Babin v. C.I.R.

• Decision Date: 06 May 1994
• Docket Number: No. 93-1614,93-1614
• Citation: 23 F.3d 1032
• Parties: -1961, 94-1 USTC P 50,224 Stephen BABIN; Betty Boehm Babin, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1032

23 F.3d 1032

73 A.F.T.R.2d 94-1961, 94-1 USTC P 50,224

Stephen BABIN; Betty Boehm Babin, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 93-1614.

United States Court of Appeals, Sixth Circuit.

Argued April 21, 1994.

Decided May 6, 1994.

Rehearing and Suggestion for Rehearing En Banc Denied July 7, 1994.

J. Timothy Bender (argued and briefed), Joseph P. Alexander and David G. Lambert (briefed), Kadish & Bender, Cleveland, OH, for petitioners-appellants.

David L. Jordan, I.R.S., Office of Chief Counsel, Gary R. Allen, Acting Chief (briefed), Kenneth L. Greene (argued), Gilbert S. Rothenberg, Randolph L. Hutter, U.S. Dept. of Justice, Appellate Section Tax Div., Washington, DC, for respondent-appellee.

Before: MILBURN and GUY, Circuit Judges, and TIMBERS, Senior Circuit Judge. ^*

MILBURN, Circuit Judge.

Petitioner C. Stephen Babin appeals the judgment of the Tax Court finding him liable for federal tax deficiencies for the year 1978, among others. ¹ On appeal, the sole issue is whether the Tax Court erred in failing to increase the adjusted basis of petitioner's interest in a partnership under 26 U.S.C. Sec. 705(a)(1)(A) by the amount of the discharge of indebtedness income that petitioner did not have to recognize by reason of the judicially created insolvency exception. For the reasons that follow, we affirm.

I.

A.

In 1974, the Lakewood Center Medical Construction Associates ("Partnership"), an Ohio limited partnership, was formed. Petitioner, one of two general partners of the Partnership, held a 51% interest in the income and loss of the Partnership and a 75% interest in the Partnership's liabilities. The other general partner and the six limited partners held the remaining interests of the Partnership. The Partnership's primary asset was a 70,000 square foot medical office building adjacent to Lakewood Hospital. Construction of the medical office building was financed by the Cleveland Trust Company ("Cleveland Trust"), which held both a first and second mortgage on the building and also debtor's certificates. All the debt held by Cleveland Trust was recourse as to the two general partners.

Upon the failure of the Partnership to maintain the debt service payments, Cleveland Trust instituted foreclosure proceedings on the medical building, and the Partnership filed a petition in April 1977 under Chapter XII of the Bankruptcy Act. During the bankruptcy proceedings, the Partnership agreed to sell all its assets to a third party for $2,850,000. In addition, the Partnership and Cleveland Trust discussed the settlement of the Partnership's debts. At the time, the Partnership was indebted to Cleveland Trust in the amount of $5,170,019.

The Partnership and Cleveland Trust subsequently agreed to the resolution of the Partnership's debt. Under the settlement agreement, the Partnership agreed to pay Cleveland Trust $2,750,000 in full satisfaction of the two mortgages and the debtor's certificates. In return, Cleveland Trust agreed to forgive $2,420,019, the remaining portion of the debt owed by the Partnership. In January 1978, a bankruptcy court approved the settlement and dismissed the proceedings.

B.

In April 1989, respondent Commissioner of Internal Revenue issued a notice of deficiency to petitioner for three tax years: 1978, 1979, and 1982. The notice informed petitioner of several determinations made by respondent, including the determination that petitioner must recognize an increased amount of income as a result of the transactions involving the Partnership and Cleveland Trust. As relevant to this appeal, respondent determined that the Partnership received a total of $5,270,019 from the sale of its assets and the discharge of its indebtedness; $100,000 from the sale proceeds from the third party and $5,170,019 from discharge of the indebtedness to Cleveland Trust. Respondent also determined that petitioner's share of this amount, $3,952,514 (75% of $5,270,019), exceeded the adjusted basis of petitioner's interest in the Partnership, $2,663,180, by $1,289,334. Accordingly, respondent determined that petitioner had to recognize $1,289,334 in capital gain. See 26 U.S.C. Sec. 731(a). Because the year at issue in this case antedates the Tax Reform Act of 1986, our statutory references are to the Internal Revenue Code of 1954.

