T.C. Summary Opinion 2007-19
UNITED STATES TAX COURT
STUART RAYMOND QUARTEMONT AND VELVET FENNER QUARTEMONT,
Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3584-06S. Filed February 6, 2007.
Stuart R. Quartemont, pro se.
David Cao, for respondent.
JACOBS, Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code in effect
at the time the petition was filed. Unless otherwise indicated,
subsequent section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
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Tax Court Rules of Practice and Procedure. The decision to be
entered is not reviewable by any other court, and this opinion
should not be cited as authority.
Respondent determined a $27,326 deficiency in petitioners’
2003 Federal income tax, as well as a penalty of $5,465 under
section 6662(d). Respondent subsequently conceded that the
section 6662(d) penalty was not applicable. Consequently, the
only issue remaining for decision is whether petitioners may
exclude the value of their residence, which is exempt property
for State bankruptcy law purposes, in determining whether they
were insolvent for purposes of section 108(a)(1)(B), pertaining
to exclusion from discharge of indebtedness income.
Background
This case was submitted fully stipulated, and the stipulated
facts are so found. The stipulation of facts and the attached
exhibits are incorporated herein by this reference. At the time
petitioners filed the petition, they resided in College Station,
Texas.
Beginning in 2001, petitioners encountered financial
difficulty stemming from an unrelated party’s default on an
unsecured loan of $100,000 made by petitioners in 2000. In
connection with such loan, petitioners incurred substantial
amounts of credit card debt, believing that they would be able to
repay their debts to the credit card companies when their debtor
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repaid the loan owed to them. By the time petitioners realized,
in 2001, that the loan they had made in 2000 would never be
repaid, petitioners had incurred more than $100,000 in credit
card debt.
Petitioners considered filing for bankruptcy, but decided
instead to negotiate with the credit card companies to extinguish
their debts by paying a lesser sum than was owed. Petitioners
succeeded in making these arrangements in 2002 and in 2003. The
amount by which their credit card debt exceeded their actual
payment (i.e., the amount of relief from indebtedness) was
$77,265 in 2003, the tax year in issue.1 Petitioners did not
include this amount in income for 2003. Respondent determined
that such discharge of indebtedness should have been included in
income and accordingly determined a deficiency in petitioners’
2003 Federal income tax.
Discussion
As a general rule, the Commissioner’s determinations in the
notice of deficiency are presumed correct, and the burden of
proving an error is on the taxpayer. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933).
1
The cancellation of indebtedness occurred on two occasions:
Feb. 3, 2003, in the amount of $62,040 and May 12, 2003, in the
amount of $15,225.
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Gross income is defined in section 61(a) as all income from
whatever source derived, and income from discharge of
indebtedness is specifically included in the definition of gross
income. Sec. 61(a)(12).
The Supreme Court long ago articulated the principle that
increases in net worth from forgiveness or cancellation of
indebtedness give rise to gross income, United States v. Kirby
Lumber Co., 284 U.S. 1 (1931), but there are recognized
exceptions to this general principle. The Court of Appeals for
the Fifth Circuit, to which this case would be appealable if it
had not been heard pursuant to section 7463, was among the first
Courts of Appeals to develop an “insolvency exception”, in Dallas
Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95
(5th Cir. 1934), revg. 27 B.T.A. 651 (1933).
In Dallas Transfer & Terminal Warehouse Co. v. Commissioner,
supra at 96, the taxpayer’s relief from indebtedness did not
result in gross income where he was insolvent both before and
after the debt was discharged. The court stated:
This [relief from indebtedness] does not result in the
debtor acquiring something of exchangeable value in addition
to what he had before. There is a reduction or
extinguishment of liabilities without any increase of
assets. There is an absence of such a gain or profit as is
required to come within the accepted definition of income.
Eisner v. Macomber, 252 U.S. 189, 40 S.Ct. 189, 64 L.Ed.
521, 9 A.L.R. 1570; Merchants’ L. & T. Co. v. Smietanka, 255
U.S. 509, 519, 41 S.Ct. 386, 65 L.Ed. 751, 15 A.L.R. 1305.
It hardly would be contended that a discharged insolvent or
bankrupt receives taxable income in the amount by which his
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provable debts exceed the value of his surrendered assets.
The income tax statute does not purport to treat as income
what did not come within the meaning of that word before the
statute was enacted. * * * [Id.]
Section 108, Income from Discharge of Indebtedness, codifies
the result reached in Dallas Transfer, and identifies in
subsection (a), Exclusions From Gross Income, four occasions in
which discharge of indebtedness is not included in gross income.
The instant case involves the exception found in section
108(a)(1)(B), which provides:
(1) In general.--Gross income does not include any
amount which (but for this subsection) would be includible
in gross income by reason of the discharge (in whole or in
part) or indebtedness of the taxpayer if --
* * * * * * *
(B) the discharge occurs when the debtor is insolvent
* * *
The parties in this case do not agree on whether petitioners
were insolvent at the time the discharge of indebtedness
occurred. Resolution of the parties’ disagreement turns on the
calculation, for purposes of section 108(d)(3), of the value of
petitioners’ assets prior to the discharge of their debt to the
credit companies.
