116 T.C. No. 6
UNITED STATES TAX COURT
DENNIS AND DORINDA J. JELLE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20059-98. Filed January 31, 2001.
Ps are the owners of agricultural property which, prior to the transactions at issue, was subject to outstanding mortgages held by the Farmers Home Administration (FmHA). After Ps became unable to meet payment obligations under these mortgages, Ps and FmHA negotiated an alternative arrangement. Pursuant thereto, (1) Ps in 1996 paid to FmHA the $92,057 net recovery value of their property, (2) FmHA in that year wrote off the remaining loan balance of $177,772, and (3) Ps entered into a net recovery buyout recapture agreement to repay to FmHA amounts written off in the event that they disposed of the land within a 10-year period.
Held: Ps are required to recognize income in 1996 under sec. 61(a)(12), I.R.C., on account of a $177,772 discharge of indebtedness in that year.
Held, further, Ps must report as income 85 percent of amounts they received in the form of Social Security benefits, in accordance with sec. 86(a), I.R.C. - 2 -
Held, further, Ps are liable for the sec. 6662(a), I.R.C., accuracy-related penalty on grounds of a substantial understatement of income tax.
Gregory W. Wagner, for petitioners.
Michael J. Calabrese and Mark J. Miller, for respondent.
OPINION
NIMS, Judge: Respondent determined a Federal income tax
deficiency for petitioners’ 1996 taxable year in the amount of
$46,993. Respondent further determined an accuracy-related
penalty of $9,399, pursuant to section 6662(a). The issues for
decision are:
(1) Whether petitioners are required to recognize income in
1996 from cancellation of indebtedness;
(2) whether petitioners must report as income amounts
received in the form of Social Security benefits; and
(3) whether petitioners are liable for the section 6662(a)
accuracy-related penalty on account of a substantial
understatement of income tax.
Unless otherwise indicated, all section references are to
sections of the Internal Revenue Code in effect for the year at
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure. - 3 -
Background
This case was submitted fully stipulated in accordance with
Rule 122, and the facts are so found. The stipulations of the
parties, with accompanying exhibits, are incorporated herein by
this reference. At the time the petition was filed in this
matter, petitioners resided in the State of Wisconsin.
Prior to and during the year at issue, petitioners operated
a 235-acre farm in Dane County, Wisconsin. A principal activity
of petitioners’ agricultural enterprises was the production of
milk. In 1991, however, petitioners’ milk production fell to the
point that they were no longer able to make monthly payments due
under two outstanding mortgages on their farm real estate. These
mortgages were held by the Farmers Home Administration (FmHA) and
encumbered 135 acres of petitioners’ property. The first had
been entered on December 27, 1979, in the amount of $182,000.
The underlying loan had originally borne interest at a rate of 10
percent, which rate had subsequently been reduced to 8.25
percent. The second mortgage, in the amount of $24,090, had been
executed on July 23, 1984, to secure a loan bearing 5-percent
interest.
Faced with the above-mentioned inability to meet payment
obligations on these mortgages, petitioners contacted Richard A.
Guenther, County Supervisor and Agriculture Credit Manager of the
Dane County office of the Farm Service Agency, to explain their - 4 -
situation and to consider payment alternatives. Between 1991 and
1996, petitioners explored with Mr. Guenther two alternatives to
foreclosure of the FmHA mortgages. The first of these options
involved a debt restructuring, and the second entailed a buyout
of the mortgages by petitioners at net recovery value. Net
recovery value was calculated as the amount that would be
realized from liquidation of the mortgaged collateral, reduced by
prior liens and certain costs.
In April and May of 1996, FmHA advised petitioners that they
did not qualify for debt restructuring, that FmHA intended to
foreclose on its mortgages, and that petitioners could avoid
foreclosure by buying out the FmHA loans at net recovery value.
A Debt and Loan Restructuring System Analysis Report, dated April
18, 1996, contained the following language: “You may buy out
your FmHA loans for the Net Recovery Value of $92,057.00. * * *
If you pay the Net Recovery Value, any remaining balance on your
FmHA accounts will be written off. The debt written off may be
subject to recapture.” A Notice of Intent To Accelerate or To
Continue Acceleration and Notice of Borrowers’ Rights, dated May
6, 1996, further detailed the terms of these arrangements and
informed petitioners:
If you are eligible and pay the recovery value, FmHA will write off the rest of your debt up to $300,000. If you are eligible to pay the recovery value, FmHA will require you to sign a recapture agreement. This agreement would allow FmHA to require you to pay the difference between the recovery value and the current - 5 -
market value of your real estate securing the loan if you sell it within 10 years of the agreement. FmHA can never recapture more than it wrote off.
