Is Income from Discharge of Indebtedness Really Income at All? A Proposal for a More Reasoned Analysis

University of Memphis Law Review, The, Spring 2004 by Musselman, James L

I. INTRODUCTION

The income tax concept of income from discharge of indebtedness has generated a substantial amount of analysis, criticism, and controversy since it was first recognized as a potential item of gross income in 1926.1 Numerous commentators have discussed and criticized the opinions and rationale of courts that have recognized the concept, and have suggested various theories and proposals for its application in the particular factual contexts in which it has thus far been treated by the courts.2 No commentator or court has yet proposed or applied a rationale for the inclusion in income of discharge of indebtedness that has been uniformly accepted. As a result, the concept has been inconsistently applied by the courts in the factual contexts so far presented,3 and a danger exists that new cases presenting different facts will result in decisions that lack a logical and meaningful basis for support.4

The determination of whether a taxpayer must include a discharge of indebtedness in gross income requires, as with most other gross income issues, a two-part analysis.5 It must first be determined whether gross income conceptually exists pursuant to an analysis under section 61 of the Internal Revenue Code (Code),6 and applicable case law.7 If this analysis results in a determination that gross income does in fact exist, it must then be determined whether any portion of such amount may be excluded from gross income under section 108 of the Code8 or some other applicable exclusionary section.9 A number of conceptual bases have been adopted by the courts over the years for the non-inclusion of income from discharge of debt in certain factual contexts, which have now been codified in section 108.10 This article focuses entirely on the first part of the analysis under section 61 and applicable case law,11 and will not attempt to address issues involving the current version of section 108 or any other exclusionary section, except where necessary to offer an explanation for the result of certain cases hereinafter discussed.

This article traces the judicial history of the concept of income from discharge of indebtedness, identifying and discussing the opinions and rationale that the courts have so far offered for this concept.12 It then reviews and discusses relevant commentary regarding the theoretical basis and application of the concept.13 Next, the article proposes a more reasoned and logical approach to the determination of when and whether a discharge of indebtedness will result in inclusion in gross income, and the amount of any such inclusion.14 Specifically, the article suggests that the issue of income from discharge of indebtedness is no different from other gross income issues, requiring at the outset an inquiry into whether gross income conceptually exists pursuant to an analysis under section 61 of the Code. That inquiry, as this article proposes, simply requires a determination whether a discharge of indebtedness has resulted in a clearly realized accession to wealth and in what amount. Finally, the article discusses the application of this proposed approach to the factual situations identified in the cases previously discussed15 and to additional hypothetical factual situations yet to appear in reported cases.16

II. JUDICIAL HISTORY OF DISCHARGE OF INDEBTEDNESS

A. Early United States Supreme Court Cases Recognizing Discharge of Indebtedness as a Potential Item of Gross Income

1. Bowers v. Kerbaugh-Empire Co.

The income tax concept of income from discharge of indebtedness was first recognized as a potential item of gross income by the United States Supreme Court in 1926, in the case of Bowers v. Kerbaugh-Empire Co.17 In Kerbaugh-Empire, the taxpayer, between 1911 and 1913, borrowed funds from the Deutsche Bank of Germany (Bank) to finance work being done by its subsidiary.18 The promissory notes evidencing the loans were payable by the taxpayer in German marks or their equivalent in U.S. gold coin.19 The borrowed funds were advanced by the taxpayer to its subsidiary, and were expended by the subsidiary and lost in the operation of its business.20 After the United States entered World War I, the Bank became an alien enemy.21 After the war, the taxpayer finally repaid the loans, with the result that the amounts borrowed exceeded the amounts repaid (measured in U.S. dollars) by $684,456.18.22

The Internal Revenue Service (IRS) determined that such amount was includable in the taxpayer's gross income for the year in which the loans were repaid.23 In response, the taxpayer argued that the borrowed funds had been lost by its subsidiary in the operation of its business, and therefore no gross income derived from the transaction taken as a whole.24 The Kerbaugh-Empire Court, citing Eisner v. Macomber25 for the definition of income subject to the federal income tax, held that "[t]he transaction here in question did not result in gain from capital and labor, or from either of them, or in profit gained through the sale or conversion of capital . . . [because t]he result of the whole transaction was a loss."26 The Court explained its decision as follows: