                       116 T.C. No. 6



                UNITED STATES TAX COURT



     DENNIS AND DORINDA J. JELLE, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 20059-98.                    Filed January 31, 2001.


     Ps are the owners of agricultural property which,
prior to the transactions at issue, was subject to
outstanding mortgages held by the Farmers Home
Administration (FmHA). After Ps became unable to meet
payment obligations under these mortgages, Ps and FmHA
negotiated an alternative arrangement. Pursuant
thereto, (1) Ps in 1996 paid to FmHA the $92,057 net
recovery value of their property, (2) FmHA in that year
wrote off the remaining loan balance of $177,772, and
(3) Ps entered into a net recovery buyout recapture
agreement to repay to FmHA amounts written off in the
event that they disposed of the land within a 10-year
period.

     Held: Ps are required to recognize income in 1996
under sec. 61(a)(12), I.R.C., on account of a $177,772
discharge of indebtedness in that year.

     Held, further, Ps must report as income 85 percent
of amounts they received in the form of Social Security
benefits, in accordance with sec. 86(a), I.R.C.
                                 - 2 -

          Held, further, Ps are liable for the sec. 6662(a),
     I.R.C., accuracy-related penalty on grounds of a
     substantial understatement of income tax.


     Gregory W. Wagner, for petitioners.

     Michael J. Calabrese and Mark J. Miller, for respondent.




                                OPINION


     NIMS, Judge:   Respondent determined a Federal income tax

deficiency for petitioners’ 1996 taxable year in the amount of

$46,993.   Respondent further determined an accuracy-related

penalty of $9,399, pursuant to section 6662(a).   The issues for

decision are:

     (1) Whether petitioners are required to recognize income in

1996 from cancellation of indebtedness;

     (2) whether petitioners must report as income amounts

received in the form of Social Security benefits; and

     (3) whether petitioners are liable for the section 6662(a)

accuracy-related penalty on account of a substantial

understatement of income tax.

     Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the year at

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.
                                - 3 -

                             Background

     This case was submitted fully stipulated in accordance with

Rule 122, and the facts are so found.     The stipulations of the

parties, with accompanying exhibits, are incorporated herein by

this reference.   At the time the petition was filed in this

matter, petitioners resided in the State of Wisconsin.

     Prior to and during the year at issue, petitioners operated

a 235-acre farm in Dane County, Wisconsin.     A principal activity

of petitioners’ agricultural enterprises was the production of

milk.   In 1991, however, petitioners’ milk production fell to the

point that they were no longer able to make monthly payments due

under two outstanding mortgages on their farm real estate.     These

mortgages were held by the Farmers Home Administration (FmHA) and

encumbered 135 acres of petitioners’ property.     The first had

been entered on December 27, 1979, in the amount of $182,000.

The underlying loan had originally borne interest at a rate of 10

percent, which rate had subsequently been reduced to 8.25

percent.    The second mortgage, in the amount of $24,090, had been

executed on July 23, 1984, to secure a loan bearing 5-percent

interest.

     Faced with the above-mentioned inability to meet payment

obligations on these mortgages, petitioners contacted Richard A.

Guenther, County Supervisor and Agriculture Credit Manager of the

Dane County office of the Farm Service Agency, to explain their
                                 - 4 -

situation and to consider payment alternatives.       Between 1991 and

1996, petitioners explored with Mr. Guenther two alternatives to

foreclosure of the FmHA mortgages.       The first of these options

involved a debt restructuring, and the second entailed a buyout

of the mortgages by petitioners at net recovery value.       Net

recovery value was calculated as the amount that would be

realized from liquidation of the mortgaged collateral, reduced by

prior liens and certain costs.

     In April and May of 1996, FmHA advised petitioners that they

did not qualify for debt restructuring, that FmHA intended to

foreclose on its mortgages, and that petitioners could avoid

foreclosure by buying out the FmHA loans at net recovery value.

