Discharge of Indebtedness

Discharge of Indebtedness

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  § 108(b)—losses that you’re carrying forward must be reduced by excluded cancellation of indebtedness
  
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    i.e. if you discharge $300K of indebtedness you don’t have to pay taxes on that $300K BUT you have to adjust the basis of an asset by $300K so that when you sell that asset that $300K income will be taxed
    
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  Insolvency exception
  
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    Idea: you can defer paying taxes while in bankruptcy, but cannot if you come out of bankruptcy later—we don’t want to exacerbate precarious financial position
    

Zarin had $3,435,000 in gambling debt—paid $500,000—difference is taxable—Can he deduct gambling losses against this income? No—different years

Tries to argue that he received nothing of “tangible value”—Resorts risk that he would win and cash his chips

**he isn’t paying for happiness or pleasure—it’s opportunity

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  In 1978-79 he lost $2.5M and paid it off to Resorts—indicates that he intended to repay the $3.5M
  
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  Was the reduction in obligation a debt reduction?
  
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    If it was a reduction—he owes taxes on $3M cancellation of indebtedness income
    
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    If it was not a reduction—no taxes
    
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  Two models:
  
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    Taking a world-wide trip, get bank to loan you $1M, spend everything but $300K—which you repay and the bank would write down as a bad loan
    
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      $700K you can’t deduct the money you blow going around the world
      
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    Failed widget business, borrow $1M and settle with the bank for $300K (which you have from other sources)—insolvency—would either have a $1M loss with $300K restitution OR have $700K loss
    
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  Arguments:
  
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    Zarin looks more like the around the world model—consumption in gambling or traveling
    
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    Could argue a purchase-price reduction—marker not currency—can’t spend however he wants
    

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  If we’re really thinking about Hague-Simons income is Mr. Zarin $3M better off? Setting aside the law, is the $3M an indicator of his ability to pay?
  
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    Student: He’s already in a bad situation and making him pay taxes exacerbates
    
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      LB: but other people could take out a loan for a trip in bad situations, is this different?
      
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    Student: He did something bad (compulsive gambling)—it doesn’t make sense to reward him for his bad act.
    
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      If we allow him to not pay taxes on this we implicitly raise taxes for everyone else. Is that fair?
      
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      Assumes that we aren’t going to decrease spending and everyone else will have to carry greater burden than if we taxed Zarin
      
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    Student: he gave up the opportunity of spending this $3M in another way
    
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    Student (Elliot’s idea): less utility than if he were engaged in actual business practice—unfair to tax the failed legitimate businessman and not the compulsive gambler
    
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      LB: but if it’s a business, you get to take a deduction for the loss which is taxed for cancelled indebtedness so it’s not comparatively punitive (widget example from last class)
      
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      Student: because the chips were only used for gambling—one product or securitized obligation—it looks like a dedicated business loan which would be only for the proposed business plan
      
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        Economically, how are these ‘loans’ different?
        
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          Could you sell the chips to someone else? Could you transfer the loan to another businessman? Does our treatment change predicated on liquidity?
          
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          Is gambling an enterprise of purchasing entertainment or a business investment?
          
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    Student: looks like purchase price reduction—couldn’t spend marker anywhere but the casino
    
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      LB: Resorts International probably wouldn’t just give him a loan—he could probably only get the money for gambling and not for a loan—looks very much like purchase price reduction when seller finances a purchase
      
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      How are gambling markers and purchase price adjustments the same (Sandy’s argument)?
      
