UNITED STATES TAX COURT

116 T.C. No. 9

UNITED STATES TAX COURT

RODERICK E. CARLSON AND JEANETTE S. CARLSON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12068-99.

Filed February 23, 2001.

Ps, husband and wife, purchased a fishing vessel

(vessel). They financed that purchase by borrowing

money from a bank. As security for the loan, Ps granted the bank a mortgage interest in the vessel. Ps

became delinquent in making payments to the bank on the

loan, and the bank foreclosed on the vessel, sold it as

part of that foreclosure, used the proceeds from that

sale to reduce the outstanding principal balance of the

loan, and discharged the remaining balance of the loan.

As a result, Ps realized capital gain of $28,621 and

discharge of indebtedness (DOI) income of $42,142.

Ps excluded the DOI income from their gross income

pursuant to the insolvency exception of sec.

108(a)(1)(B), I.R.C., because they determined that they

were insolvent within the meaning of sec. 108(d)(3),

I.R.C. In making the insolvency calculation prescribed

by sec. 108(d)(3), I.R.C., Ps excluded certain assets

that they claim are exempt from the claims of creditors

under applicable State law. The parties agree that if

- 2 such assets may not be excluded in making that calculation, Ps were not insolvent within the meaning of sec.

108(d)(3), I.R.C., and may not exclude the DOI income

from gross income pursuant to sec. 108(a)(1)(B), I.R.C.

Held: The word “assets” as used in sec.

108(d)(3), I.R.C., includes assets exempt from the

claims of creditors under applicable State law.

Held, further: Ps are liable for the accuracyrelated penalty under sec. 6662(a), I.R.C., to the

extent stated herein.

Terry P. Draeger, for petitioners.

Kay Hill, for respondent.

OPINION

CHIECHI, Judge:

Respondent determined a deficiency in, and

an accuracy-related penalty under section 6662(a)1 on, petitioners’ Federal income tax (tax) for 1993 in the amounts of $14,449

and $2,890, respectively.

The issues remaining for decision are:

(1) Are petitioners entitled to exclude from gross income

under section 108(a)(1)(B) discharge of indebtedness (DOI) income

in the amount of $42,142?

We hold that they are not.

(2) Are petitioners liable for the accuracy-related penalty

1

Unless otherwise indicated, all section references are to

the Internal Revenue Code (Code) in effect for the year at issue.

All Rule references are to the Tax Court Rules of Practice and

Procedure.

- 3 under section 6662(a)?

We hold that they are to the extent

stated herein.

Background

This case was submitted fully stipulated.

The facts that

have been stipulated are so found.

Petitioners’ mailing address was in Chignik, Alaska, at the

time the petition was filed.

In 1988, petitioner Roderick E. Carlson, whose occupation

during the year at issue was commercial fisherman, and petitioner

Jeanette S. Carlson purchased the fishing vessel Yantari

(Yantari), a 44-foot seiner made of fiber glass that was built in

1982.

They paid $202,451 for that fishing vessel, which included

the engine.

Petitioners financed their purchase of the Yantari

by borrowing money (loan) from Seattle First National Bank (bank

or Seattle First).

As security for that loan, petitioners

granted to the bank a so-called preferred marine mortgage interest (mortgage) in the Yantari.

During 1992, petitioners became delinquent in making payments to the bank on the loan.

On February 8, 1993, when the

unpaid principal balance of the loan was $137,142, the bank

foreclosed on the Yantari, the Yantari was sold for $95,000 as

part of that foreclosure, the proceeds from that sale were used

to reduce the outstanding principal balance of the loan by

$95,000, and the bank discharged the remaining $42,142 of the

- 4 loan.

(For convenience, we shall refer collectively to the

bank’s foreclosure on the Yantari and the concomitant sale of the

Yantari and other events that occurred on February 8, 1993, as

the foreclosure sale.)

As a result of the foreclosure sale,

petitioners realized capital gain of $28,621 and DOI income of

$42,142.

Immediately preceding the foreclosure sale on February 8,

1993, petitioners had (1) assets located in the States of Alaska

and Washington which had an aggregate fair market value of

$875,251 and (2) liabilities which totaled $515,930.2

Included

2

Petitioners’ description of petitioners’ liabilities immediately preceding the foreclosure sale on Feb. 8, 1993, and the

amounts thereof stipulated by the parties are:

Description of

Liability

Seattle First

Washington Mutual

HFC (2nd Mortgage)

Seattle First

Seattle First

Seattle First

Seattle First Cr.

Alaska Airlines

Coastal Trans.

Discover

Hartig Rhodes

HFC Visa

Medden

Nordstrom

Bon Marche

Guiness Assoc.

Security Pacific

HFC Charge

Household Finance

Amount of

Liability

$137,142 (principal)

23,973 (interest)

96,280

61,546

9,575

4,196

11,456

4,068

284

5,610

1,710

4,447

804

1,246

806

1,855

35,100

4,319

6,941

2,828

(continued...)

- 5 in petitioners’ assets immediately preceding the foreclosure sale

on February 8, 1993, was a so-called Alaska limited entry fishing

permit which had a fair market value of $393,400.3

Petitioners’

Alaska limited entry fishing permit was a purse seine permit for

the commercial fishing of salmon in the Chignik, Alaska fishery

(petitioners’ fishing permit).

Petitioners jointly filed Form 1040, U.S. Individual Income

Tax Return, for 1993 (petitioners’ joint return).

In petition-

ers’ joint return, petitioners did not report any gain or loss or

any DOI income as a result of the foreclosure sale of the

2

(...continued)

Washington Mutual

I.R.S.

Sea Catch

ISA

Tina Carlson

1,039

28,000

24,950

22,755

25,000

3

The remaining assets included in petitioners’ total assets

immediately preceding the foreclosure sale on Feb. 8, 1993, and

the respective fair market values thereof stipulated by the

parties were:

Asset

Cash

Land in Chignik, Alaska

F/V Yantari

F/V Little One

Fish Bldg., Chignik, Alaska

Residence, Chignik, Alaska

Residence, Edmonton, Wash.

1989 Ford Aerostar

1988 Ford F150 Pickup

Personal prop., Chignik, Alaska

Office equip., Chignik, Alaska

Arabian horse

Fair Market Value

$ 7,261

35,000

95,000

1,964

1,500

150,000

159,026

15,000

10,000

2,100

2,000

3,000

- 6 Yantari.

However, petitioners attached to that return Form 1099-

A, Acquisition or Abandonment of Secured Property (Form 1099-A),

which the bank issued to petitioners and which showed that, on a

date that is not legible,4 the outstanding principal balance of

the loan secured by the Yantari was $137,142.

The following was

written by hand at the bottom of Form 1099-A that was attached to

petitioners’ joint return:

“Taxpayer Was Insolvent - No Tax

Consequence” (written statement).

Respondent timely issued to petitioners a notice of deficiency for 1993 (notice).

In the notice, respondent determined,

inter alia, to increase petitioners’ income by $42,142 for

“RELIEF OF DEBT” and by $28,629 for “DISPOSITION OF F/V YANTARNI

[sic]”.

Respondent also determined in the notice to impose an

accuracy-related penalty under section 6662(a).

Discussion

Petitioners bear the burden of proving that the determinations in the notice are erroneous.

Helvering, 290 U.S. 111, 115 (1933).

See Rule 142(a); Welch v.

That this case was submit-

ted fully stipulated does not change that burden or the effect of

a failure of proof.

