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Zarin v. Commissioner - 916 F.2d 110 (3d Cir. 1990)

Rule:

Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes. 

Facts:

Appellant Zarin, a taxpayer, was extended gambling credit by casino and became a compulsive gambler. The state casino control commissioner issued an emergency order making further extension of credit to the taxpayer illegal, but the casino continued to extend credit. Zarin ran up a debt in excess of $3 million, and the casino filed suit to collect. The taxpayer stated that the debt was unenforceable under state law, and the matter settled for $500,000. The Internal Revenue Service asserted that the forgiven portion of the contested debt was income to the taxpayer and imposed tax. The United States Tax Court agreed and the taxpayers sought review of the decision of the Tax Court, which held that taxpayer recognized income from discharge of indebtedness resulting from his gambling activities and that he should be taxed on the income.

Issue:

Did the taxpayer receive taxable income when his gambling indebtedness was discharged by the casino?

Answer:

No

Conclusion:

Instead of analyzing the transaction at issue as cancelled debt, the Court of Appeals for the Third Circuit viewed the discharge as a disputed debt or contested liability.  Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes. Thus, if a taxpayer took out a loan for $10,000, refused in good faith to pay the full $10,000 back, and then reached an agreement with the lendor that he would pay back only $7000 in full satisfaction of the debt, the transaction would be treated as if the initial loan was $7000. When the taxpayer tenders the $7000 payment, he will have been deemed to have paid the full amount of the initially disputed debt. Accordingly, there is no tax consequence to the taxpayer upon payment. Similarly, the transaction between Zarin and the casino can best be characterized as a disputed debt, or contested liability. Zarin owed an unenforceable debt of $3,435,000 to Resorts. After Zarin in good faith disputed his obligation to repay the debt, the parties settled for $500,000, which Zarin paid. That $500,000 settlement fixed the amount of loss and the amount of debt cognizable for tax purposes. Since Zarin was deemed to have owed $500,000, and since he paid the casino $500,000, no adverse tax consequences attached to Zarin as a result.

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