Dudley B. and La Donna K. Merkel v. Commissioner

109 T.C. No. 22UNITED STATES TAX COURT
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. Filed December 30, 1997.
Ps realized income on account of the discharge of
indebtedness. Ps excluded that income pursuant to the
insolvency exclusion of sec. 108(a)(1)(B), I.R.C., by
including certain “contingent” liabilities in the
insolvency calculation of sec. 108(d)(3), I.R.C.
Held: The term “liabilities” in sec. 108(d)(3),
I.R.C., requires Ps to prove with respect to any
obligation claimed to be a liability that Ps will be
called upon to pay that obligation in the amount
claimed. Held, further, Ps failed to prove that they
would be called upon to pay any amount with respect to
either of the obligations claimed to be liabilities.
Held, further, Ps failed to prove that, on the
measurement date, their liabilities exceeded the fair
market value of their assets and, therefore, may not
exclude any income under sec. 108(a)(1)(B), I.R.C.
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Gregory W. MacNabb, for petitioners.
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
section 108(a)(1)(B) certain income from the discharge of
indebtedness. Unless otherwise noted, all section references are
to the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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,
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realized income on account of the discharge of indebtedness. On
their 1991 U.S. Individual Income Tax Returns (Forms 1040; filing
status of married filing joint return), the Merkels and the
Hepburns each (couple) disclosed their distributive share of that
income, $359,721, but excluded such amount from gross income on
the ground that each was insolvent immediately before that income
was realized by the partnership.
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.
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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:
(1) SLC is to pay to the bank $1,100,000 (the payoff) on or
before August 2, 1991 (the settlement date);
(2) the bank will release its security interest in the
remaining collateral upon payment of the payoff by the settlement
date; and
(3) 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.
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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.
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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 section 108(a)(1)(B) (the insolvency issue). There
is no question that, if section 108(a)(1)(B) (the insolvency
exclusion) does not apply to petitioners, $359,721 would be
included in the gross income of each of the Merkels and the
Hepburns for 1991 as each couple's distributive share of certain
discharge of indebtedness income realized by a partnership in
which both couples were partners. The parties have stipulated
that resolution of the insolvency issue depends on whether
petitioners may include in the insolvency calculation provided in
section 108(d)(3) (the statutory insolvency calculation) either
of the following obligations: (1) “the liability of each of the
petitioners as guarantors of the loan made by Security Pacific
Bank to SLC” (petitioners' guarantees) and (2) “the personal
liability, if any, of petitioners Dudley Merkel and David Hepburn
as officers of SLC for unpaid sales and use taxes assessed by the
State of North Carolina against SLC” (the assessment against SLC
shall be referred to as the State tax assessment and the personal
liability, if any, of petitioners with respect to the State tax
assessment shall be referred to as the State tax exposure). In
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addition, the parties have stipulated that the “exposure of each
of petitioners Merkel and Hepburn” pursuant to petitioners'
guarantees and the State tax exposure was $1 million and
$490,000, respectively, and, “if the petitioners properly may
include the amount of their exposure under either * * *, the
petitioners were each insolvent to the extent of the full amount
of the * * * discharge of indebtedness income to each.”
Petitioners bear the burden of proof on all questions of fact.
Rule 142(a).
B. Arguments of the Parties
Respondent argues that the term “liabilities”, as used in
section 108(d)(3), “must be given its plain meaning” and
encompasses “only liabilities ripe and in existence on the
measurement date”. Respondent would have the Court find that
petitioners' guarantees were contingent liabilities and, thus,
not liabilities in existence on the measurement date for purposes
of section 108(d)(3). Respondent would have the Court also find
that, as of the measurement date, the State tax exposure was not
a liability for purposes of section 108(d)(3), contingent or
otherwise.
Petitioners argue that the plain meaning of the term
“liabilities” in section 108(d)(3) “includes all liabilities,
whether contingent or otherwise”, and “whether and how much of a
liability is counted must be determined on a liability-by-
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liability basis with due regard to all of the circumstances that
existed” at the time insolvency is to be determined. With
respect to contingent liabilities, petitioners concede: (1) “the
likelihood of the occurrence of the contingency * * * [may be] so
remote as not to give rise to a liability” and (2) “a contingent
liability may be a liability; however, the amount of that
liability may be less than the amount of full exposure.”
