Merkel v. Comm'r of Internal Revenue
| Decision Date | 30 December 1997 |
| Docket Number | No. 10031–95,10032–95.,10031–95 |
| Citation | 109 T.C. No. 22,109 T.C. 463 |
| Parties | Dudley B. and La Donna K. MERKEL, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.David A. and Nancy J. HEPBURN, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Gregory W. MacNabb, for petitioners.
Ann M. Welhaf, for respondent.
In these consolidated cases, respondent determined deficiencies in the Federal income tax of petitioners Dudley and La Donna Merkel and David and Nancy Hepburn for their 1991 taxable (calendar) years in the amounts of $115,420 and $116,347, respectively. Both cases involve similar circumstances and require us to determine whether petitioners in the two cases (the Merkels and the Hepburns, respectively) may exclude under section 108(a)(1)(B)certain income from the discharge of indebtedness. Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Some of the facts have been stipulated and are so found. The stipulation of facts, with accompanying exhibits, is incorporated herein by this reference.
At the time the petitions were filed, the Merkels and the Hepburns resided in Scottsdale and Paradise Valley, Arizona, respectively.
During 1991, the Merkels and the Hepburns were all partners in a partnership (the partnership) that, on September 1, 1991, realized income on account of the discharge of indebtedness. On their 1991 U.S. Individual Income Tax Returns (Forms 1040; filing status of married filing joint return), the Merkels and the Hepburns each (couple) disclosed their distributive share of that income, $359,721, but excluded such amount from gross income on the ground that each was insolvent immediately before that income was realized by the partnership.
Systems Leasing Corp. (SLC) is an Arizona corporation organized in 1979 by petitioners Dudley Merkel and David Hepburn to engage in the computer leasing business. SLC is owned “50/50” by Dudley Merkel and David Hepburn. Dudley Merkel and David Hepburn were officers of SLC during its fiscal years ended February 29, 1992, and February 28, 1993, and received officer compensation for those years as follows:
+--------------------------------------+
¦¦ ¦FYE 2/29/92¦FYE 2/28/93¦
++-------------+-----------+-----------¦
¦¦Dudley Merkel¦$183,202 ¦$191,150 ¦
++-------------+-----------+-----------¦
¦¦David Hepburn¦182,824 ¦191,151 ¦
+--------------------------------------+
In 1986, SLC incurred an indebtedness to Security Pacific Bank (the indebtedness and the bank, respectively), evidenced by a note (the SLC note). The SLC note was personally guaranteed by each petitioner (collectively, petitioners' guarantees). As of April 16, 1991, the unpaid balance of the SLC note was in excess of $3,100,000, and SLC was in default of its obligations under the SLC note.
On May 31, 1991, SLC, the bank, and petitioners, as guarantors, entered into an agreement (the agreement) containing the terms and conditions of a structured workout concerning the repayment of the indebtedness to the bank. The agreement, in part, provides as follows:
(1) SLC is to pay to the bank $1,100,000 (the payoff) on or before August 2, 1991 (the settlement date);
(2) the bank will release its security interest in the remaining collateral upon payment of the payoff by the settlement date; and
(3) after the payoff by the settlement date, the bank will refrain from exercising any remedies under the SLC note or petitioners' guarantees if bankruptcy is not filed by or for SLC or petitioners, among others, voluntarily or involuntarily, within 400 days after the settlement date.
SLC made the payoff by the settlement date, and the bank released its security interests in the remaining collateral of SLC. The other conditions of the agreement were met, and the bank, at the expiration of the 400–day period, released SLC from its liability as maker of the SLC note and petitioners from petitioners' guarantees.
At no time did the bank make any formal written request or formal written demand for payment from petitioners pursuant to petitioners' guarantees.
