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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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