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We observed in Merkel:
The Board’s approach to a taxpayer in financial
distress being discharged of an indebtedness, which
approach was crystallized in Lakeland Grocery Co. v.
Commissioner, supra, has been called, among other
things, the “net assets” test. That 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 previ-
ously offset by the obligation of bonds now extinct”.
* * * The net assets test is a corollary of the princi-
ple in Dallas Transfer that an insolvent debtor does
not realize income when discharged of indebtedness.
Under the net assets test, if the debtor remains insol-
vent (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 dis-
charged, then the discharge has freed the debtor’s
assets from the offset of his liabilities to that
extent, and, 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.
Id. at 472-473; fn. ref. omitted.
We explained in Merkel that Congress
codified the net assets test in section 108(a)(1)(B),
(a)(3), and (d)(3) as a means of determining an exclu-
sion 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 exclu-
sion, * * * 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 liabilities for the purpose of determining
whether the debtor’s net worth turns positive (assets
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