                    109 T.C. No. 22



                UNITED STATES TAX COURT



   DUDLEY B. AND LA DONNA K. MERKEL, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent

     DAVID A. AND NANCY J. HEPBURN, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 10031-95, 10032-95.       Filed December 30, 1997.



     Ps realized income on account of the discharge of
indebtedness. Ps excluded that income pursuant to the
insolvency exclusion of sec. 108(a)(1)(B), I.R.C., by
including certain “contingent” liabilities in the
insolvency calculation of sec. 108(d)(3), I.R.C.
     Held: The term “liabilities” in sec. 108(d)(3),
I.R.C., requires Ps to prove with respect to any
obligation claimed to be a liability that Ps will be
called upon to pay that obligation in the amount
claimed. Held, further, Ps failed to prove that they
would be called upon to pay any amount with respect to
either of the obligations claimed to be liabilities.
Held, further, Ps failed to prove that, on the
measurement date, their liabilities exceeded the fair
market value of their assets and, therefore, may not
exclude any income under sec. 108(a)(1)(B), I.R.C.
                                -2-

     Gregory W. MacNabb, for petitioners.

     Ann M. Welhaf, for respondent.



     HALPERN, Judge:   In these consolidated cases, respondent

determined deficiencies in the Federal income tax of petitioners

Dudley and La Donna Merkel and David and Nancy Hepburn for their

1991 taxable (calendar) years in the amounts of $115,420 and

$116,347, respectively.   Both cases involve similar circumstances

and require us to determine whether petitioners in the two cases

(the Merkels and the Hepburns, respectively) may exclude under

section 108(a)(1)(B) certain income from the discharge of

indebtedness.   Unless otherwise noted, all section references are

to the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts, with accompanying exhibits, is

incorporated herein by this reference.

     At the time the petitions were filed, the Merkels and the

Hepburns resided in Scottsdale and Paradise Valley, Arizona,

respectively.

Discharge of Indebtedness Income

     During 1991, the Merkels and the Hepburns were all partners

in a partnership (the partnership) that, on September 1, 1991,
                                -3-

realized income on account of the discharge of indebtedness.      On

their 1991 U.S. Individual Income Tax Returns (Forms 1040; filing

status of married filing joint return), the Merkels and the

Hepburns each (couple) disclosed their distributive share of that

income, $359,721, but excluded such amount from gross income on

the ground that each was insolvent immediately before that income

was realized by the partnership.

The SLC Indebtedness

     Systems Leasing Corp. (SLC) is an Arizona corporation

organized in 1979 by petitioners Dudley Merkel and David Hepburn

to engage in the computer leasing business.     SLC is owned “50/50”

by Dudley Merkel and David Hepburn.     Dudley Merkel and David

Hepburn were officers of SLC during its fiscal years ended

February 29, 1992, and February 28, 1993, and received officer

compensation for those years as follows:

                          FYE 2/29/92           FYE 2/28/93

     Dudley Merkel         $183,202              $191,150
     David Hepburn          182,824               191,151

     In 1986, SLC incurred an indebtedness to Security Pacific

Bank (the indebtedness and the bank, respectively), evidenced by

a note (the SLC note).   The SLC note was personally guaranteed by

each petitioner (collectively, petitioners’ guarantees).      As of

April 16, 1991, the unpaid balance of the SLC note was in excess

of $3,100,000, and SLC was in default of its obligations under

the SLC note.
                                 -4-

       On May 31, 1991, SLC, the bank, and petitioners, as

guarantors, entered into an agreement (the agreement) containing

the terms and conditions of a structured workout concerning the

repayment of the indebtedness to the bank.    The agreement, in

part, provides as follows:

       (1) SLC is to pay to the bank $1,100,000 (the payoff) on or

before August 2, 1991 (the settlement date);

       (2) the bank will release its security interest in the

remaining collateral upon payment of the payoff by the settlement

date; and

       (3) after the payoff by the settlement date, the bank will

refrain from exercising any remedies under the SLC note or

petitioners’ guarantees if bankruptcy is not filed by or for SLC

or petitioners, among others, voluntarily or involuntarily,

within 400 days after the settlement date.

       SLC made the payoff by the settlement date, and the bank

released its security interests in the remaining collateral of

SLC.    The other conditions of the agreement were met, and the

bank, at the expiration of the 400-day period, released SLC from

its liability as maker of the SLC note and petitioners from

petitioners’ guarantees.

       At no time did the bank make any formal written request or

formal written demand for payment from petitioners pursuant to

petitioners’ guarantees.
                                 -5-

North Carolina's Sales and Use Tax

     SLC was engaged in the business of leasing computer systems

in the State of North Carolina during the relevant period.    The

North Carolina Department of Revenue (the Department of Revenue)

issued a “Notice of Sales and Use Tax Due” (the notice) to SLC

dated June 14, 1991.   The notice identifies the amount of taxes,

penalties, and interest due, a total of $980,511.84, and states

that the assessment is final and conclusive.   The assessment of

sales and use tax identified in the notice was for taxes that

were never collected by SLC.    After receipt of the notice, SLC's

recourse was to pay the assessed amount and file a suit for

refund or to protest the assessment if the Department of Revenue,

in the exercise of its discretion, permitted additional time to

file a protest.   As of August 31, 1991, SLC had not paid the

amount identified as due on the notice, nor had SLC requested

time to file a protest.

     On October 14, 1991, petitioners engaged an attorney to

protest the sales and use tax assessment.   The Department of

Revenue granted SLC 60 days to file a protest.   As a result of

that protest, the Department of Revenue abated the assessment

against SLC in full.

     The Department of Revenue never proposed nor made an

assessment against any of petitioners relating to the sales and

use tax assessed against SLC.
                                  -6-

                                OPINION

I.   Introduction

      A.   Issue

      The issue in these consolidated cases is whether petitioners

were insolvent on August 31, 1991 (the measurement date), for

purposes of section 108(a)(1)(B) (the insolvency issue).       There

is no question that, if section 108(a)(1)(B) (the insolvency

exclusion) does not apply to petitioners, $359,721 would be

included in the gross income of each of the Merkels and the

Hepburns for 1991 as each couple's distributive share of certain

discharge of indebtedness income realized by a partnership in

which both couples were partners.       The parties have stipulated

that resolution of the insolvency issue depends on whether

petitioners may include in the insolvency calculation provided in

section 108(d)(3) (the statutory insolvency calculation) either

of the following obligations:    (1) “the liability of each of the

petitioners as guarantors of the loan made by Security Pacific

Bank to SLC” (petitioners' guarantees) and (2) “the personal

liability, if any, of petitioners Dudley Merkel and David Hepburn

as officers of SLC for unpaid sales and use taxes assessed by the

State of North Carolina against SLC” (the assessment against SLC

shall be referred to as the State tax assessment and the personal

liability, if any, of petitioners with respect to the State tax

assessment shall be referred to as the State tax exposure).       In
                                -7-

addition, the parties have stipulated that the “exposure of each

of petitioners Merkel and Hepburn” pursuant to petitioners'

guarantees and the State tax exposure was $1 million and

$490,000, respectively, and, “if the petitioners properly may

include the amount of their exposure under either * * *, the

petitioners were each insolvent to the extent of the full amount

of the * * * discharge of indebtedness income to each.”