See Rule 122(b); Borchers v. Commissioner,

95 T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th Cir. 1991).

4

Although the date on Form 1099-A is illegible, the parties

stipulated that the date for determining discharge of indebtedness income is Feb. 8, 1993.

- 7 DOI Income--Section 108

Section 61(a) defines the term “gross income” broadly to

mean all income from whatever source derived, including income

from discharge of indebtedness.

See sec. 61(a)(12).

Section

108(a) provides certain exceptions to section 61(a)(12).

See

Gitlitz v. Commissioner, 531 U.S. __, __, 69 U.S.L.W. 4060, 4062

(Jan. 9, 2001).

As pertinent here, section 108(a)(1)(B) (insol-

vency exception) excludes from gross income any amount that

otherwise would be includable in gross income by reason of the

discharge in whole or in part of indebtedness of the taxpayer if

the discharge occurs when the taxpayer is insolvent.

The amount

of DOI income excluded under section 108(a)(1)(B) is not to

exceed the amount by which the taxpayer is insolvent.

108(a)(3).

See sec.

The term “insolvent” is defined in section 108(d)(3)

as follows:

(3) Insolvent.–-For purposes of this section

[108], the term “insolvent” means the excess of liabilities over the fair market value of assets. With

respect to any discharge, whether or not the taxpayer

is insolvent, and the amount by which the taxpayer is

insolvent, shall be determined on the basis of the

taxpayer’s assets and liabilities immediately before

the discharge.

The parties’ general dispute here is whether, pursuant to

section 108(a)(1)(B), petitioners may exclude from gross income

for the year at issue $42,142 of DOI income resulting from the

foreclosure sale on February 8, 1993.

The parties agree that

resolution of that issue depends on whether, immediately before

- 8 that foreclosure sale, petitioners were insolvent within the

meaning of section 108(d)(3).

The parties’ specific dispute here

concerns the meaning of the word “assets” as used in section

108(d)(3).

It is petitioners’ position that the word “assets” as used

in section 108(d)(3) does not include assets that are exempt from

the claims of creditors under applicable State law.

In support

of that argument, petitioners rely principally on Cole v. Commissioner, 42 B.T.A. 1110 (1940), and Hunt v. Commissioner, T.C.

Memo. 1989-335.

According to petitioners, petitioners’ fishing

permit, which had a fair market value of $393,400 immediately

preceding the foreclosure sale on February 8, 1993, is an asset

exempt from the claims of creditors under the law of the State of

Alaska.5

5

Petitioners maintain that, pursuant to Cole and Hunt,

Petitioners also contend that certain other assets, i.e.,

petitioners’ principal residence, petitioners’ household goods

and wearing apparel, petitioners’ tools of the trade, and petitioners’ motor vehicle (collectively, petitioners’ other assets),

are assets exempt from the claims of creditors under applicable

State law to the extent of $54,000, $3,000, $2,800, and $3,000,

respectively. According to petitioners, those assets also are

not to be included in petitioners’ assets in performing the

calculation set forth in sec. 108(d)(3) for determining whether

petitioners are insolvent (insolvency calculation). Assuming

arguendo that we were to hold that the word “assets” as used in

sec. 108(d)(3) does not include assets that are exempt from the

claims of creditors under applicable State law and that petitioners’ fishing permit is an asset that is exempt from the claims of

creditors under the law of the State of Alaska, petitioners would

be insolvent within the meaning of sec. 108(d)(3) without regard

to whether a total of $62,800 of petitioners’ other assets that

petitioners claim are exempt from the claims of creditors under

(continued...)

- 9 petitioners’ fishing permit should be excluded in performing the

insolvency calculation under section 108(d)(3).

If the Court

were to sustain petitioners’ position, the parties agree that

petitioners would be insolvent within the meaning of section

108(d)(3) and that the insolvency exception of section

108(a)(1)(B) would exclude from their gross income for the year

at issue $42,142 of DOI income resulting from the foreclosure

sale on February 8, 1993.

Respondent counters that Cole v. Commissioner, supra, and

Hunt v. Commissioner, supra, on which petitioners rely do not

apply in the instant case.

According to respondent, the plain

meaning of the word “assets”, as well as the legislative history

of section 108(a)(1)(B), rejects the narrow definition of that

word which petitioners proffer.

Respondent argues in the alter-

native that even if the Court were to sustain petitioners’

5

(...continued)

applicable State law are to be excluded in the insolvency calculation under that section. Conversely, assuming arguendo that we

were to hold that the word “assets” as used in sec. 108(d)(3)

does not include assets that are exempt from the claims of

creditors under applicable State law and that a total of $62,800

of petitioners’ other assets are exempt from the claims of

creditors under applicable State law, petitioners would not be

insolvent within the meaning of sec. 108(d)(3) unless petitioners’ fishing permit were exempt from the claims of creditors

under applicable State law and were to be excluded in performing

the insolvency calculation under that section. Consequently, we

shall address petitioners’ argument regarding the meaning of the

word “assets” as used in sec. 108(d)(3) in the context solely of

petitioners’ fishing permit, and not in the context of petitioners’ other assets, all of which they claim are exempt from the

claims of creditors under applicable State law.

- 10 position as to the meaning of the word “assets” as used in

section 108(d)(3), petitioners have failed to show that petitioners’ fishing permit is in all instances exempt from the claims of

creditors under the law of the State of Alaska.

Our function in interpreting the Code is to construe it in a

way that will give effect to the intent of Congress.

See Merkel

v. Commissioner, 109 T.C. 463, 468 (1997), affd. 192 F.3d 844

(9th Cir. 1999).

Our starting point in resolving the parties’

dispute over the meaning of the word “assets” as used in section

108(d)(3) is the plain meaning of the language used by Congress.

See American Tobacco Co. v. Patterson, 456 U.S. 63, 68 (1982);

Merkel v. Commissioner, 192 F.3d 844, 848 (9th Cir. 1999), affg.

109 T.C. 463 (1997).

Where, as is the case here, the statute

does not define the word,6 we generally interpret it by using its

ordinary and common meaning.

See Merkel v. Commissioner, 192

F.3d at 848 (quoting United States v. Iverson, 162 F.3d 1015,

1022 (9th Cir. 1998)).

If the ordinary and common meaning of the

statutory language in question supports only one construction,

6

When Congress defined the term “insolvent” in sec.

108(d)(3) to mean the excess of liabilities over the fair market

value of assets, it did not provide in sec. 108 a definition of

the word “assets” (or the word “liabilities”, see Merkel v.

Commissioner, 109 T.C. 463, 468 (1997), affd. 192 F.3d 844 (9th

Cir. 1999)). Nor does the Code contain any generally applicable

definition of the word “assets” (or the word “liabilities”, see

id.). The regulations promulgated under sec. 108 do not elaborate on the definition of the term “insolvency” in sec. 108(d)(3)

and do not define the word “assets” (or the word “liabilities”,

see id.) used in that definition.

- 11 that statutory language is unambiguous.

See id. (quoting Cali-

fornia v. Montrose Chem. Corp., 104 F.3d 1507, 1514 (9th Cir.

1997)).

However, where the ordinary and common meaning of the

statutory language supports more than one interpretation, the

statutory language is ambiguous, and we may consult legislative

history to assist us in interpreting the language in question.

See Merkel v. Commissioner, 109 T.C. at 468-469.