SLC was engaged in the business of leasing computer systems in the State of North Carolina during the relevant period. The North Carolina Department of Revenue (the Department of Revenue) issued a “Notice of Sales and Use Tax Due” (the notice) to SLC dated June 14, 1991. The notice identifies the amount of taxes, penalties, and interest due, a total of $980,511.84, and states that the assessment is final and conclusive. The assessment of sales and use tax identified in the notice was for taxes that were never collected by SLC. After receipt of the notice, SLC's recourse was to pay the assessed amount and file a suit for refund or to protest the assessment if the Department of Revenue, in the exercise of its discretion, permitted additional time to file a protest. As of August 31, 1991, SLC had not paid the amount identified as due on the notice, nor had SLC requested time to file a protest.
On October 14, 1991, petitioners engaged an attorney to protest the sales and use tax assessment. The Department of Revenue granted SLC 60 days to file a protest. As a result of that protest, the Department of Revenue abated the assessment against SLC in full.
The Department of Revenue never proposed nor made an assessment against any of petitioners relating to the sales and use tax assessed against SLC.
OPINIONI. IntroductionA. Issue
The issue in these consolidated cases is whether petitioners were insolvent on August 31, 1991 (the measurement date), for purposes of section 108(a)(1)(B) (the insolvency issue). There is no question that, if section 108(a)(1)(B) (the insolvency exclusion) does not apply to petitioners, $359,721 would be included in the gross income of each of the Merkels and the Hepburns for 1991 as each couple's distributive share of certain discharge of indebtedness income realized by a partnership in which both couples were partners. The parties have stipulated that resolution of the insolvency issue depends on whether petitioners may include in the insolvency calculation provided in section 108(d)(3) () either of the following obligations: (1) “the liability of each of the petitioners as guarantors of the loan made by Security Pacific Bank to SLC” (petitioners' guarantees) and (2) “the personal liability, if any, of petitioners Dudley Merkel and David Hepburn as officers of SLC for unpaid sales and use taxes assessed by the State of North Carolina against SLC” (the assessment against SLC shall be referred to as the State tax assessment and the personal liability, if any, of petitioners with respect to the State tax assessment shall be referred to as the State tax exposure). In addition, the parties have stipulated that the “exposure of each of petitioners Merkel and Hepburn” pursuant to petitioners' guarantees and the State tax exposure was $1 million and $490,000, respectively, and, “if the petitioners properly may include the amount of their exposure under either * * *, the petitioners were each insolvent to the extent of the full amount of the * * * discharge of indebtedness income to each.” Petitioners bear the burden of proof on all questions of fact. Rule 142(a).
B. Arguments of the Parties
Respondent argues that the term “liabilities”, as used in section 108(d)(3), “must be given its plain meaning” and encompasses “only liabilities ripe and in existence on the measurement date”. Respondent would have the Court find that petitioners' guarantees were contingent liabilities and, thus, not liabilities in existence on the measurement date for purposes of section 108(d)(3). Respondent would have the Court also find that, as of the measurement date, the State tax exposure was not a liability for purposes of section 108(d)(3), contingent or otherwise.
Petitioners argue that the plain meaning of the term “liabilities” in section 108(d)(3) “includes all liabilities, whether contingent or otherwise”, and “whether and how much of a liability is counted must be determined on a liability-by-liability basis with due regard to all of the circumstances that existed” at the time insolvency is to be determined. With respect to contingent liabilities, petitioners concede: (1) “the likelihood of the occurrence of the contingency * * * [may be] so remote as not to give rise to a liability” and (2) “a contingent liability may be a liability; however, the amount of that liability may be less than the amount of full exposure.” Petitioners would have the Court find that both petitioners' guarantees and the State tax exposure were liabilities in existence on the measurement date, to be taken into account (perhaps at “less than the amount of full exposure”) under section 108(d)(3).
II. AnalysisA. The Code
Section 61(a)(12) provides that gross income means all income from whatever source derived, including income from discharge of indebtedness. In certain circumstances, however, income from discharge of indebtedness is excluded from gross income. In relevant part, section 108(a) provides:
(B) the discharge occurs when the taxpayer is insolvent * * *
* * * * * * *
(3) Insolvency exclusion limited to amount of insolvency.—In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.
The term “insolvent” is defined in section 108(d)(3) as follows:
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