Petitioners bear the burden of proof on all questions of fact.

Rule 142(a).

     B.   Arguments of the Parties

     Respondent argues that the term “liabilities”, as used in

section 108(d)(3), “must be given its plain meaning” and

encompasses “only liabilities ripe and in existence on the

measurement date”.   Respondent would have the Court find that

petitioners' guarantees were contingent liabilities and, thus,

not liabilities in existence on the measurement date for purposes

of section 108(d)(3).   Respondent would have the Court also find

that, as of the measurement date, the State tax exposure was not

a liability for purposes of section 108(d)(3), contingent or

otherwise.

     Petitioners argue that the plain meaning of the term

“liabilities” in section 108(d)(3) “includes all liabilities,

whether contingent or otherwise”, and “whether and how much of a

liability is counted must be determined on a liability-by-
                                    -8-

liability basis with due regard to all of the circumstances that

existed” at the time insolvency is to be determined.         With

respect to contingent liabilities, petitioners concede:         (1) “the

likelihood of the occurrence of the contingency * * * [may be] so

remote as not to give rise to a liability” and (2) “a contingent

liability may be a liability; however, the amount of that

liability may be less than the amount of full exposure.”

Petitioners would have the Court find that both petitioners'

guarantees and the State tax exposure were liabilities in

existence on the measurement date, to be taken into account

(perhaps at “less than the amount of full exposure”) under

section 108(d)(3).

II.   Analysis

      A.   The Code

      Section 61(a)(12) provides that gross income means all

income from whatever source derived, including income from

discharge of indebtedness.      In certain circumstances, however,

income from discharge of indebtedness is excluded from gross

income.    In relevant part, section 108(a) provides:

           (1) In general.--Gross income does not include any
      amount which (but for this subsection) would be
      includible in gross income by reason of the discharge
      (in whole or in part) of indebtedness of the taxpayer
      if--

                    (A) the discharge occurs in a title 11
            case,

                 (B) the discharge occurs when the
            taxpayer is insolvent * * *
                                     -9-

                     *    *      *   *     *   *   *

          (3) Insolvency exclusion limited to amount of
     insolvency.--In the case of a discharge to which
     paragraph (1)(B) applies, the amount excluded under
     paragraph (1)(B) shall not exceed the amount by which
     the taxpayer is insolvent.

     The term “insolvent” is defined in section 108(d)(3) as

follows:

     For purposes of this section, the term “insolvent”
     means the excess of liabilities over the fair market
     value of assets. With respect to any discharge,
     whether or not the taxpayer is insolvent, and the
     amount by which the taxpayer is insolvent, shall be
     determined on the basis of the taxpayer's assets and
     liabilities immediately before the discharge.

Section 108 contains no definition of the term “liabilities”, nor

does the Code contain any generally applicable definition of that

term.     The regulations interpreting section 108 neither add to

the statutory definition of insolvency nor define the term

“liabilities”.

     Section 108(e)(1) states that, except as provided in section

108, “there shall be no insolvency exception from the general

rule that gross income includes income from the discharge of

indebtedness.”

     B.     Extrinsic Sources

             1.   Introduction

        This Court's function in the interpretation of the Code is

to construe the statutory language so as to give effect to the

intent of Congress.      See United States v. American Trucking

Associations, 310 U.S. 534, 542 (1940); Fehlhaber v.
                                 -10-

Commissioner, 94 T.C. 863, 865 (1990), affd. 954 F.2d 653 (11th

Cir. 1992); U.S. Padding Corp. v. Commissioner, 88 T.C. 177, 184

(1987), affd. 865 F.2d 750 (6th Cir. 1989).      Where the statute is

ambiguous, it is well established that we may look to its

legislative history and to the reason for its enactment.      See

United States v. American Trucking Associations, supra at 543-

544; Centel Communications Co. v. Commissioner, 92 T.C. 612, 628

(1989), affd. 920 F.2d 1335 (7th Cir. 1990); U.S. Padding Corp.

v. Commissioner, supra at 184.

     In the context of the parties' dispute, we believe that the

term “liabilities” in section 108(d)(3) is ambiguous, in

particular as to the nature of the examination to be afforded to

obligations claimed to be liabilities for purposes of the

statutory insolvency calculation.1      Therefore, this Court shall

examine the legislative purpose of the insolvency exclusion and

its related provisions.

          2.   Legislative History

     The insolvency exclusion was added to the Code by the

Bankruptcy Tax Act of 1980 (the Bankruptcy Tax Act), Pub. L. 96-

589, sec. 2(a), 94 Stat. 3389-3392.      In the Bankruptcy Tax Act,

which was enacted 2 years after Congress revised and modernized

1
     Previous cases provide only limited guidance in resolving
the question presented in this case. See, e.g., Correra v.
Commissioner, T.C. Memo. 1997-356; Ng v. Commissioner, T.C. Memo.
1997-248; Caton v. Commissioner, T.C. Memo. 1995-80; Traci v.
Commissioner, T.C. Memo. 1992-708; Bressi v. Commissioner, T.C.
Memo. 1991-651, affd. without published opinion 989 F.2d 486 (3d
Cir. 1993).
                               -11-

the bankruptcy law, Pub. L. 95-598, 92 Stat. 2549, Congress

“intended to complete the process of revising and updating

Federal bankruptcy laws by providing rules governing the tax

aspects of bankruptcy and related tax issues.”   Staff of Joint

Comm. on Taxation, Description of H.R. 5043 (Bankruptcy Tax Act

of 1980) as Passed the House, at 3 (J. Comm. Print 1980).

     The relevant committee reports (the committee reports)

accompanying H.R. 5043, 96th Cong., 2d Sess. (1980), which became

the Bankruptcy Tax Act, provide that the proposed insolvency

exclusion is intended to insure that an insolvent debtor outside

of bankruptcy (like a debtor coming out of bankruptcy, who is

accorded a “fresh start” under the bankruptcy law) is not

burdened with an immediate tax liability.   See S. Rept. 96-1035,

at 10 (1980), 1980-2 C.B. 620, 624; H. Rept. 96-833, at 9 (1980).

The pre-existing law is described as follows:

     Under a judicially developed “insolvency exception,” no
     income arises from discharge of indebtedness if the
     debtor is insolvent both before and after the
     transaction;1 and if the transaction leaves the debtor
     with assets whose value exceeds remaining liabilities,
     income is realized only to the extent of the excess.2
     * * *
     1
       Treas. Regs. § 1[.]61-12(b)(1); Dallas Transfer &
     Terminal Warehouse Co. v. Comm'r, 70 F.2d 95 (5th Cir.
     1934).
     2
       Lakeland Grocery Co., 36 B.T.A. 289 (1937).