We are to

construe exclusions from income, like section 108(a)(1)(B),

narrowly in favor of taxation.

See Merkel v. Commissioner, 192

F.3d at 848 (citing United States v. Centennial Sav. Bank FSB,

499 U.S. 573, 583 (1991); Harbor Bancorp & Subsidiaries v.

Commissioner, 115 F.3d 722, 732 (9th Cir. 1997)).

Bearing in mind the foregoing principles of statutory

construction, we shall consider initially respondent’s contention

that the plain meaning of the word “assets” supports only one

construction of that word as used in section 108(d)(3).

As

pertinent here, the common and ordinary meaning of the word

“assets” set forth in Merriam-Webster’s Collegiate Dictionary 69

(10th ed. 1996) is:

1 pl a : the property of a deceased person subject by

law to the payment of his or her debts and legacies b :

the entire property of a person, association, corporation, or estate applicable or subject to the payment of

debts * * * 3 * * * b pl : the items on a balance sheet

showing the book value of property owned

The first and second dictionary definitions of the word “assets”

quoted above appear to exclude from that definition assets exempt

- 12 from the claims of creditors under applicable State law.

That is

because under applicable State law such assets generally are not

subject to the payment of debts.

However, the third dictionary

definition of the word “assets” quoted above seems to include

assets exempt from the claims of creditors under applicable State

law.

That is because such assets are items appearing on a

balance sheet showing the value of property owned.

See Account-

ing and Fin. Reporting for Personal Fin. Statements, Statement of

Position 82-1 (AICPA 1982).

We conclude that the common and

ordinary meaning of the word “assets” as reflected in the dictionary definition of that word does not support only one construction.

We next turn to pertinent legislative history for guidance

in interpreting what Congress intended by its use of the word

“assets” in the definition of the term “insolvent” in section

108(d)(3).

Congress enacted section 108(a)(1)(B) and related provisions

(i.e., section 108(a)(3), (d)(3), and (e)(1)) into the Code in

1980 as part of the Bankruptcy Tax Act of 1980, Pub. L. 96-589,

sec. 2(a), 94 Stat. 3389 (1980 Bankruptcy Tax Act).

The stated

purpose of the 1980 Bankruptcy Tax Act was to “accommodate

bankruptcy policy and tax policy.”

(1980), 1980-2 C.B. 620, 624.

S. Rept. 96-1035 at 9-10

Such an accommodation was neces-

sary after Congress made significant changes to the Federal

bankruptcy laws in 1978 by passing the Bankruptcy Reform Act of

- 13 1978, Pub. L. 95-598, 92 Stat. 2549 (1978 Bankruptcy Reform Act),

which enacted title 11 into the United States Code (title 11).

In passing the 1980 Bankruptcy Tax Act, Congress “intended to

complete the process of revising and updating Federal bankruptcy

laws by providing rules governing the tax aspects of bankruptcy

and related tax issues.”

Staff of Joint Comm. on Taxation,

Description of H.R. 5043 (Bankruptcy Tax Act of 1980) as Passed

by the House, at 3 (J. Comm. Print 1980).

Both the Senate and

House reports accompanying H.R. 5043, 96th Cong., 2d Sess. (1980)

(H.R. 5043), which became the 1980 Bankruptcy Tax Act, indicate

that the proposed insolvency exception in section 108(a)(1)(B)

was intended to ensure that an insolvent debtor outside of

bankruptcy (like a debtor coming out of bankruptcy who is accorded a “fresh start” under the Federal bankruptcy laws) is not

to be burdened with an immediate tax liability.

See S. Rept. 96-

1035, supra, 1980-2 C.B. at 624; H. Rept. 96-833, at 9 (1980).

The committee reports accompanying H.R. 5043 describe in

pertinent part the tax law governing DOI income that was extant

at the time Congress passed the 1980 Bankruptcy Tax Act, as

follows:

Under present law, income is realized when indebtedness is forgiven or in other ways cancelled (sec.

61(a)(12) of the Internal Revenue Code). For example,

if a corporation has issued a $1,000 bond at par which

it later repurchases for only $900, thereby increasing

its net worth by $100, the corporation realizes $100 of

income in the year of repurchase (United States v.

Kirby Lumber Co., 284 U.S. 1 (1931)).

- 14 There are several exceptions to the general rule

of income realization. Under a judicially developed

“insolvency exception,” no income arises from discharge

of indebtedness if the debtor is insolvent both before

and after the transaction;1 and if the transaction

leaves the debtor with assets whose value exceeds

remaining liabilities, income is realized only to the

extent of the excess.2 * * *

1

Treas. Regs. § 1[.]61-12(b)(1); Dallas Transfer &

Terminal Warehouse Co. v. Comm’r, 70 F.2d 95 (5th Cir.

1934).

2

Lakeland Grocery Co., 36 B.T.A. 289 (1937).

S. Rept. 96-1035, supra, 1980-2 C.B. at 623; see H. Rept. 96-833,

supra at 7.

We shall discuss in greater detail the three cases referred

to in the foregoing excerpt of the committee reports accompanying

H.R. 5043.

In United States v. Kirby Lumber Co., 284 U.S. 1

(1931), the Supreme Court of the United States (Supreme Court)

established the rule that a debtor realizes (and must recognize)

income when discharged of indebtedness, i.e., when relieved of

indebtedness without full payment of the amount owed.

In Kirby

Lumber Co., the taxpayer had issued bonds for which it received

par value.

In the same year, the taxpayer repurchased some of

those bonds in the open market for less than their par value

issue price.

See id. at 2.

The Supreme Court held that the

taxpayer must recognize income in an amount (i.e., $137,521.30)

equal to the difference between the issue price and the repurchase price of the bonds in question.

See id. at 2, 3.

In so

holding, the Supreme Court reasoned:

“As a result of its [tax-

- 15 payer’s] dealings it made available $137,521.30 [of] assets

previously offset by the obligation of bonds now extinct.”

Id.

at 3.

Several years after the Supreme Court decided Kirby Lumber

Co., the U.S. Court of Appeals for the Fifth Circuit distinguished that case and established an insolvency exclusion to the

rule that the Supreme Court had announced in that case.

See

Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d

95 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933).

In Dallas

Transfer & Terminal Warehouse Co., the taxpayer was relieved of

indebtedness as the lessee of certain real property with respect

to unpaid rent and other bills totaling $107,881 when it conveyed

to the lessor of that property certain real property of lesser

value (i.e., $42,507) in which the taxpayer’s equity at the time

of conveyance was $17,507.

See id.

The Court of Appeals held

that the taxpayer did not realize income as a result of that

transaction.

See id. at 96.

In so holding, the Court of Appeals

stated:

In effect the transaction was similar to what occurs in

an insolvency or bankruptcy proceeding when, upon a

debtor surrendering, for the benefit of his creditors,

property insufficient in value to pay his debts, he is

discharged from liability for his debts. This does not

result in the debtor acquiring something of exchangeable value in addition to what he had before. There is

a reduction or extinguishment of liabilities without

any increase of assets. There is an absence of such a

gain or profit as is required to come within the accepted definition of income. * * * It hardly would be

contended that a discharged insolvent or bankrupt

- 16 receives taxable income in the amount by which his

provable debts exceed the value of his surrendered

assets. * * *

Id.

The Court of Appeals distinguished United States v. Kirby

Lumber Co., supra, as follows:

The instant case is substantially different from the

[Kirby Lumber Co.] case * * *. In the last-mentioned

case a corporation issued its bonds at par and in the

same year repurchased some of them at less than par.

