Zarin v. C.I.R., 90-1240

• Decision Date: 10 October 1990
• Docket Number: No. 90-1240,90-1240
• Citation: 916 F.2d 110
• Parties: -5679, 59 USLW 2256, 90-2 USTC P 50,530 David & Louise ZARIN v. COMMISSIONER OF INTERNAL REVENUE. Appeal of David ZARIN and Louise Zarin.
• Court: U.S. Court of Appeals — Third Circuit

Page 110

916 F.2d 110

66 A.F.T.R.2d 90-5679, 59 USLW 2256, 90-2

USTC P 50,530

David & Louise ZARIN v. COMMISSIONER OF INTERNAL REVENUE Appeal of David ZARIN and Louise Zarin.

No. 90-1240.

United States Court of Appeals Third Circuit.

Argued Aug. 20, 1990.

Decided Oct. 10, 1990.

William M. Goldstein (argued), Theodore P. Seto, Drinker, Biddle & Reath, Philadelphia, Pa., for appellants.

Bruce Ellisen (argued), Gary R. Allen, U.S. Dept. of Justice, Tax Div., Washington, D.C., for appellee.

Before STAPLETON, COWEN and WEIS, Circuit Judges.

OPINION OF THE COURT

COWEN, Circuit Judge.

David Zarin ("Zarin") appeals from a decision of the Tax Court holding that he recognized $2,935,000 of income from discharge of indebtedness resulting from his gambling activities, and that he should be taxed on the income. ¹ This Court has jurisdiction to review the Tax Court's decision under section 7482 of the Internal Revenue Code (1954) (the "Code"). After considering the issues raised by this appeal, we will reverse.

I.

Zarin was a professional engineer who participated in the development, construction, and management of various housing projects. A resident of Atlantic City, New Jersey, Zarin occasionally gambled, both in his hometown and in other places where gambling was legalized. To facilitate his gaming activities in Atlantic City, Zarin applied to Resorts International Hotel ("Resorts") for a credit line in June, 1978. Following a credit check, Resorts granted Zarin $10,000 of credit. Pursuant to this credit arrangement with Resorts, Zarin could write a check, called a marker, ² and in return receive chips, which could then be used to gamble at the casino's tables.

Before long, Zarin developed a reputation as an extravagant "high roller" who routinely bet the house maximum while playing craps, his game of choice. Considered a "valued gaming patron" by Resorts, Zarin had his credit limit increased at regular intervals without any further credit checks, and was provided a number of complimentary services and privileges. By November, 1979, Zarin's permanent line of credit had been raised to $200,000. Between June, 1978, and December, 1979, Zarin lost $2,500,000 at the craps table, losses he paid in full.

Responding to allegations of credit abuses, the New Jersey Division of Gaming Enforcement filed with the New Jersey Casino Control Commission a complaint against Resorts. Among the 809 violations of casino regulations alleged in the complaint of October, 1979, were 100 pertaining to Zarin. Subsequently, a Casino Control Commissioner issued an Emergency Order, the effect of which was to make further extensions of credit to Zarin illegal.

Nevertheless, Resorts continued to extend Zarin's credit limit through the use of two different practices: "considered cleared" credit and "this trip only" credit. ³ Both methods effectively ignored the Emergency Order and were later found to be illegal. ⁴

By January, 1980, Zarin was gambling compulsively and uncontrollably at Resorts, spending as many as sixteen hours a day at the craps table. ⁵ During April, 1980, Resorts again increased Zarin's credit line without further inquiries. That same month, Zarin delivered personal checks and counterchecks to Resorts which were returned as having been drawn against insufficient funds. Those dishonored checks totaled $3,435,000. In late April, Resorts cut off Zarin's credit.

Although Zarin indicated that he would repay those obligations, Resorts filed a New Jersey state court action against Zarin in November, 1980, to collect the $3,435,000. Zarin denied liability on grounds that Resort's claim was unenforceable under New Jersey regulations intended to protect compulsive gamblers. Ten months later, in September, 1981, Resorts and Zarin settled their dispute for a total of $500,000.

The Commissioner of Internal Revenue ("Commissioner") subsequently determined deficiencies in Zarin's federal income taxes for 1980 and 1981, arguing that Zarin recognized $3,435,000 of income in 1980 from larceny by trick and deception. After Zarin challenged that claim by filing a Tax Court petition, the Commissioner abandoned his 1980 claim, and argued instead that Zarin had recognized $2,935,000 of income in 1981 from the cancellation of indebtedness which resulted from the settlement with Resorts.

