Tax Aspects of Distressing Times

Transcription

1 Tax Aspects of Distressing Times In and Out of Bankruptcy 56 th Annual Texas CPA Tax Institute Tax Institute Outline November 19 20, 2009 Richardson, Texas & San Antonio, Texas William H. Hornberger Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas Robert Richardson Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas William H. Hornberger, Matthew S. Beard and Robert Richardson IRS Circular 230 Notice: The statements contained herein are not intended to and do not constitute an opinion as to any tax or other matter. They are not intended or written to be used, and may not be relied upon, by you or any other person for the purpose of avoiding penalties that may be imposed under any Federal tax law or otherwise v.2

2 TABLE OF CONTENTS I. Step 1: Determine the Structure of the Debt...1 A. Assemble Relevant Debt Documentation:...1 B. Review all Relevant Debt Documentation:...1 C. If the Debtor is An Entity, Determine its Ownership Structure:...2 II. Step 2: Consider the Federal Income Tax Consequences of Transferring Property to the Creditor in Satisfaction of the Debt....2 A. Distinguish Between Gain Derived from Dealings in Property Under Section 61(a)(3) and Income From Discharge of Indebtedness Under Section 61(a)(12)...2 B. If the Debtor Has Made a Transfer or Other Disposition of Property to a Creditor in Satisfaction of Indebtedness, Apply Sections 61(a)(3) and 1001 to Determine the Federal Income Tax Consequences of the Transfer Section 61(a)(3) Applies to Transfer or Other Disposition of Property in Satisfaction of Indebtedness For Purposes of Section 61(a)(3), Section 1001 and the Regulations Thereunder Govern the Method for Determining the Amount of Gain or Loss Realized Upon the Transfer of Property Exception to General Rule If Liability Not Taken Into Account in Determining Transferor s Basis for the Property Special Partnership Considerations...19 III. Step 3: Determine Whether Debt Has Been Discharged and, if so, the Amount of Cancellation of Indebtedness Income that is Includible by the Debtor Unless an Exception or Exclusion Applies...21 A. Elements Necessary for the Existence of Discharge of Indebtedness Income...21 B. Determining Amount of Cancellation of Indebtedness...23 C. Debtor s Purchase of Obligation at Less Than Its Face Value...28 D. Purchase of Debtor s Obligation by Person Related to Debtor Statutory Background Acquisition of Debtor s Obligation by a Related Person Results in the Realization of Cancellation of Indebtedness Income (to the Extent Required by Sections 61(a)(12) and 108)...28 a. Direct Acquisition...29 b. Indirect Acquisitions...29 c. Exceptions...31 (1) Indebtedness Retired Within One Year...31 (2) Acquisitions by Securities Dealers v.2 i

3 d. Amount of Discharge of Indebtedness Income Realized...32 (1) Holder Acquired the Indebtedness by Purchase On or Less Than Six Months Before the Direct or Indirect Acquisition Date...32 (2) Holder Did Not Acquire the Indebtedness by Purchase On or Less Than Six Months Before the Acquisition Date...33 (3) Avoidance Transactions...33 e. Correlative Adjustments (1) Deemed Issuance Rule...34 (2) Treatment of Related Holder...34 f. Example...35 E. Treatment of Release from Guarantee...35 F. Equity-for-Debt Exchanges Indebtedness Treated as Satisfied With an Amount of Money Equal to the Fair Market Value of the Stock or Partnership Interest Recapture of Gain on Subsequent Sale of Equity Interest...38 G. Contribution of Debt Instrument to Capital of a Corporation...38 H. Indebtedness Satisfied by Issuance of Debt Instrument...38 IV. Step4: Prior to Applying Exclusions in Section 108(a), Determine Whether Any Exception to Cancellation of Indebtedness Applies...38 A. Income Not Realized to Extent of Lost Deductions...38 B. Purchase-Money Debt Reduction...39 C. Disputed Debt Doctrine Origins of the Disputed Debt Doctrine Question Exists as to Scope of Doctrine...43 a. Third Circuit Decision in Zarin v. Commissioner...43 b. Tenth Circuit Decision in Preslar v. Commissioner...44 D. Gift Exception to Cancellation of Debt Income...45 V. Step 5: Determine Whether Cancellation of Indebtedness Income is Excludable (or, With Respect to Certain Reacquisitions of Debt Instruments, Deferred) Under Section A. Section 108(a)(1): Overview Section 108 is an Exception to the General Rule of Section 61(a)(12) Exclusions Under Section 108(a)(1) In General v.2 ii

4 3. Definition of Indebtedness for Purposes of Section B. Discharges Occurring in Title 11 Cases The Exclusion Priority of Exclusion Reduction of Debtor s Tax Attributes Special Partnership Considerations S Corporation Considerations...51 C. Discharges Occurring When Taxpayer is Insolvent The Exclusion...52 a. Exclusion Limited to Amount of Insolvency...53 b. Definition of Insolvency...53 (1) Assets...53 (2) Liabilities (A) (B) Treatment of Contingent Liabilities...54 Treatment of Nonrecourse Debt Priority of Exclusion Reduction of Debtor s Tax Attributes Partnership Considerations S Corporation Considerations No Other Insolvency Exception...57 D. Solvent Taxpayer Out of Bankruptcy - Debt Discharged is Qualified Farm Indebtedness The Exclusion...58 a. Definition of Qualified Farm Indebtedness...58 b. Discharge Must Be by Qualified Person...58 c. Limitation on Amount Excludable...58 (1) Definition of Adjusted Tax Attributes...58 (2) Coordination With Insolvency Exclusion Priority of Exclusion Reduction of Debtor s Tax Attributes Special Partnership Considerations Special S Corporation Considerations...60 E. Solvent Non-C Corporation Taxpayers Out of Bankruptcy - Debt Discharged is Qualified Real Property Business Indebtedness v.2 iii

5 1. The Exclusion...60 a. Identifying Qualified Real Property Business Indebtedness b. Definition of Qualified Acquisition Indebtedness...61 c. Limitations on Amount Excludable...61 (1) Indebtedness-in-Excess-of-Value Limitation...61 (2) Overall limitation...62 d. Making the Election Priority Rules Reduction of Basis Example Partnership Considerations S Corporation Considerations...64 F. Reduction of Tax Attributes; Election Under Section 108(b)(5); Basis Reduction Rules Reduction of Tax Attributes...65 a. Sections 108(b)(1) and 108(b)(2) (1) NOLs:...65 (2) General Business Credits:...65 (3) Minimum Tax Credits:...66 (4) Capital Loss Carryovers:...66 (5) Basis Reduction:...66 (6) Passive Activity Loss and Credit Carryovers:...66 (7) Foreign Tax Credit Carryovers:...66 b. Amount of Reduction...66 c. Ordering Rules...66 (1) Reductions Made After Determination of Tax for the Year...66 (2) Net Operating Losses and Capital Loss Carryover Ordering Rules...66 (3) General Business and Foreign Tax Credit Carryovers...67 (4) Amount of Cancellation of Debt Income in Excess of Taxpayer s Tax Attributes is Disregarded...67 d. Carryovers and Carrybacks...67 e. Examples Election Under Section 108(b)(5)...68 a. Section 108(b)(5) b. Making the Election v.2 iv

6 3. Section a. Timing of Basis Reductions...69 b. General Rules for Basis Reduction...69 (1) Properties Subject to Basis Reduction and Order of Reduction...69 (2) Prior Tax-Attribute Reduction...70 (3) Multiple Discharged Indebtednesses...70 (4) Special Rules Applicable to Basis Reductions in Bankruptcy or Insolvency...70 (A) (B) Limitation on Basis Reductions Under Section 108(b)(2)(E) in Bankruptcy or Insolvency...70 Reduction Not to be Made to Exempt Property in Bankruptcy...71 (5) Special Rules Apply to Basis Reductions Due to Exclusion of Income From Discharge of Qualified Farm Debt...71 c. Reductions Required Under Sections 108(b)(5) or 108(c) (1) Reductions Required to Be Made to Depreciable Property Only...71 (2) Order of Basis Reduction...71 (A) Reductions Under Section 108(b)(5) (i) Ordering of Basis Reduction...71 (ii) Partial Basis Reductions Under Section 108(b)(5) (iii) Modification of Fresh Start Rule for Prior Basis Reductions Under Section 108(B)(5)...72 (B) Reductions Under Section 108(c) (i) Order of Basis Reductions...73 (ii) Basis of Real Property Secured by QRPBI Must Be Reduced Prior to Other Depreciable Real Property...73 (iii) Basis Reduction Made Prior to Disposition of Property...73 d. Partnership Considerations (1) Partnership COD Income...73 (2) Partnership Interest Treated as Depreciable Property...73 (3) Partner s Share of Partnership Basis...75 (4) Treatment of Basis Reduction...75 (A) Basis Adjustment...75 (B) Recovery of Adjustments to Basis of Partnership Property...75 (C) Effect of Basis Reduction v.2 v

7 e. Recapture Rule For Purposes of Sections 108(b)(1) and 108(b)(5), the Estate of Individual in Bankruptcy (and not the Individual) is Treated as the Taxpayer...76 G. Qualified Principal Residence Indebtedness The Exclusion...77 a. Qualified Principal Residence Indebtedness...77 b. Exclusion Limitation...77 c. Ordering Rule...77 d. Effective Date Priority of Exclusion...78 a. Qualified Principal Residence Exclusion Does Not Apply in a Title 11 Case...78 b. Principal Residence Exclusion Takes Precedence Over Insolvency Exclusion Unless Taxpayer Elects Otherwise Reduction of Basis...78 H. Deferral of Cancellation of Indebtedness Income Arising from Certain Reacquisitions of Debt Instruments Provision Defers Cancellation of Indebtedness Income Arising from Reacquisitions of Certain Debt Instruments After December 31, 2008, and Before January 1, a. Inclusion of Deferred Income...79 b. Applicable Debt Instrument...79 c. Reacquisition Special Deferral of Deduction Rule for OID in Debt for Debt Exchanges Acceleration of Deferred Items...80 a. Special Rule for Pass-Through Entities...80 b. Special Rule for Partnerships Effective Date Priority Rules Procedures for Election...81 VI. Overview of Types of Bankruptcy...81 A. Chapter 7 in a Nutshell...82 B. Chapter 11 in a Nutshell v.2 vi

8 C. Chapter D. Chapter Advantages of Chapter Chapter 13 Eligibility How Chapter 13 Works The Chapter 13 Plan and Confirmation Hearing Making the Plan Work The Chapter 13 Discharge...91 VII. Filing of Bankruptcy Petition in Individual Chapter 7 and 11 Bankruptcy Cases...92 A. Filing of Bankruptcy Petition Creates a Separate Taxable Estate in Individual Chapter 7 and 11 Bankruptcy Cases Treatment of Transfers Between Debtor and Estate Tax Attributes a. Estate Succeeds to Tax Attributes of the Debtor...92 b. Debtor Succeeds to Tax Attributes of the Estate Upon Termination of the Estate...94 B. Trustee or Debtor in Possession Must Obtain an Employer Identification Number...94 C. Effect of Dismissal of Individual Chapter 7 and Chapter 11 Bankruptcy Cases...95 D. Computation of Taxable Income of Estate...95 E. Taxable Year of Debtors Effect of Election Effect if No Election Made Treatment of Income, Deductions and Credits a. Estate s Share of Debtor s Income...96 b. Debtor s Share of Debtor s Income...97 c. Rule for Making Determinations With Respect to Deductions, Credits and Employment Taxes...97 F. Return Filing Requirements...97 VIII. Selected Federal Income Tax Procedural Issues in Bankruptcy...97 A. Automatic Stay Does Not Prohibit Service from Sending Notice of Deficiency During Bankruptcy...97 B. Tax Court Jurisdiction Suspension of 90-Day Period for Filing Tax Court Petition During Period in Which Automatic Stay Prohibits Filing of Tax Court Petition v.2 vii

9 a. Bankruptcy Code Stays Commencement or Continuation of Tax Court Proceeding Upon Filing of Bankruptcy Petition...98 b. Suspension of 90-Day Period for Filing Tax Court Petition C. Bankruptcy Court Jurisdiction Overview of 11 U.S.C. 505(a). Section 505(a) of the Bankruptcy Code, as amended as shown below in italics by the 2005 Bankruptcy Act, provides as follows: Discretionary Authority of Bankruptcy Court to Determine Debtor s Tax Liability Under 11 U.S.C. 505(a) a. Overview of Bankruptcy Court s Authority to Abstain b. No Asset Cases U.S.C. 505(a)(2)(A): Tax Liability Previously Contested or Adjudicated a. Contested b. Adjudicated Determination of Tax Liability of Third Parties Section 505(a)(2)(C) Limitation Applicable Ad Valorem Taxes D. Cases of Concurrent Jurisdiction Between the Bankruptcy Court and the Tax Court E. Refund Procedures General Overview of Refund Procedure Outside Bankruptcy a. Claim for Refund b. Refund Suit Bankruptcy a. Claim for Refund (1) Claim for Refund Is Jurisdictional (2) Claim for Refund in Offset Context b. Refund Suit (1) Application of Statute of Limitations (2) Debtor Actions Under Section 505(a)(2)(B) F. Section 505(b) v.2 viii

10 I. Step 1: Determine the Structure of the Debt. The first step in analyzing the federal income tax consequences of a debt restructuring is to determine the structure of the debt. Important issues in this step include the following: A. Assemble Relevant Debt Documentation: In assembling debt documentation, request the following: 1. Closing binders evidencing the initial debt transaction and all refinancings; and 2. Balance sheets showing how the debt was treated for federal income tax and financial statement purposes. B. Review all Relevant Debt Documentation: In reviewing the debt documentation, consider the following: 1. Review any promissory notes or other written evidence of indebtedness. Determine who signed the promissory notes as maker; 2. Review any amendments to the debt instruments; 3. Determine why the debt was incurred; 4. Note all of the relevant terms of the debt, including: a. Makers and lenders; b. Maturity date; c. Interest rate; d. Terms of repayment; e. Assets serving as security and terms of security agreements; and f. Subordination, if any; 5. Determine whether the debt is guaranteed; 6. Determine whether the debtor has a right of reimbursement or contribution or indemnification from any other party with respect to liability under the debt; and 7. Determine (a) whether the creditor has recourse against the debtor if the security is not sufficient to pay the debt or, alternatively, (b) whether the creditor may look only to the property that is subject to the lien to satisfy his debt and cannot look to the debtor personally for payment v.2 1

11 C. If the Debtor is An Entity, Determine its Ownership Structure: In making this determination, consider the following: 1. Determine whether the debtor is an individual, general partnership, joint venture, limited partnership, limited liability company, C corporation, S corporation or another type of entity; 2. If the debtor is an entity, review the organizational documents and operating agreements to determine the internal rights and obligations of the entity and its shareholders, partners, members or other interest owners; and of the debt. 3. Consider how state law may impact ultimate responsibility for repayment II. Step 2: Consider the Federal Income Tax Consequences of Transferring Property to the Creditor in Satisfaction of the Debt. A. Distinguish Between Gain Derived from Dealings in Property Under Section 61(a)(3) and Income From Discharge of Indebtedness Under Section 61(a)(12). Section 61(a) of the Internal Revenue Code of 1986, as amended 1 provides that gross income includes all income from whatever source derived, including gains derived from dealings in property under Section 61(a)(3) and income from discharge of indebtedness under Section 61(a)(12). There is a distinction, however, between gains derived from dealings in property under Section 61(a)(3) and income from discharge of indebtedness under Section 61(a)(12). 2 Sections 61(a)(3) and 61(a)(12) are separate, independent, and not overlapping provisions in respect of the includability of a particular item in income. 3 Consequently, the Tax Court has concluded that the first steps in analyzing the consequences of a transfer of property in satisfaction of an indebtedness, in whole or in part, are to determine whether (1) gain or loss occurred under Section 61(a)(3), and/or (2) there was cancellation of indebtedness under Section 61(a)(12). Only after it is determined that the latter provision applies does one reach the question of... the applicability of Section The determination of whether a transaction is governed by Section 61(a)(3) or Section 61(a)(12) depends on the particular facts of the case. 5 B. If the Debtor Has Made a Transfer or Other Disposition of Property to a Creditor in Satisfaction of Indebtedness, Apply Sections 61(a)(3) and 1001 to Determine the Federal Income Tax Consequences of the Transfer. 1 All section references herein shall be to the Internal Revenue Code of 1986, as amended, unless otherwise stated Briarpark Ltd. v. Commissioner, 163 F.3d 313, 317 (5 th Cir. 1999) ( There is a distinction between what constitutes income realized from the discharge of indebtedness under Section 61(a)(12) and income realized from gains derived from dealing in property under Section 61(a)(3). ). 3 Gehl v. Commissioner, 102 T.C. 784, 789 (1994). 4 Gehl v. Commissioner, 102 T.C. 784, 789 (1994) Briarpark Ltd. v. Commissioner, 163 F.3d 313, 320 (5 th Cir. 1999) v.2 2

12 1. Section 61(a)(3) Applies to Transfer or Other Disposition of Property in Satisfaction of Indebtedness. Section 61(a)(3) provides that gross income includes gains derived from dealings in property. 6 In 2925 Briarpark Ltd. v. Commissioner, 7 the Fifth Circuit concluded that Section 61(a)(3) applies when a taxpayer agrees to surrender the property in exchange for the cancellation of a debt. The Fifth Circuit stated that [u]nder Section 61(a)(12), a debtor may realize income from the discharge of indebtedness where his debt is canceled, forgiven or otherwise discharged for less than the full amount of the debt. In contrast, the Court stated that Section 61(a)(3) applies if the transaction: (1) relieved the taxpayer-owner of his obligation to repay the debt, and (2) the taxpayer is relieved of title of the property For Purposes of Section 61(a)(3), Section 1001 and the Regulations Thereunder Govern the Method for Determining the Amount of Gain or Loss Realized Upon the Transfer of Property. For purposes of Section 61(a)(3), Section 1001 and the Regulations thereunder govern the method by which the amount of gain or loss realized upon a sale or disposition of property is calculated. 9 Under Section 1001(a), the gain from the sale or 6 I.R.C. 61(a)(3) F.3d 313, 317 (5 th Cir. 1999) Briarpark Ltd. v. Commissioner, 163 F.3d 313, 318 (5 th Cir. 1999); Yarbro v. Commissioner, 737 F.2d 479, 486 (5 th Cir. 1984) ( The abandonment followed by the mortgagee s foreclosure in this case is the functional equivalent of the foreclosure sale in Hammel, the tax forfeiture in Nebraska Bridge Supply, and the quitclaims in lieu of foreclosure in Laport and Freeland. In all these transactions, the taxpayer-owner is relieved of his obligation to repay the debt and is relieved of title of the property. Because the mortgagee is legally entitled to recover title to the property in any of these cases, the fact that out of prudence he concludes he must go through foreclosure proceedings to formalize his interest in the land is not a rational basis for altering the character of the gain or loss realized by the taxpayer on the transaction. The differences in these transactions is not a difference in substance, but only in form. ); cf. NSAR , Vaughn # (Feb. 7, 2002) ( Section 61(a)(3) applies when a taxpayer agrees to surrender the property in exchange for the cancellation of a debt. Under this scenario, the transaction may be characterized as a sale or exchange of property giving rise to income under 61(a)(3) with the whole amount of the canceled nonrecourse indebtedness being includable in the amount realized under Therefore, 61(a)(3) applies if the transaction: (1) relieved the taxpayer-owner of his obligation to repay the debt, and (2) the taxpayer is relieved of title of the property. Yarbro v. Commissioner, 737 F.2d 479 (5th Cir. 1982). In that case, the Court held that an abandonment qualified as a sale or exchange notwithstanding the absence of a counterparty offering a quid pro quo in exchange for the property, because of the presence of the two described events. The Court ruled that if the substance of the transaction was a sale under these criteria, the taxpayer s attempts to structure the form of the transaction to avoid this result would not be respected. ). Private letter rulings, technical advice memoranda, field service advice and service center advice are not binding as precedent, but often represent a substantial indication of the position of the Internal Revenue Service on an issue. 9 Treas. Reg (a); 2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313, 317 (5 th Cir. 1999) ( Section 1001(a), which governs the computation of gains from dealings in property, provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided. ); Gehl v. Commissioner, 50 F.3d 12, 13 (8 th Cir. 1995) ( Further, the Tax Court s treatment of the land transfers, irrespective of other portions of the restructuring agreement, cannot be criticized. Section 1001 governs the determination of gains and losses on the sale or exchange of property., aff g 102 T.C. 784, (1994) ( In sum, we... hold that/getdoc?docid=t0tregs: &pinpnt= Section , Income Tax Regs. accurately reflects the proper treatment of the elements involved where property is transferred by the debtor to a creditor having a fair market value in excess of basis but less than the amount of a recourse debt and which is reflected in respondent s position herein. Accordingly, the gains in question do not constitute income from discharge of indebtedness under Section 61(a)(12) and are therefore not excludable under Section 108. ); 2925 Briarpark Ltd. v. Commissioner, 73 T.C.M. (CCH) 3218, 3221; ( For purposes of Section 61(a)(3), Section v.2 3

13 other disposition of property is the excess of the amount realized over the adjusted basis. Conversely, the loss from the sale or other disposition of property is the excess of the adjusted basis over the amount realized. a. In Applying Section 1001 and the Regulations Thereunder, Courts Have Interpreted Sale or Other Disposition Broadly. In distinguishing between transfers under Section 61(a)(3) and a discharge of indebtedness of Section 61(a)(12), the courts have tended to interpret the sale or other disposition language under Section 1001 broadly and have interpreted discharge of indebtedness narrowly. 10 (1) Examples of Transactions Constituting Dispositions. Examples of transactions constituting dispositions include: (A) liabilities to which the property is subject; 11 A debtor s transfer of property in satisfaction of (B) A debtor s voluntary transfer of property to a creditor in satisfaction of a recourse debt pursuant to a settlement agreement; 12 (C) A mortgage foreclosure; 13 foreclosure; 14 (D) The transfer of property by deed in lieu of and the regulations thereunder govern the method by which the amount of gain or loss realized upon a sale or disposition of property is calculated. ); Rev. Rul , C.B. 12 ( Section (a) of the Income Tax Regulations provides that the specific rules for computing the amount of gain or loss from dealings in property under Section 61(a)(3) are contained in Section 1001 and the regulations thereunder. ). 10 Slavin v. Commissioner, 57 T.C.M. (CCH) 343, 347 ( In distinguishing between a sale or exchange and a discharge of indebtedness, the courts have interpreted sale or exchange broadly and have interpreted discharge of indebtedness narrowly. ); cf. F.S.A (Sept. 4, 2001) ( When a debt is forgiven, gross income includes the income from the discharge of the debt. Cancellation of indebtedness produces income to the debtor in an amount equal to the difference between the amount due on the obligation and the amount paid for the discharge. The determination of whether income is produced through cancellation of debt, or through the sale of property in exchange for an assumption of debt, is not always clear. However, as a general matter, courts have tended to interpret the term sale or exchange broadly and the term discharge of indebtedness narrowly. ). 11 Treas. Reg (a)(4)(iii). 12 Rev. Rul , C.B Helvering v. Hammel, 311 U.S. 504 (1941) ( We can find no basis in the language of the Act, its purpose or its legislative history, for saying that losses from sales of capital assets under the 1934 Act, more than its predecessors, were to be treated any differently whether they resulted from forced sales or voluntary sales. ); Commissioner v. Electro-Chemical Engraving Co., 110 F.2d 614, 616 ( We see no valid distinction between a sale by a broker who holds his customer s securities and a sale of mortgaged real estate by means of a decree in foreclosure. ), aff d, 311 U.S. 513 (1941); Danenberg v. Commissioner, 73 T.C. 370, 382 (1979) ( A voluntary sale and a mortgage foreclosure are both dispositions within the scope of the gain or loss provisions of Section ); Rev. Rul , C.B. 12 ( A mortgage foreclosure, like a voluntary sale, is a disposition within the scope of the gain or loss provisions of Section 1001 of the Code. ); G.C.M. 39,814 (Apr. 4, 1990) ( It is well established that a mortgage foreclosure, like a voluntary sale, is a disposition within the scope of the gain or loss provisions of Section ) v.2 4

14 (E) A repossession of property securing a debt; 15 and (F) A seizure or any other involuntary transfer. 16 (2) Abandonment of Property. (A) Abandonment Outside of Bankruptcy. For purposes of determining whether there has been a sale or other disposition of property under Section 1001(a) in abandonments occurring prior to a foreclosure sale, however, characterization of the indebtedness as recourse or nonrecourse is relevant. (i) Property Subject to Nonrecourse Debt. When property is subject to nonrecourse indebtedness, the courts have treated an abandonment prior to a foreclosure sale as a taxable disposition on which gain or loss may be recognized. 17 In 14 Allan v. Commissioner, 856 F.2d 1169, 1172 (8 th Cir. 1988) ( It is well settled that the transfer of property by deed in lieu of foreclosure constitutes a sale or exchange for federal income tax purposes. ); Laport v. Commissioner, 671 F.2d 1028, 1032 (7th Cir. 1982) ( Laport argues that the footnote describes his case: he received no cash from Surfside; he had no personal indebtedness to Surfside and so realized no gain in the form of debt forgiveness; and he had enjoyed no tax benefit in the earlier stages of the transaction for which he should now be held accountable. In short, he asserts that the complete dearth of consideration means that his quitclaim of the property cannot be characterized as the sale or exchange of a capital asset and should instead qualify as an abandonment. * * * There are two obstacles that preclude the result Laport wants and both of them were recognized by the Tax Court. ); Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1672 ( The transfer of property by deed in lieu of foreclosure is a sale or exchange. ). 15 Estate of Delman v. Commissioner, 73 T.C. 15, 28 (1979). 16 Correra v. Commissioner, 74 T.C.M. 273, 274 (1997) ( [A] seizure or any other involuntary transfer qualifies as a disposition of the property. ), citing Helvering v. Hammel, 311 U.S. 504, (1941); Helvering v. Nebraska Bridge Supply & Lumber Co., 312 U.S. 666 (1941) (per curiam) (tax forfeiture). 17 See Green v. Commissioner, 126 F.2d 70, 72 (3 rd Cir. 1942) ( The fact in the Hoffman case that there was no mortgage liability on the part of the surrendering taxpayers was of fundamental importance to the decision in that case. But where, as here, the taxpayer is liable for the debt, interest and taxes by virtue of the mortgage or the bond thereby secured, the property continues until foreclosure sale to have some value which, when determined by the sale, bears directly upon the extent to the owner s liability for a deficiency judgment. ); Yarbro v. Commissioner, 737 F.2d 479, 481 (5 th Cir. 1984) ( [W]e affirm the Tax Court s holding that the Commissioner s interpretation of sale or exchange as including an abandonment of property subject to nonrecourse debt is a reasonable one. ), aff g 45 T.C.M. (CCH) 170, 171 (1982) ( We believe that Middleton case is indistinguishable from the factual situation here present and consequently we reach the same conclusion here. We therefore hold that as a result of the abandonment of the undeveloped tract in 1976 petitioner incurred a capital loss subject to the limitations of Sections 1211 and [Footnote omitted]); Lockwood v. Commissioner, 94 T.C. 252, 259 (1990) ( We also note that abandonment of real property secured by nonrecourse indebtedness has been regarded a sale or exchange for purposes of determining when a loss is sustained. ); Middleton v. Commissioner, 77 T.C. 293, 303 (1981) ( We agree with respondent s alternative position in this case. While our decision in Freeland was based upon the mortgagor s relief from indebtedness as a result of the voluntary reconveyance in lieu of foreclosure, and not the consequent abandonment under California law, we think the same result should obtain where the relief from indebtedness is the result of abandonment of the property by the mortgagor. All of the consequences, which flow from voluntary reconveyance where property is subject to nonrecourse debt, likewise flow from abandonment of property subject to nonrecourse debt: the mortgagor in each case is relieved of encumbered property and also is relieved of the obligations to pay taxes and assessments against the property. ); Matz v. Commissioner, 76 T.C.M. (CCH) 465, 471 (1998) ( We recognize that, under certain circumstances, the abandonment of mortgaged property can qualify as a sale or exchange. ); L&C Springs Associates v. Commissioner, 74 T.C.M. (CCH) 928, 937 (1997) v.2 5

15 Middleton v. Commissioner, 18 a Tax Court case affirmed by the Eleventh Circuit Court of Appeals, taxpayers were limited partners in a partnership that purchased undeveloped land by paying cash, taking the property subject to existing nonrecourse mortgages, and making nonrecourse purchase-money mortgages. The fair market value of the properties decreased substantially below the amounts due on the mortgages and the partnerships abandoned the properties. 19 The mortgagees refused the partnership s offer to deed the parcels back, and foreclosed in due course. 20 The Tax Court held that the partnership sustained losses at the time of the abandonment and that the loss was realized as an exchange at the time of the abandonment and not at the subsequent foreclosure sale. 21 Similarly, in Yarbro v. Commissioner, 22 the taxpayer had invested in raw land whose value subsequently declined below the amount due on a nonrecourse bank mortgage taken out at the purchase. Faced with increased carrying costs, the taxpayer in 1976 notified the bank that he was abandoning the property, but he declined the bank s request for a deed in lieu of foreclosure on the ground that he wished to have no further involvement with the property. The bank foreclosed the following year, and the taxpayer claimed an ordinary loss from the abandonment in his 1976 income tax return. The Commissioner contested the ordinary loss deduction on the ground that the taxpayer had incurred a capital loss because the surrender itself was a sale. 23 The Fifth Circuit analyzed the transaction as a transfer of property by the taxpayer and the receipt of a benefit by him in the form of satisfaction of that portion of the debt equal to the property s value. 24 It viewed that benefit as precisely the same benefit received by the taxpayer in the foreclosure of a nonrecourse tax lien. The Court therefore held that the surrender constituted a sale or exchange. It could see no difference between the act of surrender before it and a deed in lieu of foreclosure. It reasoned that both transactions are the functional equivalents ( Other events, however, may also constitute an identifiable event that will trigger realization of gain or loss relating to ownership of property. An involuntary foreclosure sale of real property, a tax forfeiture of real property, a conveyance of real property to a mortgagee by quitclaim deed in lieu of foreclosure, a decline in the value of real property below the amount of nonrecourse debt associated with the property combined with a conveyance of the property by quitclaim deed to the mortgagee, an abandonment of property subject to nonrecourse debt, relief from indebtedness associated with property, and extinguishment of a taxpayer s right of redemption following a foreclosure sale of property may all be treated as a sale or exchange triggering realization of gain or loss relating to property. ); cf. Priv. Ltr. Rul (Dec. 13, 1991) ( Relief of indebtedness upon abandonment also characterizes the transaction as a sale. ); Priv. Ltr. Rul (Feb. 14, 1991) ( An abandonment my also be a disposition within the scope of Section 1001 of the Code. ); Priv. Ltr. Rul (Sept. 10, 1986) ( When property is subject to nonrecourse indebtedness, the courts have treated an abandonment prior to the foreclosure sale as a taxable disposition on which gain or loss may be recognized. ) T.C. 310, (1981), aff d, 693 F.2d 124 (11th Cir. 1982) T.C. at T.C. at T.C. at F.2d 479, 482 (5 th Cir. 1984) F.2d at F.2d at v.2 6

16 of a foreclosure sale taxable to the owner, and that the taxpayer should not be able to change the tax consequences when the substance remains the same. It regarded the foreclosure which followed abandonment as merely a mechanical process to clear title. Conceding that the nonrecourse nature of the mortgage restricted the taxpayer s true benefit to the value of the secured claim discharged in the surrender, the Court was constrained to follow the U.S. Supreme Court s decision in Tufts v. Commissioner, 25 in measuring the gain by reference to the full amount of the nonrecourse debt discharged. 26 (ii) Property Subject to Recourse Debt. Where recourse debt is involved, abandonment or other disposition of the underlying property should not trigger a sale or exchange because the debt is not necessarily extinguished. The possibility of a deficiency judgment against the debtor exists based on the recourse nature of the debt obligation, and the amount of the gain or loss cannot be fixed until the foreclosure sale takes place U.S. 300 (1983) F.2d at Commissioner v. Green, 126 F.2d 70, (3rd Cir. 1942) ( In the Hoffman case the court was of the opinion that there was ample evidence to support a specific finding by the Board that the taxpayers interest in the property had become entirely worthless in the year when they abandoned it and so advised the mortgagee. But, furthermore, and of first importance, the taxpayers in the Hoffman case had not assumed liability for the mortgage to which their property was subject. In such circumstances, the definitive event which cuts off the taxpayers interest in a property does not necessarily depend upon the foreclosure sale. Nor, more particularly, does the foreclosure sale then serve as a means for determining the amount of any deficiency judgment against the surrendering owners. The fact in the Hoffman case that there was no mortgage liability on the part of the surrendering taxpayers was of fundamental importance to the decision in that case. But where, as here, the taxpayer is liable for the debt, interest and taxes by virtue of the mortgage or the bond thereby secured, the property continues until foreclosure sale to have some value which, when determined by the sale, bears directly upon the extent to the owner s liability for a deficiency judgment. ); L&C Spring Associates v. Commissioner, 74 T.C.M. (CCH) 928, 937 (1997) ( Petitioners rely on cases involving recourse debt and argue that no sale or exchange occurs until a foreclosure sale occurs and until a taxpayer s right of redemption of the foreclosed property expires. Where, however, recourse debt is involved (as distinguished from nonrecourse debt that is involved in the instant cases) abandonment or other disposition of the underlying property will not trigger a sale or exchange because the debt is not necessarily extinguished. The possibility of a deficiency judgment against the debtor exists based on the recourse nature of the debt obligation, and the amount of the gain or loss cannot be fixed until the foreclosure sale takes place. [Citations omitted.]); see 2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313, 318 n.2 (5 th Cir. 1999) ( Case law firmly establishes that when a taxpayer is relieved of nonrecourse debt, his obligation is canceled and he realizes a value. Determining whether that value falls under Section 61(a)(3) or Section 61(a)(12) will further determine whether the insolvent petitioner herein will have to pay taxes on that value or be absolved under Section 108. With a recourse debt, a debtor remains liable for the unpaid balance after a foreclosure sale. Therefore, the unpaid portion is not used to calculate amount realized under Section 1001(b). Furthermore, if the recourse debt is subsequently forgiven, or the judgment is permitted to lapse uncollected, the recourse debt would then fall under Section 61(a)(12). Therefore, if this Court determines that the transaction constituted a sale or exchange, the value from the nonrecourse debt herein would be governed by Section 61(a)(3) and included to calculate amount realized under Section 1001(b). [Citations omitted.]); George v. United States, 78 AFTR 2d , (Dist. CO 1996) ( Property which secures a taxpayer s recourse obligation is not worthless prior to foreclosure. Likewise, property which secures a taxpayer s recourse obligation may not be considered abandoned for purposes of a loss deduction prior to foreclosure. ), aff d 124 F.3d 216 (10 th Cir. 1997); Daily v. Commissioner, 81 T.C. 161, 165 (1983) ( Middleton involved a nonrecourse mortgage transaction wherein the sellers only remedy in the event of default was to foreclose on the property. In contrast, the sellers in the instant case had the right to bring an action for specific performance. Thus, throughout v.2 7

17 (B) Abandonment In Bankruptcy. The courts are split on whether an abandonment by the trustee in bankruptcy is a taxable disposition. 28 (3) Gift. The Regulations provide that a disposition of property includes a gift of the property. 29 In Guest v. Commissioner, the taxpayer purchased certain real properties for $67,500 cash and took the properties subject to nonrecourse mortgages of $2,989,000. In 1970 he made charitable contributions of those real properties subject to the nonrecourse mortgages, which then secured debts of $2,015,957. While the taxpayer held the 1976 the possibility existed that the sellers would force the partnership to acquire clear title to the 5th Avenue property despite the partnership s efforts to abandon it. In the event of such enforcement, the 5th Avenue property would clearly have substantial value to the partnership when all payments under the contract were completed and retrieval would be inevitable. [Footnote omitted.]); cf, Aizawa v. Commissioner, 99 T.C. 197, (1992) (The key to the resolution of the issue before us lies in the recognition that, in this case, there is a clear separation between the foreclosure sale and the unpaid recourse liability for mortgage principal which survives as part of a deficiency judgment. In the decided cases, the courts concluded that such survival did not exist and that the discharge of the recourse liability was closely related to, and should be considered an integral part of, the foreclosure sale. ), aff d without published opinion, 29 F.3d 630 (9th Cir. 1994). 28 Compare In re Lane, 133 B.R. 264, 270 (Bank. MA 1991) ( The reasoning in Yarbro is inescapable. In the abandonment of overly encumbered property, as in the granting of a deed in lieu of foreclosure, a benefit is received in the amount of the secured debt which is discharged, the very same benefit which flows from the foreclosure of a nonrecourse mortgage. Where, as here, the debt is of the recourse variety, it is of course possible for borrower and lender to agree upon the discharge of the entire obligation so that the borrower receives that additional benefit. But this only changes the amount of benefit; it does not prevent the abandonment from constituting a sale. In declining to treat abandonment as a transfer taxable to the bankruptcy estate, the McGowan and Olson decisions, discussed later in connection with 26 U.S.C. 1398, failed to recognize that the estate received a benefit in the discharge of the secured portion of the debt. ) with Samore v. Olson (In re Olson), 100 B.R. 458, (Bankr. N.D. Iowa 1989), aff d, 121 B.R (N.D. Iowa 1990), aff d, 30 F.2d 6, 8 (8th Cir.1991) ( We conclude that the judgment of the district court should be affirmed. First, we agree with the bankruptcy and district courts that abandonment of property of the estate is not a sale or exchange, and thus is not a taxable event which gives rise to a tax liability of the estate. No sale or exchange occurs when the trustee abandons property. Although the trustee is relieved from administering a valueless or unprofitable asset when that asset is abandoned, this benefit is not the kind of benefit required for a sale or exchange under the tax code. ) and In re McGowan, 95 B.R. 104, 108 (Bankr.N.D. Iowa 1988) The court further concludes that the abandonment of property by the trustee is a transfer within the meaning of 26 U.S.C. 1398(f)(2) and is therefore not one which shall be treated as a disposition for purposes of assigning tax consequences to the trustee. The case of Yarbro v. C.I.R., 737 F.2d 479 (5th Cir. 1984)(reh g. denied 1984), cited by the accountants for the trustee is distinguishable on the point that an abandonment is a sale or disposition which triggers income tax consequences. That case did not deal with a bankruptcy but instead with the abandonment by a taxpayer-debtor of real estate subject to non-recourse debt. ); see generally Tatlock, 540-2d T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, A-55 ( The cases have split on the issue of whether taxable gain arises on the midstream abandonment of property subject to indebtedness in excess of basis by the bankruptcy estate of an individual debtor. ); Wallace, Is a Midstream Abandonment of Property by a Bankruptcy Trustee Taxable to the Estate?, J. Tax n (July 1992). 29 Treas. Reg (a)(4)(iii); Notice of Proposed Rulemaking, LR-52-79, 44 F.R (Dec. 28, 1979) ( [T]he disposition of encumbered property includes, for example, gifts of the property and transfers to creditors in satisfaction of the outstanding liability. ); see Guest v. Commissioner, 77 T.C. 9, 21 (1981) ( [G]ifts (including charitable contributions) are dispositions within the meaning of Section 1001(a). ); cf. Treas. Reg (a)(3) ( If property is transferred subject to an indebtedness, the amount of the indebtedness must be treated as an amount realized for purposes of determining whether there is a sale or exchange to which Section 1011 (b) and this Section apply, even though the transferee does not agree to assume or pay the indebtedness. ); Brown v. Commissioner, 72 T.C.M. (CCH) 139, 143 (1996) ( A charitable contribution of property can be treated as a sale or exchange. ) v.2 8

18 properties, deductions for depreciation of $1,283,752 were taken on his tax returns. At the time the taxpayer gifted the properties, their adjusted basis to him was $1,616,214. The Court held in Guest that since the taxpayer was relieved of nonrecourse indebtedness upon his disposition of the real properties, such disposition was required to be treated as a sale or exchange for purposes of determining whether his gain should be measured by using his adjusted basis in the properties. In Johnson v. Commissioner, 30 the taxpayers borrowed approximately $200,000 each from a bank on a nonrecourse basis pledging as security in each case stock with a basis of approximately $10,800, but worth $500,000. Shortly after borrowing, the taxpayers transferred this stock, subject to the encumbrances, to trusts for the benefit of their children. The Tax Court held that the transfers of the stock to the trust represented, in substance, gifts to the extent the fair market value exceeded the loans. The Court further held that to the extent the transfers were subject to the loans, they were sales and the taxpayers realized gain in an amount equal to the excess of the loan proceeds over their basis in the stock. 31 (4) Special Partnership Considerations. Contributions and distributions of property between a partner and a partnership are not sales or other dispositions of property for purposes of Section Thus, such transactions are subject to the partnership rules relating to contributions and distributions. 32 b. Determining the Amount Realized from the Transfer or Other Disposition for Purposes of the Gain Computation Under Section 1001 and the Regulations Thereunder. (1) General Rule. The amount realized from the sale or other disposition is generally the sum of any money received plus the fair market value of the property (other than money) received. 33 The Regulations provide, as a general rule, that the amount realized from a sale or other disposition of property includes the amount of the liabilities from which the transferor is discharged as a result of the sale or disposition T.C. 791 (1973), aff d. 495 F.2d 1079 (6th Cir. 1974), cert. denied 419 U.S (1974). 31 See 59 T.C. at 807 ( We also agree that the mere making of a gift is not of itself a taxable event for Federal income tax purposes. Where, however, as here, property is given to another subject to a loan obtained by the donor in excess of his adjusted basis in the property transferred, and the transferee pays or assumes payment of the loan, the transaction is in part a gift and in part a sale. To the extent the fair market value of the property transferred exceeds the amount of the loan it is a net gift subject only to the payment of the gift taxes thereon. To the extent, however, that the loan exceeds his basis in the property transferred it is a sale and the transferor has realized income subject to capital gain taxes. ). 32 Treas. Reg (a)(iv); see T.D. 7741, C.B. 430, 430 ( The Treasury decision makes it clear that contributions and distributions of encumbered property between a partner and a partnership are not sales or other dispositions for purposes of Section Thus, such transactions are subject to the partnership rules relating to contributions and distributions. ). 33 I.R.C. 1001(b). 34 Treas. Reg (a)(1); Michaels v. Commissioner, 87 T.C. 1412, 1415 (1986) ( As a general rule, when a transferor is discharged from a liability in connection with a sales transaction, the entire current balance of such v.2 9

19 (2) Determining the Amount Realized from a Debtor s Transfer or Other Disposition of Property in Satisfaction of a Debt. Although the Regulations provide, as a general rule, that the amount realized from a sale or other disposition of property includes the amount of the liabilities from which the transferor is discharged as a result of the sale or disposition, 35 the amount realized from the transfer of property in consideration of the discharge or reduction of indebtedness depends on whether the debt is recourse or nonrecourse in nature. 36 Generally, a recourse obligation for purposes of Section 1001 is one for which the debtor is personally liable, that is, the creditor may have recourse against the debtor if the security is not sufficient to pay the debt. A nonrecourse debt generally means that the lienor may look only to the property that is subject to his lien to satisfy his debt and cannot look to the debtor personally for payment. 37 The task of classifying an obligation as recourse or nonrecourse for Federal tax purposes generally requires an examination of all the facts and circumstances with the legal rights and obligations of the parties determined under applicable state law. 38 liability is included in the amount realized. Sec (a)(1), Income Tax Regs.; Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947). ); see, e.g., Priv. Ltr. Rul ( Although the taxpayers will remain the sole obligors for the recourse loan that encumbers the property, under the agreement their daughter will be responsible for repaying one half of the loan s principal balance, computed as of the time of the transfer of the interest in the property to her. Thus, under (a) (1) the taxpayers will be discharged from liability to that extent. ). 35 Treas. Reg (a)(1); Michaels v. Commissioner, 87 T.C. 1412, 1415 (1986) ( As a general rule, when a transferor is discharged from a liability in connection with a sales transaction, the entire current balance of such liability is included in the amount realized. Sec (a)(1), Income Tax Regs.; Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947). ); see, e.g., Priv. Ltr. Rul ( Although the taxpayers will remain the sole obligors for the recourse loan that encumbers the property, under the agreement their daughter will be responsible for repaying one half of the loan s principal balance, computed as of the time of the transfer of the interest in the property to her. Thus, under (a) (1) the taxpayers will be discharged from liability to that extent. ). 36 Frazier v. Commissioner, 111 T.C. 243, 246 (1998); cf. F.S.A (Sept. 4, 2001) ( The proper treatment of a transaction in which property is disposed of in connection with the relief of a debt obligation may depend on whether the debt is recourse or nonrecourse. ). 37 Bressi v. Commissioner, 62 T.C.M. (CCH) 1668 (1991) ( The term nonrecourse has been defined as the status of a person who holds an instrument which gives him no legal right against prior endorsers or the drawer to compel payment if the instrument is dishonored. Black s Law Dictionary (5th Edition 1979). Thus, the term nonrecourse means that the lienor may look only to the property that is subject to his lien to satisfy his debt and cannot look to the debtor personally for payment. ). 38 See Raphan v. United States, 759 F.2d 879, 885 (Fed. Cir. 1985) ( Indebtedness is generally characterized as nonrecourse if the creditor s remedies are limited to particular collateral for the debt and as recourse if the creditor s remedies extend to all the debtor s assets. ); Great Plains Gasification Associates, et al. v. Comm., 92 T.C.M. (CCH) 534, 556 (2006) ( Indebtedness is generally characterized as nonrecourse if the creditor s remedies are limited to particular collateral for the debt and as recourse if the creditor s remedies extend to all the debtor s assets. ); cf. NSAR (Feb. 26, 2002) ( Generally, a recourse obligation is one for which the debtor is personally liable, that is, the creditor may have recourse against the debtor if the security is not sufficient to pay the debt. The task of classifying an obligation as recourse or nonrecourse for Federal tax purposes generally requires an examination of all the facts and circumstances with the legal rights and obligations of the parties determined under applicable state law. There are several Code Sections under which the issue of debt classification as recourse or nonrecourse most frequently arise. ); but see Elliott, Practitioners Debate Definition of Nonrecourse and Recourse Debt, 2009 TNT 4-7 (Jan. 8, 2009) (questioning any implication from Great Plains case that a nonrecourse debt for v.2 10

20 (A) Treatment of Recourse Liabilities Regulations Adopt Bifurcation Method. The Regulations provide an exception from the general rule for determining amount realized in the case of a disposition of property securing a recourse liability. 39 Treas. Reg (a)(2) provides that the amount realized on a sale or other disposition of property securing a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under Section 61(a)(12). 40 The Regulations establish a bifurcated method of realizing income when property is transferred to satisfy a recourse debt. 41 The amount of the debt satisfied up to the fair market value of the property is considered an amount realized for purposes of computing gain and loss under Section Only the additional debt discharged is considered to be discharge of indebtedness income taxable (if at all) under Section 61(a)(12). 42 To illustrate, Example (8) of Treas. Reg (c) provides as follows: 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 liable. The amount realized on the purposes of Section 752 is also nonrecourse for Section 1001 purposes); see also Zung, Bar Panel Explains When Passthrough Debts Are Recourse or Nonrecourse, 28 Tax Mgmt. Wkly. Rep. (BNA) (Jan. 12, 2009). ( Using various scenarios involving general partnerships, limited partnerships, and limited liability companies, a panel at a District of Columbia Bar Association session Jan. 7 explained how a single liability could be classified in different ways for different tax purposes. ); but cf. Real Estate Group Seeks Guidance on Cancellation of Indebtedness Rules, 2008 TNT (July 1, 2008) ( A definition of nonrecourse and recourse debt for purposes of Section 1001 should be provided. a. For example, many states, such as California, have specific limits on the remedies of creditors. Do these limits make the debt nonrecourse.? b. A definition of nonrecourse and recourse debt for purposes of Section 1001 should be providing the context of partnerships and LLCs that are the borrower. The holding in Great Plains Gasification v. Commissioner, 92 TCM (CCH) 534 (2006) should be clarified. ). 39 Treas. Reg (a)(2); see, e.g., Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1674 (1991) ( An exception to the general rule is provided in Section (a)(2), Income Tax Regs., which bifurcates the gain for recourse liabilities. ). 40 Treas. Reg (a)(2); see T.D. 7741, C.B. 430, 430 ( A number of comments suggested that amounts treated as income from discharge of indebtedness under existing regulations might be treated as amounts realized on the sale or other disposition of property under the proposed regulations. Therefore, the Treasury decision makes it clear that the amount realized on the sale or other disposition of property that secures a recourse liability does not include amounts that are income from the discharge of indebtedness. ). 41 Michaels v. Commissioner, 87 T.C. 1412, 1415 (1986) ( This regulation effectively bifurcates the instant transaction, by removing the amount of the discount from the computation of the amount realized and recognizing it as a separate income item. Therefore, although the prepayment of petitioners mortgage was an integral part of the sale, the regulation treats it as a separate transaction for tax purposes. ); Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1674 (1991) ( An exception to the general rule is provided in Section (a)(2), Income Tax Regs., which bifurcates the gain for recourse liabilities. ); cf. FSA 1621 (July 27, 1995) ( The regulations under Section 1001 establish a bifurcated method of realizing income when property is transferred to satisfy a recourse debt. ). 42 Frazier v. Commissioner, 111 T.C. 243, 245 (1998) ( In the case of recourse debt, on the other hand, the amount realized from the transfer of property is the fair market value of the property. * * * Furthermore, the amount realized from the sale or other disposition of property that secures a recourse debt does not include income from the discharge of indebtedness under Section 61(a)(12). Such income will arise when the discharged amount of the recourse debt exceeds the fair market value of the property. ); Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1674 (1991) ( Under the bifurcated approach, income from discharge of indebtedness is the excess of the debt over the fair market value of the property transferred. ) v.2 11

21 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). This example in the Regulations effectively bifurcates the instant transaction into a taxable transfer of property and a taxable discharge from indebtedness. Thus, according to the regulation, each should be treated as a separate transaction for tax purposes. 43 Any income from the transfer of property is potentially part capital gain and part discharge of indebtedness income. 44 Example (1) of Treas. Reg (c) illustrates the determination of the amount realized in a case where there is no cancellation of indebtedness income ( COD income ). The facts of that example are as follows: In 1976 A, a cash method calendar-year taxpayer, purchases an asset for $10,000. A pays the seller $1,000 in cash and signs a note payable to the seller for $9,000. A is personally liable for repayment with the seller having full recourse in the event of default. In addition, the asset which was purchased is pledged as security. During the years 1976 and 1977, A takes depreciation deductions on the asset in the amount of $3,100. During this same time period A reduces the outstanding principal on the note to $7,600. At the beginning of 1978 A sells the asset. The buyer pays A $1,600 in cash and assumes personal liability for the $7,600 outstanding liability. A becomes secondarily liable for repayment of the liability. A s amount realized is $9,200 ($1,600 + $7,600). Since A s adjusted basis in the asset is $6,900 ($10,000 $3,100), A realizes a gain of $2,300 ($9,200 $6,900). 45 (i) Application of Bifurcation Method to Debtor s Voluntary Transfer of Property to a Creditor in Satisfaction of a Recourse Debt. Consistent with the foregoing, in Revenue Ruling 90-16, 46 the taxpayer transferred property to a bank in satisfaction of a recourse debt that was secured by the property. At the time of the transfer, the debtor was insolvent. The Revenue Ruling holds that the taxpayer realizes gain under Sections 61(a)(3) and 1001(c) to the extent the fair market value of the property transferred exceeds the adjusted basis of the property. To the extent the amount of the debt exceeds the fair market value, the taxpayer also realizes discharge of indebtedness under Section 61(a)(12), subject to the insolvency exclusion under Section 108(a)(1)(B) (discussed in detail in Section V of this outline). The exclusion under Section 108(a)(1)(B) did not apply to the Section 61(a)(3) income. (ii) Application of Bifurcation Method to Transfer of Property to a Creditor Pursuant to Foreclosure Proceedings. If a debt is 43 Frazier, et ux. v. Commissioner; 111 T.C. 243, 249 (1998). 44 Cf. F.S.A (Sept. 4, 2001) ( Thus, if the note is recourse, any income from the sale of the property is potentially part capital gain and part discharge of indebtedness income. ). 45 Treas. Reg (c), Example (1) C.B v.2 12

