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RECOMMENDED FOR FULL-TEXT PUBLICATION 24 Friedman, et al. v. Commissioner No. 98-2378 Pursuant to Sixth Circuit Rule 206 ELECTRONIC CITATION: 2000 FED App. 0195P (6th Cir.) File Name: 00a0195p.06 COD income for the 1992 taxable year. Accordingly, we AFFIRM the judgment of the Tax Court. UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT _________________ ;  MICHAEL FRIEDMAN, et al.,  Petitioners-Appellants,   No. 98-2378 v.  > COMMISSIONER OF INTERNAL   Respondent-Appellee.  REVENUE,  1 On Appeal from the United States Tax Court. Nos. 96-18735, 96-18736. Argued: December 17, 1999 Decided and Filed: June 8, 2000 Before: BOGGS and NORRIS, Circuit Judges; NUGENT, District Judge.* * The Honorable Donald C. Nugent, United States District Judge for the Northern District of Ohio, sitting by designation. 1 2 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 23 _________________ evidence shows that the bankruptcy trustee was actively administering New Manchester’s estate well into 1995, COUNSEL collecting and disbursing monies. Moreover, some of New Manchester’s creditors were, in fact, actively pursuing ARGUED: Joseph P. Alexander, ROETZEL & ANDRESS, payment owed them as evidenced by the fraudulent Cleveland, Ohio, for Appellants. Teresa E. McLaughlin, U.S. conveyance claim filed in December, 1992. DEPARTMENT OF JUSTICE, APPELLATE SECTION TAX DIVISION, Washington, D.C., for Appellee. In view of all the circumstances, this Court finds that no ON BRIEF: Joseph P. Alexander, J. Timothy Bender, identifying event occurred in 1992 to fix the date of discharge ROETZEL & ANDRESS, Cleveland, Ohio, for Appellants. of indebtedness in that year. The absence of anything in the Teresa E. McLaughlin, Ann Belanger Durney, Paula K. record, including the stipulation of the facts by both Speck, U.S. DEPARTMENT OF JUSTICE, APPELLATE Commissioner and Taxpayers, even suggesting an identifiable SECTION TAX DIVISION, Washington, D.C., for Appellee. event in 1992, satisfies Commissioner’s burden in that regard. Accordingly, the Tax Court did not commit clear error in _________________ finding that a discharge of indebtedness did not occur during the 1992 taxable year. OPINION _________________ IV. Stock Basis of Shareholders in S Corporation NUGENT, District Judge. The Commissioner of Internal Taxpayers also contend that the income from the discharge Revenue (hereinafter “Commissioner”) issued notices of tax of indebtedness passes through to them as shareholders of deficiencies to Michael and Madeline Friedman and Edward New Manchester, an S corporation. As a result, Taxpayers and Deborah Rosenthal1 (hereinafter “Taxpayers”) for the contend, the basis of their stock in New Manchester increases. years 1989 and 1990. The notices stated that Taxpayers were Because the Court found herein that Taxpayers did not realize not entitled to a loss in the amount of $5,055,116. As a discharge of indebtedness, or COD income, in 1992, there shareholders of an S corporation, Taxpayers made claims for is no need to address the pass-through issue at this time. net operating losses of their S corporation, New Manchester, Should Taxpayers, however, wish to claim the COD income by using the corporation’s 1992 discharge of indebtedness for a different year, they can refer to Gaudiano v. income (a.k.a. “COD income”) to increase their stock basis, Commissioner, No. 99-1294, in which this Court decided the and then in turn, using the increased basis to claim net issue concerning a shareholder’s COD income and his stock operating losses from prior years. The Commissioner denied basis, for guidance. Taxpayers’ claims for net operating loss deductions, determining that COD income of an insolvent S corporation Conclusion cannot be used to increase the shareholders’ basis. In sum, the Court finds that the Tax Court did not commit clear error in holding that New Manchester did not realize 1 Appellants’ counsel filed notice with the Court that Michael demonstrate that the debts were, in fact, discharged. Cozzi, 88 T.C. at Friedman passed away recently; however, counsel stated that Mr. 445. In this case, there was no such event. This Court agrees with the Friedman’s death would not affect the continuation of this matter. Tax Court’s disposition in that regard. 22 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 3 couple of years. Such activity included collecting accounts Taxpayers petitioned the United States Tax Court for receivable, seeking buyers for saleable assets, and filing redetermination of the tax deficiencies. The Tax Court periodic reports with the bankruptcy court concerning assets, upheld the deficiencies, holding that there was no discharge receipts, and disbursements. In fact, in addition to a report of indebtedness income during the relevant tax year, and thus, filed in August of 1992, the trustee filed reports with the court New Manchester did not realize COD income for the 1992 in January, 1993, and January, 1995. Moreover, the trustee taxable year. Further, the Tax Court held that even if the S filed his Final Report on November 30, 1995. The report corporation had realized COD income for 1992, such income included a “Cash Receipts and Disbursement Record” which does not increase the basis of the shareholders. identified numerous transactions in New Manchester’s bank accounts throughout 1994 and 1995. The trustee filed a Taxpayers filed this timely appeal. For the reasons that Supplemental Final Report in 1996. follow, we