The taxpayer’s [Kirby Lumber Co.’s] assets having been

increased by the cash received for the bonds, by the

repurchase of some of those bonds at less than par the

taxpayer, to the extent of the difference between what

it received for those bonds and what it paid in repurchasing them, had an asset which had ceased to be

offset by any liability, with a result that after that

transaction the taxpayer had greater assets than it had

before. The decision [Kirby Lumber Co.] * * * that the

increase in clear assets so brought about constituted

taxable income is not applicable to the facts of the

instant case, as the cancellation of the respondent’s

[Dallas Transfer & Terminal Warehouse Co.’s] past due

debt to its lessor did not have the effect of making

the respondent’s assets greater than they were before

that transaction occurred. * * *

Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra

at 96.

In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289

(1937), the Board of Tax Appeals (Board) considered the insolvency exclusion established by Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra.

In Lakeland Grocery Co., the

taxpayer entered into a so-called composition settlement under

which the taxpayer paid its creditors $15,473 in consideration of

being relieved of its indebtedness to those creditors in the

amount of $104,710.

Prior to entering into the composition

- 17 settlement, the taxpayer was insolvent.

After that settlement,

the taxpayer had net assets of $39,597, which, as noted by the

Board, “were freed from the claims of creditors as a result of

the * * * [discharge of indebtedness].”

Commissioner, supra at 291.

Lakeland Grocery Co. v.

The Board distinguished Dallas

Transfer & Terminal Warehouse Co. v. Commissioner, supra, from

the facts before it and concluded that the rationale of United

States v. Kirby Lumber Co., 284 U.S. 1 (1931), was applicable to

those facts.

291-292.

See Lakeland Grocery Co. v. Commissioner, supra at

The Board held that the taxpayer realized gain to the

extent of the value of the assets freed from the claims of its

creditors, i.e., to the extent it had assets (i.e., $39,597)

which ceased to be offset by any liability.

See id. at 292.

We recently had occasion in Merkel v. Commissioner, 109 T.C.

463 (1997), to review the three cases (United States v. Kirby

Lumber Co., supra, Dallas Transfer & Terminal Warehouse Co. v.

Commissioner, supra, and Lakeland Grocery Co. v. Commissioner,

supra) to which the committee reports accompanying H.R. 5043

refer and which we discuss above.

In Merkel, as here, we had to

determine whether a debtor qualified for the insolvency exception

in section 108(a)(1)(B).

However, in order to resolve that issue

in Merkel, we had to determine the meaning of the word “liabilities” as used in the definition of the term “insolvent” in

section 108(d)(3).

See Merkel v. Commissioner, supra at 466-467.

- 18 We observed in Merkel:

The Board’s approach to a taxpayer in financial

distress being discharged of an indebtedness, which

approach was crystallized in Lakeland Grocery Co. v.

Commissioner, supra, has been called, among other

things, the “net assets” test. That test is based on

the so-called freeing-of-assets theory derived from the

Supreme Court’s statement in Kirby Lumber that the

transaction “made available $137,521.30 assets previously offset by the obligation of bonds now extinct”.

* * * The net assets test is a corollary of the principle in Dallas Transfer that an insolvent debtor does

not realize income when discharged of indebtedness.

Under the net assets test, if the debtor remains insolvent (liabilities exceed assets) after being discharged

of indebtedness, no assets have been freed as a result

of the discharge since the debtor’s assets are still

more than offset by his postdischarge liabilities, and,

thus, no gross income is realized; if the debtor is

solvent (assets exceed liabilities) after being discharged, then the discharge has freed the debtor’s

assets from the offset of his liabilities to that

extent, and, thus, gross income is realized from the

discharge. In essence, the net assets test is simply

an examination of the debtor’s net worth after he is

discharged of indebtedness–-an increase in net worth

gives rise to income, but a decrease in negative net

worth does not.

Id. at 472-473; fn. ref. omitted.

We explained in Merkel that Congress

codified the net assets test in section 108(a)(1)(B),

(a)(3), and (d)(3) as a means of determining an exclusion from gross income of an item of income derived

from the discharge of indebtedness. Aside from the

parallel descriptions in the committee reports of the

preexisting law and of the proposed insolvency exclusion, * * * that codification is apparent from the

statutory insolvency calculation coupled with the

insolvency exclusion limitation provided in section

108(a)(3), which together share the same underlying

analytical framework as the net assets test. That

framework requires an examination of the debtor’s

assets and liabilities for the purpose of determining

whether the debtor’s net worth turns positive (assets

- 19 exceed liabilities), i.e., whether assets are freed, as

a result of the debtor’s being discharged of indebtedness.

*

*

*

*

*

*

*

From our examination of the statutory language,

the legislative history, and the relevant cases cited

in the committee reports, we conclude that the analytical framework of the insolvency exclusion and its

related provisions [in section 108] is based on the

freeing-of-assets theory. * * *

A solvent debtor is capable of meeting his financial obligations because his assets equal or exceed his

liabilities. That excess (if any) is not increased

when an obligation that offsets assets is paid in full

because the reduction in liabilities is equal to the

reduction in assets. If the reduction in liabilities

exceeds the reduction in assets, then, under the

freeing-of-assets theory, the solvent debtor has realized a gain to the extent of that excess. * * * Pursuant to the freeing-of-assets theory, a debtor does not

realize income when discharged of a particular indebtedness, however, if his postdischarge liabilities equal

or exceed his postdischarge assets (if any); i.e.,

under the net assets test, the debtor’s liabilities

equal or exceed his assets after the discharge (or, the

statutory insolvency calculation shows that the debtor

is insolvent by an amount greater than or equal to the

discharge of indebtedness income * * *

Id. at 473-475; fn. ref. omitted.

With the foregoing in mind, we shall now consider petitioners’ argument that we follow Cole v. Commissioner, 42 B.T.A. 1110

(1940), in defining the word “assets” as used in the definition

of the term “insolvent” in section 108(d)(3).7

7

In Cole, the

Petitioners also urge us to follow Hunt v. Commissioner,

T.C. Memo. 1989-335. Petitioners argue that we previously held

in Hunt that, for purposes of sec. 108(a)(1)(B), the word “assets” in sec. 108(d)(3) does not include assets exempt from the

(continued...)

- 20 Board began its analysis by acknowledging that under Lakeland

Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the taxpayer,

a resident of New York, would realize income upon the discharge

of his indebtedness “to the extent of the excess of total assets

over total liabilities immediately after * * * [discharge].”

Cole v. Commissioner, supra at 1112.

In determining whether

there was such an excess, the Board stated:

In determining the amount in [sic] which petitioner’s net assets were increased as a result of the

cancellation of petitioner’s indebtedness by his creditor, i.e., the amount of petitioner’s assets which

ceased to be offset by claims of creditors, there

should be, and has been, omitted from the value of

petitioner’s assets the value of his equity in ten life

insurance policies. * * *

7

(...continued)

claims of creditors under applicable State law. We reject that

argument and petitioners’ characterization of Hunt as a case

decided under sec. 108(a)(1)(B). Hunt involved tax year 1980.