Petitioners would have the Court find that both petitioners'
guarantees and the State tax exposure were liabilities in
existence on the measurement date, to be taken into account
(perhaps at “less than the amount of full exposure”) under
section 108(d)(3).
II. Analysis
A. The Code
Section 61(a)(12) provides that gross income means all
income from whatever source derived, including income from
discharge of indebtedness. In certain circumstances, however,
income from discharge of indebtedness is excluded from gross
income. In relevant part, section 108(a) provides:
(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 * * *
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* * * * * * *
(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 section 108(d)(3) as
follows:
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.
Section 108 contains no definition of the term “liabilities”, nor
does the Code contain any generally applicable definition of that
term. The regulations interpreting section 108 neither add to
the statutory definition of insolvency nor define the term
“liabilities”.
Section 108(e)(1) states that, except as provided in section
108, “there shall be no insolvency exception from the general
rule that gross income includes income from the discharge of
indebtedness.”
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.
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Commissioner, 94 T.C. 863, 865 (1990), affd. 954 F.2d 653 (11th
Cir. 1992); U.S. Padding Corp. v. Commissioner, 88 T.C. 177, 184
(1987), affd. 865 F.2d 750 (6th Cir. 1989). Where the statute is
ambiguous, it is well established that we may look to its
legislative history and to the reason for its enactment. See
United States v. American Trucking Associations, supra at 543-
544; Centel Communications Co. v. Commissioner, 92 T.C. 612, 628
(1989), affd. 920 F.2d 1335 (7th Cir. 1990); U.S. Padding Corp.
v. Commissioner, supra at 184.
In the context of the parties' dispute, we believe that the
term “liabilities” in section 108(d)(3) is ambiguous, in
particular as to the nature of the examination to be afforded to
obligations claimed to be liabilities for purposes of the
statutory insolvency calculation.1 Therefore, this Court shall
examine the legislative purpose of the insolvency exclusion and
its related provisions.
2. Legislative History
The insolvency exclusion was added to the Code by the
Bankruptcy Tax Act of 1980 (the Bankruptcy Tax Act), Pub. L. 96-
589, sec. 2(a), 94 Stat. 3389-3392. In the Bankruptcy Tax Act,
which was enacted 2 years after Congress revised and modernized
1
Previous cases provide only limited guidance in resolving
the question presented in this case. See, e.g., Correra v.
Commissioner, T.C. Memo. 1997-356; Ng v. Commissioner, T.C. Memo.
1997-248; Caton v. Commissioner, T.C. Memo. 1995-80; Traci v.
Commissioner, T.C. Memo. 1992-708; Bressi v. Commissioner, T.C.
Memo. 1991-651, affd. without published opinion 989 F.2d 486 (3d
Cir. 1993).
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the bankruptcy law, Pub. L. 95-598, 92 Stat. 2549, 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 the House, at 3 (J. Comm. Print 1980).
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
* * *
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. The proposed insolvency exclusion is described in
terms that reflect the preexisting insolvency exception:
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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
16
The bill defines “insolvent” as the excess of
liabilities over the fair market value of assets,
determined with respect to the taxpayer's assets and
liabilities immediately before the debt discharge. The
bill provides that except pursuant to section
108(a)(1)(B) of the Code (as added by the bill), there
is to be no insolvency exception from the general rule
that gross income includes income from discharge of
indebtedness.
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
2
For convenience, amounts have been rounded to the nearest
dollar.
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marks had fallen in value, which so far as it went was
a gain for the defendant in error, and it was contended
by the plaintiff in error that the gain was taxable
income. But the transaction as a whole was a loss, and
the contention was denied. Here there was no shrinkage
of assets and the taxpayer made a clear gain. As a
result of its dealings it made available $137,521.30
assets previously offset by the obligation of bonds now
extinct. We see nothing to be gained by the discussion
of judicial definitions. The defendant in error has
realized within the year an accession to income * * * .
[United States v. Kirby Lumber Co., 284 U.S. 1, 3
(1931).]
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
3
The Board of Tax Appeals, however, noted that the taxpayer
was solvent after the discharge. See Dallas Transfer & Terminal
Warehouse Co. v. Commissioner, 27 B.T.A. 651, 657 (1933), revd.