S. Rept. 96-1035, supra, 1980-2 C.B. at 623; see H. Rept. 96-833,

supra at 7.   The proposed insolvency exclusion is described in

terms that reflect the preexisting insolvency exception:
                               -12-

          The bill provides that if a discharge of
     indebtedness occurs when the taxpayer is insolvent (but
     is not in a bankruptcy case), the amount of debt
     discharge is to be excluded from gross income up to the
     amount by which the taxpayer is insolvent.16
     16
      The bill defines “insolvent” as the excess of
     liabilities over the fair market value of assets,
     determined with respect to the taxpayer's assets and
     liabilities immediately before the debt discharge. The
     bill provides that except pursuant to section
     108(a)(1)(B) of the Code (as added by the bill), there
     is to be no insolvency exception from the general rule
     that gross income includes income from discharge of
     indebtedness.

S. Rept. 96-1035, supra, 1980-2 C.B. at 627; see H. Rept. 96-833,

supra at 12.

     3.   Relevant Cases Cited in the Committee Reports

     The Supreme Court in United States v. Kirby Lumber Co.,

284 U.S. 1 (1931), established the general rule that a debtor

realizes income when discharged of indebtedness (i.e., relieved

of indebtedness without full payment of the amount owed).    In

that case, the taxpayer repurchased some of its own bonds in the

open market for $137,5212 less than what it had received upon

issuance earlier that same year.   Justice Holmes distinguished

Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926), the Supreme

Court's first pronouncement on the subject of income from the

discharge of indebtedness, by stating:

     the defendant in error [in Kerbaugh-Empire] owned the
     stock of another company that had borrowed money
     repayable in marks or their equivalent for an
     enterprise that failed. At the time of payment the

2
     For convenience, amounts have been rounded to the nearest
dollar.
                              -13-

     marks had fallen in value, which so far as it went was
     a gain for the defendant in error, and it was contended
     by the plaintiff in error that the gain was taxable
     income. But the transaction as a whole was a loss, and
     the contention was denied. Here there was no shrinkage
     of assets and the taxpayer made a clear gain. As a
     result of its dealings it made available $137,521.30
     assets previously offset by the obligation of bonds now
     extinct. We see nothing to be gained by the discussion
     of judicial definitions. The defendant in error has
     realized within the year an accession to income * * * .
     [United States v. Kirby Lumber Co., 284 U.S. 1, 3
     (1931).]

     In Dallas Transfer & Terminal Warehouse Co. v. Commissioner,

70 F.2d 95 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933), the

taxpayer was relieved of an indebtedness with respect to unpaid

rent and interest thereon of $107,881 upon conveying to the

lessor certain real property of lesser value.   The Court of

Appeals for the Fifth Circuit held that the transaction did not

give rise to taxable income because the taxpayer remained

insolvent3 after the discharge of its debt to the lessor and

distinguished United States v. Kirby Lumber Co., supra, as

follows:

     The taxpayer's [Kirby Lumber Co.'s] assets having been
     increased by the cash received for the bonds, by the
     repurchase of some of those bonds at less than par the
     taxpayer, to the extent of the difference between what
     it received for those bonds and what it paid in
     repurchasing them, had an asset which had ceased to be
     offset by any liability, with a result that after that
     transaction the taxpayer had greater assets than it had
     before. The decision * * * that the increase in clear
     assets so brought about constituted taxable income is

3
     The Board of Tax Appeals, however, noted that the taxpayer
was solvent after the discharge. See Dallas Transfer & Terminal
Warehouse Co. v. Commissioner, 27 B.T.A. 651, 657 (1933), revd.
70 F.2d 95 (5th Cir. 1934).
                                -14-

     not applicable to the facts of the instant case, as the
     cancellation of the respondent's past due debt to its
     lessor did not have the effect of making the
     respondent's assets greater than they were before that
     transaction occurred. * * * [Dallas Transfer &
     Terminal Warehouse Co. v. Commissioner, supra at 96.]

     In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289

(1937), the taxpayer, pursuant to a “composition settlement”,

paid to its creditors $15,473 in consideration of being relieved

of the taxpayer's indebtedness to those creditors of $104,710.

Prior to the composition settlement, the taxpayer was insolvent;

after that settlement, the taxpayer had net assets of $39,597.

The Board of Tax Appeals (the Board) agreed with the Commissioner

     that the rationale of United States v. Kirby Lumber
     Co., 284 U.S. 1, should apply and that gain is realized
     to the extent of the value of the assets freed from the
     claims of creditors * * * The petitioner's net assets
     were increased from zero to $39,596.93 as a result of
     the cancellation of indebtedness by its creditors, and
     to that extent it had assets which ceased to be offset
     by any liability. * * * [Id. at 292.]

     C.   Discussion

           1.   Origin of the Net Assets Test

     The Board's approach to a taxpayer in financial distress

being discharged of an indebtedness, which approach was

crystallized in Lakeland Grocery Co. v. Commissioner, supra, has

been called, among other things, the “net assets” test.4   That

4
     See Surrey, “The Revenue Act of 1939 and the Income Tax
Treatment of Cancellation of Indebtedness”, 49 Yale L. J. 1153,
1164 (1940); Warren & Sugarman, “Cancellation of Indebtedness and
Its Tax Consequences: I”, 40 Colum. L. Rev. 1326, 1352 & n.108
(1940) (“The `net assets' test was first intimated in Porte F.
Quinn, 31 B.T.A. 142, 145 (1934).”); see also Bittker & Thompson,
                                                   (continued...)
                              -15-

test is based on the so-called “freeing-of-assets” theory derived

from the Supreme Court's statement in Kirby Lumber that the

transaction “made available $137,521.30 assets previously offset

by the obligation of bonds now extinct”.    See, e.g., Commissioner

v. Tufts, 461 U.S. 300, 311 n.11 (1983).5   The net assets test is

a corollary of the principle in Dallas Transfer that an insolvent

debtor does not realize income when discharged of indebtedness.

Under the net assets test, if the debtor remains insolvent

(liabilities exceed assets) after being discharged of

indebtedness, no assets have been freed as a result of the

discharge since the debtor's assets are still more than offset by

his postdischarge liabilities, and, thus, no gross income is

realized; if the debtor is solvent (assets exceed liabilities)

after being discharged, then the discharge has freed the debtor's

assets from the offset of his liabilities to that extent, and,



4
 (...continued)
“Income From the Discharge of Indebtedness: The Progeny of United
States v. Kirby Lumber Co.”, 66 Cal. L. Rev. 1159, 1184 & n.90
(1978) (the Board's approach illustrates the “above water”
principle).
5
     But cf. Bittker & Thompson, supra at 1184 n.90 (stating that
the above water principle in Lakeland Grocery Co. v.
Commissioner, 36 B.T.A. 289 (1937), does not necessarily require
acceptance of the freeing-of-assets theory; if horizontal equity
as between a debtor coming out of bankruptcy and an insolvent
debtor outside of bankruptcy is the guiding principle, the above
water result may be justified by disregarding income realized
from being voluntarily discharged of indebtedness outside of
bankruptcy “only to the extent that the taxpayer's financial
status after the composition or other arrangement with creditors
is comparable to the bankruptcy outcome”). But see infra secs.
II.C.2., 4.
                                 -16-

thus, gross income is realized from the discharge.     In essence,

the net assets test is simply an examination of the debtor's net

worth after he is discharged of indebtedness--an increase in net

worth gives rise to income, but a decrease in negative net worth

does not.