A Debt and Loan Restructuring System Analysis Report, dated April

18, 1996, contained the following language:       “You may buy out

your FmHA loans for the Net Recovery Value of $92,057.00. * * *

If you pay the Net Recovery Value, any remaining balance on your

FmHA accounts will be written off.       The debt written off may be

subject to recapture.”   A Notice of Intent To Accelerate or To

Continue Acceleration and Notice of Borrowers’ Rights, dated May

6, 1996, further detailed the terms of these arrangements and

informed petitioners:

     If you are eligible and pay the recovery value, FmHA
     will write off the rest of your debt up to $300,000.
     If you are eligible to pay the recovery value, FmHA
     will require you to sign a recapture agreement. This
     agreement would allow FmHA to require you to pay the
     difference between the recovery value and the current
                               - 5 -

     market value of your real estate securing the loan if
     you sell it within 10 years of the agreement. FmHA can
     never recapture more than it wrote off.

     Petitioners elected to proceed with the buyout at net

recovery value.   In order to do so, they obtained a loan from the

State Bank of Mt. Horeb.   On July 30, 1996, petitioners paid to

FmHA the net recovery value of $92,057.    Prior to the making of

this remittance, the balance owed by petitioners to FmHA was

$269,829.28.   In exchange for the payment, FmHA wrote off the

remaining $177,772.28 of indebtedness.

     Then, on July 31, 1996, petitioners and FmHA entered into a

Net Recovery Buyout Recapture Agreement.   Pursuant to this

agreement, petitioners covenanted as follows:

          If I/we do sell or convey any part or all of this
     real estate within 10 years of this agreement, I/we
     must pay FmHA the recapture amount for that part sold
     or conveyed which is the smaller of a., b., or c.

          a.   The Fair Market Value of the real estate
     parcel at the time of the sale or conveyance, as
     determined by an FmHA appraisal, minus that portion of
     the recovery value of the real estate * * * or

          b.   The Fair Market Value of the real estate
     parcel at the time of the sale or conveyance, as
     determined by an FmHA appraisal, minus the unpaid
     balance of prior liens at the time of the sale or
     conveyance, minus the net recovery value of the real
     estate * * * if this amount has not been accounted for
     as a prior lien, or

          c.   The total amount of the FmHA debt written off
     for loans secured by real estate. I/We agree that this
     amount is the outstanding balance of principal and
     interest owed on the FmHA Farmer Programs loans(s) as
     of the date of this agreement * * * [without taking
     into account the related payment of recovery value],
                                - 6 -

       minus the net recovery value of the real estate * * *.
       This amount is $177,772.28 and is the maximum amount
       that can be recaptured.

       To secure the foregoing recapture agreement and in

accordance with its terms, petitioners gave FmHA a mortgage on

the 135 acres of their farmland secured by the original FmHA

mortgages.    The recapture agreement provided that FmHA would

release this lien with respect to subject property sold or

conveyed within 10 years upon payment of the recapture amount

due.    With respect to portions of the encumbered real estate not

disposed of during the agreement’s 10-year term, the lien would

be released at the expiration of such period.    The lien was

secondary to liens held by Russell V. Jelle in the amount of

$31,000 and by the State Bank of Mt. Horeb in the amount of

$92,057.

       For the taxable year 1996, the U.S. Department of

Agriculture Farm Service Agency issued to petitioners a Form

1099-C, Cancellation of Debt, showing an “Amount of debt

canceled” of $177,772.27.    Petitioners did not report this amount

as income on their 1996 tax return and provided thereon no

reference to the buyout transaction or explanation of its

treatment.

       Petitioners additionally received Social Security benefits

during 1996 in the amount of $3,420.    No portion of these

benefits was disclosed by petitioners on their return for 1996.
                                 - 7 -

                            Discussion

I.   Discharge of Indebtedness

     As a general rule, the Internal Revenue Code imposes a

Federal tax on the taxable income of every individual.     See sec.

1.   Section 61(a) defines gross income for purposes of

calculating taxable income as “all income from whatever source

derived” and further specifies that “Income from discharge of

indebtedness” is included within this broad definition.     Sec.