22 recourse, a foreclosure sale may or may not discharge the taxpayer s liability, depending on the amount for which the foreclosed property is sold. 47 (a) Treatment Where Outstanding Balance of Recourse Debt is Discharged as Part of Foreclosure Proceedings. If property is transferred to a creditor as a result of a foreclosure proceeding in which the outstanding balance of a recourse debt is discharged, gain should be realized and recognized under Sections 61(a)(3) and 1001 to the extent the fair market value of the property transferred exceeds the debtor s basis. 48 To the extent that the amount of the debt exceeds the fair market value of the property, the debtor realizes income from the discharge of indebtedness subject to Section (b) Treatment Where Debtor Remains Liable for Portion of Recourse Debt after Foreclosure Sale. If property is transferred pursuant to a foreclosure sale and an unpaid liability continues as an enforceable liability against the debtor, the amount realized should generally be equal to the amount of the foreclosure proceeds. 50 In Aizawa v. Commissioner, 51 property subject to a recourse mortgage was sold at a foreclosure sale and a deficiency judgment was obtained. 52 The issue in the Aizawa case was the amount realized on the foreclosure sale. 53 In the Aizawa case, the Service argued that the amount 47 Aizawa v. Commissioner, 99 T.C. 197, 198 (1992) aff d without published opinion, 29 F.3d 630 (9 th Cir. 1994); Wicker v. Commissioner, 66 T.C.M. (CCH) 757, 763 (1993). 48 Rev. Rul , C.B Rev. Rul , C.B. 12; see, e.g. Frazier v. Commissioner, 111 T.C. 243, 249 (1998) ( Therefore, on the first step of the bifurcation analysis, petitioners realized a capital loss of $120,544 on the transfer of the Dime Circle property. On the second step of the analysis, petitioners realized $210,943 of ordinary income from discharge of indebtedness. [Footnotes omitted.]). 50 Aizawa v. Commissioner, 99 T.C. 197, 199 (1992) aff d without published opinion, 29 F.3d 630 (9 th Cir. 1994); see 2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313, 318 n. 2 (5 th Cir. 1999) ( An essential point to remember is that the debt herein is nonrecourse debt. Nonrecourse debt and recourse debt are treated differently by certain Sections of the Code. Case law firmly establishes that when a taxpayer is relieved of nonrecourse debt, his obligation is canceled and he realizes a value. Determining whether that value falls under Section 61(a)(3) or Section 61(a)(12) will further determine whether the insolvent petitioner herein will have to pay taxes on that value or be absolved under Section 108. With a recourse debt, a debtor remains liable for the unpaid balance after a foreclosure sale. Therefore, the unpaid portion is not used to calculate amount realized under Section 1001(b). Furthermore, if the recourse debt is subsequently forgiven, or the judgement is permitted to lapse uncollected, the recourse debt would then fall under Section 61(a)(12). Therefore, if this Court determines that the transaction constituted a sale or exchange, the value from the nonrecourse debt herein would be governed by Section 61(a)(3) and included to calculate amount realized under Section 1001(b). [Citations omitted.].); Great Plains Gasification Associates v. Commissioner, 92 T.C.M. (CCH) 534, 556 (2006) ( A foreclosure sale constitutes a sale for tax purposes. The amount realized from a foreclosure sale includes the amount of liabilities from which the transferor is discharged as a result of the sale. When debt is discharged in a foreclosure sale, tax consequences may vary depending upon whether the discharged debt is recourse or nonrecourse. In the case of nonrecourse debt, the amount realized on the foreclosure sale includes the entire amount of debt discharged. In the case of recourse debt, on the other hand, the amount realized generally equals the net proceeds received from the foreclosure sale rather than the entire recourse liability. ) T.C. 197 (1992), aff d, 29 F.3d 630 (9 th Cir. 1994) T.C. at T.C. at v.2 13

23 realized was the amount of the unpaid mortgage principal before the foreclosure without regard to the deficiency. 54 The Court rejected the Service s argument on the grounds that [i]t requires petitioners to treat as money received an amount of their unpaid mortgage principal obligation from which they have not yet been discharged, leaving to the future the tax consequences of any subsequent payments or settlement of the deficiency judgment for less than the unpaid amount. 55 The Court reasoned: The key to the resolution of the issue before us lies in the recognition that, in this case, there is a clear separation between the foreclosure sale and the unpaid recourse liability for mortgage principal which survives as part of a deficiency judgment. 56 The Court held in the Aizawa case that, where there is a foreclosure sale and an unpaid recourse liability survives as a deficiency judgment and continues as an enforceable liability against the debtor, the amount realized is the foreclosure proceeds and not the amount of the recourse liability. 57 The Court distinguished the decided cases on the grounds that the courts concluded that such survival did not exist and that the discharge of the recourse liability was closely related to, and should be considered an integral part of, the foreclosure sale. 58 The T.C. at T.C. at T.C. at T.C. at ; see Webb v. Commissioner, 70 T.C.M. (CCH) 957, 962 (1995) ( Having concluded that there was a valid and enforceable deficiency judgment against petitioner following the foreclosure sale, and that, therefore, petitioner s liability was not extinguished as a result of the failure of the clerk of court to docket the judgment, this case cannot be distinguished from the Aizawa case. Accordingly, based on the Aizawa case, the amount realized by petitioners on the foreclosure sale was the sum of $450,000, the amount for which the property was sold at public auction. The excess of petitioner s basis of $520,379 over the amount realized of $450,000 yields a loss of $70,379 to petitioners. Petitioners, therefore, are sustained on this issue. ) T.C. at 200; cf. Chilingirian v. Commissioner, 918 F.2d 1251, 1253 (6th Cir. 1990) ( The Chilingirians primary contention on this appeal is that no gain should be recognized on the foreclosure of property where the owner of the property is personally liable on the mortgage and any equity in the property is lost. Though they acknowledge the long-standing case authority holding that nonrecourse liabilities which are discharged are included in the amount realized on the disposition of property, the Chilingirians contend that there should be a different result in this case because they were personally liable for the mortgages, and thus recourse loans were at issue, and because the loans were discharged pursuant to foreclosure. We find this argument meritless. ), aff g. 52 T.C.M. (CCH) 606 (1986); R. O Dell & Sons Co. v. Commissioner, 169 F.2d 247, 248 (3rd Cir. 1948) ( We will assume for the purpose of the instant case that the provisions of the New Jersey statutes referred to do not eliminate the debt but merely afford to the mortgagor a valid defense to an action on the bond for any deficiency at the end of three months from the date of the confirmation of the sale of the mortgaged premises. In the instant case the Life Insurance Company made no attempt to procure a deficiency judgment. It follows, therefore, that on January 30, 1940, the end of the three months period set up by the New Jersey statute, the taxpayer s right of redemption thereunder was cut off and the transaction was complete. We entertain no doubt therefore that the transaction fell within the purview of Sections 111(a) and 112(a) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev.Code, 111(a) and 112(a). ), aff g. 8 T.C (1947).; Wicker v. Commissioner, 66 T.C.M. (CCH) 757, 767 n. 9 (1993) ( In some cases, however, courts have concluded that the discharge of the portion of the taxpayer s recourse liability remaining after the foreclosure sale was so closely related to that sale that the amount realized included the discharge from the entire recourse liability. ) v.2 14

24 Court also noted that there was no dispute that the foreclosure proceeds in that case represented the fair market value of the property. 59 (c) Determining Fair Market Value of Property Transferred Pursuant to a Foreclosure Sale. The Tax Court has held 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. 60 In Frazier v. Commissioner, 61 the Tax Court rejected the argument that the bid-in amount at a foreclosure sale must be used to determine the amount realized, regardless of how arbitrarily that amount may have been determined. In Frazier, the taxpayers rebutted the presumption with the required clear and convincing proof. The taxpayers introduced an appraisal opining that the fair market value of the foreclosed property was different than the amount bid in by the lender. The Service did not offer any expert testimony on the fair market value and did not challenge the accuracy of the appraisal. 62 (iii) Transfer or Other Disposition of Property Discharges the Transferor if Another Person Agrees to Pay the Liability (Whether or Not Transferor is Released). The Regulations provide that the sale or other disposition of property that secures a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from liability). 63 (iv) Solvency or Insolvency of Debtor Does Not Affect the Characterization of the Income. The solvency of the debtor, or lack thereof, does not, however, affect the characterization of income as being from the sale or exchange of assets or from the discharge of indebtedness. Instead, the debtor s solvency, or lack thereof, is T.C. at 200; see generally Wolfman, Foreclosure Sales and Recourse Debt the Aizawa Case, 98 TNT 7-71 (Jan. 12, 1998). 60 Carlson v. Commissioner, 116 T.C. 87, 108 (2001) ( 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. 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. [Citations omitted.]); Frazier v. Commissioner, 111 T.C. 243, 246 (1998) ( 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. ); Marcaccio v. Commissioner, 69 T.C.M. (CCH) 2420, 2427 (1995) ( Petitioners acknowledge 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 Community Bank v. Commissioner, 79 T.C. 789, 792 (1982), aff d. 819 F.2d 940 (9th Cir. 1987); see also In re Higgins, 101 AFTR 2d , U.S.T.C. 50,220 (Bankr. E.D. Tn.) ( [I]t 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. ) T.C. 243, 246 (1998) T.C. at Treas. Reg (a)(4)(ii); see Notice of Proposed Rulemaking LR-52-79, 44 F.R (Dec. 28, 1979) ( The proposed regulations also provide that if the transferor of encumbered property is also personally liable for the debt which the property secures and if the transferee agrees to pay the debt, the transferor s debt is treated as discharged. ); McNulty v. Commissioner, 55 T.C.M. (CCH) 1138, (1988) ( Babette sold John an undivided halfinterest in the residence subject to an existing mortgage, and he agreed to pay half of the monthly payments. Thus, whether or not the mortgage was recourse or nonrecourse, she is deemed to be discharged of the liability under Section , Income Tax Regs., and realizes the amount so discharged. Although Babette in fact remains liable, the regulation specifically states that this is irrelevant. ) v.2 15

25 relevant for purposes of determining whether income from the discharge of indebtedness is excludable from the debtor s gross income under Section 108 of the Code. 64 (B) Treatment of Nonrecourse Liabilities. (i) Sale or Other Disposition of Property Encumbered by Nonrecourse Debt Results in Full Amount of Debt Treated as Part of Amount Realized. If the debt encumbering property is nonrecourse and the debt is discharged in connection with the sale or other disposition of the property, the full amount of debt is treated as part of the amount realized 65 and the transaction should give rise to capital gain or loss under Sections 61(a)(3) and Example 7 of Treas. Reg (c) provides as follows: In 1974 E purchases a herd of cattle for breeding purposes. The purchase price is $20,000 consisting of $1,000 cash and a $19,000 note. E is not personally liable for repayment of the liability and the seller s only recourse in the event of default is to the herd of cattle. In 1977 E transfers the herd back to the original seller thereby satisfying the indebtedness pursuant to a provision in the original sales agreement. At the time of the transfer the fair market value of the 64 Rev. Rul , C.B. 12 ( In the present situation, X [an insolvent debtor] transferred the subdivision to the bank in satisfaction of the 12,000x dollar debt. To the extent of the fair market value of the property transferred to the creditor, the transfer of the subdivision is treated as a sale or disposition upon which gain is recognized under Section 1001(c) of the Code. To the extent the fair market value of the subdivision, 10,000x dollars, exceeds its adjusted basis, 8,000x dollars, X realizes and recognizes gain on the transfer. X thus recognizes 2,000x dollars of gain. * * * To the extent the amount of debt, 12,000x dollars, exceeds the fair market value of the subdivision, 10,000x dollars, X realizes income from the discharge of indebtedness. However, under Section 108(a)(1)(B) of the Code, the full amount of X s discharge of indebtedness income is excluded from gross income because that amount does not exceed the amount by which X was insolvent. ); G.C.M. 39,814 (Apr. 9, 1990) ( The only difference between the facts of the proposed ruling and that of Example 8 of the regulation is that only in the proposed ruling is the debtor stated to be insolvent at the time of the discharge. The solvency of the debtor, or lack thereof, does not, however, affect the characterization of income as being from the sale or exchange of assets or from the discharge of indebtedness. Instead, the debtor s solvency, or lack thereof, is relevant only for purposes of determining whether income from the discharge of indebtedness is excludable from the debtor s gross income under Section 108(a)(1)(B). ). 65 Tufts, 461 U.S. at 312 ( This, however, does not erase the fact that the mortgagor received the loan proceeds taxfree and included them in his basis on the understanding that he had an obligation to repay the full amount. When the obligation is canceled, the mortgagor is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent within the meaning of 1001(b). From the mortgagor s point of view, when his obligation is assumed by a third party who purchases the encumbered property, it is as if the mortgagor first had been paid with cash borrowed by the third party from the mortgagee on a nonrecourse basis, and then had used the cash to satisfy his obligation to the mortgagee. ); Yarbro, 737 F.2d at 484 ( In Middleton, as in this case, the taxpayer argued that, because the debt was nonrecourse and he therefore had no personal liability for the debt, he received nothing in exchange for his relinquishment of title. In essence, the argument is that because the taxpayer personally had no obligation to repay the debt, the abandonment could not have relieved him of any obligation. This argument is inconsistent with several Supreme Court decisions. ); Gershkowitz v. Commissioner, 88 T.C. 984, 1016 (1987) ( The amount realized by each partnership on the reconveyance of the property to COAP Planning, Inc., and Digitax, Inc., includes the amount of indebtedness to which the property is subject. ); Frazier, et ux. v. Commissioner; 111 T.C. 243, 245 (1998) ( In the case of nonrecourse debt, the amount realized includes the full amount of the remaining debt. ); cf. F.S.A (Sept. 4, 2001) ( If the debt is nonrecourse and the debt is discharged in connection with the sale or other disposition of the property, the full amount of debt is treated as part of the amount realized and the transaction is treated as a capital gain or loss under I.R.C. Sections 61(a)(3) and ) v.2 16

26 herd is $15,000 and the remaining principal balance on the note is $19,000. At that time E s adjusted basis in the herd is $16,500 due to a deductible loss incurred when a portion of the herd died as a result of disease. As a result of the indebtedness being satisfied, E s amount realized is $19,000 notwithstanding the fact that the fair market value of the herd was less than $19,000. E s realized gain is $2,500 ($19,000 $16,500). Accordingly, no part of such a transaction represents discharge of indebtedness income taxable under Section 61(a)(12) and the exclusions of Section 108 do not apply to the transaction. In Crane v. Commissioner, 66 the Supreme Court established that, in computing the amount of gain on the disposition, the outstanding debt must be included in the amount realized by the taxpayer, whether the debt is recourse or non-recourse. Following Crane, the Regulations provide that [t]he sale or other disposition of property that secures a nonrecourse liability discharges the transferor from the liability In the Crane case, however, Mrs. Crane, besides having the vendee take over the loan payments, received $2500 in cash (boot) on the sale. This left open the question of whether the nonrecourse debt would be treated the same as recourse debt in situations where the outstanding debt exceeds the fair market value of the property. In such case, the owner-debtor would not obtain any boot by abandoning the property or transferring it subject to the mortgage. In a famous footnote, the Supreme Court in Crane stated as follows: Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case. 68 The question left unanswered by the Supreme Court in Crane was subsequently answered by the Court in the Tufts case (discussed below). (ii) Discharge of Nonrecourse Liability at a Foreclosure Sale. If a foreclosure sale discharges the remaining balance of a nonrecourse liability encumbering the property, the amount realized will include the entire nonrecourse liability U.S. 1, 7 (1947). 67 Treas. Reg (a)(4)(i); see Notice of Proposed Rulemaking LR-52-79, 44 F.R (Dec. 28, 1979) ( The proposed regulations provide that upon the sale or other disposition of property, the transferor s amount realized for purposes of computing gain or loss includes the amount of any liability from which the transferor is discharged, or treated as discharged, as a result of the sale or other disposition. For example, a sale or other disposition subject to a nonrecourse liability is treated as discharging the transferor from the liability. See Crane v. Commissioner, 331 U.S. 1 (1947). ). 68 Crane, 331 U.S. at 14 n Treas. Reg (a)(1); Treas. Reg (a)(4)(i); see Commissioner v. Tufts, 461 U.S. at 302; Crane v. Commissioner, 331 U.S. at 8; see also Wicker v. Commissioner, 66 T.C.M. (CCH) 757, 763 (1993) (( [T]he extent to which an indebtedness is discharged as a result of a foreclosure sale, and thus the amount realized on such a sale, may depend on whether the taxpayer s liability is recourse or nonrecourse. If the liability is nonrecourse and the foreclosure sale discharges the entire indebtedness, the amount realized will include the entire nonrecourse liability. If the debt is recourse, a foreclosure sale may or may not discharge the taxpayer s liability, depending on v.2 17

27 (iii) Full Amount of Nonrecourse Debt is Includable Upon Sale or Other Disposition of Property Even if Fair Market Value of the Property is Less than the Amount of the Debt. The Regulations provide that the fact that the fair market value of the security at the time of sale or disposition is less than the amount of the liabilities it secures does not prevent the full amount of these liabilities from being treated as money received from the sale or other disposition of the property. 70 The Regulations follow the Supreme Court decision in Commissioner v. Tufts, 71 which was decided after Crane. In Tufts, the Supreme Court addressed the unanswered question in the Crane footnote and held that when a taxpayer sold property encumbered by a nonrecourse obligation that exceeded the fair market value of the property sold, the amount realized included the amount of the obligation discharged. 72 The Court reasoned that because a nonrecourse note is treated as a true debt upon inception (so that the loan proceeds are not taken into income at that time), a taxpayer is bound to treat the nonrecourse note as a true debt when the taxpayer is discharged from the liability upon disposition of the collateral, notwithstanding the lesser fair market value of the collateral. 73 The Regulations provide the following example: In 1976 A, a cash method calendar-year taxpayer, purchases an asset for $10,000. A pays the seller $1,000 in cash and signs a note payable to the seller for $9,000. A is not personally liable for repayment and in the event of default the seller s only recourse is to the asset. In addition, the asset which was purchased is pledged as security. During the years 1976 and 1977, A takes depreciation deductions on the asset in the amount of $3,100. During this same time period A reduces the outstanding principal on the note to $7,600. At the beginning of 1978 A sells the asset. The buyer pays A $1,600 in cash and takes the asset subject to the $7,600 outstanding liability. A s amount realized is $9,200 ($1,600 + $7,600). Since A s adjusted basis in the asset is $6,900 ($10,000 $3,100), A realizes a gain of $2,300 ($9,200 $6,900) Exception to General Rule If Liability Not Taken Into Account in Determining Transferor s Basis for the Property. An exception to this rule applies if the the amount for which the foreclosed property is sold. Aizawa v. Commissioner, supra. In such a case, the amount realized by the taxpayer will generally equal the proceeds received from the foreclosure sale rather then the entire recourse liability. [Citations and footnote omitted]). 70 Treas. Reg (b); Notice of Proposed Rulemaking, LR-52-79, 44 F.R (Dec. 28, 1979) ( [T]he proposed regulations provide that even if the fair market value of the property is less than the amount of the liabilities it secures, the full amount of those liabilities is treated as money received from the sale or other disposition of property. This rule reflects decisions in cases such as Millar v. Commissioner, 577 F.2d 212 (3 rd Cir. 1978) and Tufts v. Commission, 70 T.C. 756 (1978). ); Tufts, 461 U.S. at 310; cf. F.S.A (Sept. 4, 2001) ( If the debt is nonrecourse, the amount realized is the full amount of debt discharged. The fair market value of the property is irrelevant. ) U.S. 300, 307 (1983) U.S. at U.S. at Treas. Reg (c), Example (2) v.2 18

28 liability was incurred by reason of the acquisition of the property but such liability was not taken into account in determining the transferor s basis for the property Special Partnership Considerations. a. Partnership Adjustments. If the debtor is a partnership, then the gain or loss realized from the transfer of property in consideration of the reduction or discharge of a debt is passed through to each of the partners, 76 and is reflected in each partner s adjusted basis in the partnership. 77 Further, if discharge of indebtedness arises from the transaction, then the amount of the discharge of indebtedness is also passed through to each of the partners in accordance with his or her interest in the partnership, and is reflected as an increase in the adjusted basis of each partner in the partnership. The amount of income from the discharge of indebtedness reflects a decrease in the liabilities of the partnership and, thus, is treated as a distribution of money to the partners by the partnership. 78 As in the case of any distribution of money by a partnership, each partner would recognize gain to the extent that the amount distributed (i.e., the amount of the discharge of indebtedness) exceeds the partner s basis in the partnership. 79 The gain so recognized would be characterized as gain from the sale or exchange of the distributee partner s interest in the partnership and would be taken into income under Section 61(a)(3) as a gain from dealings in property. Further, the adjusted basis of the interest of each distributee partner in the partnership would be reduced by the amount of the distribution Treas. Reg (a)(3); see, e.g., Tech. Adv. Memo (Mar. 13, 2000); see T.D. 7741, C.B. 430, 430 ( Some comments suggested that to the extent a liability incurred by reason of the acquisition of property was excluded from the taxpayer s basis, its discharge should not be treated as an amount realized. This is consistent with the Service s ruling and litigating position and is adopted by the Treasury decision. ). 76 See I.R.C See I.R.C See I.R.C. 752(b). 79 See I.R.C. 731(a)(1). 80 See I.R.C. 733; Gershkowitz v. Commissioner, 88 T.C. 984, 1006 (1987); Brickman v. Commissioner, 76 T.C.M. (CCH) 506, 509 (1998) ( If the debtor is a partnership, then the gain or loss realized from the transfer of property in consideration of the reduction or discharge is passed through to each of the partners under Section 702 in accordance with his or her interest in the partnership and is reflected in each partner s adjusted basis in the partnership pursuant to Section 705(a). ); Marcaccio v. Commissioner, 69 T.C.M. (CCH) 2420, 2425 (1995) (( If the debtor is a partnership, then the gain or loss realized from the transfer of property in consideration of the reduction or discharge of a debt is passed through to each of the partners under Section 702, and is reflected in each partner s adjusted basis in the partnership pursuant to Section 705(a). Furthermore, if discharge of indebtedness arises from the transaction, then the amount of the discharge of indebtedness is also passed through to each of the partners under Section 702 in accordance with his or her interest in the partnership, and is reflected as an increase in the adjusted basis of each partner in the partnership pursuant to Section 705(a). In addition, the amount of income from the discharge of indebtedness reflects a decrease in the liabilities of the partnership and, thus, is treated under Section 752(b) as a distribution of money to the partners by the partnership. As in the case of any distribution of money by a partnership, each partner would recognize gain to the extent that the amount distributed; i.e., the amount of the discharge of indebtedness, exceeds the partner s basis in the partnership. The gain so recognized would be characterized as gain from the sale or exchange of the distributee partner s interest in the partnership and would be taken into income under Section 61(a)(3) as a gain from dealings in property. Furthermore, the adjusted basis of the interest of each distributee partner in the partnership would be reduced by the amount of the distribution. [Citations v.2 19

29 b. Transferor s Discharged Liabilities on Sale of Partnership Interest Include Transferor s Share of the Partnership Liabilities. In determining the amount realized on a sale or exchange of a partnership interest, liabilities are treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. 81 Thus, if a partnership interest is sold or exchanged, the reduction in the transferor partner s share of partnership liabilities is treated as an amount realized. 82 For example, if a partner sells an interest in a partnership for $750 cash and transfers to the purchaser the partner s share of partnership liabilities in the amount of $250, the sellers realizes $1,000 on the transaction. 83 The liabilities from which a transferor is discharged as a result of the sale or disposition of a partnership interest include the transferor s share of the liabilities of the partnership. 84 To illustrate, assume that in 2005 L becomes a limited partner in partnership GL. L contributes $10,000 in cash to GL and L s distributive share of partnership income and loss is 10 percent. L is not entitled to receive any guaranteed payments. In 2008, M purchases L s entire interest in partnership GL. At the time of the sale L s adjusted basis in the partnership interest is $20,000. At that time L s proportionate share of liabilities, of which no partner has assumed personal liability, is $15,000. M pays $10,000 in cash for L s interest in the partnership. L s share of partnership liabilities, $15,000, is treated as money received. Accordingly, L s amount realized on the sale of the partnership interest is $25,000 ($10,000 + $15,000). L s gain realized on the sale is $5,000 ($25,000 $20,000). 85 omitted.]); Schrott v. Commissioner, 57 T.C.M. (CCH) 981, 994 (1989) ( The allocation to each partner of a partnership s income from the discharge of indebtedness results in a corresponding increase in the basis of each partner s interest under Section 705(a)(1)(A). The reduction in a partnership s liabilities caused by a debt discharge results in a deemed distribution to each partner in an amount equal to his share of the discharged indebtedness. Such distribution results in a corresponding reduction of each partner s basis in his partnership interest under Section 733(1). [Footnote omitted.]); cf. F.S.A (undated) ( Because income from discharge of partnership debt is not excludible at the partnership level, such income is treated as an item of income which is allocated separately to each partner under Section 702(a). Thus, if a partner is insolvent, his allocable share of the partnership s income from discharge of indebtedness is excluded from that partner s gross income. Conversely, if the partner is solvent, he must recognize his allocable share of discharge of indebtedness income flowing from the partnership. The Committee Report explains further that once the discharge of indebtedness income is allocated to each partner pursuant to Section 702(a), the partner s basis in the partnership is increased by the same amount under Section 705. At the same time, debt discharge results in a deemed distribution to the partner under Section 752, and a reduction in the partner s basis in the partnership under Section 733. In this manner, the Section 733 basis reduction offsets the Section 705 basis increase. ). 81 I.R.C. 752(d); Treas. Reg (a)(v); see T.D. 7741, C.B. 430, 430 ( The Treasury decision also makes it clear that the amount realized from the sale or other disposition of a partnership interest includes the amount of partnership liabilities from which a transferor is discharged as a result of the sale or other disposition. Similarly, the transferee treats such liabilities as part of the cost of the partnership interest rather than as a contribution of money by the transferee to the partnership under Section 752(a). ). 82 Treas. Reg (h). 83 Treas. Reg (h). 84 Treas. Reg (i). 85 Treas. Reg (c), Example (3) v.2 20

30 III. Step 3: Determine Whether Debt Has Been Discharged and, if so, the Amount of Cancellation of Indebtedness Income that is Includible by the Debtor Unless an Exception or Exclusion Applies. Section 61(a)(12) expressly includes income from the discharge of indebtedness in the definition of gross income. 86 A. Elements Necessary for the Existence of Discharge of Indebtedness Income. The Tax Court has held that the elements necessary for the existence of discharge of indebtedness income under Section 61(a)(12) are that: (1) A taxpayer liability exists at the time of the alleged discharge; and (2) the taxpayer was in fact discharged from such liability. 87 Unless the gain is excluded from income or its recognition postponed because of a statutory or judicial exception to this general rule, the amount of the debt cancellation is income in the year the debt is canceled. 88 A frequently cited rationale for the rule is that the cancellation results in an accession to income by effecting a freeing of assets previously offset by the liability arising from the indebtedness. 89 This provision codifies the well-settled result reached by the Supreme Court in United States v. Kirby Lumber Co., 90 that gross income includes income from the discharge of indebtedness. The theory is that to the extent that a taxpayer has been released from indebtedness, he has realized income because the cancellation frees assets previously offset by the liability arising from such indebtedness A Debt is Considered Canceled or Discharged at the Time an Identifiable Event Occurs that Makes It Clear that the Debt Will Never Be Repaid. A debt is considered canceled or discharged at the time when an identifiable event occurs that makes it clear that the debt will never be repaid. 92 The test for determining when the necessary 86 See also Treas. Reg (a) ( The discharge of indebtedness, in whole or in part, may result in the realization of income. ). 87 Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744 (1994) ( The elements necessary for the existence of discharge of indebtedness income under Section 61(a)(12) are that: (1) A taxpayer liability exists at the time of the alleged discharge; and (2) the taxpayer was in fact discharged from such liability. ); Friedman v. Commissioner, 75 T.C.M. (CCH) 2883, 2388 (1998) ( An element necessary for the existence of COD income under Section 61(a)(12) is that the taxpayer was, in fact, discharged from a liability. ). 88 Montgomery v. Commissioner, 65 T.C. 511, 521 (1975); Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3127 (1996) ( The income is recognized in the year cancellation occurs. ). 89 Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3127 (1996) U.S. 1 (1931). 91 United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931) ( Here there was no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made available $137, 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, if we take words in their plain popular meaning, as they should be taken here. ); Gershkowitz v. Commissioner, 88 T.C. 984, 1005 (1987); 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. ). 92 Cozzi v. Commissioner, 88 T.C. 435 (1987); Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980) ( Rather, we believe that the moment it becomes clear that the loan will never have to be paid, the loan must be viewed as having been discharged. ), supplementing 73 T.C. 491 (1979), vacated and remanded on other grounds 692 F.2d 152 (1st Cir. 1982), aff d. in part and rev d. in part on other grounds sub nom. CRC Corp. v. Commissioner, v.2 21

31 identifiable event occurred is a practical assessment of all the facts and circumstances surrounding the likelihood of repayment of the debt. 93 The substance and not the form of the discharge governs. 94 The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income. 95 Events that can trigger cancellation of indebtedness income can include such events as (a) a formal settlement F.2d 281 (3rd Cir. 1982); accord Coburn v. Commissioner, 91 T.C.M. (CCH) 243, 1245 (2006); Owens v. Commissioner, 84 T.C.M. (CCH) 419, 425 n.7 (2002); Friedman v. Commissioner, 75 T.C.M. (CCH) 2383, 2388 (1998); Slavin v. Commissioner, 57 T.C.M. (CCH) 343, 347 (1989) ( A taxpayer has been forgiven or released from a debt when the facts reasonably establish that the debt will probably never be paid, that the taxpayer does not intend to repay the loan, and that the party who loaned the money does not intend to enforce its claim against the taxpayer. The facts in this case do not establish any forgiveness of any of the loans owed to the bank. No agreement of any type existed between petitioner and American Fletcher National Bank to reflect that the Bank did not intend to enforce the loans against the partnerships and/or petitioner. To the contrary, after numerous meetings to discuss the overdue loans, American Fletcher National Bank notified petitioner that he would either have to increase the collateral securing the loans or the bank would foreclose. Petitioner testified he considered but decided not to declare bankruptcy because of the effect he believed it would have on his opportunities to engage in future real estate transactions. In any event, he decided to transfer his interest to Mr. Schmadeke, who would provide additional collateral only if he obtained petitioner s interest in the partnerships. ). 93 Id. see, e.g., Carlins v. Commissioner, 55 T.C.M. (CCH) 227, 234 (1988) ( The abandonment of a worthless collateral which represents a debt s sole payment source is an identifiable event which establishes the moment when the underlying debt is discharged. ); Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744, 746 (1994) ( The test for determining when the necessary identifiable event occurred is a practical assessment of all the facts and circumstances surrounding the likelihood of repayment of the debt. ); Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1282 (2006) ( A debt is deemed discharged as soon as it becomes clear, on the basis of a practical assessment of all the facts and circumstances, that it will never have to be repaid. ). 94 Friedman v. Commissioner, 216 F.3d 537, 547 (6 th Cir. 2000) ( First and foremost, in order for COD income to occur under Section 61(a)(12), the taxpayer must have been discharged from a liability. Such liability, or debt, must be viewed as having been discharged when it becomes clear that the debt will never have to be paid. The test for determining such a moment is a practical assessment of the facts and circumstances relating to the likelihood of payment. Any identifiable event which fixes the loss with certainty may be taken into consideration. (quoting Cozzi, 88 T.C. at 445)); Cozzi v. Commissioner, 88 T.C. 435, 445 (1987) ( Whether a debt has been discharged is dependent on the substance of the transaction. ); accord Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1281 (2006) ( Whether a debt has been discharged is dependent on the substance of the transaction. ); Rinehart v. Commissioner, 83 T.C.M. (CCH) 1379, 1380 (2002) ( The nonreceipt of a Form 1099 does not convert taxable income into nontaxable income. ). 95 Exch. Sec. Bank v. United States, 492 F.2d 1096, 1099 (5th Cir. 1974) ( The right to receive cancellation of the debt accrued to appellants in March, 1959, and it was reaffirmed by the judicial order in August, At that point it was determined with certainty that the debt could never be enforced. The faint possibility of required revival as a consequence of a future appeal to this Court did not change the actual realization of the gain. [Citations omitted.]); accord Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1282 (2006) ( The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income. ); Toberman v. Commissioner, 80 T.C.M. (CCH) 81, 85 (2000) ( A debt is deemed to be discharged as soon as it becomes clear, on the basis of a practical assessment of all the facts and circumstances, that it will never have to be paid. Any identifiable event that fixes with certainty the amount to be discharged may be taken into consideration. The event may or may not be overt; ultimately, it is the actions of the taxpayer in the context of the circumstances of a case that determine whether an abandonment or discharge of indebtedness has taken place. [Citations omitted.]), rev d on other grounds, 294 F.3d 985 (8 th Cir. 2002); Rivera v. Commissioner, 66 T.C.M. (CCH) 1682, 1683 (1993) ( The existence of a faint possibility that a debt will be collected does not prevent the recognition of discharge of indebtedness income. ) v.2 22

32 agreement; 96 (b) waiver of a reimbursement claim; 97 (c) the abandonment of security; 98 (d) a unilateral discharge by a creditor; 99 and (e) the entry of an item on corporate books. 100 The fact that a creditor, however, has failed to remove a debt from its books does not mean that the debt has not been canceled An Agreement to Cancel a Debt in the Future Will Not Be Deemed to Discharge the Indebtedness if the Cancellation is Contingent Upon Future Events. The Tax Court has held that [i]t is well settled that an agreement to cancel debt in the future will not be deemed to discharge the indebtedness immediately if the cancellation is contingent upon future events. 102 B. Determining Amount of Cancellation of Indebtedness. A cancellation of indebtedness generally produces income to the debtor in an amount equal to the difference 96 Exch. Sec. Bank v. United States, 345 F. Supp. 486 (N.D. Ala. 1972), aff d 492 F.2d 1096 (5th Cir. 1974); Rivera v. Commissioner, 66 T.C.M. (CCH) 1682, 1685 (1993) ( In the present case, the execution of the settlement agreement, the order from the District Court, and the payment in full of the $20,000, together established that full payment of the note would not transpire. All of these events took place during Petitioners have presented no evidence of events that could be deemed to have established the cancellation of the debt in 1988, instead of ). 97 Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1281 (2006) ( Respondent contends that petitioners received $900,000 of discharge of indebtedness income on December 29, 1994, when the Rapp Group paid that amount as guarantors in partial satisfaction of the Miller/Huntington Loan. Petitioner was at this point released from his obligation to the extent of $900,000, respondent argues, because the Rapp Group had waived any right to reimbursement from petitioner under the guarantor waivers. Petitioners contend that no discharged occurred on December 29, 1994, because petitioner remained liable to the Rapp Group for the $900,000 they paid as guarantors. We agree with respondent. ). 98 Cozzi, 88 T.C. 435; Carlins v. Commissioner, 55 T.C.M. (CCH) 228, 233 (1988). 99 Waterhouse v. Commissioner, 68 T.C.M. (CCH) 744, 747 (1994) ( The identifiable event which established petitioner s discharge from his 38 U.S.C. sec. 3104(c) obligation to repay the total amount of excess Veterans Administration disability payments was made manifest on January 9, 1989, when the Veterans Administration Regional Office Committee on Waivers and Compromises specifically granted petitioner a waiver of any repayment obligation concerning the disputed Veterans Administration benefit amount. ). 100 Schneller v. Commissioner, 71 T.C.M. (CCH) 2089, 2093 (1996) ( In this case, the discharge took place in 1990 when Delivery charged off the accounts against retained earnings. In sum, we hold that as a result of the 1990 writeoff, petitioners realized income from the discharge of indebtedness in that year. ), aff d without published opinion 129 F.3d 1265 (6th Cir. 1997); Shapiro v. Commissioner, 53 T.C.M. (CCH) 317, 320 (1987) ( Whether a debt has been discharged is dependent on the substance of the transactions. Mere formalisms arranged by the parties are not binding in the application of the tax laws. Consequently, bookkeeping entries are not conclusive but can be considered along with other available evidence in determining whether income has resulted from cancellation of indebtedness. ). 101 Rivera v. Commissioner, 66 T.C.M. (CCH) 1682, 1685 (1993) (citing Exchange Security Bank v. United States, 492 F.2d 1096 (5 th Cir. 1974)). 102 Lowry v. Commissioner, 82 T.C.M. (CCH) 499, 501 (2001) (citing Walker v. Commissioner, 88 F.2d 170 (5 th Cir. 1937), aff g White v. Commissioner, 34 B.T.A. 424 (1936)); Rivera v. Commissioner, 66 T.C.M. (CCH) 1682, 1683 (1993) ( [A]n agreement to cancel an agreement to cancel a debt in the future will not be deemed to have discharged the indebtedness immediately if the cancellation is contingent upon future events. ); Shannon v. Commissioner, 66 T.C.M. (CCH) 1418, 1422 (1993) ( Even prior to execution of that final agreement, the conditions embodied in the earlier preliminary binding agreement of December 1986 reflected in the exchange of the attorneys letters prevented the cancellation of debt from becoming effective prior to payment of the entire $607,000 to the bank. ) v.2 23

33 between the amount due on the obligation and the amount paid for the discharge. Special rules apply to debt that was issued at a discount or a premium. 103 If no consideration is paid for the discharge, then the entire amount of the debt is usually considered the amount of income which the debtor must include in income Discharge of a Debt in Connection with Transfer of Property in Satisfaction of the Debt. As discussed above, a debtor s transfer of property to a creditor in satisfaction of a nonrecourse liability is treated as a sale or other disposition of the property, and any resulting income constitutes gain on the disposition of property rather than discharge of indebtedness income. 105 In contrast, a debtor s transfer of property to a creditor in satisfaction of a recourse liability results in gain from the sale or other disposition of property to the extent that the fair market value of the property exceeds its basis and, to the extent that the liability exceeds the property s fair market value, discharge of indebtedness income is realized See Treas. Reg (c)(2); cf Priv. Ltr. Rul (May 31, 2002) ( ( Under 61(a)(12) of the Internal Revenue Code, except as otherwise provided, gross income means all income, including income from the discharge of indebtedness. Section (c)(2)(ii) of the Income Tax Regulations provides that an issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of (b)). The amount of discharge of indebtedness income is equal to the excess of the adjusted issue price over the repurchase price. ). 104 I.R.C. 61(a)(12); Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994) ( Thus, in general, where a debt owed by a taxpayer is discharged, the difference between the face value of the debt and the amount paid in satisfaction of the debt is includable in the taxpayer s gross income under 26 U.S.C. Section 61(a)(12). ), aff g 64 T.C.M. (CCH) 1357 (1992); Hill v. Commissioner, 97 T.C.M. (CCH) 1521, 1523 (2009) ( Caselaw indicates that where indebtedness from a credit card account is being discharged, the amount of income as a result of the discharge equals the difference between the amount due on the obligation and the amount paid for the discharge, or if no consideration is paid for the discharge, then the entire amount of the debt is considered the amount of income that the debtor must include in income. ); Whitmer v. Commissioner, 71 T.C.M. (CCH) 2213, 2216 n. 6 (1996) ( A cancellation of debt generally produces income to the debtor in an amount equal to the difference between the amount due on the obligation and the amount paid for the discharge. If no consideration is paid for the discharge, the entire amount of the debt is usually considered the amount of income that must be recognized by the debtor. ); Cronin v. Commissioner, 77 T.C.M. (CCH) 1293, 1294 (1999) ( A cancellation of indebtedness generally produces income to the debtor in an amount equal to the difference between the amount due on the obligation and the amount paid for the discharge. If no consideration is paid for the discharge, then the entire amount of the debt is considered the amount of income which the debtor must include in income. ); Friedman v. Commissioner, 75 T.C.M. (CCH) 2383, 2387 (1998) ( A cancellation of indebtedness generally produces income to the debtor in an amount equal to the difference between the amount due on the obligation and the amount paid for the discharge. If no consideration is paid for the discharge, then the entire amount of the debt is considered the amount of income which the debtor must include in income. ). 105 Treas. Reg (c); Examples 1 & 2; Coburn v. Commissioner, 91 T.C.M. (CCH) 1243, 1249 (2005) (( [A] debtor s transfer, or abandonment, of property to a creditor in satisfaction of a nonrecourse liability is treated as a sale or other disposition of the property, and any resulting income constitutes gain on the disposition of property rather than discharge of indebtedness income. In contrast, a debtor s transfer of property to a creditor in satisfaction of a recourse liability results in gain from the sale or other disposition of property to the extent that the fair market value of the property exceeds its basis and, to the extent that the liability exceeds the property s fair market value, discharge of indebtedness income is realized. ). 106 Johnson v. Commissioner, 77 T.C.M. (CCH) 2005, 2006 (1999) ( Where a recourse mortgage has been discharged, cancellation of indebtedness income arises to the extent the amount of the debt exceeds the fair market v.2 24

34 2. Discharge of a Recourse or Nonrecourse Debt Without a Corresponding Transfer of Property. The discharge of a recourse or nonrecourse debt without a corresponding transfer of property results in income from discharge of indebtedness. 107 a. Fair Market Value of Property Greater Than Principal Balance of Mortgage. In Revenue Ruling , a taxpayer prepaid the mortgage held by a third party lender on the taxpayer s residence for less than the principal balance of the mortgage. At the time of the prepayment, the fair market value of the residence was greater than the principal balance of the mortgage. The revenue ruling holds that the taxpayer realizes discharge of indebtedness income under Section 61(a)(12), whether the mortgage is recourse or nonrecourse and whether it is partially or fully prepaid. b. Fair Market Value of Property Less Than Principal Balance of Mortgage. In Gershkowitz v. Commissioner, 108 several partnerships were involved in two identical transactions. Each partnership satisfied $250,000 of nonrecourse loans with a cash payment of $40,000 but retained the property securing the loans. 109 Each partnership obtained the funds to settle the above loans by borrowing the $40,000 from another lender on a nonrecourse basis and ultimately satisfying the latter loan by transferring the encumbered property to the lender. 110 The Tax Court held that the cancellation of the $250,000 of nonrecourse loans without the surrender of the property securing those loans resulted in discharge of indebtedness income under Section 61(a)(12) to the extent that the canceled debt exceeded the cash payment. 111 With respect to each nonrecourse loan of $40,000, the Court held that the entire outstanding balance of the loan must be included in the amount realized in the calculation of gain under Section Revenue Ruling amplified Revenue Ruling to apply whether the fair market value of the residence is greater or less than the principal balance of the mortgage at the value of the property. [Citations omitted.]), aff d, 211 F.3d 1265 (4 th Cir. 2000) (per curiam); Coburn v. Commissioner, 91 T.C.M. (CCH) 1243, 1249 (2005); Frazier v. Commissioner, 111 T.C. 243, 245 (1998). 107 Centennial Savings Bank FSB v. United States, 887 F.2d 595, 606 (5 th Cir. 1989) ( Both the courts and the Internal Revenue Service agree that an individual homeowner/debtor realizes income from partial discharge of his home mortgage debt if he agrees to prepay his loan at a discount to his lender. S & Ls and banks frequently offer their mortgagors this prepayment opportunity in order to permit the creditor S & L or bank to profit by reloaning the mortgage money at higher interest rates. ); Rev. Rul , C.B T.C. 984 (1987) T.C. at , T.C. at Gershkowitz v. Commissioner, 88 T.C. at T.C. at 1016; see Parker Properties Joint Venture v. Commissioner, 71 T.C.M. (CCH) 3195, 3196 ( In line with Gershkowitz, we hold that the partnerships realized income to the extent that their loan balances exceed the consideration paid to Commercial on extinguishment. This income must be recognized by the partners of Parker Properties and Twenty Mile as a separately stated item under Section 702(a)(7), subject to the limitations of Section 108 at the partner level. [Citations and footnote omitted.]), aff d, 200 F.3d 1268 (10 th Cir. 1999) CB v.2 25

35 time of the refinancing. In Revenue Ruling 91-31, the Service held that the reduction of the principal amount of an undersecured nonrecourse debt by the holder of a debt who was not the seller of the property securing the debt results in the realization of discharge of indebtedness income under Section 61(a)(12). The facts in that Ruling were as follows: In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. A had no personal liability with respect to the note, which was secured by an office building valued at $1,000,000 that A acquired from B with the proceeds of the nonrecourse financing. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note s principal amount to $800,000. The modified note bore adequate stated interest. The Service held that the reduction of the principal amount of an undersecured nonrecourse debt by the holder of a debt who was not the seller of the property securing the debt results in the realization of discharge of indebtedness income under Section 61(a)(12). 114 Revenue Ruling states that the Service will follow the holding in Gershkowitz where a taxpayer is discharged from all or a portion of a nonrecourse liability when there is no disposition of the collateral. Thus, under the facts of the Ruling, A realizes $200,000 of discharge of indebtedness income in 1989 as a result of the modification of A s note payable to C. In 2925 Briarpark Ltd. v. Commissioner, 115 a bank with a nonrecourse mortgage on partnership property agreed to cancel its note and mortgage on the property if the property were sold to a specified buyer for a specified amount of cash, with the partnership assigning the sales proceeds and certain additional amounts to the bank in satisfaction of the debt. 116 The partnership reported (i) the difference between the face amount of the bank debt and the sales proceeds paid to the bank as discharge of indebtedness income and (ii) a loss on the sale of the property to the specified buyer. 117 The Tax Court found that the sale of the property and the assignment of sale proceeds to the bank has the same practical effect as several other transactions which have been held to be a sale or exchange. 118 According to the Court, the transaction at issue was the functional equivalent of a foreclosure, reconveyance in lieu of foreclosure, abandonment, or repossession because the mortgagor in each case is relieved of debt encumbering property and also is relieved of the obligation to pay taxes and assessments against the property. 119 The Court rejected the partnership s argument that the bank should be regarded as having forgiven, independently of the sale, the excess of the bank debt over the cash received. The Court reasoned that the record was replete with evidence that both loans were discharged as a result of a single transaction involving the sale of encumbered property. 120 The bank conditioned the discharge of the loans upon the sale of the property, and the buyer 114 Rev. Rul CB T.C.M. (CCH) 3218 (1997), aff d per curiam, 163 F.3d 313 (5th Cir. 1999) F.3d at F.3d at T.C.M. (CCH) 3218, 3221 (1997) T.C.M. (CCH) 3218, 3221 (1997) T.C.M. (CCH) 3218, 3222 (1997) v.2 26

36 conditioned the purchase upon that discharge. 121 At the end of the day, the Court observed, the bank had the proceeds from the sale, the buyer had the property, and the partnership was relieved of the entire balance of the loans. On appeal, the Fifth Circuit Court of Appeals affirmed the Tax Court. The Court held that the full amount of the nonrecourse mortgage constituted gain from the sale under Section 61(a)(3) and not discharge of indebtedness income. The Court reasoned that section 61(a)(3) applies if the court determines that the transaction: (1) relieved the tax payer-owner of his obligation to repay the debt; and (2) the taxpayer is relieved of title of the property. 122 The Court stated that [u]nlike section 61(a)(12) cases, where debt forgiveness occurs as a single transaction and the realization of the property income occurs in a later and separate transaction, the debt forgiveness in the case herein was closely intertwined with the terms of the agreement. Therefore, this was a single transaction governed by section 61(a)(3). 123 The Court said that [t]he Tax Court properly distinguished Gershkowitz from this case. In Gershkowitz, the debts were not discharged in connection with the disposition of the property. Since there was no disposition of property upon the discharge of the debts, the Tax Court held that there was no amount realized upon disposition that could be regarded as flowing from the discharge of indebtedness, and, hence, no gain or loss on disposition to be computed. 124 In Revenue Ruling 91-31, the Service rejected any interpretation of Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519 (1934), a 1934 Board of Tax Appeals decision, that a reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller of the property securing the liability results in a reduction of the basis in that property, rather than discharge of indebtedness income for the year of the reduction. In Fulton Gold Corp., a taxpayer purchased property without assuming an outstanding mortgage and subsequently satisfied the mortgage for less than its face amount. The Service in Revenue Ruling stated that [i]n a decision based on unclear facts, the Board of Tax Appeals, for purposes of determining the taxpayer s gain or loss upon the sale of the property in a later year, held that the taxpayer s basis in the property should have been reduced by the amount of the mortgage debt forgiven in the earlier year. The Service reasoned that the Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton Gold that a reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller of the property securing the liability results in a reduction of the basis in that property, rather than discharge of indebtedness income for the year of the reduction. The Service concluded that Fulton Gold, interpreted in this manner, is inconsistent with Tufts and Gershkowitz. Therefore, that interpretation is rejected and will not be followed T.C.M. (CCH) 3218, 3222 (1997) F.3d at 317 [Footnote omitted.] F.3d at 317 [Citations omitted.] F.3d at 318; see generally James B. Sowell, Partnership Workouts: Is It That Time Again? 42 Tax Mgmt. Mem. (BNA) 414 (2001), T.M. Memorandum (September 10, 2001) v.2 27

37 C. Debtor s Purchase of Obligation at Less Than Its Face Value. Under Section 61(a)(12), gross income includes income from the discharge of indebtedness. A taxpayer may realize income by the payment or purchase of his obligations at less than their face value. 125 D. Purchase of Debtor s Obligation by Person Related to Debtor. 1. Statutory Background. Section 108(e)(4)(A) provides that, for purposes of determining income of a debtor from discharge of indebtedness, to the extent provided in the Regulations, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in Sections 267(b) or 707(b)(1) from a person who does not bear such a relationship to the debtor is treated as the acquisition of such indebtedness by the debtor. Section 108(e)(4) was enacted by the Bankruptcy Tax Act of 1980 to prevent taxpayers from avoiding discharge of indebtedness through acquisitions of outstanding indebtedness by related parties. The legislative history notes that, under prior law, a related party (such as the parent corporation of a debtor) can acquire the taxpayer s debt at a discount and effectively eliminate it as a real liability to outside interests, but the debtor thereby avoids the tax treatment which would apply if the debtor had directly retired the debt by repurchasing it. 126 Thus, to the extent required by Sections 61(a)(12) and 108, a debtor realizes discharge of indebtedness income upon the acquisition of its debt at a discount by a related party from an unrelated party Acquisition of Debtor s Obligation by a Related Person Results in the Realization of Cancellation of Indebtedness Income (to the Extent Required by Sections 61(a)(12) and 108). Treas. Reg (a) provides that the acquisition of outstanding indebtedness by a person related to the debtor from a person who is not related to the debtor results in the realization by the debtor of income from discharge of indebtedness (to the extent required by Sections 61(a)(12) and 108). 128 Income realized pursuant to this rule is excludible from gross income to the extent provided in Section 108(a). 129 These rules apply if indebtedness is acquired directly by a person related to the debtor in a direct acquisition or if a holder of indebtedness becomes related to the debtor in an indirect acquisition. 130 For this purpose, persons are considered related if they are related within the meaning of Sections 267(b) or 707(b)(1). 131 However, (i) Sections 267(b) and 707(b)(1) are applied as if Section 267(c)(4) 125 Treas. Reg (a); Hudson v. Commissioner, 103 T.C. 90, 107 (1994) ( Under Section 61(a)(12), gross income includes income from the discharge of indebtedness. With exceptions not here relevant, taxpayers generally realize discharge of indebtedness income by the purchase of their debt obligations at less than the principal amount. The acquisition of outstanding indebtedness by a person related to the debtor is treated as an acquisition of indebtedness by the debtor. [Citations omitted.]); Salva v. Commissioner, 65 T.C.M. (CCH) 2080, 2082 (1993) ( [G]ross income may be realized to a taxpayer who purchases his obligations at less than their face value. ). 126 H.R. Rep. No. 833, 96th Cong., 2d Sess. 9 (1980); S. Rep. No. 1035, 96th Cong., 2d Sess. 10 (1980) reprinted in C.B. 620; T.D. 8460, C.B T.D. 8460, C.B Treas. Reg (a). 129 Treas. Reg (a). 130 Treas. Reg (a). 131 I.R.C. 108(e)(4)(A); Treas. Reg (d)(2) v.2 28

38 provided that the family of an individual consists of the individual s spouse, the individual s children, grandchildren, and parents, and any spouse of the individual s children or grandchildren; 132 and (ii) two entities that are treated as a single employer under subsection (b) or (c) of Section 414 are treated as having a relationship to each other that is described in Section 267(b). 133 a. Direct Acquisition. An acquisition of outstanding indebtedness is a direct acquisition if a person related to the debtor (or a person who becomes related to the debtor on the date the indebtedness is acquired) acquires the indebtedness from a person who is not related to the debtor. 134 Thus, the realization rule of Section 108(e)(4) applies if, for example, an acquirer simultaneously purchases the debtor s indebtedness and an ownership interest in the debtor. 135 b. Indirect Acquisitions. In general, an indirect acquisition is a transaction in which a holder of outstanding indebtedness becomes related to the debtor, if the holder acquired the indebtedness in anticipation of becoming related to the debtor. 136 (1) Proof of Anticipation of Relationship. In determining whether indebtedness was acquired by a holder in anticipation of becoming related to the debtor, all relevant facts and circumstances are considered. 137 Such facts and circumstances include, but are not limited to, the intent of the parties at the time of the acquisition, the nature of any contacts between the parties (or their respective affiliates) before the acquisition, the period of time for which the holder held the indebtedness, and the significance of the indebtedness in proportion to the total assets of the holder group. 138 For this purpose, the holder group consists of the holder of the indebtedness and all persons who are both (a) related to the holder before the holder becomes related to the debtor; and (b) related to the debtor after the holder becomes related to the debtor. 139 For example, if a holder acquired the indebtedness in the ordinary course of its portfolio investment activities and the holder s acquisition of the indebtedness preceded any discussions concerning the acquisition of the holder by the debtor (or by a person related to the debtor) or the acquisition of the debtor by the holder (or by a person related to the holder), as the case may be, these facts, taken together, would ordinarily establish that the holder did not 132 I.R.C. 108(e)(4)(B); Treas. Reg (d)(2). 133 I.R.C. 108(e)(4)(C); Treas. Reg (d)(2). 134 Treas. Reg (b). 135 Notice of Proposed Rulemaking, CO-90-90, reprinted in 91 TNT 64-12; see T.D. 8460, C.B. 19 ( In response to comments received, the Service intends to study the extent, if any, to which a direct acquisition should not occur if the indebtedness and an ownership interest in the debtor are acquired together from the same person, and that person was related to the debtor immediately prior to the transaction. 136 Treas. Reg (c)(1). 137 Treas. Reg (c)(2). 138 Treas. Reg (c)(2). 139 Treas. Reg (c)(5) v.2 29