The insolvency exception in sec. 108(a)(1)(B) that was enacted

into the Code as part of the 1980 Bankruptcy Tax Act became

effective for transactions occurring after Dec. 31, 1980. See

1980 Bankruptcy Tax Act, Pub. L. 96-589, sec. 7(a)(1), 94 Stat.

3411. Although in certain circumstances Congress made available

to debtors in bankruptcy cases or similar judicial proceedings an

election to substitute Sept. 30, 1979, as the effective date of

the 1980 Bankruptcy Tax Act, see id. at sec. 7(f)(1), there is no

indication in Hunt that the taxpayers involved there made such an

election, see Hunt v. Commissioner, supra. Our discussion in

Hunt of sec. 108 as amended by the 1980 Bankruptcy Tax Act

(amended sec. 108) is dictum and appears in Hunt after we resolved the issue presented to us with respect to DOI income under

the tax law that was extant prior to the passage of the 1980

Bankruptcy Tax Act. See Hunt v. Commissioner, supra. In this

connection, it is noteworthy that we began our discussion of

amended sec. 108 in Hunt by stating: “Furthermore, the correctness of our result is reinforced by the language of [amended]

section 108.” Id.

- 21 Id. at 1113.

The Board explained in Cole that it excluded the

value of the taxpayer’s equity in certain life insurance policies

from its determination of the value of the taxpayer’s assets

because “Under the applicable law of New York * * * such equity

in insurance was free from claims of creditors.”

Id.

We reject petitioners’ argument that we apply Cole in this

case.

When Congress enacted the insolvency exception into the

Code as section 108(a)(1)(B), one of the related provisions it

also enacted is section 108(e)(1).8

Section 108(e)(1) provides

that, for purposes of title 26 of the United States Code (i.e.,

the Internal Revenue Code, including section 61(a)(12)), “there

shall be no insolvency exception from the general rule that gross

income includes income from the discharge of indebtedness”

except as provided in section 108(a)(1)(B).

8

As the Supreme Court

When Congress “codified the net assets test in section

108(a)(1)(B), (a)(3), and (d)(3),” Merkel v. Commissioner, 109

T.C. at 473, it codified the net assets test developed by Dallas

Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95

(5th Cir. 1934), revg. 27 B.T.A. 651 (1933), and Lakeland Grocery

Co. v. Commissioner, 36 B.T.A. 289 (1937). It did not codify the

application of the net assets test by Cole v. Commissioner, 42

B.T.A. 1110 (1940). The committee reports accompanying H.R. 5043

make no reference to and do not describe the holding of Cole,

whereas those reports do refer to and describe the holdings of

Dallas Transfer & Terminal Warehouse Co. and Lakeland Grocery Co.

Nor do those committee reports refer to the two cases that

applied Cole v. Commissioner, supra, which had been decided as of

the time Congress passed the 1980 Bankruptcy Tax Act, i.e., Davis

v. Commissioner, 69 T.C. 814, 833-834 (1978), and Estate of

Marcus v. Commissioner, T.C. Memo. 1975-9. See also Babin v.

Commissioner, T.C. Memo. 1992-673, affd. on other grounds 23 F.3d

1032 (6th Cir. 1994); Hunt v. Commissioner, supra, decided after

Congress passed that Act.

- 22 very recently stated, “Section 108(e)[(1)] precludes us from

relying on any understanding of the judicial insolvency exception

that was not codified in §108.”

Gitlitz v. Commissioner, 531

U.S. at __, 69 U.S.L.W. at 4063.

Even before Gitlitz was de-

cided, we reached a similar conclusion in Merkel v. Commissioner,

109 T.C. 463 (1997).

We stated in pertinent part:

As Congress enacted the insolvency exclusion

[section 108(a)(1)(B)], it eliminated the net assets

test as a judicially created exception to the general

rule of income from the discharge of indebtedness. See

sec. 108(e)(1). The fundamental difference between the

insolvency exclusion [in section 108(a)(1)(B)] and the

[judicially developed] net assets test is that the

insolvency exclusion is applicable only if there exists

income from the discharge of indebtedness, whereas the

net assets test engages in the threshold inquiry.

Therefore, unlike the net assets test, the insolvency

exclusion does not necessarily invade the province of

section 61(a)(12).

Essentially, the insolvency exclusion defers to

section 61(a)(12) as to the definition of the term

“gross income”, but represents a policy judgment that

certain of that income should not give rise to an

immediate tax liability. The relevant committee reports intimate that the policy judgment underlying the

insolvency exclusion serves a humanitarian purpose–-to

avoid burdening an insolvent debtor outside of bankruptcy with an immediate tax liability. * * *

Merkel v. Commissioner, supra at 481-482; fn. ref. omitted.

We conclude that section 108(e)(1) precludes in this case

(or in any other case involving the insolvency exception in

section 108(a)(1)(B)) the application of Cole v. Commissioner,

supra, and any other judicially developed insolvency exception to

the general rule of section 61(a)(12) that gross income includes

- 23 income from the discharge of indebtedness.

See Gitlitz v.

Commissioner, supra at ___, 69 U.S.L.W. at 4063; Merkel v.

Commissioner, supra at 481.

Our conclusion that Cole v. Commissioner, 42 B.T.A. 1110

(1940), has no application in the instant case not only carries

out the directive of section 108(e)(1), it also carries out the

intention of Congress in enacting section 108(d)(3) that assets

exempt from the claims of creditors under applicable State law

are not to be excluded in determining the fair market value of a

taxpayer’s assets for purposes of ascertaining whether the

taxpayer is insolvent within the meaning of section 108(d)(3).

Congress’ intention is disclosed by an examination of section

108(d)(3) together with the 1978 Bankruptcy Reform Act and its

legislative history and the 1980 Bankruptcy Tax Act and its

legislative history.

One of the stated policies of the 1978

Bankruptcy Reform Act was “to provide a fresh start”, S. Rept.

95-989, at 6 (1978), for debtors coming out of bankruptcy.

The

principal mechanism adopted by Congress in the 1978 Bankruptcy

Reform Act for providing such a “fresh start” in the Federal

bankruptcy laws is through the discharge of debts.9

See id. at

98.

9

The discharge-of-debt provisions of the 1978 Bankruptcy

Reform Act, Pub. L. 95-598, sec. 727, 92 Stat. 2609, are described in the accompanying Senate report as “the heart of the

fresh start provisions of the bankruptcy law”. S. Rept. 95-989,

at 7, 98 (1978).

- 24 Congress also adopted another method in the 1978 Bankruptcy

Reform Act for providing a “fresh start” to debtors coming out of

bankruptcy, namely, allowing debtors in bankruptcy to retain

after bankruptcy certain property classified as exempt property

for purposes of title 11 (title 11 exempt property), which

includes property exempt from the claims of creditors under

applicable State law.

See 1978 Bankruptcy Reform Act, Pub. L.

95-598, sec. 522(b)(2)(A), 92 Stat. 2549, 2586, 11 U.S.C. sec.

522(b)(2)(A) (Supp. II, 1978);10 see also S. Rept. 95-989, supra

at 6.

The role of title 11 exempt property in the Federal

bankruptcy laws is evidenced by, for example, the definition of

the term “insolvent” for purposes of title 11 that Congress

adopted in section 101(26) of the 1978 Bankruptcy Reform Act, 92

10

Although there have been amendments to 11 U.S.C. sec.

522(b) as originally enacted that were in effect for the year at

issue, those amendments are not material to a resolution of the

issue presented here under sec. 108. See 11 U.S.C. sec. 522(b)

(1994).

