Dudley B. and La Donna K. Merkel - Page 18

                                        -18-                                          
               A solvent debtor is capable of meeting his financial                   
          obligations because his assets equal or exceed his liabilities.             
          That excess (if any) is not increased when an obligation that               
          offsets assets is paid in full because the reduction in                     
          liabilities is equal to the reduction in assets.  If the                    
          reduction in liabilities exceeds the reduction in assets, then,             
          under the freeing-of-assets theory, the solvent debtor has                  
          realized a gain to the extent of that excess.  See, e.g.,                   
          Milenbach v. Commissioner, 106 T.C. 184, 202 (1996); Cozzi v.               
          Commissioner, 88 T.C. 435, 445 (1987) (“The general theory is               
          that to the extent that a taxpayer has been released from                   
          indebtedness, he has realized an accession to income because the            
          cancellation effects a freeing of assets previously offset by the           
          liability arising from such indebtedness.”) (citing United States           
          v. Kirby Lumber Co., 284 U.S. 1 (1931)).8  Pursuant to the                  

          8    That understanding of the nature of liabilities comports               
          with the ordinary and common meaning of the term “liability”:               
          “That which one is under obligation to pay, or for which one is             
          liable.  Specif., in the pl., one's pecuniary obligations, or               
          debts, collectively;--opposed to assets.”  Webster's New                    
          International Dictionary 1423 (2d ed. 1940).                                
               It should also be noted that the freeing-of-assets theory,             
          much like its descendant the net assets test, has been                      
          criticized:                                                                 
                    A particularly troublesome legacy of * * * [the                   
               passage in Kirby Lumber that the transaction “made                     
               available $137,521.30 assets previously offset by the                  
               obligation of bonds now extinct”] has been the tendency                
               of some courts to read Kirby Lumber as holding that it                 
               is the freeing of assets on the cancellation of                        
               indebtedness, rather than the cancellation itself, that                
                                                             (continued...)           



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