                  T.C. Summary Opinion 2005-147



                     UNITED STATES TAX COURT



                 DAVID O. ALEGRIA, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8620-04S.             Filed October 11, 2005.


     David O. Alegria, pro se.

     Douglas S. Polsky, for respondent.



     ARMEN, Special Trial Judge:   This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect at the time that the petition was filed.1   The decision to




     1
        Unless otherwise indicated, all subsequent section
references are to the Internal Revenue Code in effect for 2001,
the taxable year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
                                 - 2 -

be entered is not reviewable by any other court, and this opinion

should not be cited as authority.

     Respondent determined a deficiency in petitioner’s Federal

income tax for the taxable year 2001 of $9,427 and an accuracy-

related penalty under section 6662(a) of $1,885.

     The issues for decision are:

     (1)    Whether petitioner received unreported discharge of

indebtedness income of $31,327 in taxable year 2001.      We hold

that he did.

     (2)    Whether petitioner is liable under section 6662(a) for

an accuracy-related penalty.    We hold that he is not.

     Adjustments to the amount of petitioner’s itemized

deductions, child tax credit, and alternative minimum tax are

purely computational matters, the resolution of which is

dependent on our disposition of the first disputed issue.

                              Background

     Some of the facts have been stipulated, and they are so

found.     We incorporate by reference the parties’ stipulation of

facts and accompanying exhibits.

     At the time that the petition was filed, petitioner resided

in Topeka, Kansas.

     In 1984, petitioner obtained a credit card from MBNA America

Bank (MBNA), which he used on occasion over the next 15 years.
                               - 3 -

     In 1998, petitioner sold his home in Topeka, Kansas.     In May

1999, petitioner purchased a new home.   Between the time that

petitioner sold his former home and moved into his new home, he

received mail at a post office box address.

     In the fall of 1999, petitioner received a statement from

MBNA reflecting an outstanding balance of approximately $36,000.

Petitioner contacted MBNA, stating that approximately $30,000 of

the charges were not made by him.   MBNA informed petitioner that

such amount was traceable to a convenience check.2    Petitioner

offered to pay MBNA $6,000.   For about 6 months thereafter,

petitioner made monthly payments to MBNA of $200-300.    Sometime

in 1999, petitioner’s MBNA card was canceled.3

     In 2000, NCO Financial Systems, Inc. (NCO), contacted

petitioner on behalf of MBNA to collect the outstanding balance

on petitioner’s MBNA card of approximately $36,000.    NCO’s “Fact

Sheet” indicated that the “status” of petitioner’s account was

“settlement” and that the “collection unit” was   “purchase

dispute”.   Petitioner informed NCO that the charges were not his,

that he had a lot of debt that he could not pay, and that he was

willing to pay only $6,000.



     2
        Petitioner admits that he has used convenience checks
against his MBNA card in the past.
     3
        The record does not disclose whether petitioner or MBNA
canceled the card.
                                 - 4 -

     On October 17, 2001, NCO sent petitioner a collection letter

indicating that the amount owed was $39,627, but that the amount

due on October 31, 2001, was $6,000.     The letter further

indicated that “Your regularly scheduled payment * * * is now due

according to the terms you arranged with our office.”     On October

31, 2001, petitioner paid NCO $6,000 with respect to his MBNA

account.

     For 2001, NCO sent to petitioner a Form 1099-C, Cancellation

of Debt, reporting debt canceled on October 31, 2001, of $31,327.

     On his Federal income tax return for 2001, petitioner did

not report the amount reported on the Form 1099-C.

     Respondent determined that petitioner failed to report on

his tax return for 2001 income from the cancellation of

indebtedness of $31,327.   Respondent further determined that

petitioner is liable for the accuracy-related penalty for

substantial understatement of income tax.

                            Discussion

A.   Discharge of Indebtedness

     Gross income includes all income from whatever source

derived, including but not limited to discharge of indebtedness.

