                                                                   RECOMMENDED FOR FULL-TEXT PUBLICATION
24   Friedman, et al. v. Commissioner    No. 98-2378                    Pursuant to Sixth Circuit Rule 206
                                                                ELECTRONIC CITATION: 2000 FED App. 0195P (6th Cir.)
                                                                            File Name: 00a0195p.06
COD income for the 1992 taxable year. Accordingly, we
AFFIRM the judgment of the Tax Court.
                                                        UNITED STATES COURT OF APPEALS
                                                                          FOR THE SIXTH CIRCUIT
                                                                            _________________


                                                                                      ;
                                                                                       
                                                         MICHAEL FRIEDMAN, et al.,
                                                                                       
                                                              Petitioners-Appellants,
                                                                                       
                                                                                       
                                                                                           No. 98-2378
                                                                  v.
                                                                                       
                                                                                        >
                                                         COMMISSIONER OF INTERNAL      
                                                                                       
                                                               Respondent-Appellee. 
                                                         REVENUE,

                                                                                       
                                                                                      1
                                                             On Appeal from the United States Tax Court.
                                                                     Nos. 96-18735, 96-18736.
                                                                          Argued: December 17, 1999
                                                                        Decided and Filed: June 8, 2000
                                                        Before: BOGGS and NORRIS, Circuit  Judges; NUGENT,
                                                                          District Judge.*




                                                            *
                                                             The Honorable Donald C. Nugent, United States District Judge for
                                                        the Northern District of Ohio, sitting by designation.

                                                                                         1
2       Friedman, et al. v. Commissioner            No. 98-2378      No. 98-2378             Friedman, et al. v. Commissioner            23

                     _________________                               evidence shows that the bankruptcy trustee was actively
                                                                     administering New Manchester’s estate well into 1995,
                          COUNSEL                                    collecting and disbursing monies. Moreover, some of New
                                                                     Manchester’s creditors were, in fact, actively pursuing
ARGUED: Joseph P. Alexander, ROETZEL & ANDRESS,                      payment owed them as evidenced by the fraudulent
Cleveland, Ohio, for Appellants. Teresa E. McLaughlin, U.S.          conveyance claim filed in December, 1992.
DEPARTMENT OF JUSTICE, APPELLATE SECTION
TAX DIVISION, Washington, D.C., for Appellee.                           In view of all the circumstances, this Court finds that no
ON BRIEF: Joseph P. Alexander, J. Timothy Bender,                    identifying event occurred in 1992 to fix the date of discharge
ROETZEL & ANDRESS, Cleveland, Ohio, for Appellants.                  of indebtedness in that year. The absence of anything in the
Teresa E. McLaughlin, Ann Belanger Durney, Paula K.                  record, including the stipulation of the facts by both
Speck, U.S. DEPARTMENT OF JUSTICE, APPELLATE                         Commissioner and Taxpayers, even suggesting an identifiable
SECTION TAX DIVISION, Washington, D.C., for Appellee.                event in 1992, satisfies Commissioner’s burden in that regard.
                                                                     Accordingly, the Tax Court did not commit clear error in
                     _________________                               finding that a discharge of indebtedness did not occur during
                                                                     the 1992 taxable year.
                         OPINION
                     _________________                               IV. Stock Basis of Shareholders in S Corporation
  NUGENT, District Judge. The Commissioner of Internal                  Taxpayers also contend that the income from the discharge
Revenue (hereinafter “Commissioner”) issued notices of tax           of indebtedness passes through to them as shareholders of
deficiencies to Michael and   Madeline Friedman and Edward           New Manchester, an S corporation. As a result, Taxpayers
and Deborah Rosenthal1 (hereinafter “Taxpayers”) for the             contend, the basis of their stock in New Manchester increases.
years 1989 and 1990. The notices stated that Taxpayers were          Because the Court found herein that Taxpayers did not realize
not entitled to a loss in the amount of $5,055,116. As               a discharge of indebtedness, or COD income, in 1992, there
shareholders of an S corporation, Taxpayers made claims for          is no need to address the pass-through issue at this time.
net operating losses of their S corporation, New Manchester,         Should Taxpayers, however, wish to claim the COD income
by using the corporation’s 1992 discharge of indebtedness            for a different year, they can refer to Gaudiano v.
income (a.k.a. “COD income”) to increase their stock basis,          Commissioner, No. 99-1294, in which this Court decided the
and then in turn, using the increased basis to claim net             issue concerning a shareholder’s COD income and his stock
operating losses from prior years. The Commissioner denied           basis, for guidance.
Taxpayers’ claims for net operating loss deductions,
determining that COD income of an insolvent S corporation                                        Conclusion
cannot be used to increase the shareholders’ basis.
                                                                       In sum, the Court finds that the Tax Court did not commit
                                                                     clear error in holding that New Manchester did not realize