70 F.2d 95 (5th Cir. 1934).
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not applicable to the facts of the instant case, as the
cancellation of the respondent'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 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
4
See Surrey, “The Revenue Act of 1939 and the Income Tax
Treatment of Cancellation of Indebtedness”, 49 Yale L. J. 1153,
1164 (1940); Warren & Sugarman, “Cancellation of Indebtedness and
Its Tax Consequences: I”, 40 Colum. L. Rev. 1326, 1352 & n.108
(1940) (“The ``net assets' test was first intimated in Porte F.
Quinn, 31 B.T.A. 142, 145 (1934).”); see also Bittker & Thompson,
(continued...)
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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 previously offset
by the obligation of bonds now extinct”. See, e.g., Commissioner
v. Tufts, 461 U.S. 300, 311 n.11 (1983).5 The net assets test is
a corollary of the principle in Dallas Transfer that an insolvent
debtor does not realize income when discharged of indebtedness.
Under the net assets test, if the debtor remains insolvent
(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 discharged, then the discharge has freed the debtor's
assets from the offset of his liabilities to that extent, and,
4
(...continued)
“Income From the Discharge of Indebtedness: The Progeny of United
States v. Kirby Lumber Co.”, 66 Cal. L. Rev. 1159, 1184 & n.90
(1978) (the Board's approach illustrates the “above water”
principle).
5
But cf. Bittker & Thompson, supra at 1184 n.90 (stating that
the above water principle in Lakeland Grocery Co. v.
Commissioner, 36 B.T.A. 289 (1937), does not necessarily require
acceptance of the freeing-of-assets theory; if horizontal equity
as between a debtor coming out of bankruptcy and an insolvent
debtor outside of bankruptcy is the guiding principle, the above
water result may be justified by disregarding income realized
from being voluntarily discharged of indebtedness outside of
bankruptcy “only to the extent that the taxpayer's financial
status after the composition or other arrangement with creditors
is comparable to the bankruptcy outcome”). But see infra secs.
II.C.2., 4.
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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.
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 section
108(a)(1)(B), (a)(3), and (d)(3) as a means of determining an
exclusion 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 exclusion, see supra sec. II.B.2., 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
6
See, e.g., Eustice, “Cancellation of Indebtedness and the
Federal Income Tax: A Problem of Creeping Confusion”, 14 Tax L.
Rev. 225, 246-247 (1959); see also Estate of Newman v.
Commissioner, 934 F.2d 426, 427 (2d Cir. 1991) (“confusion as to
the theoretical basis for taxing discharges of indebtedness has
spawned an illogical, judge-made ``insolvency exception'”), revg.
T.C. Memo. 1990-230. The net assets test and other judicially
created insolvency exceptions have been described as “an
emotional response by the courts to the plight of financially
embarrassed debtors rather than * * * any strict application of
judicial logic.” Eustice, supra at 246.
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liabilities for the purpose of determining whether the debtor's
net worth turns positive (assets exceed liabilities), i.e.,
whether assets are freed, as a result of the debtor's being
discharged of indebtedness.7
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.
7
It should be noted that the net assets test requires an
examination of the debtor's net worth after he is discharged of
the indebtedness, whereas the statutory insolvency calculation
requires an examination immediately before the discharge. That
distinction, however, does not produce disparate results and is
simply the product of the manner in which the insolvency
exclusion and its limitation operate. For purposes of
illustration, assume the following facts: (1) a debtor has
indebtedness of $100 owed to C, assets of $130, and another
liability of $100 and (2) C discharges the debtor of the
indebtedness for payment of $20. The net assets test would find
that, after the discharge, the debtor has assets of $110 ($130 -
$20) and liabilities of $100 ($200 - $100), and, therefore, the
debtor realizes income to the extent his assets exceed his
liabilities, $10 ($110 - $100). The statutory insolvency
calculation would provide that the debtor is insolvent by $70
($200 - $130) and the amount of the exclusion under sec.
108(a)(1)(B) would be limited to that amount pursuant to sec.
108(a)(3); the debtor under sec. 61(a)(12) realizes $80 ($100 -
$20) of income and excludes $70 of that amount under sec.
108(a)(1)(B), for net income recognition of $10 (same as the net
assets test).
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A solvent debtor is capable of meeting his financial
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
realized a gain to the extent of that excess. See, e.g.,
Milenbach v. Commissioner, 106 T.C. 184, 202 (1996); Cozzi v.