            2.   Codification of the Net Assets Test

     The net assets test has been criticized, particularly for

employing an improper criterion in the definition of income.6

Congress, however, codified the net assets test in section

108(a)(1)(B), (a)(3), and (d)(3) as a means of determining an

exclusion from gross income of an item of income derived from the

discharge of indebtedness.    Aside from the parallel descriptions

in the committee reports of the preexisting law and of the

proposed insolvency exclusion, see supra sec. II.B.2., that

codification is apparent from the statutory insolvency

calculation coupled with the insolvency exclusion limitation

provided in section 108(a)(3), which together share the same

underlying analytical framework as the net assets test.    That

framework requires an examination of the debtor's assets and

6
     See, e.g., Eustice, “Cancellation of Indebtedness and the
Federal Income Tax: A Problem of Creeping Confusion”, 14 Tax L.
Rev. 225, 246-247 (1959); see also Estate of Newman v.
Commissioner, 934 F.2d 426, 427 (2d Cir. 1991) (“confusion as to
the theoretical basis for taxing discharges of indebtedness has
spawned an illogical, judge-made `insolvency exception'”), revg.
T.C. Memo. 1990-230. The net assets test and other judicially
created insolvency exceptions have been described as “an
emotional response by the courts to the plight of financially
embarrassed debtors rather than * * * any strict application of
judicial logic.” Eustice, supra at 246.
                                -17-

liabilities for the purpose of determining whether the debtor's

net worth turns positive (assets exceed liabilities), i.e.,

whether assets are freed, as a result of the debtor's being

discharged of indebtedness.7

          3.   The Freeing-of-Assets Theory and the Statutory
               Insolvency Calculation

     From our examination of the statutory language, the

legislative history, and the relevant cases cited in the

committee reports, we conclude that the analytical framework of

the insolvency exclusion and its related provisions is based on

the freeing-of-assets theory.   That theory establishes the

foundation for understanding the nature of the examination to be

afforded to obligations claimed to be liabilities for purposes of

the statutory insolvency calculation.

7
     It should be noted that the net assets test requires an
examination of the debtor's net worth after he is discharged of
the indebtedness, whereas the statutory insolvency calculation
requires an examination immediately before the discharge. That
distinction, however, does not produce disparate results and is
simply the product of the manner in which the insolvency
exclusion and its limitation operate. For purposes of
illustration, assume the following facts: (1) a debtor has
indebtedness of $100 owed to C, assets of $130, and another
liability of $100 and (2) C discharges the debtor of the
indebtedness for payment of $20. The net assets test would find
that, after the discharge, the debtor has assets of $110 ($130 -
$20) and liabilities of $100 ($200 - $100), and, therefore, the
debtor realizes income to the extent his assets exceed his
liabilities, $10 ($110 - $100). The statutory insolvency
calculation would provide that the debtor is insolvent by $70
($200 - $130) and the amount of the exclusion under sec.
108(a)(1)(B) would be limited to that amount pursuant to sec.
108(a)(3); the debtor under sec. 61(a)(12) realizes $80 ($100 -
$20) of income and excludes $70 of that amount under sec.
108(a)(1)(B), for net income recognition of $10 (same as the net
assets test).
                              -18-

     A solvent debtor is capable of meeting his financial

obligations because his assets equal or exceed his liabilities.

That excess (if any) is not increased when an obligation that

offsets assets is paid in full because the reduction in

liabilities is equal to the reduction in assets.   If the

reduction in liabilities exceeds the reduction in assets, then,

under the freeing-of-assets theory, the solvent debtor has

realized a gain to the extent of that excess.   See, e.g.,

Milenbach v. Commissioner, 106 T.C. 184, 202 (1996); Cozzi v.

Commissioner, 88 T.C. 435, 445 (1987) (“The general theory is

that to the extent that a taxpayer has been released from

indebtedness, he has realized an accession to income because the

cancellation effects a freeing of assets previously offset by the

liability arising from such indebtedness.”) (citing United States

v. Kirby Lumber Co., 284 U.S. 1 (1931)).8   Pursuant to the

8
     That understanding of the nature of liabilities comports
with the ordinary and common meaning of the term “liability”:
“That which one is under obligation to pay, or for which one is
liable. Specif., in the pl., one's pecuniary obligations, or
debts, collectively;--opposed to assets.” Webster's New
International Dictionary 1423 (2d ed. 1940).

     It should also be noted that the freeing-of-assets theory,
much like its descendant the net assets test, has been
criticized:

          A particularly troublesome legacy of * * * [the
     passage in Kirby Lumber that the transaction “made
     available $137,521.30 assets previously offset by the
     obligation of bonds now extinct”] has been the tendency
     of some courts to read Kirby Lumber as holding that it
     is the freeing of assets on the cancellation of
     indebtedness, rather than the cancellation itself, that
                                                   (continued...)
                               -19-

freeing-of-assets theory, a debtor does not realize income when

discharged of a particular indebtedness, however, if his post-

discharge liabilities equal or exceed his postdischarge assets

(if any); i.e., under the net assets test, the debtor's

liabilities equal or exceed his assets after the discharge (or,

the statutory insolvency calculation shows that the debtor is

insolvent by an amount greater than or equal to the discharge of

indebtedness income, see supra note 7).   Clearly, an

indiscriminate inclusion of obligations to pay in the calculation

of postdischarge liabilities (or, in the statutory insolvency

calculation), without any consideration of how speculative those

obligations may be, would render meaningless any inquiry as to

whether assets are freed upon the discharge of indebtedness.

Logic dictates that an obligation to pay is a liability under the

freeing-of-assets theory only if it can be said with a

satisfactory degree of certainty that the obligation offsets

assets.   The critical inquiry, of course, is the level of

certainty that is satisfactory.


8
 (...continued)
     creates the taxable gain. Such reasoning misses the
     point. Income results from the discharge of
     indebtedness because the taxpayer received (and
     excluded from income) funds that he is no longer
     required to pay back, not because assets are freed of
     offsetting liabilities on the balance sheet. * * *

Bittker & Thompson, supra at 1165. That criticism, however, does
not apply to a statutory exclusion from income that simply
employs the freeing-of-assets theory to achieve objectives other
than a definition of income. See infra sec. II.C.6.
                               -20-

     Congress has not specified the minimum level of certainty,

but Congress’ indicated purpose of not burdening an insolvent

debtor outside of bankruptcy with an immediate tax liability, see

supra sec. II.B.2., together with the operation of the insolvency

exclusion and its limitation under section 108(a)(3), in

accordance with the statutory insolvency calculation, suggest

that Congress intended to make a debtor’s ability to pay an

immediate tax on income from discharge of indebtedness the

controlling factor in determining whether a tax burden is

imposed.9   Indeed, if a debtor has the ability to pay an

immediate tax, in the sense that assets of the debtor exceed

liabilities that he will be called upon to pay (and not in the

sense that the debtor simply has assets on hand), the concern of

imposing an unfair or unwarranted immediate tax burden vanishes.