    1
     Appellants’ counsel filed notice with the Court that Michael    demonstrate that the debts were, in fact, discharged. Cozzi, 88 T.C. at
Friedman passed away recently; however, counsel stated that Mr.      445. In this case, there was no such event. This Court agrees with the
Friedman’s death would not affect the continuation of this matter.   Tax Court’s disposition in that regard.
22       Friedman, et al. v. Commissioner                 No. 98-2378        No. 98-2378               Friedman, et al. v. Commissioner               3

couple of years. Such activity included collecting accounts                    Taxpayers petitioned the United States Tax Court for
receivable, seeking buyers for saleable assets, and filing                   redetermination of the tax deficiencies. The Tax Court
periodic reports with the bankruptcy court concerning assets,                upheld the deficiencies, holding that there was no discharge
receipts, and disbursements. In fact, in addition to a report                of indebtedness income during the relevant tax year, and thus,
filed in August of 1992, the trustee filed reports with the court            New Manchester did not realize COD income for the 1992
in January, 1993, and January, 1995. Moreover, the trustee                   taxable year. Further, the Tax Court held that even if the S
filed his Final Report on November 30, 1995. The report                      corporation had realized COD income for 1992, such income
included a “Cash Receipts and Disbursement Record” which                     does not increase the basis of the shareholders.
identified numerous transactions in New Manchester’s bank
accounts throughout 1994 and 1995. The trustee filed a                         Taxpayers filed this timely appeal. For the reasons that
Supplemental Final Report in 1996.                                           follow, we AFFIRM the decision of the Tax Court.
   Further evidence that a discharge had not occurred in 1992                             Factual and Procedural Background
is the fraudulent conveyance claim filed in December, 1992,
by several of New Manchester’s creditors for $11 million.                      Appellants Michael Friedman and Edward Rosenthal were
The trustee obtained independent counsel to investigate the                  shareholders  in an S corporation known as Manchester Steel,
claim in September, 1993. While Taxpayers initially offered                  Inc.2 (a.k.a. New Manchester). Madeline Friedman and
$300,000 in February of 1994, to settle the creditors’ claim,                Deborah Rosenthal, spouses of Michael Friedman and
this offer was refused by the bankruptcy court. The claim was                Edward Rosenthal, respectively, were not shareholders of
eventually settled on or about April 11, 1995, for $2.2                      New Manchester; however, they are parties in this case solely
million. These facts demonstrate that not only was the                       by virtue3 of having filed joint tax returns with their
fraudulent conveyance claim still pending after 1992, but the                husbands.
value of the claim was in dispute well into 1995. Thus,
because the value of the claim was uncertain in 1992, the                      New Manchester is a steel service company which
actual amount New Manchester’s estate would realize from                     processes and distributes flat rolled steel and other related
the claim was not ascertainable in that year. Therefore, the                 products. It was incorporated on April 17, 1990, and it had
total debt that would be discharged could not have been                      elected to be taxed as an S corporation under Subchapter S of
discerned in 1992.                                                           the Internal Revenue Code. Mr. Friedman and Mr. Rosenthal
                                                                             each owned 97.5 shares of New Manchester. Their individual
  In light of the above, regardless of how improbable it was
that all of, or any of, New Manchester’s outstanding liabilities
would be paid, the fact remains that no identifying event                        2
                                                                                   A Subchapter S corporation is a small corporation that has elected,
occurred from     which this Court can determine the debt was                under the Internal Revenue Code (“IRC”), to be taxed similarly to
discharged.8 See Cozzi, 88 T.C. at 445. On the contrary, the                 partnerships. When a corporation has elected to be taxed under
                                                                             Subchapter S, the corporation itself is not subject to income tax. Rather,
                                                                             the income tax is imposed directly on the shareholders on a pro rata basis.
                                                                             In other words, the corporation’s income “passes through” to the
     8                                                                       shareholders, who then report that income on their individual tax returns.
      Taxpayers also argue that by virtue of New Manchester’s
insolvency, as effectively stipulated by the parties, there was a de facto   See 26 U.S.C. §1366.
discharge, pursuant to 26 U.S.C. §108(a)(1)(B). While it may be true that        3
because of New Manchester’s insolvency its liabilities would unlikely be          Hereafter, “Taxpayers” shall refer to Michael Friedman and Edward
paid, the result is the same. There must be some identifiable event to       Rosenthal.
4    Friedman, et al. v. Commissioner            No. 98-2378      No. 98-2378               Friedman, et al. v. Commissioner               21

