Preslar v. Commissioner
1999 Colo. J. C.A.R. 1870, 167 F.3d 1323, 83 A.F.T.R.2d (RIA) 851 (1999)
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Rule of Law:
The contested liability doctrine, which exempts a settled debt from being treated as discharge-of-indebtedness income, applies only when the original amount of the debt is unliquidated and genuinely in dispute, not when only the method of repayment or enforceability of a liquidated debt is challenged.
Facts:
- In 1983, Layne and Sue Preslar agreed to purchase a ranch for $1 million from High Nogal Ranch, Inc.
- The purchase was financed through a $1 million promissory note executed by the Preslars in favor of Moncor Bank.
- The Preslars and Moncor Bank had a separate, informal arrangement allowing the loan to be repaid by assigning installment sales contracts from lots subdivided and sold from the ranch.
- Between 1983 and 1985, the Preslars sold several lots and Moncor Bank credited approximately $200,000 against the loan principal through this assignment arrangement.
- In August 1985, Moncor Bank was declared insolvent and the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver.
- The FDIC refused to continue accepting the assignment of sales contracts as loan repayment and directed the Preslars to cease selling lots.
- The Preslars made no further payments on the loan after the FDIC took over.
- In December 1988, the Preslars and the FDIC settled the dispute, with the Preslars paying $350,000 to fully extinguish the remaining loan balance of $799,463, resulting in a debt cancellation of $449,463.
Procedural Posture:
- The Preslars did not include the $449,463 debt write-off as income on their 1989 joint tax return.
- The Commissioner of Internal Revenue audited the return, determined the Preslars had realized discharge-of-indebtedness income, and assessed a tax deficiency and a penalty.
- The Preslars petitioned the United States Tax Court for a redetermination of the deficiency.
- The Tax Court, invoking the contested liability doctrine, ruled in favor of the Preslars, finding no tax deficiency.
- The Commissioner of Internal Revenue (appellant) appealed the Tax Court's decision to the United States Court of Appeals for the Tenth Circuit.
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Issue:
Does a taxpayer realize taxable discharge-of-indebtedness income upon the settlement of a liquidated loan for less than its face value, where the dispute with the creditor concerns the method of repayment rather than the original amount of the debt?
Opinions:
Majority - Briscoe, Circuit Judge
Yes, the settlement of a liquidated debt for less than its face value results in taxable discharge-of-indebtedness income. The contested liability doctrine requires a dispute over the original amount of the debt, which must be unliquidated. Here, the Preslars never disputed the $1 million principal of the note; their dispute with the FDIC concerned only the method of repayment. A challenge to the enforceability or terms of a debt is not sufficient to render the underlying liquidated amount 'contested' for tax purposes. Furthermore, the purchase price adjustment under I.R.C. § 108(e)(5) is inapplicable because the debt was reduced by a third-party lender (FDIC), not the original seller of the property (High Nogal).
Dissenting - Ebel, Circuit Judge
No, the settlement did not create discharge-of-indebtedness income because there was a legitimate dispute regarding the nature and amount of the Preslars' liability. The majority misconstrues the contested liability doctrine by limiting it to unliquidated debts. The evidence supported the Tax Court's finding that the inflated $1 million purchase price was inextricably linked to the unique repayment scheme. When the FDIC refused to honor that scheme, it created a legitimate dispute traceable to the origin of the debt, meaning the settlement merely established the true amount of liability. Additionally, the case should be remanded to determine if Moncor Bank was the de facto seller, which could make the settlement a non-taxable purchase price adjustment under § 108(e)(5).
Analysis:
This decision significantly narrows the scope of the judicially-created 'contested liability' doctrine, clarifying that it does not apply to disputes over the terms of repayment for a liquidated debt. By distinguishing between disputes over the original amount of a debt versus its enforceability, the court reinforces the broad scope of 'gross income' under § 61(a)(12). The ruling limits a taxpayer's ability to recharacterize debt forgiveness as a non-taxable event, creating a clearer, albeit stricter, line for when debt cancellation must be recognized as income. It also strictly interprets the seller-purchaser requirement for the statutory purchase price adjustment rule.
