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law of the State to determine the ownership of community property
and community income). Simply put, Federal law defines what is
income for Federal income tax purposes, and State law determines
who "owns", or has the right to, the income.
Federal law provides that, generally, a taxpayer must
recognize income from the discharge of indebtedness. Sec.
61(a)(12); United States v. Kirby Lumber Co., 284 U.S. 1 (1931).
The Code provides an exception to the recognition of COD income
in cases where the discharge occurs when the taxpayer is
insolvent. See sec. 108(a)(1)(B); see also Babin v.
Commissioner, 23 F.3d 1032, 1035 (6th Cir. 1994), affg. T.C.
Memo. 1992-673. Section 108(b)(1) provides in turn that, upon
discharge, the taxpayer must reduce certain tax attributes by the
amount of the COD income excluded from gross income. Section
108(b)(2) provides that NOL's are the first tax attribute to be
reduced,8 and section 108(b)(3) provides that they be reduced
dollar-for-dollar by the amount of the COD income excluded under
section 108(a).
If the debtor is a partnership, then the gain or loss
realized from the transfer of property in consideration of the
reduction or discharge of a debt is passed through to each of the
8 A taxpayer can elect to reduce the basis of any
depreciable property by the amount of debt discharged before
reducing the amount of any other tax attributes. Sec. 108(b)(5).
Petitioners did not make such an election.
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Last modified: May 25, 2011