Opinion
6225-16 16847-16
04-11-2022
MICHAEL R. KELLY, ET AL., Petitioner(s) v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Joseph Robert Goeke, Judge
On December 3, 2021, the parties each filed a computation for entry of decision under Rule 155 which has resulted in a disagreement with respect to certain items. By Orders dated December 7, 2021, and February 4, 2022, we directed the parties to address the items of disagreement. Remaining unresolved are computations for 2010 and 2011 with respect to: (1) cancellation of debt (COD) income for 2010 and (2) additional rental expense deductions for 2010 and 2011 for Kelly Hospitality.
Unless otherwise indicated, all statutory references are to the Internal Revenue Code, Title 26 U.S.C. (Code) and all regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
COD Income
1. Discharge of NSI Debt
Respondent states that petitioner had COD income from the discharge of NSI debt of $35.5 million and includes a distribution from NSI in his Rule 155 computation of $38, 981, 696 from the discharged debt. He asks us to reconsider our Order dated February 4, 2022, in which we stated that COD income from discharged NSI debt would be excludable from gross income under § 108(a)(1)(B) to the extent that petitioner was insolvent at year-end 2010. He argues that the § 108 insolvency exception does not apply where the discharged debt was shareholder debt owed to the corporation. When a corporation cancels shareholder debt, the cancellation is treated as distribution of property under § 301. Smith v. Commissioner, 151 T.C. 41 (2018); Treas. Reg. § 1.301-1(m). Although Treas. Reg. § 1.301-1(m) treats the COD income as a distribution, it does not preclude application of the insolvency exception. Accordingly, petitioner may exclude the COD income from the discharge of NSI debt to the extent that he was insolvent. See Toberman v. Commissioner, 294 F.3d 985 (8th Cir. 2002) (applying the insolvency exception to the discharge of shareholder debt owed to his S corporation).
Respondent misstates the holding of our Opinion that we held that the insolvency exception is not applicable to discharged debt treated as a distribution under Treas. Reg. § 1, 301-1(m). We clarify our holding, Treas. Reg. § 1.301-1(m) does not permit taxpayers to use the fair market value of the discharged debt as the amount of the distribution and the distribution is the face amount of the debt. To allow otherwise would impose an issue of solvency under the regulation where none exists. However, the regulation does not preclude application of the § 108 insolvency exception.
2. Insolvency Computation
Also unresolved is the extent of petitioner's insolvency. In our February 4, 2022, Order, we determined that petitioner was insolvent as of year-end 2010 but did not resolve the solvency computation as respondent had not yet provided a revised computation. The parties agree that petitioner had assets of $70, 732, 424.88.
Respondent has submitted a revised liability amount of $94, 550, 519.95 on the basis of our Opinion. Petitioner objects to respondent's liability computation arguing that respondent mistakenly omitted pre-2008 NSI debt. Petitioner asserts that his year-end 2010 liabilities were approximately $145 million including approximately $60 million of pre-2008 debt although it is unclear how petitioner arrived at this amount.
The taxpayer's insolvency is determined on the basis of his assets and liabilities "immediately before the discharge" including the discharged debt. § 108(d)(3). However, only discharged debt personally owed by the taxpayer is counted. See Miller v. Commissioner, T.C. Memo. 2006-125. Thus, we held that NSI debt owed by Kelly Capital and Kelly Investment are not properly included in petitioner's insolvency calculation. Kelly, T.C. Memo. 2021-76, at 63-64.
On the basis of the record, NSI transferred $25.5 million to petitioner personally before 2008 and NSI distributed this approximate amount to Kelly Capital as a dividend during 2008, allegedly making petitioner liable to Kelly Capital for the debt. The record does not establish a debt obligation of the petitioner to NSI based upon the transfer to the petitioner before 2008. Accordingly the petitioner having failed to carry his burden of proof on this issue, it is improper to include any NSI debt in the liability computation as petitioner has failed to established that he was personally liable for a debt to NSI.
We determine that petitioner had liabilities of $94, 550, 519.95 as of year-end 2010 and had a negative net worth of $23, 818, 095.07, resulting in part of petitioner's COD income from the discharge of NSI debt being excluded from his gross income under § 108.
3. Discharge of FCC and Greenback Debt
Respondent's computation includes COD income from the discharge of debt owed by Greenback Entertainment, Inc. (Greenback) of $2, 014, 061 and First Commercial Corp. (FCC) of $11, 157, 337, the respective loan balances as of year-end 2007. Petitioner's computation reflects no adjustment for either entity citing on our finding that transfers occurring on or after January 1, 2008, were not bona fide.
The pre-2008 transfers were bona fide loans and their discharge resulted in COD income. We held that petitioner did not establish either entity's insolvency at the time of the discharge. Kelly, at 67. Accordingly, petitioner must include COD income of $2, 014, 061 and $11, 157, 337 from Greenback and FCC, respectively, in gross income.
Rental Expense Deduction for Kelly Hospital
Petitioner's computation includes the allowance of additional deductions for 2010 and 2011 of $10, 310, 995 and $5, 525, 150, respectively, for expenses allegedly paid by Kelly Hospitality on behalf of Ivy Hotel. The amounts of the additional deductions arise from the audit of Ivy Hotel's partnership return, at the conclusion of which the partners, Kelly Capital and Julian Country Estates, LLC, agreed in March 2016 to an increase in rental income in these amounts.
Respondent did not determine an income or expense adjustment with respect to Kelly Hospitality for either year in the Notice of Deficiency, and petitioner did not assert the additional deductions in his pleadings.
Petitioner has not substantiated that Kelly Hospitality paid the amounts claimed or that he did not previously claim them on his returns. Deductions are a matter of legislative grace, and taxpayers bear the burden of proving that they are entitled to them. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Petitioner has failed to establish that Kelly Hospitality is entitled to deductions in excess of the amounts claimed on his returns for 2010 and 2011 and, thus, he is not entitled to the additional deductions that he seeks as part of the Rule 155 computation.
Upon due consideration, it is
ORDERED that the Court's Order served March 21, 2022, is amended in that the time in which the parties are to submit to the Court revised joint or separate Rule 155 computations is extended from April 20, 2022 to July 15, 2022.