Zarin v. Commissioner
92 T.C. No. 68, 1989 U.S. Tax Ct. LEXIS 75, 92 T.C. 1084 (1989)
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Rule of Law:
The settlement of a gambling debt for less than its face amount results in income from the discharge of indebtedness under Section 61(a)(12) of the Internal Revenue Code. The legal enforceability of the underlying debt under state law is not determinative for federal income tax purposes if the taxpayer received something of value in exchange for the debt.
Facts:
- David Zarin, a professional engineer, began gambling on credit at Resorts International Hotel, Inc. (Resorts) in Atlantic City in 1978.
- Resorts granted Zarin a line of credit, which by November 1979 had been increased to $200,000.
- In October 1979, the New Jersey Casino Control Commission issued an emergency order prohibiting Resorts from extending credit to patrons beyond their approved limits.
- To circumvent the order, Resorts treated Zarin's personal checks as 'considered cleared' and granted him 'this trip only' credit, leading Zarin to believe he had an unlimited credit line.
- By early 1980, Zarin was gambling compulsively, betting up to $15,000 per roll of the dice.
- In April 1980, Zarin delivered personal checks and markers to Resorts totaling $3,435,000, which were ultimately returned for insufficient funds.
- After Resorts cut off his credit, Zarin entered into a settlement agreement on September 28, 1981, to resolve the $3,435,000 debt by paying Resorts a total of $500,000.
Procedural Posture:
- The Commissioner of Internal Revenue initially issued a notice of deficiency to David Zarin for the 1980 tax year, asserting income from larceny by trick and deception.
- Resorts International Hotel, Inc. filed a complaint in New Jersey State Court against Zarin on November 18, 1980, to collect the $3,435,000 debt.
- Zarin filed an answer in the state court proceeding on March 4, 1981, denying liability and asserting various affirmative defenses.
- The state court lawsuit was settled by the parties on September 28, 1981.
- Zarin filed a petition in the United States Tax Court to contest the Commissioner's determination.
- In his answer to the petition, the Commissioner abandoned the larceny claim and asserted a new matter: that Zarin realized $2,935,000 of income in 1981 from the discharge of indebtedness.
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Issue:
Does the settlement of a gambling debt for an amount less than its face value constitute taxable income from the discharge of indebtedness under Section 61(a)(12) of the Internal Revenue Code, even if the underlying debt may have been unenforceable under state law?
Opinions:
Majority - Judge Cohen
Yes, the settlement of the gambling debt for less than its face value constitutes taxable income from the discharge of indebtedness. The taxpayer received value when he incurred the debt, and the forgiveness of the obligation to repay that value creates income. The court rejected the 'diminution of loss' theory from Bowers v. Kerbaugh-Empire Co., finding it superseded by United States v. Kirby Lumber Co., which holds that a taxpayer realizes income when assets are freed from an obligation. Zarin received $3,435,000 in credit tax-free on the assumption of repayment; when that obligation was discharged, he realized an accession to wealth. The unenforceability of the debt under state law is not determinative for federal tax purposes. Furthermore, the 'purchase price adjustment' exception in Section 108(e)(5) does not apply because the 'opportunity to gamble' is not the type of 'property' contemplated by the statute.
Dissenting - Judge Tannenwald
No, the settlement did not create taxable income. The majority's reliance on the 'opportunity to gamble' as value is flawed, as Zarin did not receive a measurable monetary benefit that would otherwise go untaxed. The unenforceability of the debt under New Jersey law is the critical factor; because the debt was unenforceable from the outset, there was no 'freeing up of assets' as required by Kirby Lumber to create income. The settlement was of a genuinely disputed liability, which does not give rise to discharge-of-indebtedness income.
Dissenting - Judge Jacobs
No, the settlement did not create taxable income in 1981. The debt was void from the beginning under New Jersey law and thus was not a true debt for tax purposes. The proper analysis is that Zarin realized income in 1980 equal to the value of the chips received, but this income should be classified as a 'gain from a wagering transaction' under Section 165(d). Consequently, his gambling losses from that same year would fully offset this income, resulting in no net tax liability. The majority's holding improperly taxes the petitioner on his gambling losses.
Dissenting - Judge Ruwe
No, the settlement did not create taxable income because the debt reduction should be treated as a non-taxable purchase price adjustment under Section 108(e)(5). The majority incorrectly concludes that the gambling chips Zarin purchased do not constitute 'property' for the purposes of that section, despite the parties' stipulation that they were property. The term 'property' should be interpreted broadly, and since all statutory conditions of Section 108(e)(5) were met, the discharge of debt should have been treated as a purchase price adjustment rather than taxable income.
Analysis:
This Tax Court decision broadly applies the discharge of indebtedness doctrine, extending it to a non-commercial context involving potentially unenforceable gambling debts. The majority's reasoning decouples the federal tax consequences of debt forgiveness from the debt's validity under state law, focusing instead on whether the debtor received an initial economic benefit. This expansive view solidifies the principle that any accession to wealth, including the relief from a contested obligation, is presumptively taxable. The multiple, well-reasoned dissents highlight significant legal friction, particularly regarding the definition of 'property' under Section 108(e)(5) and the characterization of unenforceable debts, setting the stage for appellate review.