- 25 Stat. 2553, 11 U.S.C. sec. 101(26) (Supp. II, 1978).11

11

In deter

Sec. 101(26) of the 1978 Bankruptcy Reform Act provides:

(26) “insolvent” means--

(A) with reference to an entity other than a

partnership, financial condition such that the sum of

such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of–(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud

such entity’s creditors; and

(ii) property that may be exempted from property of the [bankruptcy] estate under section 522

of this title; * * *

1978 Bankruptcy Reform Act, sec. 101(26), 92 Stat. 2549, 11

U.S.C. sec. 101(26) (Supp. II, 1978). Although there have been

amendments to sec. 101(26) of title 11 as originally enacted that

were in effect for the year at issue, those amendments are not

material to a resolution of the issue presented here under sec.

108. See 11 U.S.C. sec. 101(32) (1994).

Sec. 522(b) of the 1978 Bankruptcy Reform Act, 92 Stat.

2586, 11 U.S.C. sec. 522(b) (Supp. II, 1978), which allows a

debtor in bankruptcy to exclude exempt title 11 property from

property of the debtor’s bankruptcy estate, provides:

(b) Notwithstanding section 541 of this title, an

individual debtor may exempt from property of the

[bankruptcy] estate either–(1) property that is specified under subsection (d) of this section, unless the State law

that is applicable to the debtor under paragraph

(2)(A) of this subsection specifically does not so

authorize; or, in the alternative,

(2)(A) any property that is exempt under

Federal law, other than subsection (d) of this

section, or State or local law that is applicable

on the date of the filing of the petition at the

place in which the debtor’s domicile has been

(continued...)

- 26 mining whether a debtor in bankruptcy is insolvent for purposes

of title 11, the debtor’s title 11 exempt property, which includes property exempt from the claims of creditors under applicable State law, is excluded from the property he otherwise owns.

See 1978 Bankruptcy Reform Act, sec. 101(26), 11 U.S.C. sec.

101(26) (Supp. II, 1978).

When it passed the 1980 Bankruptcy Tax Act, Congress was

aware of the role that it had decided to give title 11 exempt

property in the 1978 Bankruptcy Reform Act.

In particular, when

Congress enacted into the Code the insolvency exception in

section 108(a)(1)(B) and the definition of “insolvent” in section

108(d)(3), it knew that it had decided to, and did, define the

term “insolvent” in section 101(26) of the 1978 Bankruptcy Reform

Act, 11 U.S.C. sec. 101(26) (Supp. II, 1978), to exclude specifi-

11

(...continued)

located for the 180 days immediately preceding the

date of the filing of the petition, or for a longer portion of such 180-day period than in any

other place; and

(B) any interest in property in which the

debtor had, immediately before the commencement of

the case, an interest as a tenant by the entirety

or joint tenant to the extent that such interest

as a tenant by the entirety or joint tenant is

exempt from process under applicable nonbankruptcy

law.

Sec. 541 of the 1978 Bankruptcy Reform Act, 92 Stat. 2594,

governs the creation and composition of the bankruptcy estate.

Sec. 522(d) of the 1978 Bankruptcy Reform Act, 92 Stat. 2586,

identifies 11 categories of property, each of which is considered

title 11 exempt property.

- 27 cally title 11 exempt property of a debtor in bankruptcy, including property exempt from the claims of creditors under applicable

State law, in determining whether that debtor is insolvent for

purposes of the Federal bankruptcy laws.

24 (1980), 1980-2 C.B. 620, 632.12

See S. Rept. 96-1035 at

However, Congress decided to,

and did, adopt a different definition of the term “insolvent” in

section 108(d)(3) for purposes of section 108.

Unlike the

definition of the term “insolvent” in section 101(26) of the 1978

Bankruptcy Act, 11 U.S.C. sec. 101(26) (Supp. II, 1978), which

Congress adopted for purposes of the Federal bankruptcy laws, the

definition of that term which Congress adopted for purposes of

section 108 does not specifically exclude assets of a debtor that

are exempt from the claims of creditors under applicable State

law or any other title 11 exempt property in determining whether

the debtor is insolvent.

We conclude that the decision of

12

The Senate report accompanying the 1980 Bankruptcy Tax Act

states in pertinent part:

Under bankruptcy law, the commencement of a liquidation or reorganization case involving an individual

debtor creates an “estate” which consists of property

formerly belonging to the debtor. The bankruptcy

estate generally is administered by a trustee for the

benefit of creditors, and it may derive its own income

and incur expenditures. At the same time, the individual is given a “fresh start”–-that is, wages earned by

the individual after commencement of the case and

after-acquired property do not become part of the

bankruptcy estate, but belong to the individual, and

certain property may be set aside as exempt.

S. Rept. 96-1035 at 24 (1980), 1980-2 C.B. 620, 632.

- 28 Congress not to define the term “insolvent” in section 108(d)(3)

to exclude specifically such exempt assets in determining whether

a debtor is insolvent for purposes of section 108 was intentional.13

We further conclude that Congress did not intend to

exclude assets exempt from the claims of creditors under applicable State law from a taxpayer’s assets for purposes of determining whether the taxpayer is insolvent within the meaning of

section 108(d)(3).

If Congress had intended to exclude such

exempt assets from a taxpayer’s assets in determining whether the

taxpayer is insolvent for purposes of section 108, Congress would

have so stated in section 108(d)(3).

It did not.

Our conclusion that Cole v. Commissioner, 42 B.T.A. 1110

(1940), has no application in the instant case also leads to a

result that comports with the intention of Congress in enacting

13

In this regard, Myron M. Sheinfeld (Mr. Sheinfeld), a

witness who testified at the Congressional hearings on H.R. 5043

as passed by the House of Representatives (House), see H.R. 5043,

96th Cong., 1st Sess. (1979), pointed out at those hearings that

the definition of “insolvent” in H.R. 5043 as passed by the House

was different from the definition of that term in title 11 and

that “the differing definitions of insolvent will, unless made

consistent, cause substantial trouble and litigation.” Hearings

on H.R. 5043 Before the Subcomm. on Select Revenue Measures of

the House Comm. on Ways and Means (Hearings on H.R. 5043), 96th

Cong., 1st Sess. 41 (1979) (statement of Myron M. Sheinfeld,

Chairman, Committee on Tax Matters, National Bankruptcy Conference). Mr. Sheinfeld recommended that Congress adopt as the

definition of the term “insolvent” in the final version of H.R.

5043 the same definition of the term “insolvent” that Congress

had adopted in sec. 101(26) of the 1978 Bankruptcy Reform Act, 11

U.S.C. sec. 101(26) (Supp. II, 1978). See Hearings on H.R. 5043,

supra at 43. Congress chose not to do so.

- 29 section 108(a)(1)(B) and related provisions into the Code.

As we

explained in Merkel v. Commissioner, 109 T.C. at 475,

Congress’ indicated purpose of not burdening an insolvent debtor outside of bankruptcy with an immediate tax

liability, * * *, together with the operation of the

insolvency exclusion [section 108(a)(1)(B)] and its

limitation under section 108(a)(3), in accordance with

the statutory insolvency calculation [section

108(d)(3)], suggest that Congress intended to make a

debtor’s ability to pay an immediate tax on income from

discharge of indebtedness the controlling factor in

determining whether a tax burden is imposed. * * *

Ability to pay an immediate tax (i.e., the statutory notion of insolvency) is a question of fact

* * * .

