Dudley B. and La Donna K. Merkel - Page 16

          thus, gross income is realized from the discharge.  In essence,             
          the net assets test is simply an examination of the debtor's net            
          worth after he is discharged of indebtedness--an increase in net            
          worth gives rise to income, but a decrease in negative net worth            
          does not.                                                                   
                    2.  Codification of the Net Assets Test                           
               The net assets test has been criticized, particularly for              
          employing an improper criterion in the definition of income.6               
          Congress, however, codified the net assets test in section                  
          108(a)(1)(B), (a)(3), and (d)(3) as a means of determining an               
          exclusion from gross income of an item of income derived from the           
          discharge of indebtedness.  Aside from the parallel descriptions            
          in the committee reports of the preexisting law and of the                  
          proposed insolvency exclusion, see supra sec. II.B.2., that                 
          codification is apparent from the statutory insolvency                      
          calculation coupled with the insolvency exclusion limitation                
          provided in section 108(a)(3), which together share the same                
          underlying analytical framework as the net assets test.  That               
          framework requires an examination of the debtor's assets and                

          6    See, e.g., Eustice, “Cancellation of Indebtedness and the              
          Federal Income Tax: A Problem of Creeping Confusion”, 14 Tax L.             
          Rev. 225, 246-247 (1959); see also Estate of Newman v.                      
          Commissioner, 934 F.2d 426, 427 (2d Cir. 1991) (“confusion as to            
          the theoretical basis for taxing discharges of indebtedness has             
          spawned an illogical, judge-made `insolvency exception'”), revg.            
          T.C. Memo. 1990-230.  The net assets test and other judicially              
          created insolvency exceptions have been described as “an                    
          emotional response by the courts to the plight of financially               
          embarrassed debtors rather than * * * any strict application of             
          judicial logic.”  Eustice, supra at 246.                                    

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