Petitioner thereafter filed a petition in the Tax Court challenging, among other things, the calculation with respect to capital gain. Petitioner argued that before respondent calculated capital gain, respondent should have increased the adjusted basis of petitioner's interest in the Partnership, pursuant to 26 U.S.C. Sec. 705(a)(1)(A), by petitioner's distributive share of the income the Partnership realized upon the forgiveness by Cleveland Trust of the $2,420,019 owed by the Partnership. Had respondent increased petitioner's adjusted basis in the manner urged by petitioner, petitioner would have recognized little or no capital gain as opposed to recognizing $1,289,334 in capital gain as determined by respondent. The Tax Court, however, rejected petitioner's argument and affirmed respondent's calculations in this respect. This timely appeal followed.

II.

Resolution of whether the Tax Court erred in failing to increase the adjusted basis of petitioner's interest in the Partnership pursuant to 26 U.S.C. Sec. 705(a)(1)(A) is a question of law. Estate of Newman v. Commissioner, 934 F.2d 426, 434 (2d Cir.1991). Thus, we review the judgment of the Tax Court de novo. North American Rayon Corp. v. Commissioner, 12 F.3d 583, 586 (6th Cir.1993). In order to reach our conclusion, we must analyze several distinct portions of the Internal Revenue Code, each of which operate independently.

We begin with the rule that the discharge of a debt below face value accords the debtor an economic benefit functionally equivalent to income. This rule was first articulated by the Supreme Court in United States v. Kirby Lumber Company, 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131 (1931). In that case, a corporation issued its own bonds for approximately $12,000 for which it received their par value. During the same year, the corporation purchased some of the bonds at less than par value. The difference in price was $137,521.30. Reasoning that "[a]s a result of its dealing [the corporation] made available $137,521.30 [of] assets previously offset by the obligation of bonds now extinct," the Supreme Court concluded that the corporation "realized within the year an accession to income." Id. at 3, 52 S.Ct. at 4. In 1954, Congress codified the ruling in Kirby Lumber, specifically providing that gross income includes "[i]ncome from discharge of indebtedness." 26 U.S.C. Sec. 61(a)(12). 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. Sec. 61(a)(12).

Accompanying the discharge of indebtedness income rule, however, is a judicially created exception, commonly referred to as the "insolvency exception." Under the insolvency exception, "a debtor will not recognize income under section 61(a)(12) if he is insolvent following the discharge of indebtedness." Gershkowitz v. Commissioner, 88 T.C. 984, 1005, 1987 WL 49310 (1987) (citing Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95 (5th Cir.1934) and Astoria Marine Constr. Co. v. Commissioner, 12 T.C. 798, 1949 WL 205 (1949)).

The theory of this exception is that no accession to income has occurred if after the debt cancellation, the taxpayer remains insolvent since no assets have been freed. To the extent the cancellation renders the taxpayer solvent, however, he is deemed to have realized income in the amount by which his assets exceed his liabilities immediately after the cancellation.

Estate of Delman v. Commissioner, 73 T.C. 15, 32, 1979 WL 3693 (1979) (citations omitted); see also Jacob Mertens, Jr., Mertens Law of Federal Taxation, Sec. 11.42 (1990). The insolvency exception, among other things, is premised on the belief that it is inequitable "to kick someone when he is down." 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, p 6.4.1 at 6-27 (2d ed. 1989).

In addition to providing for the rules governing whether a partner realizes income under 26 U.S.C. Sec. 61(a)(12) as a result of the discharge of indebtedness, the Internal Revenue Code also provides separate and distinct rules governing whether a partner recognizes capital gain under 26 U.S.C. Sec. 731(a)(1) as a result of the discharge of indebtedness. Under the partnership provisions of the Internal Revenue Code, "a partner's interest in the partnership is itself a capital asset, subject to gain or loss like any other capital asset." Stackhouse v. United States, 441 F.2d 465, 467 (5th Cir.1971). As relevant to this case, the calculation of capital gain requires the determination of two separate factors: (1) the amount of money, if any, distributed by the partnership to the partner; and (2) the adjusted basis of such partner's interest in the partnership immediately before the distribution. If the money distributed by the partnership to the partner exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution, then the excess amount of money distributed must be recognized as capital gain. 26 U.S.C. Sec. 731(a)(1). Section 705(a)(1)(A) is the relevant provision in this case to the determination of the adjusted basis of a partner's interest in the partnership.

Applying these principles, the Tax Court made two conclusions. First, it concluded that because petitioner was insolvent both before and after the discharge of the debt held by Cleveland Trust, the insolvency exception mandated that petitioner recognize no income under 26 U.S.C. Sec. 61(a)(12) from the discharge of indebtedness income....