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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,
4(...continued)
“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”
principle).
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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