Petitioners elected to proceed with the buyout at net
recovery value. In order to do so, they obtained a loan from the
State Bank of Mt. Horeb. On July 30, 1996, petitioners paid to
FmHA the net recovery value of $92,057. Prior to the making of
this remittance, the balance owed by petitioners to FmHA was
$269,829.28. In exchange for the payment, FmHA wrote off the
remaining $177,772.28 of indebtedness.
Then, on July 31, 1996, petitioners and FmHA entered into a
Net Recovery Buyout Recapture Agreement. Pursuant to this
agreement, petitioners covenanted as follows:
If I/we do sell or convey any part or all of this real estate within 10 years of this agreement, I/we must pay FmHA the recapture amount for that part sold or conveyed which is the smaller of a., b., or c.
a. The Fair Market Value of the real estate parcel at the time of the sale or conveyance, as determined by an FmHA appraisal, minus that portion of the recovery value of the real estate * * * or
b. The Fair Market Value of the real estate parcel at the time of the sale or conveyance, as determined by an FmHA appraisal, minus the unpaid balance of prior liens at the time of the sale or conveyance, minus the net recovery value of the real estate * * * if this amount has not been accounted for as a prior lien, or
c. The total amount of the FmHA debt written off for loans secured by real estate. I/We agree that this amount is the outstanding balance of principal and interest owed on the FmHA Farmer Programs loans(s) as of the date of this agreement * * * [without taking into account the related payment of recovery value], - 6 -
minus the net recovery value of the real estate * * *. This amount is $177,772.28 and is the maximum amount that can be recaptured.
To secure the foregoing recapture agreement and in
accordance with its terms, petitioners gave FmHA a mortgage on
the 135 acres of their farmland secured by the original FmHA
mortgages. The recapture agreement provided that FmHA would
release this lien with respect to subject property sold or
conveyed within 10 years upon payment of the recapture amount
due. With respect to portions of the encumbered real estate not
disposed of during the agreement’s 10-year term, the lien would
be released at the expiration of such period. The lien was
secondary to liens held by Russell V. Jelle in the amount of
$31,000 and by the State Bank of Mt. Horeb in the amount of
$92,057.
For the taxable year 1996, the U.S. Department of
Agriculture Farm Service Agency issued to petitioners a Form
1099-C, Cancellation of Debt, showing an “Amount of debt
canceled” of $177,772.27. Petitioners did not report this amount
as income on their 1996 tax return and provided thereon no
reference to the buyout transaction or explanation of its
treatment.
Petitioners additionally received Social Security benefits
during 1996 in the amount of $3,420. No portion of these
benefits was disclosed by petitioners on their return for 1996. - 7 -
Discussion
I. Discharge of Indebtedness
As a general rule, the Internal Revenue Code imposes a
Federal tax on the taxable income of every individual. See sec.
1. Section 61(a) defines gross income for purposes of
calculating taxable income as “all income from whatever source
derived” and further specifies that “Income from discharge of
indebtedness” is included within this broad definition. Sec.
61(a)(12). The underlying rationale for such inclusion is that
to the extent a taxpayer is released from indebtedness, he or she
realizes an accession to income due to the freeing of assets
previously offset by the liability. See United States v. Kirby
Lumber Co., 284 U.S. 1, 3 (1931).
Statutory exceptions to the above rule are set forth in
section 108. Section 108(a) excludes from the operation of
section 61(a) indebtedness which is discharged in a title 11
case, which is discharged when the taxpayer is insolvent, which
consists of qualified farm indebtedness, or which consists of
qualified real property business indebtedness. Additional
circumstances in which no income from cancellation of
indebtedness need be recognized are established by case law. For
instance, the refinancing of a debt may operate as an exception
to the requirement of inclusion. See Zappo v. Commissioner, 81
T.C. 77, 85-86 (1983). When one obligation has merely been - 8 -
substituted for another, there has been no consequent freeing of
assets so as to justify application of the rule in United States
v. Kirby Lumber Co., supra.
The parties here do not contest the viability of these
general principles. Petitioners in fact concede that the subject
net recovery buyout transaction could result in a cancellation of
indebtedness. They further do not argue that any of the
exceptions of section 108 should operate to shield resultant
income from recognition. (For the sake of completeness, we note
petitioners have stipulated that neither the qualified farm
indebtedness nor the insolvency provision is at issue in this
case, and no evidence in the record would suggest that either
bankruptcy or qualified real property business indebtedness could
support exclusion.) Petitioners contend, however, that any
relevant discharge, requiring reporting of income, can occur
under the recapture agreement only upon the conveyance of
encumbered land or the passing of 10 years. According to
petitioners, until such time their potential obligation to repay
some part or all of the $177,772 written off precludes a finding
that the debt has been forgiven. They view receiving a
discharge, and the amount thereof, as contingent on eventually
obtaining the release of their property from the recapture
agreement. - 9 -
Conversely, respondent maintains that the net recovery
buyout transaction effected a discharge of indebtedness in 1996
within the meaning of section 61(a)(12). Respondent further
asserts that the recapture agreement is too contingent and
indefinite to constitute a substitution, continuation, or
refinancing of the original debt so as to delay recognition.