AFFIRM the decision of the Tax Court. Further evidence that a discharge had not occurred in 1992 Factual and Procedural Background is the fraudulent conveyance claim filed in December, 1992, by several of New Manchester’s creditors for $11 million. Appellants Michael Friedman and Edward Rosenthal were The trustee obtained independent counsel to investigate the shareholders in an S corporation known as Manchester Steel, claim in September, 1993. While Taxpayers initially offered Inc.2 (a.k.a. New Manchester). Madeline Friedman and $300,000 in February of 1994, to settle the creditors’ claim, Deborah Rosenthal, spouses of Michael Friedman and this offer was refused by the bankruptcy court. The claim was Edward Rosenthal, respectively, were not shareholders of eventually settled on or about April 11, 1995, for $2.2 New Manchester; however, they are parties in this case solely million. These facts demonstrate that not only was the by virtue3 of having filed joint tax returns with their fraudulent conveyance claim still pending after 1992, but the husbands. value of the claim was in dispute well into 1995. Thus, because the value of the claim was uncertain in 1992, the New Manchester is a steel service company which actual amount New Manchester’s estate would realize from processes and distributes flat rolled steel and other related the claim was not ascertainable in that year. Therefore, the products. It was incorporated on April 17, 1990, and it had total debt that would be discharged could not have been elected to be taxed as an S corporation under Subchapter S of discerned in 1992. the Internal Revenue Code. Mr. Friedman and Mr. Rosenthal each owned 97.5 shares of New Manchester. Their individual In light of the above, regardless of how improbable it was that all of, or any of, New Manchester’s outstanding liabilities would be paid, the fact remains that no identifying event 2 A Subchapter S corporation is a small corporation that has elected, occurred from which this Court can determine the debt was under the Internal Revenue Code (“IRC”), to be taxed similarly to discharged.8 See Cozzi, 88 T.C. at 445. On the contrary, the partnerships. When a corporation has elected to be taxed under Subchapter S, the corporation itself is not subject to income tax. Rather, the income tax is imposed directly on the shareholders on a pro rata basis. In other words, the corporation’s income “passes through” to the 8 shareholders, who then report that income on their individual tax returns. Taxpayers also argue that by virtue of New Manchester’s insolvency, as effectively stipulated by the parties, there was a de facto See 26 U.S.C. §1366. discharge, pursuant to 26 U.S.C. §108(a)(1)(B). While it may be true that 3 because of New Manchester’s insolvency its liabilities would unlikely be Hereafter, “Taxpayers” shall refer to Michael Friedman and Edward paid, the result is the same. There must be some identifiable event to Rosenthal. 4 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 21 percentage stock ownership was 24.375%. The remaining therefore, the project (and the loan) was deemed abandoned. shareholders, Vernon Bremberg and Irwin Kramer, each Cozzi, 88 T.C. at 445-447. owned 102.5 shares. Their percentage of stock ownership was collectively 51.250%. While the cases cited above do rely on the importance of, among all the facts and circumstances of the particular case, On or about April 17, 1990, New Manchester acquired the improbability that a debt will actually have to be paid, portions of the assets of Manchester Consolidated Industries, these cases also stand for the proposition that there must also Inc. (a.k.a. Old Manchester), including cash, accounts be some identifiable event which fixes the loss with certainty. receivable, equipment, inventory, land, buildings, See Cozzi, 88 T.C. at 445. The Tax Court considered the improvements, fixtures, goodwill, trade name, and the trade likelihood of payment on the debts in the above cases cited by mark from Old Manchester. New Manchester also assumed Taxpayers; however, as Commissioner correctly notes, both $12.8 million of Old Manchester’s liabilities, including a cases also contain some identifiable event from which the Tax secured trade debt. New Manchester financed such Court determined that a discharge of debt had occurred. In acquisition using the assets purchased from Old Manchester contrast to Cozzi and Fidelity-Philadelphia Trust Co., there is as security. When New Manchester purchased these assets, no identifiable event in the instant matter from which this Old Manchester amended its Articles of Incorporation and Court can determine that a loss was fixed with certainty, or changed its name to E&M Investments Co. that a discharge of debt occurred. New Manchester was not a successful corporation. It As previously stated herein, Taxpayers contend that the suffered significant operating losses due to a variety of stipulated facts in this case demonstrate that as of December, factors. In 1991 and in 1992, New Manchester claimed over 1992, future payment of New Manchester’s prepetition $10 million in losses from its trade or business activities. In indebtedness in excess of $19 million was impossible, and the addition, New Manchester had a number of creditors to whom indebtedness would never be paid. Assuming for the moment it owed in excess of $30 million. As a result of the continuing that it was unlikely that payment towards New Manchester’s losses, on March 3, 1992, an involuntary petition for outstanding debt was possible, the record is devoid of any bankruptcy was filed on behalf of New Manchester pursuant identifying event that established a discharge of the to Chapter 7 of the United States Bankruptcy Code. A trustee indebtedness.7 in bankruptcy, who was authorized to operate New Manchester’s business, was appointed on March 30, 1992. The record demonstrates that not only was the bankruptcy The trustee engaged in a number of activities on behalf of proceeding still pending as of December 31, 1992, the New Manchester, including the following: collecting accounts bankruptcy trustee was actively conducting New receivable, seeking buyers for saleable assets, paying claims, Manchester’s business at that time and well into the next and filing reports with the bankruptcy court. 