Preslar v. C.I.R., 97-9016

• Decision Date: 16 February 1999
• Docket Number: No. 97-9016,97-9016
• Citation: 167 F.3d 1323
• Parties: -851, 99-1 USTC P 50,258, 1999 CJ C.A.R. 1870 Layne E. PRESLAR and Sue F. Preslar, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 1323

167 F.3d 1323

83 A.F.T.R.2d 99-851, 99-1 USTC P 50,258,

1999 CJ C.A.R. 1870

Layne E. PRESLAR and Sue F. Preslar, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

No. 97-9016.

United States Court of Appeals Tenth Circuit.

Feb. 16, 1999.

John A. Dudeck, Jr. (Richard Farber with him on the brief), Tax Division, Department of Justice, Washington, DC, for appellant.

Ron Lewis, Ruidoso, New Mexico, for appellees.

Before EBEL and BRISCOE, Circuit Judges, and MARTEN, District Judge. ¹ BRISCOE, Circuit Judge.

The Commissioner of Internal Revenue appeals the United States Tax Court's decision to redetermine the tax deficiency assessed against Layne and Sue Preslar for underpayment of 1989 federal income taxes. The Tax Court held the Preslars' settlement of a loan obligation for less than the face amount of the loan did not create taxable income because the contested liability/disputed debt exception to the general discharge-of-indebtedness income rule rendered the write-off nontaxable. We exercise jurisdiction pursuant to 26 U.S.C. § 7482(a)(1), and reverse and remand.

I.

Layne Preslar, a real estate agent of twenty-five years, commenced negotiations in 1983 to purchase a 2500-acre ranch near Cloudcroft, New Mexico. High Nogal Ranch, Inc., owned the ranch and was a debtor-in-possession in a Chapter 11 bankruptcy proceeding. Citizens State Bank of Carrizozo, Security Bank and Trust of Alamogordo, and Moncor Bank held mortgages in the ranch. Moncor Bank, which had been experiencing serious financial difficulties and whose interest was subordinate to the other banks, took the lead in assisting in negotiations between High Nogal and Preslar. Moncor Bank's actions were designed to avoid foreclosure and recoup as much of its loan as possible.

On July 12, 1983, after six months of talks, Layne and Sue Preslar agreed to purchase the ranch for $1 million, with the sale to be financed by Moncor Bank. The agreement expressly referred to the fact that Moncor Bank was financing the purchase, but only the Preslars and the president of High Nogal signed the contract on September 1, 1983. The Preslars executed a $1 million promissory note in favor of Moncor Bank, secured by a mortgage on the ranch. The Preslars were to pay fourteen annual installments of $66,667, with interest at twelve percent per annum, with final payment due September 1, 1998. Moncor Bank used $760,000 of the loan proceeds to satisfy the mortgages of Citizens State Bank and Security Bank and Trust. The Preslars thus received title to the ranch free and clear of all of High Nogal's prior mortgages.

The Preslars intended to develop the ranch as a sportsman's resort by subdividing 160 acres and selling one-- to two-acre lots for cabins or vacation homes, and permitting lot owners to hunt and engage in other outdoor recreational activities on the remaining 2,340 acres. The goal was to sell each cabin lot for approximately $16,500, with total gross revenues exceeding $1.5 million. The Preslars' 1989 joint tax return indicates several lots sold for substantially higher amounts.

Moncor Bank permitted the Preslars to repay their loan by assigning the installment sales contracts of purchasers of cabin lots to Moncor Bank at a discount. There is no reference to this unique repayment arrangement in the loan documents. The first written description of this repayment method appears in a May 3, 1984, letter from Joseph Ferlo, a representative of Moncor Bank, to Layne Preslar. The arrangement is also discussed in an unsigned 1985 "Dealer Agreement" between Moncor Bank and the Preslars. When each cabin lot was sold, the Preslars assigned and physically transferred the written sales contract to Moncor Bank. In return, Moncor Bank credited the Preslars' debt obligation in an amount equal to 95 percent of the stated principal contract price, regardless of actual payments received from the purchaser. Moncor Bank received a security interest in each lot sold to protect its interests in the event a purchaser defaulted. Between September 1983 and August 1985, the Preslars sold nineteen cabin lots and had assigned most of the contracts to Moncor Bank prior to its declared insolvency. Moncor Bank had credited the Preslars' principal loan balance with approximately $200,000. Funds applied to interest are not included in this amount; thus, the aggregate amount of discounted installment contracts assigned to Moncor Bank exceeded $200,000.