Respondent relies particularly on the fact that petitioners have
no definite obligation to make any further payments.
In essence then, the principal disagreement between the
parties centers on whether the recapture agreement executed by
petitioners continues their obligation to FmHA in a manner such
that there was in 1996 no discharge of indebtedness within the
meaning of the Internal Revenue Code. Furthermore, as their
respective contentions reveal, the two sides reach opposing
answers to this question in large part because each characterizes
a different aspect of the buyout arrangement as contingent.
Petitioners view the cancellation itself as contingent, asserting
that the subject transaction merely generated an agreement to
cancel their debt at a future time. Respondent, on the other
hand, styles the instant scenario as involving a present
cancellation with a contingent future obligation to repay.
If there exists only an agreement to cancel prospectively,
the debt is discharged not at the time the agreement is made but
at the time conditions specified therein are satisfied. See - 10 -
Walker v. Commissioner, 88 F.2d 170 (5th Cir. 1937), affg. White
v. Commissioner, 34 B.T.A. 424 (1936); Shannon v. Commissioner,
T.C. Memo. 1993-554. For example, Walker v. Commissioner, supra
at 171, involved a settlement entered in 1927 whereby the
creditor agreed to cancel the balance of a debt after payments
totaling a prescribed amount were made by the debtor. This
payment level was reached in 1930, and the discharge was held to
have occurred in that year. See id.
In contrast, if an arrangement effects a present
cancellation of one liability but imposes a replacement
obligation, the mere chance of some future repayment does not
delay income recognition where the replacement liability is
highly contingent or of a fundamentally different nature. See
Carolina, Clinchfield & Ohio Ry. v. Commissioner, 82 T.C. 888
(1984), affd. 823 F.2d 33 (2d Cir. 1987); Zappo v. Commissioner,
81 T.C. 77 (1983). Specifically, we stated in Zappo v.
Commissioner, supra at 88, that “A note or obligation will not be
treated as a true debt for tax purposes when it is highly
unlikely, or impossible to estimate, whether and when the debt
will be repaid.” We explained that “highly contingent
obligations should not be treated in pari materia with their more
conventional counterparts”, and we further found that “this
reasoning applies with equal force to the issue of refinancing an - 11 -
indebtedness.” Id. at 89. In addition, we described the manner
in which this precept was to be employed in a discharge setting,
as follows:
When an obligation is highly contingent and has no presently ascertainable value, it cannot refinance or substitute for the discharge of a true debt. The very uncertainty of the highly contingent replacement obligation prevents it from reencumbering assets freed by discharge of the true debt until some indeterminable date when the contingencies are removed. In a word, there is no real continuation of indebtedness when a highly contingent obligation is substituted for a true debt. Consequently, the rule in Kirby Lumber applies, and gain is realized to the extent the taxpayer is discharged from the initial indebtedness. [Id.]
The original debt in Zappo v. Commissioner, supra at 90, had
been characterized by a fixed amount, a stated rate of interest,
and a due date certain. The replacement liability was for an
amount that could not be ascertained until the end of 5 years,
did not bear interest, and would be credited with amounts paid by
a third party. See id. In those circumstances, we held that
the foregoing rule precluded treatment of the new obligation as
replacement indebtedness. See id.; see also Carolina,
Clinchfield & Ohio Ry. v. Commissioner, supra.
Turning to the matter at bar, we believe that the precedent
discussed above counsels a finding that petitioners’ indebtedness
to FmHA was discharged in 1996, for the simple reason that
whether and when petitioners would ever be required to make any
further payments to FmHA rested totally within their own control.
If petitioners chose to sell their property within 10 years from - 12 -
the inception of the net recovery buyout recapture agreement,
then in accordance with the terms of that agreement, petitioners
could be required to repay part or all of the $177,722 written
off by FmHA. If petitioners chose not to dispose of their
property, then, of course, nothing further would be due.
Petitioners’ obligation was thus “highly contingent” in every
sense of the word. This state of affairs fits perfectly within
the precept formulated in Zappo v. Commissioner, supra, that a
highly contingent obligation will not be treated in pari materia
with a more conventional counterpart.
Petitioners’ initial debt to FmHA, the “conventional
counterpart” in this case, was fixed in amount, bore a stated
rate of interest, and required periodic payments. In contrast,
petitioners’ liability under the recapture agreement had no
certain amount, was not interest bearing, and mandated no
definite payments. An enforceable financial obligation may in
fact never materialize at all. Faced with these differences, we
cannot reasonably view the latter alleged debt as a mere
substitute for the former.