Although an asset of a debtor may be exempt from the claims

of creditors under applicable State law, if that asset and the

debtor’s other assets exceed the debtor’s liabilities, the debtor

has the ability to pay an immediate tax on income from discharged

indebtedness.

In the instant case, immediately preceding the

foreclosure sale on February 8, 1993, the aggregate fair market

value of petitioners’ assets was $875,251, which included petitioners’ fishing permit valued at $393,400 that they claim is

exempt from the claims of creditors under the law of the State of

Alaska.

At that time, petitioners’ liabilities totaled $515,930.

On the record before us, we find that petitioners had the “ability to pay an immediate tax on”, id., the $42,142 of DOI income

resulting from the foreclosure sale in question.14

14

Requiring

Not only did petitioners have the ability to pay an imme(continued...)

- 30 petitioners to include that income in their gross income for the

year at issue and pay a tax thereon is a result that is consistent with the intention of Congress in enacting section

108(a)(1)(B) and related provisions into the Code.

We hold that the word “assets” as used in the definition of

the term “insolvent” in section 108(d)(3) includes assets exempt

from the claims of creditors under applicable State law.15

The

14

(...continued)

diate tax on the DOI income at issue, petitioners’ fishing permit

is subject to lien and levy by respondent to pay that tax. See

secs. 6321, 6331. In this regard, apparently there has been some

dispute between the State of Alaska and the Internal Revenue

Service as to whether permits like petitioners’ fishing permit

constitute property or a right to property for purposes of secs.

6321 and 6331. See Internal Revenue Service Restructuring and

Reform Act of 1998, Pub. L. 105-206, sec. 3445(c)(2), 112 Stat.

763; 144 Cong. Rec. S4518 (daily ed. May 7, 1998) (statement of

Sen. Stevens) (“The State of Alaska has never conceded that these

permits are property that may be seized by IRS. Yet, the IRS

seizes them”.). However, in the instant case, the parties

stipulated that petitioners’ fishing permit is an asset (i.e.,

property).

In addition, it is noteworthy that, effective Aug. 1, 2000,

petitioners may obtain a loan in an amount which does not exceed

$30,000, see Alaska Stat. sec. 16.10.310 (Lexis 2000), and which

is secured by petitioners’ fishing permit in order “to satisfy

past due federal tax obligations that may result in the execution

on and involuntary transfer of [that permit]”. Alaska Stat. sec.

16.10.310(a)(1)(A)(iii) (Lexis 2000).

15

Assuming arguendo that we had found that the word “assets”

as used in sec. 108(d)(3) does not include assets exempt from the

claims of creditors under applicable State law, we nonetheless

find on the record before us that petitioners have failed to

establish that petitioners’ fishing permit qualifies in all

instances as such an asset. On brief, petitioners rely on Alaska

Stat. sec. 09.38.015(a)(8) (Lexis 2000), and on Alaska Stat. sec.

16.43.150(g) (Lexis 2000), to show that petitioners’ fishing

(continued...)

- 31 parties agree that if we were to so hold, petitioners would not

be “insolvent” within the meaning of section 108(d)(3), and the

insolvency exception of section 108(a)(1)(B) would not apply to

the $42,142 of DOI income resulting from the foreclosure sale in

question.

Consequently, we sustain respondent’s determination to

include that DOI income in petitioners’ gross income for the year

at issue.

Accuracy-Related Penalty--Section 6662

Respondent determined that petitioners are liable for the

year at issue for the accuracy-related penalty under section

15

(...continued)

permit is exempt from creditors’ claims under the laws of the

State of Alaska. Petitioners are correct that Alaska Stat. sec.

09.38.015(a)(8) (Lexis 2000) generally exempts limited entry

fishing permits like petitioners’ fishing permit from the claims

of creditors. See also Alaska Stat. sec. 09.38.500(5) (Lexis

2000). In addition, Alaska Stat. sec. 16.43.150(g)(1) (Lexis

2000) provides that such permits cannot be “pledged, mortgaged,

leased, or encumbered in any way”, except as specifically provided in certain enumerated sections of the Alaska statutes.

However, petitioners fail to indicate that limited entry fishing

permits, like petitioners’ fishing permit, are not exempt from

creditors’ claims under Alaska law for all purposes and that such

permits may be used to secure a loan for the payment of past due

Federal tax obligations. For example, petitioners do not discuss

the effect of Alaska Stat. sec. 09.38.065 (Lexis 2000), which

allows under certain circumstances creditors to make claims

against certain assets that are generally exempt from creditors’

claims under certain provisions of the Alaska statutes. In

addition, petitioners do not mention that petitioners’ fishing

permit is subject to lien and levy by respondent. See supra

n.14. Nor do petitioners address the effect of recently enacted

legislation in Alaska that allows petitioners to obtain a loan in

an amount not exceeding $30,000, secured by petitioners’ fishing

permit, in order to pay their past due Federal tax liabilities

that may result in the execution on and involuntary transfer of

petitioners’ fishing permit. See supra n.14.

- 32 6662(a).

In the notice and on brief, respondent asserted two

alternative grounds for the imposition of that penalty:

A

substantial understatement of income tax under section 6662(b)(2)

and negligence under section 6662(b)(1).

Respondent concedes that if the Court were to hold that

petitioners must recognize the DOI income at issue, the accuracyrelated penalty should not be imposed on that portion of the

underpayment of tax attributable to that income.

That is because

respondent takes the position that petitioners made an adequate

disclosure under section 6662(d)(2)(B)(ii)(I) and that they had a

reasonable basis under section 6662(d)(2)(B)(ii)(II) for their

treatment of such income in petitioners’ joint return.

Petitioners concede that the accuracy-related penalty should

be imposed on the remaining portion of the underpayment of tax

except to the extent it relates to the capital gain that they

concede on brief they realized and must recognize as a result of

the foreclosure sale of the Yantari (petitioners’ capital gain).

With respect to the accuracy-related penalty relating to the

portion of the underpayment of tax attributable to petitioners’

capital gain, petitioners contend that

Petitioners made the same disclosure as it applies to

the gain on sale as to the gain on forgiveness of debt.

If taxpayer, without having the ability of hindsight,

had believed the vessel only had a value of $60,000,

the gain from the deemed sale would be $0.00 and the

gain from the discharge of indebtedness would have

correspondingly increased from $35,000 to $77,000. The

same disclosure Petitioners made with respect to the

- 33 disclosure of indebtedness issue, which was adequate

for that issue, also applies to the capital gain from

the same transaction.

*

*

*

*

*

*

*

The Petitioners adequately disclosed their position by

indicating that the entire debt forgiveness should not

be recognized due to Petitioners’ insolvency. In

Petitioners’ calculation, there was no capital gain,

only gain from the discharge of indebtedness. * * *

As we understand petitioners’ position with respect to the

accuracy-related penalty relating to the underpayment of tax

attributable to petitioners’ capital gain, they advance two

separate contentions.

First, petitioners maintain that they made

adequate disclosure under section 6662(d)(2)(B)(ii)(I) regarding

that gain by attaching Form 1099-A to petitioners’ joint return

and writing thereon “Taxpayer Was Insolvent – No Tax Consequence”.

Second, petitioners maintain that they did not know

that the value of the Yantari when it was sold at the foreclosure

sale was $95,000, and consequently they did not know that there

was a gain on that sale.

According to petitioners, they there-

fore had a reasonable basis for, and were not negligent in,

failing to report petitioners’ capital gain in petitioners’ joint

return.

