Discharge Of Debt – Undisputed Liquid Obligation Required

The discharge-of-indebtedness doctrine applies when a taxpayer who has incurred an [undisputed] financial obligation is thereafter relieved of liability, in whole or in part. When that happens, the taxpayer recognizes taxable income equal to the difference between the initial obligation and the amount, if any, paid to discharge that obligation. A prerequisite to applying the doctrine, then, is that the taxpayer shall have incurred a financial obligation. Smith v. Commissioner, 198 F.3d 515, 530 (5th Cir. 1999)

In Smith, a deceased mineral rights royalty recipient was sued for having been overpaid by Exxon Oil. Based on the premise that that the amount claimed by Exxon for overpayment could be characterized as ‘discharged’ or ‘forgiven’ debt, her estate claimed a tax deduction for the full amount sought. However, the lawsuit was not resolved until after the decedent passed, and indeed after the deduction for discharged debt was claimed on the appropriate tax returns.

The Smith Court ultimately concluded that a claim vastly in excess of the amount actually settled upon at a later date cannot give rise to a tax deduction in the original amount while it was still subject to dispute and therefore ‘unliquidated’, reasoning that the lack of a defined obligation precluded the finding of preexisting indebtedness under IRC § § 61(a)(12).

In this respect, whereas the verbiage employed by the court framed the issue in terms of the liquidated/unliquidated dichotomy, the fact is that, as in the Zarin case, the obligation was unliquidated simply because the amount owing, if any, was still in dispute as of the date that the deduction was originally claimed. Smith at 530. This dispute was both as to the amount as well as the enforceability underlying amount.

The Court in Smith noted the differing results in Zarin and Preslar v. Commissioner 167 F.3d 1323 (10th Cir 1999), and opined as follows: “We need not choose today between the broad view of the contested liability doctrine accepted by the Third Circuit in Zarin and the more narrow view taken by the Tenth Circuit in Preslar. For here, both the amount and the enforceability of the debt were contested vigorously by the Estate; it was not until settlement that Exxon’s claim became liquidated. Thus, even if we assume arguendo that the view of the Preslar court is the correct one, the contested liability doctrine [**52]  applies here and buttresses our conclusion that the Estate did not realize income from the discharge of indebtedness.”

Ultimately, the Court focused on the lack of any borrowed funds at stake in the controversy, thus negating the precept that the forgiveness of an acknowledged obligation must have existed to warrant a discharge in the first place: “Borrowed funds are excluded from income in the first instance because the taxpayer’s obligation to repay the funds offsets any increase in the taxpayer’s assets; if the taxpayer is thereafter released from his obligation to repay, the taxpayer enjoys a net increase in assets equal to the forgiven portion of the debt and the basis for the original exclusion thus evaporates. …Thus analyzed, the reason why the discharge-of-indebtedness concept has no application to these facts becomes clear: There were no borrowed funds that were excluded from taxable income in the first place. 67 Rather, Decedent had paid income tax on Exxon’s royalty payments when she received them. There could be no release from an obligation to repay    that is, no “discharge”     because, until the parties settled the case, no such obligation actually existed.” Smith at 531. Thus concluding that no borrowing of money had occurred giving rise to an undisputed obligation, the Smith Court concluded that there could be no corresponding tax deduction for discharged indebtedness, in any amount, even that eventually settled upon.