39 acquire the indebtedness in anticipation of becoming related to the debtor. 140 The absence of discussions between the debtor and the holder (or their respective affiliates), however, does not by itself establish that the holder did not acquire the indebtedness in anticipation of becoming related to the debtor (if, for example, the facts and circumstances show that the holder was considering a potential acquisition of or by the debtor, or the relationship is created within a relatively short period of time of the acquisition, or the indebtedness constitutes a disproportionate portion of the holder group s assets). 141 (2) Holder is Treated as Having Acquired Indebtedness in Anticipation of Becoming Related to the Debtor if Indebtedness is Acquired Less Than 6 Months Before Becoming Related. A holder is treated as having acquired indebtedness in anticipation of becoming related to the debtor if the holder acquired the indebtedness less than 6 months before the date the holder becomes related to the debtor. 142 (3) Disclosure of Potential Indirect Acquisition. (A) In General. If a holder of outstanding indebtedness becomes related to the debtor under one of two circumstances, the debtor is required to attach a statement (described below) to its tax return (or to a qualified amended return within the meaning of Treas. Reg (c)(3)) for the taxable year in which the debtor becomes related to the holder, unless the debtor reports its income on the basis that the holder acquired the indebtedness in anticipation of becoming related to the debtor. 143 The two circumstances are: (i) Indebtedness Represents More Than 25 Percent of Holder Group s Assets: On the date the holder becomes related to the debtor, indebtedness of the debtor represents more than 25 percent of the fair market value of the total gross assets of the holder group. 144 In determining the total gross assets of the holder group, total gross assets do not include any cash, cash item, marketable stock or security, short-term indebtedness, option, futures contract, notional principal contract, or similar item (other than indebtedness of the debtor), nor do total gross assets include any asset in which the holder has substantially reduced its risk of loss. In addition, total gross assets do not include any ownership interest in or indebtedness of a member of the holder group. 145 (ii) Indebtedness Acquired 6 Months or More But Less Than 24 Months of Becoming Related: The holder acquired the indebtedness Treas. Reg (c)(2). 141 Treas. Reg (c)(2). 142 Treas. Reg (c)(3). 143 Treas. Reg (c)(4)(i). 144 Treas. Reg (c)(4)(ii)(A). 145 Treas. Reg (c)(4)(ii)(B) v.2 30

40 months or more before the date the holder becomes related to the debtor, but less than 24 months before that date. 146 (B) Contents of Statement. The above-referenced disclosure statement must include the following: disclosure under Treas. Reg (c); respect to which disclosure is made; (i) (ii) A caption identifying the statement as An identification of the indebtedness with (iii) The amount of such indebtedness and the amount of income from discharge of indebtedness if the realization rule of Section 108(e)(4) were to apply; (iv) Whether the 25%-of-holder-group-asset test or the 6-to-24-month test applies to the transaction; and (v) A statement describing the facts and circumstances supporting the debtor s position that the holder did not acquire the indebtedness in anticipation of becoming related to the debtor. 147 (C) Failure to Disclose. In addition to any other penalties that may apply, if a debtor fails to provide the required statement, the holder is presumed to have acquired the indebtedness in anticipation of becoming related to the debtor unless the facts and circumstances clearly establish that the holder did not acquire the indebtedness in anticipation of becoming related to the debtor. 148 c. Exceptions. The regulations provide two exceptions to the relatedparty-acquisition rule of Treas. Reg (a). (1) Indebtedness Retired Within One Year. The first exception provides that Treas. Reg (a) does not apply to a direct or indirect acquisition of indebtedness with a stated maturity date on or before the date that is one year after the date of the direct or indirect acquisition. 149 Indebtedness qualifies for this exception only if it is, in fact, retired on or before its stated maturity date. 150 The Preamble to the Final Regulations provides that, while Section 108(e)(4) could be applied in such cases, the one-year rule was adopted so 146 Treas. Reg (c)(4)(iii). 147 Treas. Reg (c)(4)(iv). 148 Treas. Reg (c)(4)(v). 149 Treas. Reg (e)(1). 150 Treas. Reg (e)(1) v.2 31

41 that taxpayers would not be required to report income from discharge of indebtedness and then make correlative adjustments during such a short period. 151 (2) Acquisitions by Securities Dealers. The second exception provides that Treas. Reg (a) does not apply to a direct acquisition or an indirect acquisition of indebtedness by a dealer that acquires and disposes of such indebtedness in the ordinary course of its business of dealing in securities if (A) the dealer accounts for the indebtedness as a security held primarily for sale to customers in the ordinary course of business; (B) the dealer disposes of the indebtedness (or it matures while held by the dealer) within a period consistent with the holding of the indebtedness for sale to customers in the ordinary course of business, taking into account the terms of the indebtedness and the conditions and practices prevailing in the markets for similar indebtedness during the period in which it is held; and (C) the dealer does not sell or otherwise transfer the indebtedness to a person related to the debtor (other than in a sale to a dealer that in turn meets the requirements of this second exception). 152 Special rules are provided for indebtedness that is exchanged for successor indebtedness. 153 d. Amount of Discharge of Indebtedness Income Realized. (1) Holder Acquired the Indebtedness by Purchase On or Less Than Six Months Before the Direct or Indirect Acquisition Date. The amount of discharge of indebtedness income realized under Treas. Reg (a) is generally measured by reference to the adjusted basis of the related holder (or of the holder that becomes related to the debtor) in the indebtedness on the direct or indirect acquisition date if the holder acquired the indebtedness by purchase on or less than six months before such date. 154 For purposes of this 151 T.D. 8460, 1993 C.B Treas. Reg (e)(2)(i). 153 Treas. Reg (e)(2)(ii). 154 Treas. Reg (f)(1). The Preamble to the final regulations provides the following helpful background to the development of this rule: In most cases (for example, where an affiliate of the debtor buys the indebtedness for cash), the holder s cost should equal, or at least approximate, the fair market value of the indebtedness. However, disparities could potentially arise in three significant cases. One is where the related party acquires the indebtedness in exchange for its own indebtedness (a debt swap) and the issue price of the related party s indebtedness is not determined by reference to the fair market value of either instrument. Another is in an indirect acquisition, where the value of the indebtedness can change between the time the holder acquires the indebtedness and the time the holder becomes related to the debtor. The third is where the indebtedness is acquired in a nonrecognition transaction, in which case the holder s basis generally reflects the transferor s earlier cost rather than the current economic cost to the debtor group of acquiring the indebtedness. The proponents of a cost standard argued that the treatment of an indebtedness acquired by a related person under Section 108(e)(4) should mirror the treatment of an acquisition of indebtedness by the debtor itself. In the latter case, under Section and Section 108(e)(11), the amount of income from discharge of indebtedness is generally determined by reference to the debtor s cost of acquiring the indebtedness v.2 32

42 rule, indebtedness is acquired by purchase if the indebtedness in the hands of the holder is not substituted basis property. 155 Indebtedness, however, is also considered acquired by purchase within six months before the acquisition date if the holder acquired the indebtedness as transferred basis property from a person who acquired the indebtedness by purchase on or less than six months before the acquisition date. 156 (2) Holder Did Not Acquire the Indebtedness by Purchase On or Less Than Six Months Before the Acquisition Date. The amount of discharge of indebtedness income realized under Treas. Reg (a) is measured by reference to the fair market value of the indebtedness on the acquisition date if the holder (or the transferor to the holder in a transferred basis transaction) did not acquire the indebtedness by purchase on or less than six months before the acquisition date. 157 (3) Avoidance Transactions. The amount of discharge of indebtedness income realized by the debtor under Treas. Reg (a) is measured by reference to the fair market value of the indebtedness on the acquisition date if the indebtedness is acquired in a direct or an indirect acquisition in which a principal purpose for the acquisition is the avoidance of federal income tax. 158 The Preamble to the Final Regulations provides that such As noted above, in most cases subject to Section 108(e)(4), the cost and fair market value standards should produce similar results. The Service and Treasury believe that, where the two standards would differ, the correct economic measure of the cost of acquiring the debt (and, thus, of discharge of indebtedness income) is by reference to fair market value. However, the Service and Treasury have concluded that, in most circumstances, the related holder s cost of acquiring the indebtedness is a reasonable measure for determining the amount of discharge of indebtedness income. For example, because discharge of indebtedness income in debt swaps by the debtor is measured by reference to the debtor s cost rather than always measured by reference to fair market value, the Service and Treasury are persuaded that the cost standard should generally apply in debt swaps by debtor affiliates. Moreover, the use of cost is significantly less burdensome because it eliminates the need to value the indebtedness. Consequently, the final regulations adopt a cost standard in computing discharge of indebtedness income for most transactions subject to Section 108(e)(4). Except in certain special cases, this rule applies as long as the related holder (or a holder that becomes related to the debtor) acquires the debt by purchase on or less than six months before the acquisition date. For this purpose, a purchase occurs if the indebtedness in the hands of the holder is not substituted basis property within the meaning of Section 7701(a)(42) (e.g., if the holder has a cost basis under Section 1012 or a fair market value basis under Section 301(d)). Where the holder s basis is not established by purchase within the six month period, the final regulations retain the fair market value measuring standard. In that case, the holder s cost of acquiring the indebtedness provides a less reliable measure of the debtor s discharge of indebtedness, i.e., that cost would be less likely to bear a reasonable relationship to the fair market value of the debt and, thus, to the economic cost to the debtor group of reacquiring its debt. It is expected that this rule will apply infrequently because of the limited scope of the indirect acquisition rules. 155 T.D. 8460, 1993 C.B Treas. Reg (f)(1). 157 Treas. Reg (f)(2). 158 Treas. Reg (f)(4) v.2 33

43 an avoidance purpose may be inferred, for example, in a transaction that shifts the discharge of indebtedness income of a domestic corporation to a foreign affiliate. 159 e. Correlative Adjustments. (1) Deemed Issuance Rule. If a debtor realizes income from discharge of its indebtedness in a direct or an indirect acquisition under Treas. Reg (a) with respect to any indebtedness (whether or not the income is excludible under Section 108(a)), the debtor s indebtedness is treated as new indebtedness issued by the debtor to the related holder on the date of the direct or indirect acquisition (the deemed issuance ). 160 The new indebtedness is deemed issued with an issue price equal to the amount used to compute the amount realized by the debtor (i.e., either the holder s adjusted basis or the fair market value of the indebtedness, as the case may be). 161 The deemed issuance applies for all purposes of the Code. 162 The consequence of the deemed issuance is that the excess of the stated redemption price at maturity (as defined in Section 1273(a)(2)) of the indebtedness over its issue price is original issue discount (under Section 1273(a)(1)). 163 Thus, to the extent provided in Sections 163 and 1272, original issue discount ( OID ) is deductible by the debtor and includible in the gross income of the related holder. 164 Under Section 1273(a)(1), the excess of the stated redemption price at maturity (as defined in Section 1273(a)(2)) of the indebtedness over its issue price is OID which, to the extent provided in Sections 163 and 1272, is deductible by the debtor and includible in the gross income of the related holder. 165 (2) Treatment of Related Holder. The related holder does not recognize any gain or loss on the deemed issuance. 166 The related holder s adjusted basis in the indebtedness remains the same as it was immediately before the deemed issuance. 167 The deemed issuance is treated as a purchase of the indebtedness by the related holder for purposes of Section 1272(a)(7) (pertaining to reduction of original issue discount where a subsequent holder pays acquisition premium) and Section 1276 (pertaining to acquisitions of debt at a market discount). 168 The Notice of Proposed Rulemaking states that this will rule enable the holder to 159 T.D. 8460, 1993 C.B Treas. Reg (g)(1). 161 Treas. Reg (g)(1). 162 Treas. Reg (g)(1). 163 Treas. Reg (g)(1); Notice of Proposed Rulemaking, CO-90-90, reprinted in 91 TNT Treas. Reg (g)(1); Notice of Proposed Rulemaking, CO-90-90, reprinted in 91 TNT Treas. Reg (g)(1). 166 Treas. Reg (g)(2). 167 Treas. Reg (g)(2). 168 Treas. Reg (g)(2) v.2 34

44 use any basis in excess of the new issue price as an offset against the OID of the reissued indebtedness. 169 f. Example. The following example taken from the Regulations illustrates the application of the correlative adjustment rule. In this example, all taxpayers are calendar-year taxpayers, no taxpayer is insolvent or under the jurisdiction of a court in a title 11 case and no indebtedness is qualified farm indebtedness. 170 P, a domestic corporation, owns 70 percent of the single class of stock of S, a domestic corporation. S has outstanding indebtedness that has an issue price of $10,000,000 and provides for monthly interest payments of $80,000 payable at the end of each month and a payment at maturity of $10,000,000. The indebtedness has a stated maturity date of December 31, On January 1, 1992, P purchases S s indebtedness from I, an unrelated individual, for cash in the amount of $9,000,000. S repays the indebtedness in full at maturity. S realizes $1,000,000 of income from discharge of indebtedness on January 1, The indebtedness is treated as issued to P on January 1, 1992, with an issue price of $9,000, The $1,000,000 excess of the stated redemption price at maturity of the indebtedness ($10,000,000) over its issue price ($9,000,000) is original issue discount, 173 which is includible in gross income by P and deductible by S over the remaining term of the indebtedness. 174 Accordingly, S deducts and P includes in income original issue discount, in addition to stated interest, as follows: in 1992, $289,144.88; in 1993, $331,286.06; and in 1994, $379, E. Treatment of Release from Guarantee. The Tax Court has held that the release from a guarantee does not result in cancellation of indebtedness income. In Landreth v. Commissioner, 176 the Tax Court addressed this issue and concluded as follows: If the respondent intends to suggest that any person who guarantees the payment of a loan realizes income when the principal debtor discharges the loan, we reject the proposition. The respondent cites, and we have found, no authority for the proposition that a guarantor constructively receives income when the debtor makes payments to the creditor on his obligation, and we think that it has no foundation in the principles of tax law. The situation of a guarantor is not like that of a debtor who as a result of the original loan obtains a nontaxable increase in assets. The guarantor obtains nothing except perhaps a taxable consideration for his promise. Where a debtor is relieved of his obligation to repay the loan, his net worth is increased over what it would have been if the original transaction had 169 Notice of Proposed Rulemaking, CO-90-90, reprinted in 91 TNT Treas. Reg (g)(4). 171 I.R.C. 61(a)(12); I.R.C. 108(e)(4); Treas. Reg (a); Treas. Reg (f). 172 Treas. Reg (g)(1). 173 See I.R.C. 1273(a). 174 See I.R.C. 163(e) and 1272(a). 175 Treas. Reg (g)(4), Example T.C. 803 (1968) v.2 35

45 never occurred. This real increase in wealth may be properly taxable. United States v. Kirby Lumber Co., 284 U.S. 1 (1931). However, where 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. Commissioner v. Rail Joint Co., 61 F.2d 751 (C.A. 2, 1932); Fashion Park, Inc., 21 T.C. 600 (1954). Payment by the principal debtor does not increase the guarantor s net worth; it merely prevents it, pro tanto, from being decreased. The guarantor no more realizes income from the transaction that he would if a tornado, bearing down on his home and threatening a loss, changes course and leaves the house intact Landreth v. Commissioner, 50 T.C. 803, ; See Payne v. Commissioner, 75 T.C.M. (CHH) 2548, 2561 (1998) ( In Landreth v. Commissioner, we distinguished the situation involving a guarantor of a debt from that of a primary obligor on a debt, and we concluded that a guarantor of a debt, upon the payment of the debt by the primary obligor, does not realize discharge of indebtedness income when relieved of an obligation under a guaranty. * * * On the evidence before us, we conclude that the discharge of the balance due on Payne & Potter s $705,000 debt obligation to TexCommBk may have resulted in discharge of indebtedness income to Payne & Potter but not to petitioner. When petitioner s contested liability as guarantor of the debt obligation was settled, petitioner did not realize an increase in net worth, and petitioner is not to be charged with discharge of indebtedness income with regard thereto. ); Whitmer v. Commissioner, 71 T.C.M. (CCH) 2213, 2215 (1996) ( It is hornbook law that gross income includes income from the discharge of debt, and that a taxpayer may realize COD income by paying an obligation at less than its face value. It does not naturally follow from this firmly established law, however, that a guarantor such as petitioner will always realize COD income on the discharge of a primary obligor s debt. We have found no case in which a guarantor such as petitioner realized COD income from a discharge of debt. In Kirby Lumber, the seminal case on COD income, the debtor was primarily liable for the debt. ); see also Merkel v. Commissioner, 109 T.C. 463, (1997) ( In Landreth v. Commissioner, 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. 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. [Citations omitted.]); Hunt v. Commissioner, 59 T.C.M. (CCH), 635, 650 (1990) ( Even assuming, arguendo, that the PCA represented true debt, it was a contingent liability in that it bound the three limited partners only in the event that the partnership income was insufficient to meet partnership expenses. Since the three brothers were never called upon to make these payments, the PCA remained a contingent liability. At the dissolution of PIL in 1982, Placid, the creditor, chose not to look to the limited partners to make their PCA payments. Placid had good business reasons for not forcing the limited partners into paying their PCA obligations. Forcing the limited partners to pay would have caused them to seek the protection of the bankruptcy laws, causing damage to Placid s business relationships and credit. Placid also had an opportunity to profit handsomely from its retention of substantial silver assets which were depressed at that time. The receipt of the North Dakota lignite reserves also served to even up the accounts and gave Placid another opportunity to profit. None of the three Hunt brothers, as limited partners, had cancellation of indebtedness income as a result of his release from the contingent PCA obligation, which, as we have opined earlier, was not true debt in the sense of Section 61, but only a contingent contract requirement to make capital contributions. ); cf. FSA 2050 (Feb. 28, 1997) ( In Landreth v. Commissioner, 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 v.2 36

46 In a nonbinding 2002 Information Letter, the Service stated that while the Service rejects the Rail Joint rationale, we generally agree that a guarantor (whether or not the primary obligor has defaulted and the guarantor has become liable for the indebtedness) does not realize cancellation of indebtedness income on release of a liability, based upon 108(e)(2). 178 Section 108(e)(2) provides that no income is realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction F. Equity-for-Debt Exchanges. 1. Indebtedness Treated as Satisfied With an Amount of Money Equal to the Fair Market Value of the Stock or Partnership Interest. If a corporation transfers stock, or a partnership transfers a capital or profits interest in such partnership, to a creditor in satisfaction of its indebtedness, then such corporation or partnership is treated as having satisfied its indebtedness with an amount of money equal to the fair market value of the stock or interest. 179 In the case of any partnership, any discharge of indebtedness income recognized under the preceding sentence is included in the distributive shares of taxpayers which were the partners in the partnership immediately before such discharge. 180 On October 31, 2008, the Service issued Proposed Regulations providing guidance regarding the determination of obligation to repay the loan, enjoys an increase in net worth that may be properly taxable. 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. [Citations omitted.]). 178 Info. Ltr (Mar. 29, 2002) ( The Tax Court has used a similar rationale in cases relating to whether a guarantor realizes cancellation of indebtedness income. As discussed in the Memorandum on page 21, in Landreth v. Commissioner, the Tax Court found that a guarantor does not realize cancellation of indebtedness income when the underlying debt is paid. The Landreth case also relies on the Rail Joint line of authority: However, where 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. Payment by the principal debtor does not increase the guarantor s net worth; it merely prevents it, pro tanto, from being decreased. The Tax Court extended the Rail Joint rationale to a guarantor in a case in which the underlying obligation is unpaid and the guarantor becomes liable for the indebtedness. The Service has generally disagreed with the rationale in the Rail Joint case. Thus, the Service has generally taken the position that COD income must be recognized to the extent indebtedness has been cancelled, notwithstanding that nothing of value was received when the personal liability notes were executed. For example, in a recent Chief Counsel Advice memorandum, cancellation of a penalty imposed upon an individual for failure to perform a service obligation under a contract was determined to be cancellation of indebtedness income regardless of the fact that the debtor arguably obtained nothing of value when the indebtedness was incurred. However, while the Service rejects the Rail Joint rationale, we generally agree that a guarantor (whether or not the primary obligor has defaulted and the guarantor has become liable for the indebtedness) does not realize cancellation of indebtedness income on release of a liability, based upon 108(e)(2). ). 179 I.R.C. 108(e)(8); see generally Blumenreich, Proposed Regulations on Partnership Debt for Equity Exchanges IRS Addresses Certain Outstanding Questions But Defers on Others, 25 Tax Mgmt. Real Est. J. (BNA) 83 (2009); AICPA Comments on Proposed Regs on Discharge of Partnership Indebtedness Income, 2009 TNT (Apr. 22, 2009); Bar Report Proposes Code Changes Regarding Partnerships, 2007 TNT (May 31, 2007). 180 I.R.C. 108(e)(8); cf. Priv. Ltr. Rul (Mar. 20, 1998) ( Section 108(e)(8), not Section 108(e)(6) applies, because the Debtor issued stock in return for cancellation of each of the debts, which issuance of stock cannot, on the facts be ignored. ) v.2 37

47 discharge of indebtedness income of a partnership that transfers a partnership interest to a creditor in satisfaction of the partnership s indebtedness. 2. Recapture of Gain on Subsequent Sale of Equity Interest. If a creditor acquires stock of the debtor corporation in exchange for the corporation s indebtedness, then upon subsequent disposition of the stock, any deduction taken with respect to the debt either as a bad debt deduction or as an ordinary loss on the exchange (reduced by any gain on the exchange) is subject to recapture under the rules of Section The IRS is authorized to issue regulations applying similar rules with respect to the indebtedness of a partnership. 182 G. Contribution of Debt Instrument to Capital of a Corporation. If a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, Section 118 (providing, in general, that in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer) does not apply, but the corporation is treated as satisfying such indebtedness with an amount of money equal to the shareholder s adjusted basis in the indebtedness. 183 H. Indebtedness Satisfied by Issuance of Debt Instrument. If a debtor issues a debt instrument in satisfaction of indebtedness, such debtor is treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument. 184 For this purpose, the issue price of any debt instrument is determined under Sections 1273 and IV. Step4: Prior to Applying Exclusions in Section 108(a), Determine Whether Any Exception to Cancellation of Indebtedness Applies. The general rule is that taxable income includes discharge of indebtedness income. There are several exceptions in the law to this general rule. Prior to applying the exclusions in Section 108(a), it is important to determine whether any other exceptions to the inclusion of cancellation of indebtedness apply. These exceptions include the cancellation of a deductible debt, the reduction of a purchase-money debt, the disputed debt doctrine and the cancellation of a debt intended as a gift. A. Income Not Realized to Extent of Lost Deductions. Section 108(e)(2) 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. 186 The legislative history 181 I.R.C. 108(e)(7). 182 I.R.C. 108(e)(7)(E). 183 I.R.C. 108(e)(6); see, e.g., Priv. Ltr. Rul (Sept. 26, 2005) ( Sub 1 will be treated as having satisfied Loan 2 with an amount of money equal to the fair market value of the Sub 1 stock issued to Foreign Sub 4 in exchange for the contribution of Loan 2. [Citation omitted.]). 184 I.R.C. 108(e)(10)(A). 185 I.R.C. 108(e)(10)(B). For purposes of the preceding sentence, Section 1273(b)(4) is applied by reducing the stated redemption price of any instrument by the portion of such stated redemption price which is treated as interest. I.R.C. 108(e)(10)(B). 186 Cf (Sept. 18, 1992) ( Because payment of the portion of the debt allocable to the stock would give rise to a deduction, Section 108(e)(2) applies to that portion of the debt. * * * Similarly, the accrued interest with respect v.2 38

48 provides the following example: Assume a cash-basis taxpayer owes $1,000 to its cash-basis employee as salary and has not actually paid such amount. If later the employee forgives the debt (whether or not as a contribution to capital), then the discharge does not give rise to income or require any reduction of tax attributes. 187 B. Purchase-Money Debt Reduction. Section 108(e)(5) permits a debt reduction to be treated as a purchase price adjustment under certain circumstances. 188 Section 108(e)(5) provides that if (A) the debt of a purchaser of property to the seller arising out of the purchase is reduced, (B) the debt reduction does not occur in a title 11 bankruptcy case or when the purchaser is insolvent, and (C) the reduction would be treated as income to the purchaser from the discharge of indebtedness but for Section 108(e)(5), then such reduction will be treated as a purchase price adjustment. 189 This purchase price adjustment treatment will result in a reduction in the basis of the property securing the debt rather than discharge of indebtedness income. 190 Section 108(e)(5) provides an exception to Section 61(a)(12) where the buyer of property negotiates with the seller/creditor for a discharge of all or part of the purchase money to properties 3 through 8 and with respect to the stock in X is also not taken into account. [Citations omitted.]); Priv. Ltr. Rul (Dec. 30, 1985) ( Assuming Corp B properly accrues income and properly makes a charge to its bad debt reserve when the foreign borrower does not discharge Corp B s foreign tax liability, Corp B arguably realizes income from the discharge of indebtedness under Section 61(a)(12) of the Code when the foreign government fails to collect the delinquent taxes from it. In the instant case, payment by Corp B of its foreign tax liability could have given rise to a deduction under Section 164 of the Code, had Corp B not elected to claim a foreign credit under Section 901 of the Code. Therefore, under Section 108(e)(2) no income would be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction. It is the Service s position that Section 108(e)(2) was intended to cover the situation presented here, notwithstanding that Section s specific reference to a deduction instead of a credit. Therefore, Corp B should not realize discharge of indebtedness income when the foreign government fails to collect delinquent taxes from it. ); F.S.A. 896 (Apr. 29, 1992) ( We also note that if[redacted text] is considered to be released from making lease payments in an amount less than legally required under the lease it would not give rise to discharge of indebtedness under Section 108(e)(2). Section 108(e)(2) provides that no income is realized to the extent payment of the liability would have given rise to a deduction. Presumably, if this were classified as a lease payment [redacted text] would be able to deduct the payment. Thus, a release for an amount less then legally required under the lease would not give rise to discharge of indebtedness income. ); NSAR 08741, Vaughn #8741 ( Section 108(e)(2) provides that no income is realized from the discharge of indebtedness to the extent that payment of the indebtedness would have given rise to a deduction. For example, since due but unpaid interest on a loan incurred in a trade or business of a taxpayer would generally be deductible under Section 163 of the Code if paid, Section 108(e)(2) precludes the realization of income from the discharge of such interest indebtedness that would have been deductible if paid. ); Info. Ltr (Mar. 29, 2002) ( Section 108(e)(2) provides that no COD income is realized if payment of the obligation would have given rise to a deduction. A guarantor generally has a claim against the original debtor in an amount equal to the amount of the guarantee that is paid. Assuming such a claim is uncollectible, it would give rise to a bad debt deduction or capital loss for the guarantor if the guarantee were paid. Therefore, cancellation of an obligation that arises pursuant to a guarantee appears to be subject to 108(e)(2). If the notes under which the taxpayers became personally liable on the indebtedness would entitle them to a claim against the original entity under applicable local law, which would give rise to a bad debt deduction, it could be argued that there is no COD on cancellation of the notes because of 108(e)(2). ). 187 S. Rep. No. 1035, reprinted in C.B Rev. Rul , C.B Rev. Rul Rev. Rul v.2 39

49 indebtedness. Commonly such a discharge reflects a decline in the value of the property. The resulting discharge of indebtedness is characterized not as taxable income but in effect as a retroactive reduction of the purchase price. Section 108(e)(5) was enacted to eliminate disagreements between the Service and the debtor as to whether, in a particular case to which the provision applies, the debt reductions should be treated as discharge income or a true price adjustment. 191 The provisions of this Section are not elective. 192 For a reduction in the amount of a debt to be treated as a purchase price adjustment under Section 108(e)(5), the Tax Court has held that the following conditions must be met: (1) the debt must be that of a purchaser of property to the seller which arose out of the purchase of such property; 193 (2) the taxpayer must be solvent and not in bankruptcy when the debt reduction occurs; 194 and (3) except for Section 108(e)(5), the debt reduction would otherwise have resulted in discharge of indebtedness income S. Rep. No (1980), C.B. 620, 628; Zarin v. Commissioner, 92 T.C. 1084, 1098 (1989), rev d on other grounds, 916 F.2d 110 (3rd Cir. 1990); see also Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3122 n. 2 (1996) ( In Zarin v. Commissioner, we concluded that sec. 108(e)(5) was inapplicable to the settlement of gambling debts, and that conclusion was not disturbed or criticized by the Court of Appeals for the Third Circuit. [Citation omitted.]). 192 Zarin v. Commissioner, 92 T.C. at Preslar v. Commissioner, 167 F.3d 1323, 1331 (10 th Cir. 1999) ( Section 108(e)(5) applies only to direct agreements between a purchaser and seller. S. Rep. No at 16 (1980), reprinted in 1980 U.S.C.C.A.N. 7017, If the debt has been transferred by the seller to a third party (whether or not related to the seller), or if the property has been transferred by the buyer to a third party (whether or not related to the buyer), the purchase price reduction exception is not available and normal discharge-of-indebtedness rules control. ); Sutphin v. Commissioner, 61 AFTR 2d (14 Cl Ct 545) (1988) ( [Sec. 108(e)(5)] only applies if the debt of a purchaser of property to the SELLER of such property is reduced. The plaintiffs here are clearly not indebted to the seller of their residence; Park View did not sell the Sutphins their residence. Consequently, Section 108(e)(5) is unavailable to plaintiffs. ); Payne v. Commissioner, 95 T.C.M. (CCH) 1253, 1254 (2008) ( Where, however, the only relationship between the parties is that of debtor and creditor, The rule of Kirby Lumber is clearly applicable. [Emphasis in original.]); O Malley, et ux v. Commissioner, 93 T.C.M. (CCH) 1064, 1084 n. 31 (2007) ( Nonetheless, it is noteworthy that, consistent with its plain language, the legislative history of sec. 108(e)(5) provides that that Section applies only when the debt of a purchaser of property to the seller of such property, which arose out of the purchase of such property, is reduced. ); see Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1674 (1991) ( Petitioners are not eligible for this exception because they have not shown that the debt of the purchase of the property was owed to the seller of the property. * * * They have provided no evidence that the debt which was reduced was the debt of a purchaser to the seller. Consequently, we hold that Section 108(e)(5) does not apply here. ); Juister v. Commissioner, 53 T.C.M. (CCH) 1079, 1081 (1987) ( The reduction by Standard Federal of the principle amount of petitioners mortgage also cannot be treated as a purchase price adjustment under Section 108(e)(5) because petitioners were indebted to Standard Federal and not the seller of the property. ); cf. Field Service Advice 768, Vaughn #768 (July 15, 1993) ( We believe that it is entirely consistent with the general reorganization tax policy of Section 381 to treat [redacted text] as succeeding to [redacted text] status as original purchaser for purposes of Section 108(e)(5) notwithstanding the fact that Section 381 does not explicitly provide for such status. Therefore, [redacted text] as the successor of [redacted text] under Section 381, should succeed to [redacted text] status as original purchaser. ). 194 House v. Commissioner, 69 T.C.M. (CCH) 2005, 2011 (1995) ( The parties stipulated that the debt reduced was that owed to the Georges, who were the sellers of the property. There is no evidence that petitioners were insolvent at the time of the reduction, or that the reduction occurred in the context of a title 11 case. Consequently, this v.2 40

50 In addition to these literal statutory requirements, the Tax Court, relying on the legislative history to the statute, has concluded that Section 108(e)(5) was intended to apply only if the following requirements are also met: (a) the price reduction must result from an agreement between the purchaser and the seller and not, for example, from a discharge as a result of the bar of the statute of limitations on enforcement of the obligation; (b) there has been no transfer of the debt by the seller to a third party; and (c) there has been no transfer of the purchased property from the purchaser to a third party. 196 In Revenue Ruling 92-99, the Service concluded that if the principal amount of an undersecured nonrecourse debt that arose out of the purchase of property is reduced by the holder of the debt who was not the seller of the property, this debt reduction may not be treated as a purchase price adjustment (in the absence of an infirmity that clearly relates back to the original sale) but results in discharge of indebtedness income under Section 61(a)(12). The Service will, however, treat a debt reduction in third-party lender cases as a purchase price adjustment to the extent that the debt reduction by the third-party lender is based on an infirmity that clearly relates back to the original sale (e.g., the seller s inducement of a higher purchase price by misrepresentation of a material fact or by fraud). 197 Revenue Ruling considers the following facts: In 1988, individual A purchased an office building from B for $1,000,000, its fair market value. To pay for the building, A signed a note payable to C, a third-party lender, for $1,000,000. The note bore interest at a fixed market rate payable annually and was secured by the office building. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note s principal amount to $800,000. The facts assume that C s reduction in the note was not based on an infirmity that clearly related back to B s original sale. The modified note bore adequate stated interest within the meaning of Section 1274(c)(2) of the Code. The Ruling concludes that A realizes $200,000 of discharge of indebtedness income in 1989 under Section 61(a)(12) of the Code. The Service reasoned that an agreement to reduce a debt between a purchaser and a third-party lender is not a true adjustment of the purchase price paid for the property because the seller has received the entire purchase price from the purchaser and is not a party to the debt reduction agreement. Revenue Procedure provides guidance on the federal income tax treatment of a discharge of indebtedness owed by a bankrupt or insolvent partnership that would meet the requirements of a purchase price adjustment under Section 108(e)(5) but for the bankruptcy or insolvency of the partnership. In that Revenue Procedure, the Service announced that, in the case of a partnership that is either bankrupt or insolvent for purposes of Section 108, the Service transaction falls within the parameters of Section 108(e)(5), and petitioners do not have discharge of indebtedness income. ) T.C. at S. Rep. No. 1035, C.B. 620, 628; Zarin v. Commissioner, 92 T.C. at 1099; cf. Field Service Advice 768, Vaughn #768 (July 15, 1993) (referencing additional requirements from legislative history). 197 Rev. Rul C.B v.2 41

51 will not challenge the partnership s treatment of a reduction (in whole or in part) of an indebtedness owed by such partnership as a purchase price adjustment, provided the transaction would qualify as a purchase price adjustment within the meaning of Section 108(e)(5) but for the bankruptcy or insolvency of the partnership. This treatment will not apply to a partnership, however, if any partner in that partnership adopts a federal income tax reporting position with respect to the debt discharge that is not consistent with the partnership s federal income tax treatment of that discharge. 199 C. Disputed Debt Doctrine. The contested liability or, as it is occasionally known, disputed debt doctrine rests on the premise that if a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of that dispute is treated as the amount of debt cognizable for tax purposes. In other words, the excess of the original debt over the amount determined to have been due may be disregarded in calculating gross income. 200 The scope of the disputed debt doctrine is not entirely settled. The Tenth Circuit has observed that the few decisions that have interpreted this doctrine have generated considerable controversy. 1. Origins of the Disputed Debt Doctrine. The origins of the contested liability doctrine can be traced to N. Sobel, Inc. v. Commissioner, 201 a case arising during the Great Depression. 202 In that case, a New York corporation purchased 100 shares of a bank s stock and signed a $21,700 note as payment. Upon the maturity of the note, the stock was worthless. The corporation sued the bank for rescission, insisting the loan contravened state law and the bank had failed to fulfill its promise to guarantee the corporation against loss. Shortly thereafter, the state superintendent of banks closed the bank because of insolvency and initiated a countersuit against the corporation for the amount of the note. The parties ultimately settled the consolidated proceedings with the corporation paying the superintendent $10,850 in return for discharge of the debt. The corporation then took a $10,850 deduction in the year of settlement. The Commissioner disallowed the deduction and assessed a $10,850 deficiency, representing the amount of the original loan over the settlement figure. 203 The Board of Tax Appeals reversed the Commissioner and upheld the deduction, concluding the corporation s ownership of the shares and the degree of liability on the note were 199 Cf. Priv. Ltr. Rul (June 10, 2003) ( Under the facts presented, the seller of the property, B, agreed to discharge the debt that was part of the purchase price owed by the Taxpayer, who was insolvent at the time. F s assertion of its rights under the Agreement did not effectively force B to discharge the Note. Taxpayer is not directly or indirectly indebted to F with respect to the Note; B currently retains all rights as creditor with respect to the Note. The debt being discharged is owned by Taxpayer to B, and B is discharging Taxpayer s Note. Based solely on the information provided and the representations made, we conclude that under Rev. Proc Taxpayer may treat B s discharge of Taxpayer s Note as a purchase price adjustment. This treatment will not apply if any partner in Taxpayer adopts a federal income tax reporting position inconsistent with Taxpayer s treatment. ). 200 Preslar v. Commissioner, 167 F.3d 1323, 1327 (10 th Cir. 1999) (quoting Zarin v. Commissioner, 916 F.2d 110, 115 (3rd Cir. 1990)); see Estate of Smith v. Commissioner, 198 F.3d 515 (5 th Cir. 1999) B.T.A (1939). 202 Preslar v. Commissioner, 167 F.3d 1323, 1327 (10 th Cir. 1999) B.T.A. at v.2 42

52 highly unclear. 204 The Board found the corporation s financial obligations could not be assessed definitively prior to resolution of its dispute with the superintendent and, since settlement compromised the parties claims and precluded recognition of their legal rights, the existence and amount of the corporation liability were not fixed until the date of settlement. Thus, release of the note did not amount to a gain for the corporation Question Exists as to Scope of Doctrine. The Tax Court has noted that there is some question as to whether the disputed debt rule applies only to an unliquidated debt, i.e., one the amount of which is undetermined, regardless whether the debt is enforceable, or whether the rule also applies where there is a dispute as to a debt s enforceability. 206 a. Third Circuit Decision in Zarin v. Commissioner. In Zarin v. Commissioner, 207 the Third Circuit embraced the reasoning of N. Sobel Inc. while reversing the Commissioner s recognition of discharge-of-indebtedness income. The state gaming commission identified Zarin as a compulsive gambler and ordered an Atlantic City casino to refrain from issuing him additional credit, but the casino ignored the commission. 208 When Zarin s debt surpassed $3.4 million, the casino filed a state action to collect the funds. Zarin initially denied liability on the grounds the casino s claim was unenforceable under New Jersey law. The parties later settled the dispute for $500, After Zarin failed to account for the debt write-off on his tax return, the Commissioner assessed a deficiency for approximately $2.9 million, the amount by which Zarin s underlying debt exceeded his settlement with the casino. The Tax Court affirmed. However, a divided Third Circuit held Zarin had no discharge-ofindebtedness income because his transaction with the casino arose from a contested liability. 210 Citing no authority, the majority reasoned that [w]hen a debt is unenforceable, it follows that the amount of the debt, and not just the liability thereon, is in dispute. 211 Therefore, the $500,000 settlement fixed the amount of loss and the amount of debt cognizable for tax purposes See id. at 1265 ( There is question whether the taxpayer bought property in 1929 and question as to its liability and the amount thereof, and this question was suspended in litigation until the 1935 compromise agreement with the state superintendent of banks. ) B.T.A. at Rood v. Commissioner, 71 T.C.M. (CCH) 3125, 3132, n. 1 (1996) ( We note that there is some question as to whether the disputed debt rule applies only to an unliquidated debt, i.e., one the amount of which is undetermined, regardless whether the debt is enforceable, or whether the rule also applies where there is a dispute as to a debt s enforceability. We need not address that question, however, because we hold below that petitioner has not carried his burden of proving that there was a dispute as to either the amount or the enforceability of his debt to Caesar s. [Citations omitted.]) F.2d 110, 115 (3rd Cir. 1990) F.2d at F.2d at F.2d at Id. at Id v.2 43

53 b. Tenth Circuit Decision in Preslar v. Commissioner. In Preslar v. Commissioner, 213 the Tenth Circuit criticized the Third Circuit s reliance on the contested liability doctrine in Zarin. 214 In Preslar, the Court of Appeals examined the history of the disputed debt doctrine. 215 The debt in Preslar was the balance owing on a $1 million promissory note. The note had been given to a bank by the taxpayers in connection with the purchase of a ranch that was to be developed by the taxpayers. 216 The bank permitted the taxpayers to repay the loan by assigning the installment sales contracts of the purchasers of the developed property to the bank at a discount. 217 When the payee-bank became insolvent, the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver. 218 The FDIC refused to accept further assignments of sales contracts as repayment. The taxpayers ceased making payments and filed an action against the FDIC. The action was settled after the FDIC agreed to accept $350,000 in full satisfaction of the indebtedness, on which the then balance was $799,463. The Court of Appeals held that the contested liability doctrine did not apply because the amount of the taxpayers debt was at all times liquidated. 219 The Court stated, in part: In addition, the Preslars characterization of their dispute with the FDIC as the culmination of their dispute over the ranch loan is not faithful to the evidence. The dispute with the FDIC focused only on the terms of repayment; it did not touch upon the amount or validity of the Preslars debt. *** In sum, the Preslars underlying indebtedness remained liquidated at all times. 220 The Preslar court criticized the Zarin decision for not recognizing the difference that the Preslar court perceived between disputes about the amount of the debt on the one hand and the F.3d 1323 (10 th Cir. 1999), rev g, 72 T.C.M. (CCH) 1496 (1996) F.3d at F.3d at F.3d at F.3d at F.3d at F.3d at 1327; see also Earnshaw v. Commissioner, 84 T.C.M. (CCH) 146, 148 (2002) ( We agree with respondent that the rationale of Preslar and similar cases applies to the balance of petitioner s Mastercard account as of the time in May 1996 that he made a $1,000 payment and acknowledged the balance of $29, before the payment. Petitioner has not disputed that he owed reimbursement to MBNA for the $1,200 cash advance in August 1996 and the $10 cash advance fee, and those amounts also appear to be liquidated. * * * We do not agree with respondent, however, that Mastercard s subsequent posting of various finance charges and late payment fees to petitioner s account creates a liquidated indebtedness. We need not address all of the implications of the Preslar opinion as to the scope of exceptions to the discharge of indebtedness income. The question in this case is whether a debt existed as asserted by respondent in the amount of $32, before the settlement between petitioner and MBNA. On the facts of this case, we do not totally agree with either party. ), aff d, 150 Fed. Appx. 745, 747 n. 1 (10 th Cir. 2005) ( The concept of discharge-of-indebtedness income,... codified in 26 U.S.C. 61(a)(12), requires taxpayers who have incurred a financial obligation that is later discharged in whole or in part, to recognize as taxable income the extent of the reduction in the obligation. ); Preslar v. Comm r, 167 F.3d 1323, 1327 (10th Cir. 1999) ( A discharged debt is not treated as income, however, if the taxpayer contested the debt. Thus, if a taxpayer contests the original amount of an alleged debt in good faith, a subsequent settlement of that dispute is treated as the amount of debt cognizable for tax purposes. In other words, the excess of the original debt over the amount determined to have been due may be disregarded in calculating gross income. Id. (quotations omitted). ). 220 Id. at v.2 44

54 enforceability of a claim for a sum certain on the other. 221 The Preslar court stated that [t]he problem with the Third Circuit s holding is it treats liquidated and unliquidated debts alike. The Tenth Circuit reasoned that [t]he whole theory behind requiring that the amount of a debt be disputed before the contested liability exception can be triggered is that only in the context of disputed debts is the Internal Revenue Service (IRS) unaware of the exact consideration initially exchanged in a transaction. 222 As the Preslar court more fully explained, [t]he mere fact that a taxpayer challenges the enforceability of a debt in good faith does not necessarily mean he or she is shielded from discharge of indebtedness income upon resolution of the dispute. To implicate the contested liability doctrine, the original amount of the debt must be unliquidated. A total denial of liability is not a dispute touching upon the amount of the underlying debt. 223 The Tenth Circuit stated that a holding to the contrary would strain the Service s treatment of unenforceable debts and, in large part, disavow the Supreme Court s mandate that the phrase gross income be interpreted as broadly as the Constitution permits. The Tenth Circuit also said that this conclusion is underscored by the Supreme Court s holding in Tufts that a nonrecourse mortgage (i.e., taxpayer has no personal liability upon default) must be treated as an enforceable loan both when it is made and when it is discharged. The Court reasoned that because the indebtedness is treated as a true debt when it is incurred, it must be treated as a true debt when it is discharged, with all the attendant tax consequences. The Court noted, however, if the debt is unenforceable as a result of an infirmity at the time of its creation (e.g., fraud or misrepresentation), tax liability may be avoided through a purchase price reduction under 26 U.S.C. Section 108(e)(5) or an infirmity exception. In Estate of Smith v. Commissioner, 224 the Fifth Circuit noted the broad view of the contested liability doctrine accepted by the Third Circuit in Zarin and the more narrow view taken by the Tenth Circuit in Preslar. For here, both the amount and the enforceability of the debt were contested vigorously by the Estate; it was not until settlement that Exxon s claim became liquidated. Thus, even if we assume arguendo that the view of the Preslar court is the correct one, the contested liability doctrine applies here and buttresses our conclusion that the Estate did not realize income from the discharge of indebtedness. D. Gift Exception to Cancellation of Debt Income. If the forgiveness of a debt constitutes a gift from the creditor to the debtor, the debtor realizes no income. 225 Although there 221 Preslar v. Commissioner, 167 F.3d 1323, 1328 (10 th Cir. 1999); Estate of Smith v. Commissioner, 198 F.3d 515, 525 (5 th Cir. 1999) F.3d at F.3d at 1329 (Footnote omitted). 224 Estate of Smith v. Commissioner, 198 F.3d 515 (5 th Cir. 1999). 225 Rev. Rul , C.B. 583 ( Not every indebtedness that is cancelled results in the debtor realizing gross income by reason of discharge of indebtedness within the meaning of 61(a)(12) and 108(a). Debt discharge that is only a medium for some other form of payment, such as a gift or salary, is treated as that form of payment, rather than under the debt discharge rules. S. Rep. No. 1035, 96th Cong., 2d Sess. 8 n.6 (1980), C.B. 620, 624 n.6. ); DiLaura v. Commissioner, 53 T.C.M. (CCH) 1077, 1078 (1987) ( There are, however, a number of statutory and judicial exceptions that cushion the impact of the general rule of discharge of indebtedness v.2 45

55 is no express abolition of the gift exception in Section 108, the legislative history of the Bankruptcy Tax Act of 1980, which amended Section 108, states, in the course of discussing provisions relating to the realization of cancellation of indebtedness income arising from contributions by a shareholder of debt to the capital of a corporation, that it is intended that there will not be any gift exception in a commercial context (such as a shareholder-corporation relationship) to the general rule that income is realized on the discharge of indebtedness. 226 V. Step 5: Determine Whether Cancellation of Indebtedness Income is Excludable (or, With Respect to Certain Reacquisitions of Debt Instruments, Deferred) Under Section 108. A. Section 108(a)(1): Overview. 1. Section 108 is an Exception to the General Rule of Section 61(a)(12). Section 61(a)(12) states in relevant part, [e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived, including...[i]ncome from discharge of indebtedness. 227 Section 108(a) provides certain exceptions to Section 61(a)(12). 228 The exceptions in Section 108 apply only to income from discharge of indebtedness and not to income from the sale or other disposition of the property Exclusions Under Section 108(a)(1) In General. Section 108(a)(1) provides, in part, that gross income does not include any amount which (but for Section 108(a)) income. An important exception to the Kirby Lumber rule arises in the gift context. Section 102 excludes from the definition of gross income any amount received as a gift or bequest. Accordingly, if the forgiveness of a debt constitutes a gift from the creditor to the debtor, the debtor realizes no income. ); Juister v. Commissioner, 53 T.C.M. (CCH) 1079, 1080 (1987) ( There are, however, a number of statutory and judicial exceptions that cushion the impact of the general rule of discharge of indebtedness income. An important exception to the Kirby Lumber rule arises in the gift context. Section 102 excludes from the definition of gross income any amount received as a gift or bequest. Accordingly, if the forgiveness of a debt constitutes a gift from the creditor to the debtor, the debtor realizes no income. ). 226 H.R. Rep. No. 833, at 15 n.21 (1980); S. Rep. 1035, at 19 n.22 (1980) reprinted in C.B. 620, 629; see Rood v. Commissioner, 71 T.C.M. (CCH) 3125, n. 12 (1996) ( [A]lthough there is no express abolition of the gift exception in sec. 108, the legislative history of the Bankruptcy Tax Act of 1980, Pub. L , 94 Stat. 3389, which amended sec. 108, states, in the course of discussing provisions relating to the realization of cancellation of indebtedness income arising from contributions by a shareholder of debt to the capital of a corporation, that it is intended that there will not be any gift exception in a commercial context (such as a shareholder-corporation relationship) to the general rule that income is realized on the discharge of indebtedness. H. Rep. No. 833, at 15 n.21 (1980); S. Rep. No. 1035, at 19 n.22 (1980); C.B. 620, 629. Consequently, there is at least a question whether the gift exception continues to be applicable to commercial transactions, such as the one in issue in the instant case. ). 227 I.R.C. 61(a)(12). 228 See Gitlitz v. Commissioner, 531 U.S. 206 (Jan. 9, 2001); Carlson v. Commissioner, 116 T.C. 87, 91 (2001). 229 Gehl v. Commissioner, 102 T.C. 784 (1984), aff d, 50 F.3d 12 (1995); cf. F.S.A (June 27, 1995) ( Even if a taxpayer were entitled to an exclusion from discharge of indebtedness income under Section 108(a), that exclusion applies only to the income from discharge of indebtedness and not to the income from the sale or other disposition of the property. ) v.2 46

56 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; 230 b. The discharge occurs when the taxpayer is insolvent; 231 c. The indebtedness discharged is qualified farm indebtedness; 232 d. In the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness; 233 or e. The indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, Definition of Indebtedness for Purposes of Section 108. For purpose of Section 108, the term indebtedness of the taxpayer means any indebtedness (1) for which the taxpayer is liable or (2) subject to which the taxpayer holds the property. 235 B. Discharges Occurring in Title 11 Cases. 1. The Exclusion. Section 108(a)(1)(A) excludes from gross income any amount includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs under title 11 United States Code. For this purpose, the term title 11 case means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court. 236 The Tax Court has read 230 I.R.C. 108(a)(1)(A). 231 I.R.C. 108(a)(1)(B). 232 I.R.C. 108(a)(1)(C). 233 I.R.C. 108(a)(1)(D). 234 I.R.C. 108(a)(1)(E). 235 I.R.C. 108(d)(1)(A); Waterhouse v. Commissioner, 68 T.C.M. (CCH) 774, 778 (1994) ( The term indebtedness of the taxpayer for purposes of Section 108 includes any indebtedness for which a taxpayer may be liable. Sec. 108(d)(1)(A). Petitioner s obligation to repay the excess disability benefits constitutes an indebtedness which falls within the scope of Section 108(a) if one of the specific conditions of Section 108(a)(1) is present. ). 236 I.R.C. 108(d)(2); see, e.g., Johnson v. Commissioner, 132 Fed. Appx. 550 (5 th Cir. 2005) ( In summary, the Tax Court s and bankruptcy court s findings are not in tension-- the bankruptcy court found that $4,916 in debt was discharged as to creditors that filed proofs of claim against the estate, and the Tax Court made the additional finding that the CMI debts were also discharged as a result of the bankruptcy court s order, although they were not specifically mentioned in the final order of relief. The Tax Court appropriately found that the CMI debts were discharged as a result of the grant of relief from the bankruptcy court under Bankr. Code 727(b), so they plainly fell within the definition of discharged debt in a title 11 case as defined by I.R.C. 108(d)(2), and thus were appropriately excludable under 108(a) and applicable to offset Johnson s NOL under 108(b)(2). [Footnote omitted.]) v.2 47