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        Student: Chips come from the casino—the bank isn’t loaning a businessman money to buy widgets for the bank
        
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        Student: return on chips produces chips; return on widgets produces cash
        
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    Student: casino doesn’t produce wealth like a business loan
    
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      Student: but our entertainment industry provides legitimate income and industry
      
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      LB: should we penalize gambling because we think it’s a ‘bad’ way to spend money
      
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    Student: markers aren’t like loans—they will make money every time they settle so long as the settlement value exceeds the services provided
    
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      LB: why does it matter that this is seller financing? Maybe casino knew he wouldn’t be able to pay it back—then they know his debts will exceed their comp-ed services—no third party screen determining whether or not purchase predicate was worth the loan amount
      
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      Student: casino derives value from compulsive gamblers even if he cannot settle his entire bill
      
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    LB: Code generally doesn’t try to value utility—if we were going to look at utitlity we could say that he suffered from a gambling addiction but legally the better arguments
    
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  Legal Arguments
  
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    Disputed debts—if parties don’t agree on debts we cannot value it properly—Zarin didn’t dispute the markers’ face value, but their enforceability
    
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      Markers not enforceable in NJ  should $3M be treated as taxable income?
      
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        Yes—if it’s not taxable it would be a windfall—affects whether or not he has to repay the marker but NOT the tax consequences
        
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      What about deducting gambling losses?
      
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        Student: current structure discourages people from gambling their whole tax liability to increase their deduction—to allow the deduction of all gambling losses would incentive gambling
        
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    Jacobs’ dissent—page 193
    
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      Gain from wagering transaction
      
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      Chip income is gambling gains Zarin can offset losses against tax liability
      
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      Does this make sense?
      
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        Student: no, because the chip marker is inconsistent with a win—you repay a marker and retain chips
        
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      What would happen to § 165(d) if we followed Jacobs opinion?
      
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        Zarin got $3.5M in chips would become gambling gain, then everything you lose can be claimed against chip income
        
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      Trying to make an end-run around § 165(d)—get Zarin out of his liability
      
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    Purchase money debt reduction
    
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      Unclear what the property is—is the opportunity to gamble considered property?
      
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  LB: Zarin is really a valuation case:
  
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    He borrowed from a seller (not a bank)
    
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    He didn’t pay back the whole debt  raises purchase money debt reduction
    
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  Think back to Collins—is the holding in Collins fair relative to Zarin?
  
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    Zarin took money with mutuality of agreement and (plausibly) Resorts only expected to get back $500,000—Collins stole the money
    

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  “seller financing should always make you look twice at a transaction”
  

3. 
   Corporation X issued 1,000 bonds with a face amount of $500 each. Corporation X received $500 for each bond issued (total $500,000). The bonds are now trading for $200 in the market because many investors think that the corporation will not pay off the bonds. Corporation X buys back all its bonds in the market and pays $200 cash for each bond (total $200,000). The fair market value of the corporation's assets exceeds its total liabilities both before and after the bond buyback. Does Corporation X have any income for tax purposes as a result of the transaction?
   

4. 
   How would your answer to (3) change if Corporation X's buyback of its bonds were pursuant to a bankruptcy plan approved by a Federal court in a Chapter 11 bankruptcy proceeding? Are there any collateral tax consequences to Corporation X in that case?
   

BUT still traded and transferred  not taxable? § 108(e)(10)—“debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument”—does this hang on when instruments are repurchased?

5. 
   Sue sold an apartment building to Taylor in exchange for Taylor’s $1.5 million promissory note, which bears interest at a market rate. Taylor later discovers that the property is contaminated with asbestos, and, as a result, he must incur $500,000 of asbestos removal costs. The contract of sale had warranted the building to be free of asbestos. Sue agrees to reduce the amount of Taylor's debt by $500,000 to avoid a lawsuit.
   
   1. 
      Does Taylor have income for tax purposes as a result of the cancellation of part of his debt? (See Section 108(e).)
      

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  not bankruptcy,
  
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  purchaser not insolvent, and
  
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  price reduction must come from Sue
  

2. 
   What is Taylor’s basis in the apartment building after the cancellation of debt?
   

Can he keep his basis at $1.5M?

Cost basis (imagine he discovered asbestos and Sue adjusted sale price pre-sale) would still be $1M under § 1012

**depends if he deducted the $500K