61(a)(12).   The underlying rationale for such inclusion is that

to the extent a taxpayer is released from indebtedness, he or she

realizes an accession to income due to the freeing of assets

previously offset by the liability.      See United States v. Kirby

Lumber Co., 284 U.S. 1, 3 (1931).

     Statutory exceptions to the above rule are set forth in

section 108.   Section 108(a) excludes from the operation of

section 61(a) indebtedness which is discharged in a title 11

case, which is discharged when the taxpayer is insolvent, which

consists of qualified farm indebtedness, or which consists of

qualified real property business indebtedness.     Additional

circumstances in which no income from cancellation of

indebtedness need be recognized are established by case law.       For

instance, the refinancing of a debt may operate as an exception

to the requirement of inclusion.    See Zappo v. Commissioner, 81

T.C. 77, 85-86 (1983).   When one obligation has merely been
                               - 8 -

substituted for another, there has been no consequent freeing of

assets so as to justify application of the rule in United States

v. Kirby Lumber Co., supra.

     The parties here do not contest the viability of these

general principles.   Petitioners in fact concede that the subject

net recovery buyout transaction could result in a cancellation of

indebtedness.   They further do not argue that any of the

exceptions of section 108 should operate to shield resultant

income from recognition.   (For the sake of completeness, we note

petitioners have stipulated that neither the qualified farm

indebtedness nor the insolvency provision is at issue in this

case, and no evidence in the record would suggest that either

bankruptcy or qualified real property business indebtedness could

support exclusion.)   Petitioners contend, however, that any

relevant discharge, requiring reporting of income, can occur

under the recapture agreement only upon the conveyance of

encumbered land or the passing of 10 years.   According to

petitioners, until such time their potential obligation to repay

some part or all of the $177,772 written off precludes a finding

that the debt has been forgiven.   They view receiving a

discharge, and the amount thereof, as contingent on eventually

obtaining the release of their property from the recapture

agreement.
                              - 9 -

     Conversely, respondent maintains that the net recovery

buyout transaction effected a discharge of indebtedness in 1996

within the meaning of section 61(a)(12).   Respondent further

asserts that the recapture agreement is too contingent and

indefinite to constitute a substitution, continuation, or

refinancing of the original debt so as to delay recognition.

Respondent relies particularly on the fact that petitioners have

no definite obligation to make any further payments.

     In essence then, the principal disagreement between the

parties centers on whether the recapture agreement executed by

petitioners continues their obligation to FmHA in a manner such

that there was in 1996 no discharge of indebtedness within the

meaning of the Internal Revenue Code.   Furthermore, as their

respective contentions reveal, the two sides reach opposing

answers to this question in large part because each characterizes

a different aspect of the buyout arrangement as contingent.

Petitioners view the cancellation itself as contingent, asserting

that the subject transaction merely generated an agreement to

cancel their debt at a future time.   Respondent, on the other

hand, styles the instant scenario as involving a present

cancellation with a contingent future obligation to repay.

     If there exists only an agreement to cancel prospectively,

the debt is discharged not at the time the agreement is made but

at the time conditions specified therein are satisfied.    See
                              - 10 -

Walker v. Commissioner, 88 F.2d 170 (5th Cir. 1937), affg. White

v. Commissioner, 34 B.T.A. 424 (1936); Shannon v. Commissioner,

T.C. Memo. 1993-554.   For example, Walker v. Commissioner, supra

at 171, involved a settlement entered in 1927 whereby the

creditor agreed to cancel the balance of a debt after payments

totaling a prescribed amount were made by the debtor.     This

payment level was reached in 1930, and the discharge was held to

have occurred in that year.   See id.