Sec. 61(a)(12); sec. 1.61-12(a), Income Tax Regs.     A discharge of

indebtedness generally produces income in an amount equal to the

difference between the amount due on the obligation and the
                                 - 5 -

amount paid for the discharge.    See Babin v. Commissioner, 23

F.3d 1032, 1034 (6th Cir. 1994), affg. T.C. Memo. 1992-673.

     As explained by the Supreme Court of the United States, the

general theory is that to the extent that a taxpayer has been

released from indebtedness, the taxpayer has realized an

accession to income because the cancellation of indebtedness

effects a freeing of assets previously offset by the liability

arising from such indebtedness.     United States v. Kirby Lumber

Co., 284 U.S. 1, 3 (1931); see Cozzi v. Commissioner, 88 T.C.

435, 445 (1987).   If, however, the cancellation of all or part of

a debt is made in settlement of a dispute concerning the debt, no

income from cancellation of indebtedness arises.     N. Sobel, Inc.

v. Commissioner, 40 B.T.A. 1263, 1265 (1939); Exch. Sec. Bank v.

United States, 345 F. Supp. 486, 490-491 (N.D. Ala. 1972), revd.

on other grounds 492 F.2d 1096 (5th Cir. 1974); see Colonial Sav.

Association v. Commissioner, 85 T.C. 855, 862-863 (1985), affd.

854 F.2d 1001 (7th Cir. 1988).    Settlement in such circumstances

does not occasion a freeing of assets and accession to income.

N. Sobel, Inc. v. Commissioner, supra at 1265.

     As a general rule, the Commissioner’s determinations are

presumed correct, and the taxpayer bears the burden of proving

that those determinations are erroneous.     Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).     This rule, however, is

subject to the provisions of section 7491(a), under which the
                               - 6 -

burden of proof may, under certain circumstances, be shifted to

the Commissioner if the taxpayer introduces credible evidence

with respect to any factual issue relevant to ascertaining the

taxpayer’s income tax liability.    The legislative history of

section 7491 defines “credible evidence” as “the quality of

evidence which, after critical analysis, the court would find

sufficient upon which to base a decision on the issue if no

contrary evidence were submitted (without regard to the judicial

presumption of IRS correctness).”    H. Conf. Rept. 105-599, at

240-241 (1998), 1998-3 C.B. 747, 994-995; see Higbee v.

Commissioner, 116 T.C. 438, 442 (2001).    On the basis of the

record, we hold that section 7491(a) does not operate to place

the burden of proof on respondent; in short, petitioner did not

introduce testimonial (or other) evidence sufficient to place in

doubt the documentary evidence in the record.4

     Petitioner claims that he disputed his debt with MBNA in the

fall of 1999, alleging that someone not authorized by him made

charges to his account, which MBNA informed him were attributable

to a convenience check.   As a result, petitioner contends that he

offered to pay $6,000 of charges that he admittedly made, which

     4
        Sec. 6201(d) also does not apply in this case to place on
respondent the burden of producing evidence to supplement the
information return filed by NCO Financial Services, Inc. In this
regard, the record does not demonstrate that all of the
requirements of sec. 6201(d) were satisfied, including the
requirement that “the taxpayer has fully cooperated with the
Secretary”.
                                - 7 -

he claims that MBNA agreed to accept in settlement of the

dispute.   Petitioner further claims that when NCO contacted him

with respect to the same debt, he informed NCO that MBNA agreed

to accept $6,000 in settlement of the dispute, at which time

petitioner made full payment of the $6,000 to NCO.   Therefore, in

petitioner’s view, he did not realize income from the

cancellation of the $30,000 that NCO claimed was owed by

petitioner.

