Michael Friedman v. Commissioner of Internal Revenue

24 Friedman, et al. v. Commissioner No. 98-2378
COD income for the 1992 taxable year. Accordingly, we
AFFIRM the judgment of the Tax Court.
*The Honorable Donald C. Nugent, United States District Judge for
the Northern District of Ohio, sitting by designation.
1
RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206
ELECTRONIC CITATION: 2000 FED App. 0195P (6th Cir.)
File Name: 00a0195p.06
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
_________________
M ICHAEL FRIEDMAN , et al.,
Petitioners-Appellants,
v.
C OMMISSIONER OF INTERNAL
R EVENUE ,
Respondent-Appellee.
;>

1
No. 98-2378
On Appeal from the United States Tax Court.
Nos. 96-18735, 96-18736.
Argued: December 17, 1999
Decided and Filed: June 8, 2000
Before: BOGGS and NORRIS, Circuit Judges; NUGENT,
District Judge.*

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2 Friedman, et al. v. Commissioner No. 98-2378
1Appellants’ counsel filed notice with the Court that Michael
Friedman passed away recently; however, counsel stated that Mr.
Friedman’s death would not affect the continuation of this matter.
_________________
COUNSEL
ARGUED: Joseph P. Alexander, ROETZEL & ANDRESS,
Cleveland, Ohio, for Appellants. Teresa E. McLaughlin, U.S.
DEPARTMENT OF JUSTICE, APPELLATE SECTION
TAX DIVISION, Washington, D.C., for Appellee.
ON BRIEF: Joseph P. Alexander, J. Timothy Bender,
ROETZEL & ANDRESS, Cleveland, Ohio, for Appellants.
Teresa E. McLaughlin, Ann Belanger Durney, Paula K.
Speck, U.S. DEPARTMENT OF JUSTICE, APPELLATE
SECTION TAX DIVISION, Washington, D.C., for Appellee.
_________________
OPINION
_________________
NUGENT, District Judge. The Commissioner of Internal
Revenue (hereinafter “Commissioner”) issued notices of tax
deficiencies to Michael and Madeline Friedman and Edward
and Deborah Rosenthal1 (hereinafter “Taxpayers”) for the
years 1989 and 1990. The notices stated that Taxpayers were
not entitled to a loss in the amount of $5,055,116. As
shareholders of an S corporation, Taxpayers made claims for
net operating losses of their S corporation, New Manchester,
by using the corporation’s 1992 discharge of indebtedness
income (a.k.a. “COD income”) to increase their stock basis,
and then in turn, using the increased basis to claim net
operating losses from prior years. The Commissioner denied
Taxpayers’ claims for net operating loss deductions,
determining that COD income of an insolvent S corporation
cannot be used to increase the shareholders’ basis.
No. 98-2378 Friedman, et al. v. Commissioner 23
demonstrate that the debts were, in fact, discharged. Cozzi, 88 T.C. at
445. In this case, there was no such event. This Court agrees with the
Tax Court’s disposition in that regard.
evidence shows that the bankruptcy trustee was actively
administering New Manchester’s estate well into 1995,
collecting and disbursing monies. Moreover, some of New
Manchester’s creditors were, in fact, actively pursuing
payment owed them as evidenced by the fraudulent
conveyance claim filed in December, 1992.
In view of all the circumstances, this Court finds that no
identifying event occurred in 1992 to fix the date of discharge
of indebtedness in that year. The absence of anything in the
record, including the stipulation of the facts by both
Commissioner and Taxpayers, even suggesting an identifiable
event in 1992, satisfies Commissioner’s burden in that regard.
Accordingly, the Tax Court did not commit clear error in
finding that a discharge of indebtedness did not occur during
the 1992 taxable year.
IV. Stock Basis of Shareholders in S Corporation
Taxpayers also contend that the income from the discharge
of indebtedness passes through to them as shareholders of
New Manchester, an S corporation. As a result, Taxpayers
contend, the basis of their stock in New Manchester increases.
