any
other place; and
(B) any interest in property in which the
debtor had, immediately before the commencement of
the case, an interest as a tenant by the entirety
or joint tenant to the extent that such interest
as a tenant by the entirety or joint tenant is
exempt from process under applicable nonbankruptcy
law.
Sec. 541 of the 1978 Bankruptcy Reform Act, 92 Stat. 2594,
governs the creation and composition of the bankruptcy estate.
Sec. 522(d) of the 1978 Bankruptcy Reform Act, 92 Stat. 2586,
identifies 11 categories of property, each of which is considered
title 11 exempt property.
- 27 -
cally title 11 exempt property of a debtor in bankruptcy, includ-
ing property exempt from the claims of creditors under applicable
State law, in determining whether that debtor is insolvent for
purposes of the Federal bankruptcy laws. See S. Rept. 96-1035 at
24 (1980), 1980-2 C.B. 620, 632.12 However, Congress decided to,
and did, adopt a different definition of the term “insolvent” in
section 108(d)(3) for purposes of section 108. Unlike the
definition of the term “insolvent” in section 101(26) of the 1978
Bankruptcy Act, 11 U.S.C. sec. 101(26) (Supp. II, 1978), which
Congress adopted for purposes of the Federal bankruptcy laws, the
definition of that term which Congress adopted for purposes of
section 108 does not specifically exclude assets of a debtor that
are exempt from the claims of creditors under applicable State
law or any other title 11 exempt property in determining whether
the debtor is insolvent. We conclude that the decision of
12
The Senate report accompanying the 1980 Bankruptcy Tax Act
states in pertinent part:
Under bankruptcy law, the commencement of a liqui-
dation or reorganization case involving an individual
debtor creates an “estate” which consists of property
formerly belonging to the debtor. The bankruptcy
estate generally is administered by a trustee for the
benefit of creditors, and it may derive its own income
and incur expenditures. At the same time, the individ-
ual is given a “fresh start”–-that is, wages earned by
the individual after commencement of the case and
after-acquired property do not become part of the
bankruptcy estate, but belong to the individual, and
certain property may be set aside as exempt.
S. Rept. 96-1035 at 24 (1980), 1980-2 C.B. 620, 632.
- 28 -
Congress not to define the term “insolvent” in section 108(d)(3)
to exclude specifically such exempt assets in determining whether
a debtor is insolvent for purposes of section 108 was inten-
tional.13 We further conclude that Congress did not intend to
exclude assets exempt from the claims of creditors under applica-
ble State law from a taxpayer’s assets for purposes of determin-
ing whether the taxpayer is insolvent within the meaning of
section 108(d)(3). If Congress had intended to exclude such
exempt assets from a taxpayer’s assets in determining whether the
taxpayer is insolvent for purposes of section 108, Congress would
have so stated in section 108(d)(3). It did not.
Our conclusion that Cole v. Commissioner, 42 B.T.A. 1110(1940), has no application in the instant case also leads to a
result that comports with the intention of Congress in enacting
13
In this regard, Myron M. Sheinfeld (Mr. Sheinfeld), a
witness who testified at the Congressional hearings on H.R. 5043
as passed by the House of Representatives (House), see H.R. 5043,
96th Cong., 1st Sess. (1979), pointed out at those hearings that
the definition of “insolvent” in H.R. 5043 as passed by the House
was different from the definition of that term in title 11 and
that “the differing definitions of insolvent will, unless made
consistent, cause substantial trouble and litigation.” Hearings
on H.R. 5043 Before the Subcomm. on Select Revenue Measures of
the House Comm. on Ways and Means (Hearings on H.R. 5043), 96th
Cong., 1st Sess. 41 (1979) (statement of Myron M. Sheinfeld,
Chairman, Committee on Tax Matters, National Bankruptcy Confer-
ence). Mr. Sheinfeld recommended that Congress adopt as the
definition of the term “insolvent” in the final version of H.R.