57 the statute to contemplate that, in general, in a title 11 case, the bankruptcy court must grant the discharge either in a specific order, or as part of a plan approved by the court itself Priority of Exclusion. The bankruptcy case exclusion of Section 108(a)(1)(A) takes precedence over the other exclusions. 238 Thus, taxpayers who have their debts discharged in bankruptcy must use the bankruptcy case exclusion provided in Section 108(a)(1)(A) rather than the insolvency exclusion provided in Section 108(a)(1)(B) Reduction of Debtor s Tax Attributes. The amount excluded from gross income under Section 108(a)(1)(A) is applied to reduce the taxpayer s tax attributes in the order provided under Section 108(b)(2). 240 If the taxpayer makes an election under Section 108(b)(5), then the amount excluded under Section 108(a)(1)(A) is used to reduce the basis of the taxpayer s depreciable property Special Partnership Considerations. In the case of a partner in a partnership, the bankruptcy exclusion of Section 108(a)(1)(A) is applied at the partner level. 242 The Service apparently reads this requirement to mean that the partner must be in bankruptcy before the exclusion applies. 243 The legislative history to the statute indicates that Congress 237 Friedman v. Commissioner, 75 T.C.M. (CCH) 2383, 2389 (1998) ( The language in Section 108(d)(2) is fairly explicit. It provides that a title 11 case means a case under title 11 (the bankruptcy code), but only if the taxpayer is under the jurisdiction of the bankruptcy court and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court. Sec. 108(d)(2). Consequently, we read the statute to contemplate that, in general, in a title 11 case, the bankruptcy court must grant the discharge either in a specific order, or as part of a plan approved by the court itself. ). 238 I.R.C. 108(d)(2)(A). 239 I.R.C. 108(a)(2)(A); cf. Waterhouse v. Commissioner, 68 T.C.M. (CCH) 774, 778 (1994) ( The evidence shows that petitioner s $52, indebtedness was discharged on January 9, 1989, and not during the course of a title 11 bankruptcy proceeding, as would be required by Section 108(a)(1)(A). ); cf. PLR (Mar. 29, 1991) ( Taxpayers who have their debts discharged in bankruptcy must use the exclusion provided in Section 108(a)(1)(A) of the Code rather than the insolvency exclusion provided in Section 108(a)(1)(B). Section 108(a)(2) provides that the bankruptcy exclusion takes precedence over the insolvency exclusion. Therefore, where a taxpayer s debts are discharged in bankruptcy, whether the taxpayer is insolvent is irrelevant for purposes of Section 108. ). 240 I.R.C. 108(b)(1). 241 I.R.C. 108(b)(1); see I.R.C. 1017; cf. Priv. Ltr. Rul (Dec. 7, 1993) ( Because Target will be a debtor in a title 11 case at the time its indebtedness is discharged in accordance with Section 108(d)(2), any cancellation of indebtedness income realized by Target under the Plan will be excluded from gross income under Section 108(a)(1)(A). Target will be required to reduce its attributes in the order provided under Section 108(b)(2) by an amount equal to the discharge of indebtedness income realized in connection with the Plan but excluded from gross income under Section 108(a)(1)(A). If Target makes the election under Section 108(b)(5), then the amount equal to the discharge of indebtedness income realized in connection with the Plan but excluded from gross income under Section 108(a)(1)(A) will be used to reduce the basis of Target s depreciable property under Section ). 242 I.R.C. 108(d)(6). 243 Cf. PLR (Mar. 25, 1994) ( As an initial matter, we note that the exception set forth in Section 108(a)(1)(A) for discharges in bankruptcy will not apply to exclude any discharge of indebtedness income resulting from the restructuring of Partnership s indebtedness to Bank. Section 108(d)(6) provides that in the case of a partnership, subsection (a) shall be applied at the partner level. Because Partnership, rather than the Partners, is in bankruptcy, the exception set forth in Section 108(a)(1)(A) does not apply to exclude discharge of indebtedness v.2 48

58 intended that income from discharge of a partnership debt would not be excludable at the partnership level, but instead would be allocated separately to each partner. 244 The Senate Committee report states that [t]he tax treatment of the amount of discharged partnership debt which is allocated as an income item to a particular partner depends on whether that partner is in a bankruptcy case, is insolvent (but not in a bankruptcy case), or is solvent (and not in a bankruptcy case). 245 In a series of four related 2004 memorandum decisions, the Tax Court adopted a broad reading of the statute and held that the bankruptcy exclusion applied to partners that were under the jurisdiction of the bankruptcy court as part of the partnership bankruptcy case (but not in bankruptcy themselves). 246 In each of these cases, the partnership filed a petition in bankruptcy. As part of the partnership s bankruptcy case, the trustee reached a negotiated settlement with some of the general partners, including the taxpayers, whereby in exchange for paying agreedupon sums to the partnership s bankruptcy estate, the contributing partners would be discharged from liability as permitted by the confirmed bankruptcy plan. Each of the taxpayers executed a contribution agreement and pursuant to its terms contributed a sum of money to the partnership s bankruptcy estate in exchange for release of all claims or potential claims of creditors against * * * [taxpayer] arising out of or related to the partnership. The bankruptcy court subsequently entered an order approving the contribution agreement and specifically discharging and releasing the taxpayers from any and all liability to the trustee and the bank arising out of or relating to the partnership, the taxpayers status as general partners in the partnership and a personal guaranty agreement. In addition, the bankruptcy court s order released the taxpayers from the claims or potential claims of all creditors of the partnership. With respect to each taxpayer, the bankruptcy court further ordered that such taxpayer is subject to the jurisdiction of the Bankruptcy Court. The partnership issued the taxpayers Schedules K-1, allocating to each of them discharge of indebtedness income. Each of the taxpayers excluded this entire amount from his 1995 gross income. The Service issued a notice of deficiency determining that the discharged debt should be included in the taxpayers 1995 income. The Tax Court held for the taxpayer. The Tax Court stated that the relevant question is whether petitioner s debt (as opposed to the partnership s debt) was discharged in a title 11 case. The court interpreted Section 108(d)(2) as having two requirements: (1) the taxpayer income from the Partners gross income. Therefore, Section 108(a)(2)(A), which provides, in part, that the exception provided for in Section 108(a)(1)(D) shall not apply to a discharge that occurs in bankruptcy, does not prevent the application of Section 108(a)(1)(D) to the Partners. ); Priv. Ltr. Rul (Dec. 7, 1993) ( Because Target will be a debtor in a title 11 case at the time its indebtedness is discharged in accordance with Section 108(d)(2), any cancellation of indebtedness income realized by Target under the Plan will be excluded from gross income under Section 108(a)(1)(A). ). 244 S. Rep. No. 1035, C.B. at S. Rep. No. 1035, C.B. at See Gracia v. Commissioner, 87 T.C.M. (CCH) 1423, 1425 (2004); Mirachi v. Commissioner, 87 T.C.M. (CCH) 1425, 1426 (2004); Price v. Commissioner, 87 T.C.M. (CCH) 1426, 1427 (2004); Estate of Martinez, 87 T.C.M. (CCH) 1428, 1429 (2004) v.2 49

59 must be under the jurisdiction of the bankruptcy court (but not necessarily in bankruptcy) and (2) the discharge must be granted by the court or pursuant to a plan approved by the court. The Court reasoned that the partnership s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to the bankruptcy court order, the bankruptcy court discharged and released the taxpayer from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, taxpayer s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over the taxpayer for this purpose. Consequently, the Tax Court concluded that the taxpayer s debts in question were discharged in a title 11 case within the meaning of Section 108(d)(2) and held that the taxpayer s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). 247 There is some question as to the correctness of the Tax Court s decision Gracia v. Commissioner, 87 T.C.M. (CCH) 1423, 1424 (2004) ( The partnership s chapter 11 bankruptcy was a case under title 11 of the United States Code. See 11 U.S.C. ch. 11 (2000). Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court s assertion of jurisdiction over petitioner in the partnership s chapter 11 bankruptcy case. * * * We conclude that petitioner s debts in question were discharged in a title 11 case within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). ); Mirachi v. Commissioner, 87 T.C.M. (CCH) 1424, 1425 (2004) ( The partnership s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court s assertion of jurisdiction over petitioner in the partnership s chapter 11 bankruptcy case. * * * We conclude that petitioner s debts in question were discharged in a title 11 case within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). [Citations and footnote omitted.]); Price v. Commissioner, 87 T.C.M. (CCH) 1426, 1428 (2004) ( The partnership s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released petitioner from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, petitioner s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over petitioner for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court s assertion of jurisdiction over petitioner in the partnership s chapter 11 bankruptcy case. * * * We conclude that petitioner s debts in question were discharged in a title 11 case within the meaning of Section 108(d)(2). Accordingly, we hold that petitioner s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). [Citations omitted.]); Estate of Martinez v. Commissioner, 87 T.C.M. (CCH) 1428, 1429 (2004) ( The partnership s chapter 11 bankruptcy was a case under title 11 of the United States Code. Pursuant to its December 19, 1995, order, the bankruptcy court discharged and released decedent from all liability to the trustee, the bank, and all other creditors that might have claims arising from or relating to the partnership, decedent s status as a general partner in the partnership, and the April 9, 1985, personal guaranty agreement. In the same order, the bankruptcy court explicitly asserted its jurisdiction over decedent for this purpose. Giving due regard to principles of judicial comity, we discern no reason to second-guess the bankruptcy court s assertion of jurisdiction over decedent in the partnership s chapter 11 bankruptcy case. * * * We conclude that decedent s debts in question were discharged in a v.2 50

60 5. S Corporation Considerations. a. Rules for Exclusion of Cancellation of Debt Income and for Reduction of Tax Attributes are Applied at the Corporate Level. Section 108(d)(7)(A), as amended by the Job Creation and Worker Assistance Act of 2002, 249 provides, in part, that the rules under Section 108(a) for the exclusion of COD income and under Section 108(b) for the reduction of tax attributes are applied at the corporate level, including by not taking into account under Section 1366(a) any amount excluded under Section 108(a). 250 Thus, income from the discharge of indebtedness of an S corporation that is excluded from the S corporation s income is not taken into account as an item of income by any shareholder and, thus, does not increase the basis of any shareholder s stock in the corporation. 251 For this purpose, a shareholder s suspended loss is treated as a net operating loss tax attribute that is reduced. 252 Thus, if the S corporation is in bankruptcy or is insolvent, any income from the discharge of indebtedness by a creditor of the S corporation is excluded from the corporation s income, and the S corporation reduces its tax attributes (including any suspended losses). 253 The legislative history provides the following illustration of these rules. Assume that a sole shareholder of an S corporation has zero basis in its stock of the corporation. The S corporation borrows $100 from a third party and loses the entire $100. Because the shareholder has no basis in its stock, the $100 loss is suspended at the corporate level. If the $100 debt is forgiven when the corporation is in bankruptcy or is insolvent, the $100 income from the discharge of indebtedness is excluded from income, and the $100 suspended loss should be title 11 case within the meaning of Section 108(d)(2). Accordingly, we hold that decedent s discharge of indebtedness income is excludable from gross income pursuant to Section 108(a)(1)(A). [Citations omitted.]). 248 See generally Partners May Exclude COD Income in Connection with Partnership s Chapter 11 Bankruptcy, Business Entities (Sept./Oct. 2004); Solvent Partners of Bankrupt Partnerships May Be Thankful for Gracia, J. Tax n (Aug. 2004). 249 Pub. L. No I.R.C. 108(d)(7)(A). 251 I.R.C. 108(d)(7)(A). 252 I.R.C. 108(d)(7)(B). 253 Staff of the Joint Committee on Taxation, 107th Cong., 2d Sess., Technical Explanation of the Job Creation and Worker Assistance Act of 2002, 28 (2002); cf. H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, ( In applying this provision to income from the discharge of indebtedness of an S corporation, the election is made by the S corporation (sec. 1363(c)), and the exclusion and basis reduction are both made at the S corporation level (sec. 108(d)(7)). The shareholders basis in their stock is not adjusted by the amount of debt discharge income that is excluded at the corporate level. As a result of these rules, if an amount is excluded from the income of an S corporation under this provision, the income flowing through to the shareholders will be reduced (compared to what the shareholders income would have been without the exclusion). Where the reduced basis in the corporation s depreciable property later results in additional income (or a smaller loss) to the corporation because of reduced depreciation or additional gain (or smaller loss) on disposition of the property, the additional income (or smaller loss) will flow through to the shareholders at that time, and will then result in a larger increase (or smaller reduction) in the shareholder s basis that if this provision had not previously applied. Thus, the provision simply defers income to the shareholders. ) v.2 51

61 eliminated in order to achieve a tax result that is consistent with the economics of the transactions in that the shareholder has no economic gain or loss from these transactions. 254 b. IRS Issues Final Regulations Providing Guidance on Reduction of Tax Attributes by an S Corporation. On October 30, 2009, the Revenue Service issued final regulations that provide guidance on the manner in which an S corporation reduces its tax attributes under section 108(b) for taxable years in which the S corporation has discharge of indebtedness income that is excluded from gross income under section 108(a). 255 In particular, the regulations address situations in which the aggregate amount of the shareholders disallowed section 1366(d) losses and deductions that are treated as a net operating loss tax attribute of the S corporation exceeds the amount of the S corporation s excluded discharge of indebtedness income. The regulations affect S corporations and their shareholders. C. Discharges Occurring When Taxpayer is Insolvent. 1. The Exclusion. Section 108(a)(1)(B) provides that gross income does not include an amount that would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent Staff of the Joint Committee on Taxation, 107th Cong., 2d Sess., Technical Explanation of the Job Creation and Worker Assistance Act of 2002, 28 (2002). 255 T.D. 9469, 2009 TNT Note that Treasury Regulation Section (b) restates the pre-section 108 judicially created insolvency exception. It provides as follows: Income is not realized by a taxpayer by virtue of the discharge, under Section 14 of the Bankruptcy Act (11 U.S.C. 32), of his indebtedness as the result of an adjudication in bankruptcy, or by virtue of an agreement among his creditors not consummated under any provision of the Bankruptcy Act, if immediately thereafter the taxpayer s liabilities exceed the value of his assets. Furthermore, unless one of the principal purposes of seeking a confirmation under the Bankruptcy Act is the avoidance of income tax, income is not realized by a taxpayer in the case of a cancellation or reduction of his indebtedness under (i) A plan of corporate reorganization confirmed under Chapter X of the Bankruptcy Act (11 U.S.C., ch. 10); (ii) An arrangement or a real property arrangement confirmed under Chapter XI or XII, respectively, of the Bankruptcy Act (11 U.S.C., ch. 11, 12); or (iii) A wage earner s plan confirmed under Chapter XIII of the Bankruptcy Act (11 U.S.C., ch. 13). Treas. Reg (b), adopted by T.D. 6272, C.B. 18, 31, restates the pre-section 108 judicially created insolvency exception. Winn v. Commissioner, 73 T.C.M. (CCH) 3167 (1997). Section 108 codified the insolvency exception as an exclusion from gross income. Bankruptcy Tax Act of 1980, Pub. L , sec. 2, 94 Stat Winn v. Commissioner, 73 T.C.M. (CCH) 3167, 3169 (1997). Section 108(e)(1) provides that 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. Thus, Section 108, not Section (b), Income Tax Regs., should now control in insolvency cases. Winn, 73 T.C.M. (CCH) at 3169; see also Gitlitz v. Commissioner, 531 U.S. 206, 216 (2001) ( The insolvency exception was a rule that the discharge of indebtedness of an insolvent taxpayer was not taxable income. But the exception has since been limited by Section 108(e). Section 108(e) precludes us from relying on any understanding of the judicial insolvency exception that was not codified in Section 108. And as v.2 52

62 a. Exclusion Limited to Amount of Insolvency. The amount excludable under the insolvency exclusion cannot exceed the amount by which the taxpayer is insolvent. 257 b. Definition of Insolvency. Section 108(d)(3) defines insolvent to mean the excess of liabilities over the fair market value of assets. 258 With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, insolvency is determined on the basis of the taxpayer s assets and liabilities immediately before the discharge. 259 (1) Assets. The Tax Court has held 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. 260 (2) Liabilities. explained above, the language and logic of Section 108 clearly establish that, although discharge of indebtedness of an insolvent taxpayer is not included in gross income, it is nevertheless income. ). 257 I.R.C. 108(a)(3); Bressi, Jr. v. Commissioner, 62 T.C.M. (CCH) 1668, 1673 (1991) ( The exclusion is limited to the amount by which the taxpayer is insolvent. ); Rev. Rul , C.B. 48 ( Section 108(a)(3) limits the amount of income excluded by reason of Section 108(a)(1)(B) to the amount by which the taxpayer is insolvent. ); see, e.g., Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1283 (2006) ( We therefore agree with petitioners that the $1,375,000 balance on the Miller/Huntington Loan as of December 29, 1994, should be counted as a liability in determining whether petitioner was insolvent when the discharge occurred, which results in insolvency on that date to the extent of $1,102,000. As the amount of petitioner s insolvency exceeds $900,000, the entire amount of the discharge of indebtedness income is excluded from petitioners gross income under Section 108(a)(1)(B). ); Traci v. Commissioner, 64 T.C.M. (CCH) 1515, 1516 ( [T]he amount of discharge of indebtedness income excluded from gross income may not exceed the amount of the taxpayer s insolvency. ). 258 Bressi v. Commissioner, 62 T.C.M. (CCH) 1668, 1673 (1991) ( Insolvency is the excess of liabilities over the fair market value of assets. ). 259 I.R.C. 108(d)(3); see Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1283 (2006) ( The quoted language evidences an intent to count those liabilities for which discharge is imminent. ). 260 Carlson v. Commissioner, 116 T.C. 87 (2001); see generally Witt, Discharge of Indebtedness: Some Unexpected Results, T.M. Memo (March 3, 2008) ( Over the past 15 years, there has been a confluence of events which will create unexpected results for taxpayers with COD income. Simply, there will be additional trouble for financially troubled taxpayers in these fact patterns: (1) limited liability companies taxed as partnerships, with solvent members; (2) single-member limited liability companies that are entities disregarded for all federal tax purposes, with solvent sole members; and (3) individuals counting on the 108 insolvency exception but who have retirement accounts (IRAs/401(k)s) or other assets exempt from creditors under state law who will be made solvent if these exempt assets are counted as assets for purposes of the tax law insolvency calculation. ); but cf. Real Estate Group Seeks Guidance on Cancellation of Indebtedness Rules, 2008 TNT (July 1, 2008) ( The definition of assets for purposes of the Section 108(a)(1)(B) insolvency exception should be clarified to conform federal law to state law for purposes of what assets are exempt. Assets excluded from the reach of creditors should not be counted as an asset in the insolvency calculation. Thus, for example, retirement accounts, IRAs and homesteads that are beyond the reach of creditors should not be counted as an asset. The holding in Carlson v. Commission, 116 T.C. 87 (2001) and Gale v. Commissioner, T.C. Summary Opin , 2006 Tax Ct. Summary LEXIS 54 (Sept. 14, 2006) should no longer be followed. [Certain Citations omitted.]) v.2 53

63 (A) Treatment of Contingent Liabilities. To claim the benefit of the insolvency exclusion, the Tax Court has held that the taxpayer 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. 261 The Tax Court has also held that the discharged debt may count as a liability for purposes of determining the taxpayer s insolvency. 262 (B) Treatment of Nonrecourse Debt. In Revenue Ruling 92-53, C.B. 48, the Service concluded that the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of Section 108(d)(3), but only to the extent that the excess nonrecourse debt is discharged. Revenue Ruling considers the following three fact situations: (i) Situation 1: Individual A borrowed $1,000,000 from C in 1988 and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. The note was secured by an office building valued in excess of $1,000,000 that A acquired from B with the proceeds of the note. A was not personally liable on the note. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note s principal amount to $825,000. The modified note bore adequate stated interest within the meaning of Section 1274(c)(2) of the Code. At the time of the modification, A s only other assets had an aggregate fair market value of $100,000, and A was personally liable to D on other indebtedness in the amount of $50, Merkel v. Commissioner, 109 T.C. 463, 484 (1997) ( 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. ); aff d. 192 F.3d 844 (9th Cir. 1999); Toberman v. Commissioner, 80 T.C.M. (CCH) 81, 86 (2000) ( To claim the benefit of the insolvency exclusion, the taxpayer: 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. quoting Merkel v. Commissioner, 109 T.C. at 484.); Acuncius v. Commissioner, 83 T.C.M. (CCH) 1122, 1224 (2002) ( A taxpayer claiming the benefit of the insolvency exception 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 FMV of his assets. quoting Merkel); Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1283 n. 32 (2006) ( However, petitioner s liability under the remaining $475,000 portion of the Miller/Huntington Loan, which was purchased by the Rapp Group on Dec. 29, 1994, satisfies the standard set forth in Merkel v. Commissioner for recognizing a liability for purposes of the insolvency exception, because it was more probable than not, immediately before the discharge, that petitioner would be called upon to pay that obligation in the stated amount. [Citations omitted.]). 262 Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1282 (2006) ( We believe respondent misreads Merkel. The contingent liabilities at issue in Merkel were not the same indebtedness that was being discharged, as is largely the case here. To suggest as respondent does that the discharged debt, because it is being discharged, does not count as a liability for purposes of determining insolvency under Section 108(a)(1)(B) contravenes the statute s design and purpose. ) v.2 54

64 (ii) Situation 2: The facts are the same as Situation 1, except that D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A s recourse indebtedness of $50,000, and C did not reduce A s nonrecourse note. (iii) Situation 3: the facts are the same as Situation 1, except that pursuant to a prearranged work-out plan, D agreed to accept assets from A with a fair market value (and basis to A) of $40,000 in settlement of A s recourse indebtedness of $50,000, and shortly thereafter C reduced the principal amount of A s nonrecourse note to $825,000. The Ruling provides that these examples do not involve the bankruptcy or qualified farm indebtedness of the taxpayer. Thus, the specific exclusions provided by Sections 108(a)(1)(A) and 108(a)(1)(C) do not apply. The Ruling holds that [t]he amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of Section 108(d)(3), but only to the extent that the excess nonrecourse debt is discharged. The Ruling reasons that to provide tax relief that will preserve a fresh start, the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt ( excess nonrecourse debt ) should be treated as a liability in determining insolvency for purposes of Section 108 to the extent that the excess nonrecourse debt is discharged. Otherwise, the discharge could give rise to a current tax when the taxpayer lacks the ability to pay that tax. Nonrecourse debt should also be treated as a liability in determining insolvency under Section 108 to the extent of the fair market value of the property securing the debt. Excess nonrecourse debt, however, that is not discharged does not have a similar effect on a taxpayer s ability to pay a current tax resulting from the discharge of another debt (whether recourse or nonrecourse). Thus, that excess nonrecourse debt should not be treated as a liability in determining insolvency for purposes of Section 108. The Ruling reaches the following conclusions on the three situations: (i) Situation 1. In this situation, $175,000 of A s $200,000 excess nonrecourse debt is discharged and, therefore, that portion of the excess nonrecourse debt is taken into account in determining whether, and to what extent, A is insolvent. Thus, A has liabilities of $1,025,000, consisting of the full $50,000 amount for which A is personally liable, plus the portion of the nonrecourse debt equal to the sum of the $800,000 fair market value of the property securing the nonrecourse debt and the $175,000 of excess nonrecourse debt that is discharged. Because A s $1,025,000 of liabilities exceed the $900,000 fair market value of A s assets ($800,000 + $100,000) by $125,000 immediately before the indebtedness is discharged, A is insolvent to the extent of $125,000. Accordingly, pursuant to Section 108(a)(1)(B) and (a)(3), A must include only $50,000 of the $175,000 of discharged indebtedness ($175,000 $125,000) as cancellation of indebtedness income under Section 61(a)(12). (ii) Situation 2. In this situation no portion of the excess nonrecourse debt is discharged. Instead, $10,000 of A s recourse debt is discharged v.2 55

65 Therefore, the excess nonrecourse debt is not taken into account in determining whether, and to what extent, A is insolvent. As a result, A is solvent immediately before the discharge because its $850,000 of liabilities ($800,000 + $50,000) do not exceed the $900,000 fair market value of its assets ($800,000 + $100,000). Accordingly, A must include the entire $10,000 of discharged indebtedness in income as cancellation of indebtedness income under Section 61(a)(12). (iii) Situation 3. In this situation, pursuant to the prearranged work-out plan, $10,000 of A s recourse debt is discharged, and shortly thereafter $175,000 of A s nonrecourse debt is discharged. Because of the prearranged plan, the discharges are viewed as occurring simultaneously, but solely for purposes of determining whether, and to what extent, A is insolvent. As a result, A must include only $60,000 of the total of $185,000 of discharged indebtedness in income under Section 61(a)(12). The $60,000 is comprised of (1) the $50,000 discharge of indebtedness income as determined with respect to the nonrecourse debt in Situation 1, and (2) the $10,000 discharge of indebtedness income as determined with respect to the recourse debt in Situation Priority of Exclusion. The insolvency exclusion does not apply in a title 11 bankruptcy case. 263 The insolvency exclusion takes precedence over the qualified farm indebtedness and qualified real property business indebtedness exclusions and, therefore, the latter exclusions do not apply to the extent the taxpayer is insolvent. 264 The insolvency exclusion does not apply to the extent the qualified principal residence exclusion applies unless the taxpayer elects otherwise Reduction of Debtor s Tax Attributes. The amount excluded from gross income under the insolvency exclusion is applied to reduce the taxpayer s tax attributes in the order provided under Section 108(b)(2). 266 If the taxpayer makes an election under Section 108(b)(5), then the amount excluded under the insolvency exclusion is used to reduce the basis of the taxpayer s depreciable property I.R.C. 108(a)(2)(A). 264 I.R.C. 108(a)(2)(B); cf. Priv. Ltr. Rul (May 2, 2008) ( Section 108(a)(2)(B) provides that the insolvency exclusion takes precedence over the qualified farm exclusion and the qualified real property business exclusion. The exclusions for discharge of qualified farm indebtedness and qualified real property business indebtedness shall not apply to a discharge to the extent the taxpayer is insolvent. ). 265 I.R.C. 108(a)(2)(C). 266 I.R.C. 108(b)(1). 267 I.R.C. 108(b)(1); U.S. v. Farley, 202 F.3d 198, 203 (3 rd Cir. 2000) ( The exclusion of discharge of indebtedness income from gross income provided for in Section 108(a)(1)(B) is not without a price. A taxpayer excluding discharge of indebtedness income from gross income must make corresponding reductions in certain tax attributes, attributes that might otherwise yield future tax benefits. Pursuant to Section 108(b)(1) of the Internal Revenue Code, [t]he amount excluded from gross income under [Section 108(a)(1)(b)] shall be applied to reduce tax attributes of the taxpayer as provided in [Section 108(b)(2)]. Discharge of indebtedness income is thus offset against the various tax attributes listed in Section 108(b)(2) net operating losses, general business credits, minimum tax credits, capital loss carryovers, basis (to the extent permitted under Section 1017(b) of the Internal Revenue Code), passive activity loss and credit carryovers, and foreign tax credit carryovers. [Citations and footnote omitted.]); accord Miller v. Commissioner, 91 T.C.M. (CCH) 1267, 1283 (2006) ( Any amount excluded under Section 108(a)(1)(B) v.2 56

66 4. Partnership Considerations. In the case of a partner in a partnership, the insolvency exclusion is applied at the partner level S Corporation Considerations. Section 108(d)(7)(A), as amended by the Job Creation and Worker Assistance Act of 2002, 269 provides, in part, that the rules under Section 108(a) for the exclusion of COD income and under Section 108(b) for the reduction of tax attributes are applied at the corporate level, including by not taking into account under Section 1366(a) any amount excluded under Section 108(a). See the discussion above of S corporation considerations under the bankruptcy exclusion. 6. No Other Insolvency Exception. Section 108(e)(1) provides that, for purposes of the Internal Revenue Code, 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. The Supreme Court has stated that section 108(e)[(1)] precludes us from relying on any understanding of the judicial insolvency exception that was not codified in section The Tax Court has thus concluded 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... any other judicially developed insolvency exception to the general rule of section 61(a)(12) that gross income includes income from the discharge of indebtedness. 271 D. Solvent Taxpayer Out of Bankruptcy - Debt Discharged is Qualified Farm Indebtedness. must be applied to reduce certain tax attributes of the taxpayer, including, inter alia, any net operating loss or net capital loss for the taxable year of the discharge and any net operating loss carryover or any capital loss carryover to such taxable year. ). 268 I.R.C. 108(d)(6); Marcaccio v. Commissioner, 69 T.C.M. (CCH) 2420, 2426 (1995) (It is important to note that, in the case of a partnership, the insolvency and bankruptcy exceptions to recognition of discharge of indebtedness income provided by Section 108(a) are applied at the partner level. ); Brickman v. Commissioner, 76 T.C.M. (CCH) 506, 509 (1998) ( In the case of a partnership, the insolvency exception to the recognition of COD income provided by Section 108(a) is applied at the partnership level. ). 269 Pub. L. No , 116 Stat Gitlitz v. Commissioner, 531 U.S. at Carlson v. Commissioner, 116 T.C. 87, 100 (2001); see Acuncius v. Commissioner, 73 T.C.M. (CCH) 3167, 3169 (2002) ( We note Section 108(e)(1) provides that, 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, eliminating any judicially created exceptions to the general rule of income from discharge of indebtedness. ); Winn v. Commissioner, 73 T.C.M. (CCH) 3167, 3168 ( 108(e)(1) provides that 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. Thus, Section 108, not Section (b), Income Tax Regs., controls in these cases. ); see also Merkel v. Commissioner, 109 T.C. 463, 481 (1997) ( 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). [Footnote omitted.]); cf. FSA (Aug. 13, 1999) ( I.R.C. Section 108(a)(1)(B) sets forth an exception to this recognition rule for insolvent taxpayers. Insolvency is defined in the Code as the excess of liabilities over the fair market value of assets, and is measured immediately prior to the time of the discharge of indebtedness. I.R.C. Section 108(d)(3). No other exception to the recognition of COD income for insolvent taxpayers is provided in the Code. I.R.C. Section 108(e)(1). The insolvency exception excludes income only up to the amount by which a taxpayer is insolvent. I.R.C. Section 108(a)(3). ) v.2 57

67 1. The Exclusion. Section 108(a)(1)(C) provides that gross income does not include any amount which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness discharged is qualified farm indebtedness. a. Definition of Qualified Farm Indebtedness. Indebtedness of a taxpayer is treated as qualified farm indebtedness if: (A) such indebtedness was incurred directly in connection with the operation by the taxpayer of the trade or business of farming, 272 and (B) 50 percent or more of the aggregate gross receipts of the taxpayer for the 3 taxable years preceding the taxable year in which the discharge of such indebtedness occurs is attributable to the trade or business of farming. 273 b. Discharge Must Be by Qualified Person. The qualified farm indebtedness exclusion applies only if the discharge is by a qualified person. 274 A qualified person is a person engaged in the business of lending money who is not (1) a related person (within the meaning of Section 465(b)(3)(C) 275 ) with respect to the taxpayer, (2) a person from whom the taxpayer acquired the property (or a related person to such person), or (3) a person who receives a fee with respect to the taxpayer s investment in the property (or a related person to such person). 276 It also includes any Federal, State, or local government or agency or instrumentality thereof. 277 c. Limitation on Amount Excludable. The exclusion for the discharge of farm indebtedness is limited to the total of the taxpayer s adjusted tax attributes in the year the debt is cancelled plus the total adjusted basis in all qualified property held by the taxpayer as of the beginning of the tax year after the tax year in which the discharge occurred. 278 (1) Definition of Adjusted Tax Attributes. The adjusted tax attributes means the sum of the following tax attributes except that each of the credits below are multiplied $3 for each $1 of credit: 279 (A) Any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year; 272 I.R.C. 108(g)(2)(A). 273 I.R.C. 108(g)(2)(B). 274 I.R.C. 108(g)(1)(A). 275 I.R.C. 49(a)(1)(D)(v). Under Section 465(b)(3)(C), a person is related to any person if (i) the related person bears a relationship to such person specified in Section 267(b) or 707(b)(1), or (ii) the related person and such person are engaged in trades or business under common control. 276 I.R.C. 49(a)(1)(D)(iv). 277 I.R.C. 108(g)(1)(B). 278 I.R.C. 108(g)(3)(A). 279 I.R.C. 108(g)(3)(B) v.2 58

68 (B) Any carryover to or from the taxable year of a discharge of an amount for purposes for determining the amount allowable as a credit under Section 38 (relating to general business credit); (C) The amount of the minimum tax credit available under Section 53(b) as of the beginning of the taxable year immediately following the taxable year of the discharge; (D) Any net capital loss for the taxable year of the discharge, and any capital loss carryover to such taxable year under Section 1212; (E) Any passive activity loss or credit carryover of the taxpayer under Section 469(b) from the taxable year of the discharge; and (F) Any carryover to or from the taxable year of the discharge for purposes of determining the amount of the credit allowable under Section 27. Anything over the limitation amount is recognized as taxable income. 280 (2) Coordination With Insolvency Exclusion. The adjusted basis of any qualified property and the amount of the adjusted tax attributes is determined after any reduction of basis by reason of amounts excluded from gross income under the insolvency exclusion Priority of Exclusion. The qualified farm indebtedness exclusion does not apply in a title 11 case. 282 It also does not apply to a discharge to the extent the taxpayer is insolvent Reduction of Debtor s Tax Attributes. The amount excluded from gross income under the farm indebtedness exclusion is applied to reduce the taxpayer s tax attributes in the order provided under Section 108(b)(2). 284 If the taxpayer makes an election under Section 108(b)(5), then the amount excluded under Section 108(a)(1)(C) is used to reduce the basis of the taxpayer s Target s depreciable property under Section IRS Market Segment Specialization Program Guidelines, Irvine Farm Industry, Chapter 5 Income from Discharge of Indebtedness (Dec. 1, 2002), 2003 TNT ; S. Rep. No. 445, 100th Cong., 2d Sess. 29 (1988) reprinted in 1988 U.S.C.C.A.N. 4515, I.R.C. 108(g)(3)(B). 282 I.R.C. 108(a)(2)(A). 283 I.R.C. 108(a)(2)(B). 284 I.R.C. 108(b)(1). 285 I.R.C. 108(b)(1) v.2 59

69 4. Special Partnership Considerations. In the case of a partner in a partnership, the insolvency exclusion of Section 108(a)(1)(C) is applied at the partner level Special S Corporation Considerations. Section 108(d)(7)(A), as amended by the Job Creation and Worker Assistance Act of 2002, 287 provides, in part, that the rules under Section 108(a) for the exclusion of COD income and under Section 108(b) for the reduction of tax attributes are applied at the corporate level, including by not taking into account under Section 1366(a) any amount excluded under Section 108(a). See the discussion above of S corporation considerations under the bankruptcy exclusion. E. Solvent Non-C Corporation Taxpayers Out of Bankruptcy - Debt Discharged is Qualified Real Property Business Indebtedness. 1. The Exclusion. Section 108(a)(1)(D) provides that gross income does not include any amount includible in gross income by reason of the discharge of indebtedness if, in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness. a. Identifying Qualified Real Property Business Indebtedness. (1) Definition of Qualified Real Property Business Indebtedness. Qualified real property business indebtedness (sometimes referred to herein as QRPBI ) is defined as indebtedness which: 288 (2) Was incurred or assumed by the taxpayer in connection with real property used in a trade or business 289 and is secured by such real property; 290 (3) Was incurred or assumed before January 1, 1993, or if incurred or assumed after such date, is qualified acquisition indebtedness (sometimes referred to herein as QAI ); 291 and (4) With respect to which the taxpayer makes an election to have Section 108(c)(3) apply I.R.C. 108(d)(6). 287 Pub. L. No , I.R.C. 108(c)(3). 289 Cf. Juister v. Commissioner, 53 T.C.M. (CCH) 1079, 1081 (1987) ( Furthermore, a qualified business indebtedness is limited to indebtedness incurred by an individual in connection with property used in his trade or business. The discharge here involved an indebtedness on petitioners home that was not used in connection with a trade or business. [Citation omitted.]). 290 I.R.C. 108(c)(3)(A). 291 I.R.C. 108(c)(3)(B). 292 I.R.C. 108(c)(3)(C); cf (Apr. 10, 2000) ( The Revenue Reconciliation Act of 1993 amended Section 108(a)(1) to provide that, in certain instances, the gross income of a taxpayer does not include COD income v.2 60

70 b. Definition of Qualified Acquisition Indebtedness. Qualified acquisition indebtedness is indebtedness incurred or assumed to acquire, construct, reconstruct or substantially improve business real property. 293 QAI includes indebtedness resulting from the refinancing of qualified acquisition indebtedness but only to the extent it does not exceed the amount of the indebtedness being refinanced. 294 c. Limitations on Amount Excludable. (1) Indebtedness-in-Excess-of-Value Limitation. Section 108(c)(2)(A) provides that the amount excluded from gross income as discharge of qualified real property business indebtedness under Section 108(a)(1)(D) is limited to the excess (if any) of (i) the outstanding principal amount of such indebtedness (immediately before the discharge), over (ii) the fair market value of the real property which secures such indebtedness and is used in a trade or business (as of such time) reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property (as of such time). 295 For this purpose, outstanding principal amount generally means the principal amount of indebtedness together with all additional amounts owed that, immediately before the discharge, are equivalent to principal, in that interest on such amounts would accrue and compound in the future. 296 Amounts that are subject to Section 108(e)(2) (relating to amounts that would give rise to a Section 108(c)(3) sets forth the criteria that must be satisfied in order for a debt to be QRPBI. First, the debt must have been incurred or assumed in connection with real property used in a trade or business. Whether the in connection with requirement is satisfied is determined as of the time the debt was incurred or assumed. Second, at the time the debt is forgiven, it must be secured by real property used in the trade or business. Third, the debt must have been incurred or assumed prior to 1993, or, if incurred or assumed after 1992, the debt must be qualified acquisition indebtedness (QAI) as defined in Section 108(c)(4). QAI is indebtedness incurred or assumed to acquire, construct, reconstruct or substantially improve business real property. Finally, the taxpayer must elect to exclude the COD income. ). from the discharge of QRPBI./getDoc?DocID=T0TCODE:3395.1&pinpnt=TCODE: I.R.C. 108(c)(4). 294 I.R.C. 108(d)(4). 295 I.R.C. 108(c)(2)(A); Treas. Reg (a). Treas. Reg (c)(1); cf. Priv. Ltr. Rul (May 2, 2008) ( Section 108(c)(2)(A) provides that the amount excluded from gross income as discharge of qualified real property business indebtedness under Section 108(a)(1)(D) shall not exceed the excess (if any) of (i) the outstanding principal amount of such indebtedness (immediately before the discharge), over (ii) the fair market value of the real property which secures such indebtedness and is used in a trade or business (as of such time) reduced by the amount of any other qualified real property business indebtedness secured by such property (as of such time). ). 296 Treas. Reg (a); see T.D. 8787, C.B. 621, 622 ( Two commentators requested that the regulations clarify that any outstanding accrued and unpaid interest is included in determining the outstanding principal amount of the indebtedness for purposes of this limitation. Given the purpose of this limitation, which is to prevent taxpayers from using the Section 108(a)(1)(D) exclusion to the extent that debt cancellation would create equity in property (H.R. Rep , 103d Cong., 1st Sess., (1993)), the IRS and Treasury Department believe that it is inappropriate to strictly limit the exclusion by reference to the amount stated as principal in the debt instrument. Accordingly, the final regulations provide that, for purposes of Section 108(c)(2)(A) and Section only, outstanding principal amount means the principal amount of an indebtedness and all additional amounts owed that, immediately before the discharge, are equivalent to principal, in that interest on such amounts would accrue and compound in the future. ) v.2 61

71 deduction if paid) are excepted from the definition of principal amount. 297 Special adjustments are required to be made to account for unamortized premium and discount. 298 (2) Overall limitation. The amount excluded from gross income under Section 108(a)(1)(D) is limited to the aggregate adjusted bases of all depreciable real property held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of the discharge) reduced by the sum of any (1) depreciation claimed for the taxable year the taxpayer excluded discharge of indebtedness from gross income under Section 108(a)(1)(D); and (2) reductions to the adjusted bases of depreciable real property required under Section 108(b) (reduction of tax attributes) and Section 108(g) (discharge of qualified farm indebtedness) for the same taxable year. 299 d. Making the Election. An election to exclude the discharge of qualified real property business indebtedness from gross income is made on a timely-filed (including extensions) federal income tax return for the taxable year in which the taxpayer has discharge of indebtedness income that is excludible from gross income under Section 108(a). 300 The election is to be made on a completed Form 982, in accordance with the Form 982 and the instructions thereto. 301 The election is revocable with the consent of the Commissioner Priority Rules. The QRPBI exclusion does not apply to a discharge which occurs in a title 11 case 303 and does not apply to a discharge to the extent that the taxpayer is insolvent. 304 QRPBI does not include qualified farm indebtedness Treas. Reg (a). 298 Treas. Reg (a). 299 I.R.C. 108(c)(2)(B); Treas. Reg (b); cf. Priv. Ltr. Rul (May 2, 2008) ( Section 108(c)(2)(B) provides that the amount excluded under Section 108(a)(1)(D)(discharge of qualified real property business indebtedness) shall not exceed the aggregate adjusted bases of depreciable real property determined after any reductions under Sections 108(b)(reduction of tax attributes) and 108(g)(discharge of qualified farm indebtedness) held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge). 300 I.R.C. 108(d)(9)(A); Treas. Reg (b); Compare Priv. Ltr. Rul (May 2, 2008) ( Provided that: (i) the period of limitations on assessment under Section 6501(a) is open for the Taxpayer s taxable year which ended on Date 6 and for each subsequent taxable year; (ii) the indebtedness on Property #1 would be properly characterized as qualified real property business indebtedness; (iii) the Taxpayer either was solvent immediately before the discharge of indebtedness on Property #1 or the amount of indebtedness discharged was in excess of the amount by which the Taxpayer was insolvent; (iv) the amount subject to exclusion under Section 108(a)(D) is determined in accordance with the limitations provided in Section 108(c)(2); the Taxpayer s request for relief to make a late election for application of Section 108(c) is granted. ) with Priv. Ltr. Rul (Oct. 28, 2005) ( You are not permitted an extension of time under to make the 108(c)(3)(C) election because to do so would prejudice the interests of the government. ). 301 I.R.C. 108(d)(3)(C); Treas. Reg (b). 302 I.R.C. 108(d)(3)(B); Treas. Reg (c). 303 I.R.C. 108(a)(2)(A). 304 I.R.C. 108(a)(2)(B); cf. Priv. Ltr. Rul (May 2, 2008) ( The Taxpayer s amended return includes a statement indicating that the Taxpayer was insolvent at the time of the discharge of a portion of the indebtedness on v.2 62

72 3. Reduction of Basis. The amount excluded from gross income under Section 108(a)(1)(D) is applied to reduce the basis of the depreciable real property of the taxpayer Example. Assume that on July 1, 1993, individual J owns a building worth $150,000, used in his trade or business, that is subject to a first mortgage securing a debt of J s of $110,000 and second mortgage securing a second debt of J s of $90,000. J is neither a bankrupt nor insolvent and neither debt is qualified farm indebtedness. J agrees with his second mortgagee to reduce the second mortgage debt to $30,000, resulting in discharge of indebtedness income in the amount of $60,000. Under the provision, assuming that J has sufficient basis in business real property to absorb the reduction (see below), J can elect to exclude $50,000 of that discharge from gross income. This is because the principal amount of the discharged debt immediately before the discharge (i.e., $90,000) exceeds the fair market value of the property securing it (i.e., $150,000 of free and clear value less $110,000 of other qualified business real property debt or $40,000) by $50,000. The remaining $10,000 of discharge is included in gross income Partnership Considerations. The legislative history underlying Section 108(a)(1)(D) provides that in the case of discharge of indebtedness of a partnership, the determination of whether debt is qualified real property business indebtedness (and the application of the fair market value limitation) is made at the partnership level. For example, if partnership debt is discharged, the determination of whether the debt was incurred or assumed in connection with real property used in a trade or business is made with reference to the trade or business of the partnership and real property owned by the partnership. 308 The election to apply the provision is made at the partner level, however, on a partner by partner basis. 309 An interest of a partner in a partnership that owns depreciable real property is treated as depreciable real Property #1. No information was provided with respect to the Taxpayer s financial position or the extent, if any, to which he may have been insolvent immediately before the discharge of indebtedness on Property #1. However, if the Taxpayer was insolvent immediately before the discharge of indebtedness on Property #1, the exclusion for discharge of indebtedness provided by Section 108(a)(2)(B) would apply to the extent the Taxpayer was insolvent immediately before the discharge. It will be necessary to determine whether and to what extent, if any, the Taxpayer was insolvent immediately before the discharge in order to determine how much, if any, of the discharged indebtedness on Property #1 would be excluded from gross income pursuant to Section 108(a)(2)(B). * * * If the Taxpayer was solvent before the discharge of indebtedness on Property #1 or the amount of the indebtedness discharged exceeded the amount by which the taxpayer was insolvent immediately before the discharge, it will be necessary to determine whether the discharged indebtedness was qualified real property business indebtedness. In order to make that determination, it will be necessary to know the balance of the indebtedness on Date 5 and the use of the debt proceeds. The portion of the indebtedness incurred or assumed before January 1, 1993, or incurred or assumed in connection with real property used in the Taxpayer s trade or business and secured by such real property would have been characterized as qualified real property business indebtedness. ). 305 I.R.C. 108(e)(4). 306 I.R.C. 108(c)(1)(A). 307 H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, I.R.C. 108(d)(6); H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, v.2 63

73 property to the extent of the partner s proportionate interest in the depreciable real property held by the partnership. The partnership s basis in depreciable real property with respect to such partner is correspondingly reduced. 310 According to the legislative history, the deemed distribution (under Section 752) arising from the reduction in a partner s share of partnership liabilities attributable to the discharge of partnership debt are intended to operate as follows: The allocation of an amount of debt discharge income to a partner results in that partner s basis in the partnership being increased by such amount under Section The reduction in a partner s share of partnership liabilities caused by the debt discharge also results in a deemed distribution under Section 752 which in turn results in a reduction under Section 733 of the partner s basis in his partnership interest. This Section 733 basis reduction is separate from any reduction in basis of the partner s interest under the provision, i.e., the basis reduction that occurs as a result of treating the partnership interest as depreciable real property to the extent of the partner s proportionate interest in the depreciable real property held by the partnership (provided the partnership makes a corresponding reduction in the basis of depreciable partnership real property with respect to that partner) S Corporation Considerations. Section 108(d)(7)(A), as amended by the Job Creation and Worker Assistance Act of 2002, 313 provides, in part, that the rules under Section 108(a) for the exclusion of COD income and under Section 108(b) for the reduction of tax attributes are applied at the corporate level, including by not taking into account under Section 1366(a) any amount excluded under Section 108(a). 314 The exception for qualified real 310 H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, ; cf. Priv. Ltr. Rul (Oct. 2, 1998) ( The legislative history underlying Section 108(a)(1)(D) provides that in the case of discharge of indebtedness of a partnership, the determination of whether debt is qualified real property business indebtedness (and the application of the fair market value limitation) is made at the partnership level. For example, if partnership debt is discharged, the determination of whether the debt was incurred or assumed in connection with real property used in a trade or business is made with reference to the trade or business of the partnership and real property owned by the partnership. The election to apply the provision is made at the partner level, however, on a partner by partner basis. H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, Therefore, the determination of whether Partnership s indebtedness to Lender was incurred or assumed in connection with real property used in a trade or business will be made by reference to the ownership and rental of the property by Partnership. The election to apply Section 108(a)(1)(D) must be made by the partners, on a partner by partner basis. ). 311 I.R.C H.R. Rep. No. 111, 103d Cong., 1st Sess., at (1993), C.B. 167, ; see Mezrah v. Commissioner, 95 T.C.M. (CCH) 1444, 1449 (2008) ( If petitioners were allowed to make a sec. 108(c)(3)(C) election and a concomitant sec reduction in basis of the partner s proportionate interest in depreciable property held by that partnership, the partnership correspondingly must reduce the partnership s basis in depreciable property with respect to such partner. ). 313 Pub. L. No I.R.C. 108(d)(7)(A) v.2 64

74 property business indebtedness will not result in the reduction of a suspended loss as described above under the bankruptcy, insolvency and qualified farm indebtedness exclusions. 315 F. Reduction of Tax Attributes; Election Under Section 108(b)(5); Basis Reduction Rules. 1. Reduction of Tax Attributes. a. Sections 108(b)(1) and 108(b)(2). The legislative history of the Bankruptcy Tax Act states that the exclusion of discharge of indebtedness from gross income under Section 108 is intended to promote a debtor s fresh start. 316 The exclusion provided by the statute generally operates, however, to defer, rather than eliminate, income from discharge of indebtedness. 317 The deferral of income provided by statute is generally achieved by requiring a taxpayer to reduce specified tax attributes (including adjusted bases of property) under Section 108(b) by an amount equal to the COD income excluded from gross income under Section 108(a). 318 Section 108(b)(1) provides that amounts excluded from gross income under the bankruptcy, insolvency or qualified farm indebtedness exclusions are required to be applied to reduce certain tax attributes of the taxpayers. Section 108(b) requires the reduction of certain tax attributes in an amount that reflects the amount excluded from gross income, thereby generally deferring, rather than permanently eliminating, the inclusion of COD income. 319 Section 108(b)(2) requires the reduction of the following tax attributes of the taxpayer in the following order: 320 (1) NOLs: Any net operating loss for the taxable year of the discharge, and any net operating loss carryover to such taxable year; 321 (2) General Business Credits: Any carryover to or from the taxable year of a discharge of an amount for purposes for determining the amount allowable as a credit under Section 38 (relating to general business credit); I.R.C. 108(d)(7)(B) (last sentence); see Eustice & Kuntz, Federal Income Taxation of S Corporations, 14.04[3] (2009) ( The exception for qualified real property business indebtedness will not result in the reduction of a loss suspended at the shareholder-level for lack of basis. [Emphasis in original; footnote omitted]). 316 S. Rep. No. 1035, 96th Cong., 2d Sess. 10 (1980), C.B. 620, 624; H.R. Rep. No. 833, 96th Cong., 2d Sess. 11 (1980). 317 T.D. 9080, C.B. 696 (July 18, 2003). 318 T.D. 9080, C.B. 696 (July 18, 2003). 319 T.D. 9080, C.B. 696 (July 18, 2003). 320 I.R.C. 108(b)(2); Treas. Reg (a). 321 I.R.C. 108(b)(2)(A). 322 I.R.C. 108(b)(2)(B) v.2 65

75 (3) Minimum Tax Credits: The amount of the minimum tax credit available under Section 53(b) as of the beginning of the taxable year immediately following the taxable year of the discharge; 323 (4) Capital Loss Carryovers: Any net capital loss for the taxable year of the discharge, and any capital loss carryover to such taxable year under Section 1212; 324 taxpayer; 325 (5) Basis Reduction: The basis of the property of the (6) Passive Activity Loss and Credit Carryovers: Any passive activity loss or credit carryover of the taxpayer under Section 469(b) from the taxable year of the discharge; 326 and (7) Foreign Tax Credit Carryovers: Any carryover to or from the taxable year of the discharge for purposes of determining the amount of the credit allowable under Section b. Amount of Reduction. Except for the credit carryover reductions, the reductions in the tax attributes are to be one dollar for each dollar excluded from gross income under Section 108(a). 328 The general business credit, minimum tax credit, passive activity loss credit, and the foreign tax credit carryovers are reduced by $0.33 ⅓ for each dollar of debt discharged. 329 c. Ordering Rules. (1) Reductions Made After Determination of Tax for the Year. The tax attribute reductions are made after the determination of the tax imposed for the taxable year of the discharge. 330 (2) Net Operating Losses and Capital Loss Carryover Ordering Rules. The reductions of net operating losses and capital loss carryovers are made 323 I.R.C. 108(b)(2)(C). 324 I.R.C. 108(b)(2)(D). 325 I.R.C. 108(b)(2)(E)(i). 326 I.R.C. 108(b)(2)(F). 327 I.R.C. 108(b)(2)(G). 328 I.R.C. 108(b)(3)(A). 329 I.R.C. 108(b)(3)(B). 330 I.R.C. 108(b)(4)(A) v.2 66

76 first in the loss for the taxable year of the discharge and then in the carryovers to such taxable year in the order of the taxable years from which each such carryover arose. 331 (3) General Business and Foreign Tax Credit Carryovers. General business and foreign tax credit carryovers are reduced in the order in which they are taken into account for the year of the discharge. 332 (4) Amount of Cancellation of Debt Income in Excess of Taxpayer s Tax Attributes is Disregarded. If the excluded discharge income exceeds the sum of the taxpayer s tax attributes, the excess is permanently excluded from the taxpayer s gross income and is disregarded such that it does not have other tax consequences. 333 d. Carryovers and Carrybacks. The tax attributes subject to reduction that are carryovers to the taxable year of the discharge, or that may be carried back to taxable years preceding the year of the discharge, are taken into account by the taxpayer for the taxable year of the discharge or the preceding years, as the case may be, before such attributes are reduced. 334 e. Examples. (1) Example 1. Assume that in Year 4, X, a corporation in bankruptcy, is entitled under Section 108(a)(1)(A) to exclude from gross income $100,000 of COD income. For Year 4, X has gross income in the amount of $50,000. In each of Years 1 and 2, X had no taxable income or loss. In Year 3, X had a net operating loss of $100,000, the use of which when carried over to Year 4 is not subject to any restrictions other than those of Section 172. X takes into account the net operating loss carryover from Year 3 in computing its taxable income for Year 4 before any portion of the COD income excluded under the bankruptcy exclusion is applied to reduce tax attributes. 335 Thus, the reduced amount of the net operating loss carryover is $50, (2) Example 2. Assume that the facts are the same as in Example 1, except that in Year 4, X sustains a net operating loss in the amount of $100,000. In addition, in each of Years 2 and 3, X reported taxable income in the amount of $25, I.R.C. 108(b)(4)(B). 332 I.R.C. 108(b)(4)(C). 333 Treas. Reg (a)(2); T.D. 9080, C.B. 696 (2003); see H.R. Rep. No. 833, at 11 (1980). 334 Treas. Reg (b). 335 Treas. Reg (b). 336 Treas. Reg (d), Example (1) v.2 67