Because the Court found herein that Taxpayers did not realize
a discharge of indebtedness, or COD income, in 1992, there
is no need to address the pass-through issue at this time.
Should Taxpayers, however, wish to claim the COD income
for a different year, they can refer to Gaudiano v.
Commissioner, No. 99-1294, in which this Court decided the
issue concerning a shareholder’s COD income and his stock
basis, for guidance.
Conclusion
In sum, the Court finds that the Tax Court did not commit
clear error in holding that New Manchester did not realize

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

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4 Friedman, et al. v. Commissioner No. 98-2378
percentage stock ownership was 24.375%. The remaining
shareholders, Vernon Bremberg and Irwin Kramer, each
owned 102.5 shares. Their percentage of stock ownership
was collectively 51.250%.
On or about April 17, 1990, New Manchester acquired
portions of the assets of Manchester Consolidated Industries,
Inc. (a.k.a. Old Manchester), including cash, accounts
receivable, equipment, inventory, land, buildings,
improvements, fixtures, goodwill, trade name, and the trade
mark from Old Manchester. New Manchester also assumed
$12.8 million of Old Manchester’s liabilities, including a
secured trade debt. New Manchester financed such
acquisition using the assets purchased from Old Manchester
as security. When New Manchester purchased these assets,
Old Manchester amended its Articles of Incorporation and
changed its name to E&M Investments Co.
New Manchester was not a successful corporation. It
suffered significant operating losses due to a variety of
factors. In 1991 and in 1992, New Manchester claimed over
$10 million in losses from its trade or business activities. In
addition, New Manchester had a number of creditors to whom
it owed in excess of $30 million. As a result of the continuing
losses, on March 3, 1992, an involuntary petition for
bankruptcy was filed on behalf of New Manchester pursuant
to Chapter 7 of the United States Bankruptcy Code. A trustee
in bankruptcy, who was authorized to operate New
Manchester’s business, was appointed on March 30, 1992.
The trustee engaged in a number of activities on behalf of
New Manchester, including the following: collecting accounts
receivable, seeking buyers for saleable assets, paying claims,
and filing reports with the bankruptcy court.
On May 7, 1992, New Manchester filed a schedule of assets
and liabilities and a statement of financial affairs with the
bankruptcy court. The schedule stated that New Manchester
possessed tangible assets--real and personal property--valued
at $9,241,153 and intangible assets--trade name, customer
lists, and covenant not to compete--valued at $3,991,457.
No. 98-2378 Friedman, et al. v. Commissioner 21
7Without considering the requirement of an identifiable event, the
Court notes first, as a technical matter, that according to the United States
Bankruptcy Code, a “discharge” may not be granted in a chapter 7
proceeding to a corporation. 11 U.S.C. §727(a)(1). Section 727(a)(1)
states that “[t]he court shall grant the debtor a discharge, unless...the
debtor is not an individual.” 11 U.S.C. §727(a)(1). Therefore, New
Manchester, as a corporate debtor, cannot obtain a “discharge” under the
chapter 7 petition it filed with the Bankruptcy Court on March 3, 1992.
therefore, the project (and the loan) was deemed abandoned.
Cozzi, 88 T.C. at 445-447.
While the cases cited above do rely on the importance of,
among all the facts and circumstances of the particular case,
the improbability that a debt will actually have to be paid,
these cases also stand for the proposition that there must also
be some identifiable event which fixes the loss with certainty.
See Cozzi, 88 T.C. at 445. The Tax Court considered the
likelihood of payment on the debts in the above cases cited by
Taxpayers; however, as Commissioner correctly notes, both
cases also contain some identifiable event from which the Tax
Court determined that a discharge of debt had occurred. In
contrast to Cozzi and Fidelity-Philadelphia Trust Co., there is
no identifiable event in the instant matter from which this
Court can determine that a loss was fixed with certainty, or
that a discharge of debt occurred.