5043 the same definition of the term “insolvent” that Congress
had adopted in sec. 101(26) of the 1978 Bankruptcy Reform Act, 11
U.S.C. sec. 101(26) (Supp. II, 1978). See Hearings on H.R. 5043,
supra at 43. Congress chose not to do so.
- 29 -
section 108(a)(1)(B) and related provisions into the Code. As we
explained in Merkel v. Commissioner, 109 T.C. at 475,
Congress’ indicated purpose of not burdening an insol-
vent debtor outside of bankruptcy with an immediate tax
liability, * * *, together with the operation of the
insolvency exclusion [section 108(a)(1)(B)] and its
limitation under section 108(a)(3), in accordance with
the statutory insolvency calculation [section
108(d)(3)], suggest that Congress intended to make a
debtor’s ability to pay an immediate tax on income from
discharge of indebtedness the controlling factor in
determining whether a tax burden is imposed. * * *
Ability to pay an immediate tax (i.e., the statu-
tory notion of insolvency) is a question of fact
* * * .
Although an asset of a debtor may be exempt from the claims
of creditors under applicable State law, if that asset and the
debtor’s other assets exceed the debtor’s liabilities, the debtor
has the ability to pay an immediate tax on income from discharged
indebtedness. In the instant case, immediately preceding the
foreclosure sale on February 8, 1993, the aggregate fair market
value of petitioners’ assets was $875,251, which included peti-
tioners’ fishing permit valued at $393,400 that they claim is
exempt from the claims of creditors under the law of the State of
Alaska. At that time, petitioners’ liabilities totaled $515,930.
On the record before us, we find that petitioners had the “abil-
ity to pay an immediate tax on”, id., the $42,142 of DOI income
resulting from the foreclosure sale in question.14 Requiring
14
Not only did petitioners have the ability to pay an imme-
(continued...)
- 30 -
petitioners to include that income in their gross income for the
year at issue and pay a tax thereon is a result that is consis-
tent with the intention of Congress in enacting section
108(a)(1)(B) and related provisions into the Code.
We hold that the word “assets” as used in the definition of
the term “insolvent” in section 108(d)(3) includes assets exempt
from the claims of creditors under applicable State law.15 The
14
(...continued)
diate tax on the DOI income at issue, petitioners’ fishing permit
is subject to lien and levy by respondent to pay that tax. See
secs. 6321, 6331. In this regard, apparently there has been some
dispute between the State of Alaska and the Internal Revenue
Service as to whether permits like petitioners’ fishing permit
constitute property or a right to property for purposes of secs.
6321 and 6331. See Internal Revenue Service Restructuring and
Reform Act of 1998, Pub. L. 105-206, sec. 3445(c)(2), 112 Stat.
763; 144 Cong. Rec. S4518 (daily ed. May 7, 1998) (statement of
Sen. Stevens) (“The State of Alaska has never conceded that these
permits are property that may be seized by IRS. Yet, the IRS
seizes them”.). However, in the instant case, the parties
stipulated that petitioners’ fishing permit is an asset (i.e.,
property).
In addition, it is noteworthy that, effective Aug. 1, 2000,
petitioners may obtain a loan in an amount which does not exceed
$30,000, see Alaska Stat. sec. 16.10.310 (Lexis 2000), and which
is secured by petitioners’ fishing permit in order “to satisfy
past due federal tax obligations that may result in the execution
on and involuntary transfer of [that permit]”. Alaska Stat. sec.
16.10.310(a)(1)(A)(iii) (Lexis 2000).
15
Assuming arguendo that we had found that the word “assets”
as used in sec. 108(d)(3) does not include assets exempt from the
claims of creditors under applicable State law, we nonetheless
find on the record before us that petitioners have failed to
establish that petitioners’ fishing permit qualifies in all
instances as such an asset. On brief, petitioners rely on Alaska
Stat. sec. 09.38.015(a)(8) (Lexis 2000), and on Alaska Stat. sec.
16.43.150(g) (Lexis 2000), to show that petitioners’ fishing
(continued...)