Insolvency is defined in section 108(d)(3) as “the excess of
liabilities over the fair market value of assets.” Petitioners
contend that property that would be exempt from creditors’ claims
under State law in bankruptcy proceedings is not taken into
account in determining the value of one’s “assets” for purposes
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of section 108(d)(3). The only such exempt property in this case
is petitioners’ house. The fair market value of petitioners’
house immediately before any discharge of indebtedness was
$335,110. Petitioners’ house was encumbered by a mortgage in the
amount of $189,354.
If petitioners’ house is included as an asset (and the
encumbering debt is included as a liability) in the insolvency
calculation, then petitioners were not insolvent either before or
after the forgiveness of debt,2 and such discharge of indebtedness
is includable in their gross income. If, on the other hand, the
house is not included as an asset (and any debt thereon is not
included as a liability), then petitioners were insolvent both
before and after the forgiveness of debt (on both the February
and May occasions), and the discharge of indebtedness is not
includable in their gross income.
In Carlson v. Commissioner, 116 T.C. 87 (2001), after a
thorough examination of the statutory history of section 108,
this Court found that Congress chose not to define insolvent to
exclude exempt assets. We held that the word “assets” as used in
section 108(d)(3) includes assets exempt from the claims of
creditors under applicable State law. Petitioners argue that our
2
This would be the case whether the February or May occasion
is considered.
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holding in Carlson produces an anomalous result, in the light of
other provisions of section 108.
Section 108(a)(1)(A) provides that gross income does not
include “any amount which * * * would be includable in gross
income by reason of the discharge * * * of indebtedness * * * if
the discharge occurs in a title 11 case”. Therefore, petitioners
point out, under the Carlson rationale, a taxpayer who declares
bankruptcy would not be required to include discharge of
indebtedness in gross income, whereas a taxpayer seeking to pay
his debts and avoid bankruptcy would potentially find himself
burdened with additional tax as a consequence. Petitioners are
correct in this description of the statutory regime as determined
under Carlson. However, consistent with congressional purpose in
according a debtor coming out of bankruptcy a “fresh start” and
leaving him unburdened with an immediate tax liability, Carlson
v. Commissioner, supra at 95, we see nothing anomalous in a
statutory framework that simultaneously requires solvent
taxpayers, like petitioners, to pay taxes according to the usual
formula.3 Furthermore, not following our precedent in Carlson
would produce anomalous results.
3
We note that sec. 108(a)(3) limits the amount of discharged
indebtedness that is excludable from gross income under the
insolvency provision to the amount by which the taxpayer is
insolvent. No such limitation applies when discharge occurs in a
title 11 case, such being another example of the statutory
framework that distinguishes between bankrupt and nonbankrupt
taxpayers.
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In Hunt v. Commissioner, T.C. Memo. 1989-335, decided with
respect to a taxable year prior to the effective date of section
108(a)(1)(B) and (d)(3), we held, as petitioners wish us to hold
today, that assets exempt from the claims of creditors by State
law were excluded from the definition of assets for purposes of
determining whether a nonbankrupt debtor was insolvent. This
entailed our holding that exempt assets included assets that, in
the event of bankruptcy, would be protected from the reach of
creditors under State exemptions, and not Federal exemptions,
even though (1) State law permitted debtors to elect either State
exemptions or Federal exemptions, and (2) Federal exemptions
would be more beneficial. In furtherance of this holding, we
noted:
While this conclusion may lead to different results for
taxpayers who actually file for bankruptcy and those who do
not, we note that different answers also result from those
debtors who file for bankruptcy and reside in different
states. The reason for the lack of consistency is twofold.
First, the Federal exemptions must be elected. Second, many
states do not allow their residents to choose Federal
exemptions over those offered by the state. Therefore, no
matter what path we choose today [in deciding whether state
exemptions or Federal exemptions are to be used], we still
cannot guarantee nationwide uniformity in determining which
assets are exempt from the claims of creditors when making a
determination of solvency. [Fn. ref. omitted.]
Excluding assets exempt under State bankruptcy law from the
section 108 definition of assets would result in inconsistencies
among taxpayers in different States that have different exemption
categories or amounts, another anomaly. In any event, section
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108 was amended by the Bankruptcy Tax Act of 1980, Pub. L. 96-
589, section 2(a), 94 Stat. 3389, to include a definition of
insolvency in section 108(d)(3). That section does not exclude
exempt assets from the definition of insolvent for purposes of
section 108. The amendments also added section 108(e)(1), which
provides that “Except as otherwise provided in this section,
there shall be no insolvency exception from the general rule that
gross income includes income from the discharge of indebtedness.”
In interpreting the amended statute, we noted in Carlson that
Hunt was inapplicable because it was decided before the effective
date of the amendments, and that section 108 as amended required
the opposite result from Hunt. Carlson v. Commissioner, supra at
99 n.7.
Concluding, we find that petitioners were not insolvent
within the meaning of section 108, either before or after their
debt was discharged. Consequently, we hold that the discharge of
indebtedness income, as determined by respondent, is includable
in petitioners’ gross income for 2003.
To reflect respondent’s concession with respect to the
section 6662(d) penalty,
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Decision will be entered
for respondent as to the
deficiency and for petitioners
as to the accuracy-related
penalty.