As previously stated herein, Taxpayers contend that the
stipulated facts in this case demonstrate that as of December,
1992, future payment of New Manchester’s prepetition
indebtedness in excess of $19 million was impossible, and the
indebtedness would never be paid. Assuming for the moment
that it was unlikely that payment towards New Manchester’s
outstanding debt was possible, the record is devoid of any
identifying event that established a discharge of the
indebtedness.7
The record demonstrates that not only was the bankruptcy
proceeding still pending as of December 31, 1992, the
bankruptcy trustee was actively conducting New
Manchester’s business at that time and well into the next

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20 Friedman, et al. v. Commissioner No. 98-2378
While the taxpayer bank maintained that it received no
income in the year at issue because the bank was still liable in
full to the depositors, the Tax Court held that in exercising
control over the accounts, the bank realized income with
respect to those accounts. The court determined that the act
of a book entry closing out the accounts with old deposits and
placing the money in a surplus account created income in the
year in which it was done. Fidelity-Philadelphia Trust Co.,
23 T.C. at 530. In reaching its conclusion, the court
considered the fact that the bank would most likely not have
to honor its obligations to the depositors in question, and the
probability of having to make payments to the depositors in
the future was slim enough that the income could be
determined to be in the year of the book entry. Id.
Taxpayers, in the present case, contend that both Cozzi and
Fidelity-Philadelphia Trust Co. endorse the proposition that
the improbability of future payment is the triggering event for
determining the occurrence of a discharge of indebtedness.
Taxpayers Br. at 19. As such, because it was clear as of
December 31, 1992 that New Manchester’s debt of over $19
million would never be repaid, as stipulated by the parties,
such debt must be viewed as having been discharged in that
year.
Taxpayers, however, are only partly correct. In Fidelity-
Philadelphia Trust Co., the Tax Court considered the
improbability of the bank ever having to honor the obligation
of its depositors in holding that the bank realized income the
year it closed the accounts at issue. Fidelity-Philadelphia
Trust Co., 23 T.C. at 530. The court reasoned that the
possibility that the taxpayer might have to make a payment to
a depositor in a later year may give it a right to a deduction in
such year; however, “it does not prevent the inclusion of the
unclaimed deposits in gross income in the earlier year, when
such future payment appears improbable.” Id. at 531.
Similarly, much later in Cozzi, the court contemplated the
likelihood of payment in holding that it was not likely that a
future payment on the loan agreement would be made;
No. 98-2378 Friedman, et al. v. Commissioner 5
The schedule also reported liabilities totaling $30,360,669.
On July 2, 1992, the trustee’s report of sale of New
Manchester’s tangible assets was filed.
Several of New Manchester’s creditors commenced a
proceeding in Bankruptcy Court, on December 10, 1992,
alleging potential fraudulent conveyances and/or preferential
transfers with respect to New Manchester prior to the filing of
the petition for bankruptcy. The creditors claimed that such
fraudulent conveyances or preferential transfers rendered New
Manchester insolvent or undercapitalized. The creditors
sought $11 million from Taxpayers and E&M Investments.
The bankruptcy court granted the trustee’s request to obtain
independent counsel to investigate and prosecute such claim
in September, 1993. In February, 1994, Taxpayers offered to
settle the creditors’ claim for $300,000. The offer, however,
upon a motion by the trustee, was refused by the court.
Eventually, upon a second motion by the trustee, on April 11,
1995, the trustee was authorized to settle the claim for $2.2
million.
Throughout the bankruptcy proceeding, the trustee filed
periodic reports with the court concerning assets, receipts, and
disbursements. Such reports were filed in August of 1992,
January of 1993, and January of 1995. On November 30,
1995, the trustee filed a final report with the bankruptcy court.
The Final Report stated, in part, as follows:
All property of the estate, except that claimed as exempt
by the debtor, without objection, or determined by the
[bankruptcy] Court as exempt, has been inventoried,
collected and liquidated, or abandoned. Any property not
heretofore abandoned by the trustee is now
abandoned...All claims have been examined and
objections have been resolved....