- 31 -
parties agree that if we were to so hold, petitioners would not
be “insolvent” within the meaning of section 108(d)(3), and the
insolvency exception of section 108(a)(1)(B) would not apply to
the $42,142 of DOI income resulting from the foreclosure sale in
question. Consequently, we sustain respondent’s determination to
include that DOI income in petitioners’ gross income for the year
at issue.
Accuracy-Related Penalty--Section 6662
Respondent determined that petitioners are liable for the
year at issue for the accuracy-related penalty under section
15
(...continued)
permit is exempt from creditors’ claims under the laws of the
State of Alaska. Petitioners are correct that Alaska Stat. sec.
09.38.015(a)(8) (Lexis 2000) generally exempts limited entry
fishing permits like petitioners’ fishing permit from the claims
of creditors. See also Alaska Stat. sec. 09.38.500(5) (Lexis
2000). In addition, Alaska Stat. sec. 16.43.150(g)(1) (Lexis
2000) provides that such permits cannot be “pledged, mortgaged,
leased, or encumbered in any way”, except as specifically pro-
vided in certain enumerated sections of the Alaska statutes.
However, petitioners fail to indicate that limited entry fishing
permits, like petitioners’ fishing permit, are not exempt from
creditors’ claims under Alaska law for all purposes and that such
permits may be used to secure a loan for the payment of past due
Federal tax obligations. For example, petitioners do not discuss
the effect of Alaska Stat. sec. 09.38.065 (Lexis 2000), which
allows under certain circumstances creditors to make claims
against certain assets that are generally exempt from creditors’
claims under certain provisions of the Alaska statutes. In
addition, petitioners do not mention that petitioners’ fishing
permit is subject to lien and levy by respondent. See supra
n.14. Nor do petitioners address the effect of recently enacted
legislation in Alaska that allows petitioners to obtain a loan in
an amount not exceeding $30,000, secured by petitioners’ fishing
permit, in order to pay their past due Federal tax liabilities
that may result in the execution on and involuntary transfer of
petitioners’ fishing permit. See supra n.14.
- 32 -
6662(a). In the notice and on brief, respondent asserted two
alternative grounds for the imposition of that penalty: A
substantial understatement of income tax under section 6662(b)(2)
and negligence under section 6662(b)(1).
Respondent concedes that if the Court were to hold that
petitioners must recognize the DOI income at issue, the accuracy-
related penalty should not be imposed on that portion of the
underpayment of tax attributable to that income. That is because
respondent takes the position that petitioners made an adequate
disclosure under section 6662(d)(2)(B)(ii)(I) and that they had a
reasonable basis under section 6662(d)(2)(B)(ii)(II) for their
treatment of such income in petitioners’ joint return.
Petitioners concede that the accuracy-related penalty should
be imposed on the remaining portion of the underpayment of tax
except to the extent it relates to the capital gain that they
concede on brief they realized and must recognize as a result of
the foreclosure sale of the Yantari (petitioners’ capital gain).
With respect to the accuracy-related penalty relating to the
portion of the underpayment of tax attributable to petitioners’
capital gain, petitioners contend that
Petitioners made the same disclosure as it applies to
the gain on sale as to the gain on forgiveness of debt.
If taxpayer, without having the ability of hindsight,
had believed the vessel only had a value of $60,000,
the gain from the deemed sale would be $0.00 and the
gain from the discharge of indebtedness would have
correspondingly increased from $35,000 to $77,000. The
same disclosure Petitioners made with respect to the
- 33 -
disclosure of indebtedness issue, which was adequate
for that issue, also applies to the capital gain from
the same transaction.
* * * * * * *
The Petitioners adequately disclosed their position by
indicating that the entire debt forgiveness should not
be recognized due to Petitioners’ insolvency. In
Petitioners’ calculation, there was no capital gain,
only gain from the discharge of indebtedness. * * *
As we understand petitioners’ position with respect to the
accuracy-related penalty relating to the underpayment of tax
attributable to petitioners’ capital gain, they advance two
separate contentions. First, petitioners maintain that they made
adequate disclosure under section 6662(d)(2)(B)(ii)(I) regarding
that gain by attaching Form 1099-A to petitioners’ joint return
and writing thereon “Taxpayer Was Insolvent – No Tax Conse-
quence”. Second, petitioners maintain that they did not know
that the value of the Yantari when it was sold at the foreclosure
sale was $95,000, and consequently they did not know that there
was a gain on that sale. According to petitioners, they there-
fore had a reasonable basis for, and were not negligent in,
failing to report petitioners’ capital gain in petitioners’ joint
return.