     On the basis of the evidence in the record, however, we are

not persuaded that petitioner did not receive income from the

cancellation of indebtedness.   We do not doubt that petitioner

communicated with MBNA about his account or that petitioner paid

NCO $6,000 with respect to his MBNA account.   Petitioner,

however, did not present any documentary evidence, such as

correspondence to or from MBNA, notes of his discussions with

MBNA, or a copy of the alleged fraudulent convenience check,

demonstrating that NCO accepted his $6,000 payment as a

settlement of his dispute with MBNA in the amount of $30,000.

Indeed, NCO’s “Fact Sheet” indicates that there was a “purchase

dispute” with respect to petitioner’s MBNA account, but there is

nothing in the record to explain the nature or the amount of the

“purchase dispute”.   Rather, the entirety of the record indicates

that NCO canceled petitioner’s debt in the amount of $30,000

because of petitioner’s inability to readily pay the outstanding
                                 - 8 -

balance.5   Accordingly, respondent’s determination is sustained

on this issue.    Rule 142(a); Welch v. Helvering, supra.

B.     Section 6662(a) Penalty

       In the notice of deficiency, respondent determined that

petitioner is liable under section 6662(a) for an underpayment of

tax that is attributable to substantial understatement of income

tax.

       Section 6662(a) imposes a penalty equal to 20 percent of any

underpayment of tax that is attributable to substantial

understatement of income tax.    See sec. 6662(a) and (b)(2).    An

understatement of income tax is “substantial” if it exceeds the

greater of 10 percent of the tax required to be shown on the

return, or $5,000.    Sec. 6662(d)(1)(A).   An “understatement” is

defined as the excess of the tax required to be shown on the

return over the tax actually shown on the return.    Sec.

6662(d)(2)(A).    Tax is not understated to the extent that the

treatment of the item related thereto is based on substantial

authority or is adequately disclosed in the return or in a

statement attached to the return, and there is a reasonable basis

for the tax treatment of such item by the taxpayer.    Secs.

6662(d)(2)(B), 6664(c)(1).



       5
        There is evidence in the record, including petitioner’s
own testimony, to suggest that petitioner was not able to pay his
credit card debt without financial hardship.
                               - 9 -

     By virtue of section 7491(c), respondent has the burden of

production with respect to the accuracy-related penalty.   To meet

this burden, respondent must produce sufficient evidence

indicating that it is appropriate to impose the penalty.     Higbee

v. Commissioner, 116 T.C. at 446.   Once respondent meets this

burden of production, the taxpayer has the burden of proof with

regard to whether respondent’s determination of the penalty is

correct.   Rule 142(a); Higbee v. Commissioner, supra.   As a

defense to the penalty, the taxpayer bears the burden of proving

that he or she acted with reasonable cause and in good faith.

See sec. 6664(c)(1); see also Higbee v. Commissioner, supra; sec.

1.6664-4(b)(1), Income Tax Regs.

     Respondent satisfied his burden of production under section

7491(a)(1) because the record shows that petitioner substantially

understated his income tax for 2001.    See sec. 6662(d)(1)(A)(ii);

Higbee v. Commissioner, supra at 442.    Accordingly, petitioner

bears the burden of proving that the accuracy-related penalty

should not be imposed with respect to any portion of the

understatement for which he acted with reasonable cause and in

good faith.   See sec. 6664(c)(1); Higbee v. Commissioner, supra

at 446.

     Although the issue may not be free from doubt, we are

satisfied, based on the totality of the facts and circumstances

in the instant case, that petitioner had reasonable cause to
                               - 10 -

believe that he did not realize income from his canceled debt and

that he acted in good faith.   Accordingly, we hold that

petitioner is not liable for the accuracy-related penalty.

                           Conclusion

     We have considered all of the other arguments made by the

parties, and, to the extent that we have not specifically

addressed them, we conclude that they are without merit.

     Reviewed and adopted as the report of the Small Tax Case

Division.

     To reflect our disposition of the disputed issues,



                                    Decision will be entered

                               for respondent as to the

                               deficiency in tax and for

                               petitioner as to the penalty.