Trustee’s Final Report, November 30, 1995. A Supplemental
Final Report was filed on January 31, 1996. Subsequently,
the bankruptcy court issued its final decree on July 15, 1996,
thus closing New Manchester’s Chapter 7 proceeding and
discharging the trustee.

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6 Friedman, et al. v. Commissioner No. 98-2378
During the pendency of the bankruptcy proceeding,
Taxpayers filed joint federal income tax returns with the
Internal Revenue Service for the calendar years of 1989,
1990, and 1992. On October 15, 1993, the Friedmans filed an
application for a tentative refund, Form 1045, Application for
Tentative Refund. The refunds were claimed for 1989 and
1990 in the amounts of $765,440 and $792,469, respectively.
In such application, the Friedmans claimed net operating loss
deductions from carrybacks relating to Mr. Friedman’s stock
interest in New Manchester.
On November 12, 1993, the Rosenthals filed a Form 1045,
Application for Tentative Refund. The tentative refunds were
claimed for 1989 and 1990 in the amounts of $834,729 and
$810,331, respectively. The Rosenthals also claimed net
operating loss deductions in its application from carrybacks
relating to Mr. Rosenthal’s stock interest in New Manchester.
The Rosenthals filed an amended tax return for the 1988 tax
year, claiming a carryback of a net operating loss for the years
1988 to 1991.
In its federal income tax return for 1991, Form 1120S, New
Manchester claimed a loss of $10,102,289. In its tax return
for 1992, New Manchester claimed a loss of $10,751,953.
The Commissioner issued notices of deficiencies to
Taxpayers for the calendar years 1989 and 1990, on May 29,
1996. The Commissioner stated that Taxpayers owed
additional amounts as follows: The Friedmans owed $686,400
for 1989 and $793,860 for 1990; and the Rosenthals owed
$617,446 for 1989 and $811,723 for 1990. The notices of
deficiencies stated that, for the taxable year ending 1992,
Taxpayers were not entitled to a loss in excess of $5 million
each from their interest in New Manchester. The
Commissioner found that Taxpayers were not entitled to
increase their basis in New Manchester by the cancellation of
indebtedness income. Thus, Taxpayers’ 1992 taxable income
was increased accordingly.
Subsequently, Taxpayers filed separate petitions with the
United States Tax Court, on August 27, 1996, for a
No. 98-2378 Friedman, et al. v. Commissioner 19
In finding that Hap recognized a discharge of indebtedness
in 1980, the Cozzi Court looked for an identifiable event to
demonstrate the abandonment of security for a debt that
would, in turn, show a release from debt and corresponding
COD income. In viewing all of the circumstances
surrounding the various agreements, the court concluded that
Sargon had no intention of enforcing its rights against Hap
under the loan agreement, and the scheduled final payment by
Hap to Sargon in 1980, under the loan agreement, “was an
‘identifiable event’ sufficient to evidence Hap’s abandonment
of the picture.” Cozzi, 88 T.C. at 447. With no payment
made by Hap to Sargon and no arrangement by the parties to
defer such payment, “[t]he final payment under [the loan
agreement] was an important event, and the failure to make
such payment is clear evidence of abandonment.” Id. In so
holding, the court noted that the failure to make the final
payment was not the only identifiable event, but it was a
reasonable choice. Id. Thus, Hap realized a discharge of
indebtedness in the taxable year 1980.
Taxpayers also cite Fidelity-Philadelphia Trust Co. v.
Commissioner, 23 T.C. 527 (1954) in support of their
argument that New Manchester realized a discharge of
indebtedness in 1992. In Fidelity-Philadelphia Trust Co., the
taxpayer was incorporated as a national bank in 1934. At that
time, it acquired various assets and assumed certain liabilities
of a liquidated national bank. Among such liabilities were
certain depositors’ accounts of the liquidated bank.