     In contrast, if an arrangement effects a present

cancellation of one liability but imposes a replacement

obligation, the mere chance of some future repayment does not

delay income recognition where the replacement liability is

highly contingent or of a fundamentally different nature.     See

Carolina, Clinchfield & Ohio Ry. v. Commissioner, 82 T.C. 888

(1984), affd. 823 F.2d 33 (2d Cir. 1987); Zappo v. Commissioner,

81 T.C. 77 (1983).   Specifically, we stated in Zappo v.

Commissioner, supra at 88, that “A note or obligation will not be

treated as a true debt for tax purposes when it is highly

unlikely, or impossible to estimate, whether and when the debt

will be repaid.”   We explained that “highly contingent

obligations should not be treated in pari materia with their more

conventional counterparts”, and we further found that “this

reasoning applies with equal force to the issue of refinancing an
                                 - 11 -

indebtedness.”   Id. at 89.    In addition, we described the manner

in which this precept was to be employed in a discharge setting,

as follows:

          When an obligation is highly contingent and has no
     presently ascertainable value, it cannot refinance or
     substitute for the discharge of a true debt. The very
     uncertainty of the highly contingent replacement
     obligation prevents it from reencumbering assets freed
     by discharge of the true debt until some indeterminable
     date when the contingencies are removed. In a word,
     there is no real continuation of indebtedness when a
     highly contingent obligation is substituted for a true
     debt. Consequently, the rule in Kirby Lumber applies,
     and gain is realized to the extent the taxpayer is
     discharged from the initial indebtedness. [Id.]

     The original debt in Zappo v. Commissioner, supra at 90, had

been characterized by a fixed amount, a stated rate of interest,

and a due date certain.    The replacement liability was for an

amount that could not be ascertained until the end of 5 years,

did not bear interest, and would be credited with amounts paid by

a third party.   See id.      In those circumstances, we held that

the foregoing rule precluded treatment of the new obligation as

replacement indebtedness.     See id.; see also Carolina,

Clinchfield & Ohio Ry. v. Commissioner, supra.

     Turning to the matter at bar, we believe that the precedent

discussed above counsels a finding that petitioners’ indebtedness

to FmHA was discharged in 1996, for the simple reason that

whether and when petitioners would ever be required to make any

further payments to FmHA rested totally within their own control.

If petitioners chose to sell their property within 10 years from
                              - 12 -

the inception of the net recovery buyout recapture agreement,

then in accordance with the terms of that agreement, petitioners

could be required to repay part or all of the $177,722 written

off by FmHA.   If petitioners chose not to dispose of their

property, then, of course, nothing further would be due.

Petitioners’ obligation was thus “highly contingent” in every

sense of the word.   This state of affairs fits perfectly within

the precept formulated in Zappo v. Commissioner, supra, that a

highly contingent obligation will not be treated in pari materia

with a more conventional counterpart.

     Petitioners’ initial debt to FmHA, the “conventional

counterpart” in this case, was fixed in amount, bore a stated

rate of interest, and required periodic payments.   In contrast,

petitioners’ liability under the recapture agreement had no

certain amount, was not interest bearing, and mandated no

definite payments.   An enforceable financial obligation may in

fact never materialize at all.   Faced with these differences, we

cannot reasonably view the latter alleged debt as a mere

substitute for the former.

     We are convinced that the rationale of United States v.

Kirby Lumber Co., 284 U.S. 1 (1931), is particularly applicable

here where the recapture agreement leaves petitioners in complete

control of their assets and free to arrange their affairs so that

none of their property’s value need ever be delivered to FmHA.
                                 - 13 -

We hold that petitioners received discharge of indebtedness

income in 1996 when FmHA wrote off $177,772 of petitioners’

outstanding loan obligation.

II.   Social Security Benefits

      The second question raised by this litigation is whether a

portion of the Social Security benefits received by petitioners

is includable in their gross income.      Although this issue is

largely computational, we address it briefly to ensure lucidity.

The parties stipulated that petitioners received such benefits in

the amount of $3,420.   Of this total, respondent contends that 85

percent, or $2,907, must be reported as gross income.

Petitioners have offered no argument related to their Social

Security benefits.