     Ability to pay an immediate tax (i.e., the statutory notion

of insolvency) is a question of fact and, although Congress has

specifically instructed us that (in determining ability to pay)

assets are to be valued at fair market value, see sec. 108(d)(3),

Congress has not otherwise instructed us on how to make that

finding or what measure of persuasion carries the burden of

proof.   A taxpayer with the burden of proof must, thus, persuade

us of whether and in what amount he (as debtor) will be called


9
     The Commissioner apparently agrees. See Rev. Rul. 92-53,
1992-2 C.B. 48, 49 (when a taxpayer’s liabilities exceed the fair
market value of his assets, “the taxpayer is unable to pay either
the indebtedness or the tax”).
                               -21-

upon to pay an obligation claimed to be a liability for purposes

of the statutory insolvency calculation under the usual measure

of persuasion applicable in this Court.10   The usual measure of

persuasion required to prove a fact in this Court is

“preponderance of the evidence”, see, e.g., Schaffer v.

Commissioner, 779 F.2d 849, 858 (2d Cir. 1985), affg. in part and

remanding Mandina v. Commissioner, T.C. Memo. 1982-34, which

means that the proponent must prove that the fact is more

probable than not, see, e.g., 2 McCormick on Evidence, sec. 339,

at 439 (4th ed. 1992).   Therefore, a taxpayer claiming the

benefit of the insolvency exclusion must prove (1) with respect

to any obligation claimed to be a liability, that, as of the

calculation date, it is more probable than not that he will be

called upon to pay that obligation in the amount claimed and

(2) that the total liabilities so proved exceed the fair market

value of his assets, see sec. 108(d)(3).    See infra sec. II.C.7.

for further discussion relating to the measure of proof required

for an obligation claimed to be a liability for purposes of the

statutory insolvency calculation.


10
     The terms of the agreement creating the claimed obligation
to pay generally would determine whether and in what amount the
taxpayer will be called upon to pay; e.g., with respect to
petitioners' guarantees, the likelihood of a bankruptcy event and
the amount that the bank would have the right to demand upon such
occurrence governs the analysis, see infra sec. II.D.2. We
acknowledge, however, that the examination in other contexts of
obligations claimed to be liabilities for purposes of the
statutory insolvency calculation may involve considerations not
addressed in this report.
                               -22-

          4.   Horizontal Equity is Not the Guiding Principle

     Although we have concluded that the analytical framework of

the insolvency exclusion and its related provisions is based on

the freeing-of-assets theory, we note that the committee reports

indicate that Congress intended to achieve a measure of

horizontal equity in enacting section 108(a)(1)(A) (the

bankruptcy exclusion) and the insolvency exclusion; i.e.,

affording similar treatment to debtors coming out of bankruptcy

and insolvent debtors outside of bankruptcy:

     To preserve the debtor's “fresh start” after
     bankruptcy, the bill provides that no income is
     recognized by reason of debt discharge in bankruptcy,
     so that a debtor coming out of bankruptcy (or an
     insolvent debtor outside bankruptcy) is not burdened
     with an immediate tax liability. * * * [Emphasis
     added.]

S. Rept. 96-1035, at 10 (1980), 1980-2 C.B. 620, 624; H. Rept.

96-833, at 9 (1980).   That expression of legislative purpose may

suggest that, in making an examination of obligations claimed to

be liabilities for purposes of the statutory insolvency

calculation, Congress intended an examination that is dependent

on the treatment of such obligations in the bankruptcy context.

See supra note 5; see also infra sec. II.C.7. (petitioners’

“likelihood of occurrence” test).     The broad reach of the

insolvency exclusion, however, indicates that Congress recognized

the significant differences between a debtor coming out of

bankruptcy and an insolvent debtor outside of bankruptcy and

realized that different avenues of excluding income from
                               -23-

discharge of indebtedness and the consequences thereof were

necessary and inevitable.

     Title 11 of the United States Code (the Bankruptcy Code)

offers bankruptcy relief for various types of debtors.   1 Collier

on Bankruptcy, par. 1.03, at 1-21 (15th ed. Revised 1996).

Chapter 7 of the Bankruptcy Code governs liquidation of a debtor,

colloquially known as “straight bankruptcy”, and provides the

mechanism for “the collection, liquidation, and distribution of

the property of the debtor”, culminating in the discharge of the

debtor.   6 Collier on Bankruptcy, par. 700.01, at 700-1 (15th ed.

Revised 1996).   Being thus relieved of his debts, the debtor

coming out of bankruptcy is accorded a fresh start.   To preserve

that fresh start, the debtor pursuant to the bankruptcy exclusion

is not burdened with an immediate tax liability on account of

income from the discharge in bankruptcy of indebtedness.

     For the insolvent debtor outside of bankruptcy, until (and

unless) all of his debts are settled or discharged, he is not in

the identical fresh start position as the debtor coming out of

bankruptcy.   Section 108(d)(3) recognizes that fact and provides

for a calculation of insolvency and not an actual marshaling and

sale of assets followed by a satisfaction of debts.   When

Congress codified the net assets test, see supra sec. II.C.2.,

the insolvency exclusion was made available to all insolvent
                               -24-

debtors outside of bankruptcy.11   The necessary consequence of

that choice is that the nature of the examination to be afforded

to obligations claimed to be liabilities for purposes of the

statutory insolvency calculation depends on an analytical

framework based on the freeing-of-assets theory and not on the

treatment of such obligations in some analogous context, e.g.,

“debt” in the bankruptcy context.12

          5.   Respondent's Plain Meaning Argument

     Respondent argues that the term “liabilities” in section

108(d)(3) must be given its plain meaning, which requires

excluding contingent liabilities from the statutory insolvency

calculation.   As evidence of such exclusive meaning, respondent

relies on principles of financial accounting established by the

Financial Accounting Standards Board (FASB).   Respondent asserts

11
     If Congress were interested primarily in promoting
horizontal equity, Congress could have adopted the more
restrictive approach suggested by the American Law Institute in
its Draft of a Federal Income Tax Statute. See Surrey & Warren,
“The Income Tax Project of the American Law Institute: Gross
Income, Deductions, Accounting, Gains and Losses, Cancellation of
Indebtedness”, 66 Harv. L. Rev. 761, 817 (1953); see also Fifth
Ave.-Fourteenth St. Corp. v. Commissioner, 147 F.2d 453, 457 (2d
Cir. 1944) (test based on a hypothetical liquidation of the
debtor), revg. 2 T.C. 516 (1943).
12
     See, e.g., Bankruptcy Code secs. 101(5), 101(12), 726, 727.
In addition, adherence to bankruptcy procedures and policies, for
example, the estimation of contingent or unliquidated debt
pursuant to Bankruptcy Code sec. 502(c)(1), among other things,
would unnecessarily and unjustifiably import unrelated
considerations into the statutory insolvency calculation. See
Bankruptcy Code sec. 502(c)(1) (requiring estimation when the
fixing or liquidation of any contingent or unliquidated claim
would unduly delay the administration of the bankruptcy
petition).
                               -25-

that:   “Under Generally Accepted Accounting Principles [GAAP],

true contingent liabilities are merely disclosed in the footnotes

to the financial statements as petitioner Hepburn did in this

case, rather than accrued in the statements as a liability.      See

FASB Statement No. 5”.