In 1948, after fruitless searches to locate depositors by mail,
advertising, and other means, the taxpayer bank transferred to
its surplus account several of the depositors’ accounts which
were unclaimed, dormant, and inactive. In doing so, the bank
closed out its unclaimed deposit accounts. On its tax return
for 1948, the monies resulting from the closing of the above
accounts was shown as “a Sundry Credit to Earned Surplus,”
not as income. In assessing a tax deficiency, Commissioner
treated this amount as additional income.

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

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8 Friedman, et al. v. Commissioner No. 98-2378
Taxpayers’ appeal follows the decision of the Tax Court.
Discussion
The primary issue in this case is whether Taxpayers are
entitled to an increase in their basis in an S corporation’s
stock as a result of the discharge of indebtedness income, or
COD income, realized by the corporation. As a threshold
matter, however, we must determine whether New
Manchester actually realized COD income in 1992, which
would, in turn, establish whether Taxpayers may claim, and
carry back, a loss in excess of $5 million each.
I. Standard of Review
This Court reviews the Tax Court’s findings of fact for
clear error and its application of law de novo. Ekman v.
Commissioner, 184 F.3d 522, 524 (6th Cir.1999). Regarding
the specific question of the timing of the discharge of
indebtedness, however, Taxpayers present two possible
standards of review.
In the main body of their brief, Taxpayers state that the time
of the discharge is essentially a question of fact which would
be subject to review for clear error. Taxpayers Br. at 18
(citing Carl T. Miller Trust v. Commissioner, 76 T.C. 191,
195 (1981)(“Determination of the point in time at which a
taxpayer’s obligation has been cancelled, giving rise to
income, is essentially a question of fact.”); Taxpayers Br. at
24 (concluding that the Tax Court’s finding “that no discharge
occurred in 1992" is clearly erroneous). However, in the
section of their brief entitled “Standard of Review,”
Taxpayers suggest that “whether sufficient evidence has been
submitted to meet a party’s burden is a mixed question of law
and fact.” Taxpayers Br. at 38. Taxpayers appear to reach this
conclusion by combining two prior assertions: (1) that the
sufficiency of evidence submitted by a party is a question of
No. 98-2378 Friedman, et al. v. Commissioner 17
§108. Income from discharge of indebtedness
(a) Exclusion from gross income.
(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;
(C) the indebtedness discharged is qualified farm
indebtedness; or
(D) in the case of a taxpayer other than a C
corporation, the indebtedness discharged is qualified real
property business indebtedness.
26 U.S.C. §108(a)(1). In the instant matter, the relevant
exception is “the discharge occurs in a title 11 case,” as
Taxpayers filed a petition for bankruptcy on March 3, 1992.
Section 108(d)(2) defines a “title 11 case” as “a case under
title 11 of the United States Bankruptcy Code (relating to
bankruptcy), but only if the taxpayer is under the jurisdiction
of the court in such case and the discharge is granted by the
court or is pursuant to a plan approved by the court.” 26
U.S.C. §108(d)(2).
First and foremost, in order for COD income to occur under
section 61(a)(12), the taxpayer must have been discharged
from a liability. Such liability, or debt, must be viewed as
having been discharged when it becomes clear that the debt
will never have to be paid. Cozzi v. Commissioner, 88 T.C.
435, 445 (1987). The test for determining such a moment is
a practical assessment of the facts and circumstances relating
to the likelihood of payment. Cozzi, 88 T.C. at 445 (citing
Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980), supp.
opinion to 73 T.C. 491 (1979), vacated and remanded on
other grounds, 692 F.2d 152 (1st Cir.1982), aff’d in part and
rev’d in part on other grounds sub nom. CRC Corp. v.
Commissioner, 693 F.2d 281 (3d Cir.1982)). “Any

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

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10 Friedman, et al. v. Commissioner No. 98-2378
5The burden of proof does not change when a case is fully stipulated,
as is presently the case before this Court. See Tax Rule 122(b); Zarin v.
