Dudley B. and La Donna K. Merkel - Page 15

          test is based on the so-called “freeing-of-assets” theory derived           
          from the Supreme Court's statement in Kirby Lumber that the                 
          transaction “made available $137,521.30 assets previously offset            
          by the obligation of bonds now extinct”.  See, e.g., Commissioner           
          v. Tufts, 461 U.S. 300, 311 n.11 (1983).5  The net assets test is           
          a corollary of the principle in Dallas Transfer that an insolvent           
          debtor does not realize income when discharged of indebtedness.             
          Under the net assets test, if the debtor remains insolvent                  
          (liabilities exceed assets) after being discharged of                       
          indebtedness, no assets have been freed as a result of the                  
          discharge since the debtor's assets are still more than offset by           
          his postdischarge liabilities, and, thus, no gross income is                
          realized; if the debtor is solvent (assets exceed liabilities)              
          after being discharged, then the discharge has freed the debtor's           
          assets from the offset of his liabilities to that extent, and,              

          “Income From the Discharge of Indebtedness: The Progeny of United           
          States v. Kirby Lumber Co.”, 66 Cal. L. Rev. 1159, 1184 & n.90              
          (1978) (the Board's approach illustrates the “above water”                  
          5    But cf. Bittker & Thompson, supra at 1184 n.90 (stating that           
          the above water principle in Lakeland Grocery Co. v.                        
          Commissioner, 36 B.T.A. 289 (1937), does not necessarily require            
          acceptance of the freeing-of-assets theory; if horizontal equity            
          as between a debtor coming out of bankruptcy and an insolvent               
          debtor outside of bankruptcy is the guiding principle, the above            
          water result may be justified by disregarding income realized               
          from being voluntarily discharged of indebtedness outside of                
          bankruptcy “only to the extent that the taxpayer's financial                
          status after the composition or other arrangement with creditors            
          is comparable to the bankruptcy outcome”).  But see infra secs.             
          II.C.2., 4.                                                                 

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