Commissioner, 88 T.C. 435, 445 (1987) (“The general theory is
that to the extent that a taxpayer has been released from
indebtedness, he has realized an accession to income because the
cancellation effects a freeing of assets previously offset by the
liability arising from such indebtedness.”) (citing United States
v. Kirby Lumber Co., 284 U.S. 1 (1931)).8 Pursuant to the
8
That understanding of the nature of liabilities comports
with the ordinary and common meaning of the term “liability”:
“That which one is under obligation to pay, or for which one is
liable. Specif., in the pl., one's pecuniary obligations, or
debts, collectively;--opposed to assets.” Webster's New
International Dictionary 1423 (2d ed. 1940).
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...)
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freeing-of-assets theory, a debtor does not realize income when
discharged of a particular indebtedness, however, if his post-
discharge 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, see supra note 7). Clearly, an
indiscriminate inclusion of obligations to pay in the calculation
of postdischarge liabilities (or, in the statutory insolvency
calculation), without any consideration of how speculative those
obligations may be, would render meaningless any inquiry as to
whether assets are freed upon the discharge of indebtedness.
Logic dictates that an obligation to pay is a liability under the
freeing-of-assets theory only if it can be said with a
satisfactory degree of certainty that the obligation offsets
assets. The critical inquiry, of course, is the level of
certainty that is satisfactory.
8
(...continued)
creates the taxable gain. Such reasoning misses the
point. Income results from the discharge of
indebtedness because the taxpayer received (and
excluded from income) funds that he is no longer
required to pay back, not because assets are freed of
offsetting liabilities on the balance sheet. * * *
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.
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Congress has not specified the minimum level of certainty,
but Congress’ indicated purpose of not burdening an insolvent
debtor outside of bankruptcy with an immediate tax liability, see
supra sec. II.B.2., together with the operation of the insolvency
exclusion and its limitation under section 108(a)(3), in
accordance with the statutory insolvency calculation, 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.9 Indeed, if a debtor has the ability to pay an
immediate tax, in the sense that assets of the debtor exceed
liabilities that he will be called upon to pay (and not in the
sense that the debtor simply has assets on hand), the concern of
imposing an unfair or unwarranted immediate tax burden vanishes.
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 sec. 108(d)(3),
Congress has not otherwise instructed us on how to make that
finding or what measure of persuasion carries the burden of
proof. A taxpayer with the burden of proof must, thus, persuade
us of whether and in what amount he (as debtor) will be called
9
The Commissioner apparently agrees. See Rev. Rul. 92-53,
1992-2 C.B. 48, 49 (when a taxpayer’s liabilities exceed the fair
market value of his assets, “the taxpayer is unable to pay either
the indebtedness or the tax”).
-21-
upon to pay an obligation claimed to be a liability for purposes
of the statutory insolvency calculation under the usual measure
of persuasion applicable in this Court.10 The usual measure of
persuasion required to prove a fact in this Court is
“preponderance of the evidence”, see, e.g., Schaffer v.
Commissioner, 779 F.2d 849, 858 (2d Cir. 1985), affg. in part and
remanding Mandina v. Commissioner, T.C. Memo. 1982-34, which
means that the proponent must prove that the fact is more
probable than not, see, e.g., 2 McCormick on Evidence, sec. 339,
at 439 (4th ed. 1992). Therefore, 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, see sec. 108(d)(3). See infra sec. II.C.7.
for further discussion relating to the measure of proof required
for an obligation claimed to be a liability for purposes of the
statutory insolvency calculation.
10
The terms of the agreement creating the claimed obligation
to pay generally would determine whether and in what amount the
taxpayer will be called upon to pay; e.g., with respect to
petitioners' guarantees, the likelihood of a bankruptcy event and
the amount that the bank would have the right to demand upon such
occurrence governs the analysis, see infra sec. II.D.2. We
acknowledge, however, that the examination in other contexts of
obligations claimed to be liabilities for purposes of the
statutory insolvency calculation may involve considerations not
addressed in this report.
-22-
4. Horizontal Equity is Not the Guiding Principle
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 section 108(a)(1)(A) (the
bankruptcy exclusion) and the insolvency exclusion; i.e.,
affording similar treatment to debtors coming out of bankruptcy
and insolvent debtors outside of bankruptcy:
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
-23-
discharge of indebtedness and the consequences thereof were
necessary and inevitable.