percentage stock ownership was 24.375%. The remaining             therefore, the project (and the loan) was deemed abandoned.
shareholders, Vernon Bremberg and Irwin Kramer, each              Cozzi, 88 T.C. at 445-447.
owned 102.5 shares. Their percentage of stock ownership
was collectively 51.250%.                                            While the cases cited above do rely on the importance of,
                                                                  among all the facts and circumstances of the particular case,
  On or about April 17, 1990, New Manchester acquired             the improbability that a debt will actually have to be paid,
portions of the assets of Manchester Consolidated Industries,     these cases also stand for the proposition that there must also
Inc. (a.k.a. Old Manchester), including cash, accounts            be some identifiable event which fixes the loss with certainty.
receivable, equipment, inventory, land, buildings,                See Cozzi, 88 T.C. at 445. The Tax Court considered the
improvements, fixtures, goodwill, trade name, and the trade       likelihood of payment on the debts in the above cases cited by
mark from Old Manchester. New Manchester also assumed             Taxpayers; however, as Commissioner correctly notes, both
$12.8 million of Old Manchester’s liabilities, including a        cases also contain some identifiable event from which the Tax
secured trade debt.        New Manchester financed such           Court determined that a discharge of debt had occurred. In
acquisition using the assets purchased from Old Manchester        contrast to Cozzi and Fidelity-Philadelphia Trust Co., there is
as security. When New Manchester purchased these assets,          no identifiable event in the instant matter from which this
Old Manchester amended its Articles of Incorporation and          Court can determine that a loss was fixed with certainty, or
changed its name to E&M Investments Co.                           that a discharge of debt occurred.
   New Manchester was not a successful corporation. It               As previously stated herein, Taxpayers contend that the
suffered significant operating losses due to a variety of         stipulated facts in this case demonstrate that as of December,
factors. In 1991 and in 1992, New Manchester claimed over         1992, future payment of New Manchester’s prepetition
$10 million in losses from its trade or business activities. In   indebtedness in excess of $19 million was impossible, and the
addition, New Manchester had a number of creditors to whom        indebtedness would never be paid. Assuming for the moment
it owed in excess of $30 million. As a result of the continuing   that it was unlikely that payment towards New Manchester’s
losses, on March 3, 1992, an involuntary petition for             outstanding debt was possible, the record is devoid of any
bankruptcy was filed on behalf of New Manchester pursuant         identifying event     that established a discharge of the
to Chapter 7 of the United States Bankruptcy Code. A trustee      indebtedness.7
in bankruptcy, who was authorized to operate New
Manchester’s business, was appointed on March 30, 1992.             The record demonstrates that not only was the bankruptcy
The trustee engaged in a number of activities on behalf of        proceeding still pending as of December 31, 1992, the
New Manchester, including the following: collecting accounts      bankruptcy trustee was actively conducting New
receivable, seeking buyers for saleable assets, paying claims,    Manchester’s business at that time and well into the next
and filing reports with the bankruptcy court.
                                                                      7
   On May 7, 1992, New Manchester filed a schedule of assets            Without considering the requirement of an identifiable event, the
and liabilities and a statement of financial affairs with the     Court notes first, as a technical matter, that according to the United States
bankruptcy court. The schedule stated that New Manchester         Bankruptcy Code, a “discharge” may not be granted in a chapter 7
possessed tangible assets--real and personal property--valued     proceeding to a corporation. 11 U.S.C. §727(a)(1). Section 727(a)(1)
                                                                  states that “[t]he court shall grant the debtor a discharge, unless...the
at $9,241,153 and intangible assets--trade name, customer         debtor is not an individual.” 11 U.S.C. §727(a)(1). Therefore, New
lists, and covenant not to compete--valued at $3,991,457.         Manchester, as a corporate debtor, cannot obtain a “discharge” under the
                                                                  chapter 7 petition it filed with the Bankruptcy Court on March 3, 1992.
20    Friedman, et al. v. Commissioner             No. 98-2378      No. 98-2378           Friedman, et al. v. Commissioner         5

   While the taxpayer bank maintained that it received no           The schedule also reported liabilities totaling $30,360,669.
income in the year at issue because the bank was still liable in    On July 2, 1992, the trustee’s report of sale of New
full to the depositors, the Tax Court held that in exercising       Manchester’s tangible assets was filed.
control over the accounts, the bank realized income with
respect to those accounts. The court determined that the act           Several of New Manchester’s creditors commenced a
of a book entry closing out the accounts with old deposits and      proceeding in Bankruptcy Court, on December 10, 1992,
placing the money in a surplus account created income in the        alleging potential fraudulent conveyances and/or preferential
year in which it was done. Fidelity-Philadelphia Trust Co.,         transfers with respect to New Manchester prior to the filing of
23 T.C. at 530. In reaching its conclusion, the court               the petition for bankruptcy. The creditors claimed that such
considered the fact that the bank would most likely not have        fraudulent conveyances or preferential transfers rendered New
to honor its obligations to the depositors in question, and the     Manchester insolvent or undercapitalized. The creditors
probability of having to make payments to the depositors in         sought $11 million from Taxpayers and E&M Investments.
the future was slim enough that the income could be                 The bankruptcy court granted the trustee’s request to obtain
determined to be in the year of the book entry. Id.                 independent counsel to investigate and prosecute such claim
                                                                    in September, 1993. In February, 1994, Taxpayers offered to
  Taxpayers, in the present case, contend that both Cozzi and       settle the creditors’ claim for $300,000. The offer, however,
Fidelity-Philadelphia Trust Co. endorse the proposition that        upon a motion by the trustee, was refused by the court.
the improbability of future payment is the triggering event for     Eventually, upon a second motion by the trustee, on April 11,
determining the occurrence of a discharge of indebtedness.          1995, the trustee was authorized to settle the claim for $2.2
Taxpayers Br. at 19. As such, because it was clear as of            million.
December 31, 1992 that New Manchester’s debt of over $19
million would never be repaid, as stipulated by the parties,          Throughout the bankruptcy proceeding, the trustee filed
such debt must be viewed as having been discharged in that          periodic reports with the court concerning assets, receipts, and
year.                                                               disbursements. Such reports were filed in August of 1992,
                                                                    January of 1993, and January of 1995. On November 30,
   Taxpayers, however, are only partly correct. In Fidelity-        1995, the trustee filed a final report with the bankruptcy court.
Philadelphia Trust Co., the Tax Court considered the                The Final Report stated, in part, as follows:
improbability of the bank ever having to honor the obligation
of its depositors in holding that the bank realized income the        All property of the estate, except that claimed as exempt
year it closed the accounts at issue. Fidelity-Philadelphia           by the debtor, without objection, or determined by the
Trust Co., 23 T.C. at 530. The court reasoned that the                [bankruptcy] Court as exempt, has been inventoried,
possibility that the taxpayer might have to make a payment to         collected and liquidated, or abandoned. Any property not
a depositor in a later year may give it a right to a deduction in     heretofore abandoned by the trustee is now
such year; however, “it does not prevent the inclusion of the         abandoned...All claims have been examined and
unclaimed deposits in gross income in the earlier year, when          objections have been resolved....
such future payment appears improbable.” Id. at 531.
Similarly, much later in Cozzi, the court contemplated the          Trustee’s Final Report, November 30, 1995. A Supplemental
likelihood of payment in holding that it was not likely that a      Final Report was filed on January 31, 1996. Subsequently,
future payment on the loan agreement would be made;                 the bankruptcy court issued its final decree on July 15, 1996,
                                                                    thus closing New Manchester’s Chapter 7 proceeding and
                                                                    discharging the trustee.
6     Friedman, et al. v. Commissioner            No. 98-2378      No. 98-2378           Friedman, et al. v. Commissioner         19