Agreeing with the Commissioner, the Tax Court decided, eleven judges to eight, that Zarin had indeed recognized $2,935,000 of income from the discharge of indebtedness, namely the difference between the original $3,435,000 "debt" and the $500,000 settlement. Zarin v. Commissioner, 92 T.C. 1084 (1989). Since he was in the seventy percent tax bracket, Zarin's deficiency for 1981 was calculated to be $2,047,245. With interest to April 5, 1990, Zarin allegedly owes the Internal Revenue Service $5,209,033.96 in additional taxes. Zarin appeals the order of the Tax Court.

II.

The sole issue before this Court is whether the Tax Court correctly held that Zarin had income from discharge of indebtedness. ⁶ Section 108 and section 61(a)(12) of the Code set forth "the general rule that gross income includes income from the discharge of indebtedness." I.R.C. Sec. 108(e)(1). The Commissioner argues, and the Tax Court agreed, that pursuant to the Code, Zarin did indeed recognize income from discharge of gambling indebtedness.

Under the Commissioner's logic, Resorts advanced Zarin $3,435,000 worth of chips, chips being the functional equivalent of cash. At that time, the chips were not treated as income, since Zarin recognized an obligation of repayment. In other words, Resorts made Zarin a tax-free loan. However, a taxpayer does recognize income if a loan owed to another party is cancelled, in whole or in part. I.R.C. Secs. 61(a)(12), 108(e). The settlement between Zarin and Resorts, claims the Commissioner, fits neatly into the cancellation of indebtedness provisions in the Code. Zarin owed $3,435,000, paid $500,000, with the difference constituting income. Although initially persuasive, the Commissioner's position is nonetheless flawed for two reasons.

III.

Initially, we find that sections 108 and 61(a)(12) are inapplicable to the Zarin/Resorts transaction. Section 61 does not define indebtedness. On the other hand, section 108(d)(1), which repeats and further elaborates on the rule in section 61(a)(12), defines the term as any indebtedness "(A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property." I.R.C. Sec. 108(d)(1). In order to bring the taxpayer within the sweep of the discharge of indebtedness rules, then, the IRS must show that one of the two prongs in the section 108(d)(1) test is satisfied. It has not been demonstrated that Zarin satisfies either.

Because the debt Zarin owed to Resorts was unenforceable as a matter of New Jersey state law, ⁷ it is clearly not a debt "for which the taxpayer is liable." I.R.C. Sec. 108(d)(1)(A). Liability implies a legally enforceable obligation to repay, and under New Jersey law, Zarin would have no such obligation.

Moreover, Zarin did not have a debt subject to which he held property as required by section 108(d)(1)(B). Zarin's indebtedness arose out of his acquisition of gambling chips. The Tax Court held that gambling chips were not property, but rather, "a medium of exchange within the Resorts casino" and a "substitute for cash." Alternatively, the Tax Court viewed the chips as nothing more than "the opportunity to gamble and incidental services ..." Zarin, 92 T.C. at 1099. We agree with the gist of these characterizations, and hold that gambling chips are merely an accounting mechanism to evidence debt.

Gaming chips in New Jersey during 1980 were regarded "solely as evidence of a debt owed to their custodian by the casino licensee and shall be considered at no time the property of anyone other than the casino licensee issuing them." N.J.Admin.Code tit. 19k, Sec. 19:46-1.5(d) (1990). Thus, under New Jersey state law, gambling chips were Resorts' property until transferred to Zarin in exchange for the markers, at which point the chips became "evidence" of indebtedness (and not the property of Zarin).

Even were there no relevant legislative pronouncement on which to rely, simple common sense would lead to the conclusion that chips were not property in Zarin's hands. Zarin could not do with the chips as he pleased, nor did the chips have any independent economic value beyond the casino. The chips themselves were of little use to Zarin, other than as a means of facilitating gambling. They could not have been used outside the casino. They could have been used to purchase services and privileges within the casino, including food, drink, entertainment, and lodging, but Zarin would not have utilized them as such, since he received those services from Resorts on a complimentary basis. In short, the chips had no economic substance.

Although the Tax Court found that theoretically, Zarin could have redeemed the chips he received on credit for cash and walked out of the casino, Zarin, 92 T.C. at 1092, the reality of the situation was quite different. Realistically, before cashing in his chips, Zarin would have been required to pay his outstanding IOUs. New Jersey state law requires casinos to "request patrons to apply any chips or plaques in their possession in reduction of personal checks or Counter Checks exchanged for purposes of gaming prior to exchanging such chips or plaques for cash or prior to departing from the casino area." N.J.Admin.Code tit. 19k, Sec. 19:45-1.24(s) (1979) (currently N.J.Admin.Code tit. 19k, Sec. 19:45-1.25(o) (1990) (as amended)). Since his debt at all times equalled or exceeded the number of chips he possessed, redemption would have left Zarin with no chips, no cash, and certainly nothing which could have been characterized as property.

Not only were the chips non-property in Zarin's hands, but upon transfer to Zarin, the chips also ceased to be the...