We are convinced that the rationale of United States v.
Kirby Lumber Co., 284 U.S. 1 (1931), is particularly applicable
here where the recapture agreement leaves petitioners in complete
control of their assets and free to arrange their affairs so that
none of their property’s value need ever be delivered to FmHA. - 13 -
We hold that petitioners received discharge of indebtedness
income in 1996 when FmHA wrote off $177,772 of petitioners’
outstanding loan obligation.
II. Social Security Benefits
The second question raised by this litigation is whether a
portion of the Social Security benefits received by petitioners
is includable in their gross income. Although this issue is
largely computational, we address it briefly to ensure lucidity.
The parties stipulated that petitioners received such benefits in
the amount of $3,420. Of this total, respondent contends that 85
percent, or $2,907, must be reported as gross income.
Petitioners have offered no argument related to their Social
Security benefits.
Income tax treatment of Social Security benefits is governed
by section 86. Section 86 applies to require inclusion of
payments if the taxpayer’s adjusted gross income, with certain
modifications not relevant here, plus one-half of the Social
Security benefits received, exceeds a specified base amount. See
sec. 86(b). This base amount, in the case of taxpayers filing a
joint return, is $32,000. See sec. 86(c)(1)(B). Since
petitioners reported adjusted gross income of $8,466 and we have
just held that they must include an additional $177,772 from
discharge of indebtedness, the base amount threshold is clearly
exceeded. - 14 -
In general then, section 86(a)(1) provides that gross income
includes the lesser of: (1) One-half of the Social Security
benefits received during the year; or (2) one-half of the excess
of the sum of (a) modified adjusted gross income plus (b) one-
half of the Social Security benefits, over the base amount. The
includable percentage is increased, however, if modified adjusted
gross income plus one-half of the Social Security benefits
exceeds an adjusted base amount of, for a joint return, $44,000.
See sec. 86(a)(2), (c)(2)(B). Accordingly, petitioners are
subject to the greater inclusion, which, on these facts, would be
calculated at 85 percent of the Social Security benefits
received. See sec. 86(a)(2). We therefore sustain respondent’s
determination that $2,907, 85 percent of the stipulated $3,420 in
Social Security benefits, must be included in petitioners’ gross
income for 1996.
III. Accuracy-Related Penalty
Subsection (a) of section 6662 imposes an accuracy-related
penalty in the amount of 20 percent of any underpayment that is
attributable to causes specified in subsection (b). Among the
causes so enumerated is any substantial understatement of income
tax. See sec. 6662(b)(2). A “substantial understatement” is
defined in section 6662(d)(1) to exist where the amount of the
understatement exceeds the greater of 10 percent of the tax
required to be shown on the return for the taxable year or - 15 -
$5,000. For purposes of this computation, the amount of the
understatement is reduced to the extent attributable to an item:
(1) If there existed substantial authority for the taxpayer’s
treatment of the item, or (2) if the relevant facts affecting the
treatment of the item were adequately disclosed on the taxpayer’s
return or an attached statement, and there was a reasonable basis
for the taxpayer’s treatment of the item. See sec.
6662(d)(2)(B).
An exception to the section 6662(a) penalty is set forth in
section 6664(c)(1) and reads: “No penalty shall be imposed under
this part with respect to any portion of an underpayment if it is
shown that there was a reasonable cause for such portion and that
the taxpayer acted in good faith with respect to such portion.”
The taxpayer bears the burden of establishing that this
reasonable cause exception is applicable, as respondent’s
determination of an accuracy-related penalty is presumed correct.
See Rule 142(a).
Regulations interpreting section 6664(c) state:
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case- by-case basis, taking into account all pertinent facts and circumstances. * * * Generally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. * * * [Sec. 1.6664-4(b)(1), Income Tax Regs.]
Applying these principles to the matter at hand, we are
constrained to rule that petitioners have failed to meet their - 16 -
burden of showing the section 6662(a) penalty inappropriate here.
Again, petitioners have offered no discussion or argument on this
issue.
Petitioners reported on their 1996 return a tax liability of
$0 and disclosed neither the cancellation of debt income for
which they received a Form 1099-C nor their Social Security
payments. Based on our holdings above, however, they in fact owe
taxes for 1996 well in excess of the level constituting a
substantial understatement. Furthermore, none of the avenues of
relief provided in the statutory text is open to petitioners.
There exists no substantial authority for their complete failure
to report or disclose, so the amount of their understatement is
not subject to reduction under section 6662(d)(2)(B).
Additionally, due to the absence of explanation or evidence by
petitioners on this issue, we lack any grounds upon which to
conclude that their treatment was a product of reasonable cause
and good faith for purposes of the section 6664(c) exception.
Petitioners therefore are liable for the accuracy-related
penalty.
To reflect the foregoing,
Decision will be entered
for respondent.