Merkel v. CIR

• Decision Date: 11 March 1999
• Docket Number: No. 98-70420,98-70420
• Parties: (9th Cir. 1999) DUDLEY B. MERKEL; LADONNA K. MERKEL; DAVID A. HEPBURN, and NANCY J. HEPBURN, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
• Court: U.S. Court of Appeals — Ninth Circuit

Page 844

192 F.3d 844 (9th Cir. 1999)

DUDLEY B. MERKEL; LADONNA K. MERKEL; DAVID A. HEPBURN, and NANCY J. HEPBURN, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 98-70420

U.S. Court of Appeals for the Ninth Circuit

Argued and Submitted March 11, 1999--Berkeley, California

Filed September 17, 1999

Gregory W. MacNabb, Plattner, Schneidman & Schneider, Phoenix, Arizona, for the petitioners-appellants.

Steven W. Parks, United States Department of Justice, Tax Division, Washington D.C., for the respondent-appellee.

Appeal from a Decision of the United States Tax Court, James S. Halpern, Tax Court Judge, Presiding, Tax Ct. Nos. 10031-95, 10032-95

Before: Diarmuid F. O'Scannlain, Kim McLane Wardlaw and William A. Fletcher, Circuit Judges.

Opinion by Judge WARDLAW; Dissent by Judge O'Scannlain.

WARDLAW, Circuit Judge:

This case calls upon us to decide the standard for determining when a contingent obligation to pay is a "liability" for purposes of determining insolvency under 26 U.S.C. S 108(d)(3).

Appellants Dudley and La Donna Merkel and David and Nancy Hepburn ("Appellants") appeal from the Tax Court's decision sustaining determinations of income tax deficiency for the tax year 1991 made by the Commissioner of Internal Revenue ("Commissioner"). The Tax Court found that Appellants failed to prove that as of the measurement date it was likely they "would be called upon to pay" a claimed liability, and thus Appellants' total liabilities did not exceed the fair market value of their assets. Accordingly, the Tax Court found that Appellants were not insolvent under S 108(d)(3) and therefore could not exclude discharge of indebtedness income under the insolvency exclusion set forth in 26 U.S.C. S 108(a)(1)(B). We have jurisdiction pursuant to 26 U.S.C. S 7482, and we affirm.

I

For the most part, the facts of this case are undisputed. During the taxable year 1991, Appellants were general partners in HMH Partners ("HMH"). The Merkels and Hepburns each owned twenty-five percent of HMH, and a third party owned the remaining fifty percent. On September 1, 1991, Great Western Bank granted forgiveness to HMH on a $1,439,000 non recourse note. As a result, as twenty-five percent partners, the Merkels and Hepburns each received $359,721 of discharge of indebtedness as distributable income. ¹ Appellants reported this debt discharge in their 1991 income tax returns. They excluded it from income, however, under 26 U.S.C. S 108(a)(1)(B) based upon their claimed insolvency.²

On March 24, 1995, the Commissioner mailed notices of deficiency pursuant to 26 U.S.C. S 6212 to the Merkels and Hepburns, indicating that for the taxable year 1991, each couple's federal income tax was deficient in the amounts of $115,420 and $116,347, respectively. On June 12, 1995, the Merkels and Hepburns filed petitions in the United States Tax Court challenging the Commissioner's determinations of deficiency. The Tax Court granted the Commissioner's motion to consolidate the cases.

The parties stipulated that the issue before the Tax Court was whether Appellants were insolvent within the meaning of 26 U.S.C. S 108(d)(3) immediately before the forgiveness of the note by Great Western Bank on September 1, 1991. Section 108(d)(3) defines "insolvent" as "the excess of liabilities over the fair market value of assets."³ To determine whether Appellants were insolvent under the statute, the Tax Court had to decide whether Appellants' guaranty on a loan was a S 108(d)(3) "liability" as of August 31, 1991.⁴ If the guaranty was a liability, Appellants were insolvent and the debt discharge was properly excludable from gross income under 108(a)(1)(B).

Appellants personally had guaranteed a loan made in 1986 by Security Pacific Bank (the "Bank") to Systems Leasing Corporation ("SLC"), a computer leasing business of which the Merkels and Hepburns each owned half.⁵ SLC was the sole maker of the note evidencing the debt to the Bank. Appellants personally guaranteed the SLC note pursuant to a document entitled "Continuing Guaranty (and Security Agreement)" (the "Guaranty"). As of April 16, 1991, the unpaid balance of the SLC note exceeded $3,100,000, and SLC was in default of its note obligations. At no time did the Bank make any formal written demand for payment from Appellants pursuant to the Guaranty.