Commissioner, 92 T.C. 1084, 1088 (1989), remanded on other grounds,
916 F.2d 110 (3d Cir.1990).
clear error. See also In re Newman, 7 F.3d 234 (Table), 1993
WL 328035, **2 (6th Cir.1993)(unpublished opinion)(“The
question of whether a particular set of facts satisfies (or fails
to satisfy) the requisite burden of proof is an inseparable part
of the factfinding process and as such is reviewed -- together
with the facts -- for clear error.”)(citing 1 Steven A. Childress
& Martha S. Davis, Federal Standards of Review §2, 18, at 2-
130 (2d ed. 1991)).
II. Burden of Proof
Taxpayers maintain that Commissioner bears the burden of
proof with respect to the timing of the discharge of
indebtedness. Tax Rule 142(a) states as follows:
The burden of proof shall be upon the petitioner, except
as otherwise provided by statute or determined by the
Court; and except that, in respect of any new matter,
increases in deficiency, and affirmative defenses, pleaded
in the answer, it shall be upon the respondent.5
Based on this Rule, Taxpayers contend that the question of
whether the discharge of indebtedness occurred in 1992, as
opposed to another year, is a “new matter.” Taxpayers argue,
therefore, that Commissioner bears the burden of proof.
Without resolving this issue, the Tax Court merely concluded
that if the burden were shifted to Commissioner, “he would
have fulfilled that requirement by a substantial preponderance
of the evidence.” J.A. at 43.
The Notices of Deficiency issued to Taxpayers stated as
follows:
IT IS DETERMINED THAT FOR THE TAXABLE
YEAR ENDING 1992, YOU ARE NOT ENTITLED TO
No. 98-2378 Friedman, et al. v. Commissioner 15
these assets would never be repaid.” J.A. at 64. Thus,
Taxpayers contend that since it was stipulated that
indebtedness in excess of the value of New Manchester’s
assets as of December 31, 1992 would never be repaid, there
was, effectively, a discharge in the amount of $19,471,684 in
1992.
Commissioner, on the other hand, maintains that there was
no discharge because there was no identifying event in 1992
demonstrating that a debt had been discharged. In support of
his position, Commissioner emphasizes two points: First, the
stipulated record demonstrates that the bankruptcy trustee was
actively administering the bankruptcy estate well into 1995,
collecting accounts receivable, seeking buyers for saleable
assets, and filing reports with the bankruptcy court. Second,
a claim for fraudulent conveyance in the amount of $11
million was initiated by several of New Manchester’s
creditors. While at one point Taxpayers offered to settle the
claim for $300,000, it was eventually settled in 1995 for $2.2
million. Based upon the fluctuation in anticipated value,
initial offer, and actual settlement, Commissioner contends
that the value of the fraudulent conveyance claim was highly
uncertain. Therefore, for all of these reasons, Commissioner
maintains that no event had occurred in 1992 to fix a
discharge of indebtedness, nor could there have been any
certainty at that time as to the amount of any discharge.
The Court must note, however, that Commissioner does not
explicitly reconcile the discrepancy between the stipulated
statement that the fraudulent conveyance claim had an
anticipated value of $2,400,000 as of December 31, 1992, and
Commissioner’s argument in his brief that the claim’s value
could not be fixed in 1992. Implicitly, the argument appears
to be that the anticipated value could not be expected to
reflect the actual value of the claim, especially in light of the

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14 Friedman, et al. v. Commissioner No. 98-2378
disallowing the loss claimed by Taxpayers is new grounds for
disallowance; it does not clarify or develop an original
determination by Commissioner. The new grounds requires
the introduction of different evidence. As such, as justice and
fairness require, the burden of proving that the discharge did
not occur in the year at issue is on Commissioner.