7 On May 7, 1992, New Manchester filed a schedule of assets Without considering the requirement of an identifiable event, the and liabilities and a statement of financial affairs with the Court notes first, as a technical matter, that according to the United States bankruptcy court. The schedule stated that New Manchester Bankruptcy Code, a “discharge” may not be granted in a chapter 7 possessed tangible assets--real and personal property--valued proceeding to a corporation. 11 U.S.C. §727(a)(1). Section 727(a)(1) states that “[t]he court shall grant the debtor a discharge, unless...the at $9,241,153 and intangible assets--trade name, customer debtor is not an individual.” 11 U.S.C. §727(a)(1). Therefore, New lists, and covenant not to compete--valued at $3,991,457. Manchester, as a corporate debtor, cannot obtain a “discharge” under the chapter 7 petition it filed with the Bankruptcy Court on March 3, 1992. 20 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 5 While the taxpayer bank maintained that it received no The schedule also reported liabilities totaling $30,360,669. income in the year at issue because the bank was still liable in On July 2, 1992, the trustee’s report of sale of New full to the depositors, the Tax Court held that in exercising Manchester’s tangible assets was filed. control over the accounts, the bank realized income with respect to those accounts. The court determined that the act Several of New Manchester’s creditors commenced a of a book entry closing out the accounts with old deposits and proceeding in Bankruptcy Court, on December 10, 1992, placing the money in a surplus account created income in the alleging potential fraudulent conveyances and/or preferential year in which it was done. Fidelity-Philadelphia Trust Co., transfers with respect to New Manchester prior to the filing of 23 T.C. at 530. In reaching its conclusion, the court the petition for bankruptcy. The creditors claimed that such considered the fact that the bank would most likely not have fraudulent conveyances or preferential transfers rendered New to honor its obligations to the depositors in question, and the Manchester insolvent or undercapitalized. The creditors probability of having to make payments to the depositors in sought $11 million from Taxpayers and E&M Investments. the future was slim enough that the income could be The bankruptcy court granted the trustee’s request to obtain determined to be in the year of the book entry. Id. independent counsel to investigate and prosecute such claim in September, 1993. In February, 1994, Taxpayers offered to Taxpayers, in the present case, contend that both Cozzi and settle the creditors’ claim for $300,000. The offer, however, Fidelity-Philadelphia Trust Co. endorse the proposition that upon a motion by the trustee, was refused by the court. the improbability of future payment is the triggering event for Eventually, upon a second motion by the trustee, on April 11, determining the occurrence of a discharge of indebtedness. 1995, the trustee was authorized to settle the claim for $2.2 Taxpayers Br. at 19. As such, because it was clear as of million. December 31, 1992 that New Manchester’s debt of over $19 million would never be repaid, as stipulated by the parties, Throughout the bankruptcy proceeding, the trustee filed such debt must be viewed as having been discharged in that periodic reports with the court concerning assets, receipts, and year. disbursements. Such reports were filed in August of 1992, January of 1993, and January of 1995. On November 30, Taxpayers, however, are only partly correct. In Fidelity- 1995, the trustee filed a final report with the bankruptcy court. Philadelphia Trust Co., the Tax Court considered the The Final Report stated, in part, as follows: improbability of the bank ever having to honor the obligation of its depositors in holding that the bank realized income the All property of the estate, except that claimed as exempt year it closed the accounts at issue. Fidelity-Philadelphia by the debtor, without objection, or determined by the Trust Co., 23 T.C. at 530. The court reasoned that the [bankruptcy] Court as exempt, has been inventoried, possibility that the taxpayer might have to make a payment to collected and liquidated, or abandoned. Any property not a depositor in a later year may give it a right to a deduction in heretofore abandoned by the trustee is now such year; however, “it does not prevent the inclusion of the abandoned...All claims have been examined and unclaimed deposits in gross income in the earlier year, when objections have been resolved.... such future payment appears improbable.” Id. at 531. Similarly, much later in Cozzi, the court contemplated the Trustee’s Final Report, November 30, 1995. A Supplemental likelihood of payment in holding that it was not likely that a Final Report was filed on January 31, 1996. Subsequently, future payment on the loan agreement would be made; the bankruptcy court issued its final decree on July 15, 1996, thus closing New Manchester’s Chapter 7 proceeding and discharging the trustee. 