In August 1985, Moncor Bank was declared insolvent and the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver. The FDIC notified the Preslars of the insolvency and advised them to make all future payments on their loan to the FDIC. The FDIC refused to accept further assignments of sale contracts as repayment and ordered the Preslars to suspend sales of cabin lots. The Preslars complied with the suspension directive, but made no further payments on the loan.

The Preslars filed an action against the FDIC for breach of contract in September 1985, seeking an order requiring the FDIC to accept assignment of sales contracts as loan repayment. The parties settled the action in December 1988 after the FDIC agreed to accept $350,000 in full satisfaction of the Preslars' indebtedness. The Preslars borrowed the $350,000 from another bank and, after the funds were remitted to the FDIC, the original $1 million promissory note was marked "paid."

At the time of the settlement, the unpaid balance on the Preslars' loan was $799,463. The Preslars paid a total of $550,537 on the loan ($350,000 settlement plus $200,537 credited for assignment of sales contracts). Therefore, as a result of the settlement, the Preslars' outstanding debt obligation was reduced by $449,463 ($1 million less $550,537).

The Preslars did not include the $449,463 debt write-off as discharge-of-indebtedness income on their 1989 joint tax return. Rather, they opted to reduce their basis in the ranch by $430,000 pursuant to Internal Revenue Code § 108(e)(5), 26 U.S.C. § 108(e)(5). The Preslars' 1989 tax return was audited and they were assessed a deficiency because (1) they had realized $449,463 in discharge-of-indebtedness income, and (2) they were not eligible to treat such income as a purchase price adjustment under § 108(e)(5). A penalty was also assessed under Internal Revenue Code § 6651(a)(1), 26 U.S.C. § 6651(a)(1), for failure to file a timely return.

The Preslars sought a redetermination of the deficiency in United States Tax Court, insisting they were free to treat their settlement with the FDIC as a purchase price adjustment pursuant to § 108(e)(5) and/or common law. They supported this theory in part by claiming the FDIC's refusal to honor their repayment agreement with Moncor Bank amounted to an infirmity relating back to the original sale, thereby negating the general prohibition against treating debt reductions as purchase price adjustments. They further argued the complicated nature of their return was good cause for not timely filing. At no time, however, did the Preslars dispute their underlying liability on the $1 million note.

The Commissioner responded that the Preslars could not invoke § 108(e)(5) because that provision applies only to situations where the seller of property agrees to reduce the amount of the purchaser's debt flowing from the property sale. In this case, the Commissioner argued, the property seller was High Nogal. The party responsible for reducing the Preslars' debt was not the seller but was the FDIC (as receiver for Moncor Bank), thereby rendering § 108(e)(5) inapplicable. The Commissioner also argued the common law purchase price adjustment rule did not survive the adoption of § 108(e)(5). Finally, the Commissioner maintained the Preslars had not demonstrated good cause for the untimely filing of their 1989 return.

The Tax Court ruled in favor of the Preslars without addressing the purchase price adjustment issue. Instead, the court sua sponte invoked the contested liability doctrine and held the Preslars' unusual payment arrangement with Moncor Bank caused their liability for the full $1 million loan to be brought into question. The court determined the true amount of the Preslars' indebtedness was not firmly established until they settled with the FDIC; thus, no discharge-of-indebtedness income could have accrued to the Preslars as a result of the settlement. Although the court held the Preslars' untimely filing was not justified, it reasoned the absence of a tax deficiency negated the penalty assessment. The Preslars do not appeal the determination that their untimely filing was not justified.

II.

Decisions of the United States Tax Court are reviewed "in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury." 26 U.S.C. § 7482(a)(1). We review the Tax Court's factual findings for clear error and its legal conclusions de novo. See Schelble v. Commissioner, 130 F.3d 1388, 1391 (10th Cir.1997). The Preslars have the burden of proving the Commissioner's determinations are incorrect on factual issues. See id. (citing Tax Ct. R. Prac. & Proc. 142(a); Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 78 L.Ed. 212 (1933)). ²

Discharge-of-Indebtedness Income

Section 61(a) of the Internal Revenue Code broadly defines "gross income" as "all income from whatever source derived" except as expressly provided otherwise. 26 U.S.C. § 61(a). The phrase is intended to capture all "accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431, 75 S.Ct. 473, 99 L.Ed. 483 (1955). From its enactment, the "sweeping scope" of this provision and its statutory predecessors has been consistently emphasized by the Supreme Court. See Commissioner v. Schleier, 515 U.S. 323, 327-28, 115 S.Ct. 2159, 132 L.Ed.2d 294 (1995); Glenshaw Glass, 348 U.S. at 429-32 &...