77 The net operating loss sustained in Year 4 is carried back to Years 2 and 3 before any portion of the COD income excluded under the bankruptcy exclusion is applied to reduce tax attributes. 337 Thus, the reduced amount of the net operating loss is $50, Election Under Section 108(b)(5). a. Section 108(b)(5). Instead of reducing tax attributes in the order set forth in Section 108(b)(2), 339 a taxpayer may elect under Section 108(b)(5) to reduce first the adjusted bases of depreciable property to the extent of the excluded COD income before making the reductions required under the ordering rules set forth in Section 108(b)(2). 340 The amount to which the election applies is limited to the aggregate adjusted basis of the depreciable property held by the taxpayer as of the beginning of the taxable year following the taxable year in which the discharge occurs. 341 If the adjusted bases of depreciable property are insufficient to offset the entire amount of excluded cancellation of indebtedness income, the taxpayer must then reduce any remaining tax attributes in the order set forth in Section 108(b)(2). 342 In a Training Guide, the Service has stated that [t]his is a very attractive election for a solvent taxpayer with credits or net operating losses which are usable in the next tax year. The effect of the election is that the lower depreciation is incurred ratably over the life of the asset while allowing an immediate benefit from the other tax attributes. The longer the asset life, the more attractive this election is to the taxpayer. 343 b. Making the Election. To make an election under Section 108(b)(5), a taxpayer must enter the appropriate information on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), 344 and attach the form to the timely filed (including extensions) federal income tax return for the taxable year in which the taxpayer has COD income that is excluded from gross income under Section 108(a). 345 An election under Section 108(b)(5) may be revoked only with the consent of the Commissioner Treas. Reg (b); I.R.C Treas. Reg (d), Example (2). 339 See I.R.C. 108(b)(5)(C). 340 I.R.C. 108(b)(5)(A). 341 I.R.C. 108(b)(5)(B). 342 Treas. Reg (a)(2); T.D. 9080, C.B. 696, 697 (July 18, 2003). 343 IRS Market Segment Specialization Program Guidelines, Irvine Farm Industry, Chapter 5 - Income from Discharge of Indebtedness (Dec. 1, 2002) 2003 TNT I.R.C. 108(d)(9)(C). 345 I.R.C 108(d)(9)(A); Treas. Reg (b). 346 I.R.C. 108(d)(9)(B); Treas. Reg (b) v.2 68

78 3. Section Section 1017 provides rules regarding any basis reductions required by, or elected under, Section a. Timing of Basis Reductions. Section 1017(a) provides the general rule that if (1) an amount is excluded from gross income under Sections (a), (b)(2)(e), (b)(5), or (c)(1) of Section 108, any portion of that amount is to be applied to reduce basis, then that portion is applied in reduction of basis of any property held by the taxpayer at the beginning of the taxable year following the taxable year in which discharge occurs. b. General Rules for Basis Reduction. (1) Properties Subject to Basis Reduction and Order of Reduction. The Regulations provide rules concerning the amount of reduction to be applied to basis of properties and the particular properties that are subject to basis reduction. 348 A taxpayer must reduce in the following order, to the extent of the excluded COD income (but not below zero), the adjusted bases of property held on the first day of the taxable year following the taxable year that the taxpayer excluded COD income from gross income (in proportion to adjusted basis): (A) Real property used in a trade or business or held for investment, other than certain real property held primarily for sale to customers in the ordinary course of a trade or business), that secured the discharged indebtedness immediately before the discharge; 349 (B) Personal property used in a trade or business or held for investment, other than inventory, accounts receivable, and notes receivable, that secured the discharged indebtedness immediately before the discharge; 350 (C) Remaining property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable, and real property described in Section 1221(1); 351 (D) Inventory, accounts receivable, notes receivable, and certain real property held primarily for sale to customers in the ordinary course of a trade or business; 352 and investment. 353 (E) Property not used in a trade or business nor held for 347 See I.R.C. 108(b)(2)(E)(ii). 348 I.R.C. 1017(b)(1). 349 Treas. Reg (a)(1). 350 Treas. Reg (a)(2). 351 Treas. Reg (a)(3). 352 Treas. Reg (a)(4) v.2 69

79 For example, if an indebtedness secured by a building, a parcel of land used in the taxpayer s trade or business, office equipment, and office furniture is discharged, the taxpayer proportionately reduces the adjusted bases of the building and the parcel of land, based upon their relative adjusted bases, to the full extent of the excluded COD income before reducing the adjusted bases of the office equipment and the office furniture. 354 (2) Prior Tax-Attribute Reduction. The amount of excluded COD income applied to reduce basis does not include any COD income applied to reduce tax attributes under Sections 108(b)(2)(A) through (D) and, if applicable, Section 108(b)(5). 355 For example, if a taxpayer excludes $100 of COD income from gross income and reduces tax attributes by $40 under Sections 108(b)(2)(A) through (D), the taxpayer is required to reduce the adjusted bases of property by $60 ($100 $40) under Section 108(b)(2)(E). 356 (3) Multiple Discharged Indebtednesses. If a taxpayer has COD income attributable to more than one discharged indebtedness resulting in the reduction of tax attributes under Sections 108(b)(2)(A) through (D) and, if applicable, Section 108(b)(5), the prior tax attribution reduction rule must be applied by allocating the tax-attribute reductions among the indebtednesses in proportion to the amount of COD income attributable to each discharged indebtedness. For example, if a taxpayer excludes $20 of COD income attributable to secured indebtedness A and excludes $80 of COD income attributable to unsecured indebtedness B (a total exclusion of $100), and if the taxpayer reduces tax attributes by $40 under Sections 108(b)(2)(A) through (D), the taxpayer must reduce the amount of COD income attributable to secured indebtedness A to $12 ($20 ($20 / $100 $40)) and must reduce the amount of COD income attributable to unsecured indebtedness B to $48 ($80 ($80 / $100 $40)). 357 Bankruptcy or Insolvency. (4) Special Rules Applicable to Basis Reductions in (A) Limitation on Basis Reductions Under Section 108(b)(2)(E) in Bankruptcy or Insolvency. If COD income arises from a discharge of indebtedness in a title 11 bankruptcy case or while the taxpayer is insolvent, the amount of any basis reduction under Section 108(b)(2)(E) is limited to the excess of (a) the aggregate of the adjusted bases of property and the amount of money held by the taxpayer immediately after the discharge; over (b) the aggregate of the liabilities of the taxpayer immediately after the discharge. 358 The legislative history states that a sale of all the taxpayer s assets immediately 353 Treas. Reg (a)(5). 354 Notice of Proposed Rulemaking, REG , C.B Treas. Reg (b)(1). 356 Treas. Reg (b)(1). 357 Treas. Reg (b)(2). 358 I.R.C. 1017(b)(2); Treas. Reg (b)(3); T.D. 8787, C.B. 621 ( The revised statute, in Section 1017(b)(2), provides only one limitation on basis reduction for insolvent and bankrupt taxpayers who do not make an election under Section 108(b)(5). Under that rule, the basis reduction may not exceed the excess of the aggregate v.2 70

80 after the discharge generally will not result in income tax liability unless the sale proceeds and cash on hand exceed the amount needed to pay off the remaining liabilities. 359 The preceding rule, however, does not apply to any reduction in basis pursuant to an election under Section 108(b)(5). 360 (B) Reduction Not to be Made to Exempt Property in Bankruptcy. In the case of an amount excluded from gross income in a title 11 bankruptcy case, no reduction in basis is made under Section 1017 in the basis of property which the debtor treats as exempt property under Section 522 of title 11 of the United States Code. 361 (5) Special Rules Apply to Basis Reductions Due to Exclusion of Income From Discharge of Qualified Farm Debt. If the basis reduction required by Section 108(b)(2) is due to the exclusion of income realized from the discharge of qualified farm debt, special basis reductions apply. 362 c. Reductions Required Under Sections 108(b)(5) or 108(c). (1) Reductions Required to Be Made to Depreciable Property Only. Any amount which under Sections 108(b)(5) or 108(c)(1) is to be applied to reduce basis is applied to reduce only the basis of depreciable property held by the taxpayer. 363 (2) Order of Basis Reduction. The general ordering rules prescribed above apply, with appropriate modifications, to basis reductions under Sections 108(b)(5) and (c). 364 (A) Reductions Under Section 108(b)(5). (i) Ordering of Basis Reduction. A taxpayer that elects to reduce basis under Section 108(b)(5) may, to the extent that the election applies, reduce the adjusted basis of depreciable properties 365 within the following categories of properties: (a) Real property used in a trade or business or held for investment, other than certain real property held primarily for sale to of the bases of the property held by the taxpayer immediately after the discharge over the aggregate of the liabilities of the taxpayer immediately after the discharge. ). 359 S. Rep. No. 1035, C.B., 620, I.R.C. 1017(b)(2). 361 I.R.C. 1017(c)(1). 362 See I.R.C. 1017(b)(4). 363 I.R.C. 1017(b)(3)(A). 364 Treas. Reg (c)(1). 365 I.R.C. 1017(b)(3)(A); Treas. Reg (c)(1) v.2 71

81 customers in the ordinary course of a trade or business), that secured the discharged indebtedness immediately before the discharge; (b) Personal property used in a trade or business or held for investment, other than inventory, accounts receivable, and notes receivable, that secured the discharged indebtedness immediately before the discharge; (c) Remaining property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable, and real property described in Section 1221(1); (d) If a special election is made, inventory, accounts receivable, notes receivable, and real property described in Section To make such an election, a taxpayer must enter the appropriate information on Form 982 and attach the form to a timely filed (including extensions) Federal income tax return for the taxable year in which the taxpayer has COD income that is excluded from gross income under Section 108(a). Such an election may be revoked only with the consent of Service. 367 (ii) Partial Basis Reductions Under Section 108(b)(5). If the amount of basis reductions under Section 108(b)(5) is less than the amount of the COD income excluded from gross income under Section 108(a), the taxpayer must reduce the balance of its tax attributes, including any remaining adjusted bases of depreciable and other property, by following the ordering rules under Section 108(b)(2). For example, if a taxpayer excludes $100 of COD income from gross income under Section 108(a) and elects to reduce the adjusted bases of depreciable property by $10 under Section 108(b)(5), the taxpayer must reduce its remaining tax attributes by $90, starting with net operating losses under Section 108(b)(2). 368 (iii) Modification of Fresh Start Rule for Prior Basis Reductions Under Section 108(B)(5). After reducing the adjusted bases of depreciable property under Section 108(b)(5), a taxpayer must compute the limitation on basis reductions using the aggregate of the remaining adjusted bases of property. For example, if, immediately after the discharge of indebtedness in a title 11 case, a taxpayer s adjusted bases of property is $100 and its undischarged indebtedness is $70, and if the taxpayer elects to reduce the adjusted bases of depreciable property by $10 under Section 108(b)(5), Section 1017(b)(2) limits any further basis reductions under Section 108(b)(2)(E) to $20 (($100-$10)-$70). 369 (B) Reductions Under Section 108(c). 366 Treas. Reg (c)(1). 367 I.R.C. 1017(b)(3)(E); Treas. Reg (f)(2). 368 Treas. Reg (c)(2). 369 Treas. Reg (c)(3) v.2 72

82 (i) Order of Basis Reductions. A taxpayer that elects to apply Section 108(c) may reduce only the adjusted basis of depreciable real property described in the following categories of properties: (a) Real property used in a trade or business or held for investment, other than certain real property described in Section 1221(1), that secured the discharged indebtedness immediately before the discharge; and (b) Remaining property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable, and real property described in Section (ii) Basis of Real Property Secured by QRPBI Must Be Reduced Prior to Other Depreciable Real Property. For basis reductions under Section 108(c), a taxpayer must reduce the adjusted basis of real property secured by QRPBI 371 to the extent of the discharged qualified real property business indebtedness before reducing the adjusted bases of other depreciable real property. 372 (iii) Basis Reduction Made Prior to Disposition of Property. If the property whose debt is reduced is sold in the same year as the debt cancellation, the basis reductions are required to be effected immediately before the sale. 373 As a result, basis reductions will be immediately triggered into income (as ordinary income due recapture rule discussed below) upon the sale. 374 This immediate recapture normally will take any tax benefit away from Section 108(c). 375 d. Partnership Considerations. (1) Partnership COD Income. The Regulations provide that, for basis reduction purposes, a taxpayer must treat a distributive share of a partnership s COD income as attributable to a discharged indebtedness secured by the taxpayer s interest in that partnership. 376 (2) Partnership Interest Treated as Depreciable Property. (A) For purposes of making basis reductions, if a taxpayer makes an election under Section 108(b)(5) (or 108(c)), the taxpayer must treat a 370 Treas. Reg (c)(1). 371 Treas. Reg (c)(1). 372 Treas. Reg (c)(1). 373 I.R.C. 1017(a)(3)(F). 374 I.R.C. 1017(b)(3)(F)(iii). 375 IRS Market Segment Specialization Program Guideline, Partnership Returns, Chapter 8 Real Estate Issues in Partnerships (Dec. 1, 2002), 2003 TNT Treas. Reg (g)(1) v.2 73

83 partnership interest as depreciable property when reducing adjusted bases under Section 108(b)(5) (or depreciable real property when reducing adjusted bases under Section 108(c)) to the extent of the partner s proportionate share of the partnership s basis in depreciable property (or depreciable real property), provided that the partnership consents to a corresponding reduction in the partnership s basis (inside basis) in depreciable property (or depreciable real property) with respect to such partner. 377 (B) Request by Partner and Consent of Partnership. (i) In General. A taxpayer may generally choose whether or not to request that a partnership reduce the inside basis of its depreciable property (or depreciable real property) with respect to the taxpayer, and the partnership may grant or withhold such consent, in its sole discretion. A request by the taxpayer must be made before the due date (including extensions) for filing the taxpayer s Federal income tax return for the taxable year in which the taxpayer has COD income that is excluded from gross income under Section 108(a). 378 (ii) Request for Consent Required. A taxpayer must request a partnership s consent to reduce inside basis if, at the time of the discharge, the taxpayer owns (directly or indirectly) a greater than 50 percent interest in the capital and profits of the partnership, or if reductions to the basis of the taxpayer s depreciable property (or depreciable real property) are being made with respect to the taxpayer s distributive share of COD income of the partnership. 379 (iii) Granting of Request Required. A partnership must consent to reduce its partners shares of inside basis with respect to a discharged indebtedness if consent is requested with respect to that indebtedness by partners owning (directly or indirectly) an aggregate of more than 80 percent of the capital and profits interests of the partnership or five or fewer partners owning (directly or indirectly) an aggregate of more than 50 percent of the capital and profits interests of the partnership. For example, if there is a cancellation of partnership indebtedness that is secured by real property used in a partnership s trade or business, and if partners owning (in the aggregate) 90 percent of the capital and profits interests of the partnership elect to exclude the COD income under Section 108(c), the partnership must make the appropriate reductions in those partners shares of inside basis I.R.C. 1017(b)(3)(C); Treas. Reg (g)(2)(i). 378 Treas. Reg (g)(2)(ii)(A); see Notice of Proposed Rulemaking, REG (Jan. 6, 1997), reprinted in C.B. 726 ( The proposed regulations generally provide that a taxpayer may freely choose whether or not to request that a partnership reduce the partner s share of depreciable basis in partnership property and thereby permit the taxpayer to treat the partnership interest as depreciable property (or depreciable real property). In addition, the proposed regulations generally provide that the partnership is free to grant or deny its consent. ). 379 Treas. Reg (g)(2)(ii)(B). 380 Treas. Reg (g)(2)(ii)(C); see T.D. 8787, C.B. 621, 623 ( The ability to freely choose whether or not to request or grant consent, however, provides opportunities to avoid the general ordering rules of the proposed regulations through the use of a partnership. Therefore, the proposed regulations provided that, in a limited v.2 74

84 (iv) Partnership Consent Statement. (a) Partnership Requirement. A consenting partnership must include with the Form 1065, U.S. Partnership Return of Income, for the taxable year following the year that ends with or within the taxable year the taxpayer excludes COD income from gross income under Section 108(a), and must provide to the taxpayer on or before the due date of the taxpayer s return (including extensions) for the taxable year in which the taxpayer excludes COD income from gross income, a statement that (1) contains the name, address, and taxpayer identification number of the partnership; and (2) states the amount of the reduction of the partner s proportionate interest in the adjusted bases of the partnership s depreciable property or depreciable real property, whichever is applicable. 381 (b) Taxpayer s Requirement. Taxpayers must retain the statements and keep them available for inspection, but are not required to attach the statements to their returns. 382 (3) Partner s Share of Partnership Basis. The Regulations describe how to determine a partner s proportionate share of the adjusted basis of depreciable property (or depreciable real property) under Section 1017, and clarify that an adjustment to the basis of partnership property is treated in the same manner as an adjustment to the basis of partnership property made under Section (4) Treatment of Basis Reduction. (A) Basis Adjustment. The amount of the reduction to the basis of depreciable partnership property constitutes an adjustment to the basis of partnership property with respect to the partner only. No adjustment is made to the common basis of partnership property. Thus, for purposes of income, deduction, gain, loss, and distribution, the partner will have a special basis for those partnership properties the bases of which are adjusted. 384 (B) Recovery of Adjustments to Basis of Partnership Property. Adjustments to the basis of partnership property are recovered in the manner described in Treas. Reg number of situations; (i) a partner is required to request the partnership s consent, and (ii) the partnership is required to grant that consent. ). 381 Treas. Reg (g)(2)(iii)(A). 382 Treas. Reg (g)(2)(iii)(B). 383 REG , 63 F.R , reprinted in C.B Treas. Reg (g)(2)(v)(A). 385 Treas. Reg (g)(2)(v)(B) v.2 75

85 (C) Effect of Basis Reduction. Adjustments to the basis of partnership property are treated in the same manner and have the same effect as an adjustment to the basis of partnership property under Section 743(b). 386 e. Recapture Rule. If the basis of property is reduced pursuant to the attribute reduction rules of Section 1017, any gain on a subsequent disposition of the property is subject to depreciation recapture under Section 1245 or, in the case of depreciable real property, under Section (Application of the recapture rule of Section 1245 to property the basis of which has been reduced by reason of the realization of excluded COD income ensures that the character of the income deferred by reason of attribute reduction (i.e., the extra gain that may be recognized on the disposition of an asset the basis of which has been reduced) will be ordinary (even if the asset is held as a capital asset), which character the excluded COD income would have had if it had been included in income when realized. 388 ) This recapture rule applies to any reduced-basis asset, whether depreciable or nondepreciable, and whether or not a disposition of such asset otherwise would be subject to depreciation recapture. 389 The computation of the amount of straight-line depreciation (under Section 1250(b)) is determined as if there had been no reduction of basis under Section For Purposes of Sections 108(b)(1) and 108(b)(5), the Estate of Individual in Bankruptcy (and not the Individual) is Treated as the Taxpayer. Section 1398 provides rules for treatment of tax attributes for years in which individuals are in bankruptcy under chapters 7 or 11 of title 11. Section 1398 provides that a bankruptcy estate is a separate taxable entity from the debtor. Section 1398(g) provides that when an individual commences a bankruptcy case, the bankruptcy estate succeeds and takes into account the individual s tax attributes, including net operating loss carryovers. Section 1398(i) provides that when a bankruptcy estate terminates, the debtor succeeds to and takes into account any tax attributes of the estate. In the case of an individual in a Chapter 7 or 11 bankruptcy, the taxpayer for purposes of Sections 108(b)(1) and 108(b)(5) is the estate and not the individual. 391 Thus, the reduction in tax attributes is made by the bankruptcy estate in the case of an individual Chapter 7 or 11 bankruptcy. Further, to the extent required under Section 108(b), the basis of any property in the hands of A will be reduced in accordance with Section The reduction in basis of the 386 Treas. Reg (g)(2)(v)(C). 387 I.R.C. 1017(d)(1)(B). 388 T.D C.B. 721 (03/12/2004). 389 I.R.C. 1017(d)(1)(A); S. Rep. No. 1035, 1035 (1980). 390 I.R.C. 1017(d)(2). 391 I.R.C. 108(d)(8). 392 I.R.C. 108(d)(8); see Kahle v. Commissioner, 73 T.C.M. (CCH) 2080, 2082 ( Section 108(a) provides that debt discharged in bankruptcy is not includable in gross income. Section 108(b)(1) provides in turn that, upon discharge, the taxpayer must reduce any tax attributes by the amount of the debt discharged. Section 108(b)(2) provides that NOL s are the first attribute to be reduced, and Section 108(b)(3) provides that they be reduced dollar-for-dollar by the amount of the debt discharged in the bankruptcy. Section 108(b)(4)(A) provides that the reduction is made after the determination of the tax imposed by this chapter for the taxable year of the discharge. In the alternative, the taxpayer can elect under Section 108(b)(5) to first reduce the basis of any depreciable property by the amount of v.2 76

86 estate s property takes place before the taxpayer is required to reduce any adjusted basis of property. 393 G. Qualified Principal Residence Indebtedness. 1. The Exclusion. Section 108(a)(1)(E) excludes from the gross income of a taxpayer any discharge of indebtedness income by reason of a discharge (in whole or in part) of qualified principal residence indebtedness. a. Qualified Principal Residence Indebtedness. Qualified principal residence indebtedness generally means indebtedness which is incurred in the acquisition, construction, or substantial improvement of the principal residence 394 of the individual and is secured by the residence. 395 It also includes refinancing of such indebtedness to the extent the amount of the refinancing does not exceed the amount of the refinanced indebtedness. 396 b. Exclusion Limitation. The maximum amount that a taxpayer can treat as qualified principal residence indebtedness is $2,000,000 ($1,000,000 in the case of a married taxpayer filing a separate return). 397 The exclusion does not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer. 398 c. Ordering Rule. If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, the exclusion applies only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness. 399 Thus, assume that a principal residence is secured by an indebtedness of $1 million, of which $800,000 is qualified principal residence indebtedness. If the residence is sold for $700,000 and debt discharged, before reducing the amount of any tax attributes. Importantly, Section 108(d)(8) clarifies that the taxpayer for purposes of Section 108(b)(1) and (5) is the bankruptcy estate, and not the individual debtor. ); cf. F.S.A (May 7, 2001) ( I.R.C. Section 108(a)(1)(A) provides that gross income does not include discharge of indebtedness income if the discharge occurs in a Title 11 case. However, Section 108(b) provides that certain tax attributes, including NOLs, of a taxpayer are reduced if the taxpayer is entitled to an exclusion under Section 108(a). Section 108(d)(8) provides that the reduction in tax attributes is made by the bankruptcy estate in the case of an individual bankruptcy. ). 393 Treas. Reg (h). 394 For these purposes the term principal residence has the same meaning as under Section 121 of the Code. I.R.C. 108(h)(5). 395 I.R.C. 108(h)(2); I.R.C. 163(h)(3)(B)(i); H.R. Rep. No. 356, 110th Cong., 1st Sess. 4 (2007), reprinted in 2007 U.S.C.C.A.N. 574, I.R.C. 108(h)(2); I.R.C. 163(h)(3)(B)(i); H.R. Rep. No. 356 supra at 4, 2007 U.S.C.C.A.N. at I.R.C. 108(h)(2); I.R.C. 163(h)(3)(B)(ii). 398 I.R.C. 108(h)(3). 399 I.R.C. 108(h)(3) v.2 77

87 $300,000 debt is discharged, then only $100,000 of the amount discharged may be excluded from gross income under this provision. 400 d. Effective Date. The provision is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, Priority of Exclusion. a. Qualified Principal Residence Exclusion Does Not Apply in a Title 11 Case. The qualified principal residence exclusion does not apply to a taxpayer in a title 11 case. 402 b. Principal Residence Exclusion Takes Precedence Over Insolvency Exclusion Unless Taxpayer Elects Otherwise. In the case of an insolvent taxpayer that is not in bankruptcy, the qualified principal residence exclusion applies unless the taxpayer elects to have the insolvency exclusion apply instead Reduction of Basis. The basis of the individual s principal residence is reduced by the amount excluded from income under the qualified principal residence exclusion. 404 H. Deferral of Cancellation of Indebtedness Income Arising from Certain Reacquisitions of Debt Instruments. 1. Provision Defers Cancellation of Indebtedness Income Arising from Reacquisitions of Certain Debt Instruments After December 31, 2008, and Before January 1, Section 108(i)(1) permits a taxpayer to elect to defer cancellation of indebtedness income arising from a reacquisition of an applicable debt instrument after December 31, 2008, and before January 1, H.R. Rep. No. 356, supra at 4, 2007 U.S.C.C.A.N. at Mortgage Forgiveness Debt Relief Act of 2007, P.L , 121 Stat. 1803, 2(a), 2(d); Emergency Economic Stabilization Act of 2008, P.L , 122 Stat. 3765, 303(a), 303(b). 402 I.R.C. 108(a)(2)(A). 403 I.R.C. 108(a)(2)(C); cf. IRS Info. Ltr (Apr. 14, 2009) ( In certain situations, however, taxpayers may exclude discharge of indebtedness income from gross income. For example, if qualified principal residence indebtedness ( qualified debt ) is discharged on or after January 1, 2007, and before January 1, 2013, the amount discharged generally is excluded from gross income (Section 108(a)(1)(E) of the Code). In addition, if a discharge of indebtedness occurs when a taxpayer is insolvent, the amount of debt discharged is excluded from gross income up to the amount by which the taxpayer is insolvent (Sections 108(a)(1)(B) and 108(a)(3) of the Code). Insolvency is defined as the excess of liabilities over the fair market value of assets, based on the taxpayer s assets and liabilities immediately before the debt discharge (Section 108(d)(3) of the Code) ). 404 I.R.C. 108(h)(1). 405 See H.R. Conf. Rep. No. 16, 111th Cong., 1st Sess. 564 (2009); see generally Practitioners Hear Preview of Initial COD Election Guidance, 2009 TNT (June 30, 2009) (discussion of Section 108(i)); ABA Members Seek Guidance for Partnerships on COD Deferral Election, 2009 TNT (May 5, 2009) (comments on the v.2 78

88 a. Inclusion of Deferred Income. Income deferred pursuant to the election must be included in the gross income of the taxpayer ratably in the five taxable years beginning with (1) for acquisitions in 2009, the fifth taxable year following the taxable year in which the reacquisition occurs or (2) for reacquisitions in 2010, the fourth taxable year following the taxable year in which the reacquisition occurs. 406 b. Applicable Debt Instrument. An applicable debt instrument is any debt instrument issued by (1) a C corporation or (2) any other person in connection with the conduct of a trade or business by such person. 407 For purposes of the provision, a debt instrument means a bond, debenture, note, certificate or any other instrument or contractual arrangement constituting indebtedness. 408 c. Reacquisition. A reacquisition is any acquisition of an applicable debt instrument by (1) the debtor that issued (or is otherwise the obligor under) such debt instrument or (2) any person related (within the meaning of Section 108(e)(4) 409 ) to the debtor. 410 For purposes of the provision, an acquisition includes (1) an acquisition of a debt instrument for cash, (2) the exchange of a debt instrument for another debt instrument (including an exchange resulting from a modification of a debt instrument), (3) the exchange of corporate stock or a partnership interest for a debt instrument, (4) the contribution of a debt instrument to the capital of the issuer, and (5) the complete forgiveness of a debt instrument by a holder of such instrument Special Deferral of Deduction Rule for OID in Debt for Debt Exchanges. If a taxpayer makes the election for a debt-for-debt exchange in which the new debt instrument issued in satisfaction of an outstanding debt instrument of the debtor has original issue discount, then any otherwise allowable deduction for original issue discount with respect to such newly issued debt instrument that (1) accrues before the first year of the five-taxable-year period in which the related, deferred discharge of indebtedness income is includible in the gross income of the taxpayer and (2) does not exceed such related, deferred discharge of indebtedness income, is deferred and allowed as a deduction ratably over the same five-taxable-year period in which the deferred discharge of indebtedness income is included in gross income. 412 The foregoing rule can apply also in certain cases when a debtor reacquires its debt for cash. If the taxpayer issues a debt instrument and the proceeds of such issuance are used directly or indirectly to reacquire a debt instrument of the taxpayer, Section 108(i)(2)(B) treats the newly application of Section 108(i) to partnerships and partners); Wagman, Selected Issues Relating to the Election to Defer COD Income, 2009 TNT 94-9 (May 19, 2009) (analyzing Section 108(i)). 406 I.R.C. 108(i)(1). 407 I.R.C. 108(i)(3)(A). 408 I.R.C. 108(i)(3)(B). 409 I.R.C. 108(i)(5)(A). 410 I.R.C. 108(i)(4)(A). 411 I.R.C. 108(i)(4)(B). 412 I.R.C. 108(i)(A) v.2 79

89 issued debt instrument as if it were issued in satisfaction of the retired debt instrument. If the newly issued debt instrument has original issue discount, the rule described above applies. 413 Thus, all or a portion of the interest deductions with respect to original issue discount on the newly issued debt instrument are deferred into the five-taxable-year period in which the discharge of indebtedness income is recognized Acceleration of Deferred Items. Cancellation of indebtedness income and any related deduction for original issue discount that is deferred by an electing taxpayer (and has not previously been taken into account) generally is accelerated and taken into income in the taxable year in which the taxpayer: (1) dies, (2) liquidates or sells substantially all of its assets (including in a title 11 or similar case), (3) ceases to do business, or (4) or is in similar circumstances. 415 In a case under title 11 or a similar case, any deferred items are taken into income as of the day before the petition is filed. 416 The legislative history states that deferred items are accelerated in a case under title 11 where the taxpayer liquidates, sells substantially all of its assets, or ceases to do business, but not where a taxpayer reorganizes and emerges from the title 11 case. 417 a. Special Rule for Pass-Through Entities. In the case of a pass thru entity, the acceleration rule also applies to the sale, exchange, or redemption of an interest in the entity by a holder of such interest. 418 b. Special Rule for Partnerships. In the case of a partnership, any income deferred under Section 108(i) is allocated to the partners in the partnership immediately before the discharge of indebtedness in the manner such amounts would have been included in the distributive shares of such partners under Section 704 if such income were recognized at the time of the discharge. 419 Any decrease in a partner s share of liabilities as a result of such discharge is not taken into account for purposes of Section 752 at the time of the discharge to the extent the deemed distribution under Section 752 would cause the partner to recognize gain under Section Thus, the deemed distribution under Section 752 is deferred with respect to a partner to the extent it exceeds such partner s basis. 421 Amounts so deferred are taken into account at the same time, and to the extent remaining in the same amount, as income deferred under the provision is recognized by the partner H.R. Conf. Rep. No. 16, 111th Cong., 1st Sess. 562 (2009). 414 I.R.C. 108(i)(2)(B); H.R. Conf. Rep. No. 16, 111th Cong., 1st Sess. 564 (2009). 415 I.R.C. 108(i)(5)(D)(i). 416 I.R.C. 108(i)(5)(D)(i). 417 H.R. Conf. Rep. No. 16, supra at I.R.C. 108(i)(5)(D). 419 I.R.C. 108(i)(6). 420 I.R.C. 108(i). 421 H.R. Conf. Rep. No. 16, supra at I.R.C. 108(i)(7) v.2 80

90 4. Effective Date. The provision is effective for discharges in taxable years ending after December 31, Priority Rules. Where a taxpayer makes the election provided by Section 108(i) with respect to an applicable debt instrument, the exclusions for bankruptcy cases, insolvency, qualified farm indebtedness and qualified real property business indebtedness do not apply to the income from the discharge of such indebtedness for the year in which the taxpayer makes the election or any subsequent year. 423 Thus, for example, an insolvent taxpayer may elect under the provision to defer income from the discharge of indebtedness rather than excluding such income and reducing tax attributes by a corresponding amount Procedures for Election. The election is to be made on an instrument by instrument basis. 425 Once made, the election is irrevocable. 426 A taxpayer makes an election with respect to a debt instrument by including with its return for the taxable year in which the reacquisition of the debt instrument occurs a statement that (1) clearly identifies the debt instrument and (2) includes the amount of deferred income to which the provision applies and such other information as may be prescribed by the Secretary. 427 The IRS is authorized to require reporting of the election (and other information with respect to the reacquisition) for years subsequent to the year of the reacquisition. 428 On August 17, 2009, the Revenue Service issued Rev. Proc , I.R.B. 309, providing the exclusive procedures for taxpayers to make an election to defer recognizing discharge of indebtedness income under 108(i) of the Internal Revenue Code. This revenue procedure applies to taxpayers that realize COD income from a reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument, as provided in 108(i). 429 VI. Overview of Types of Bankruptcy. The United States Bankruptcy Code ( Bankruptcy Code ) is a complex and comprehensive set of statutes designed essentially to administer, and sometimes distribute to creditors, a debtor s assets in a fair manner. 430 To provide guidance in the application of the statutes the Federal Rules of Bankruptcy Procedure ( Bankruptcy Rules ) have been 423 I.R.C. 108(i)(5)(C). 424 H.R. Conf. Rep. No. 16, supra at H.R. Conf. Rep. No. 16, supra at 566; see I.R.C. 108(i)(5)(B). 426 I.R.C. 108(i)(5)(B)(ii). 427 I.R.C. 108(i)(5)(B)(i). 428 I.R.C. 108(i)(5)(B)(i). 429 Rev. Proc , Throughout this paper, we will use terms that have special meanings in the bankruptcy context. Where appropriate, we will define these terms and explain how these terms are used. The first term that merits definition is Bankruptcy Code, which is the set of statutes that govern the filing and administration of a Bankruptcy Case. The Bankruptcy Code is located in title 11 of the United States Code. Unless stated otherwise, all references to a section or a chapter will mean a section or chapter of the Bankruptcy Code v.2 81

91 promulgated. While those unfamiliar with the process often equate filing for bankruptcy with throwing in the business towel, that assumption is often untrue. In fact, a large number of bankruptcy cases are reorganizations instituted under Chapter 11 to afford the debtor a respite from the collection efforts of its creditors and provide it an opportunity to restructure debts and assets, and formulate a new business plan to attempt to turn the debtor s business around. Thus, although commencing a bankruptcy case is certainly a drastic step, it may also be an effective business tool when used properly. 431 To seek relief under the Bankruptcy Code, a company must file a bankruptcy petition ( Petition ). 432 The day the company files the Petition is called the Petition Date or Filing Date. This date controls many deadlines in the Bankruptcy Case and preserves rights of the debtor and other parties. The voluntary commencement of the case constitutes an order for relief. ( Order for Relief ). 433 There are two paths, or Chapters, that a business debtor usually considers taking when starting down the bankruptcy road: Chapter 7 or Chapter The decision as to whether to file and, if so, under which chapter depends in large part on the ultimate goal that a company seeks to achieve. The filing of a petition under either Chapters 7 or 11 commences a bankruptcy case. 435 A. Chapter 7 in a Nutshell. A Chapter 7 bankruptcy case simply entails the liquidation of a debtor s assets and, after payment of administrative expenses, distribution of the liquid assets to the creditors. This type of case is certainly the easiest to manage from the debtor s perspective because usually the company merely files the bankruptcy petition under Chapter 7 and turns the keys, books and records over to a Chapter 7 trustee appointed by the United States Trustee. 436 After that, the debtor has only limited additional responsibilities, including the duty to prepare Schedules and Statements of Financial Affairs, 437 participate in the meeting of creditors required by Section 341 of the Bankruptcy Code, and cooperate with the 431 Certain entities are not entitled to file for protection under the Bankruptcy Code, such as insurance companies and banks. See 11 U.S.C See for a form of Voluntary Petition. 433 See 11 U.S.C In an involuntary case under chapter 11, if the involuntary petition is not timely controverted by the company, the court shall order relief. See 11 U.S.C. 303(h). In an involuntary case, the Order For Relief is not a simultaneous event with the filing of the Petition. 434 Other chapter paths in the Bankruptcy Code are: Chapter 9 for municipalities and Chapter 12 for family farms with regular annual income. 435 The term bankruptcy case means the entire bankruptcy proceeding which includes the collection of assets, filing and litigation of creditor claims and other matters affecting the administration of the case (contested matters), prosecution of claims against third parties by the debtor or trustee (adversary actions), and payment of estate assets to creditors, either through distributions or a confirmed plan of reorganization. Therefore, when we refer to a bankruptcy case, we are talking about this global proceeding, not simply one small aspect of the case. 436 See 11 U.S.C See for forms of Schedules and Statement of Financial Affairs v.2 82

92 trustee. 438 Otherwise, the trustee does all the work to liquidate the assets, pay the administrative expenses and make the distribution to creditors. 439 In addition, the trustee must review creditor claims and litigate any claims that should not be allowed. Under Chapter 7, there is no right for the principals of the company to continue to control any of the debtor s assets, the liquidation proceeding, or the distribution. There can be no receiver appointed in a bankruptcy case. Rarely is there a creditors committee formed. Although authority exists to permit the trustee to operate a business in Chapter 7 for a limited period, that authority is infrequently requested. 440 If a company wants to continue to operate in a bankruptcy case and after the case is closed, Chapter 7 is not the path to choose. Because in a Chapter 7 the company is liquidated and out of business, there is no discharge of its debts. 441 In contrast, an individual Chapter 7 debtor typically gets a discharge unless it is denied under Section 727 or the debt of a particular creditor is determined to be nondischargeable under Section 523. Therefore, a Chapter 7 bankruptcy case is desirable if the company s goal is simply to cease to exist. When the principals lack the incentive or motivation to continue the business; when they do not have valuable assets they want to preserve; when they can easily go down the street to start over with a new entity; when they do not want to control the sale of significant assets; when they have insufficient operating capital and the inability to borrow; and when they are not necessarily concerned that the assets are sold for their maximum price Chapter 7 may be the best, and sometimes the only, path to take. B. Chapter 11 in a Nutshell. In contrast to a liquidation under Chapter 7, a company that wants to survive by reorganizing should consider filing under Chapter 11. Chapter 11 provides numerous benefits to a business that has principals who want to continue to operate and sufficient financial resources to survive the expenses associated with the administration of a reorganization case. Two of the most attractive features of a Chapter 11 bankruptcy case are (a) the principals of the debtor company generally maintain control over the business (the debtor in possession or DIP 442 concept) and (b) the company continues to operate albeit with some court and creditor oversight. The company who has filed for bankruptcy under Chapter 11 generally continues with the same management. This role as Debtor-in-Possession places fiduciary duties on the company, not only to its shareholders, but to the entire creditor body See 11 U.S.C See 11 U.S.C See 11 U.S.C See 11 U.S.C Unless stated otherwise, the powers, duties, rights, or obligations of a trustee and DIP are materially the same, and therefore, in the interest of brevity we will refer to either a trustee or DIP in a Chapter 11 context as the debtor. 443 See 7 COLLIER ON BANKRUPTCY [3] (Alan Resnick & Henry Sommer eds., 15 th ed. 2002) v.2 83

93 The traditional goal of a Chapter 11 case is to reorganize a company pursuant to a plan that must be approved by the Bankruptcy Court. Generally, a plan allows for the company to continue its operations after a plan of reorganization has been confirmed and the administration of the company in the bankruptcy case has concluded. The company is then a reorganized debtor. Often overlooked in considering whether to file a Petition under Chapter 11 is the option to propose a liquidation plan or even to convert to a liquidation under Chapter 7 if reorganization under Chapter 11 is no longer necessary or appropriate. Often a liquidating plan is coupled with the establishment of a liquidation trust and the appointment of a liquidating trustee to administer the liquidation of assets (often including the prosecution of lawsuits) and the distribution of the proceeds to creditors. The trustee often manages causes of action that will take many years to conclude. The trust arrangement allows the bankruptcy case to be concluded within a reasonable period of time and still provide a vehicle for the future recovery of assets and the satisfaction of creditor claims. This liquidation alternative under Chapter 11 is particularly attractive if the principals want to remain in control of the bankruptcy case to guide the liquidation of the assets with respect to which they have special knowledge. This knowledge of the assets (sometimes very sophisticated high tech equipment) and potential purchasers often results in the generation of sale proceeds that would not be matched if the assets were sold at a liquidation sale in a Chapter 7 case by a bankruptcy trustee. If all or substantially all of the assets are sold in the Chapter 11 case, the case might then be converted to a Chapter 7 for wrap up. Reorganization cases are expensive and distracting to management. These burdens are placed on an already financially weak company. There has been considerable debate about the deficiencies of Chapter 11, particularly in the context of small or middle sized companies. The debtor will often pay substantial fees to attorneys, accountants, financial advisors and investment bankers. In addition, Chapter 11 debtors have to pay the professionals who assist the Official Committee of Unsecured Creditors ( Unsecured Creditors Committee ) and any other official committees that may be appointed in large cases. 444 Although a Chapter 11 case is unattractive in some respects, it also has many advantages. No trustee is appointed unless cause or gross mismanagement is proven. 445 The debtor-inpossession functions as a trustee with the same duties, rights and powers. 446 The debtor has tremendous powers regarding the rejection of executory contracts and leases. 447 The company can avoid certain preferential and fraudulent transfers. 448 A plan can be confirmed that 444 See 11 U.S.C See Section IV, infra, for a discussion about the creation, duties, and powers of committees. 445 See 11 U.S.C See 11 U.S.C. 1104, Section 1104 authorizes the appointment of a trustee in a Chapter 11 case on the request of a party in interest or to the United States Trustee upon a showing of cause or if the appointment is in the interest of creditors, any equity security holders, and other interests of the estate. 447 See 11 U.S.C See 11 U.S.C v.2 84

94 restructures the indebtedness of the company and provides for the payment of obligations in amounts substantially less than the actual amounts owed and over several years. Increasingly debtors are attempting to reduce the overwhelming expense and the morass of an extended stay in Chapter 11 by trying to negotiate at least the major terms of a consensual plan before filing the bankruptcy case. Sometimes these are called prepackaged plans but technically a prepak involves actual pre-filing solicitation of votes from creditors for the acceptance of a plan that will be filed immediately after the case is filed. The prefiling solicitation is allowed under Section 1126(b) but is complicated and often attacked if there are disgruntled creditors. The pre-filing discussion and attempt to obtain a consensus among the major creditors, although not actually a prepackaged plan, is much better than merely filing a petition without consultation with at least the major creditors and trying to negotiate a plan in the sometimes inflamed context of the bankruptcy case. Chapter 11 has a place in our bankruptcy system but it is no panacea. Some uninformed (or misinformed) prospective bankruptcy debtors are almost anxious to rush to the light of bankruptcy thinking that Chapter 11 will solve all of the company s problems. It will not. When a company picks the Chapter 11 path, it must be prepared to spend a considerable amount of its precious cash reserves on professionals (and similar outlays of cash that do not make or sell more products) and endure the demands and distractions of court hearings and creditors scrutinizing the business decisions. This path is worth the trouble, however, if you have a company that can be profitable with some debt relief and that needs to dispose of liabilities quickly through the rejection of contracts. C. Chapter 12. Chapter 12 is designed for family farmers or family fishermen with regular annual income. It enables financially distressed family farmers and fishermen to propose and carry out a plan to repay all or part of their debts. Under chapter 12, debtors propose a repayment plan to make installment payments to creditors over three to five years. Generally, the plan must provide for payments over three years unless the court approves a longer period for cause. But unless the plan proposes to pay 100% of the domestic support claims (i.e., child support and alimony) if any exist, it must be for five years and must include all of the debtor s disposable income. In no case may a plan provide for payments over a period longer than five years. 11 U.S.C. 1222(b)-(c). In tailoring bankruptcy law to meet the economic realities of family farming and the family fisherman, Chapter 12 eliminates many of the barriers such debtors would face if seeking to reorganize under either Chapters 11 or 13 of the Bankruptcy Code. For example, Chapter 12 is more streamlined, less complicated, and less expensive than Chapter 11, which is better suited to large corporate reorganizations. In addition, few family farmers or fishermen find Chapter 13 to be advantageous because it is designed for wage earners who have smaller debts than those facing family farmers. In Chapter 12, Congress sought to combine the features of the Bankruptcy Code which can provide a framework for successful family farmer and fisherman reorganizations. The Bankruptcy Code provides that only a family farmer or family fisherman with regular annual income may file a petition for relief under Chapter U.S.C. 101(18) (family farmer definition), 101(19A) (family fisherman), 109(f) (authority to file). The purpose v.2 85

95 of this requirement is to ensure that the debtor s annual income is sufficiently stable and regular to permit the debtor to make payments under a Chapter 12 plan. But Chapter 12 makes allowance for situations in which family farmers or fishermen have income that is seasonal. Relief under Chapter 12 is voluntary, and only the debtor may file a petition under the chapter. Under the Bankruptcy Code, family farmers and family fishermen fall into two categories: (1) an individual or individual and spouse and (2) a corporation or partnership. Farmers or fishermen falling into the first category must meet each of the following four criteria as of the date the petition is filed in order to qualify for relief under Chapter 12: 1. The individual or husband and wife must be engaged in a farming operation or a commercial fishing operation. 2. The total debts (secured and unsecured) of the operation must not exceed specified amounts that are subject to adjustment pursuant to Section If a family farmer, at least 50%, and if family fisherman at least 80%, of the total debts that are fixed in amount (exclusive of debt for the debtor s home) must be related to the farming or commercial fishing operation. 4. More than 50% of the gross income of the individual or the husband and wife for the preceding tax year (or, for family farmers only, for each of the 2nd and 3rd prior tax years) must have come from the farming or commercial fishing operation. A debtor cannot file under Chapter 12 (or any other chapter) if during the preceding 180 days a prior bankruptcy petition were dismissed due to the debtor s willful failure to appear before the court or comply with orders of the court or was voluntarily dismissed after creditors sought relief from the bankruptcy court to recover property upon which they hold liens. 11 U.S.C. 109(g), 362(d) and (e). D. Chapter 13. A Chapter 13 bankruptcy was formerly referred to as a wage earner s plan. It enables individuals with regular income to develop a plan to repay all or part of their debts. Under this chapter, debtors propose a repayment plan to make installments to creditors over three to five years. If the debtor s current monthly income is less than the applicable state median, the plan will be for three years unless the court approves a longer period for cause. 449 In no case may a plan provide for payments over a period longer than five years. 11 U.S.C. 1322(d)(2)(C). During this time the law forbids creditors from starting or continuing collection efforts. 1. Advantages of Chapter 13. Chapter 13 offers individuals a number of advantages over liquidation under Chapter 7. Perhaps most significantly, Chapter 13 offers 449 The "current monthly income" received by the debtor is a defined term in the Bankruptcy Code and means the average monthly income received over the six calendar months before commencement of the bankruptcy case, including regular contributions to household expenses from nondebtors and including income from the debtor's spouse if the petition is a joint petition, but not including social security income or certain payments made because the debtor is the victim of certain crimes. 11 U.S.C. 101(10A) v.2 86

96 individuals an opportunity to save their homes from foreclosure. By filing under this chapter, individuals can stop foreclosure proceedings and may cure delinquent mortgage payments over time. Nevertheless, they must still make all mortgage payments that come due during the Chapter 13 plan on time. Another advantage of Chapter 13 is that it allows individuals to reschedule secured debts (other than a mortgage for their primary residence) and extend them over the life of the Chapter 13 plan. Doing this may lower the payments. Chapter 13 also has a special provision that protects third parties who are liable with the debtor on consumer debts. This provision may protect co-signers. Finally, Chapter 13 acts like a consolidation loan under which the individual makes the plan payments to a Chapter 13 trustee who then distributes payments to creditors. Individuals will have no direct contact with creditors while under Chapter 13 protection. 2. Chapter 13 Eligibility. Any individual with regular income, even if selfemployed or operating an unincorporated business, is eligible for Chapter 13 relief if the individual s unsecured debts are less than $336,900 and secured debts are less than $1,010, U.S.C. 109(e). These amounts are adjusted periodically to reflect changes in the consumer price index. A corporation or partnership may not be a Chapter 13 debtor. Id. An individual cannot file under Chapter 13 or any other chapter if, during the preceding 180 days, a prior bankruptcy petition was dismissed due to the debtor s willful failure to appear before the court or comply with orders of the court or if the case was voluntarily dismissed after creditors sought relief from the bankruptcy court to recover property upon which they hold liens. 11 U.S.C. 109(g), 362(d) and (e). In addition, no individual may be a debtor under Chapter 13 or any chapter of the Bankruptcy Code unless he or she has, within 180 days before filing, received credit counseling from an approved credit counseling agency either in an individual or group briefing. 11 U.S.C. 109, 111. There are exceptions in emergency situations or where the U.S. trustee (or bankruptcy administrator) has determined that there are insufficient approved agencies to provide the required counseling. If a debt management plan is developed during required credit counseling, it must be filed with the court. 3. How Chapter 13 Works. A Chapter 13 case begins by filing a petition with the bankruptcy court serving the area where the debtor has a domicile or residence. Unless the court orders otherwise, the debtor must also file with the court: (1) schedules of assets and liabilities; (2) a schedule of current income and expenditures; (3) a schedule of executory contracts and unexpired leases; and (4) a statement of financial affairs. Fed. R. Bankr. P. 1007(b). The debtor must also file a certificate of credit counseling and a copy of any debt repayment plan developed through credit counseling; evidence of payment from employers, if any, received 60 days before filing; a statement of monthly net income and any anticipated increase in income or expenses after filing; and a record of any interest the debtor has in federal or state qualified education or tuition accounts. 11 U.S.C The debtor must provide the Chapter 13 case trustee with a copy of the tax return or transcripts for the most recent tax year as well as tax returns filed during the case (including tax returns for prior years that had not been filed when the case began). Id. A husband and wife may file a joint petition or individual petitions. 11 U.S.C. 302(a). In order to complete the Official Bankruptcy Forms that make up the petition, statement of financial affairs, and schedules, the debtor must compile the following information: v.2 87

97 1. A list of all creditors and the amounts and nature of their claims; 2. The source, amount, and frequency of the debtor s income; 3. A list of all of the debtor s property; and 4. A detailed list of the debtor s monthly living expenses, i.e., food, clothing, shelter, utilities, taxes, transportation, medicine, etc. Married individuals must gather this information for their spouse regardless of whether they are filing a joint petition, separate individual petitions, or even if only one spouse is filing. In a situation where only one spouse files, the income and expenses of the non-filing spouse is required so that the court, the trustee and creditors can evaluate the household s financial position. When an individual files a Chapter 13 petition, an impartial trustee is appointed to administer the case. 11 U.S.C In some districts, the U.S. trustee or bankruptcy administrator appoints a standing trustee to serve in all Chapter 13 cases. 28 U.S.C. 586(b). The Chapter 13 trustee both evaluates the case and serves as a disbursing agent, collecting payments from the debtor and making distributions to creditors. 11 U.S.C. 1302(b). Filing the petition under Chapter 13 automatically stays (stops) most collection actions against the debtor or the debtor s property. 11 U.S.C Filing the petition does not, however, stay certain types of actions listed under 11 U.S.C. 362(b), and the stay may be effective only for a short time in some situations. The stay arises by operation of law and requires no judicial action. As long as the stay is in effect, creditors generally may not initiate or continue lawsuits, wage garnishments, or even make telephone calls demanding payments. The bankruptcy clerk gives notice of the bankruptcy case to all creditors whose names and addresses are provided by the debtor. Chapter 13 contains a special automatic stay provision that also protects co-debtors. Unless the bankruptcy court authorizes otherwise, a creditor may not seek to collect a consumer debt from any individual who is liable along with the debtor. 11 U.S.C. 1301(a). Consumer debts are those incurred by an individual primarily for a personal, family, or household purpose. 11 U.S.C. 101(8). Individuals may use a Chapter 13 proceeding to save their home from foreclosure. The automatic stay stops the foreclosure proceeding as soon as the individual files the Chapter 13 petition. The individual may then bring the past-due payments current over a reasonable period of time. Nevertheless, the debtor may still lose the home if the mortgage company completes the foreclosure sale under state law before the debtor files the petition. 11 U.S.C. 1322(c). The debtor may also lose the home if he or she fails to make the regular mortgage payments that come due after the Chapter 13 filing. Between 20 and 50 days after the debtor files the Chapter 13 petition, the Chapter 13 trustee will hold a meeting of creditors. If the U.S. trustee or bankruptcy administrator schedules the meeting at a place that does not have regular U.S. trustee or bankruptcy administrator staffing, the meeting may be held no more than 60 days after the debtor files. Fed. R. Bankr. P v.2 88

98 2003(a). During this meeting, the trustee places the debtor under oath, and both the trustee and creditors may ask questions. The debtor must attend the meeting and answer questions regarding his or her financial affairs and the proposed terms of the plan. 11 U.S.C If a husband and wife file a joint petition, they both must attend the creditors meeting and answer questions. In order to preserve their independent judgment, bankruptcy judges are prohibited from attending the creditors meeting. 11 U.S.C. 341(c). The parties typically resolve problems with the plan either during or shortly after the creditors meeting. Generally, the debtor can avoid problems by making sure that the petition and plan are complete and accurate, and by consulting with the trustee prior to the meeting. In a Chapter 13 case, to participate in distributions from the bankruptcy estate, unsecured creditors must file their claims with the court within 90 days after the first date set for the meeting of creditors. Fed. R. Bankr. P. 3002(c). A governmental unit, however, has 180 days from the date the case is filed file a proof of claim. 11 U.S.C. 502(b)(9). After the meeting of creditors, the debtor, the Chapter 13 trustee, and those creditors who wish to attend will come to court for a hearing on the debtor s chapter 13 repayment plan. 4. The Chapter 13 Plan and Confirmation Hearing. Unless the court grants an extension, the debtor must file a repayment plan with the petition or within 15 days after the petition is filed. Fed. R. Bankr. P. 3015(b). A plan must be submitted for court approval and must provide for payments of fixed amounts to the trustee on a regular basis, typically biweekly or monthly. The trustee then distributes the funds to creditors according to the terms of the plan, which may offer creditors less than full payment on their claims. There are three types of claims: priority, secured, and unsecured. Priority claims are those granted special status by the bankruptcy law, such as most taxes and the costs of bankruptcy proceeding. Secured claims are those for which the creditor has the right to foreclose on certain property (i.e., the collateral) if the debtor does not pay the underlying debt. In contrast to secured claims, unsecured claims are generally those for which the creditor has no special rights to collect against particular property owned by the debtor. The plan must pay priority claims in full unless a particular priority creditor agrees to different treatment of the claim or, in the case of a domestic support obligation, unless the debtor contributes all disposable income - discussed below - to a five-year plan. 11 U.S.C. 1322(a). If the debtor wants to keep the collateral securing a particular claim, the plan must provide that the holder of the secured claim receive at least the value of the collateral. If the obligation underlying the secured claim was used to buy the collateral (e.g., a car loan) and, there is a purchase money security interest, and the debt was incurred within certain time frames before the bankruptcy filing, the plan must provide for full payment of the debt, not just the value of the collateral (which may be less due to depreciation). Payments to certain secured creditors (i.e., the home mortgage lender), may be made over the original loan repayment schedule (which may be longer than the plan) so long as any arrearage is made up during the plan. The debtor should consult an attorney to determine the proper treatment of secured claims in the plan v.2 89