      Income tax treatment of Social Security benefits is governed

by section 86.   Section 86 applies to require inclusion of

payments if the taxpayer’s adjusted gross income, with certain

modifications not relevant here, plus one-half of the Social

Security benefits received, exceeds a specified base amount.       See

sec. 86(b).   This base amount, in the case of taxpayers filing a

joint return, is $32,000.   See sec. 86(c)(1)(B).     Since

petitioners reported adjusted gross income of $8,466 and we have

just held that they must include an additional $177,772 from

discharge of indebtedness, the base amount threshold is clearly

exceeded.
                                  - 14 -

       In general then, section 86(a)(1) provides that gross income

includes the lesser of:    (1) One-half of the Social Security

benefits received during the year; or (2) one-half of the excess

of the sum of (a) modified adjusted gross income plus (b) one-

half of the Social Security benefits, over the base amount.       The

includable percentage is increased, however, if modified adjusted

gross income plus one-half of the Social Security benefits

exceeds an adjusted base amount of, for a joint return, $44,000.

See sec. 86(a)(2), (c)(2)(B).      Accordingly, petitioners are

subject to the greater inclusion, which, on these facts, would be

calculated at 85 percent of the Social Security benefits

received.    See sec. 86(a)(2).    We therefore sustain respondent’s

determination that $2,907, 85 percent of the stipulated $3,420 in

Social Security benefits, must be included in petitioners’ gross

income for 1996.

III.    Accuracy-Related Penalty

       Subsection (a) of section 6662 imposes an accuracy-related

penalty in the amount of 20 percent of any underpayment that is

attributable to causes specified in subsection (b).      Among the

causes so enumerated is any substantial understatement of income

tax.    See sec. 6662(b)(2).   A “substantial understatement” is

defined in section 6662(d)(1) to exist where the amount of the

understatement exceeds the greater of 10 percent of the tax

required to be shown on the return for the taxable year or
                                - 15 -

$5,000.   For purposes of this computation, the amount of the

understatement is reduced to the extent attributable to an item:

(1) If there existed substantial authority for the taxpayer’s

treatment of the item, or (2) if the relevant facts affecting the

treatment of the item were adequately disclosed on the taxpayer’s

return or an attached statement, and there was a reasonable basis

for the taxpayer’s treatment of the item.   See sec.

6662(d)(2)(B).

     An exception to the section 6662(a) penalty is set forth in

section 6664(c)(1) and reads:    “No penalty shall be imposed under

this part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

The taxpayer bears the burden of establishing that this

reasonable cause exception is applicable, as respondent’s

determination of an accuracy-related penalty is presumed correct.

See Rule 142(a).

     Regulations interpreting section 6664(c) state:

          The determination of whether a taxpayer acted with
     reasonable cause and in good faith is made on a case-
     by-case basis, taking into account all pertinent facts
     and circumstances. * * * Generally, the most important
     factor is the extent of the taxpayer’s effort to assess
     the taxpayer’s proper tax liability. * * * [Sec.
     1.6664-4(b)(1), Income Tax Regs.]

     Applying these principles to the matter at hand, we are

constrained to rule that petitioners have failed to meet their
                              - 16 -

burden of showing the section 6662(a) penalty inappropriate here.

Again, petitioners have offered no discussion or argument on this

issue.

     Petitioners reported on their 1996 return a tax liability of

$0 and disclosed neither the cancellation of debt income for

which they received a Form 1099-C nor their Social Security

payments.   Based on our holdings above, however, they in fact owe

taxes for 1996 well in excess of the level constituting a

substantial understatement.   Furthermore, none of the avenues of

relief provided in the statutory text is open to petitioners.

There exists no substantial authority for their complete failure

to report or disclose, so the amount of their understatement is

not subject to reduction under section 6662(d)(2)(B).

Additionally, due to the absence of explanation or evidence by

petitioners on this issue, we lack any grounds upon which to

conclude that their treatment was a product of reasonable cause

and good faith for purposes of the section 6664(c) exception.

Petitioners therefore are liable for the accuracy-related

penalty.

     To reflect the foregoing,



                                         Decision will be entered

                                    for respondent.