6 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 19 During the pendency of the bankruptcy proceeding, In finding that Hap recognized a discharge of indebtedness Taxpayers filed joint federal income tax returns with the in 1980, the Cozzi Court looked for an identifiable event to Internal Revenue Service for the calendar years of 1989, demonstrate the abandonment of security for a debt that 1990, and 1992. On October 15, 1993, the Friedmans filed an would, in turn, show a release from debt and corresponding application for a tentative refund, Form 1045, Application for COD income. In viewing all of the circumstances Tentative Refund. The refunds were claimed for 1989 and surrounding the various agreements, the court concluded that 1990 in the amounts of $765,440 and $792,469, respectively. Sargon had no intention of enforcing its rights against Hap In such application, the Friedmans claimed net operating loss under the loan agreement, and the scheduled final payment by deductions from carrybacks relating to Mr. Friedman’s stock Hap to Sargon in 1980, under the loan agreement, “was an interest in New Manchester. ‘identifiable event’ sufficient to evidence Hap’s abandonment of the picture.” Cozzi, 88 T.C. at 447. With no payment On November 12, 1993, the Rosenthals filed a Form 1045, made by Hap to Sargon and no arrangement by the parties to Application for Tentative Refund. The tentative refunds were defer such payment, “[t]he final payment under [the loan claimed for 1989 and 1990 in the amounts of $834,729 and agreement] was an important event, and the failure to make $810,331, respectively. The Rosenthals also claimed net such payment is clear evidence of abandonment.” Id. In so operating loss deductions in its application from carrybacks holding, the court noted that the failure to make the final relating to Mr. Rosenthal’s stock interest in New Manchester. payment was not the only identifiable event, but it was a The Rosenthals filed an amended tax return for the 1988 tax reasonable choice. Id. Thus, Hap realized a discharge of year, claiming a carryback of a net operating loss for the years indebtedness in the taxable year 1980. 1988 to 1991. Taxpayers also cite Fidelity-Philadelphia Trust Co. v. In its federal income tax return for 1991, Form 1120S, New Commissioner, 23 T.C. 527 (1954) in support of their Manchester claimed a loss of $10,102,289. In its tax return argument that New Manchester realized a discharge of for 1992, New Manchester claimed a loss of $10,751,953. indebtedness in 1992. In Fidelity-Philadelphia Trust Co., the taxpayer was incorporated as a national bank in 1934. At that The Commissioner issued notices of deficiencies to time, it acquired various assets and assumed certain liabilities Taxpayers for the calendar years 1989 and 1990, on May 29, of a liquidated national bank. Among such liabilities were 1996. The Commissioner stated that Taxpayers owed certain depositors’ accounts of the liquidated bank. additional amounts as follows: The Friedmans owed $686,400 for 1989 and $793,860 for 1990; and the Rosenthals owed In 1948, after fruitless searches to locate depositors by mail, $617,446 for 1989 and $811,723 for 1990. The notices of advertising, and other means, the taxpayer bank transferred to deficiencies stated that, for the taxable year ending 1992, its surplus account several of the depositors’ accounts which Taxpayers were not entitled to a loss in excess of $5 million were unclaimed, dormant, and inactive. In doing so, the bank each from their interest in New Manchester. The closed out its unclaimed deposit accounts. On its tax return Commissioner found that Taxpayers were not entitled to for 1948, the monies resulting from the closing of the above increase their basis in New Manchester by the cancellation of accounts was shown as “a Sundry Credit to Earned Surplus,” indebtedness income. Thus, Taxpayers’ 1992 taxable income not as income. In assessing a tax deficiency, Commissioner was increased accordingly. treated this amount as additional income. Subsequently, Taxpayers filed separate petitions with the United States Tax Court, on August 27, 1996, for a 18 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 7 ‘identifiable event’ which fixes the loss with certainty may be redetermination of their respective income tax deficiencies for taken into consideration.” Cozzi, 88 T.C. at 445 (citing the taxable years at issue. In each case, Taxpayers claimed United States v. S.S. White Dental Mfg. Co., 274 U.S. 398 entitlement to the 1992 loss and carried the loss back to their (1927)). respective tax years of 1989 and 1990. The two petitions were consolidated for the purpose of briefing and opinion in Taxpayers rely on Cozzi v. Commissioner, supra, in support the Tax Court. of their position that in December, 1992, it was clear that part of New Manchester’s indebtedness, in the amount of On May 27, 1998, the Tax Court issued its opinion, $19,471,684, would never be repaid. Cozzi involved a upholding Taxpayers’ tax deficiencies. In its opinion, the Tax limited partnership, Hap Production Company (“Hap”), Court stated that the principal issue before it was