     FASB establishes and improves standards of financial

accounting and reporting for the guidance and education of the

public, including issuers, auditors, and users of financial

statements.   Kay & Searfoss, Handbook of Accounting and

Auditing 46-8 (2d ed. 1989).   Respondent directs our attention to

FASB Statement of Financial Accounting Standards No. 5,

Accounting for Contingencies (FASB Statement No. 5).   By FASB

Statement No. 5, FASB establishes standards of financial

accounting and reporting for “loss contingencies”, which term is

defined to mean, in general, a situation of possible loss that

will be resolved in the future, see FASB Statement No. 5, par. 1.

The likelihood of a loss can range from “probable” to “remote”.

Id. at par. 3.   The estimated loss associated with a liability

must be accrued by a charge to income (which would result in a

balance sheet liability) if both (1) information indicates that

it is probable that the liability has been incurred and (2) the

amount of the loss can be reasonably estimated.   Id. at par. 8.13

13
     Guarantees are specifically included in the examples of loss
contingencies contained in FASB Statement No. 5. FASB Statement
No. 5., par. 4.h. (“Guarantees of indebtedness of others”). The
current practice under Generally Accepted Accounting Principles
                                                   (continued...)
                                -26-

      Certain guarantees, which are contingent, must be reported

as a liability under GAAP.   Therefore, whether an obligation,

such as a guarantee, is a “true” contingent liability cannot be

ascertained without an examination of the nature of the

contingency.14   Although the accrual or nonaccrual of a liability

on a taxpayer's balance sheet may provide evidence as to whether

the taxpayer will be called upon to pay that liability, such

reporting for financial accounting purposes is not dispositive.

The treatment of contingent liabilities under GAAP is consistent

with the examination required of obligations claimed to be

liabilities for purposes of the statutory insolvency calculation,

see supra sec. II.C.3.; however, this Court shall not abdicate

its responsibility to examine such obligations independently.



13
 (...continued)
(GAAP) with respect to guarantees is as follows:

          It is accepted current practice that a guarantor
     does not report on its balance sheet a liability for
     the obligation under guarantee; typically, however,
     there is disclosure of guarantees in footnotes. If it
     is determined “probable” that the guarantor will have
     to perform under the guarantee agreement (i.e., pay the
     lender on behalf of the borrower), an accrual for such
     amounts should be established by the guarantor in
     accordance with the principles of FASB Statement 5,
     “Accounting for Contingencies.”

FASB Emerging Issues Task Force, Issue Summary No. 85-20
(emphasis added).
14
     The Commissioner apparently recognizes that principle.    See
Rev. Rul. 97-3, 1997-2 I.R.B. 5, 6 (“Affixing a label to an
undertaking (for example, referring to an arrangement as a
`guarantee') does not alone decide its character.”).
                                 -27-

           6.    Respondent's Consistency Argument

     In Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968), we

rejected the Commissioner's suggestion that any person who

guarantees the payment of a loan realizes income when the

principal debtor makes payments on the loan.    We distinguished

the situation of a guarantor, who “obtains nothing except perhaps

a taxable consideration for his promise”, from that of a debtor,

“who as a result of the original loan obtains a nontaxable

increase in assets”, and who, if relieved of the obligation to

repay the loan, enjoys an increase in net worth that “may be

properly taxable.    United States v. Kirby Lumber, Co., 284 U.S. 1

(1931).”   Id. at 813.   This Court stated:   “[W]here the guarantor

is relieved of his contingent liability, either because of

payment by the debtor to the creditor or because of a release

given him by the creditor, no previously untaxed accretion in

assets thereby results in an increase in net worth.”     Id.

     Respondent relies heavily on Landreth for the proposition

that petitioners are precluded “from using their status as

guarantors to render themselves insolvent within the meaning of

I.R.C. § 108.”    Respondent argues:

          The Landreth Court reasoned that “[p]ayment by the
     principal debtor does not increase the guarantor's net
     worth; it merely prevents it, pro tanto, from being
     decreased.” Landreth v. Commissioner, 50 T.C. at
     * * * [813]. This rationale is sound for several
     reasons. The guarantor did not receive the tax-free
     accretion in wealth upon payment of the loan funds, but
     rather the principal obligor did. When the principal
     obligor makes payments pursuant to the loan, there is
                               -28-

     no liability to the guarantor that is being reduced by
     such payments which would increase the guarantor's net
     worth. This is so because the guarantee did not
     represent a liability to the guarantor in the first
     instance, it merely represented the possibility of a
     liability in the future upon the occurrence or
     nonoccurrence of some future event.

          * * * the guarantees were not a liability to
     petitioners within the meaning of I.R.C. § 108 for
     purposes of income or the insolvency exception to that
     income. To hold otherwise would result in an
     inconsistent application of this statute. If discharge
     of the contingent liability does not give rise to
     discharge income pursuant to I.R.C. § 108, Congress
     could not have intended for taxpayers to use that very
     same debt to render themselves insolvent under that
     section. [Fn. ref. omitted; emphasis added.]

     We believe that respondent misreads Landreth v.

Commissioner, supra.   The touchstone of this Court's analysis in

Landreth is the absence of any “previously untaxed accretion in

assets” that, by reason of the guarantor's being relieved of the

contingent liability, “results in an increase in net worth”, id.

at 813, and not the absence of a liability, the reduction of

which increases the guarantor's net worth.   Indeed, the cases

relied on by this Court in Landreth, Commissioner v. Rail Joint

Co., 61 F.2d 751 (2d Cir. 1932), affg. 22 B.T.A. 1277 (1931);

Fashion Park, Inc. v. Commissioner, 21 T.C. 600 (1954),

specifically rejected the rationale that respondent now suggests

is the basis of this Court's decision in Landreth.     See

Commissioner v. Rail Joint Co., supra at 752 (“But it is not

universally true that by discharging a liability for less than

its face the debtor necessarily receives a taxable gain.”);
                               -29-

Fashion Park, Inc. v. Commissioner, supra at 604.   The basis of

the decision in Landreth is that a guarantor does not obtain

initially a nontaxable increase in assets for his promise.

Therefore, respondent may not use Landreth to argue that, because

relief from a guarantee does not give rise to discharge of

indebtedness income, since a guarantee is not a liability,

considering a guarantee as a liability for purposes of the

statutory insolvency calculation results in an inconsistent

application of section 108.

     Respondent's argument, in any event, reveals a more

fundamental misconception regarding the insolvency exclusion and

its related provisions.   Without any justification in the Code or

in the legislative history of section 108, respondent assumes

that the insolvency exclusion and section 61(a)(12), which

defines gross income as including income from discharge of

indebtedness,15 are identical in terms of legislative purpose;

i.e., that the scope of both provisions is the definition of the

term “gross income”.   When respondent argues that Congress could

not have intended for taxpayers to use liabilities, the discharge

of which does not give rise to income, to exclude discharge of




15
     For purposes of sec. 108, sec. 108(d)(1) defines the term
“indebtedness of the taxpayer” as “any indebtedness--(A) for
which the taxpayer is liable, or (B) subject to which the
taxpayer holds property.” There is no indication that the term
“indebtedness” in sec. 61(a)(12) with respect to a particular
taxpayer differs from the definition provided in sec. 108(d)(1).
                                -30-

indebtedness income, respondent fails to recognize that the

apparent inconsistency may be an inconsistency in policy.