On May 31, 1991, SLC, the Bank and Appellants, as guarantors, entered into a structured workout agreement (the "Letter Agreement") concerning the repayment of the indebtedness to the Bank. Under the Letter Agreement: (1) SLC agreed to pay the Bank $1,100,000 (the "payoff") on or before August 2, 1991 (the "settlement date"); (2) the Bank agreed to release its security interests in the remaining collateral upon payment of the payoff by the settlement date; and (3) after payment of the payoff by the settlement date, the Bank would refrain from exercising any remedies under the SLC note or the Guaranty if bankruptcy were not filed by or for SLC or the Merkels or Hepburns, among others, voluntarily or involuntarily, within 400 days after the settlement date (a "bankruptcy event").

SLC paid $1,100,000 to the Bank by the settlement date as called for under the Letter Agreement, and the Bank thereafter released its security interests in the remaining collateral of SLC. No bankruptcy petition was filed with respect to SLC, the Merkels or Hepburns, or any other persons or entities relevant to the Letter Agreement as of August 31, 1991. ⁶

The Commissioner argued before the Tax Court that Appellants' obligation under the Guaranty was not a liability for purposes of calculating insolvency under S 108(d)(3) because the term "liabilities" encompasses only obligations to pay that are ripe and in existence immediately before the discharge of indebtedness. In sustaining the Commissioner's determinations of income tax deficiency, the Tax Court took a different tack, holding that Appellants failed to prove by a preponderance of the evidence that as of August 31, 1991 (the measurement date), they "would be called upon to pay " their obligation under the Guaranty, and that therefore, the obligation was not a liability for purposes of calculating insolvency under S 108(d)(3). Accordingly, the Tax Court found that Appellants' total liabilities so proved did not exceed the fair market value of their assets and held that the discharge of indebtedness income could not be excluded under S 108(a)(1)(B). This appeal followed.

II

We review decisions of the Tax Court on the same basis as we would a decision rendered by a district court in a bench trial. See Estate of Rapp v. Commissioner, 140 F.3d 1211, 1214 (9th Cir. 1998). Its factual findings are reviewed for clear error. See id. That is, we must accept the Tax Court's findings of fact unless we are left with the definite and firm conviction that a mistake has been committed. See Sawyer v. Whitley, 505 U.S. 333, 346 n.14 (1992). The Tax Court's conclusions of law and construction of the Internal Revenue Code are reviewed de novo. See Estate of Rapp , 140 F.3d at 1215. Because the Tax Court has special expertise in the field, however, its opinions bearing on the Internal Revenue Code are "entitled to respect." Harbor Bancorp & Subsidiaries v. Commissioner, 115 F.3d 722, 727 (9th Cir. 1997), cert. denied, 118 S. Ct. 1035 (1998).

III

A

The parties agree that the determinative issue in this case is whether on August 31, 1991, Appellants' Guaranty was a "liability" for purposes of determining insolvency under S 108(d)(3). In resolving this issue, we must take into account that under the Letter Agreement, Appellants' obligation to pay pursuant to the Guaranty was contingent upon the occurrence of a bankruptcy event.

"When interpreting a statute, we ordinarily first look to the plain meaning of the language used by Congress. But if the statute is ambiguous, we consult the legislative history, to the extent that it is of value, to aid in our interpretation." Moyle v. Director, Office of Workers' Compensation Programs, 147 F.3d 1116, 1120 (9th Cir. 1998), cert. denied , 119 S. Ct. 1454 (1999) (quoting Straub v. A.P. Green, Inc., 38 F.3d 448, 452 (9th Cir. 1994). "When a statute does not define a term, we generally interpret that term by employing the ordinary, contemporary, and common meaning of the words that Congress used." United States v. Iverson, 162 F.3d 1015, 1022 (9th Cir. 1998). "If the plain meaning of the statute only supports one interpretation, the statute is not ambiguous." California v. Montrose Chemical Corp. of California, 104 F.3d 1507, 1514 (9th Cir. 1997). We are to construe exclusions from gross income narrowly in favor of taxation. See United States v. Centennial Savs. Bank, 499 U.S. 573, 583 (1991); Harbor Bancorp, 115 F.3d at 732.

In determining whether the Guaranty, as modified by the Letter Agreement, was a liability under S 108(d)(3), we find little guidance from the text and structure of the statute. The term "liabilities" is not defined in the Internal Revenue Code or in any Treasury Regulation. Moreover, S 108(d)(3) does not indicate how likely the occurrence of a contingency must be in order to count the obligation as a liability.

Black's Law Dictionary defines "liability" as a "broad legal term . . . including almost every character of hazard or responsibility, absolute, contingent, or likely. " Black's Law Dictionary 914 (6th ed. 1990). Under this definition, the Guaranty could be considered a liability because it is a "responsibility" that is "contingent." But, it is not clear from the statute whether Congress intended for all contingent liabilities to be considered in the insolvency calculation under S 108(d)(3). See 14 Mertens Law of Federal Income Taxation S 54.06 (1998) ("It is not clear whether the taxpayer can take into account contingent liabilities or contested liabilities; however, if a contingent liability is too remote to be reflected in basis, such...