99 The plan need not pay unsecured claims in full as long it provides that the debtor will pay all projected disposable income over an applicable commitment period, and as long as unsecured creditors receive at least as much under the plan as they would receive if the debtor s assets were liquidated under Chapter U.S.C In Chapter 13, disposable income is income (other than child support payments received by the debtor) less amounts reasonably necessary for the maintenance or support of the debtor or dependents and less charitable contributions up to 15% of the debtor s gross income. If the debtor operates a business, the definition of disposable income excludes those amounts which are necessary for ordinary operating expenses. 11 U.S.C. 1325(b)(2)(A) and (B). The applicable commitment period depends on the debtor s current monthly income. The applicable commitment period must be three years if current monthly income is less than the state median for a family of the same size - and five years if the current monthly income is greater than a family of the same size. 11 U.S.C. 1325(d). The plan may be less than the applicable commitment period (three or five years) only if unsecured debt is paid in full over a shorter period. Within 30 days after filing the bankruptcy case, even if the plan has not been approved by the court, the debtor must start making plan payments to the trustee. 11 U.S.C. 1326(a)(1). If any secured loan payments or lease payments come due before the debtor s plan is confirmed (typically home and automobile payments), the debtor must make adequate protection payments directly to the secured lender or lessor - deducting the amount paid from the amount that would otherwise be paid to the trustee. Id. No later than 45 days after the meeting of creditors, the bankruptcy judge must hold a confirmation hearing and decide whether the plan is feasible and meets the standards for confirmation set forth in the Bankruptcy Code. 11 U.S.C. 1324, Creditors will receive 25 days notice of the hearing and may object to confirmation. Fed. R. Bankr. P. 2002(b). While a variety of objections may be made, the most frequent ones are that payments offered under the plan are less than creditors would receive if the debtor s assets were liquidated or that the debtor s plan does not commit all of the debtor s projected disposable income for the three or five year applicable commitment period. If the court confirms the plan, the Chapter 13 trustee will distribute funds received under the plan as soon as is practicable. 11 U.S.C. 1326(a)(2). If the court declines to confirm the plan, the debtor may file a modified plan. 11 U.S.C The debtor may also convert the case to a liquidation case under Chapter U.S.C. 1307(a). If the court declines to confirm the plan or the modified plan and instead dismisses the case, the court may authorize the trustee to keep some funds for costs, but the trustee must return all remaining funds to the debtor (other than funds already disbursed or due to creditors). 11 U.S.C. 1326(a)(2). Occasionally, a change in circumstances may compromise the debtor s ability to make plan payments. For example, a creditor may object or threaten to object to a plan, or the debtor may inadvertently have failed to list all creditors. In such instances, the plan may be modified either before or after confirmation. 11 U.S.C. 1323, Modification after confirmation is not limited to an initiative by the debtor, but may be at the request of the trustee or an unsecured creditor. 11 U.S.C. 1329(a) v.2 90

100 5. Making the Plan Work. The provisions of a confirmed plan bind the debtor and each creditor. 11 U.S.C Once the court confirms the plan, the debtor must make the plan succeed. The debtor must make regular payments to the trustee either directly or through payroll deduction, which will require adjustment to living on a fixed budget for a prolonged period. Furthermore, while confirmation of the plan entitles the debtor to retain property as long as payments are made, the debtor may not incur new debt without consulting the trustee, because additional debt may compromise the debtor s ability to complete the plan. 11 U.S.C. 1305(c), 1322(a)(1), A debtor may make plan payments through payroll deductions. This practice increases the likelihood that payments will be made on time and that the debtor will complete the plan. In any event, if the debtor fails to make the payments due under the confirmed plan, the court may dismiss the case or convert it to a liquidation case under chapter 7 of the Bankruptcy Code. 11 U.S.C. 1307(c). The court may also dismiss or convert the debtor s case if the debtor fails to pay any post-filing domestic support obligations (i.e., child support, alimony), or fails to make required tax filings during the case. 11 U.S.C. 1307(c) and (e), 1308, The Chapter 13 Discharge. A Chapter 13 debtor is entitled to a discharge upon completion of all payments under the Chapter 13 plan so long as the debtor: (1) certifies (if applicable) that all domestic support obligations that came due prior to making such certification have been paid; (2) has not received a discharge in a prior case filed within a certain time frame (two years for prior Chapter 13 cases and four years for prior Chapters 7, 11 and 12 cases); and (3) has completed an approved course in financial management (if the U.S. trustee or bankruptcy administrator for the debtor s district has determined that such courses are available to the debtor). 11 U.S.C The court will not enter the discharge, however, until it determines, after notice and a hearing, that there is no reason to believe there is any pending proceeding that might give rise to a limitation on the debtor s homestead exemption. 11 U.S.C. 1328(h). The discharge releases the debtor from all debts provided for by the plan or disallowed (under section 502), with limited exceptions. Creditors provided for in full or in part under the chapter 13 plan may no longer initiate or continue any legal or other action against the debtor to collect the discharged obligations. As a general rule, the discharge releases the debtor from the obligation to pay all debts for which payment is provided by the plan or disallowed, with the exception of certain debts referenced in 11 U.S.C Debts not discharged in Chapter 13 include certain long term obligations (such as a home mortgage), debts for alimony or child support, certain taxes, debts for most government funded or guaranteed educational loans or benefit overpayments, debts arising from death or personal injury caused by driving while intoxicated or under the influence of drugs, and debts for restitution or a criminal fine included in a sentence on the debtor s conviction of a crime. To the extent that they are not fully paid under the Chapter 13 plan, the debtor will still be responsible for these debts after the bankruptcy case has concluded. Debts for money or property obtained by false pretenses, debts for fraud or defalcation while acting in a fiduciary capacity, and debts for restitution or damages awarded in a civil case for willful or malicious actions by the debtor that cause personal injury or death to a person will be discharged v.2 91

101 unless a creditor timely files and prevails in an action to have such debts declared nondischargeable. 11 U.S.C. 1328, 523(c); Fed. R. Bankr. P. 4007(c). The discharge in a Chapter 13 case is somewhat broader than in a Chapter 7 case. Debts dischargeable in a Chapter 13, but not in Chapter 7, include debts for willful and malicious injury to property (as opposed to a person), debts incurred to pay nondischargeable tax obligations, and debts arising from property settlements in divorce or separation proceedings. 11 U.S.C. 1328(a). VII. Filing of Bankruptcy Petition in Individual Chapter 7 and 11 Bankruptcy Cases. A. Filing of Bankruptcy Petition Creates a Separate Taxable Estate in Individual Chapter 7 and 11 Bankruptcy Cases. Section 1399 provides that [e]xcept in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11 of the United States Code. Section 1398(a) of the Code states, in general, that section 1398 applies to any case under chapter 7 (relating to liquidations) or chapter 11 (relating to reorganizations) of title 11 of the United States Code in which the debtor is an individual. Thus, pursuant to Section 1399 and 1398(a), (1) except for cases under Chapter 13 of the Bankruptcy Code (adjustment of debts of an individual with regular income), a bankrupt individual s estate in Chapter 7 and 11 bankruptcies is treated as a separate entity for federal income tax purposes; 450 and (2) separate taxable entities are not created for a bankrupt corporation or partnership. 1. Treatment of Transfers Between Debtor and Estate. Section 1398(f)(1) of the Internal Revenue Code, which is applicable to any case under Chapter 7 or Chapter 11 of Title 11 of the United States Code in which the debtor is an individual, provides that a transfer (other than by sale or exchange) of an asset from the debtor to the estate shall not be treated as a disposition for purposes of any provision of the Code assigning tax consequences to a disposition, and that the estate shall be treated as the debtor would be treated with respect to such asset. Similarly, in the case of a termination of such an estate, a transfer (other than by sale or exchange) of an asset from the estate to the debtor shall not be treated as a disposition for purposes of any provision of this title assigning tax consequences to a disposition, and the debtor shall be treated as the estate would be treated with respect to such asset Tax Attributes. a. Estate Succeeds to Tax Attributes of the Debtor. Upon the filing of an individual Chapter 7 or 11 bankruptcy case, the estate succeeds to and take into account the 450 See In re Hall, 376 B.R. 741 (Bankr. AZ 2007) ( The Internal Revenue Code creates a separate taxable entity upon the filing of petitions by individuals under Chapters 7 and 11, but does not create a separate taxable entity in cases filed by individuals under Chapters 12 and 13. ), rev d on other grounds, 393 B.R. 857 (D. AR 2008); Katz v. Commissioner, 116 T.C. 5 (2001) ( When an individual files a chapter 7 petition in bankruptcy, a bankruptcy estate is created as a separate entity for purposes of both bankruptcy law and tax law. ), rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003). 451 I.R.C. 1398(f)(2) v.2 92

102 following items (determined as of the first day of the debtor s taxable year in which the case commences) of the debtor: 452 (1) Net operating loss carryovers; 453 (2) Charitable contribution carryovers; 454 (3) Exclusion of recovery of tax benefit items under I.R.C. 111; 455 (4) The carryovers of any credit, and all other items which, but for the commencement of the case, would be required to be taken into account by the debtor with respect to any credit; 456 (5) Capital loss carryovers; 457 (6) In the case of any asset acquired (other than by sale or exchange) by the estate from the debtor, the basis, holding period, and character it had in the hands of the debtor; 458 (7) The method of accounting used by the debtor; 459 and 452 I.R.C. 1398(g); see Benton v. Commissioner, 122 T.C. 353, 372 (2004) (Under section 1398(g), the estate succeeds to certain of the debtor s income tax attributes, including the debtor s NOL carryovers (under section 172) and capital loss carryovers (under section 1212) from tax periods prior to the commencement of the bankruptcy. Sec. 1398(g)(1), (5). In a like manner, to the extent the estate has not used those same tax attributes, the debtor succeeds to them at the termination of the estate. Sec. 1398(i). Accordingly, upon the commencement of a bankruptcy, the estate becomes a taxpayer with respect to the debtor s property in the bankruptcy proceeding. Upon termination of the estate, the estate s status as a separate parallel taxpayer ends and its unused tax attributes transfer to the debtor. Id. ); Lassiter v. Commissioner, 83 T.C.M. (CCH) 1139 ( Further, the bankruptcy estate succeeds to and takes into account the individual debtor s tax attributes (e.g., any NOL carryforward). Sec. 1398(g). In the case of NOLs, the bankruptcy estate succeeds to the NOLs as determined under section 172, as of the first day of the individual debtor s taxable year in which the case commences. Sec. 1398(g)(1). The NOLs as determined by a calendar year individual debtor, as of January 1 of the year the debtor files a bankruptcy petition, go to the bankruptcy estate for its exclusive use for the benefit of the creditors on the commencement date. Id. The individual debtor then succeeds to and takes into account the NOLs of the bankruptcy estate at the termination of the bankruptcy case. Sec. 1398(i). This includes both the remaining NOLs that the bankruptcy estate succeeded to under section 1398(g) and the unused tax attributes accumulated by the operation of the bankruptcy estate. Id. The years in which the debtor may use the estate s NOLs and the unused NOLs that the estate succeeded to are governed by section 1398(j)(2). [Footnote omitted.]). 453 I.R.C. 1398(g)(1). 454 I.R.C. 1398(g)(2). 455 I.R.C. 1398(g)(3). 456 I.R.C. 1398(g)(4). 457 I.R.C. 1398(g)(5). 458 I.R.C. 1398(g)(6) v.2 93

103 (8) Other tax attributes of the debtor, to the extent provided in regulations prescribed by the Treasury as necessary or appropriate to carry out the purposes of Section b. Debtor Succeeds to Tax Attributes of the Estate Upon Termination of the Estate. Upon the termination of the bankruptcy estate, the debtor succeeds to and takes into account the following tax attributes of the estate: 461 (1) Net operating loss carryovers; 462 (2) Charitable contribution carryovers; (3) Recovery exclusion under section 111; (4) Credit carryovers; (5) Capital loss carryovers; and (6) Basis, holding period, and character of any asset acquired from the estate is, in the hands of the debtor, the same as in the hands of the estate. In addition, the debtor succeeds to and takes into account the other tax attributes of the estate, to the extent provided in regulations prescribed by the Treasury as necessary or appropriate to carry out the purposes of Section B. Trustee or Debtor in Possession Must Obtain an Employer Identification Number. The bankruptcy estate in individual Chapter 7 and 11 bankruptcy cases is a separate taxable entity; therefore, the trustee or debtor in possession must obtain an employer 459 I.R.C. 1398(g)(7). 460 I.R.C. 1398(g)(8). 461 I.R.C. 1398(i). 462 But see I.R.C. 1398(j)(2)(B) ( The debtor may not carry back to a taxable year before the debtor s taxable year in which the case commences any carryback from a taxable year ending after the case commences. ); Benton v. Commissioner, 122 T.C. 353, (2004) ( Although a debtor may succeed to the estate s NOLs at the termination of the estate, section 1398(j)(2)(B) places certain limitations on a debtor s ability to use NOLs. Section 1398(j)(2)(B) provides the following rules with respect to net operating losses: The debtor may not carry back to a taxable year before the debtor s taxable year in which the [bankruptcy] case commences any carryback from a taxable year ending after the case commences. This section expressly prohibits a debtor from carrying back the estate s or the debtor s postcommencement losses to prepetition taxable years. We note that section 1398(j)(2)(B) applies with respect to any carryback from a taxable year ending after the case commences. The use of the allinclusive adjective any in section 1398(j)(2)(B) would be inclusive of the estate s NOLs that are succeeded to by the debtor. Accordingly, section 1398(j)(2)(B) prohibits only carrybacks to precommencement years and does not place any limitation on postcommencement years. [Footnotes omitted.]). 463 I.R.C. 1398(i) v.2 94

104 identification number (EIN) for the estate. The trustee or debtor in possession uses the EIN on any tax returns filed for the estate. 464 C. Effect of Dismissal of Individual Chapter 7 and Chapter 11 Bankruptcy Cases. If a bankruptcy case involving an individual Chapter 7 or Chapter 11 is dismissed by the court, the estate is not treated as a separate entity. 465 The debtor s tax status is treated as if a bankruptcy proceeding had not occurred. 466 D. Computation of Taxable Income of Estate. The taxable income of an individual Chapter 7 or Chapter 11 bankruptcy estate computes its tax liability in the same manner as a married individual filing a separate return. 467 In the case of an estate which does not itemize deductions, the basic standard deduction for the estate for the taxable year shall be the same as for a married individual filing a separate return for such year. 468 E. Taxable Year of Debtors. A debtor in an individual Chapter 7 or 11 bankruptcy case may elect to divide the taxable year in which he files bankruptcy into two short years, the first of which ends on the day prior to the commencement date and the second of which begins on the commencement date. 469 A return is required to be made for each of the tax years. 470 A debtor is precluded from making the election if the debtor has no assets except exempt assets under Section 522 of the Bankruptcy Code Effect of Election. If the debtor makes the sec. 1398(d)(2) election, his tax liability for the first short taxable year becomes an allowable claim against the bankruptcy estate as a claim arising prior to the bankruptcy filing. 472 A debtor must make this election on or 464 Notice I.R.C. Sec. 1398(b)(1). 466 Notice ( If a Chapter 11 case is dismissed, the debtor is treated as if the bankruptcy case had never been filed and as if no bankruptcy estate had been created. I.R.C. 1398(b)(1). ). 467 See I.R.C. 1398(c)(1), 1398(c)(2); Katz v. Commissioner, 116 T.C. at 10-11, rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003). 468 I.R.C. 1398(c)(3). 469 I.R.C. 1398(d)(2)(A); Katz v. Commissioner, 116 T.C. at 16, rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003); see also Treas. Reg T (providing rules for making the election under section 1398(d)(2) to terminate the taxable year of an individual taxpayer.). 470 I.R.C. 1398(d)(2)(E). 471 I.R.C. 1398(d)(2)(C). 472 Katz v. Commissioner, 116 T.C. at 16 n. 11, rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003); In re Haedo, 211 B.R. 149, 152 (Bankr. S.D. NY 1997) ( If the debtor makes the election, the tax liability attributable to the prepetition year constitutes a priority claim against the estate; but if he does not, the entire liability for the year of the bankruptcy filing is a claim against the debtor but is not collectible from the estate. Here, Jorge never elected to bifurcate his tax year. Accordingly, had Jorge (and Christina) owed taxes for the 1994 tax year, his tax liability would not have been collectable from the estate, but only from Jorge (and Christina) personally. [Citations omitted.]); In re Johnson, 190 B.R. 724, 726 (Bankr. MA 1995) ( Section 1398(d)(2)(A) allows an individual debtor in a Chapter 7 or 11 case to elect to divide the taxable year in which the bankruptcy case is commenced into two short years, the first ending on the day before the date of commencement of the bankruptcy case, and the second v.2 95

105 before the due date of the return for the year ending on the day prior to the commencement date Effect if No Election Made. If a debtor declines to make the section 1398(d)(2) election, the debtor s taxable year is determined without regard to bankruptcy proceeding. 474 In the absence of a sec. 1398(d)(2) election, the debtor s tax liability for the entire year in which the bankruptcy proceeding commences is collectible directly from the debtor individually, with no portion being collectible from the bankruptcy estate Treatment of Income, Deductions and Credits. a. Estate s Share of Debtor s Income. Gross income of a bankruptcy estate is defined as the gross income of the debtor to which the estate is entitled pursuant to the U.S. Bankruptcy Code. 476 Gross income of the estate, however, does not include amounts received or accrued by the debtor prior to the commencement of the bankruptcy beginning on the date the bankruptcy case is filed. According to 26 U.S.C. section 1398(d)(2)(D), the debtor must make an election on or before the due date for filing the return. When a debtor elects to partition the tax year under section 1398, the federal income tax liability for the first short taxable year becomes an allowable claim against the bankruptcy estate as a claim arising before the commencement of the case. See 11 U.S.C. sections 101(5), 502(a), 502(i), 507(a)(8). Accordingly, any tax liability for that year is entitled to priority under section 507(a)(8) and is collectible from the estate to the extent assets are available to pay debts of that priority. [Citations and footnotes omitted]); In re Mirman, 98 B.R. 742 (Bankr. E.D. VA 1989) ( If the debtor elects to divide the taxable year pursuant to Section 1398(d)(2), his or her income tax liability for the first short taxable year becomes, under the substantive law of bankruptcy, an allowable claim against the bankruptcy estate as a claim arising before bankruptcy. However, if the debtor fails to make the election for any reason, the debtor s tax liability for the entire year is collectable directly from the individual debtor and no portion is collectible from the debtor s bankruptcy estate. ). 473 I.R.C. 1398(d)(2)(D), 6072(a); see In re Allen, 359 B.R. 1 (Bankr. MA 2006) ( A debtor must make this Election on or before the 15 th day of the fourth full month following the petition date. ). 474 See sec. 1398(d)(1); Katz v. Commissioner, 116 T.C. at 16, rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003). 475 Katz v. Commissioner, 116 T.C. at 16 n. 12 rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003); see In re Johnson, 190 B.R. 724, 726 (Bankr. MA 1995) ( A debtor s failure to make an election under section 1398(d) makes the entire tax liability a post-petition liability. Thus, in this case, section 1398(d)(2)(A) makes the Debtors entire 1992 tax liability a post-petition liability. However, that post-petition liability is not a claim against the estate entitled to administrative priority under section 503(b)(1)(B)(i). The Debtors failure to make the election under section 1398 leaves the IRS with a post-petition tax claim against the Debtors individually, with no claim whatsoever against their bankruptcy estate for any part of the 1992 tax liability. ); In re Pflug, Jr., 146 BR 687 (Bankr. E.D. VA 1992) ( Under 1398 the debtor may irrevocably elect to close his or her taxable year at the date of bankruptcy If this election is made the debtor s taxable year is essentially divided into two short taxable years. The election pursuant to section 1398 may be made only on or before the 15th day of the fourth month following commencement of the bankruptcy case. If the debtor does not make the election, no part of the debtor s tax liability from the year in which the bankruptcy case commences is collectible from the estate, but is collectible directly from the individual debtor. [Citations omitted.]). 476 See I.R.C. 1398(e)(1) v.2 96

106 proceeding. 477 IRS Notice provides guidance on amounts includible in gross income of the estate in Chapter 11 cases.. b. Debtor s Share of Debtor s Income. Gross income of the debtor is that which remains after excluding those items which are included in gross income of the estate. 478 c. Rule for Making Determinations With Respect to Deductions, Credits and Employment Taxes. In general, the determination of whether or not any amount paid or incurred by the estate is allowable as a deduction or credit to the estate or is wages is made as if the amount were paid or incurred by the debtor and as if the debtor were still engaged in the trades and businesses, and in the activities, the debtor was engaged in before the commencement of the case. 479 The estate is, however, generally allowed a deduction for administrative expenses allowed under section 503 of the Bankruptcy Code and for any fee or charge assessed against the estate under chapter 123 of title 28 of the United States Code. 480 F. Return Filing Requirements. The debtor in possession or trustee of every individual Chapter 7 and Chapter 11 estate has a duty to file an income tax return if the amount of gross income earned during the estate s taxable year is above the exemption amount and the basic standard deduction. 481 In preparing the returns for an individual Chapter 11 estate, the debtor in possession or trustee must follow the rules prescribed in Notice VIII. Selected Federal Income Tax Procedural Issues in Bankruptcy. A. Automatic Stay Does Not Prohibit Service from Sending Notice of Deficiency During Bankruptcy. The Service is not prohibited by the automatic stay from sending a notice of deficiency to a taxpayer after the filing of a bankruptcy petition See I.R.C. 1398(e)(1). 478 See I.R.C. 1398(e)(2); Katz v. Commissioner, 116 T.C. at 14-15, rev d on other grounds, 335 F.3d 1121 (10 th Cir. 2003). 479 I.R.C. 1398(e)(3). 480 I.R.C. 1398(h)(1). 481 I.R.C. 6012(a)(9); Notice U.S.C. 362(b)(9)(B); see Bigelow v. Commissioner, 65 F.3d 127, 129 n.2 (9 th Cir. 1995) ( The automatic stay would not have prevented the IRS from issuing a notice of tax deficiency to the Bigelows. Section 362(b)(9) expressly permits a notice of tax deficiency to be issued to a debtor notwithstanding an automatic stay. Section 362(b)(9) was amended by the Bankruptcy Act of 1994, which applies to cases commenced after October 22, ); Kieu v. Commissioner, 105 T.C. 387, 391 (1995) ( [Commissioner] is free to issue a notice of deficiency to a taxpayer involved in bankruptcy proceedings. ); Zimmerman v. Commissioner, 105 T.C. 220, (1995) ( Read together, these provisions indicate that, while the Commissioner may issue a notice of deficiency during the pendency of a bankruptcy case, the Tax Court s jurisdiction is limited by the automatic stay imposed under 11 U.S.C. section 362(a)(8). ); Wood v. Commissioner, 88 T.C.M. (CCH) 198 (2004) ( A chapter 11 filing, however, does not operate as a stay of either an audit by a governmental unit to determine tax liability or the issuance to the debtor by a governmental unit of a notice of deficiency. ); In re Larsen, 232 B.R. 482, 483 (Bankr. D. Wyo. 1998), ( Regarding the automatic stay imposed by 362(a), the statute creates an exception 362(b)(9) for a taxpayer v.2 97

107 B. Tax Court Jurisdiction. 1. Suspension of 90-Day Period for Filing Tax Court Petition During Period in Which Automatic Stay Prohibits Filing of Tax Court Petition. a. Bankruptcy Code Stays Commencement or Continuation of Tax Court Proceeding Upon Filing of Bankruptcy Petition. While the Service may issue a notice of deficiency during the pendency of a bankruptcy case, the Tax Court s jurisdiction is limited by the automatic stay imposed under 11 U.S.C. 362(a). 11 U.S.C. 362(a)(8) (as amended as shown below in italics by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (sometimes referred to herein as the 2005 Bankruptcy Act or the Act )) 483 generally provides that the filing of a bankruptcy petition operates as a stay of: the commencement or continuation of a proceeding before the United States Tax Court concerning a corporate debtor s tax liability for a taxable period the bankruptcy court may determine or concerning the tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title. Unless relief from the automatic stay is granted by order of the bankruptcy court, 484 the automatic stay generally remains in effect until the earliest of the closing of the case, dismissal of the case, or the grant or denial of a discharge. 485 Thus, the filing of a Tax Court petition, as well as the continuation of a Tax Court proceeding, are precluded while the automatic stay is in audit, a tax assessment or issuance of a notice of tax deficiency, among other things. ); cf. Field Serv. Adv , 2001 FSA LEXIS 115, *3 (Sept. 14, 2001) ( While the case was pending, the Service sent her a statutory notice of deficiency for the Year 1 tax liability on July 3, 1996, an act permitted by the express language of 11 U.S.C. section 362(b)(9). ); 1998 FSA LEXIS 488 (March 6, 1998) ( Bankruptcy Code 362(b)(9)(B) provides that the issuance of a notice of deficiency is not prohibited by the automatic stay. ). 483 The President signed into law the 2005 Bankruptcy Act on April 20, The tax amendments described in the outline are generally effective 180 days after the date of enactment (i.e., October 17, 2005). Act 1501(a). The amendments do not apply, however, with respect to bankruptcy cases commenced before the effective date. 484 See 11 U.S.C. 362(d) U.S.C. 362(c)(2); see Allison v. Commissioner, 97 T.C. 544, 545 (1991) ( Once a petition in bankruptcy is filed, the automatic stay of 11 U.S.C. section 362(a) prevents the commencement or continuation of a proceeding against the debtor in any court, including the Tax Court. 11 U.S.C. sec. 362(a). The stay continues until the earliest of one of three occurrences: (1) The time the case is closed, (2) the time the case is dismissed, or (3) the time a discharge is granted or denied. 11 U.S.C. sec. 362(c)(2). ); Smith v. Commissioner, 96 T.C. 10, 14 (1991) ( [W]hile respondent may issue a notice of deficiency during the pendency of a bankruptcy case, the Tax Court s jurisdiction is limited by the stay imposed by 11 U.S.C. section 362(a)(8). Unless relief from the stay is granted by order of the bankruptcy court, see 11 U.S.C section 362(d), the stay remains in effect until the earliest of the closing of the case, dismissal of the case, or the grant or denial of a discharge. ); Neilson v. Commissioner, 94 T.C. 1, 8 (1990) ( Section 362(a)(8) of the Bankruptcy Code provides for an automatic stay prohibiting the commencement or continuation of a proceeding before the United States Tax Court concerning the debtor. Unless the stay is removed by an order of the bankruptcy court, it continues until the earliest of the case closing, case dismissal, or the time a discharge is granted. 11 U.S.C. sec. 362(c)(2)... Accordingly, where a bankruptcy proceeding is closed, dismissed, or a discharge is granted, the automatic stay is lifted and is no longer in effect. After the automatic stay has been removed there is no bar to this Court s accepting jurisdiction or continuing a proceeding that had been petitioned prior to the automatic stay. ) v.2 98

108 effect. 486 The Tax Court has held that if the automatic stay was in effect at the time of the filing of the Tax Court petition, then the petition is invalid and the case must be dismissed for lack of jurisdiction. 487 In Reagoso v. Commissioner, 488 the taxpayers filed a Chapter 7 bankruptcy petition on May 21, On July 29, 1991, the Revenue Service issued a statutory notice of deficiency. Petitioners filed their Tax Court petition on October 30, The bankruptcy court entered an order of discharge on August 6, On July 15, 1993, the Service filed in the Tax Court a motion to dismiss for lack of jurisdiction, claiming that the automatic stay under 11 U.S.C. 362(a)(8) precluded commencement or continuation of the case. On August 16, 1993, the taxpayers filed an opposition to the Service s motion, contending they were unaware that the automatic stay invalidated their Tax Court petition. The taxpayers requested the Tax Court to defer action on the Service s motion until the bankruptcy court ruled on the taxpayers request for a determination of the amount of their taxes, or, in the alternative, granted a retroactive lifting of the automatic stay to validate their Tax Court petition. 489 The Tax Court held that the automatic stay precluded the taxpayers from commencing a proceeding until August 6, 1992, the date the bankruptcy court granted a final discharge. Thus, the improper petition was filed in violation of the automatic stay at a time when the Tax Court could not acquire jurisdiction over the taxpayers and, accordingly, the Tax Court ordered the case dismissed. The Tax Court stated that regardless of the bankruptcy court s decision to grant retroactive lifting of the automatic stay, the Tax Court ultimately has jurisdiction to decide its jurisdiction and since a valid petition is a prerequisite to its jurisdiction, the Tax Court was required to grant the Service s motion. 490 Section 709 of the 2005 Bankruptcy Act amended section 362(a)(8) of the Bankruptcy Code to specify that the automatic stay is limited to an individual debtor s prepetition taxes (taxes incurred before entering bankruptcy). The amendment clarifies that the automatic stay does not apply to an individual debtor s postpetition taxes. In addition, section 709 provides that the stay applies to both prepetition and postpetition tax liabilities of a corporation so long as it is U.S.C. 362(a)(8); Kieu v. Commissioner, 105 T.C. 387, 392 (1995) ( It is not disputed that petitioners were precluded by the automatic stay imposed under 11 U.S.C. section 362(a)(8) (1988), from filing a petition with this Court at that time. ). 487 Halpern v. Commissioner, 96 T.C. 895, 897 (1991) ( If the automatic stay imposed by 11 U.S.C. section 362(a)(8) applies to claims for Federal tax liabilities arising subsequent to the filing of a petition for relief under the Bankruptcy Code, then the petition in question is invalid and we are without jurisdiction. ); Wahlstrom v. Commissioner, 92 T.C. 703, 707 (1989) ( Since there was no termination of the automatic stay provisions of 11 U.S.C. section 362, this Court lacks jurisdiction over this case and respondent s motion to dismiss will be granted. ); see Reagoso v. Commissioner, 66 T.C.M. (CCH) 850, 852 (1993) ( In the present case, the automatic stay provisions of the Bankruptcy Code precluded petitioners from commencing a proceeding before the Tax Court until after August 6, 1992, the date the bankruptcy court granted a final discharge in bankruptcy. The improper petition filed on October 31, 1991, therefore, was filed in violation of the automatic stay provision at a time when this Court could not acquire jurisdiction over petitioners. Accordingly, this case must be dismissed. ), aff d, 39 F.3d 1171 (3d Cir. 1994) T.C.M. (CCH) 850 (1993), aff d, 39 F.3d 1171 (3d Cir. 1994) T.C.M. (CCH) at T.C.M. (CCH) at v.2 99

109 a liability that the bankruptcy court may determine. The House Judiciary Committee Report to the 2005 Bankruptcy Act provides that [u]nder current law, the filing of a petition for relief under the Bankruptcy Code activates an automatic stay that enjoins the commencement or continuation of a case in the United States Tax Court. This rule was arguably extended in Halpern v. Commissioner, 491 which held that the tax court did not have jurisdiction to hear a case involving a postpetition year. Section 362(a)(8) was amended to address this issue. b. Suspension of 90-Day Period for Filing Tax Court Petition. Although the Bankruptcy Code permits the Revenue Service to issue a notice of deficiency to a taxpayer who has filed a bankruptcy petition, 492 the normal 90-day period for filing a timely Tax Court petition is suspended for the period during which the taxpayer is prohibited by reason of the automatic stay from filing a petition in the Tax Court and for 60 days thereafter. 493 Thus, due T.C. 895 (1991). 492 See 11 U.S.C. 362(b)(9)(B). 493 I.R.C. 6213(f) ( In any case under title 11 of the United States Code, the running of the time prescribed by subsection (a) for filing a petition in the Tax Court with respect to any deficiency shall be suspended for the period during which the debtor is prohibited by reason of such case from filing a petition in the Tax Court with respect to such deficiency, and for 60 days thereafter. ); Guerra v. Commissioner, 110 T.C. 271, 274 (1998) ( Although respondent is free to issue a notice of deficiency to a taxpayer that has filed a bankruptcy petition, see 11 U.S.C. sec. 362(b)(9)(1994), the normal 90-day period for filing a timely petition with this Court is suspended for the period during which the taxpayer is prohibited by reason of the automatic stay from filing a petition in this Court and for 60 days thereafter. [footnote omitted]); Olson v. Commissioner, 86 T.C. 1314, (1986) ( Section 6213(f)... provides that the running of the time for filing a petition in the Tax Court shall be suspended for the period during which the debtor is prohibited from filing a petition in this Court and for 60 days thereafter. ); Thompson v. Commissioner, 84 T.C. 645, 648 (1985) ( We agree with respondent that petitioner has 150 days from February 12, 1985, to file his petition. Section 6213(f),... provides that the running of the time for filing a petition in this Court shall be suspended for a period during which the debtor is prohibited from filing a petition in this Court (90 days under section 6213(a), I.R.C. 1954, as amended) and for 60 days thereafter. [citations and footnote omitted]); McClamma v. Commissioner, 76 T.C. 754, 758 (1981) ( Section 6213(f) provides that the running of time for filing a petition in this Court shall be suspended for a period during which the debtor is prohibited from filing a petition in this Court and for 60 days thereafter. ); Howard v. Commissioner, 76 T.C.M. (CCH) 294, 296 (1998) ( Although respondent is free to issue a notice of deficiency to a taxpayer who has filed a bankruptcy petition, see 11 U.S.C. sec. 362(b)(9) (1994), the normal 90-day period for filing a timely petition with this Court is suspended for the period during which the taxpayer is prohibited by reason of the automatic stay from filing a petition in this Court and for 60 days thereafter. [footnote omitted]); Douglass v. Commissioner, 73 T.C.M. (CCH) 3046, 3047 (1997) ( [T]he running of the 90-day period prescribed by section 6213(a) for filing a petition in this Court with respect to the 1991 notice was suspended for the period during which the automatic stay was in effect (namely, from December 15, 1994, to May 3, 1996), and for 60 days thereafter. See sec. 6213(a), (f)(1). Accordingly, petitioner had a total of 150 days from May 3, 1996, or until September 30, 1996, within which to file timely a petition in this Court with respect to the 1991 notice. ); Ash v. Commissioner, 57 T.C.M. (CCH) 1056, 1057 (1989) ( [T]he unexpired portion of the 90-day period provided under section 6213(a) is added to the 60 days provided by section 6213(f). Since the 90-day period was stayed by the filing of a bankruptcy petition after having run 26 days, 64 days plus the 60 days yields 124 days... However, here, the bankruptcy proceeding is still pending. Therefore, the 124- day period for filing a petition with this Court will not commence to run until the earliest of the time the case is closed by the Bankruptcy Court, the time the case is dismissed by the Bankruptcy Court or, if the case is under chapter 13 of Title 11, the time a discharge is granted or denied by the Bankruptcy Court, or until the bankruptcy judge chooses to lift the stay. [citations omitted]); cf. Field Serv. Adv (Jan. 18, 2002), 2001 FSA LEXIS 209, *20 ( With the automatic stay preventing the taxpayer from petitioning the Tax Court, the taxpayer s period for filing a Tax Court petition is suspended pursuant to IRC 6213(f)(1), and the Service is precluded from making an assessment pursuant to IRC 6213(a) prior to the expiration of the period for filing a Tax Court petition v.2 100

110 to the stay imposed by 11 U.S.C. 362(a)(8) on the filing of a Tax Court petition, I.R.C. 6213(f) suspends the 90-day period for 60 days, plus the period the automatic stay is in effect. McClamma v. Commissioner 494 presents an interesting illustration of the operation of this rule (and the sometimes harsh consequences arising from its application). In McClamma, the Tax Court was presented with the question of the proper computation of the expanded period for filing a timely petition with the Tax Court pursuant to I.R.C. 6213(f) where the taxpayers had filed a bankruptcy petition after receiving a notice of deficiency. 495 The Revenue Service issued a notice of deficiency to John and Catherine McClamma on February 15, On March 3, 1980, John McClamma filed a bankruptcy petition under chapter 7 of the Bankruptcy Code. 497 On April 18, 1980, while John McClamma s bankruptcy case was pending, the taxpayers filed a joint petition for redetermination with the Tax Court. 498 On September 19, 1980, the Bankruptcy Court issued a discharge order in John McClamma s bankruptcy case. 499 The Revenue Service subsequently filed with the Tax Court a motion to dismiss the Tax Court action for lack of jurisdiction as to John McClamma on the grounds that: (1) John McClamma was barred by the bankruptcy automatic stay from filing a petition for redetermination with the Tax Court on April 18, 1980; and (2) John McClamma did not file a timely petition following his discharge in bankruptcy. 500 In granting the Revenue Service s motion to dismiss, the Tax Court concluded that the automatic stay barred John McClamma from filing a petition with the Court on April 18, The Court further concluded that, following his discharge in bankruptcy, John McClamma failed to file a petition with the Court within the time prescribed in I.R.C. 6213(f). That Court stated: As to the time John had to file a new petition in this Court, respondent argues that the unexpired portion of the 90-day period provided under section 6213(a) is added to the 60 days provided by This has the effect of suspending the IRC 6501 period pursuant to IRC 6503(a)(1). ); Field Serv. Adv (July 6, 2001), 2001 FSA LEXIS 61 ( With the automatic stay preventing the taxpayer from petitioning the Tax Court, the taxpayer s period for filing a Tax Court petition is suspended pursuant to IRC 6213(f)(1), and the Service is precluded from making an assessment pursuant to IRC 6213(a) prior to the expiration of the period for filing a Tax Court petition. This has the effect of suspending the IRC 6501 period pursuant to IRC 6503(a)(1). ); 1995 FSA LEXIS 228 (March 15, 1995) ( On the other hand, the Service ordinarily prefers to rely upon specific suspensions of the tax assessment limitation period found within the Internal Revenue Code [I.R.C. 6503(h) or 6213(f)], rather than look to B.C. 108(c) and the Bankruptcy Code. The Service is also generally wary and uncomfortable with reading B.C. 105(a) in a manner that would confer broad, unrestricted equitable powers on bankruptcy courts. ) T.C. 754 (1981) T.C. at T.C. at T.C. at T.C. at T.C. at T.C. at T.C. at v.2 101

111 section 6213(f). Since the 90-day period was stayed by the filing of a bankruptcy petition after having run 17 days, 73 days plus the 60 days allowed after the automatic stay was lifted yields 133 days. We agree with respondent that John had until January 30, 1981 (133 days from the date of discharge in bankruptcy, Sept. 19, 1980), to file a new petition in this Court to contest his Federal income tax liability for In Prevo v. Commissioner, 503 a case of first impression, the Tax Court addressed the application of the automatic stay in a collection review proceeding brought in the Tax Court under I.R.C Congress enacted I.R.C (pertaining to the filing of tax liens) and I.R.C (pertaining to tax levies) as part of the Internal Revenue Service Restructuring Act of 1998, 504 to provide specified protections for taxpayers in tax collection matters. When the Commissioner issues a determination letter to a taxpayer following an administrative hearing requested pursuant to Section 6320 or 6330, a taxpayer has 30 days to file a petition for review with the Tax Court or a Federal District Court, as appropriate. 505 There is no provision analogous to section 6213(f) in section 6320 or 6330 that tolls the statutory period for filing a timely petition for lien or levy action for the period during which the person is prohibited by reason of the automatic stay from filing such a petition. 506 In Prevo, the Revenue Service issued to the taxpayer a Notice of Determination on February 23, 2004, concluding that the filing of a federal tax lien was appropriate. On March 1, 2004, the taxpayer filed a voluntary Chapter 13 bankruptcy petition. On March 29, 2004, the taxpayer filed a petition with the Tax Court challenging the Revenue Service s notice of determination. On March 31, 2004, the bankruptcy court dismissed the taxpayer s bankruptcy case. On August 4, 2004, the Revenue Service filed a motion to dismiss the taxpayer s petition in the Tax Court for lack of jurisdiction. The Tax Court granted the motion and noting that the taxpayer had fallen victim to a trap for the unwary. 507 The Court explained the trap as follows: As the notice of determination was issued to the taxpayer on February 23, 2004, the taxpayer normally would have had 30 days until March 24, 2004 to file a timely petition for lien or levy action with the Tax Court. However, upon the filing of the bankruptcy petition on March 1, 2004, the automatic stay was invoked, and the taxpayer was barred from commencing a proceeding in the Tax Court. Further, the automatic stay remained in effect until March 31, days after the 30-day statutory filing period under I.R.C. 6320(c) and 6330(d)(1) expired. Thus, but for the provisions of Bankruptcy Code 6213(f) and the lack of a tolling provision analogous to I.R.C. 6213(f), the Tax Court would have had jurisdiction over the case. 508 The Prevo court recognized the harsh result but emphasized that Congress did not include in sections 6320 and 6330 a tolling provision comparable to section 6213(f) that would T.C. at [fn. refs. omitted] T.C. 326 (2004). 504 Pub. L , 3401, 112 Stat I.R.C. 6320(c), 6330(d)(1). 506 Prevo, 123 T.C. at 193A T.C. at 193C T.C. at 193C v.2 102

112 extend the period for petitioner to file a petition for lien or levy action with the Court. Although the outcome in this case appears harsh, the gap in the collection review procedures that this case highlights is not one that can be closed by judicial fiat. A remedy, if any, must originate with Congress. 509 C. Bankruptcy Court Jurisdiction. 1. Overview of 11 U.S.C. 505(a). Section 505(a) of the Bankruptcy Code, as amended as shown below in italics by the 2005 Bankruptcy Act, 510 provides as follows: (1) Except as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested, before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. (2) The court may not so determine (A) the amount or legality of a tax, fine, penalty, or addition to tax if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case under this title ; or (B) any right of the estate to a tax refund, before the earlier of--- (i) 120 days after the trustee properly requests such refund from the governmental unit from which such refund is claimed; or (ii) a determination by such governmental unit of such request. (C) the amount or legality of any amount arising in connection with an ad valorem tax on real or personal property of the estate, if the applicable period for contesting or redetermining that amount under any law (other than a bankruptcy law) has expired. 511 Section 505(a)(1) authorizes the bankruptcy court to determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested, before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. 512 The legislative history to Section T.C. at 193D. 510 President Bush signed into law the 2005 Bankruptcy Act on April 20, The 2005 Bankruptcy Act added Section 505(a)(2)(C) to the Bankruptcy Code. 512 See IRS v. Luongo (In re Luongo), 259 F.3d 323, 328 (5 th Cir. 2001) ( Initially, we note that the IRS reading of this subsection is contrary to the broad grant of jurisdiction in 505(a)(1) permitting a bankruptcy court to determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. ); IRS v. Taylor (In re Taylor), 132 F.3d 256, 262 (5 th Cir. 1998) ( Section 505 authorizes the court to determine the amount or legality of any tax... whether or not previously assessed. ) v.2 103

113 indicates that Congress intended to vest the bankruptcy courts with a fairly broad jurisdictional grant under Section 505(a). 513 The authority granted to the bankruptcy courts under Section 505(a)(1) is not unrestricted. 514 Section 505(a)(2)(A), like 505(a)(2)(B), limits the jurisdictional grant in 505(a)(1). 515 Section 505(a)(2)(A) expressly precludes a bankruptcy court from reviewing any determination of a debtor s tax liability where that liability has already been contested or adjudicated. 516 Similarly, Code Section 505(a)(2)(B) places certain limitations on the bankruptcy court s authority to adjudicate the right of a bankruptcy estate to a tax refund Discretionary Authority of Bankruptcy Court to Determine Debtor s Tax Liability Under 11 U.S.C. 505(a). a. Overview of Bankruptcy Court s Authority to Abstain. A bankruptcy court has the discretion to either decide or refrain from determining the amount of a debtor s tax liability as the language of Section 505(a) is permissive and not mandatory. 518 Use 513 See H.R. Rep. 595, 95th Cong., 1st Sess. 356 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6312 ( Subsections (a) and (b) are derived, with only stylistic changes, from section 2a (2A) of the Bankruptcy Act, added in They permit determination by the bankruptcy court of any unpaid tax liability of the debtor that has not been contested before or adjudicated by a judicial or administrative tribunal of competent jurisdiction before the bankruptcy case, and the prosecution by the trustee of an appeal from an order of such body if the time for review or appeal has not expired before the commencement of the bankruptcy case. ); S. Rep. No. 989, 95th Cong., 2d Sess. 67 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5853 (same); In re Hunt, 95 B.R. 442, 445 (Bankr. N.D. Tex. 1989) ( [T]he reported decisions uniformly recognize the Bankruptcy Court s jurisdiction to determine a debtor s tax liability.... ); In re Educators Inv. Corp., 59 B.R. 910, 913 (Bankr. D. Nev. 1986) ( The bankruptcy judge has jurisdiction to determine the tax liability of debtors properly before the court. ); see generally 15 Collier on Bankruptcy (15 th ed. 2001) ( Section 505(a) vests the bankruptcy court with authority to determine any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid. Therefore, this provision, like the claims objection process, makes the bankruptcy court a prepayment forum. Unlike that of the Tax Court, this prepayment jurisdiction even includes tax liabilities which have been previously assessed. ). 514 D Alessio v. IRS (In re D Alessio), 181 B.R. 756, 759 (Bankr. S.D.N.Y. 1995) ( The IRS does not challenge the fact that Section 505 of the Bankruptcy Code gives me the discretionary authority to fix and determine the legality of a tax, fine or penalty, or addition to a tax owed by the debtor... This authority, however, is not unrestricted. ); In re Continental Airlines, 149 B.R. 76, 84 (D. Del. 1993) ( Title 11 U.S.C. 505(a) grants the Bankruptcy Court broad authority to hear issues related to the determination of a debtor s tax liability. This authority includes the ability to determine: the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. 11 U.S.C. 505(a)(1). While the authority of the Bankruptcy Court is broad, it is not unrestricted. ), aff d in part, rev d in part, 8 F.3d 811 (3 rd Cir. 1993). 515 IRS v. Luongo (In re Luongo), 259 F.3d 323, 329 (5 th Cir. 2001); Texas Comptroller of Public Accounts v. Trans State Outdoor Adver. Co. (In re Trans State Outdoor Adver. Co.), 140 F.3d 618, 620 (5 th Cir. 1998). 516 In re D Alessio, 181 B.R. at 759; In re Galvano, 116 B.R. 367, 372 (Bankr. E.D.N.Y. 1990) (a policy of Section 505 is to ensure the finality of determinations of tax liability reached prior to Bankruptcy ). 517 In re D Alessio, 181 B.R. at 759; see In re American Motor Club, Inc., 139 B.R. 578, 580 (Bankr. E.D.N.Y. 1992) U.S.C. 505(a)(1); Cody, Inc. v. Orange County (In re Cody, Inc.), 281 B.R. 182, 2002 U.S. Dist. LEXIS 13963, *26 (E.D.N.Y. 2002) ( [A] bankruptcy court s authority to determine a debtor s tax liability is purely v.2 104

114 of the term may not must in Section 505(a)(1) is indicative of the discretionary nature of the bankruptcy court s exercise of such jurisdictional grant. 519 Some courts have termed the discretion broad. 520 Thus, the bankruptcy court may abstain from exercising its jurisdiction to discretionary. ), judgment aff d in part, appeal dismissed in part, 338 F.3d 89 (2nd Cir. 2003); New Haven Projects LLC v. City of New Haven (In re New Haven Projects LLC), 225 F.3d 283, 288 (2nd Cir. 2000), cert. denied, 531 U.S (2001) ( Finally, we note that an overwhelming number of courts have observed that 505(a)(1) vest the bankruptcy court with general discretionary authority to redetermine a debtor s tax liability... * * * Therefore, based on the plain language of the statute, its legislative history, and relevant case law, we interpret the verb may in 11 U.S.C. 505(a)(1) as vesting the bankruptcy court with discretionary authority to redetermine a debtor s taxes. ); Donoff v. United States (In re Donoff), 99-1 USTC 50,328, 1999 Bankr. LEXIS 144, *6 (Bankr. S.D. Ohio 1999) ( Without question, a bankruptcy court has the discretion to either decide or refrain from determining the amount of a debtor s tax liability as the language of 505(a) is permissive and not mandatory. ); In re Beisel, 195 B.R. 378, 379 (Bankr. S.D. Ohio 1996) ( Section 505(a)(1) allows but does not require the Bankruptcy Court to determine a debtor s tax liabilities. ); see also In re Onondaga Plaza Maintenance Co., 206 B.R. 653, 656 (Bankr. N.D.N.Y. 1997) (stating that a court s authority under Section 505 is discretionary ); Marcellus Wood & Trucking, Inc. v. Michigan Employment Sec. Comm n (In re Marcellus Wood & Trucking, Inc.), 158 B.R. 650, 654 (Bankr. W.D. Mich. 1993) (same); In re Swan, 152 B.R. 28, 30 (Bankr. W.D.N.Y. 1992) (same); In re Queen, 148 B.R. 256, 259 (S.D. W. Va. 1992) (same), aff d without opn., 16 F.3d 411 (1994); In re AWB Assoc., 144 B.R. 270, (Bankr. E.D. Pa. 1992) (same); In re El Tropicano, Inc., 128 B.R. 153, 161 (Bankr. W.D. Tex. 1991) (same); In re Galvano, 116 B.R. 367, 372 (Bankr. E.D.N.Y. 1990) (same). 519 Cody, Inc. v. Orange County (In re Cody, Inc.), 281 B.R. 182, 2002 U.S. Dist. LEXIS 13963, *26 (E.D.N.Y. 2002) ( As this language indicates, a bankruptcy court s authority to determine a debtor s tax liability is purely discretionary. ), judgment aff d in part, appeal dismissed in part, 338 F.3d 89 (2d Cir. 2003); Northbrook Partners LLP v. County of Hennepin (In re Northbrook Partners LLP), 245 B.R. 104, 117 (Bankr. D. Minn. 2000) ( Any number of courts have observed that 505(a)(1) is a permissive empowerment--as established by the operative verb may. It is not a mandatory directive. ); In re Schmidt, 205 B.R. 394, 397 (Bankr. N.D. Ill. 1997) ( Use of the directory may not must in 505(a)(1) is indicative of the discretionary nature of the bankruptcy court s exercise of such jurisdictional grant. ); but see In re AWB Assoc., 144 B.R. 270, (Bank. E.D. Pa. 1992) ( [A]bstention from deciding a tax adjudication question under Section 505 is only appropriate under a showing that uniformity of assessment is of significant importance. ); In re Fairchild Aircraft Corp., 124 B.R. 488, 491 (Bankr. W.D. Tex. 1991) ( [A]bstention from deciding a tax adjudication question under Section 505 is only appropriate upon a showing that uniformity of assessment is of significant importance. ). The holdings in In re Fairchild Aircraft and In re AWB Assoc. have not been followed by most courts. See, e.g., New Haven Projects LLC v. City of New Haven (In re New Haven Projects LLC)., 225 F.3d 283, 287 (2d Cir. 2000) ( To the extent that Fairchild Aircraft and AWB hold that a bankruptcy court s jurisdiction under Section 505 is mandatory in the absence of uniformity of assessment concerns, we firmly reject this interpretation of the statute. To understand why, we look first to the plain language of the statute that provides that the court may determine the amount or legality of any tax.... This Court has observed that the verb may generally denotes a grant of authority that is merely permissive... We are persuaded that the ordinary meaning of the word may applies here because nothing in 505 suggests otherwise and because Congress elsewhere in the Bankruptcy Code has chosen the word shall to denote mandatory requirements. [citations omitted]); Northbrook Partners LLP v. County of Hennepin (In re Northbrook Partners LLP), 245 B.R. 104, 118 n. 26 (Bankr. D. Minn. 2000) ( The Fairchild Aircraft Co. court was correct in recognizing that abstention under 505(a) is appropriate where uniformity of assessment is of significant importance It was not correct in holding that abstention is appropriate only then. ). 520 See, e.g., In re Northbrook Partners LLP, 245 B.R. at 118 ( Some courts have termed the discretion broad. ); Custom Distrib. Servs. v. City of Perth Amboy Tax Assessor (In re Custom Distrib. Servs., Inc.), 216 B.R. 136, 148 (Bankr. D.N.J. 1997), aff d in part, rev d in part, 224 F.3d 235 (3rd Cir. 2000); Roberts v. Sullivan County (In re Penking Trust), 196 B.R. 389, 393 (Bankr. E.D. Tenn. 1996) ( In making such determination, section 505 grants a bankruptcy court broad discretionary powers to determine tax liabilities. ); In re Super Van, Inc., 161 B.R. 184, 193 (Bankr. W. D. Tex. 1993) ( This discretion is quite broad, permitting a court to evaluate a wide variety of factors in determining whether to proceed. The discretion is not unbridled, however. An abuse of discretion would occur in this context were a court to decline to hear a matter without having balanced the countervailing interests of the v.2 105