     As Congress enacted the insolvency exclusion, it eliminated

the net assets test as a judicially created exception to the

general rule of income from the discharge of indebtedness.       See

sec. 108(e)(1).16   The fundamental difference between the

insolvency exclusion and the net assets test is that the

insolvency exclusion is applicable only if there exists income

from the discharge of indebtedness, whereas the net assets test

engages in the threshold inquiry.      Therefore, unlike the net

assets test, the insolvency exclusion does not necessarily invade

the province of section 61(a)(12).

     Essentially, the insolvency exclusion defers to section

61(a)(12) as to the definition of the term “gross income”, but

represents a policy judgment that certain of that income should

not give rise to an immediate tax liability.      The relevant

committee reports intimate that the policy judgment underlying



16
     Cf. Bittker & McMahon, Federal Income Taxation of
Individuals, par. 4.5, at 4-26 (2d ed. 1995) (“by virtue of
§ 108(e)(1), § 108(a)(1) now preempts the field, precluding any
other `insolvency exception.' This attempt to outlaw judge-made
insolvency exceptions is technically flawed because it applies
only if the taxpayer realizes `income from the discharge of
indebtedness' and, hence, does not help in determining whether a
transaction by an insolvent debtor generates any income. The
message will be heeded, however, even though the draftsman
blundered.” (fn. ref. omitted)). It appears, however, that the
draftsman did not blunder because sec. 108(e)(1) applies for
purposes of title 26 of the United States Code (the Internal
Revenue Code) without regard to sec. 108(a)(1).
                                -31-

the insolvency exclusion serves a humanitarian purpose--to avoid

burdening an insolvent debtor outside of bankruptcy with an

immediate tax liability, see supra sec. II.B.2.    Even if there

exists some consistency in policy between section 61(a)(12) and

the insolvency exclusion, respondent's argument assumes that only

liabilities, the discharge of which gives rise to income, can

offset assets (which is the role of liabilities in the analytical

framework of the insolvency exclusion and its related

provisions).   There is simply no basis for respondent's

assumption.    In sum, nothing in the Code, the legislative history

of section 108, or any relevant authority requires an identity in

the class of obligations to pay for purposes of both the

statutory insolvency calculation and discharge of indebtedness

income under section 61(a)(12).17

          7.    Petitioners' “Likelihood of Occurrence” Test

     As an alternative to the argument that the full amount of

both petitioners' guarantees and the State tax exposure should be


17
     Cf. sec. 108(e)(2), which provides: “No income shall be
realized from the discharge of indebtedness to the extent that
payment of the liability would have given rise to a deduction.”
Congress did not provide that a sec. 108(e)(2) “liability” is not
a liability for purposes of the statutory insolvency calculation,
yet respondent's consistency argument leads to that conclusion.

     In addition, to the extent that respondent's consistency
argument relates to consistency in determining the existence of
indebtedness and of liabilities, we believe that the standard set
forth supra sec. II.C.3. creates no inconsistency. Cf. Zappo v.
Commissioner, 81 T.C. 77, 89 (1983) (“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.”).
                              -32-

considered as liabilities for purposes of the statutory

insolvency calculation, petitioners argue that the Court should

apply a “likelihood of occurrence” test.    Relying on Covey v.

Commercial Natl. Bank, 960 F.2d 657 (7th Cir. 1992), petitioners

suggest that this Court value the amount of a liability, “by

multiplying the full amount of the liability by the probability

of payment”.

     In Covey v. Commercial Natl. Bank, supra at 660, the Court

of Appeals for the Seventh Circuit stated that “[t]o decide

whether a firm is insolvent within the meaning of

§ 548(a)(2)(B)(i) [of the Bankruptcy Code], a court should ask:

What would a buyer be willing to pay for the debtor's entire

package of assets and liabilities?    If the price is positive, the

firm is solvent; if negative, insolvent.”    The court held that,

in making the insolvency determination for purposes of a

preference-recovery action under section 548 of the Bankruptcy

Code,18 contingent liabilities must be discounted by the

probability of their occurrence.     Id. at 660-661.

     To allow debtors to avoid an immediate tax liability by

virtue of a contingent liability that the debtor will not likely

be called upon to pay, a consequence of the likelihood of

occurrence test advanced by petitioners, would undermine the


18
     Sec. 548 of the Bankruptcy Code authorizes the trustee “to
avoid a transaction made within one year before the commencement
of the bankruptcy case, that depletes the debtor's assets to the
detriment of the bankruptcy estate.” 5 Collier on Bankruptcy,
par. 548.01, at 548-5 (15th ed. Revised 1996).
                                -33-

purposes of the insolvency exclusion and its related provisions.

Liabilities that a debtor will not likely be called upon to pay

do not offset assets and cannot be recognized as liabilities

within the analytical framework of the insolvency exclusion and

its related provisions.   The following example illustrates the

need to show the likelihood of a demand for payment on a claimed

liability.   Assume that a debtor is discharged from indebtedness

of $99 for payment of $98.    Prior to the discharge, the debtor

had cash in the amount of $100 and had guaranteed a friend's debt

of $10, which friend was solvent and not likely to default

(20 percent chance of total default) as the primary obligor.

Petitioners would argue that the debtor in the example has assets

of $100 and liabilities of $101 ($99 + 20 percent of $10 = $101)

and is entitled to exclude the $1 of discharge of indebtedness

income.   The debtor in the example, under petitioners' test,

avoids an immediate tax liability on the $1 of income by virtue

of a liability that the debtor will not likely be called upon to

pay (20 percent likelihood of occurrence of total default is less

than “more likely than not”).   In essence, the debtor avoids an

immediate tax liability when the preponderance of the evidence

suggests that the debtor has the ability to pay such tax, see

supra sec. II.C.3.   That result frustrates Congress' purpose in

enacting the insolvency exclusion and its related provisions and,

therefore, is unacceptable.
                                -34-

           8.   Conclusion

     In conclusion, a taxpayer claiming the benefit of the

insolvency exclusion must prove (1) with respect to any

obligation claimed to be a liability, that, as of the calculation

date, it is more probable than not that he will be called upon to

pay that obligation in the amount claimed and (2) that the total

liabilities so proved exceed the fair market value of his assets.

     D.   Application

           1.   Petitioners’ Burden of Proof

     As stated in section I.A., supra, the parties have

stipulated that the exposure of each of the Merkels and the

Hepburns pursuant to petitioners’ guarantees and the State tax

exposure was $1 million and $490,000, respectively, and inclusion

of the amount of their exposure under either obligation would

make each of them insolvent to the extent of the full amount of

the discharge of indebtedness income to each.   Petitioners bear

the burden of proof, Rule 142(a), but have proposed no findings

of fact with respect to the other liabilities or the fair market

value of the assets of either the Merkels or the Hepburns as of

the measurement date.   Thus, we must conclude that petitioners

intend to prove that they (each of the Merkels and the Hepburns)

were insolvent by showing that the amount of the liability under

either, both, or the sum of petitioners’ guarantees and the State

tax exposure was at least $490,000.    If it were any less, we have
                                -35-

no basis for finding that petitioners did not have assets equal

to (or in excess of) their liabilities (i.e., that petitioners

were insolvent).