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. Section 108(d)(3) recognizes that fact and provides
for a calculation of insolvency and not an actual marshaling and
sale of assets followed by a satisfaction of debts. When
Congress codified the net assets test, see supra sec. II.C.2.,
the insolvency exclusion was made available to all insolvent
-24-
debtors outside of bankruptcy.11 The necessary consequence of
that choice is that the nature of the examination to be afforded
to obligations claimed to be liabilities for purposes of the
statutory insolvency calculation depends on an analytical
framework based on the freeing-of-assets theory and not on the
treatment of such obligations in some analogous context, e.g.,
“debt” in the bankruptcy context.12
5. Respondent's Plain Meaning Argument
Respondent argues that the term “liabilities” in section
108(d)(3) must be given its plain meaning, which requires
excluding contingent liabilities from the statutory insolvency
calculation. As evidence of such exclusive meaning, respondent
relies on principles of financial accounting established by the
Financial Accounting Standards Board (FASB). Respondent asserts
11
If Congress were interested primarily in promoting
horizontal equity, Congress could have adopted the more
restrictive approach suggested by the American Law Institute in
its Draft of a Federal Income Tax Statute. See Surrey & Warren,
“The Income Tax Project of the American Law Institute: Gross
Income, Deductions, Accounting, Gains and Losses, Cancellation of
Indebtedness”, 66 Harv. L. Rev. 761, 817 (1953); see also Fifth
Ave.-Fourteenth St. Corp. v. Commissioner, 147 F.2d 453, 457 (2d
Cir. 1944) (test based on a hypothetical liquidation of the
debtor), revg. 2 T.C. 516 (1943).
12
See, e.g., Bankruptcy Code secs. 101(5), 101(12), 726, 727.
In addition, adherence to bankruptcy procedures and policies, for
example, the estimation of contingent or unliquidated debt
pursuant to Bankruptcy Code sec. 502(c)(1), among other things,
would unnecessarily and unjustifiably import unrelated
considerations into the statutory insolvency calculation. See
Bankruptcy Code sec. 502(c)(1) (requiring estimation when the
fixing or liquidation of any contingent or unliquidated claim
would unduly delay the administration of the bankruptcy
petition).
-25-
that: “Under Generally Accepted Accounting Principles [GAAP],
true contingent liabilities are merely disclosed in the footnotes
to the financial statements as petitioner Hepburn did in this
case, rather than accrued in the statements as a liability. See
FASB Statement No. 5”.
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
13
Guarantees are specifically included in the examples of loss
contingencies contained in FASB Statement No. 5. FASB Statement
No. 5., par. 4.h. (“Guarantees of indebtedness of others”). The
current practice under Generally Accepted Accounting Principles
(continued...)
-26-
Certain guarantees, which are contingent, must be reported
as a liability under GAAP. Therefore, whether an obligation,
such as a guarantee, is a “true” contingent liability cannot be
ascertained without an examination of the nature of the
contingency.14 Although the accrual or nonaccrual of a liability
on a taxpayer's balance sheet may provide evidence as to whether
the taxpayer will be called upon to pay that liability, such
reporting for financial accounting purposes is not dispositive.
The treatment of contingent liabilities under GAAP is consistent
with the examination required of obligations claimed to be
liabilities for purposes of the statutory insolvency calculation,
see supra sec. II.C.3.; however, this Court shall not abdicate
its responsibility to examine such obligations independently.
13
(...continued)
(GAAP) with respect to guarantees is as follows:
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.”
FASB Emerging Issues Task Force, Issue Summary No. 85-20
(emphasis added).
14
The Commissioner apparently recognizes that principle. See
Rev. Rul. 97-3, 1997-2 I.R.B. 5, 6 (“Affixing a label to an
undertaking (for example, referring to an arrangement as a
``guarantee') does not alone decide its character.”).
-27-
6. Respondent's Consistency Argument
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
I.R.C. § 108.” Respondent argues:
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
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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 to I.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.”);
-29-
Fashion Park, Inc. v. Commissioner, supra at 604. The basis of
the decision in Landreth is that a guarantor does not obtain
initially a nontaxable increase in assets for his promise.