  During the pendency of the bankruptcy proceeding,                   In finding that Hap recognized a discharge of indebtedness
Taxpayers filed joint federal income tax returns with the          in 1980, the Cozzi Court looked for an identifiable event to
Internal Revenue Service for the calendar years of 1989,           demonstrate the abandonment of security for a debt that
1990, and 1992. On October 15, 1993, the Friedmans filed an        would, in turn, show a release from debt and corresponding
application for a tentative refund, Form 1045, Application for     COD income. In viewing all of the circumstances
Tentative Refund. The refunds were claimed for 1989 and            surrounding the various agreements, the court concluded that
1990 in the amounts of $765,440 and $792,469, respectively.        Sargon had no intention of enforcing its rights against Hap
In such application, the Friedmans claimed net operating loss      under the loan agreement, and the scheduled final payment by
deductions from carrybacks relating to Mr. Friedman’s stock        Hap to Sargon in 1980, under the loan agreement, “was an
interest in New Manchester.                                        ‘identifiable event’ sufficient to evidence Hap’s abandonment
                                                                   of the picture.” Cozzi, 88 T.C. at 447. With no payment
  On November 12, 1993, the Rosenthals filed a Form 1045,          made by Hap to Sargon and no arrangement by the parties to
Application for Tentative Refund. The tentative refunds were       defer such payment, “[t]he final payment under [the loan
claimed for 1989 and 1990 in the amounts of $834,729 and           agreement] was an important event, and the failure to make
$810,331, respectively. The Rosenthals also claimed net            such payment is clear evidence of abandonment.” Id. In so
operating loss deductions in its application from carrybacks       holding, the court noted that the failure to make the final
relating to Mr. Rosenthal’s stock interest in New Manchester.      payment was not the only identifiable event, but it was a
The Rosenthals filed an amended tax return for the 1988 tax        reasonable choice. Id. Thus, Hap realized a discharge of
year, claiming a carryback of a net operating loss for the years   indebtedness in the taxable year 1980.
1988 to 1991.
                                                                     Taxpayers also cite Fidelity-Philadelphia Trust Co. v.
  In its federal income tax return for 1991, Form 1120S, New       Commissioner, 23 T.C. 527 (1954) in support of their
Manchester claimed a loss of $10,102,289. In its tax return        argument that New Manchester realized a discharge of
for 1992, New Manchester claimed a loss of $10,751,953.            indebtedness in 1992. In Fidelity-Philadelphia Trust Co., the
                                                                   taxpayer was incorporated as a national bank in 1934. At that
  The Commissioner issued notices of deficiencies to               time, it acquired various assets and assumed certain liabilities
Taxpayers for the calendar years 1989 and 1990, on May 29,         of a liquidated national bank. Among such liabilities were
1996. The Commissioner stated that Taxpayers owed                  certain depositors’ accounts of the liquidated bank.
additional amounts as follows: The Friedmans owed $686,400
for 1989 and $793,860 for 1990; and the Rosenthals owed               In 1948, after fruitless searches to locate depositors by mail,
$617,446 for 1989 and $811,723 for 1990. The notices of            advertising, and other means, the taxpayer bank transferred to
deficiencies stated that, for the taxable year ending 1992,        its surplus account several of the depositors’ accounts which
Taxpayers were not entitled to a loss in excess of $5 million      were unclaimed, dormant, and inactive. In doing so, the bank
each from their interest in New Manchester.              The       closed out its unclaimed deposit accounts. On its tax return
Commissioner found that Taxpayers were not entitled to             for 1948, the monies resulting from the closing of the above
increase their basis in New Manchester by the cancellation of      accounts was shown as “a Sundry Credit to Earned Surplus,”
indebtedness income. Thus, Taxpayers’ 1992 taxable income          not as income. In assessing a tax deficiency, Commissioner
was increased accordingly.                                         treated this amount as additional income.
 Subsequently, Taxpayers filed separate petitions with the
United States Tax Court, on August 27, 1996, for a
18   Friedman, et al. v. Commissioner             No. 98-2378      No. 98-2378          Friedman, et al. v. Commissioner        7