III. Discharge of Indebtedness Income
The Notice of Deficiency issued to Taxpayers states that
Taxpayers are not entitled to a loss in the amount of
$5,055,116.00 from New Manchester and they are not entitled
to increase their basis in the corporation by the cancellation of
indebtedness income. In order to resolve this issue, the Court
must determine, initially, whether New Manchester realized
a discharge of indebtedness income, or COD income, for the
taxable year ending 1992.
Taxpayers argue that there was a discharge of indebtedness
in 1992 because it was clear at the end of 1992 that
$19,471,684 of New Manchester’s indebtedness would never
be repaid. Taxpayers reached this determination as follows:
When the bankruptcy proceeding began, New Manchester had
liabilities of $30,360,669 and assets of $9,241,153. By
December 31, 1992, as the parties have stipulated, the value
of New Manchester’s assets was $1,488,985.78, in addition
to a fraudulent conveyance claim filed by New Manchester’s
creditors. The claim had an anticipated value of $2,400,000.
Because New Manchester had paid $7 million to one of its
creditors in 1992, Taxpayers assert that New Manchester’s
remaining liabilities, as of December 31, 1992, totaled
$23,360,669 (the initial liabilities of $30,360,669 minus
$7,000,000). Taxpayers thereby determined that the excess of
New Manchester’s liabilities over the fair market value of its
assets was $19,471,684 ($23,360,669 (liabilities) minus
$1,488,985.78 (assets) minus $2,400,000 (anticipated value
of the fraudulent conveyance claim)). Moreover, Taxpayers
point to the stipulation of the parties whereby Taxpayers and
Commissioner stated that “[a]s of December 31, 1992, it was
clear that prepetition indebtedness in excess of the value of
No. 98-2378 Friedman, et al. v. Commissioner 11
A LOSS IN THE AMOUNT OF $5,055,116.00 FROM
THE SMALL BUSINESS CORPORATION KNOWN
AS MANCHESTER STEEL, INC. YOU ARE NOT
ENTITLED TO INCREASE YOUR BASIS IN THE
CORPORATION BY THE CANCELLATION OF
INDEBTEDNESS INCOME. INTERNAL REVENUE
CODE SECTION 108(d)(7) PROVIDES THAT THE
EXCLUS ION FOR CANCELLATION OF
INDEBTEDNESS INCOME WILL APPLY AT THE
ENTITY LEVEL IN THE CASE OF CANCELLATION
O F A N S C O R P O R A T I O N ’ S D E B T .
CONSEQUENTLY, IF THE CANCELLATION OF
DEBT IS EXCLUDED AT THE CORPORATE LEVEL,
THERE IS NO INCOME ITEM TO FLOW THROUGH
TO THE SHAREHOLDERS AND NO INCREASE IN
YOUR STOCK BASIS. ACCORDINGLY, YOUR 1992
TAXABLE INCOME IS INCREASED $5,055,116.00.
IN ADDITION, THIS AMOUNT EXCLUDED FROM
INCOME, UNDER SECTION 108 OF THE INTERNAL
REVENUE CODE, IS TAX-DEFERRED INCOME,
NOT TAX-EXEMPT. ACCORDINGLY, THERE IS
NO INCREASE TO YOUR STOCK BASIS UNDER
SECTION 1366 OF THE INTERNAL REVENUE
CODE. THEREFORE, SINCE YOU HAD A $0.00
BASIS IN THIS STOCK, YOU ARE NOT ENTITLED
TO THE CURRENT YEAR AND/OR SUSPENDED
YEAR LOSSES CLAIMED.
IN ADDITION, YOU WOULD NOT BE ELIGIBLE
FOR THE LOSS IN THE AMOUNT OF $5,055,116.00
ON YOUR 1992 RETURN SINCE YOU WERE NOT
AT RISK FOR THESE LOSSES WITHIN THE
MEANING OF SECTION 465 OF THE INTERNAL
REVENUE CODE.
J.A. at 19 (Friedman Notice); J.A. at 33 (Rosenthal Notice).
