Hudson v. Commissioner
20 T.C. 734, 1953 U.S. Tax Ct. LEXIS 99 (1953)
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Rule of Law:
The gain realized from the settlement of a judgment with the judgment debtor is ordinary income, not capital gain, because the settlement extinguishes the debt rather than constituting a 'sale or exchange' of a capital asset as required by the Internal Revenue Code.
Facts:
- An original creditor obtained a court judgment against a debtor.
- The original creditor then assigned or transferred this judgment to the Petitioners.
- The Petitioners, as the new holders of the judgment, negotiated a settlement with the original judgment debtor.
- The judgment debtor paid Petitioners $21,150 to fully satisfy and extinguish the judgment.
- The amount Petitioners received in the settlement was greater than the amount they paid to acquire the judgment, resulting in a gain.
Procedural Posture:
- Petitioners reported the gain from a judgment settlement as a capital gain on their tax return.
- The Commissioner of Internal Revenue (Respondent) audited the return and determined the gain was ordinary income, resulting in a tax deficiency.
- Petitioners challenged the Respondent's determination by filing a petition in the Tax Court of the United States.
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Issue:
Does the gain realized by the holder of a judgment from a monetary settlement with the judgment debtor qualify as a capital gain resulting from the 'sale or exchange of a capital asset' under section 117(a) of the Internal Revenue Code?
Opinions:
Majority - Johnson, J.
No. The gain realized from the settlement of a judgment with the debtor does not result from a 'sale or exchange' and is therefore not a capital gain. For a transaction to be a sale or exchange, property must be transferred from one party to another. Here, when the judgment debtor paid to settle the judgment, the asset (the claim) was extinguished; it did not transfer to the debtor as a continuing property right. The debtor simply eliminated a liability. Citing precedents like Bingham v. Commissioner, the court reasoned that the property 'simply vanished' upon settlement. Since the transaction was a collection or extinguishment of a claim, not a sale or exchange, the resulting gain is ordinary income.
Analysis:
This decision solidifies a crucial distinction in tax law between the disposition of a capital asset and its extinguishment. It establishes that for a gain to receive preferential capital gains treatment, the underlying asset must survive the transaction and be transferred, not simply be paid off by the obligor. This precedent forces taxpayers who invest in debt instruments or judgments to carefully consider the counterparty; a sale to a third party may generate a capital gain, while a settlement with the original debtor will likely result in ordinary income. This distinction remains a fundamental concept in capital asset transactions.