Therefore, respondent may not use Landreth to argue that, because
relief from a guarantee does not give rise to discharge of
indebtedness income, since a guarantee is not a liability,
considering a guarantee as a liability for purposes of the
statutory insolvency calculation results in an inconsistent
application of section 108.
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 section 61(a)(12), which
defines gross income as including income from discharge of
indebtedness,15 are identical in terms of legislative purpose;
i.e., that the scope of both provisions is the definition of the
term “gross income”. When respondent argues that Congress could
not have intended for taxpayers to use liabilities, the discharge
of which does not give rise to income, to exclude discharge of
15
For purposes of sec. 108, sec. 108(d)(1) defines the term
“indebtedness of the taxpayer” as “any indebtedness--(A) for
which the taxpayer is liable, or (B) subject to which the
taxpayer holds property.” There is no indication that the term
“indebtedness” in sec. 61(a)(12) with respect to a particular
taxpayer differs from the definition provided in sec. 108(d)(1).
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indebtedness income, respondent fails to recognize that the
apparent inconsistency may be an inconsistency in policy.
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
sec. 108(e)(1).16 The fundamental difference between the
insolvency exclusion and the 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 reports intimate that the policy judgment underlying
16
Cf. Bittker & McMahon, Federal Income Taxation of
Individuals, par. 4.5, at 4-26 (2d ed. 1995) (“by virtue of
§ 108(e)(1), § 108(a)(1) now preempts the field, precluding any
other ``insolvency exception.' This attempt to outlaw judge-made
insolvency exceptions is technically flawed because it applies
only if the taxpayer realizes ``income from the discharge of
indebtedness' and, hence, does not help in determining whether a
transaction by an insolvent debtor generates any income. The
message will be heeded, however, even though the draftsman
blundered.” (fn. ref. omitted)). It appears, however, that the
draftsman did not blunder because sec. 108(e)(1) applies for
purposes of title 26 of the United States Code (the Internal
Revenue Code) without regard to sec. 108(a)(1).
-31-
the insolvency exclusion serves a humanitarian purpose--to avoid
burdening an insolvent debtor outside of bankruptcy with an
immediate tax liability, see supra sec. II.B.2. Even if there
exists some consistency in policy between section 61(a)(12) and
the insolvency exclusion, respondent's argument assumes that only
liabilities, the discharge of which gives rise to income, can
offset assets (which is the role of liabilities in the analytical
framework of the insolvency exclusion and its related
provisions). There is simply no basis for respondent's
assumption. In sum, nothing in the Code, the legislative history
of section 108, or any relevant authority requires an identity in
the class of obligations to pay for purposes of both the
statutory insolvency calculation and discharge of indebtedness
income under section 61(a)(12).17
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
17
Cf. sec. 108(e)(2), which provides: “No income shall be
realized from the discharge of indebtedness to the extent that
payment of the liability would have given rise to a deduction.”
Congress did not provide that a sec. 108(e)(2) “liability” is not
a liability for purposes of the statutory insolvency calculation,
yet respondent's consistency argument leads to that conclusion.
In addition, to the extent that respondent's consistency
argument relates to consistency in determining the existence of
indebtedness and of liabilities, we believe that the standard set
forth supra sec. II.C.3. creates no inconsistency. Cf. Zappo v.
Commissioner, 81 T.C. 77, 89 (1983) (“The very uncertainty of the
highly contingent replacement obligation prevents it from
reencumbering assets freed by discharge of the true debt until
some indeterminable date when the contingencies are removed.”).
-32-
considered as liabilities for purposes of the statutory
insolvency calculation, petitioners argue that the Court should
apply a “likelihood of occurrence” test. Relying on Covey v.
Commercial Natl. Bank, 960 F.2d 657 (7th Cir. 1992), petitioners
suggest that this Court value the amount of a liability, “by
multiplying the full amount of the liability by the probability
of payment”.
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
§ 548(a)(2)(B)(i) [of the Bankruptcy Code], a court should ask:
What would a buyer be willing to pay for the debtor's entire
package of assets and liabilities? If the price is positive, the
firm is solvent; if negative, insolvent.” The court held that,
in making the insolvency determination for purposes of a
preference-recovery action under section 548 of the Bankruptcy
Code,18 contingent liabilities must be discounted by the
probability of their occurrence. Id. at 660-661.