115 resolve disputed tax liabilities. 521 The following six factors are frequently cited by the courts 522 in deciding whether to abstain: efficient manner; (1) The need to administer the bankruptcy case in an orderly (2) The complexity of the tax issues to be decided; (3) The burden on the bankruptcy court s docket; (4) The length of time required for a trial and decision; (5) The asset and liability structure of the debtor; and other creditors. (6) Potential prejudice to the debtor, the taxing authority and Some courts have also considered [t]he effect that a choice of forum would have on other creditors rights and realizations from the bankruptcy estate and the relative weight of promoting bankruptcy s fresh start for debtor. 523 Courts often consider the abstention issue in light of what they identify as the two-fold purpose of Section 505: (1) Congress wanted to give parties to a bankruptcy a forum for the estate s right to invoke the statute in the first place against the interests of the taxing authority, and the interests of the court s own docket. ). 521 In re Cody, Inc., 281 B.R. 182, 2002 U.S. Dist. LEXIS (S.D.N.Y. 2002) (no abuse of discretion for abstention), judgment aff d in part, rev d in part, 338 F.3d 89 (2nd Cir. 2003); Montgomery Ward Holding Corp. v. Pappas (In re Montgomery Ward Holding Corp.), 2000 Bankr. LEXIS 1326 (Bankr. D. Del. 2000) (abstention); In re Northbrook Partners LLP, 245 B.R. 104 (Bankr. D. Minn. 2000) (abstention); In re Railroad Street Partnership, 255 B.R. 644 (Bankr. N.D.N.Y. 2000) (abstention); Donoff v. United States (In re Donoff), 1999 Bankr. LEXIS 144 (Bankr. S.D. Ohio1999) (abstention); Bissett v. United States (In re Bissett), 1999 Bankr. LEXIS 1462 (Bankr. E.D. Pa. 1999) (no abstention); In re American Motor Club, Inc., 139 B.R. 578, 581 (Bankr. E.D.N.Y. 1992) (abstention); In re Hunt, 95 B.R. 442 (Bankr. N.D. Tex. 1989) (abstention). 522 In re New Haven Projects LLC, 225 F.3d 283, 289 (2d Cir. 2000) (listing six factors); In re Cody, Inc., 281 B.R. 182, 2002 U.S. Dist. LEXIS 13963, 27 (listing six factors); In re Railroad Street Partnership, 255 B.R. 644, 647 (Bankr. N.D.N.Y. 2000) (listing six factors); In re Donoff, 1999 Bankr. LEXIS 144 (Bankr. S.D. Ohio 1999) (listing six factors); In re Bissett, 1999 Bankr. LEXIS 1462 (Bankr. E.D. Pa. 1999) (listing six factors); In re Beisel, 195 B.R. 378, 380 (Bankr. S.D. Ohio 1996) ( Bankruptcy Courts, including this Court, have incorporated these policies into six factors to be considered in deciding whether to abstain from a 505 tax review... ); D Alessio v. IRS (In re D Alessio), 181 B.R. 756, (Bankr. S.D.N.Y. 1995) (listing six factors); St. John s Nursing Home v. City of New Bedford (In re St. John s Nursing Home), 154 B.R. 117, (Bankr. D. Mass. 1993), (listing six factors), aff d, 169 B.R. 795, (D. Mass. 1994); Starnes v. United States (In re Starnes), 159 B.R. 748, 750 (Bankr. W.D.N.C. 1993) (listing six factors); Universal Life Church v. United States (In re Universal Life Church, Inc.), 127 B.R. 453, 455 (Bankr. E.D. Cal. 1991) (discussing the six factors), aff d, 965 F.2d 777 (9th Cir 1992); In re Hunt, 95 B.R. 442, 445 (Bankr. N.D. Tex. 1989) (listing six factors). 523 In re Northbrook Partners LLP, 245 B.R. 104, 118 (Bankr. D. Minn. 2000); Thornton v. United States ex rel. IRS (In re Thornton), 1995 Bankr. LEXIS 897 (Bankr. M.D. Ga. 1995); In re Queen, 148 B.R. 256, 258 (S.D. W.Va. 1992), aff d, 16 F.3d 411 (4th Cir. 1994) v.2 106

116 ready determination of the legality or amount of tax claims, which determination, if left to other proceedings, might delay conclusion of the administration of the bankruptcy estate, and (2) Congress wanted to protect creditors from the dissipation of an estate s assets which could result if creditors were bound by a tax judgment which the debtor, due to its ailing financial condition, failed to contest. 524 b. No Asset Cases. In a no-asset Chapter 7 case, the majority approach is to conclude that neither of the above two purposes - prompt administration of the bankruptcy case and protection of creditor interests - would be served by a determination of a chapter 7 debtor s tax liability in no-asset chapter 7 cases. Therefore, many courts have held that abstention from fixing the amount of the tax claim is warranted. 525 This position, however, is 524 New Haven Projects LLC, 225 F.3d 283, 288 (2d Cir. 2000), cert. denied, 531 U.S (2001) ( The exercise of such discretion is, of course, subject to the explicit limitations in Section 505 itself, and must be informed by the purpose underlying the statute. ); In re Onondaga Plaza Maintenance Co., 206 B.R. 653, 656 (Bankr. N.D.N.Y. 1997) ( [I]t is encumbent upon the Court to assure itself that the legislative purpose for drafting this provision, namely to protect the interests of both debtors and creditors... is met. Creditors are entitled to protection from the dissipation of an estate s assets in the event that the debtor failed to contest the legality and amount of taxes assessed against it... Having the bankruptcy court adjudicate the matter may also afford an alternative forum for proceedings that might otherwise delay the orderly administration of the case and distribution to the debtor s creditors. [citations omitted]); see also City Vending of Muskogee, Inc. v. Oklahoma Tax Comm n, 898 F.2d 122, 125 (10 th Cir. 1990) (stating that 505 serves to protect creditors from the dissipation of the estate s assets which could result if the creditors were bound by a tax judgment which the debtor, due to his ailing financial condition, did not contest. ), cert. denied, 498 U.S. 823 (1990); Gossman v. United States (In re Gossman), 206 B.R. 264, 266 (Bankr. N.D. Ga. 1997) ( Two concerns motivated the enactment of 505. First is the need to afford a forum for the ready determination of the legality or amount of tax claims, which determination, if left to other proceedings, might delay conclusion of the administration of the bankruptcy estate... Second, Congress was concerned with protecting creditors from the dissipation of an estate s assets which could result if creditors were bound by a tax judgment which the debtor, due to its ailing financial condition, failed to contest. ); In re Hunt, 95 B.R. 442, 444 (Bankr. N.D. Tex. 1989) ( Section 505 also provides a mechanism to ensure prompt and orderly administration of the bankruptcy estate.... [t]he history of this proviso [11 U.S.C. 505] makes it clear that its purpose was to afford a forum for the ready determination of the legality or amount of the tax claims, which determination if left to other proceedings, might delay conclusion of the administration of the bankruptcy estate. ). 525 Shapiro v. United States (In re Shapiro), 188 B.R. 140, 144 (Bankr. E.D. Pa. 1995); Thornton v. United States ex rel. IRS (In re Thornton), 1995 Bankr. LEXIS 897, *15 (Bankr. N.D. Ga. 1995) ( Case law indicates that whether the parties are the debtor, the IRS, and other creditors, or whether they are only the debtor and the IRS, no bankruptcy purpose will be served by a determination of the debtor s tax liabilities if no distribution will be made to the United States (or the creditor body) from the debtor s estate. ); see, e.g., Cody, Inc. v. Orange County (In re Cody, Inc.), 281 B.R. 182, 2002 U.S. Dist. LEXIS 13963, *27 (S.D.N.Y. 2002) ( [W]here the debtor s general unsecured creditors will not benefit from the requested assessment, bankruptcy courts generally abstain from exercising their discretion under 505(a)(1). ); Donoff v. United States (In re Donoff), 1999 Bankr. LEXIS 144 (Bankr. S.D. Ohio 1999); Gossman v. United States (In re Gossman), 206 B.R. 264, 267 (Bankr. N.D. Ga. 1997) ( Bankruptcy courts generally abstain from determining tax liability in no-asset chapter 7 cases and the courts in this district are no exception * * * In a no-asset Chapter 7 case, a determination of the dischargeable income tax liability is without a bankruptcy purpose. ); Beisel, 195 B.R. 378, 380 (Bankr. S.D. Ohio 1996) ( Also this is a no-asset case. While this Court is sensitive to the fact that the Debtor wishes to resolve his tax liability as expeditiously as possible, this case does not require a ready determination of that issue for the benefit of the Debtor s creditors. ); In re Palij, 202 B.R. 27, 33 (Bankr. D.N.J. 1996) ( [T]his court finds that nothing would be gained by having the bankruptcy court, rather than another court of competent jurisdiction, adjudicate the debtor s alleged tax liability under section 6672 of the Internal Revenue Code. ); Emrich v. United States, 1995 U.S. Dist. LEXIS 1572, *2 (D. Nev. 1995) ( [T]he United States motion to abstain is granted and this Court hereby abstains from exercising its jurisdiction over Count IV (a determination of his tax liability for the years 1981 through 1992 pursuant to 11 U.S.C. Section v.2 107

117 not unanimous ) as such a determination would serve no purpose in this no-asset Chapter 7 bankruptcy proceeding.), aff d, 98 F.3d 1345 (9 th Cir. 1996); Williams v. IRS (In re Williams), 190 B.R. 225, 228 (Bankr. W.D. Pa. 1995) ( Moreover, this is a no-asset case. Abstention is especially appropriate in such cases. ); Starnes v. United States (In re Starnes), 159 B.R. 748, 750 (Bankr. W.D.N.C. 1993) ( A determination of plaintiff s 1986 federal income tax liability would not further the administration of the estate in any manner. In several cases concerning the same legal issues, the courts have dismissed debtor s complaint to determine tax liability and granted defendant s motion for abstention where the debtors contested a nondischargeable tax debt in a no-asset Chapter 7 bankruptcy case. ); Smith v. United States (In re Smith), 1993 Bankr. LEXIS 1667, *4 (Bankr. N.D. Ga. 1993) ( Clearly, no bankruptcy purpose will be served by the Court hearing this case. As stated above, the bankruptcy court has concurrent jurisdiction on any case involving the amount or legality of any tax, fine or penalty. 11 U.S.C There are no assets to be administered, and it is unlikely that there will be any distribution from the estate to the IRS or any other creditor. The controversy as to the assessment has no effect on creditors generally; it involves only Plaintiff-Debtor and the IRS. ); Ferguson v. Commissioner (In re Ferguson), 1993 WL , at *2-3 (Bankr. W.D. Va. 1993) ( The case at bar is a no-asset Chapter 7 case and the Trustee has filed a final no-asset report. There will be no distribution from the estate and the interests of other creditors will not be served by a determination of the Debtors tax liabilities in this Court. Also, contrary to the stated legislative intent, a determination by this Court of tax liability under 11 U.S.C. 505 would only delay administration of the bankruptcy estate. Therefore, no bankruptcy purpose is served by a determination of the Debtors tax liability in this Court which would outweigh the importance of uniformity of assessment. ); Kaufman v. United States (In re Kaufman), 115 B.R. 378, 379 (Bankr. S.D. Fla. 1990) ( A determination of the Debtor s tax liabilities by this Court would not have any effect in the administration of this [Chapter 7 no-asset] bankruptcy case. The Debtor can seek such determination in any other appropriate forum without involving this Court in a determination that will serve no bankruptcy purpose. ); In re Diez, 45 B.R. 137, 139 (Bankr. S.D. Fla. 1984) ( That purpose has no application in this no-asset case involving no parties other than the debtor and the I.R.S. ). 526 Shapiro v. United States (In re Shapiro), 188 B.R. 140, 149 (Bankr. E.D. Pa. 1995); see, e.g., In re Melvin, 103 AFTR 2d (M.D. AL 2009) ( The Court rejects the Government s argument that a bankruptcy court should automatically abstain from hearing any Section 505 proceedings which arise out of no-asset Chapter 7 bankruptcy cases. To be sure, the fact that a Section 505 determination will not affect distribution to creditors is a factor to be considered. Shapiro v. United States (In re Shapiro), 188 B.R. 140 (Bankr. E.D. Pa. 1995); Parsons v. United States (In re Parsons), 153 Bl.R. 585 (Bankr. M.D. Fla. 1993); In re Diez, 45 B.R. 137 (Bankr. S.D. Fla. 1984). However, the lack of an effect upon distribution to creditors is not determinative. Anderson v. United States (In re Anderson), 171 B.R. 549, 553 (Bankr. W.D. Va. 1994)(holding that abstention no required in cases where there were no assets); Smith v. United States (In re Smith), 122 B.R. 130, (Bankr. M.D. Fla. 1999)(rejecting claim that Section 505 proceedings have no place in no-asset Chapter 7 cases). * * * In the case at bar, the nature of the transaction which gave rise to the disputed taxes is closely related to the Debtor s bankruptcy filing. When Nuvelle Credit forgave its debt, it issued a report to the Internal Revenue Service which in turn gave rise to the controversy. It is well established that the forgiveness of a debt gives rise to taxable income, unless the Debtor is insolvent, in which case no taxes are due. 26 U.S.C. 61(a)(12); 108(a)(1)(A), (B). The existence or nonexistence of the tax liability turns on the question of the Debtor s insolvency. This, of course, is the sine qua nine of the determination of the no-asset status of the Debtor s bankruptcy filing. * * * Because it has been established here that the Debtors are insolvent that no assets are available for distribution for creditors it is particularly important for this Bankruptcy Court to keep this proceeding. The Government fails to grasp the incongruity in its own position. It assessed taxes on the assumption that the Debtors were solvent, yet it argues here that the Court should not keep the Adversary Proceeding because the Debtors are so insolvent that no distribution will be made to creditors. If this Court were to abstain, as the Government requests, the Debtors would be compelled to prove their insolvency in District Court. To prove their insolvency in a refund suit, the Debtors will first have to pay their taxes, then sue for a refund, something the Debtors do not have the wherewithal to do. ); D Alessio v. IRS (In re D Alessio), 181 B.R. 756, 761 (Bankr. S.D.N.Y. 1995) ( I am troubled by a rule of law which requires me to apply rotely a doctrine which the Supreme Court has made clear must be applied with restraint... I am also disinclined to employ a rule of law which rigidly eliminates a statutory right expressly enacted by Congress. Had Congress wanted to except a large segment of the debtor population from this statutory right, it would have included another subsection to 505 which v.2 108

118 3. 11 U.S.C. 505(a)(2)(A): Tax Liability Previously Contested or Adjudicated. Although 505(a)(1) gives the bankruptcy court power to decide the amount or legality of most taxes, this grant of authority is limited by 505(a)(2)(A). 527 Section 505(a)(2)(A) bars bankruptcy courts from determining the amount or legality of a tax... if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before commencement of the bankruptcy proceeding. 528 The Ninth and Fifth Circuit Courts of Appeal have held that res judicata is closely related, if not identical to issues regarding the Bankruptcy Court s authority under Section In following the Fifth Circuit s decision in In re Teal, one Bankruptcy Court stated that [S]ection 505(a)(2)(A) expresses in jurisdictional terms the traditional principles of res judicata or claim preclusion. 530 a. Contested. The courts have held that a proceeding is contested if, prior to the bankruptcy filing, the debtor had filed a petition in the Tax Court and the IRS had filed an answer. 531 exclude from review tax disputes in no-asset cases. ); Wheeler v. United States (In re Wheeler), 183 B.R. 265, 267 (Bankr. W.D. Okla. 1995) ( The court is of the view that in these circumstances granting IRS request for abstention would only serve to delay both this adversary proceeding and the administration of the underlying bankruptcy case. ); Fyfe v. United States (In re Fyfe), 186 B.R. 290, 292 (Bankr. N.D. Ga. 1995) ( The court does not agree that there is no bankruptcy purpose in dealing with the Debtor s objection. If the claim secured by the lien is invalid but the Debtor has to pay it anyway to save his residence, his opportunity for a fresh start may be inhibited. That is reason enough for invoking this court s protection and its jurisdiction to adjudicate disputes concerning claims. The argument that the Debtor has no interest in the matter because creditors will not get anything is a spurious one. Bankruptcy courts regularly adjudicate disputes concerning lien claims in no-asset cases. ); In re Anderson, 171 B.R. 549, 551 (Bankr. W.D. Va. 1994) ( It seems that most of the decisions cited concentrate on the issue of the administration of the bankruptcy estate. If there are no assets to be distributed, then it necessarily follows that there is nothing more to be done in the Debtor s case once he is issued a discharge. That premise simply overlooks the entire substance of the Bankruptcy Reform Act or Code of ); In re Huddleston, 1994 Bankr. LEXIS 1961, *24-25 (Bankr. W.D. La. 1994) ( In sum, abstention is appropriate when its impact on the debtors is de minimis. Here, however, the outcome of the 505 determination may have an effect on the Debtors future action in their bankruptcy case. Moreover, the Debtors would be prejudiced if compelled to refile in another forum. Hence, in the interest of prompt and inexpensive justice, the Court here exercises its discretion and holds that abstention is inappropriate. ). 527 Texas Comptroller of Public Accounts v. Trans State Outdoor Adver. Co. (In re Trans State Outdoor Adver. Co.), 140 F.3d 618, 620 (5 th Cir. 1998). 528 Baker v. IRS (In re Baker), 74 F.3d 906, 909 (9 th Cir. 1996) ( The Bakers argue 505(a)(2)(A) does not apply to their case because the amount or legality of their tax was not contested and adjudicated in the Tax Court within the meaning of the statute. Neither argument is persuasive. On its face, the Tax Court judgment establishes the amount of tax owed, and we agree with the Fifth Circuit s conclusion that an assessment of the amount owed presupposes the legality of that assessment. ), cert. denied, 517 U.S (1996). 529 In re Baker, 74 F.3d at 910 n. 8; see United States, IRS v. Teal (In re Teal), 16 F.3d 619, 621 n.3 (5 th Cir. 1994). 530 Doerge v. United States (In re Doerge), 181 B.R. 358, 364 (Bankr. S.D. Ill. 1995). 531 In re Baker, 74 F.3d at 909 ( According to 505(a)(2) s legislative history, a proceeding is contested if, prior to the bankruptcy filing, the debtor had filed a petition in the Tax Court and the IRS had filed an answer... This definition has been adopted by the few courts that have considered the issue, and we see no reason to depart from it. ) v.2 109

119 In Bunyon v. Commissioner, 532 the Ninth Circuit Court of Appeals addressed the issue of whether 505(a)(2)(A) should be applied in the case of adjudication of an issue (the finality of tax court decisions) by a Court of Appeals in the first instance. The Court concluded that nothing in the text of the statute itself forecloses such an application and therefore the Court adopted the definition of contestation that is applied to Tax Court proceedings. 533 The Court held that a prior order from the Ninth Circuit dismissing certain consolidated appeals for lack of jurisdiction was an adjudication of the only issue in dispute in the present case whether the Tax Court decision was final at the time the IRS assessed the deficiencies. 534 b. Adjudicated. The Fifth Circuit Court of Appeals has held that [a] matter has been adjudicated when a judgment of a court of competent jurisdiction has been decreed. 535 In In re Teal, 536 the plaintiff argued that a Tax Court decision based on a settlement agreement should not preclude later claims based on the same tax years. The district court agreed, reasoning that res judicata did not apply because the Tax Court did not reach the merits of the legality of issues involved in the stipulated judgment. 537 The Fifth Circuit reversed, stating that [s]imply because the Tax Court decision [was] reached by agreement does not mean that [Teal s] income tax... [was] not resolved by a final judgment on the merits for the purposes of res judicata. An agreed judgment is entitled to fall res judicata effect. 538 Citing Black s Law Dictionary, the Fifth Circuit stated that adjudicate is [s]ynonymous with adjudge in its strictest sense. Thus, a matter has been adjudicated when a judgment of a court of competent jurisdiction has been decreed. 539 The judgment entered by the tax court, pursuant to the parties settlement, satisfies Section 505(a)(2)(A) F.3d 1149 (9 th Cir. 2004) F.3d at F.3d at In re Teal, 16 F.3d at 621 (quoting Black s Law Dictionary 42 (6th ed. 1990)); see, e.g., Allison v. United States (In re Allison), 232 B.R. 195, 202 (Bankr. D. Mont. 1998) ( Clearly, this Court had no jurisdiction to try the determination of the 1988 tax year assessment since that deficiency has been finally adjudicated pre-petition by the Tax Court. ); cf. In re G-I Holdings Inc., 92 AFTR 2d (D. N.J. 2003) ( [C]ontrary to the government s argument, this is a legislative reflection of claim preclusion doctrine, not an enlargement of issue preclusion. * * * In any event, the amount or legality of the tax assessment against Debtors was not contested before and adjudicated by the Tax Court... Rather, the Tax Court denied summary judgment on a basis of a statutory interpretation, in preparation for adjudicating the tax itself. At most, the Court could consider that ruling a partial adjudication. To have determined completely the amount or legality of the assessment would have required the Tax Court to reach the merits of the case.... ) F.3d 619 (5 th Cir. 1994). 537 In re Teal, 1992 U.S. Dist. LEXIS at *4-*15, rev d, 16 F.3d 619 (5 th Cir. 1994) F.3d at F.3d at F.3d at 621; see also In re Camp, 170 B.R. 610, 612 (Bankr. N.D. Ohio 1994) ( 11 U.S.C. 505(a)(2)(A) prevents this Court from relitigating the Debtor s liability for 1978 and 1979 which was previously determined [through stipulation] in the United States Tax Court. ) v.2 110

120 The Fifth Circuit observed that it appeared that the district court ruled as it did because of its concerns about the equities of the case. 541 The Court stated, however, that a bankruptcy court is barred by 505(a)(2)(A) from employing its equitable powers to look behind the judgment of the tax court... Simply stated, 505(a)(2)(A), a jurisdictional statute, is mandatory; Congress did not leave bankruptcy courts the discretion to disregard tax court adjudications and concomitantly seize jurisdiction out of equitable concerns. 542 In In re Baker, 543 which follows In re Teal, the Bakers signed a stipulated agreement with the IRS concerning their tax liability for 1975 and 1976 which the Tax Court entered as a stipulated decision. 544 The Bakers argued that the stipulated judgment was not an adjudication because it was not a decision reached based upon evidence presented to the court. 545 Rejecting this argument, the Ninth Circuit held that the Tax Court adjudicated the Bakers tax liability when it entered judgment against them. 546 The Ninth Circuit stated that [f]or res judicata purposes, an agreed or stipulated judgment is a judgment on the merits Determination of Tax Liability of Third Parties. [A]n issue arises as to whether Congress intended the bankruptcy court to determine the tax liabilities of nondebtors. 548 The courts have been split on their interpretation of whether 505(a)(1) grants jurisdiction to determine the tax liabilities of nondebtors. 549 In the early 1980s, some courts held that the bankruptcy court may apply 505(a) to determine the tax liability of parties other F.3d at F.3d at F.3d 906 (9 th Cir. 1996) F.3d at F.3d at 909; see Taylor v. Commissioner, 2000 U.S. Dist. LEXIS 6831 (D. Or. 2000) ( Taylor settled his income tax liability with the IRS for the years 1984 through 1988, and the Tax Court formalized that settlement in its stipulated Decision. Even though the Tax Court never actually adjudicated the disputed taxes, the Tax Court Decision is a judgment on the merits precluding later claims by Taylor and the IRS for the tax years ), aff d, 2001 U.S. App. LEXIS (9 th Cir. 2001) F.3d at F.3d. at 910; see also Central Valley Ag Enterprises v. United States, 531 F.3d 750 (9 th Cir. 2008) ( Section 505(a) is also a statutory embodiment of traditional principles of res judicata. If a tax claim has been litigated to a final judgment prior to the commencement of the bankruptcy case, the bankruptcy court lacks jurisdiction to consider the claim. Otherwise, the court has jurisdiction notwithstanding a default judgment or a taxpayer s failure to timely pursue its remedies under the applicable tax laws, which would ordinarily (i.e., outside of bankruptcy) prohibit redetermination of the tax assessment. * * * The district court concluded that the IRS Appeals Office s issuance of an FPAA, the opportunity for judicial review through the filing of a petition for readjustment in Tax Court, and the fact that the FPAA became final when no partner sought such review within TEFRA s limitations period, satisfy the statutory res judicata provision in 11 U.S.C. 505(a)(2)(A). We disagree. A conference with and the issuance of an FPAA by the IRS Appeals Office do not satisfy the statutory requirements that a tax matter be contested before and adjudicated by a judicial or administrative tribunal within the meaning of the statute. [Citations omitted.]). 548 In re American Motor Club, Inc., 139 B.R. 578, 584 (Bankr. E.D.N.Y. 1992). 549 In re Julien Co., 136 B.R. 760, 762 (Bankr. W.D. Tenn. 1991) v.2 111

121 than the debtor. In In re Major Dynamics, Inc., 550 one decision which some other courts found persuasive, a bankruptcy court in California held that under appropriate circumstances, jurisdiction could be exercised under 505(a) to determine the tax liability of a non-debtor. 551 In In re Major Dynamics, a creditors committee filed a motion in bankruptcy court, seeking to stay IRS audits, assessments and collections directed at the creditors. The court held: The jurisdictional grant to this court could extend to tax disputes of third parties other than the debtor provided, however, that the IRS activity to be enjoined directly affected the debtor or the estate, and that the exercise of such jurisdiction was necessary to the rehabilitation of the debtor or the orderly and efficient administration of the debtor s estate. 552 A few subsequent cases followed the In re Major Dynamics holding. 553 In most or all of these cases, the courts were asked to determine the I.R.C tax liability of the debtors employees, and concluded that they had jurisdiction to do so under 11 U.S.C. 505(a). In re Major Dynamics, and the cases which adopted its rationale, relied on a literal interpretation of the clause which states that a bankruptcy court may determine the amount or legality of any tax If the bankruptcy court could pass on the legality of any tax, the cases reasoned, then the court could certainly exercise jurisdiction over third parties whose tax liability was somehow related to that of the debtor. A few years after the decision in In re Major Dynamics, the consensus of the courts shifted away from extending Section 505(a) to parties other than the debtor. 555 In In re Brandt B.R. 969 (Bankr. S.D. Cal. 1981) B.R. at B.R. at See, e.g., In re Original Wild West Foods, Inc., 45 B.R. 202, 206 (Bankr. W.D. Tex. 1984) ( The jurisdictional grant of Section 505 is not, by its terms, limited to a determination of the tax liability of the debtor... It was in reliance on Section 505 that the Court in Major Dynamics held that the authorization given the Bankruptcy Court to determine taxes was broad enough to encompass the obligations of third parties. ); In re Jon Co., 30 B.R. 831, 833 (D. Colo. 1983) ( [T]he bankruptcy court had section 505(a)(1) jurisdiction to determine the legality of the penalty, even if it would not be assessed against the debtor. Section 505 s jurisdictional grant, by its own terms, is not limited to a determination of the debtor s tax liability. ); In re Datair Systems Corp., 37 B.R. 690, 694 (Bankr. N.D. Ill. 1983) ( Datair alleges that the 100% IRS penalty assessed against its two most vital officers will adversely affect the orderly administration of its estate and its rehabilitation. In examining the above cases and the memoranda submitted by both parties, the court finds that Datair has alleged a personal stake in the outcome of the controversy to warrant the invocation of federal court jurisdiction and thus has standing to bring its injunction suit. ); In re H&R Ice Co., 24 B.R. 28, 30 (Bankr. W.D. Mo. 1982) ( [T]he Bankruptcy Court has jurisdiction under Section 505(a)(1) to determined the legality of the assessment. The jurisdictional grant of that Section is not, by its terms, limited to a determination of tax liability of the debtor. ) U.S.C. 505(a)(1); see In re Major Dynamics, 14 B.R. 969, 972 (Bankr. S.D. Cal. 1981) ( The plain language of 505(a)(1) provides, subject to the limitations in 505(a)(2), that the bankruptcy court may determine the amount or legality of any tax. It follows that the Bankruptcy Court has jurisdiction to determine disputes between third party creditors and the IRS in an appropriate case. This result is in line with the general policy of the Bankruptcy Code to allow the Bankruptcy Court to resolve all disputes affecting a debtor s estate. ). 555 In re Wolverine Radio Co., 930 F.2d 1132, 1138 (6 th Cir. 1991), cert. denied, 503 U.S. 978 (1992); Brandt- Airflex Corp. v. Long Island Trust Co., N.A. (In re Brandt-Airflex Corp.), 843 F.2d 90, 95 (2d Cir. 1988) ( In the last few years, however, the consensus has shifted, and virtually all the courts which have considered the issue most v.2 112

122 Airflex Corp., 556 the Second Circuit Court of Appeals addressed the issue of whether 505(a) of the Bankruptcy Code confers jurisdiction on bankruptcy courts to determine the liability of individuals or entities other than the debtor under 3505 of the Internal Revenue Code. 557 The Second Circuit Court of Appeals concluded that 505(a) was not intended to permit bankruptcy courts to determine the tax liability of nondebtors: Section 505(a) was certainly not intended to allow bankruptcy courts to determine the validity of literally any tax, no matter who owes it. Moreover, the statute itself says nothing about which classes of non-debtors, if any, could permissibly invoke the bankruptcy court s jurisdiction under 505(a). A literal reading of the statute, therefore, leads either to unintended results or great uncertainty. As the above quotation suggests, some guidance is found in the legislative history. Section 505(a) is there described as permitting determination by the bankruptcy court of any unpaid tax liability of the debtor.... In light of this statement, it makes far more sense to read 505(a) as limiting the bankruptcy court s jurisdiction, than to accord it the unrestricted reading favored by Major Dynamics. 558 recently concluded that 505(a) does not extend the bankruptcy court s jurisdiction to parties other than the debtor. ); In re Long Island Co. Inc., 1995 U.S. Dist. LEXIS 17249, *1-2 (E.D.N.Y. 1995) ( [T]his Court agrees with the decision of the bankruptcy court dismissing the application of appellant [seeking a determination of his personal liability for the outstanding federal withholding taxes of the debtor corporation] on the ground that the bankruptcy court lacked jurisdiction under 11 U.S.C. 505(a) to grant the relief sought by appellant. ); Amoskeag Bank Shares (In re Amoskeag Bank Shares), 239 B.R. 653, 656 (D.N.H. 1998) ( Although the bankruptcy court s power under section 505 appears broad, most courts have limited its application to determinations of the debtor s or estate s tax liability. ); In re Cadillac Recreation, 153 B.R. 824, 828 (Bankr. C.D. Ill. 1993) ( This Court is persuaded by the reasoning in Brandt-Airflex and holds that it has no jurisdiction to determine the liability of Warren Nichols under ), aff d, 159 B.R. 244 (C.D. Ill. 1993); In re Malone Properties, 150 B.R. 160, 162 (Bankr. S.D. Miss. 1993) ( In the last few years, however, the consensus has shifted, and virtually all the courts which have considered the issue most recently concluded that 505(a) does not extend the bankruptcy court s jurisdiction to parties other than the debtor. ); In re S & S 31 Flavors, 118 B.R. 202, 204 (Bankr. E.D.N.Y. 1990) ( [Section 505] does not confer subject matter jurisdiction on the Bankruptcy Court to determine the tax liability of individuals or entities other than the debtor... Section 505(a) was only intended to permit the Bankruptcy Court to determine the unpaid tax liability of the debtor. ); In re East Wind Indus., 61 B.R. 408, 411 (D.N.J. 1986) ( There is no indication that the Bankruptcy Court has jurisdiction over the liability of non-debtors. ); Cambridge Machined Products Corp. v. United States, 58 B.R. 22, 25 (Bankr. D. Mass. 1985) ( There is no authority for bankruptcy courts to determine the tax liability of the officers of a corporate debtor. ); In re Booth Tow Services, Inc., 53 B.R. 1014, 1018 (W.D. Mo. 1985) ( While the grant of jurisdiction to bankruptcy courts in Chapter 11 actions is a broad one, I do not believe it can reasonably be extended to determining a non-debtors personal tax liability. ); but see In re Schmidt, 205 B.R. 394 (Bankr. N.D. Ill. 1997) (relying on Major Dynamics, bankruptcy court held that it had jurisdiction to determine the short-year, postpetition tax liabilities of a group of chapter 11 debtors who elected to split their taxable year under section 1398); In re Stoecker, 151 B.R. 989, (Bankr. N.D. Ill. 1992) (relying on Major Dynamics to find jurisdiction), rev d on other grounds, 179 B.R. 532 (N.D. Ill. 1995); see generally 15 Collier on Bankruptcy 5.04[5] (15 th ed. 2001) ( The pendulum now has swung in the direction of limiting the section 505(a) jurisdictional grant to determinations of tax liabilities of the debtor and the title 11 estate... Attempts to stretch the provisions of section 505(a) to reach taxpayers beyond the debtor and the bankruptcy estate are likely to be met with the argument that even if the bankruptcy estate has jurisdiction to determine such a tax liability, it should nevertheless abstain from exercising that jurisdiction. ) F.2d 90 (2d Cir. 1988) F.2d at F.2d at 96 (Emphasis in original) v.2 113

123 The Second Circuit concluded, therefore, that the Bankruptcy Court in that case did not have jurisdiction to determine the I.R.C. 3505(b) liability of a nondebtor. 559 Other cases also have found that 505 is not intended to permit bankruptcy courts to determine the tax liability of individuals or entities who are not debtors. Such cases primarily involve tax liabilities other than claims by the Government under I.R.C. 3505(b). American Principals Leasing Corp. v. United States, 560 for example, involved the tax liability of certain nondebtor partners that had arisen from the activities of the debtor partnership. The Ninth Circuit Court of Appeals agreed with the Second Circuit s reasoning in Brandt-Airflex that the legislative history underlying 505 reflects Congress s intent to limit Bankruptcy Court jurisdiction to the determination of any alleged tax liabilities of the debtor, and not of third parties. The Ninth Circuit then stated: Section 505 s location in Subchapter 1 of Chapter 5 of the bankruptcy code supports this conclusion. Chapter 5 concerns, as its title indicates, Creditors, the Debtor, and the Estate. Subchapter 1 concerns, as its title indicates, Creditors and Claims. Section 501(a) specifies that only claims held by creditors may be filed in a bankruptcy case. Section 101(9) defines a creditor as one who has a claim against the debtor, a claim against the estate, or a community claim. 11 U.S.C. 101(9)(A), (B), (C)(emphasis added). This indicates that in section 505 Congress intended to deal with tax liabilities only of the debtor. This conclusion is supported by section 505(c), which states that notwithstanding [the automatic stay provision of] section 362 of this title, after a determination by the court of a tax under this section, the governmental unit charged with responsibility for collection of such tax may assess such tax against the estate, the debtor, or a successor to the debtor. (emphasis added). 561 The Ninth Circuit concluded, therefore, that 505 does not permit Bankruptcy Courts to determine the tax liabilities of nondebtors. 562 The Eleventh Circuit Court of Appeals has reached the same conclusion without considering 11 U.S.C In United States v. Huckabee Auto Co., 563 the nondebtor officers of the debtor corporation sought to enjoin the Government from assessing and collecting the responsible person penalties against them under I.R.C The Eleventh Circuit concluded: The jurisdiction of the bankruptcy courts encompasses determinations of the tax liabilities of debtors who file petitions for relief under the bankruptcy laws. It does not, however, extend to the separate liabilities of taxpayers who are not debtors under the Bankruptcy Code. It is therefore F.2d at F.2d 477 (9th Cir. 1990) F.2d at F.2d at 481; United States v. Bell, 1997 U.S. Dist. LEXIS 5430, *10 (E.D. Cal. 1997) (following American Principals Leasing, [t]his authority [in 505(a)] is limited to the determination of tax liability of the debtor. ); cf Western Reserve Oil & Gas Co. v. Commissioner, 95 T.C. 51, 57 (1990), aff d without opn., 995 F.2d 235 (9 th Cir. 1993) (following American Leasing, [a] bankruptcy court lacks jurisdiction to determine the tax liability of nondebtor partners for the activities of a debtor partnership or to determine the tax consequences of the partnership s activities. ) F.2d 1546 (11th Cir. 1986) v.2 114

124 irrelevant that the penalty, if assessed, will adversely affect the corporate debtor s reorganization. 564 The separate tax liabilities of the nondebtor officers were outside the scope of the bankruptcy court s jurisdiction. 565 The Third Circuit Court of Appeals in Quattrone Accountants, Inc. v. Internal Revenue Service, 566 found that the Bankruptcy Court s jurisdiction to determine the responsible person tax liability of a nondebtor should be evaluated solely by 1334 of title Generally, 1334(b) provides that bankruptcy courts shall have original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title The Court concluded that the action between the nondebtor and the IRS was not related to the debtor s bankruptcy, and that the Bankruptcy Court therefore did not have jurisdiction over the claim against the nondebtor. 569 In In re Wolverine Radio Co., 570 the Sixth Circuit followed the Third Circuit s analysis in Quattrone Accountants by holding that although 11 U.S.C. 505 does not grant jurisdiction over the determination of a nondebtor s tax liability, it does not limit the bankruptcy court to determining only a debtor s tax liability. 571 The Court reasoned that given 505 s legislative history and its placement in the Bankruptcy Code chapter named Creditors, the Debtor, and the Estate, it is not applicable where the court is not dealing with the interrelationship and effect of creditors and their claims on the bankrupt debtor. 572 The Sixth Circuit therefore decided that a bankruptcy court s jurisdiction in a case involving nondebtors should be determined solely by 28 U.S.C. 1334(b) United States v. Huckabee Auto Co., 783 F.2d at F.2d at 1549; see also In re Hunt, 95 B.R. 442, 447 n. 10 (Bankr. N.D. Tex. 1989) ( While the parties did not discuss the possibility of having this court decide Mr. and Mrs. Lamar Hunt s tax liability, our jurisdiction to decide the tax liabilities of non-debtor entities remains questionable. ) (citing Huckabee, 783 F.2d 1546, 1549 (11th Cir. 1986) and In re Brandt-Airflex Corp., 843 F.2d 90, 96 (2d Cir. 1988).) F.2d 921 (3d Cir. 1990) F.2d at U.S.C. 1334(b) F.2d at 927; see IRS v. Kaplan (In re Kaplan), 104 F.3d 589, 594 (3d Cir. 1997) ( We have held that in a case involving non-debtors, the bankruptcy court s jurisdiction is to be determined solely by 28 U.S.C. 1334(b). * * * Thus, the outcome of the dispute between KBS [the nondebtor corporation] and the IRS could conceivably affect, in a positive manner, the Kaplans estate [against whom the IRS was asserting 6672 liability] in bankruptcy. ) F.2d 1132, 1140 (6 th Cir. 1991) (quoting Quattrone Accountants, Inc., 895 F.2d at 925), cert. dism d, 503 U.S. 978 (1992) F.2d at F.2d at 1140 (quoting Quattrone Accountants, Inc., 895 F.2d at 925) F.2d at 1140; see also In re LaBrum & Doak, 2000 U.S. Dist. LEXIS 12066, *16 n.5 (E.D. Pa. 2000) (following Quattrone and Wolverine, 11 U.S.C. 505 neither authorizes nor prohibits the bankruptcy court to determine the tax liability of non-debtors. It merely clarifies the bankruptcy court s jurisdiction over tax claims. ); v.2 115

125 The reluctance of bankruptcy courts to assert jurisdiction over tax claims against nondebtors is reflected in several recent decisions. In 1997, the Bankruptcy Court in In re Proactive Technologies, Inc. 574 found that it did not have subject matter jurisdiction to determine the responsible person liability of a nondebtor under 6672 of the Internal Revenue Code. The Court concluded that 505 does not grant jurisdiction to the bankruptcy court to determine tax liability of non-debtors. 575 In In re Doncheff, 576 the Court faced the issue of whether it could determine the income tax liability of a nondebtor. The Court summarized the decisions regarding its jurisdiction in such cases: It is well settled, however, that this Court does not have jurisdiction to determine the federal income tax liability of a nondebtor. (Citations omitted). 577 In United States v. Prescription Home Health Care, Inc. 578, the Fifth Circuit Court of Appeals, following the decisions of the Second Circuit in In re Brandt-Airflex Corp., the Third Circuit in Quattrone Accountants, Inc. and the Eleventh Circuit in Huckabee Auto Co., and concluded that the bankruptcy court did not have jurisdiction to enjoin the Revenue Service from assessing and collecting responsible person tax liabilities under I.R.C from a nondebtor officer of the debtor corporation. The Fifth Circuit reasoned that the general related to jurisdiction of Bankruptcy Code 1334(b) does not circumvent the specific grant of jurisdiction to the bankruptcy court to determine tax liabilities. 579 The Court noted that under the debtor s broad reading of related to, all tax matters could be adjudicated by the bankruptcy court if they In re Julien Co., 136 B.R. 760, 762 (Bankr. W.D. Tenn. 1991) ( The third party claim in the present case involves the potential tax liabilities of nondebtors, and so this Court will look to 1334(b). ) B.R. 796 (Bankr. N.D. Okla. 1997). 575 In re Proactive Techs., 215 B.R. 796, 799 (Bankr. N.D. Okla. 1997); see also United States v. Heller Healthcare Finance, Inc. (In re Numed Home Health Care, Inc.), 2002 Bankr. LEXIS 532, *16-17 (Bankr. M.D. Fla. 2002) ( The Court has considered the authorities that have addressed the issue, and concludes that this Court does not have subject matter jurisdiction to determine the 3505(b) tax liability of the Defendant, a nondebtor in this case. As stated by the Eleventh Circuit Court of Appeals in Huckabee, supra, 505(a) of the Bankruptcy Code does not permit the Bankruptcy Court to determine the tax liability of individuals or entities who are not debtors. Even under the jurisdictional test of the Third Circuit Court of Appeals as stated in Quattrone, supra, since the nondebtor Defendant s tax liability under 3505(b) is separate and distinct from any liability of the Debtor, the claim is not related to the Debtor s chapter 11 case within the meaning of 1334(b) of title 28. ); United States v. McAuley, 101 B.R. 306, 307 (Bankr. M.D. Fla. 1989) ( 505(a) does not extend the bankruptcy court s jurisdiction to parties other than the debtor.). 576 Thomas v. United States (In re Doncheff), 258 B.R. 177 (Bankr. E.D. Ark. 2001). 577 In re Doncheff, 258 B.R. at 180; see also Victory Mkts., Inc. v. NYS Unemployment Ins. (In re Victory Markets, Inc.), 263 B.R. 9, (Bankr. N.D.N.Y. 2000) ( The decision [of the Eleventh Circuit Court of Appeals] in Huckabee... elucidates the precept that tax liabilities of parties who are not debtors under a confirmed plan are irrelevant, bear nothing more than a remote and tenuous consequence on the debtor s plan and, most relevant, are outside the scope of the bankruptcy court s jurisdiction. [footnote omitted]); In re Management Control Sys., Inc., 242 B.R. 658, 661 (Bankr. S.D. Ind. 1999) ( Section 505 does not empower this court to entertain this action. This Court will not become a second tax court for any person dealing with a collateral tax liability as a result of his connection to a debtor. ) F.3d 542 (5 th Cir. 2002) F.3d 548 (5 th Cir. 2002) v.2 116

126 could conceivably affect the debtor s estate. Such a reading would render superfluous 505 s grant of jurisdiction to determine the tax liabilities of the debtor or the estate. 580 The Court also stated that the theory that a bankruptcy court has jurisdiction to enjoin any activity that threatens the debtor s reorganization prospects would permit the bankruptcy court to intervene in a wide variety of third- party disputes. For example, the bankruptcy court would have jurisdiction over any action (however personal) against key corporate employees, if they were willing to state that their morale, concentration, or personal credit would be adversely affected by that action Section 505(a)(2)(C) Limitation Applicable Ad Valorem Taxes. Section 701(b) of the 2005 Bankruptcy Act added Section 505(a)(2)(C) of the Bankruptcy Code to prevent a bankruptcy court from determining the amount or legality of an ad valorem tax on real or personal property if the applicable period for contesting or redetermining the amount of the claim under nonbankruptcy law has expired. D. Cases of Concurrent Jurisdiction Between the Bankruptcy Court and the Tax Court. The question arises concerning the extent of the bankruptcy court s jurisdiction when a Tax Court case is pending as of the bankruptcy petition date (or where a notice of deficiency is issued after the petition date). The sponsors of the compromise bill, 582 which was later enacted as the Bankruptcy Reform Act of 1978, stated as follows: In essence, under the House amendment [which stated the compromise between the House and the Senate], the bankruptcy judge will have authority to determine which court will determine the merits of the tax claim both as to claims against the estate and claims against the debtor concerning his personal liability for nondischargeable taxes. Thus, if the Internal Revenue Service, or a State or local tax authority, files a petition to determine dischargeability, the bankruptcy judge can either rule on the merits of the claim and continue the stay on any pending Tax Court proceeding or lift the stay on the Tax Court and hold the dischargeability complaint in abeyance. If he rules on the merits of the complaint before the decision of the Tax Court is reached, the bankruptcy court s decision would bind the debtor as to nondischargeable taxes and the Tax Court would be governed by that decision under principles of res judicata. If the bankruptcy judge does not rule on the merits of the complaint before the decision of the Tax Court is reached, the bankruptcy court will be bound by the decision of the Tax Court as it affects the amount of any claim against the debtor s estate F.3d 548 (5 th Cir. 2002) F.3d 548 (5 th Cir. 2002); see also Wolff v. United States, 372 B.R. 244 (D. Ma. 2007) ( [The Trustee] argues that 505 confers jurisdiction because Congress did not intend to limit the reach of the statute to only those controversies involving the tax obligations of a debtor, citing in support of the notion that 505 may be applied to non-debtors In re Major Dynamics. * * * [A] majority of courts considering the identical issue have declined to follow the holding in Major Dynamics. This court, joining the majority of courts, finds the Bankruptcy Court was correct to decline to follow the largely discredited Major Dynamics decision. [Citations omitted.]). 582 H.R. 8200, 95th Cong., 2d Sess. (1978) Cong. Rec (1978) (Statement of Representative Edwards), reprinted in 1978 U.S.C.C.A.N. 6436, ; 124 Cong. Rec (1978) (Statement of Senator DeConcini), reprinted in 1978 U.S.C.C.A.N. 6505, 6562; see also Begier v. IRS, 496 U.S. 53, 64 n.5 (1990) ( Because of the absence of a conference and the key roles played by Representative Edwards and his counterpart floor manager Senator DeConcini, we have treated their floor statements on the Bankruptcy Reform Act of 1978 as persuasive evidence of congressional intent. ) v.2 117

127 Thus, upon a request of the debtor or trustee, the bankruptcy court can in its discretion lift the automatic stay to allow the Tax Court case to continue. 584 If the bankruptcy court lifts the stay, then the jurisdiction of the Bankruptcy Court and the Tax Court are concurrent. 585 Concurrent jurisdiction means that either court has the jurisdiction to decide the tax issue, but if one court makes its determination first, the other court is bound by its decision pursuant to the principles of res judicata. 586 In United States v. Wilson, 587 the Fourth Circuit held that a bankruptcy court could determine the debtor s tax liability even though it previously had lifted the automatic stay against the Tax Court proceeding on the same issue. The Fourth Circuit concluded that the Bankruptcy Court and the Tax Court each have concurrent jurisdiction to determine a tax liability that is not adjudicated by the Tax Court before commencement of the bankruptcy action. 588 In Freytag v. Commissioner, 589 the Tax Court stated that [t]he legislative history clearly shows that Congress understood that the bankruptcy courts and this [Tax] Court would have concurrent jurisdiction in cases regarding common issues of Federal tax liability of bankrupts who are properly before both courts... If the bankruptcy court first decides the common tax issue, its decision is to be binding under principles of res judicata upon this Court: the bankruptcy judge will have authority to determine which court will determine the merits of the tax claim both as to claims against the estate and claims against the debtor concerning his personal 584 See Thornton v. United States ex rel IRS (In re Thornton), 1995 Bankr. LEXIS 897, *20 (Bankr. M.D. Ga. 1995) ( The court recognizes that the bankruptcy court does not lose jurisdiction over tax claims when the automatic stay is terminated, as its jurisdiction is concurrent with the jurisdiction of the Tax Court. ) (citing United States v. Wilson, 974 F.2d 514 (4 th Cir. 1992), cert. denied, 507 U.S. 945 (1993)); United States v. Walters (In re Walters), 176 B.R. 835, 862 n. 17 (Bankr. N.D. Ind. 1994) ( The Tax Court and Bankruptcy Court have concurrent jurisdiction to determine tax liabilities... Pursuant to 362(a)(8) the automatic stay precludes the commencement or continuation of a proceeding before the United States Tax Court, unless the bankruptcy court lifts the stay to allow it... However, even when the stay is lifted, the Bankruptcy Court retains jurisdiction concurrent with the tax court. ); Laptops Etc. Corp. v District of Columbia (In re Laptops Etc. Corp.), 164 B.R. 506, (Bankr. D. Md. 1993) (noting that [t]he Fourth Circuit Court of Appeals has ruled that a bankruptcy court may even determine a debtor s tax liability, if any, irrespective of whether it had previously granted relief from the automatic stay. ). 585 See United States v. Wilson, 974 F.2d 514 (4th Cir. 1992), cert. denied, 507 U.S. 945 (1993). 586 United States v. Wilson, 974 F.2d 514 (4th Cir. 1992), cert. denied, 507 U.S. 945 (1993); Freytag v. Commissioner, 110 T.C. 35, 40 (1998); see 124 Cong. Rec. S17406, (daily ed. October 6, 1978), reprinted in 1978 U.S.C.C.A.N. 6505, 6562; see also Fotochrome, Inc. v. Commissioner, 57 T.C. 842, 847 (1972); Valley Die Cast Corp. v. Commissioner, 45 T.C.M. (CCH) 791, 793 (1983); CC:GL ; cf. IRS CCA ( The filing of a bankruptcy petition has the effect of giving the bankruptcy court concurrent jurisdiction with the Tax Court over issues involving the debtor s tax liability. Because the bankruptcy court can lift the stay of Tax Court proceedings in its discretion, the bankruptcy court has the power to decide in which court the tax issues will be litigated. ); IRS CCA , 1999 IRS CCA LEXIS 267 (January 21, 2000) (( The filing of a bankruptcy petition has the effect of giving the bankruptcy court concurrent jurisdiction with the Tax Court over issues involving the debtor s tax liability. Because the bankruptcy court can lift the stay of Tax Court proceedings in its discretion, the bankruptcy court has the power to decide in which court the tax issues will be litigated. ) F.2d 514 (4th Cir. 1992), cert. denied, 507 U.S. 945 (1993); Kieu v. Commissioner, 105 T.C. 387, (1995). 588 Wilson, 974 F.2d at T.C. 35, 40 (1998) v.2 118

128 liability for nondischargeable taxes. Thus, * * * the bankruptcy judge can either rule on the merits of the claim and continue the stay on any pending Tax Court proceeding or lift the stay * * *. IF HE RULES ON THE MERITS OF THE COMPLAINT BEFORE THE DECISION OF THE TAX COURT IS REACHED, THE BANKRUPTCY COURT S DECISION WOULD BIND THE DEBTOR AS TO NONDISCHARGEABLE TAXES AND THE TAX COURT WOULD BE GOVERNED BY THAT DECISION UNDER PRINCIPLES OF RES JUDICATA. 590 The legislative history indicates that if a Tax Court proceeding is permitted to continue during the pendency of a chapter 7 or 11 individual bankruptcy case, the trustee can choose to intervene in the Tax Court case. 591 If the trustee intervenes, the Tax Court decision will be binding on the debtor as to its nondischargeable tax liability, and the trustee as to the validity of the tax claims against the estate. Pursuant to principles of res judicata, the bankruptcy court will then have no authority to determine the tax liability. 592 If the trustee chooses not to join the Tax Court proceeding, the Tax Court s determination will bind the debtor and the tax authority with respect to the debtor s nondischargeable tax liability, but will not govern the liability of the bankruptcy estate. Thus, the bankruptcy court can make a determination of the tax liability of the debtor, for purposes of determining the validity of the claim against the estate, despite the prior Tax Court determination. 593 E. Refund Procedures. 1. General Overview of Refund Procedure Outside Bankruptcy. If a taxpayer outside of bankruptcy fails to take advantage of the Tax Court remedy, liability for a federal income tax assessment may still be contested. In order to do so, the taxpayer must pay the assessment in full, 594 file a claim for refund of the amount paid with the IRS and, if the claim 590 Freytag, 110 T.C. at 40 (citing 124 Cong. Rec (1978) (Representative Edwards); 124 Cong. Rec (1978) (Senator DeConcini); (emphasis in original)). 591 See I.R.C ( The trustee of the debtor s estate in any case under title 11 of the United States Code may intervene on behalf of the debtor s estate, in any proceeding before the Tax Court to which the debtor is a party. ); see In re Hunt, 124 B.R. 200, 1991 Bankr. LEXIS 910, *3-4 (Bankr. N.D. Tex. 1991) ( The Liquidating Trustee, by and through his counsel, shall request permission of the Tax Court and the Fifth Circuit to intervene in the litigation pending before those courts on behalf of the debtor s bankruptcy estate and to supplant the debtors in their representation of these bankruptcy estates pursuant to Section 7464 of the Internal Revenue Code.... ) Cong. Rec., S17406, (daily ed. October 6, 1978), reprinted in U.S.C.C.A.N. 6505, 6562; cf. CC:GL , reprinted in 1992 GLB LEXIS 2 (Nov. 1992) ( The legislative history, however, explains that in an individual chapter 7 or 11 case, there is a distinction between a determination of the personal liability of the debtor for nondischargeable taxes, and the liability of the trustee as fiduciary of the bankruptcy estate. If a Tax Court proceeding is permitted to continue during the pendency of the bankruptcy case, the trustee can choose to intervene in the Tax Court case. See I.R.C If the trustee intervenes, the Tax Court decision will be binding on the debtor as to its nondischargeable tax liability, and the trustee as to the validity of the tax claims against the estate. Pursuant to principles of res judicata, the bankruptcy court will then have no authority to determine the tax liability. ) Cong. Rec. S17406, (daily ed. October 6, 1978), reprinted in U.S.C.C.A.N. 6505, 6562; cf. CC:GL , reprinted in 1992 GLB LEXIS 2 (Nov. 1992). 594 Taylor v. Commissioner, 2001 U.S. App. LEXIS 10924, **6 (9 th Cir. 2001) ( However, there is no jurisdiction in the district courts over suits for the refund of penalty amounts paid until the taxpayer has paid the full amount of the contested penalty assessment.... ); Thomas v. United States, 755 F.2d 728, 729 (9th Cir 1985) ( Ordinarily, there is no jurisdiction in the district courts over suits for the refund of penalty amounts paid until the taxpayer has v.2 119