whether formed for the purpose of producing motion picture films. Taxpayers were entitled to increase their basis in the S Hap entered into an agreement with Map Films, Ltd. to corporation’s stock as a result of any COD income realized by produce a film for Map Films in return for annual payments the corporation. Initially, however, the Court found that from 1976 through 1981. Another party, Barongreen agreed pursuant to the plain language of section 108(d)(2) of the to produce the film for Hap in exchange for certain annual Internal Revenue Code, New Manchester had not realized a payments from 1976 through 1979 to Hap on behalf of Map discharge of indebtedness, or COD income, in 1992. The Films. Hap entered into a nonrecourse loan agreement with Court observed that the trustee in New Manchester’s Sargon Establishment whereby Hap agreed to repay such loan bankruptcy case was actively conducting New Manchester’s in annual payments between 1976 and 1980. business and disbursing monies to creditors after 1992. The Court noted, in particular, that New Manchester’s creditors The film produced by the parties never made a profit. filed a fraudulent conveyance claim in December of 1992; the Consequently, none of the annual payments by Map Films, claim was not settled until 1995. Further, the Court noted that Barongreen, or Hap was ever made. Hap’s tax returns for the trustee’s final report, which concluded that all claims 1976 through 1980 reported no activity. In 1984, the parties pertaining to New Manchester had been settled, was filed in entered into settlement agreements whereby each party was 1995. released from any contractual obligations, and Sargon received the rights to the film. As a result of the cancellation The Tax Court, therefore, held that the facts and of its nonrecourse debt to Sargon, Hap reported income for circumstances as outlined above do not even suggest that New 1984. Petitioner, a limited partner in Hap, reported his Manchester’s underlying indebtedness was extinguished or distributive share of such income on his tax return for 1984. discharged by the bankruptcy court in 1992. In addition, the Court was not persuaded that New Manchester’s insolvency, The Commissioner issued a tax deficiency, stating that the in and of itself, in 1992, was sufficient to create a de facto petitioners received income from Hap in 1980 as a result of discharge, as argued by Taxpayers. Finally, the Tax Court Hap recognizing income in that year. As stated by held that even if New Manchester had realized COD income Commissioner, a possible explanation for Hap’s recognition in 1992, such income would not have increased Taxpayers’ of income in 1980 was the fact that Hap’s nonrecourse loan basis in the corporate stock because section 108(d)(7)(A) of from Sargon was discharged. As in the present case, the the Internal Revenue Code prevents a pass-through to dispute in Cozzi is not whether a discharge of indebtedness shareholders of COD income which is excluded from an S occurred, rather it is in which year such income is corporation’s gross income. recognizable. 8 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 17 Taxpayers’ appeal follows the decision of the Tax Court. §108. Income from discharge of indebtedness Discussion (a) Exclusion from gross income. The primary issue in this case is whether Taxpayers are (1) In general. Gross income does not include any entitled to an increase in their basis in an S corporation’s amount which (but for this subsection) would be stock as a result of the discharge of indebtedness income, or includible in gross income by reason of the discharge (in COD income, realized by the corporation. As a threshold whole or in part) of indebtedness of the taxpayer if matter, however, we must determine whether New (A) the discharge occurs in a title 11 case; Manchester actually realized COD income in 1992, which (B) the discharge occurs when the taxpayer is would, in turn, establish whether Taxpayers may claim, and insolvent; carry back, a loss in excess of $5 million each. (C) the indebtedness discharged is qualified farm indebtedness; or I. Standard of Review (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real This Court reviews the Tax Court’s findings of fact for property business indebtedness. clear error and its application of law de novo. Ekman v. Commissioner, 184 F.3d 522, 524 (6th Cir.1999). Regarding 26 U.S.C. §108(a)(1). In the instant matter, the relevant the specific question of the timing of the discharge of exception is “the discharge occurs in a title 11 case,” as indebtedness, however, Taxpayers present two possible Taxpayers filed a petition for bankruptcy on March 3, 1992. standards of review. Section 108(d)(2) defines a “title 11 case” as “a case under title 11 of the United States Bankruptcy Code (relating to In the main body of their brief, Taxpayers state that the time bankruptcy), but only if the taxpayer is under the jurisdiction of the discharge is essentially a question of fact which would of the court in such case and the discharge is granted by the be subject to review for clear error. Taxpayers Br. at 18 court or is pursuant to a plan approved by the court.” 26 (citing Carl T. Miller Trust v. Commissioner, 76 T.C. 191, U.S.C. §108(d)(2). 