According to Taxpayers, the Notice presupposes the fact of
the discharge of indebtedness, and it fails to raise a question
as to the timing of the discharge; hence, it is a “new matter”

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12 Friedman, et al. v. Commissioner No. 98-2378
pursuant to Tax Rule 142(a). Commissioner, on the other
hand, contends that the Notice clearly made Taxpayers aware
that Commissioner denied that New Manchester had incurred
discharge of indebtedness income in 1992, and it was
sufficiently broad to cover both the timing and the occurrence
of such income.
As previously stated, petitioners (Taxpayers) generally bear
the burden of proof. Tax Rule 142(a); Welch v. Helvering,
290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933). The
respondent (Commissioner), however, bears the burden as to
“any new matter, increases in deficiency, and affirmative
defenses, pleaded in the answer.” Tax Rule 142(a). The
issue, therefore, becomes whether the timing of the discharge
of indebtedness is a “new matter.”
A new position taken by Commissioner is not necessarily
a “new matter” if it merely clarifies or develops
Commissioner’s original determination without requiring the
presentation of different evidence, being inconsistent with
Commissioner’s original determination, or increasing the
amount of the deficiency. Achiro v. Commissioner, 77 T.C.
881, 889-91 (1981). In Zarin v. Commissioner, 92 T.C.
1084, 1089 (1989), remanded on other grounds, 916 F.2d 110
(3d Cir.1990), the Third Circuit found that new matter had
been raised when the original notice of deficiency asserted a
theory of larceny and the answer to the petition in Tax Court
raised a theory of income from discharge of indebtedness. In
reaching its conclusion, the Zarin Court determined that the
latter theory clearly required different evidence from the
ground originally asserted in the petition.
The Tax Court specifically addressed a timing issue with
respect to “new matters” in Hunter v. Commissioner, 44
T.C.M. (CCH) 385, 1982 WL 10676 (1982). In this case, the
question was whether the petitioner’s stock became worthless
during the year in question. Respondent did not raise the
issue in his notice of deficiency or in the pleadings of the
case. While the petitioner elicited testimony concerning the
timing of the worthlessness of the debt during trial, he argued
No. 98-2378 Friedman, et al. v. Commissioner 13
that the year of the loss was a new matter. The Tax Court
agreed with the petitioner and found that a challenge to the
ordinary character of a loss does not necessarily encompass a
challenge to the fact of the loss. Hunter, 1982 WL 10676, at
*20. In reaching its conclusion, the Court reasoned that “the
issue of the timing of the loss would appear to be conceded,
for if the loss was not properly taken in the year before the
Court, the issue of the character of the loss becomes moot.”
Id.
This Court finds Taxpayers’ argument on this point
persuasive. The Notice of Deficiency issued to Taxpayers
presumes the existence of a discharge of indebtedness in
stating: (1) You are not entitled to increase your basis in the
corporation by the cancellation of indebtedness income; and
(2) If the cancellation of debt is excluded at the corporate
level, there is no income to flow through to the
shareholders.... (emphasis added). Commissioner’s challenge
to Taxpayers’ loss was aimed at the nature or character of the
loss, not the year it allegedly occurred. Commissioner’s
raising of the general existence of the alleged loss does not
necessarily implicate a challenge to the timing of the alleged
loss.
Furthermore, Commissioner failed to raise specifically the
question of the existence or the timing of the income despite
having the opportunity to do so and despite advancing other
theories for the deficiencies. Such other theories include the
following: (1) the exclusion of Section 108 of the Internal
Revenue Code applies at the corporate level, therefore, there
is no income to flow through to the shareholders; (2) the
amount excluded is tax-deferred income, not tax-exempt
income; and (2) Taxpayers were not at risk for the 1992 loss
pursuant to Section 465 of the Internal Revenue Code.
Therefore, in light of the foregoing, this Court finds that the
issue of the timing of the discharge of indebtedness income is
a “new matter” for consideration. The assertion, subsequent
to the Notice of Deficiency, that New Manchester did not
experience a discharge of indebtedness in 1992 as a basis for

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