‘identifiable event’ which fixes the loss with certainty may be    redetermination of their respective income tax deficiencies for
taken into consideration.” Cozzi, 88 T.C. at 445 (citing           the taxable years at issue. In each case, Taxpayers claimed
United States v. S.S. White Dental Mfg. Co., 274 U.S. 398          entitlement to the 1992 loss and carried the loss back to their
(1927)).                                                           respective tax years of 1989 and 1990. The two petitions
                                                                   were consolidated for the purpose of briefing and opinion in
  Taxpayers rely on Cozzi v. Commissioner, supra, in support       the Tax Court.
of their position that in December, 1992, it was clear that part
of New Manchester’s indebtedness, in the amount of                    On May 27, 1998, the Tax Court issued its opinion,
$19,471,684, would never be repaid. Cozzi involved a               upholding Taxpayers’ tax deficiencies. In its opinion, the Tax
limited partnership, Hap Production Company (“Hap”),               Court stated that the principal issue before it was whether
formed for the purpose of producing motion picture films.          Taxpayers were entitled to increase their basis in the S
Hap entered into an agreement with Map Films, Ltd. to              corporation’s stock as a result of any COD income realized by
produce a film for Map Films in return for annual payments         the corporation. Initially, however, the Court found that
from 1976 through 1981. Another party, Barongreen agreed           pursuant to the plain language of section 108(d)(2) of the
to produce the film for Hap in exchange for certain annual         Internal Revenue Code, New Manchester had not realized a
payments from 1976 through 1979 to Hap on behalf of Map            discharge of indebtedness, or COD income, in 1992. The
Films. Hap entered into a nonrecourse loan agreement with          Court observed that the trustee in New Manchester’s
Sargon Establishment whereby Hap agreed to repay such loan         bankruptcy case was actively conducting New Manchester’s
in annual payments between 1976 and 1980.                          business and disbursing monies to creditors after 1992. The
                                                                   Court noted, in particular, that New Manchester’s creditors
  The film produced by the parties never made a profit.            filed a fraudulent conveyance claim in December of 1992; the
Consequently, none of the annual payments by Map Films,            claim was not settled until 1995. Further, the Court noted that
Barongreen, or Hap was ever made. Hap’s tax returns for            the trustee’s final report, which concluded that all claims
1976 through 1980 reported no activity. In 1984, the parties       pertaining to New Manchester had been settled, was filed in
entered into settlement agreements whereby each party was          1995.
released from any contractual obligations, and Sargon
received the rights to the film. As a result of the cancellation      The Tax Court, therefore, held that the facts and
of its nonrecourse debt to Sargon, Hap reported income for         circumstances as outlined above do not even suggest that New
1984. Petitioner, a limited partner in Hap, reported his           Manchester’s underlying indebtedness was extinguished or
distributive share of such income on his tax return for 1984.      discharged by the bankruptcy court in 1992. In addition, the
                                                                   Court was not persuaded that New Manchester’s insolvency,
  The Commissioner issued a tax deficiency, stating that the       in and of itself, in 1992, was sufficient to create a de facto
petitioners received income from Hap in 1980 as a result of        discharge, as argued by Taxpayers. Finally, the Tax Court
Hap recognizing income in that year. As stated by                  held that even if New Manchester had realized COD income
Commissioner, a possible explanation for Hap’s recognition         in 1992, such income would not have increased Taxpayers’
of income in 1980 was the fact that Hap’s nonrecourse loan         basis in the corporate stock because section 108(d)(7)(A) of
from Sargon was discharged. As in the present case, the            the Internal Revenue Code prevents a pass-through to
dispute in Cozzi is not whether a discharge of indebtedness        shareholders of COD income which is excluded from an S
occurred, rather it is in which year such income is                corporation’s gross income.
recognizable.
8      Friedman, et al. v. Commissioner           No. 98-2378      No. 98-2378          Friedman, et al. v. Commissioner       17

    Taxpayers’ appeal follows the decision of the Tax Court.         §108. Income from discharge of indebtedness
                         Discussion                                  (a) Exclusion from gross income.
  The primary issue in this case is whether Taxpayers are              (1) In general. Gross income does not include any
entitled to an increase in their basis in an S corporation’s         amount which (but for this subsection) would be
stock as a result of the discharge of indebtedness income, or        includible in gross income by reason of the discharge (in
COD income, realized by the corporation. As a threshold              whole or in part) of indebtedness of the taxpayer if
matter, however, we must determine whether New                            (A) the discharge occurs in a title 11 case;
Manchester actually realized COD income in 1992, which                    (B) the discharge occurs when the taxpayer is
would, in turn, establish whether Taxpayers may claim, and           insolvent;
carry back, a loss in excess of $5 million each.                          (C) the indebtedness discharged is qualified farm
                                                                     indebtedness; or
I. Standard of Review                                                     (D) in the case of a taxpayer other than a C
                                                                     corporation, the indebtedness discharged is qualified real
   This Court reviews the Tax Court’s findings of fact for           property business indebtedness.
clear error and its application of law de novo. Ekman v.
Commissioner, 184 F.3d 522, 524 (6th Cir.1999). Regarding          26 U.S.C. §108(a)(1). In the instant matter, the relevant
the specific question of the timing of the discharge of            exception is “the discharge occurs in a title 11 case,” as
indebtedness, however, Taxpayers present two possible              Taxpayers filed a petition for bankruptcy on March 3, 1992.
standards of review.                                               Section 108(d)(2) defines a “title 11 case” as “a case under
                                                                   title 11 of the United States Bankruptcy Code (relating to
  In the main body of their brief, Taxpayers state that the time   bankruptcy), but only if the taxpayer is under the jurisdiction
of the discharge is essentially a question of fact which would     of the court in such case and the discharge is granted by the
be subject to review for clear error. Taxpayers Br. at 18          court or is pursuant to a plan approved by the court.” 26
(citing Carl T. Miller Trust v. Commissioner, 76 T.C. 191,         U.S.C. §108(d)(2).
195 (1981)(“Determination of the point in time at which a
taxpayer’s obligation has been cancelled, giving rise to             First and foremost, in order for COD income to occur under
income, is essentially a question of fact.”); Taxpayers Br. at     section 61(a)(12), the taxpayer must have been discharged
24 (concluding that the Tax Court’s finding “that no discharge     from a liability. Such liability, or debt, must be viewed as
occurred in 1992" is clearly erroneous). However, in the           having been discharged when it becomes clear that the debt
section of their brief entitled “Standard of Review,”              will never have to be paid. Cozzi v. Commissioner, 88 T.C.
Taxpayers suggest that “whether sufficient evidence has been       435, 445 (1987). The test for determining such a moment is
submitted to meet a party’s burden is a mixed question of law      a practical assessment of the facts and circumstances relating
and fact.” Taxpayers Br. at 38. Taxpayers appear to reach this     to the likelihood of payment. Cozzi, 88 T.C. at 445 (citing
conclusion by combining two prior assertions: (1) that the         Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980), supp.
sufficiency of evidence submitted by a party is a question of      opinion to 73 T.C. 491 (1979), vacated and remanded on
                                                                   other grounds, 692 F.2d 152 (1st Cir.1982), aff’d in part and
                                                                   rev’d in part on other grounds sub nom. CRC Corp. v.
                                                                   Commissioner, 693 F.2d 281 (3d Cir.1982)). “Any
16       Friedman, et al. v. Commissioner                  No. 98-2378        No. 98-2378               Friedman, et al. v. Commissioner               9