195 (1981)(“Determination of the point in time at which a taxpayer’s obligation has been cancelled, giving rise to First and foremost, in order for COD income to occur under income, is essentially a question of fact.”); Taxpayers Br. at section 61(a)(12), the taxpayer must have been discharged 24 (concluding that the Tax Court’s finding “that no discharge from a liability. Such liability, or debt, must be viewed as occurred in 1992" is clearly erroneous). However, in the having been discharged when it becomes clear that the debt section of their brief entitled “Standard of Review,” will never have to be paid. Cozzi v. Commissioner, 88 T.C. Taxpayers suggest that “whether sufficient evidence has been 435, 445 (1987). The test for determining such a moment is submitted to meet a party’s burden is a mixed question of law a practical assessment of the facts and circumstances relating and fact.” Taxpayers Br. at 38. Taxpayers appear to reach this to the likelihood of payment. Cozzi, 88 T.C. at 445 (citing conclusion by combining two prior assertions: (1) that the Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980), supp. sufficiency of evidence submitted by a party is a question of opinion to 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, 693 F.2d 281 (3d Cir.1982)). “Any 16 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 9 fact that the creditors initially sought $11 million upon the fact that will not be disturbed unless clearly erroneous4; and filing of the claim.6 (2) that the allocation of the burden of proof is a question of law. The Tax Court agreed with Commissioner in that some sort of identifying event or forgiveness on the part of the creditors In support of this latter proposition, that the allocation of was necessary in order to give rise to a discharge of the burden of proof is a question of law and whether sufficient indebtedness income in 1992. Accordingly, the Court held evidence has been submitted is a mixed question of law and that the evidence supported the conclusion that New fact, Taxpayers cite two old cases from other circuits, without Manchester did not realize COD income in the year at issue specific page references: (1) Kendrick Coal & Dock Co. v. since no identifiable event occurred. Commissioner, 29 F.2d 559 (8th Cir.1928); and (2) Commissioner v. Cecil B. DeMille Productions, Inc., 90 F.2d “Gross income” is defined in the Internal Revenue Code as 12 (9th Cir.1937). In Kendrick, the most relevant language “all income from whatever source derived....” 26 U.S.C. states that “[w]hether a particular finding of fact is supported §61(a). It includes income from discharge of indebtedness, or by any substantial evidence is a question of law.” 29 F.2d at cancellation of indebtedness (COD income). 26 U.S.C. 563. The second case cited contains no language that would §61(a)(12). This means that a taxpayer who has incurred a be beneficial to Taxpayers’ position. financial obligation, which obligation is later discharged or the taxpayer is released from the indebtedness, has realized an Commissioner does little to respond to Taxpayers’ accession to income. 26 U.S.C. §61(a)(12); United States v. propositions concerning the appropriate standard of review Kirby Lumber Co., 284 U.S. 1 (1931). The rationale of this with respect to the timing of the discharge. Commissioner principle is that the discharge of a debt below the face value states only that Taxpayers “acknowledge” that the timing of of the debt accords the debtor an economic benefit equivalent realization of discharge of indebtedness “is a question of fact, to income. Id. subject to the clearly erroneous standard of review.” Commissioner Br. at 18. Accompanying the discharge of indebtedness income rule, however, is what is commonly referred to as the “insolvency Contrary to Taxpayers’ second contention regarding the exception.” Section 108(a)(1) of the Internal Revenue Code standard of review, this Court finds that the Tax Court’s provides that a debtor will not recognize income under decision regarding the timing of the discharge should be §61(a)(12) if he or she is insolvent following the discharge of reviewed for clear error. This circuit recently referred to a indebtedness. 26 U.S.C. §108(a)(1). Section 108(a) provides, determination of whether taxpayers failed to carry their in pertinent part, as follows: burden of proving that they engaged in activities within the meaning of a statute as a “factual conclusion.” See Holmes v. Commissioner, 184 F.3d 536, 543 (6th Cir.1999). Such reference indicates that this circuit views the issue of a whether a party presented evidence sufficient to meet its burden of proof as a question of fact, subject to review for 6 Perhaps Commissioner could have stipulated that “it was clear that prepetition indebtedness in excess of the value” of specific assets and the 4 fraudulent conveyance claim would never be repaid, in order to address Taxpayers cite Hoover v. Commissioner, 102 F.3d 842 (6th the indebtedness without committing to an assertion that over $19 million Cir.1996), which supports only the portion of the assertion that a question would clearly never be repaid. of fact is reviewed for clear error. See Hoover, 102 F.3d at 844. 10 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 15 clear error. See also In re Newman, 7 F.3d 234 (Table), 1993 these assets would never be repaid.” J.A. at 64. Thus, WL 328035, **2 (6th Cir.1993)(unpublished opinion)(“The Taxpayers contend that since it was stipulated that question of whether a particular set of facts satisfies (or fails indebtedness in excess of the value of New Manchester’s to satisfy) the requisite burden of proof is an inseparable part assets as of December 31, 1992 would never be repaid, there of the factfinding process and as such is reviewed -- together was, effectively, a discharge in the amount of $19,471,684 in with the facts -- for clear error.”)