129 is denied or not acted upon within six months, bring a suit for refund in the appropriate United States District Court or in the Claims Court. 595 This route, under Section 7422 of the Internal Revenue Code, is the exclusive mechanism by which a taxpayer may maintain a suit in either the federal district courts or the United States Claims Court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority. 596 The mechanics of the refund procedure and their application in the bankruptcy context are discussed below. a. Claim for Refund. Section 7422(a) provides that no suit or proceeding for refund in any court can be filed until a claim for refund has been filed with the Secretary. 597 A court does not have jurisdiction over a refund suit absent a timely administrative claim for refund. 598 I.R.C dictates the time frame for filing of refund claims. 599 Pursuant to I.R.C (a), the taxpayer must file a claim for refund with the Secretary within the later of 3 years from the time the return is filed or 2 years from the time the tax was paid. 600 paid the full amount of the contested penalty assessment... and has filed a claim for refund which the IRS has either rejected or not acted upon in six months. ) U.S.C. 6511, 6532, 7422 (2001); United States v. Dalm, 494 U.S. 596, (1990); Flora v United States, 362 U.S. 145, 146, (1960); Thompson v United States, 308 F.2d 628, 634 (9 th Cir. 1962) ( [N]o suit may be maintained in this court for repayment of a tax actually paid until a claim for refund has been duly filed in accordance with law. ); see Piljak v. IRS, 1996 U.S. Dist. LEXIS 11649, *6 (N.D. Ca. 1996) ( If the taxpayer fails to take advantage of the Tax Court remedy, liability for the assessment may still be contested. In order to do so, the taxpayer must pay the assessment in full, file a claim for refund of the amount paid with the IRS and, if the claim is denied or not acted upon within six months, bring a suit for refund in the appropriate district court or in the Claims Court. ), aff d, 1997 U.S. App. LEXIS (9 th Cir. 1997) U.S.C. 7422(a) (2001); Piljak v. IRS, 1996 U.S. Dist. LEXIS 11649, *6, aff d, 1997 U.S. App. LEXIS (9 th Cir. 1997). 597 See also Treas. Reg (a) ( Credits or refunds of overpayments may not be allowed or made after the expiration of the statutory period of limitation properly applicable unless, before the expiration of such period, a claim therefor has been filed by the taxpayer. Furthermore, under section 7422, a civil action for refund may not be instituted unless a claim has been filed within the properly applicable period of limitation. ). 598 See United States v. Dalm, 494 U.S. 596, 602 ( [U]nless a claim for refund of a tax has been filed within the time limits imposed by 6511(a), a suit for refund, regardless of whether the tax is alleged to have been erroneously, illegally, or wrongfully collected, 1346(a)(1), 7422(a), may not be maintained in any court. ), reh g denied, 495 U.S. 941 (1990); see, e.g., Ward v. Internal Revenue Service, 90 AFTR 2d , 5888 (07/24/2002) ( Because Plaintiff failed to timely file an administrative claim for refund as required by 26 U.S.C. 7422(a) and 26 U.S.C (a), the Court does not have subject matter jurisdiction over her claim for refund or recoupment of taxes wrongfully collected. Accordingly, the Court will dismiss Count One of the Plaintiff s Complaint with prejudice. ). 599 United States v. Neary (In re Armstrong), 206 F.3d 465, 469 (5 th Cir. 2000). 600 See Treas. Reg (a)-1(a)(1)( If a return is filed, a claim for credit or refund of an overpayment must be filed by the taxpayer within 3 years from the time the return was filed or within 2 years from the tax the tax was paid. ); see United States v. Neary (In re Armstrong), 206 F.3d 465, 469 (5 th Cir. 2000) ( I.R.C. 6511(a) provides that a refund claim must be filed within three years of the time the return was filed or within two years from the time the tax was paid. I.R.C. 6511(b)(1) provides that no refund shall be allowed or made unless a claim was filed within the limits set up by 6511(a). I.R.C. 6511(c) supplies an addendum to the filing deadlines: in the case of an agreement to extend the time for additional assessments, the time for filing will not expire before six months after the termination or expiration of the agreement. ) v.2 120

130 Special limitation provisions govern certain items such as bad debt deductions and net operating loss and capital carryback loss. 601 The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. 602 The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. 603 No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim except upon one or more of the grounds set forth in a claim filed before the expiration of such period. 604 b. Refund Suit. Once a claim for refund has been filed, the taxpayer must still wait six months before bringing suit, unless the IRS sooner renders an adverse decision on the claim. 605 An adverse decision on the claim triggers a two-year limitations period within which the taxpayer must bring suit Bankruptcy. 11 U.S.C. 505(a)(2)(B) provides that the bankruptcy court may not determine the right of the estate to a tax refund, before the earlier of (a) 120 days after the trustee properly requests such refund from the governmental unit from which such refund is claimed; or (b) a determination by such governmental unit of such request. The Fifth Circuit Court of Appeals, in United States v. Luongo, 607 described succinctly the operation of Section 505(a)(2)(B): Section 505(a)(2)(B), like section 505(a)(2)(A), limits the jurisdictional grant in 505(a)(1). Section 505(a)(1) grants the bankruptcy court jurisdiction over any tax claim, including refund claims; 505(a)(2)(B) then prescribes the limits particular to the bankruptcy court s ability to determine a refund. The intended purpose of subsection (a)(2)(b) was to prevent a refund claim from languishing in the administrative processes... Section 505(a)(2)(B) thus permits the bankruptcy court to make a determination of a refund if the taxing authority does not act upon a refund claim within 120 days. 608 Revenue Procedure sets out the procedure to be followed in filing a claim for a credit or a refund of any overpayment pursuant to Section 505(a)(2)(B). a. Claim for Refund. (1) Claim for Refund Is Jurisdictional. Courts have held that just as is the case outside bankruptcy, the bankruptcy court does not have jurisdiction over a 601 See I.R.C. 6511(d)(2). 602 Cf. Ward v. Internal Revenue Service, 90 AFTR 2d , 5887 (07/24/2002) (The Court finds that plaintiff s letter and attached Order were not sufficiently specific notify the IRS that plaintiff sought a refund. The letter does not identify the tax periods at issue, it does not identify the dates the credits were posted, and it does not identify the refund amount sought by Plaintiff. (Citations omitted.)). 603 Treas. Reg (b). 604 Treas. Reg (b). 605 I.R.C. 6532(a)(1). 606 I.R.C. 6532(a)(1) F.3d 323 (5 th Cir. 2001) F.3d at v.2 121

131 claim for refund absent the filing of an administrative claim for refund which meets the time limitations of Section 6511(a). 609 The Fifth Circuit Court of Appeals has held that Bankr. Code 362 does not toll the statute of limitations for the filing of a refund claim by a bankruptcy trustee under I.R.C and that Bankr. Code does not apply to the filing of 609 Dalm v. United States, 494 U.S. 596, 602 (1990) ( [Sections 7422(a) and 6511(a)] [r]ead together, the import of these sections is clear: unless a claim for refund of a tax has been filed within the time limits imposed by 6511(a), a suit for refund, regardless of whether the tax is alleged to have been erroneously, illegally, or wrongfully collected, 1346(a)(1), 7422(a), may not be maintained in any court. ); United States v. Neary (In re Armstrong), 206 F.3d 465, 472 (5 th Cir. 2000) ( A proper request under the Internal Revenue Code requires compliance with 7422 and ); United States v. Ryan (In re Ryan), 64 F.3d 1516, 1521 (11 th Cir. 1995) ( Therefore, under 11 U.S.C. 505 and 26 U.S.C. 7422, in order to decide whether the Ryans can bring an action in the bankruptcy court for refund of their 1990 tax overpayment, we must ascertain whether they had previously presented an administrative claim that satisfied the essential requirements test and that was timely filed. [footnote omitted]); Graham v. United States (In re Graham), 981 F.2d 1135, 1138 (10 th Cir. 1992) ( [T]he government does not waive sovereign immunity in a suit for a tax refund until presented with an administrative claim which it has either denied or ignored. The administrative claim itself must be filed within the later of two years after the tax was paid or three years after the return was filed. 26 U.S.C. 6511(a). * * * These rules are nonwaivable jurisdictional requirements. ); see Custom Distrib. Servs. v. City of Perth Amboy Tax Assessor (In re Custom Distrib. Servs., Inc.), 224 F.3d 235, (3 rd Cir. 2000) ( In light of the legislative history of 505(a), the overwhelming case authority interpreting it as precluding the bankruptcy court from adjudicating claims for refund of taxes that were not seasonably contested in accordance with procedures set out by the taxing authority, and the policy considerations underpinning section 505, we are persuaded that the Bankruptcy Court here did not have jurisdiction to order the City to refund excess payments for those years in which Custom paid the taxes but did not contest them in accordance with N.J.S.A. 54:3-21. ); In re Smith, 921 F.2d 136, 139 (8 th Cir. 1990) ( In the absence of a timely claim for refund, such a suit or proceeding could not be maintained. So the possibility that the trustee in bankruptcy, in the event of the affirmance of the judgment of the District Court, could file a turnover proceeding turns out to be without legal significance. Such a proceeding would be, on its face, barred by the provisions of the Internal Revenue Code just referred to. ); see also Constable Terminal Corp. v. City of Bayonne (In re Constable Terminal Corp.), 222 B.R. 734, 740 (Bankr. D. N.J. 1998) (debtor s failure to comply with state procedural requirements for obtaining refund of real estate taxes precluded bankruptcy court from ordering refund), aff d, 246 B.R. 181 (D.N.J. 2000); aff d without opn. 281 F.3d 2001 (3d Cir. 2001); Roberts v. Sullivan County (In re Penking Trust), 196 B.R. 389, 396 (Bankr. E.D. Tenn. 1996) (court has no jurisdiction under section 505(a)(2)(B) to decide the estate s right to a refund where the trustee failed to make a proper refund request under Tennessee law for taxes paid prepetition); Great Bay Power Corp. v. Town of Seabrook (In re EUA Power Corp.), 184 B.R. 631, 636 (Bankr. D.N.H. 1995) ( Under section 505(a)(2)(B)(i), the debtor must timely comply with state procedural requirements to request a refund of taxes already paid to preserve the bankruptcy court s discretionary jurisdiction to decide whether a refund is owed. ); Cumberland Farms v. Town of Barnstable (In re Cumberland Farms), 175 B.R. 138, 142 (Bankr. D. Mass. 1994); St. John s Nursing Home v. City of New Bedford (In re St. John s Nursing Home), 154 B.R. 117, 120 (Bankr. D. Mass. 1993) ( Section 505(a)(2)(B) prohibits the bankruptcy court from adjudicating the right of an estate to a tax refund unless the trustee has first requested a refund from the government authority administering the tax and was refused. ), aff d, 169 B.R. 795 (D. Mass. 1994); see also In re Dunhill Medical, Inc., 1996 WL , *7 (Bankr. D.N.J. 1996) (agreeing with Judge Queenan s decision in In re Cumberland and the majority of courts that courts are without jurisdiction to adjudicate a claim for a refund unless it has been timely filed. ); In re Carter, 125 B.R. 832, 835 (Bankr. D. Kan. 1991); In re Qual Krom South, Inc., 119 B.R. 327, 329 (Bankr. S.D. Fla. 1990) (holding that a taxpayer who failed to file a claim for a refund within the time period prescribed by federal law could not sue to recover tax); cf FSA LEXIS 302 (Aug. 25, 1998) ( Courts have held that just as is the case outside bankruptcy, the bankruptcy court does not have jurisdiction over a refund claim absent an administrative claim for refund which meets the time limitations of section 6511(a). ). 610 United States v. Neary (In re Armstrong), 206 F.3d 465, 470 (5 th Cir. 2000). 611 TLI, Inc. v. United States, 100 F.3d 424, 426 (5 th Cir. 1996) v.2 122

132 administrative claims under the Internal Revenue Code. 612 (2) Claim for Refund in Offset Context. Some courts have held that where a refund is sought as an offset, no claim is required to be filed first with the taxing authority but the taxpayer must comply with the taxing authority s timeliness requirements. In In re Dunhill Medical, Inc., 613 the Internal Revenue Service filed against the debtor a proof of claim on taxes owing, alleging that the debtor failed to remit quarterly employee withholding taxes and Federal Insurance Compensation Act (FICA) payments for certain periods between 1990 and The debtor claimed that it had overpaid withholding taxes and FICA payments during 1986 through 1991 and that the overpayments should be offset against taxes owed. 615 The Dunhill court concluded, based on the legislative history of Section 505, that Code section 505 permits a debtor to dispense with the IRS s requirement of filing a claim for refund when a refund is sought as an offset or counterclaim to a proof of claim filed by the tax authority. 616 But the Court added a caveat: Regardless of whether a claim for a credit or a refund has been properly asserted for purposes of Code section 505(a)(2)(B), the bankruptcy court must still apply the statute of limitations established by 6511 of title to each tax year at issue in this case because the timeliness of a refund claim is jurisdictional. 617 The Court thus concluded that the debtor must have filed a claim for a credit within the IRC s time requirements to qualify for consideration of a refund request. 618 The Court granted the Service s motion for summary judgment for the 1986 through 1990 tax years because the debtor s claim for a credit for taxes paid in those years was time-barred. 619 Subsequently, in Michaud v. United States, 620 the District Court for the District of New Hampshire determined that the bankruptcy court had jurisdiction to order a refund despite the failure to file a prior refund request with the Service. 621 The District Court stated that [w]hen an IRS proof of claim and a taxpayer s request for refund regard the same tax liabilities, it would be without purpose and irrational to deny the bankruptcy court jurisdiction to order a refund until the taxpayer makes a formal request for a refund from the IRS. 622 The Court rejected the IRS 612 See TLI, Inc. v. United States, 100 F.3d 424, 427 (5 th Cir. 1996) ( We agree with the other courts that have addressed the issue that the language of 108(a) does not serve to extend the statute of limitations for filing an administrative tax refund claim. ) WL (Bankr. D. N.J.); see also In re Custom Distrib. Servs., 224 F.3d 235, 244 (3 rd Cir. 2000) (citing In re Dunhill as instructive on this issue) W.L , * W.L , * WL , * WL , * WL , * W.L , * B.R. 1, 5 (D.N.H. 1997), aff g 199 B.R. 248 (Bankr. D.N.H. 1996) B.R. at B.R. at v.2 123

133 arguments that In re Dunhill was wrongly decided and that the legislative history relied upon by the Dunhill court is inconsistent with the statutory language. 623 In United States v. Kearns, 624 the Internal Revenue Service asserted that the debtor had not timely filed for the refund which was claimed as a setoff against the Service s proof of claim for tax deficiency. 625 Thus, argued the Internal Revenue Service, the bankruptcy court lacked subject matter jurisdiction under Section 505(a)(2) to determine the tax liability, including any offsets. 626 The bankruptcy court, however, rejected this argument, finding in favor of the debtor Kearns, and holding that, if a request for a refund arises from an offset or counterclaim, then there is no need for the debtor to file an administrative claim with the taxing authority in order confer jurisdiction on the bankruptcy court under Section The debtor Richard Lee Kearns became trustee of the Lincoln Land Trust in His wife Carol Kearns was one of four beneficiaries. In 1989, Kearns made three unauthorized disbursements of funds from the trust. First, Kearns withheld $460,000 of the proceeds realized on a February 1989 sale of trust land, using the money to purchase stock in Wen-Neb., Inc., an owner of Wendy s restaurants in Nebraska. In April 1989 Kearns withdraw $24,508 from a trust bank account and used the money to repay a personal loan. Finally, in August of that same year, he withdrew an additional $35,000 in trust moneys to repay a joint obligation owed by his wife and himself. The beneficiaries other than Kearns wife discovered the misappropriations in early 1990 and threatened legal action. On April 6, 1990, a settlement was reached between Kearns and the trust beneficiaries. Pursuant to the settlement, Wen-Neb., Inc., repurchased the stock from Kearns for $460,000 and Kearns assigned his interest in the proceeds to the beneficiaries other than his wife. 629 Thereafter, Kearns filed for Chapter 11 bankruptcy. Following an examination of Kearns 1989 tax return, the IRS filed a proof of claim in the amount of $142,718. The amount of tax owed was based on the unreported 1989 embezzlement income of $519,508. The bankruptcy court conducted a hearing on the issue and found that Kearns had embezzled the funds and that the funds constituted income to him. The court further found, however, that Kearns had made restitution to the victims, thus giving rise to deductions for the years in which the restitution was made. The court, therefore, indicated that it would reconsider the IRS s claim, insofar as deductions may be appropriate B.R. at F.3d 706 (8 th Cir. 1999) F.3d at F.3d at F.3d at F.3d at F.3d at F.3d at v.2 124

134 Kearns moved for reconsideration, alleging that he was entitled to an offset against the IRS s tax claim in an amount equal to the tax savings attributable to deductions taken for the restitution payments. The IRS responded that Kearns claim for a restitution deduction was inappropriate because Kearns failed to file for the refund in the proper year and was barred by the statute of limitations under I.R.C. 6511(a). Additionally, the IRS asserted that since Kearns had not timely filed for a refund, the bankruptcy court lacked subject matter jurisdiction under Title 11 U.S.C. Section 505(a)(2) to determine tax liability, including any offsets. 631 After the bankruptcy court rejected the United States statute of limitations and jurisdictional arguments, the United States, on behalf of the IRS, appealed to the Bankruptcy Appellate Panel for the Eighth Circuit ( Panel ). The Panel agreed that the bankruptcy court lacked jurisdiction over tax years 1990 through 1994, vacated the bankruptcy court s opinion, and remanded the matter with instructions to allow the IRS claim in its entirety. 632 On appeal to the Eighth Circuit Court of Appeals, the Eighth Circuit concluded that the Panel s decision was incorrect because Congress intended under Section 505 to grant jurisdiction to the bankruptcy court to determine Kearns tax liability. 633 The Eighth Circuit read 505 to confer on the bankruptcy courts jurisdiction to determine tax liability beyond the year stated in the proof of claim when that liability involves deductions resulting from repayment of embezzled funds. 634 The Eighth Circuit acknowledged the IRS argument that Section 505(a)(2) requires the Trustee or debtor to properly request a refund, and that this language of the statute incorporates provisions from the Internal Revenue Code governing application for income tax refunds. Specifically, said the Eighth Circuit, a proper request is one that, first, meets the filing requirements of I.R.C. Section 7422(a), which provides, in relevant part, that [n]o suit or proceeding shall be maintained in any court for a tax refund until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law [and regulations] in that regard. Additionally, the I.R.C. establishes that a claim for an income tax refund must be filed within three years from the time the return was filed or two years from the time the tax was paid, whichever expires later. See I.R.C. Section 6511(a). Nevertheless, the Eighth Circuit observed that, we cannot share an interpretation of the Bankruptcy Code that precludes a debtor from having the benefit of carrying back deductions that are intimately related to the adjudged tax liability. 635 The Eighth Circuit quoted Collier on Bankruptcy, stating that, if the refund results from an offset or counterclaim to a claim or request for payment by the [IRS], or other tax authority, the trustee would not first have to file an administrative claim for refund with the tax authority. The Eighth Circuit relied also on the Dunhill and Michaud decisions F.3d at F.3d at F.3d at F.3d at F.3d at v.2 125

135 The Eighth Circuit recognized that the statute of limitations is a jurisdictional requirement in suits against the United States, and that the defense may be raised at any time in the litigation. However, said the Eighth Circuit, if, when the claims of the IRS and a debtor involve the same tax liabilities, it is without purpose and irrational to deny jurisdiction over refunds absent a formal request by the debtor... it would be doubly so to apply a statutory bar to the debtor s claim for determination of tax liability. 636 Furthermore, said the Eighth Circuit, it is important to note that our resolution of this case does not detract from the policies of efficiency and conservation of resources underlying Section 505. The requirement of exhausting administrative remedies as a precondition to invocation of the judicial process will continue to vindicate the important interest of affording the IRS an opportunity to consider fully the merits of the refund or credit claim before being required to expend resources in litigation...where the IRS has filed a proof of claim, however, it has already committed itself to expending resources to resolve the taxpayer s liability for a particular year In In re Guardian Trust Co., 638 the Federal District Court for the Southern District of Mississippi followed the Eighth s Circuit s holding in In re Kearns. The United States argued in In re Guardian Trust Co. that the United States Bankruptcy Court lacked subject matter jurisdiction to consider the refunds claimed by the Trustee... because neither the Trustee nor the debtor properly filed for the refunds in question in a timely manner as required under Title 26 U.S.C The United States further argued that the word properly means the Trustee is required to file for a refund in accordance with the limitations periods set forth in the Internal Revenue Code. 640 In affirming the Bankruptcy Court s finding of subject matter jurisdiction, the District Court relied on In re Kearns, a case which was not considered by the Bankruptcy Court. 641 After an extensive discussion of the holding in In re Kearns, the District Court stated the following: In the instant case, the Internal Revenue Service has committed itself to expending resources by filing its proof of claim with the Bankruptcy Court, and has made itself subject to the claims for setoff and refunds requested by the Trustee. Once the IRS has committed itself to expending resources to resolve the taxpayer s liability for the year in question, no additional burden is levied by arming the bankruptcy court with jurisdiction to order a refund should those liability issues be resolved in favor of the taxpayer. Michaud, 206 B.R. at 5. Therefore, this court finds that the F.3d at 711 (citations refs. omitted) F.3d. at 711; cf. In re Farmland Industries, Inc., 336 B.R. 415 (Bankr. W.D. Mo. 2005) ( [T]his court concludes that 505(a)(2)(B) requires compliance with the procedures of the applicable taxing authority as a condition to the bankruptcy court s authority to determine the merits of a debtor s request for tax refunds in all situations other than the narrow exception presented in Kearns. ) B.R. 404 (S.D. Miss. 2000) B.R. at B.R. at B.R. at v.2 126

136 Bankruptcy Court properly exercised subject matter jurisdiction over the refund question in the instant case. 642 There is some question as whether a majority of courts will follow In re Kearns. In In re Constable Terminal Corp., 643 the debtor sought to offset overpaid local property taxes for the 1991 through 1994 tax years against subsequent taxes billed by the local taxing authority, and requested a refund of any excess. 644 Prior to filing the adversary proceeding, the debtor had not filed a tax appeal or request for refund for the years for which it sought an offset or refund. 645 The local taxing authority argued that the bankruptcy court did not properly request a refund from the local taxing authority as required by Section 505(a)(2)(B)(i). 646 The Bankruptcy Court concluded that Section 505(a)(2)(B) prohibits a court from adjudication of an untimely or otherwise jurisdictionally defective request for a tax refund. With respect to Constable Terminal s offset argument, the bankruptcy court was persuaded by the analysis in Dunhill Med. and finds it equally applicable to claims for refunds or credits with respect to real property taxes. Though the request for a refund may be treated as an offset to the proof of claim filed by the taxing authority it must be a timely request. 647 Constable Terminal s request for a refund was untimely and therefore the Court denied it. 648 On appeal, the district court affirmed the bankruptcy court s decision. In so doing, the district court rejected Constable Terminal s offset argument, stating that Congress did not adopt the Senate s draft of 505. Although the language contained in the Senate s version of 505 was more favorable to Constable s argument because it provided that a bankruptcy court could issue a refund to a debtor if it resulted from an offset or counterclaim, the final version of 505, which was deemed a compromise by Congress, contains no language which carves out an exception for refunds based on an offset or counterclaim to a claim or request for payment by a governmental unit. 649 In Custom Distribution Services, Inc., 650 the debtor sought to offset due and unpaid local property taxes and sewer and water charges for the 1995, 1996 and 1997 years against excess taxes paid in the years 1992, 1993 and The Third Circuit Court of Appeals held that where a refund is sought as an offset, no claim need be filed first with the taxing B.R. at Constable Terminal Corp. v. City of Bayonne, 222 B.R. 734 (Bankr. D.N.J. 1998), aff d, 246 B.R. 181 (D.N.J. 2000), aff d without opn., 281 F.3d 220 (3d Cir. 2001) B.R. at B.R. at B.R. at B.R. at B.R. at B.R. at 185 (emphasis in original). 650 Custom Distrib. Servs. v. City of Perth Amboy Tax Assessor (In re Custom Distrib. Servs., Inc.), 224 F.3d 235 (3 rd Cir. 2000) F.3d at , v.2 127

137 authority. 652 The Court relied on the legislative history to Section 505(a)(2)(B), 653 prior case law, 654 and Collier on Bankruptcy. Consistent with the decision in Dunhill, the Custom Distribution Services court said the debtor must comply with the taxing authority s timeliness requirements. Since the debtor had not claimed a credit within the time required by the New Jersey statute, the debtor s claim for offsets based on overpayments was time-barred. 655 In In re Armstrong, 656 Armstrong filed his 1984 federal tax return in September of That return resulted in an assessment against him for the amount of $140, Armstrong agreed with the Revenue Service to an extension of the statute of limitations on assessment for the 1984 tax year. The terms of the agreement provided that it would terminate with the assessment of additional taxes. The agreement also provided the taxpayer could file a claim for refund at any time up to six months after the extended assessment period ended. 657 Armstrong filed for bankruptcy under Chapter 11 on September 1, (The action was later converted into a Chapter 7 proceeding.) The extended assessment period for the 1984 tax year was still open at that time. The IRS filed a proof of claim for unpaid taxes, including those thought owed for the 1984 tax year, on October 5, The bankruptcy court discharged Armstrong from bankruptcy on March 26, 1990, although the Chapter 7 proceeding itself continued. 658 Taking the view that his discharge lifted a stay on assessment against Armstrong, the IRS made an additional assessment following notice of deficiency in the amount of $532,726 for the 1984 tax year on January 2, The IRS levied and collected $140, against that amount. According to Armstrong s agreement with the Service, Armstrong would have had six months, F.3d at Cong. Rec. H. 11, (daily ed. Sept. 28, 1978), S (daily ed. Oct. 6, 1978) (Remarks of Rep. Edwards and Sen. DeConcini) ( The House amendment adopts the rule of the Senate bill that the bankruptcy court can, under certain conditions, determine the amount of a tax refund claim by the trustee. Under the House amendment, if the refund results from an offset or counterclaim to a claim or request for payment by the Internal Revenue Service, or other tax authority, the trustee would not first have to file an administrative claim for refund with the tax authority. ). 654 See United States v. Kearns, 177 F.3d 706, 711 (8th Cir. 1999) (noting that legislative history of section 505 indicates different treatment of refunds and offsets); In re Ledgemere Land Corp., 135 B.R. 193, 198 (Bankr. D. Mass. 1991) ( Where, as here, refunds are sought as an offset or counterclaim to the claim of the taxing authority, no refund claim need first be made.); In re Constable Terminal, 222 B.R. 734, 741 (Bankr. D.N.J. 1998) (applying Dunhill reasoning to request for offset of New Jersey real estate taxes), aff d, 246 B.R. 181 (D.N.J. 2000), aff d without opn., 281 F.3d 220 (3d Cir. 2001); St. John s Nursing Home v. City of New Bedford (In re St. John s Nursing Home), 169 B.R. 795, 797 n. 4 (D. Mass. 1994) (same) F.3d at United States v. Neary (In re Armstrong), 206 F.3d 465 (5 th Cir. 2000) F.3d at F.3d at v.2 128

138 or until July 2, 1991, to file a claim for a full refund of taxes paid for Neither Armstrong nor the bankruptcy trustee filed a refund claim within that six-month period. 659 On November 14, 1991, the IRS filed an amended proof of claim against the bankruptcy estate of which $338,510 pertained to the 1984 tax year. The bankruptcy court denied the IRS proof of claim relating to 1984 taxes in March In May of 1993, Armstrong filed an adversary proceeding against the United States in which he substantiated losses which, when carried back to the 1984 tax year, reduced his 1984 tax liability to $14,758. Armstrong therefore argued that he was entitled to a refund of the $140, which he had paid for 1984 taxes since his discharge from bankruptcy. The United States argued that Armstrong had failed to satisfy the procedural requirements contained in I.R.C. 7422(a) and 6511, governing the filing of refund claims. 661 In March of 1995, Armstrong filed an administrative claim for refund with respect to the 1984 taxes. The IRS conceded that Armstrong was entitled to any payments made for the 1984 tax year in the two years prior to filing the administrative claim, under I.R.C. 6511(b)(2)(B). The Government further stipulated that with the carryback of operating losses, Armstrong s adjusted tax liability for 1984 was only $14,758. The bankruptcy court found that Armstrong s 1993 initiation of an adversary proceeding constituted an informal refund claim and that he was therefore entitled to refund of all money paid in the two years previous to the commencement of that action. Armstrong therefore received a refund of $140, i.e. the amount collected post-discharge for his 1984 taxes. 662 On December 20, 1996, the trustee in Armstrong s Chapter 7 bankruptcy filed an administrative claim, seeking a refund of the amounts in excess of the recently stipulated 1984 tax liability that Armstrong had paid prior to filing for bankruptcy. On April 22, 1997, the trustee filed an adversary proceeding against the United States in the bankruptcy court, seeking the same refund as in his administrative claim. The United States moved to dismiss or, in the alternative, for summary judgment on the grounds that the trustee s refund claim was filed too late, i.e. after July 2, 1991 (six months after the final assessment of taxes against Armstrong for the 1984 tax year). The trustee argued that he was not bound by the statute of limitations for refund claims in the Internal Revenue Code because of the automatic stay provisions under the Bankruptcy Code, and that even if his refund claim was not timely, the automatic turnover provision in the Bankruptcy Code would require the Government to refund the overpaid amount once that amount was certain. 663 The bankruptcy court held that the trustee had not filed a timely refund claim but that the estate was nonetheless entitled to a refund under the automatic turnover provision in 11 U.S.C F.3d at F.3d at F.3d at F.3d at F.3d at v.2 129

139 542(a). The United States appealed to the district court, which affirmed the judgment of the bankruptcy court. The United States appealed to the Fifth Circuit Court of Appeals. 664 After concluding that 11 U.S.C. 362 does not toll the statute of limitations for the filing of a refund claim by a bankruptcy trustee, the Fifth Circuit Court of Appeals, in a case of first impression for the Circuit, considered the trustee s argument that it was unnecessary for him to file a refund claim under I.R.C because the automatic turnover provision of 11 U.S.C. 542(a) required the IRS to return Armstrong s pre-filing overpayment to the trustee as soon as the amount of overpayment became certain. According to this theory, the IRS would have had to turn over the overpayment when it entered the stipulation with Armstrong in The Fifth Circuit, while conceding that the issue involved a close case and that there was no directly controlling precedent, disagreed with the bankruptcy court s holding that a stipulation by the Government to the amount of overpayment exempts the trustee from the filing requirements in I.R.C The Court stated that a proper request for refund under the Internal Revenue Code requires compliance with Sections 7422 and 6511 of the Code. The Court nevertheless harmonized the two statutes. 667 The Court said that a trustee acquires the same right to file a refund claim that the debtor had... Because that right is created and circumscribed by 6511 and nothing explicitly changes its terms, 542(a) cannot be read to expand the right to file for a refund to give the trustee unlimited time so long as the bankruptcy continues. 668 The Fifth Circuit concluded that Bankruptcy Code 542(a) does not in itself, or with the coincidence of a stipulation as to amount of overpayment, abrogate the overall statutory scheme requiring compliance with non-bankruptcy statutes of limitations. 669 In In re Armstrong, the Fifth Circuit Court of Appeals observed in a footnote that the holding in Kearns is limited to its narrow set of facts. 670 The Court stated: The Eighth Circuit recently considered a case raising the question of whether a bankruptcy trustee must comply in all circumstances with I.R.C and See United States v. Kearns, 177 F.3d 706 (8th Cir. 1999). The Eighth Circuit panel held that 6511 and 7422 did not deprive a bankruptcy court of jurisdiction to determine tax liability for a particular year where a live proof of claim by the IRS was before it and consideration of an alleged later repayment of embezzled funds was necessary to decide the validity of the proof of claim. While we express no opinion on our sister court s determination of the merits of that case, we do note that its holding was limited to its narrow set of facts. More importantly, there was a live claim by the IRS before the bankruptcy court and according to the panel s interpretation of the facts, it would be without purpose and irrational to deprive the bankruptcy court of jurisdiction to consider the deduction claims. See id. at 711. The decision did not address the relationship between I.R.C and Bankr. Code F.3d at F.3d at F.3d at F.3d at F.3d at F.3d at See United States v. Neary (In re Armstrong), 206 F.3d 465, 471 n.3 (5 th Cir. 2000) v.2 130

140 542(a). The Eighth Circuit s holding, thus limited to its unique facts, does not inform our resolution of the case before us. The trustee in Armstrong also argued that by filing a proof of claim in the bankruptcy court that related in part to 1984 taxes, the Revenue Service waived both sovereign immunity and the statute of limitations as to any dispute over that year s taxes. The trustee argued that because the Service put 1984 taxes in issue by filing a proof of claim, he had no need to file a separate refund claim in order to attain a refund of overpaid taxes. He further argued that his refund claim arose as a compulsory counterclaim and therefore was not subject to the statute of limitations contained in I.R.C The United States countered that under the Bankruptcy Code, a proper refund claim is a jurisdictional prerequisite to consideration of any refund due, that sovereign immunity and limitations were not expressly waived and therefore still applied, and that the trustee s refund claim does not constitute a counterclaim in any event and therefore could not possibly provide a route around the limitations period contained in The Court found that the trustee s claim was filed too late to constitute a counterclaim and, because it was filed after the IRS proof of claim had been denied, any arguable waiver of sovereign immunity or the statute of limitations would be unavailable. 671 Although not addressing the question directly, the Court stated that the law is clear that a compulsory counterclaim shall not be used to expand claims against the United States beyond their limits as already established by law... The trustee would be entitled to raise the issue of any refund due as a defense to the IRS proof of claim relating to the 1984 tax year... Failure to adhere to the administrative filing requirements and the statute of limitations could still be a jurisdictional bar to acquiring affirmative relief, however. 672 In light of the uncertain state of the case law, where a refund is sought as an offset, taxpayers would be well advised to monitor closely the claim requirements of the Service and, to the extent possible, file protective claims on a timely basis to preserve all rights before the Service. In a recent 2008 bankruptcy case, In re Rodriguez, 673 the Bankruptcy Court in the Eastern District of New York, the Trustee in a Chapter 7 bankruptcy, as a defense and counterclaim to a proof of claim filed by the IRS for the 1996 tax year, asserted refund claims against the IRS for overpayment of 1995 and 1996 federal income taxes. The Court concluded that where refunds are sought as an offset or counterclaim to a proof of claim filed by the IRS or other taxing authority, an amended tax return need not be filed first with the taxing authority. Accordingly, the Court determined that the Trustee s refund requests with respect to the 1995 and 1996 tax years contained in his Initial Claims Objection and Renewed Claims Objection constituted proper informal requests for a refund. The Court then considered whether the Trustee s refund claim was time barred. After noting that the courts in various circuits have differed on whether the debtor or the trustee needs to make its request for a refund or offset within the prescribed statutory period set forth in I.R.C is jurisdictional with respect to any untimely refund F.3d at F.3d at B.R. 76 (Bankr. E.D.N.Y. 2008) v.2 131

141 claim asserted as a counterclaim to an IRS proof of claim.. The Court declined to follow Kearns, noting that unique facts and circumstances were present in Kearns. b. Refund Suit. (1) Application of Statute of Limitations. In IRS v. Pransky, 674 the Federal District Court for the District of New Jersey applied the two-year statute of limitations in I.R.C. 6532(a) in a bankruptcy setting. Pransky filed tax returns for the 1984 through 1986 tax years on December 11, 1991, and a return for 1987 on July 20, Pransky claimed overpayments on his 1984 and 1985 tax returns, and sought to apply those amounts to his 1986 and 1987 tax liabilities. The IRS disallowed the requested credits from the 1984 and 1985 tax returns on February 20, 1992, and March 9, 1992, respectively, on the grounds that the claims were untimely pursuant to Section No disallowance was ever sent for the 1986 tax claim. In 1997, the debtor filed for bankruptcy. The IRS timely filed a proof of claim for the 1987 tax year and the debtor instituted an adversary proceeding seeking to determine his tax liability for the 1984 through 1987 tax years. The debtor contended that the overpayments for 1984 and 1985 should be applied to the liability asserted by the Revenue Service for the 1987 tax year. 675 The Revenue Service argued that the claims were untimely pursuant to Section and that the suit to recover the refunds was untimely pursuant to I.R.C. 6532(a) because it was filed more than 2 years after the Service denied the claims for refund for the 1984 and 1985 tax years. 677 The Revenue Service therefore argued that the bankruptcy court did not have jurisdiction to determine the validity of the Government s proof of claim to the extent that it involved 1984 and The bankruptcy court determined that Pransky s claims for refund were not time-barred under Section 6511 and that therefore the debtor submitted viable refund claims. 679 The court did not address the statute of limitations issue created by Section 6532(a). 680 The Government appealed to the District Court. The District Court determined that [t]he lawsuit initiated by Pransky after the IRS filed its proof of claim must be subjected to the two year statute of limitation found in 26 U.S.C. 6532(a)(1), and is barred to the extent it involved 1984 and Thus, the Bankruptcy Court lacked the necessary jurisdiction to adjudicate the debtor s refund suit for those tax years. 681 The Court was not persuaded by appellee s argument that in the context of his bankruptcy, the debtor may raise otherwise time barred issues as a defense or counterclaim to the Government s proof of claim. It is clear that the B.R. 380 (D.N.J. 2001), aff d in part and remanded, 318 F.3d 536 (3rd Cir. 2003) B.R. at B.R. at B.R. at B.R. at 383, B.R. 478, 485 (Bankr. D.N.J. 1999) B.R. at B.R. at v.2 132

142 statute of limitations created by specific provisions of the tax code are applicable to bankruptcy proceedings. 682 The District Court s decision in Pransky was affirmed by the Third Circuit Court of Appeals. 683 The Third Circuit determined that to the extent Pransky s adversary suit filed in 1998 seeks consideration of Pransky s 1984 and 1985 tax liabilities, the suit is subject to the twoyear limitation period of I.R.C. 6532, which began to run in 1992 when the Revenue Service sent notices of disallowance for Pransky s requests for refund. Accordingly, the Court concluded that the adversary suit was not timely filed and the District Court correctly held that the Bankruptcy Court did not have jurisdiction over Pransky s 1984 and 1985 taxes. The Third Circuit also concluded that although a bankruptcy court may generally use tax overpayments to offset a deficiency in a proof of claim filed by the IRS, it may do so only if each year at issue falls within the Internal Revenue Code s time requirement for refund of overpaid tax because the timeliness of a refund claim is jurisdictional. Since Pransky did not timely file his suit to recover 1984 and 1985 tax overpayments, the Bankruptcy Court does not have jurisdiction to offset those overpayments against his 1987 tax deficiencies. (2) Debtor Actions Under Section 505(a)(2)(B). The Fifth and Sixth Circuit Courts of Appeal have both rejected arguments from the Government that Section 505(a)(2)(B) is limited to actions brought by a trustee acting on behalf of the estate. In Luongo v. United States, the Fifth Circuit concluded that the bankruptcy court has jurisdiction to consider a debtor s claim to recover an income tax overpayment. The Court rejected the argument of the IRS that the language of Section 505(a)(2)(B) precludes a bankruptcy court from deciding the personal tax liability of the debtor. The Service relied on the inclusion of the terms the estate and the trustee to argue that Section 505 contemplates that only a trustee may obtain a tax refund in bankruptcy court, and then only if the trustee is seeking a refund on behalf of the estate. 684 After observing that the IRS reading of this subsection is contrary to the broad grant of jurisdiction in Section 505(a)(1), the Court stated that the legislative statements accompanying Section 505 make clear that the section authorizes the bankruptcy court to rule on the merits of any tax claim involving an unpaid tax, fine, or penalty relating to a tax, or any addition to a tax, of the debtor or the estate. 685 The Court said that the IRS cited no case supporting its restrictive reading of the bankruptcy court s jurisdiction under Section 505 and that, on the contrary, absent the express statutory limitations in Section 505(a)(2)(A) and (B), B.R. at AFTR 2d (3 rd Cir. 2001); see also In re Smythe, 93 AFTR 2d (Bankr. N.D. Ohio 2004) (follows Pransky and finds untimely motion to determine tax liability) F.3d at F.3d at 328; see 124 Cong. Rec. H (daily ed. Sept. 28, 1978) (remarks of Rep. Edwards introducing the House amendment) (emphasis added), H. Rep. No , reprinted in 1978 U.S.C.C.A.N. 5963, 6436, And under the paragraph heading Jurisdiction of the tax court in bankruptcy cases, the legislative statements instruct that the bankruptcy judge will have authority to determine which court will determine the merits of the tax claim both as to claims against the estate and claims against the debtor concerning his personal liability for nondischargeable taxes. 124 Cong. Rec (1978) (Statement of Representative Edwards), H. Rep. No , reprinted in 1978 U.S.C.C.A.N. 6436, ; 124 Cong. Rec (1978) (Statement of Senator DeConcini), reprinted in 1978 U.S.C.C.A.N. 6505, v.2 133

143 bankruptcy courts have universally recognized their jurisdiction to consider tax issues brought by the debtor, limited only by their discretion to abstain. In In re Gordon Sel-Way, Inc., 686 the Sixth Circuit Court of Appeals affirmed the District Court s decision that a debtor is allowed to institute an action under Section 505(a)(2)(B) in the bankruptcy court. The Sixth Circuit relied upon the broad language of Section 505(a), legislative history and the Fifth Circuit decision in Luongo. 687 In Schroeder v. United States, 688 the U.S. bankruptcy court for the Central District of Illinois, following the decisions in Luongo and In re Gordon Sel-Way, Inc., allowed a liquidating agent to bring a claim under Section 505(a)(2)(B). The Court rejected the Government s argument that Section 505(a)(2)(B) was restricted to claims brought by a trustee acting on behalf of an estate. The Court stated that the Government s argument had no application to the case since the liquidating agent was acting for the benefit of the estate and any recovery would inure to the benefit of the debtor s unsecured creditors under the confirmed plan. The Court also stated that the confirmation order gives the liquidating agent all of the rights of a debtor in possession under Section 1107 and, under that provision, a debtor in possession is given all of the rights of a trustee. 689 F. Section 505(b). Section 505(b) of the Bankruptcy Code, as amended as shown below in italics by the 2005 Bankruptcy Act, provides as follows: (b) (1) (A) The clerk shall maintain a list under which a Federal, State or local governmental unit responsible for the collection of taxes within the district may subsection; and (i) designate an address for service of requests under this 686 Gordon Sel-Way, Inc. v. United States (In re Gordon Sel-Way), 270 F.3d 280 (6 th Cir. 2001) F.3d at Schroeder v. United States (In re Van Dyke), 275 B.R. 854 (Bankr. C.D. Ill. 2002) B.R. at ; see also In re PT-1 Communications, Inc. 103 AFTR 2d (Bankr. E.D. NY 2009) ( The IRS s argument that 505 claims may only be brought pre-confirmation by a trustee in bankruptcy has been rejected by a number of courts. See Gordon Sel-Way, 270 F.3d at ; Van Dyke, 275 B.R. at , 861. See also I.R.S. v. Luongo ( In re Luongo), 259 F.3d 323, (5th Cir.2001) (a debtor may bring a claim under 505, and such a claim is not restricted to bankruptcy trustees). The Gordon Sel-Way and Van Dyke courts found that the IRS s argument to restrict Bankruptcy Code 505(a)(2) to bankruptcy trustees seems inconsistent with the broad language of 505(a) which allows the bankruptcy court to determine the amount or legality of any tax, any fine or any penalty relating to a tax, or any addition to a tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. Gordon Sel-Way, 270 F.3d at 285 (quoting 11 U.S.C. 505(a)); Van Dyke, 275 B.R. at 858 (quoting 11 U.S.C. 505(a)). Those courts also found support for their conclusion in the legislative history of 505, which indicates that 505 was not intended to restrict the bankruptcy court jurisdiction to claims of trustees over property of the estate. Gordon Sel-Way, 270 F.3d at 285. This Court adopts the reasoning of these courts, and rejects the IRS s argument. ) v.2 134

144 (ii) describe where further information concerning additional requirements for filing such requests may be found. (B) If such governmental unit does not designate an address and provide such address to the clerk under subparagraph (A), any request made under this subsection may be served at the address for the filing of a tax return or protest with the appropriate taxing authority of such governmental unit. 690 (b2) A trustee may request a determination of any unpaid liability of the estate for any tax incurred during the administration of the case by submitting a tax return for such tax and a request for such a determination to the governmental unit charged with responsibility for collection or determination of such tax at the address and in the manner designated in paragraph (1). Unless such return is fraudulent, or contains a material misrepresentation, the estate, the trustee, the debtor, and any successor to the debtor are discharged from any liability for such tax (1A) upon payment of the tax shown on such return, if (Ai) such governmental unit does not notify the trustee, within 60 days after such request, that such return has been selected for examination; or (Bii) such governmental unit does not complete such an examination and notify the trustee of any tax due, within 180 days after such request or within such additional time as the court, for cause, permits; (2B) upon payment of the tax determined by the court, after notice and a hearing, after completion by such governmental unit of such examination; or due. (3C) upon payment of the tax determined by such governmental unit to be Section 505(b) allows trustees to request a determination of any unpaid tax liability from the appropriate governmental unit, and provides that, unless that entity notifies the trustee within 60 days that the return has been selected for examination, the trustee, the debtor, and any successor to the debtor are discharged from any liability for such tax unless the return is fraudulent or contains a material misrepresentation. 691 Revenue Procedure provides the procedure to be followed in obtaining a prompt determination by the Service of any unpaid tax liability of the estate incurred during the administration of the case. Section 703 of the 2005 Bankruptcy Act amended section 505(b) of the Bankruptcy Code to require the clerk of each district to maintain a list of addresses designated by governmental units for service of section 505 requests. In addition, the list may also include information concerning filing requirements specified by such governmental units. If a governmental entity does not designate an address and provide that address to the bankruptcy court clerk, any request 690 The amendments to Section 505(b) are effective on October 17, U.S.C. 505(b); see, e.g., In re Estes, 87 B.R. 52, 54 (M.D. Tenn. 1988) ( In that the interest, penalties and additional taxes arising from an alleged arithmetical error are all defined as taxes, the trustee and the debtors herein are entitled to a discharge of liability with regard to such items. ) C.B v.2 135

145 made under section 505(b) of the Bankruptcy Code may be served at the address for the filing of a tax return or protest of the appropriate taxing authority of that governmental unit (b) applies to any unpaid liability of the estate for any tax incurred during the administration of the case. 694 In In re Vale, 695 the court held that 505(b) only applies to postpetition administrative taxes of the estate. The legislative history to 505(b) in the form of the House Report, clearly indicates that the purpose of this section is to protect the trustee from personal liability for a tax falling on the estate that is not assessed until after the case is closed... The final order of the Court and the payment of the tax determined, in that order, discharges the trustee, the debtor, and any successor to the debtor from any further liability for the tax. 696 It has been held that a Chapter 7 Trustee s proper filing of an expedited audit request bars the IRS from collecting any penalty or interest for that tax year, even though the tax return was untimely filed, where the IRS did not send a statutory examination notice to the Trustee as required by 505(b). 697 Prior to the amendments made by the 2005 Bankruptcy Act, 505(b) stated that if that provision is complied with by the Trustee, the trustee, the debtor, and any successor to the debtor are discharged from any liability for such tax. The language in Section 505(b) did not expressly discharge the estate from liability for the tax. The majority of courts that considered the issue, including the Fifth Circuit Court of Appeals, held that if the IRS does not respond to a prompt determination request pursuant to 505(b), the trustee, the debtor, and the debtor s successors, if any, are discharged from liability for the tax, but the estate itself is not discharged from the tax H.R. Rep. No , at 100 (2005). 694 In re Vale, 204 B.R. 716, 725 (Bankr. N.D. Ind. 1996) B.R In re Vale, 204 B.R. at 725 (citing H.R. Rep. No. 595, 95th Cong., 1st. Sess. 356 (1977)). 697 In re Carie Corp., 128 B.R. 266, 269 (D. Alaska. 1989) ( In the final analysis, however, the court is persuaded by the plain meaning and purpose of Section 505(b). There is a clear congressional policy embodied therein that the IRS must promptly respond to expedited audit requests so that the closing out of bankrupt estates may be more efficiently accomplished... Failure to so respond results in discharge of the trustee and debtor from any liability for the tax year If, as Judge Luckey and this court have concluded, the trustee s expedited audit request were properly filed, then the IRS is barred from collecting any penalty or interest for the 1984 tax year when the statutory examination notice was not sent to the trustee. [citation refs. omitted]); see In re Estes, 87 B.R. at 53 (personal liability of the trustee and the debtors for penalties and interest for income tax returns filed late, and for additional taxes arising from an alleged mathematical error, was terminated because the trustee had complied with all of the requirements of 11 U.S.C. 505(b)). 698 In re Vale, 204 B.R. at 726 ( [T]he application of the plain language of 505(b) indicates that it does not in any way purport to discharge the bankruptcy estate from any tax liability, as opposed to the trustee or the debtor personally. ); United States v. Grassgreen (In re Grassgreen), 221 B.R. 975, 977 (Bankr. M.D. Fla. 1998) ( [T]his position [that 505(b) does not authorize a discharge of the estate itself] is supported not only by the language of the statute, but also by the weight of authority construing it. ); In re Goodrich, 215 B.R. 638, 642 (Bankr. D. Mass. 1997) ( In the absence of useful legislative history, and absent a conflict with any other section of the Code, the controlling principle must be the plain language rule... For this narrow purpose only, I conclude that the discharge granted by 505(b) does not extend to the estate, as distinguished from the trustee. ); Kellogg v. United States., 155 B.R. 399, (Bankr. N.D. Tex. 1993), aff d, 54 F.3d 1194, (5 th Cir. 1995) ( [T]he clear v.2 136

146 Section 715 of the 2005 Bankruptcy Act amended section 505(b) of the Bankruptcy Code to clarify that the estate is also protected if the government does not make a determination or request an extension of time to audit the debtor s tax returns. Therefore, if the government does not make a determination of postpetition tax liabilities or request extension of time to audit, then the estate s liability for unpaid taxes is discharged. 699 distinction between the estate and successor to the debtor demonstrates that Congress did not intend for the discharge of tax liability under 505(b) to apply to the estate. ); In re Fondiller, 125 B.R. 805, 808 (N.D. Cal. 1991) ( [I]f the claim is otherwise timely made, 505(b) does not preclude the claim from being allowed against the estate. ); In re Rode, 119 B.R. 697, 699 (Bankr. E.D. Mo. 1990) (the legislative history discusses only discharge of the trustee and the debtor. Furthermore, this Court s examination of the entire legislative history revealed nothing which would lead it to believe that Congress intended the estate to be considered a successor to the debtor that would be discharged from further tax liability under section 505(b). ); but see In re Flaherty, 169 B.R. 267, 270, n. 4 (Bankr. D.N.H. 1994) ( Although the actual wording of subsection (b) of the statute is the trustee, the debtor, or any successor to the debtor are discharged from any liability for such tax, in my opinion this language effectively discharges the estate of the tax, as well, as pertains to a post-petition administrative tax liability. To the extent that the Fondiller court and the Rode court can be read to the contrary, I do not find those decisions persuasive given the realities of the situation. There simply is no remaining entity, other than some metaphysical ghost-like estate holding no assets and having no fixed location in space, that could be possibly be involved with the tax liability. ). 699 H.R. Rep. No ,at 103 (2005) v.2 137