Challenging Debt Liability Ab Initio In Order To Dispute Its Taxability Upon Discharge

In Preslar v Commissioner, 167 F.3d 1323 (10th Cir. 2000), the Tenth Federal Circuit considered the issue arising when a liquidated debt that is originally undisputed is thereafter compromised in a lesser amount. The Court ruled that, absent some infirmity in existence when the obligation is initially incurred, the settlement at a lesser amount thereafter gives rise to a taxable discharge of the amount otherwise owing, i.e., the difference between the original obligation and the settlement amount. To this extent, the Court appeared to disagree with the ruling of the Third Circuit in Zarin v Commissioner, 916 F.2d 110, 115 (3d Cir. 1990), which held that the balance otherwise remaining was not taxable as ‘forgiven’ debt.

And although the Court in Preslar preferred to contrast its holding with Zarin in terms of whether or not the obligation is ‘liquidated’ when originally incurred, in our view the two opinions can still be reconciled more intuitively, as the underlying original obligation in Zarin was always subject to dispute, having been incurred as the result of illicit gambling obligations. No such basis for disputing the original obligation was present in Preslar.

The Court in Preslar compared the case to one involving the existence of a non-recourse debt, which is taxable upon discharge in its face amount under Internal IRC §61(a)(12). Citing to Commissioner v Tufts, 461 U.S. 300, 311-13, the Court reasoned that if the distinction between recourse and non-recourse liability is no consequence in assessing taxability upon discharge, then the distinction between enforceability and unenforceability should be similarly disregarded. Preslar at 1329.

We question this rationale as perhaps overbroad. Indeed, the inducement of a fraudulently obligation cannot properly give rise to a tax benefit, nor a corresponding tax detriment under the disputed debt doctrine. Mind you, the doctrine is a judicially created one – an anathema to the well-ordered universe of the IRS – so that unscrupulous tax payers cannot derive tax benefits from deceptive trade practices.

Indeed, the court in Preslar went on to acknowledge that,  if the debt is unenforceable as a result of an infirmity at the time of its creation (e.g., fraud or misrepresentation), tax liability may be avoided through a basis reduction under 26 U.S.C. § 108(e)(5) providing for an “infirmity exception.” Preslar at 1329. It should be noted that ‘avoidance’ of taxability, in this context, is somewhat misleading, as the reduction of a tax attribute such as the basis in real property only defers its ultimate taxability upon disposition at a later time.

Accordingly, if it is reasonable to do so, any professional challenging the imputation of income for forgiveness of debt will be well served to take issue with the way in which the obligation was incurred ab initio, thereby receiving the benefit of the rulings in Preslar and Zarin. At worst, then, the taxpayer may only have to settle for a tax attribute reduction. At best, as in Zarin, there may be no taxable event at all.