Section 6662(a) imposes an accuracy-related penalty equal to
20 percent of the underpayment of tax resulting from, inter alia,
a substantial understatement of income tax, see section
6662(b)(2), or negligence or disregard of rules or regulations,
- 34 -
see section 6662(b)(1). The accuracy-related penalty under
section 6662(a) does not apply to any portion of an underpayment
if it is shown that there was reasonable cause for, and that the
taxpayer acted in good faith with respect to, such portion. See
sec. 6664(c)(1).
An understatement is equal to the excess of the amount of
tax required to be shown in the tax return over the amount of tax
shown in the tax return, see sec. 6662(d)(2)(A), and is substan-
tial in the case of an individual if it exceeds the greater of 10
percent of the tax required to be shown or $5,000, see sec.
6662(d)(1)(A). However, the amount of such understatement is to
be reduced by that portion of the understatement which is attrib-
utable to any item where (1) “the relevant facts affecting the
item’s tax treatment are adequately disclosed in the return or in
a statement attached to the return,” sec. 6662(d)(2)(B)(ii)(I)
(adequate disclosure), and (2) “there is a reasonable basis for
the tax treatment of such item by the taxpayer”, sec.
6662(d)(2)(B)(ii)(II) (reasonable basis).
For purposes of section 6662(a), the term “negligence”
includes any failure to make a reasonable attempt to comply with
the Code, and the term “disregard” includes any careless, reck-
less, or intentional disregard. See sec. 6662(c). Negligence
has also been defined as a lack of due care or failure to do what
a reasonable person would do under the circumstances. See
- 35 -
Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th Cir. 1992),
affg. T.C. Memo. 1991-179; Antonides v. Commissioner, 91 T.C.
686, 699 (1988), affd. 893 F.2d 656 (4th Cir. 1990).
We turn first to petitioners’ position with respect to
respondent’s determination under section 6662(a) and (b)(2). On
the record before us, we find that petitioners have failed to
establish that they adequately disclosed in petitioners’ joint
return or in any statement attached to that return the relevant
facts affecting the tax treatment of petitioners’ capital gain,
as required by section 6662(d)(2)(B)(ii)(I). For example, there
are no facts disclosed either in that return or in a statement
attached to that return regarding the foreclosure sale of the
Yantari, the amount realized on that sale, or petitioners’ basis
in the Yantari.
We further find on the instant record that petitioners have
failed to show that they had a reasonable basis for their failure
to report petitioners’ capital gain in petitioners’ joint return,
as required by section 6662(d)(2)(B)(ii)(II). As noted above, as
we understand their position, petitioners contend that they did
not know that the value of the Yantari when it was sold at the
foreclosure sale was $95,000. Apparently, petitioners maintain
that they believed that the value of the Yantari at that time was
less than $95,000, although they did not disclose in petitioners’
joint return, and they do not indicate on brief, what they
- 36 -
determined that value to be. Nonetheless, according to petition-
ers, “there was no capital gain” when the Yantari was sold at the
foreclosure sale. We reject petitioners’ position. It is well
established that, absent clear and convincing proof to the
contrary, the sale price of property at a foreclosure sale is
presumed to be its fair market value. See, e.g., Frazier v.
Commissioner, 111 T.C. 243, 246 (1998); Community Bank v. Commis-
sioner, 79 T.C. 789, 792 (1982), affd. 819 F.2d 940 (9th Cir.
1987). Petitioners have presented no evidence, let alone clear
and convincing evidence, that the $95,000-sale price of the
Yantari at the foreclosure sale was not its fair market value.