           2.   Petitioners’ Guarantees

     The measurement date (the date on which petitioners must

prove their insolvency) is August 31, 1991.   By that date, SLC

had defaulted on the SLC note, which petitioners had guaranteed,

and petitioners and the bank had entered into the agreement.

Under the agreement, among other things, if SLC and petitioners

(and certain others) avoided bankruptcy for 400 days after the

settlement date (August 2, 1991), petitioners would be released

from their guarantees without having to make any payment to the

bank.   The 400-day period ended September 5, 1992.

     By the terms of petitioners’ guarantees, petitioners’

obligations to pay the SLC note were unconditional.   Moreover, we

assume those obligations became fixed on April 16, 1991, when SLC

was in default on the SLC note.   Nevertheless, on the measurement

date, those fixed obligations had been replaced by obligations

that were dependent on certain conditions and, thus, were

contingent obligations.

     To address the likelihood of certain of those conditions,

petitioners propose the following finding of fact (to which

respondent objects):

          42. During the continuing efforts by SLC and the
     Petitioners to work with creditors, there was a
                               -36-

     continuing challenge as to whether acceptable workout
     arrangements could be made with these creditors. By
     the end of the summer of 1991 at about the time of the
     * * * discharge of indebtedness there was a real
     possibility that SLC and/or the guarantors would file
     for bankruptcy protection or that creditors would file
     for them. * * * [Emphasis added.]

Petitioners support that proposed finding of fact with the

testimony of Robert Kennedy, an attorney who represented SLC in a

general business capacity and who represented David Hepburn and

Dudley Merkel in connection with certain guarantees of

obligations of SLC.   Based, in part, on his memory that SLC,

David Hepburn, and Dudley Merkel owed a substantial amount (“I

think it was $800,000”), he testified that there was “a real

possibility that they could file bankruptcy at that time [by the

end of the summer of 1991]”.   Petitioners also point to the

testimony of David Hepburn, who testified that, by the end of the

summer of 1991, the possibility of bankruptcy for SLC or

petitioners was not “insignificant”.    Petitioners imply that the

State tax assessment was a significant factor giving rise to the

possibility of bankruptcy.

     The uncertain variable on the measurement date was the

probability of a bankruptcy event; the bankruptcy of either SLC

or petitioners (or certain others) was a condition precedent to

any demand for payment by the bank.    None of the petitioners,

however, provided sufficient details of their personal financial

situations from which we could draw a conclusion as to the

likelihood on the measurement date of a bankruptcy event.
                                 -37-

Although the testimony presented by petitioners indicates that

SLC may have been experiencing some cash-flow problems after the

agreement, SLC apparently had sufficient liquidity to pay both

Dudley Merkel and David Hepburn hefty salaries for SLC’s fiscal

years ending February 29, 1992, and February 28, 1993.    We take

those payments as some evidence of the nonprecarious financial

situations of both SLC and petitioners on the measurement date

and during the 400-day workout period.    The fact that the 400-day

workout period had 371 days to run on the measurement date is a

fact to be taken into account, but it does not convince us, as

petitioners suggest, that the probability of a demand for payment

under petitioners’ guarantees (as renegotiated) was 92 percent.

The State tax assessment was ultimately abated, and petitioners

have failed to convince us that such result was not foreseen.

Considering all of the evidence, petitioners have failed to

persuade us that a bankruptcy event was likely to occur.    Such a

finding is not inconsistent with the testimony of Robert Kennedy

and David Hepburn that the possibility of bankruptcy was “real”

and not “insignificant”.     Therefore, petitioners have failed to

prove that, as of the measurement date, they would be called upon

to pay any amount as a result of petitioners' guarantees.

          3.   State Tax Exposure

     The State tax assessment became final on June 14, 1991, in

the amount of $980,511.84.    As in effect and in relevant part,
                                -38-

North Carolina law provides the following regarding the

responsibility of corporate officers for corporate taxes:

          (b) Each responsible corporate officer is
     personally and individually liable for all of the
     following:

               (1) All sales and use taxes collected
          by a corporation upon taxable transactions of
          the corporation.

               (2) All sales and use taxes due upon
          taxable transactions of the corporation but
          upon which the corporation failed to collect
          the tax, but only if the responsible officer
          knew, or in the exercise of reasonable care
          should have known, that the tax was not being
          collected.

                 *      *   *     *    *   *    *

     The liability of the responsible corporate officer is
     satisfied upon timely remittance of the tax to the
     Secretary by the corporation. If the tax remains
     unpaid by the corporation after it is due and payable,
     the Secretary may assess the tax against, and collect
     the tax from, any responsible corporate officer in
     accordance with the procedures in this Article for
     assessing and collecting tax from a taxpayer. As used
     in this section, the term “responsible corporate
     officer” includes the president and the treasurer of
     the corporation and any other officers assigned the
     duty of filing tax returns and remitting taxes to the
     Secretary on behalf of the corporation. * * * [N.C.
     Gen. Stat. sec. 105-253(b) (1991).]

North Carolina law also provides procedures for assessing and

collecting tax from a taxpayer.   N.C. Gen. Stat. sec. 105-

241.1(a) (1991) requires the Secretary of the Department of

Revenue to send written notice to the taxpayer of the kind and

amount of tax due, and N.C. Gen. Stat. sec. 105-241.1(c) (1991)

provides that the taxpayer is entitled to an opportunity for a

hearing upon request.
                                -39-

       Based on a proposed finding of fact by respondent, to which

petitioners stated that they had no objection, we have found that

the State tax assessment was for sales and use taxes that were

never collected by SLC.    That being the case, under the North

Carolina statute, Dudley Merkel and David Hepburn could be liable

as corporate officers only if they were responsible officers who

knew, or should have known, that the tax was not being collected.

There is no persuasive evidence that they knew, or should have

known, that the tax was not being collected.    Also, N.C. Gen.

Stat. sec. 105-253(b) (1991) (flush language) appears to grant

the Secretary of the Department of Revenue some discretion in

assessing and collecting the tax from responsible corporate

officers.

       The Department of Revenue never proposed nor made an

assessment against any of petitioners relating to the State tax

assessment.    Petitioners have failed to prove that any assessment

was ever likely to be made against Dudley Merkel and David

Hepburn.    Therefore, we have no basis to find that, as of the

measurement date, the State tax exposure represented an

obligation to pay that would result in petitioners' being called

upon to pay any amount on account thereof.

III.    Conclusion

       Petitioners have failed to prove that they would be called

upon to pay any amount with respect to either petitioners'

guarantees or the State tax exposure, and, thus, neither
                              -40-

constitutes a liability for purposes of section 108(d)(3).

Therefore, petitioners have failed to prove that either the

Merkels or the Hepburns were insolvent on the measurement date

for purposes of section 108(a)(1)(B).   On that basis,

respondent’s determinations of deficiencies are sustained in

full.


                                          Decisions will be entered

                                     for respondent.