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
18
Sec. 548 of the Bankruptcy Code authorizes the trustee “to
avoid a transaction made within one year before the commencement
of the bankruptcy case, that depletes the debtor's assets to the
detriment of the bankruptcy estate.” 5 Collier on Bankruptcy,
par. 548.01, at 548-5 (15th ed. Revised 1996).
-33-
purposes of the insolvency exclusion and its related provisions.
Liabilities that a debtor will not likely be called upon to pay
do not offset assets and cannot be recognized as liabilities
within the analytical framework of the insolvency exclusion and
its related provisions. The following example illustrates the
need to show the likelihood of a demand for payment on a claimed
liability. Assume that a debtor is discharged from indebtedness
of $99 for payment of $98. Prior to the discharge, the debtor
had cash in the amount of $100 and had guaranteed a friend's debt
of $10, which friend was solvent and not likely to default
(20 percent chance of total default) as the primary obligor.
Petitioners would argue that the debtor in the example has assets
of $100 and liabilities of $101 ($99 + 20 percent of $10 = $101)
and is entitled to exclude the $1 of discharge of indebtedness
income. The debtor in the example, under petitioners' test,
avoids an immediate tax liability on the $1 of income by virtue
of a liability that the debtor will not likely be called upon to
pay (20 percent likelihood of occurrence of total default is less
than “more likely than not”). In essence, the debtor avoids an
immediate tax liability when the preponderance of the evidence
suggests that the debtor has the ability to pay such tax, see
supra sec. II.C.3. That result frustrates Congress' purpose in
enacting the insolvency exclusion and its related provisions and,
therefore, is unacceptable.
-34-
8. Conclusion
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
-35-
no basis for finding that petitioners did not have assets equal
to (or in excess of) their liabilities (i.e., that petitioners
were insolvent).
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
-36-
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.
-37-
Although the testimony presented by petitioners indicates that
SLC may have been experiencing some cash-flow problems after the
agreement, SLC apparently had sufficient liquidity to pay both
Dudley Merkel and David Hepburn hefty salaries for SLC’s fiscal
years ending February 29, 1992, and February 28, 1993. We take
those payments as some evidence of the nonprecarious financial
situations of both SLC and petitioners on the measurement date
and during the 400-day workout period. The fact that the 400-day
workout period had 371 days to run on the measurement date is a
fact to be taken into account, but it does not convince us, as
petitioners suggest, that the probability of a demand for payment
under petitioners’ guarantees (as renegotiated) was 92 percent.
The State tax assessment was ultimately abated, and petitioners
have failed to convince us that such result was not foreseen.
Considering all of the evidence, petitioners have failed to
persuade us that a bankruptcy event was likely to occur. Such a
finding is not inconsistent with the testimony of Robert Kennedy
and David Hepburn that the possibility of bankruptcy was “real”
and not “insignificant”. Therefore, petitioners have failed to
prove that, as of the measurement date, they would be called upon
to pay any amount as a result of petitioners' guarantees.
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,
-38-
North Carolina law provides the following regarding the
responsibility of corporate officers for corporate taxes:
(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. N.C. Gen. Stat. sec. 105-
241.1(a) (1991) requires the Secretary of the Department of
Revenue to send written notice to the taxpayer of the kind and
amount of tax due, and N.C. Gen. Stat. sec. 105-241.1(c) (1991)
provides that the taxpayer is entitled to an opportunity for a
hearing upon request.
-39-
Based on a proposed finding of fact by respondent, to which
petitioners stated that they had no objection, we have found that
the State tax assessment was for sales and use taxes that were
never collected by SLC. That being the case, under the North
Carolina statute, Dudley Merkel and David Hepburn could be liable
as corporate officers only if they were responsible officers who
knew, or should have known, that the tax was not being collected.
There is no persuasive evidence that they knew, or should have
known, that the tax was not being collected. Also, N.C. Gen.
Stat. sec. 105-253(b) (1991) (flush language) appears to grant
the Secretary of the Department of Revenue some discretion in
assessing and collecting the tax from responsible corporate
officers.
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
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constitutes a liability for purposes of section 108(d)(3).
Therefore, petitioners have failed to prove that either the
Merkels or the Hepburns were insolvent on the measurement date
for purposes of section 108(a)(1)(B). On that basis,
respondent’s determinations of deficiencies are sustained in
full.
Decisions will be entered
for respondent.