(citing 1 Steven A. Childress 1992. & Martha S. Davis, Federal Standards of Review §2, 18, at 2- 130 (2d ed. 1991)). Commissioner, on the other hand, maintains that there was no discharge because there was no identifying event in 1992 II. Burden of Proof demonstrating that a debt had been discharged. In support of his position, Commissioner emphasizes two points: First, the Taxpayers maintain that Commissioner bears the burden of stipulated record demonstrates that the bankruptcy trustee was proof with respect to the timing of the discharge of actively administering the bankruptcy estate well into 1995, indebtedness. Tax Rule 142(a) states as follows: collecting accounts receivable, seeking buyers for saleable assets, and filing reports with the bankruptcy court. Second, The burden of proof shall be upon the petitioner, except a claim for fraudulent conveyance in the amount of $11 as otherwise provided by statute or determined by the million was initiated by several of New Manchester’s Court; and except that, in respect of any new matter, creditors. While at one point Taxpayers offered to settle the increases in deficiency, and affirmative defenses, pleaded claim for $300,000, it was eventually settled in 1995 for $2.2 in the answer, it shall be upon the respondent.5 million. Based upon the fluctuation in anticipated value, initial offer, and actual settlement, Commissioner contends Based on this Rule, Taxpayers contend that the question of that the value of the fraudulent conveyance claim was highly whether the discharge of indebtedness occurred in 1992, as uncertain. Therefore, for all of these reasons, Commissioner opposed to another year, is a “new matter.” Taxpayers argue, maintains that no event had occurred in 1992 to fix a therefore, that Commissioner bears the burden of proof. discharge of indebtedness, nor could there have been any Without resolving this issue, the Tax Court merely concluded certainty at that time as to the amount of any discharge. that if the burden were shifted to Commissioner, “he would have fulfilled that requirement by a substantial preponderance The Court must note, however, that Commissioner does not of the evidence.” J.A. at 43. explicitly reconcile the discrepancy between the stipulated statement that the fraudulent conveyance claim had an The Notices of Deficiency issued to Taxpayers stated as anticipated value of $2,400,000 as of December 31, 1992, and follows: Commissioner’s argument in his brief that the claim’s value could not be fixed in 1992. Implicitly, the argument appears IT IS DETERMINED THAT FOR THE TAXABLE to be that the anticipated value could not be expected to YEAR ENDING 1992, YOU ARE NOT ENTITLED TO reflect the actual value of the claim, especially in light of the 5 The burden of proof does not change when a case is fully stipulated, as is presently the case before this Court. See Tax Rule 122(b); Zarin v. Commissioner, 92 T.C. 1084, 1088 (1989), remanded on other grounds, 916 F.2d 110 (3d Cir.1990). 14 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 11 disallowing the loss claimed by Taxpayers is new grounds for A LOSS IN THE AMOUNT OF $5,055,116.00 FROM disallowance; it does not clarify or develop an original THE SMALL BUSINESS CORPORATION KNOWN determination by Commissioner. The new grounds requires AS MANCHESTER STEEL, INC. YOU ARE NOT the introduction of different evidence. As such, as justice and ENTITLED TO INCREASE YOUR BASIS IN THE fairness require, the burden of proving that the discharge did CORPORATION BY THE CANCELLATION OF not occur in the year at issue is on Commissioner. INDEBTEDNESS INCOME. INTERNAL REVENUE CODE SECTION 108(d)(7) PROVIDES THAT THE III. Discharge of Indebtedness Income EXCLUS ION FOR CANCELLATION OF INDEBTEDNESS INCOME WILL APPLY AT THE The Notice of Deficiency issued to Taxpayers states that ENTITY LEVEL IN THE CASE OF CANCELLATION Taxpayers are not entitled to a loss in the amount of OF AN S CORPORATION’S DEBT. $5,055,116.00 from New Manchester and they are not entitled CONSEQUENTLY, IF THE CANCELLATION OF to increase their basis in the corporation by the cancellation of DEBT IS EXCLUDED AT THE CORPORATE LEVEL, indebtedness income. In order to resolve this issue, the Court THERE IS NO INCOME ITEM TO FLOW THROUGH must determine, initially, whether New Manchester realized TO THE SHAREHOLDERS AND NO INCREASE IN a discharge of indebtedness income, or COD income, for the YOUR STOCK BASIS. ACCORDINGLY, YOUR 1992 taxable year ending 1992. TAXABLE INCOME IS INCREASED $5,055,116.00. Taxpayers argue that there was a discharge of indebtedness IN ADDITION, THIS AMOUNT EXCLUDED FROM in 1992 because it was clear at the end of 1992 that INCOME, UNDER SECTION 108 OF THE INTERNAL $19,471,684 of New Manchester’s indebtedness would never REVENUE CODE, IS TAX-DEFERRED INCOME, be repaid. Taxpayers reached this determination as follows: NOT TAX-EXEMPT. ACCORDINGLY, THERE IS When the bankruptcy proceeding began, New Manchester had NO INCREASE TO YOUR STOCK BASIS UNDER liabilities of $30,360,669 and assets of $9,241,153. By SECTION 1366 OF THE INTERNAL REVENUE December 31, 1992, as the parties have stipulated, the value CODE. THEREFORE, SINCE YOU HAD A $0.00 of New Manchester’s assets was $1,488,985.78, in addition BASIS IN THIS STOCK, YOU ARE NOT ENTITLED to a fraudulent conveyance claim filed by New Manchester’s TO THE CURRENT YEAR AND/OR