Section 6662(a) imposes an accuracy-related penalty equal to

20 percent of the underpayment of tax resulting from, inter alia,

a substantial understatement of income tax, see section

6662(b)(2), or negligence or disregard of rules or regulations,

- 34 see section 6662(b)(1).

The accuracy-related penalty under

section 6662(a) does not apply to any portion of an underpayment

if it is shown that there was reasonable cause for, and that the

taxpayer acted in good faith with respect to, such portion.

See

sec. 6664(c)(1).

An understatement is equal to the excess of the amount of

tax required to be shown in the tax return over the amount of tax

shown in the tax return, see sec. 6662(d)(2)(A), and is substantial in the case of an individual if it exceeds the greater of 10

percent of the tax required to be shown or $5,000, see sec.

6662(d)(1)(A).

However, the amount of such understatement is to

be reduced by that portion of the understatement which is attributable to any item where (1) “the relevant facts affecting the

item’s tax treatment are adequately disclosed in the return or in

a statement attached to the return,” sec. 6662(d)(2)(B)(ii)(I)

(adequate disclosure), and (2) “there is a reasonable basis for

the tax treatment of such item by the taxpayer”, sec.

6662(d)(2)(B)(ii)(II) (reasonable basis).

For purposes of section 6662(a), the term “negligence”

includes any failure to make a reasonable attempt to comply with

the Code, and the term “disregard” includes any careless, reckless, or intentional disregard.

See sec. 6662(c).

Negligence

has also been defined as a lack of due care or failure to do what

a reasonable person would do under the circumstances.

See

- 35 Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th Cir. 1992),

affg. T.C. Memo. 1991-179; Antonides v. Commissioner, 91 T.C.

686, 699 (1988), affd. 893 F.2d 656 (4th Cir. 1990).

We turn first to petitioners’ position with respect to

respondent’s determination under section 6662(a) and (b)(2).

On

the record before us, we find that petitioners have failed to

establish that they adequately disclosed in petitioners’ joint

return or in any statement attached to that return the relevant

facts affecting the tax treatment of petitioners’ capital gain,

as required by section 6662(d)(2)(B)(ii)(I).

For example, there

are no facts disclosed either in that return or in a statement

attached to that return regarding the foreclosure sale of the

Yantari, the amount realized on that sale, or petitioners’ basis

in the Yantari.

We further find on the instant record that petitioners have

failed to show that they had a reasonable basis for their failure

to report petitioners’ capital gain in petitioners’ joint return,

as required by section 6662(d)(2)(B)(ii)(II).

As noted above, as

we understand their position, petitioners contend that they did

not know that the value of the Yantari when it was sold at the

foreclosure sale was $95,000.

Apparently, petitioners maintain

that they believed that the value of the Yantari at that time was

less than $95,000, although they did not disclose in petitioners’

joint return, and they do not indicate on brief, what they

- 36 determined that value to be.

Nonetheless, according to petition-

ers, “there was no capital gain” when the Yantari was sold at the

foreclosure sale.

We reject petitioners’ position.

It is well

established that, absent clear and convincing proof to the

contrary, the sale price of property at a foreclosure sale is

presumed to be its fair market value.

See, e.g., Frazier v.

Commissioner, 111 T.C. 243, 246 (1998); Community Bank v. Commissioner, 79 T.C. 789, 792 (1982), affd. 819 F.2d 940 (9th Cir.

1987).

Petitioners have presented no evidence, let alone clear

and convincing evidence, that the $95,000-sale price of the

Yantari at the foreclosure sale was not its fair market value.

Furthermore, section 1001(a) provides that gain from a sale

or other disposition of property is the excess of the amount

realized therefrom over the adjusted basis provided in section

1011 for determining gain.

The regulations under section 1001

provide guidance to taxpayers in applying section 1001(a) to

facts that are analogous to the facts presented in the instant

case.

Example (8) of section 1.1001-2(c), Income Tax Regs.

(Example (8)),16 states:

16

Example (8) applies to the discharge of indebtedness that

is recourse in nature. While the parties did not expressly

stipulate that petitioners’ loan to finance the purchase of the

Yantari constituted recourse debt, we infer from certain other

stipulations of the parties that that loan was recourse debt.

The parties stipulated that the foreclosure sale resulted in both

DOI income and capital gain, although petitioners dispute whether

they must recognize that DOI income. DOI income and capital gain

(continued...)

- 37 In 1980, F transfers to a creditor an asset with a fair

market value of $6,000 and the creditor discharges

$7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the

asset is its fair market value ($6,000). In addition,

F has income from the discharge of indebtedness of

$1,500 ($7,500 - $6,000).

Example 8 is controlling in the instant case.

As a result

of the foreclosure sale, the bank discharged a total of $137,142

of indebtedness for which petitioners were liable, $95,000 of

which it received on the disposition of the Yantari at that

foreclosure sale.

The amount realized on the disposition of the

Yantari is its fair market value which, on the record presented,

we have found to be the sale price of the Yantari at the foreclosure sale.

See Frazier v. Commissioner, supra at 246; Community

Bank v. Commissioner, supra at 792.

In addition, petitioners

have income from the discharge of indebtedness in the amount of

$42,142 ($137,142, the unpaid principal balance of the loan at

the time of the foreclosure sale, minus $95,000, the fair market

value of the Yantari at that sale).

On the record before us, we find that, in the event the

computations under Rule 155 establish that there is an understatement of tax as a result of our holdings and the parties’

concessions in this case that is greater than 10 percent of the

16

(...continued)

would result from the foreclosure sale only if petitioners’ debt

were recourse debt. See Frazier v. Commissioner, 111 T.C. 243,

245, 247 (1998); sec. 1.1001-2(a)(1) and (2) and 2(c), Example

(8), Income Tax Regs.

- 38 tax required to be shown in petitioners’ joint return or $5,000,

see sec. 6662(d)(1)(A), petitioners have failed to establish

there is no substantial understatement of tax under section

6662(b)(2) and (d).

We turn now to respondent’s determination under section

6662(a) and (b)(1).

For the reasons set forth above explaining

why we found that petitioners failed to show that they had a

reasonable basis for their position in petitioners’ joint return

regarding petitioners’ capital gain, we find on the record before

us that petitioners have failed to show that, in not reporting

that gain, (1) they made a reasonable attempt to comply with, and

did not intentionally disregard, section 1001 and the regulations

thereunder, including Example 8, Frazier v. Commissioner, supra,

and Community Bank v. Commissioner, supra, and (2) they acted

with due care and did what a reasonable person would do under the

circumstances.

We further find on that record that petitioners

have failed to establish that they were not negligent in failing

to report that gain in that return.

On the instant record, we also find that petitioners have

failed to show that they acted with reasonable cause and in good

faith with respect to the portion of the underpayment of tax for

1993 that is attributable to petitioners’ capital gain.

See sec.

6664(c).

Based on our examination of the entire record before us, we

- 39 find that petitioners have failed to establish any error in

respondent’s determination that they are liable for the year at

issue for the accuracy-related penalty under section 6662(a)

insofar as it relates to the underpayment of tax attributable to

petitioners’ capital gain.

Consequently, we sustain that deter-

mination to that extent.

We have considered all of the contentions and arguments of

petitioners that are not discussed herein, and we find them to be

without merit and/or irrelevant.

To reflect the foregoing and the concessions of the parties,

Decision will be entered under

Rule 155.