Furthermore, section 1001(a) provides that gain from a sale
or other disposition of property is the excess of the amount
realized therefrom over the adjusted basis provided in section
1011 for determining gain. The regulations under section 1001
provide guidance to taxpayers in applying section 1001(a) to
facts that are analogous to the facts presented in the instant
case. Example (8) of section 1.1001-2(c), Income Tax Regs.
(Example (8)),16 states:
16
Example (8) applies to the discharge of indebtedness that
is recourse in nature. While the parties did not expressly
stipulate that petitioners’ loan to finance the purchase of the
Yantari constituted recourse debt, we infer from certain other
stipulations of the parties that that loan was recourse debt.
The parties stipulated that the foreclosure sale resulted in both
DOI income and capital gain, although petitioners dispute whether
they must recognize that DOI income. DOI income and capital gain
(continued...)
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In 1980, F transfers to a creditor an asset with a fair
market value of $6,000 and the creditor discharges
$7,500 of indebtedness for which F is personally lia-
ble. The amount realized on the disposition of the
asset is its fair market value ($6,000). In addition,
F has income from the discharge of indebtedness of
$1,500 ($7,500 - $6,000).
Example 8 is controlling in the instant case. As a result
of the foreclosure sale, the bank discharged a total of $137,142
of indebtedness for which petitioners were liable, $95,000 of
which it received on the disposition of the Yantari at that
foreclosure sale. The amount realized on the disposition of the
Yantari is its fair market value which, on the record presented,
we have found to be the sale price of the Yantari at the foreclo-
sure sale. See Frazier v. Commissioner, supra at 246; Community
Bank v. Commissioner, supra at 792. In addition, petitioners
have income from the discharge of indebtedness in the amount of
$42,142 ($137,142, the unpaid principal balance of the loan at
the time of the foreclosure sale, minus $95,000, the fair market
value of the Yantari at that sale).
On the record before us, we find that, in the event the
computations under Rule 155 establish that there is an under-
statement of tax as a result of our holdings and the parties’
concessions in this case that is greater than 10 percent of the
16
(...continued)
would result from the foreclosure sale only if petitioners’ debt
were recourse debt. See Frazier v. Commissioner, 111 T.C. 243,
245, 247 (1998); sec. 1.1001-2(a)(1) and (2) and 2(c), Example
(8), Income Tax Regs.
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tax required to be shown in petitioners’ joint return or $5,000,
see sec. 6662(d)(1)(A), petitioners have failed to establish
there is no substantial understatement of tax under section
6662(b)(2) and (d).
We turn now to respondent’s determination under section
6662(a) and (b)(1). For the reasons set forth above explaining
why we found that petitioners failed to show that they had a
reasonable basis for their position in petitioners’ joint return
regarding petitioners’ capital gain, we find on the record before
us that petitioners have failed to show that, in not reporting
that gain, (1) they made a reasonable attempt to comply with, and
did not intentionally disregard, section 1001 and the regulations
thereunder, including Example 8, Frazier v. Commissioner, supra,
and Community Bank v. Commissioner, supra, and (2) they acted
with due care and did what a reasonable person would do under the
circumstances. We further find on that record that petitioners
have failed to establish that they were not negligent in failing
to report that gain in that return.
On the instant record, we also find that petitioners have
failed to show that they acted with reasonable cause and in good
faith with respect to the portion of the underpayment of tax for
1993 that is attributable to petitioners’ capital gain. See sec.
6664(c).
Based on our examination of the entire record before us, we
- 39 -
find that petitioners have failed to establish any error in
respondent’s determination that they are liable for the year at
issue for the accuracy-related penalty under section 6662(a)
insofar as it relates to the underpayment of tax attributable to
petitioners’ capital gain. Consequently, we sustain that deter-
mination to that extent.
We have considered all of the contentions and arguments of
petitioners that are not discussed herein, and we find them to be
without merit and/or irrelevant.
To reflect the foregoing and the concessions of the parties,
Decision will be entered under
Rule 155.