fact that the creditors initially sought $11 million upon the                 fact that will not be disturbed unless clearly erroneous4; and
filing of the claim.6                                                         (2) that the allocation of the burden of proof is a question of
                                                                              law.
  The Tax Court agreed with Commissioner in that some sort
of identifying event or forgiveness on the part of the creditors                 In support of this latter proposition, that the allocation of
was necessary in order to give rise to a discharge of                         the burden of proof is a question of law and whether sufficient
indebtedness income in 1992. Accordingly, the Court held                      evidence has been submitted is a mixed question of law and
that the evidence supported the conclusion that New                           fact, Taxpayers cite two old cases from other circuits, without
Manchester did not realize COD income in the year at issue                    specific page references: (1) Kendrick Coal & Dock Co. v.
since no identifiable event occurred.                                         Commissioner, 29 F.2d 559 (8th Cir.1928); and (2)
                                                                              Commissioner v. Cecil B. DeMille Productions, Inc., 90 F.2d
   “Gross income” is defined in the Internal Revenue Code as                  12 (9th Cir.1937). In Kendrick, the most relevant language
“all income from whatever source derived....” 26 U.S.C.                       states that “[w]hether a particular finding of fact is supported
§61(a). It includes income from discharge of indebtedness, or                 by any substantial evidence is a question of law.” 29 F.2d at
cancellation of indebtedness (COD income). 26 U.S.C.                          563. The second case cited contains no language that would
§61(a)(12). This means that a taxpayer who has incurred a                     be beneficial to Taxpayers’ position.
financial obligation, which obligation is later discharged or
the taxpayer is released from the indebtedness, has realized an                  Commissioner does little to respond to Taxpayers’
accession to income. 26 U.S.C. §61(a)(12); United States v.                   propositions concerning the appropriate standard of review
Kirby Lumber Co., 284 U.S. 1 (1931). The rationale of this                    with respect to the timing of the discharge. Commissioner
principle is that the discharge of a debt below the face value                states only that Taxpayers “acknowledge” that the timing of
of the debt accords the debtor an economic benefit equivalent                 realization of discharge of indebtedness “is a question of fact,
to income. Id.                                                                subject to the clearly erroneous standard of review.”
                                                                              Commissioner Br. at 18.
  Accompanying the discharge of indebtedness income rule,
however, is what is commonly referred to as the “insolvency                      Contrary to Taxpayers’ second contention regarding the
exception.” Section 108(a)(1) of the Internal Revenue Code                    standard of review, this Court finds that the Tax Court’s
provides that a debtor will not recognize income under                        decision regarding the timing of the discharge should be
§61(a)(12) if he or she is insolvent following the discharge of               reviewed for clear error. This circuit recently referred to a
indebtedness. 26 U.S.C. §108(a)(1). Section 108(a) provides,                  determination of whether taxpayers failed to carry their
in pertinent part, as follows:                                                burden of proving that they engaged in activities within the
                                                                              meaning of a statute as a “factual conclusion.” See Holmes v.
                                                                              Commissioner, 184 F.3d 536, 543 (6th Cir.1999). Such
                                                                              reference indicates that this circuit views the issue of a
                                                                              whether a party presented evidence sufficient to meet its
                                                                              burden of proof as a question of fact, subject to review for
     6
      Perhaps Commissioner could have stipulated that “it was clear that
prepetition indebtedness in excess of the value” of specific assets and the       4
fraudulent conveyance claim would never be repaid, in order to address              Taxpayers cite Hoover v. Commissioner, 102 F.3d 842 (6th
the indebtedness without committing to an assertion that over $19 million     Cir.1996), which supports only the portion of the assertion that a question
would clearly never be repaid.                                                of fact is reviewed for clear error. See Hoover, 102 F.3d at 844.
10       Friedman, et al. v. Commissioner                  No. 98-2378        No. 98-2378           Friedman, et al. v. Commissioner        15