SUSPENDED creditors. The claim had an anticipated value of $2,400,000. YEAR LOSSES CLAIMED. Because New Manchester had paid $7 million to one of its creditors in 1992, Taxpayers assert that New Manchester’s IN ADDITION, YOU WOULD NOT BE ELIGIBLE remaining liabilities, as of December 31, 1992, totaled FOR THE LOSS IN THE AMOUNT OF $5,055,116.00 $23,360,669 (the initial liabilities of $30,360,669 minus ON YOUR 1992 RETURN SINCE YOU WERE NOT $7,000,000). Taxpayers thereby determined that the excess of AT RISK FOR THESE LOSSES WITHIN THE New Manchester’s liabilities over the fair market value of its MEANING OF SECTION 465 OF THE INTERNAL assets was $19,471,684 ($23,360,669 (liabilities) minus REVENUE CODE. $1,488,985.78 (assets) minus $2,400,000 (anticipated value of the fraudulent conveyance claim)). Moreover, Taxpayers J.A. at 19 (Friedman Notice); J.A. at 33 (Rosenthal Notice). point to the stipulation of the parties whereby Taxpayers and According to Taxpayers, the Notice presupposes the fact of Commissioner stated that “[a]s of December 31, 1992, it was the discharge of indebtedness, and it fails to raise a question clear that prepetition indebtedness in excess of the value of as to the timing of the discharge; hence, it is a “new matter” 12 Friedman, et al. v. Commissioner No. 98-2378 No. 98-2378 Friedman, et al. v. Commissioner 13 pursuant to Tax Rule 142(a). Commissioner, on the other that the year of the loss was a new matter. The Tax Court hand, contends that the Notice clearly made Taxpayers aware agreed with the petitioner and found that a challenge to the that Commissioner denied that New Manchester had incurred ordinary character of a loss does not necessarily encompass a discharge of indebtedness income in 1992, and it was challenge to the fact of the loss. Hunter, 1982 WL 10676, at sufficiently broad to cover both the timing and the occurrence *20. In reaching its conclusion, the Court reasoned that “the of such income. issue of the timing of the loss would appear to be conceded, for if the loss was not properly taken in the year before the As previously stated, petitioners (Taxpayers) generally bear Court, the issue of the character of the loss becomes moot.” the burden of proof. Tax Rule 142(a); Welch v. Helvering, Id. 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933). The respondent (Commissioner), however, bears the burden as to This Court finds Taxpayers’ argument on this point “any new matter, increases in deficiency, and affirmative persuasive. The Notice of Deficiency issued to Taxpayers defenses, pleaded in the answer.” Tax Rule 142(a). The presumes the existence of a discharge of indebtedness in issue, therefore, becomes whether the timing of the discharge stating: (1) You are not entitled to increase your basis in the of indebtedness is a “new matter.” corporation by the cancellation of indebtedness income; and (2) If the cancellation of debt is excluded at the corporate A new position taken by Commissioner is not necessarily level, there is no income to flow through to the a “new matter” if it merely clarifies or develops shareholders.... (emphasis added). Commissioner’s challenge Commissioner’s original determination without requiring the to Taxpayers’ loss was aimed at the nature or character of the presentation of different evidence, being inconsistent with loss, not the year it allegedly occurred. Commissioner’s Commissioner’s original determination, or increasing the raising of the general existence of the alleged loss does not amount of the deficiency. Achiro v. Commissioner, 77 T.C. necessarily implicate a challenge to the timing of the alleged 881, 889-91 (1981). In Zarin v. Commissioner, 92 T.C. loss. 1084, 1089 (1989), remanded on other grounds, 916 F.2d 110 (3d Cir.1990), the Third Circuit found that new matter had Furthermore, Commissioner failed to raise specifically the been raised when the original notice of deficiency asserted a question of the existence or the timing of the income despite theory of larceny and the answer to the petition in Tax Court having the opportunity to do so and despite advancing other raised a theory of income from discharge of indebtedness. In theories for the deficiencies. Such other theories include the reaching its conclusion, the Zarin Court determined that the following: (1) the exclusion of Section 108 of the Internal latter theory clearly required different evidence from the Revenue Code applies at the corporate level, therefore, there ground originally asserted in the petition. is no income to flow through to the shareholders; (2) the amount excluded is tax-deferred income, not tax-exempt The Tax Court specifically addressed a timing issue with income; and (2) Taxpayers were not at risk for the 1992 loss respect to “new matters” in Hunter v. Commissioner, 44 pursuant to Section 465 of the Internal Revenue Code. T.C.M. (CCH) 385, 1982 WL 10676 (1982). In this case, the question was whether the petitioner’s stock became worthless Therefore, in light of the foregoing, this Court finds that the during the year in question. Respondent did not raise the issue of the timing of the discharge of indebtedness income is issue in his notice of deficiency or in the pleadings of the a “new matter” for consideration. The assertion, subsequent case. While the petitioner elicited testimony concerning the to the Notice of Deficiency, that New Manchester did not timing of the worthlessness of the debt during trial, he argued experience a discharge of indebtedness in 1992 as a basis for