clear error. See also In re Newman, 7 F.3d 234 (Table), 1993                  these assets would never be repaid.” J.A. at 64. Thus,
WL 328035, **2 (6th Cir.1993)(unpublished opinion)(“The                       Taxpayers contend that since it was stipulated that
question of whether a particular set of facts satisfies (or fails             indebtedness in excess of the value of New Manchester’s
to satisfy) the requisite burden of proof is an inseparable part              assets as of December 31, 1992 would never be repaid, there
of the factfinding process and as such is reviewed -- together                was, effectively, a discharge in the amount of $19,471,684 in
with the facts -- for clear error.”)(citing 1 Steven A. Childress             1992.
& Martha S. Davis, Federal Standards of Review §2, 18, at 2-
130 (2d ed. 1991)).                                                              Commissioner, on the other hand, maintains that there was
                                                                              no discharge because there was no identifying event in 1992
II. Burden of Proof                                                           demonstrating that a debt had been discharged. In support of
                                                                              his position, Commissioner emphasizes two points: First, the
  Taxpayers maintain that Commissioner bears the burden of                    stipulated record demonstrates that the bankruptcy trustee was
proof with respect to the timing of the discharge of                          actively administering the bankruptcy estate well into 1995,
indebtedness. Tax Rule 142(a) states as follows:                              collecting accounts receivable, seeking buyers for saleable
                                                                              assets, and filing reports with the bankruptcy court. Second,
  The burden of proof shall be upon the petitioner, except                    a claim for fraudulent conveyance in the amount of $11
  as otherwise provided by statute or determined by the                       million was initiated by several of New Manchester’s
  Court; and except that, in respect of any new matter,                       creditors. While at one point Taxpayers offered to settle the
  increases in deficiency, and affirmative defenses, pleaded                  claim for $300,000, it was eventually settled in 1995 for $2.2
  in the answer, it shall be upon the respondent.5                            million. Based upon the fluctuation in anticipated value,
                                                                              initial offer, and actual settlement, Commissioner contends
Based on this Rule, Taxpayers contend that the question of                    that the value of the fraudulent conveyance claim was highly
whether the discharge of indebtedness occurred in 1992, as                    uncertain. Therefore, for all of these reasons, Commissioner
opposed to another year, is a “new matter.” Taxpayers argue,                  maintains that no event had occurred in 1992 to fix a
therefore, that Commissioner bears the burden of proof.                       discharge of indebtedness, nor could there have been any
Without resolving this issue, the Tax Court merely concluded                  certainty at that time as to the amount of any discharge.
that if the burden were shifted to Commissioner, “he would
have fulfilled that requirement by a substantial preponderance                   The Court must note, however, that Commissioner does not
of the evidence.” J.A. at 43.                                                 explicitly reconcile the discrepancy between the stipulated
                                                                              statement that the fraudulent conveyance claim had an
  The Notices of Deficiency issued to Taxpayers stated as                     anticipated value of $2,400,000 as of December 31, 1992, and
follows:                                                                      Commissioner’s argument in his brief that the claim’s value
                                                                              could not be fixed in 1992. Implicitly, the argument appears
  IT IS DETERMINED THAT FOR THE TAXABLE                                       to be that the anticipated value could not be expected to
  YEAR ENDING 1992, YOU ARE NOT ENTITLED TO                                   reflect the actual value of the claim, especially in light of the

     5
       The burden of proof does not change when a case is fully stipulated,
as is presently the case before this Court. See Tax Rule 122(b); Zarin v.
Commissioner, 92 T.C. 1084, 1088 (1989), remanded on other grounds,
916 F.2d 110 (3d Cir.1990).
14    Friedman, et al. v. Commissioner             No. 98-2378      No. 98-2378          Friedman, et al. v. Commissioner       11

disallowing the loss claimed by Taxpayers is new grounds for          A LOSS IN THE AMOUNT OF $5,055,116.00 FROM
disallowance; it does not clarify or develop an original              THE SMALL BUSINESS CORPORATION KNOWN
determination by Commissioner. The new grounds requires               AS MANCHESTER STEEL, INC. YOU ARE NOT
the introduction of different evidence. As such, as justice and       ENTITLED TO INCREASE YOUR BASIS IN THE
fairness require, the burden of proving that the discharge did        CORPORATION BY THE CANCELLATION OF
not occur in the year at issue is on Commissioner.                    INDEBTEDNESS INCOME. INTERNAL REVENUE
                                                                      CODE SECTION 108(d)(7) PROVIDES THAT THE
III. Discharge of Indebtedness Income                                 EXCLUS ION FOR CANCELLATION OF
                                                                      INDEBTEDNESS INCOME WILL APPLY AT THE
   The Notice of Deficiency issued to Taxpayers states that           ENTITY LEVEL IN THE CASE OF CANCELLATION
Taxpayers are not entitled to a loss in the amount of                 OF AN S CORPORATION’S DEBT.
$5,055,116.00 from New Manchester and they are not entitled           CONSEQUENTLY, IF THE CANCELLATION OF
to increase their basis in the corporation by the cancellation of     DEBT IS EXCLUDED AT THE CORPORATE LEVEL,
indebtedness income. In order to resolve this issue, the Court        THERE IS NO INCOME ITEM TO FLOW THROUGH
must determine, initially, whether New Manchester realized            TO THE SHAREHOLDERS AND NO INCREASE IN
a discharge of indebtedness income, or COD income, for the            YOUR STOCK BASIS. ACCORDINGLY, YOUR 1992
taxable year ending 1992.                                             TAXABLE INCOME IS INCREASED $5,055,116.00.
   Taxpayers argue that there was a discharge of indebtedness         IN ADDITION, THIS AMOUNT EXCLUDED FROM
in 1992 because it was clear at the end of 1992 that                  INCOME, UNDER SECTION 108 OF THE INTERNAL
$19,471,684 of New Manchester’s indebtedness would never              REVENUE CODE, IS TAX-DEFERRED INCOME,
be repaid. Taxpayers reached this determination as follows:           NOT TAX-EXEMPT. ACCORDINGLY, THERE IS
When the bankruptcy proceeding began, New Manchester had              NO INCREASE TO YOUR STOCK BASIS UNDER
liabilities of $30,360,669 and assets of $9,241,153. By               SECTION 1366 OF THE INTERNAL REVENUE
December 31, 1992, as the parties have stipulated, the value          CODE. THEREFORE, SINCE YOU HAD A $0.00
of New Manchester’s assets was $1,488,985.78, in addition             BASIS IN THIS STOCK, YOU ARE NOT ENTITLED
to a fraudulent conveyance claim filed by New Manchester’s            TO THE CURRENT YEAR AND/OR SUSPENDED
creditors. The claim had an anticipated value of $2,400,000.          YEAR LOSSES CLAIMED.
Because New Manchester had paid $7 million to one of its
creditors in 1992, Taxpayers assert that New Manchester’s             IN ADDITION, YOU WOULD NOT BE ELIGIBLE
remaining liabilities, as of December 31, 1992, totaled               FOR THE LOSS IN THE AMOUNT OF $5,055,116.00
$23,360,669 (the initial liabilities of $30,360,669 minus             ON YOUR 1992 RETURN SINCE YOU WERE NOT
$7,000,000). Taxpayers thereby determined that the excess of          AT RISK FOR THESE LOSSES WITHIN THE
New Manchester’s liabilities over the fair market value of its        MEANING OF SECTION 465 OF THE INTERNAL
assets was $19,471,684 ($23,360,669 (liabilities) minus               REVENUE CODE.
$1,488,985.78 (assets) minus $2,400,000 (anticipated value
of the fraudulent conveyance claim)). Moreover, Taxpayers           J.A. at 19 (Friedman Notice); J.A. at 33 (Rosenthal Notice).
point to the stipulation of the parties whereby Taxpayers and       According to Taxpayers, the Notice presupposes the fact of
Commissioner stated that “[a]s of December 31, 1992, it was         the discharge of indebtedness, and it fails to raise a question
clear that prepetition indebtedness in excess of the value of       as to the timing of the discharge; hence, it is a “new matter”
12   Friedman, et al. v. Commissioner            No. 98-2378      No. 98-2378           Friedman, et al. v. Commissioner         13

pursuant to Tax Rule 142(a). Commissioner, on the other           that the year of the loss was a new matter. The Tax Court
hand, contends that the Notice clearly made Taxpayers aware       agreed with the petitioner and found that a challenge to the
that Commissioner denied that New Manchester had incurred         ordinary character of a loss does not necessarily encompass a
discharge of indebtedness income in 1992, and it was              challenge to the fact of the loss. Hunter, 1982 WL 10676, at
sufficiently broad to cover both the timing and the occurrence    *20. In reaching its conclusion, the Court reasoned that “the
of such income.                                                   issue of the timing of the loss would appear to be conceded,
                                                                  for if the loss was not properly taken in the year before the
   As previously stated, petitioners (Taxpayers) generally bear   Court, the issue of the character of the loss becomes moot.”
the burden of proof. Tax Rule 142(a); Welch v. Helvering,         Id.
290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933). The
respondent (Commissioner), however, bears the burden as to           This Court finds Taxpayers’ argument on this point
“any new matter, increases in deficiency, and affirmative         persuasive. The Notice of Deficiency issued to Taxpayers
defenses, pleaded in the answer.” Tax Rule 142(a). The            presumes the existence of a discharge of indebtedness in
issue, therefore, becomes whether the timing of the discharge     stating: (1) You are not entitled to increase your basis in the
of indebtedness is a “new matter.”                                corporation by the cancellation of indebtedness income; and
                                                                  (2) If the cancellation of debt is excluded at the corporate
   A new position taken by Commissioner is not necessarily        level, there is no income to flow through to the
a “new matter” if it merely clarifies or develops                 shareholders.... (emphasis added). Commissioner’s challenge
Commissioner’s original determination without requiring the       to Taxpayers’ loss was aimed at the nature or character of the
presentation of different evidence, being inconsistent with       loss, not the year it allegedly occurred. Commissioner’s
Commissioner’s original determination, or increasing the          raising of the general existence of the alleged loss does not
amount of the deficiency. Achiro v. Commissioner, 77 T.C.         necessarily implicate a challenge to the timing of the alleged
881, 889-91 (1981). In Zarin v. Commissioner, 92 T.C.             loss.
1084, 1089 (1989), remanded on other grounds, 916 F.2d 110
(3d Cir.1990), the Third Circuit found that new matter had           Furthermore, Commissioner failed to raise specifically the
been raised when the original notice of deficiency asserted a     question of the existence or the timing of the income despite
theory of larceny and the answer to the petition in Tax Court     having the opportunity to do so and despite advancing other
raised a theory of income from discharge of indebtedness. In      theories for the deficiencies. Such other theories include the
reaching its conclusion, the Zarin Court determined that the      following: (1) the exclusion of Section 108 of the Internal
latter theory clearly required different evidence from the        Revenue Code applies at the corporate level, therefore, there
ground originally asserted in the petition.                       is no income to flow through to the shareholders; (2) the
                                                                  amount excluded is tax-deferred income, not tax-exempt
   The Tax Court specifically addressed a timing issue with       income; and (2) Taxpayers were not at risk for the 1992 loss
respect to “new matters” in Hunter v. Commissioner, 44            pursuant to Section 465 of the Internal Revenue Code.
T.C.M. (CCH) 385, 1982 WL 10676 (1982). In this case, the
question was whether the petitioner’s stock became worthless         Therefore, in light of the foregoing, this Court finds that the
during the year in question. Respondent did not raise the         issue of the timing of the discharge of indebtedness income is
issue in his notice of deficiency or in the pleadings of the      a “new matter” for consideration. The assertion, subsequent
case. While the petitioner elicited testimony concerning the      to the Notice of Deficiency, that New Manchester did not
timing of the worthlessness of the debt during trial, he argued   experience a discharge of indebtedness in 1992 as a basis for
