T.C. Memo. 1998-196



                       UNITED STATES TAX COURT



     MICHAEL FRIEDMAN AND MADELINE FRIEDMAN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

     EDWARD ROSENTHAL AND DEBORAH ROSENTHAL, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 18735-96, 18736-96.             Filed May 27, 1998.



     J. Timothy Bender and Joseph P. Alexander, for petitioners.

     Nancy B. Herbert and John E. Budde, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HAMBLEN, Judge:    Respondent determined deficiencies in

petitioners Michael and Madeline Friedman's 1989 and 1990 Federal

income tax in the amounts of $686,400 and $793,860, respectively.

Respondent also determined deficiencies in petitioners Edward and
                                   - 2 -


Deborah Rosenthal's 1989 and 1990 Federal income tax in the

amounts of $617,446, and $811,723, respectively.1        The issues for

consideration are: (1) Whether petitioners' S corporation

realized discharge of indebtedness income pursuant to section

108(a)2 in the 1992 taxable year, and (2) whether petitioners may

increase the basis in their S corporation stock by the amount of

any discharge of indebtedness income realized by the

corporation.3

                             FINDINGS OF FACT

       This case was submitted fully stipulated pursuant to Rule

122.       The stipulation of facts and the exhibits are incorporated

herein and found accordingly.

       Petitioners Michael and Madeline Friedman resided in Pepper

Pike, Ohio, at the time the notice of deficiency was issued to

them.       The Friedmans filed joint Federal income tax returns for

the taxable years 1989, 1990, and 1992.         On October 15, 1993, the

Friedmans filed a claim for refund based on net operating loss

       1
      These cases were consolidated for purposes of briefing and
opinion.
       2
      All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
       3
      Madeline Friedman and Deborah Rosenthal are petitioners
solely by virtue of having filed joint returns with their
husbands. Hereafter, references to "Rosenthal," "Friedman,"
"petitioner-husband," and "petitioners" will be to petitioner-
husbands.
                                 - 3 -


deductions from carrybacks relating to petitioner-husband's

interest in Manchester Steel, Inc., an S corporation.     The

Friedmans claimed refunds in the amounts of $765,440 and $792,469

for the taxable years 1989 and 1990, respectively.

     Petitioners Edward and Deborah Rosenthal resided in Pepper

Pike, Ohio, at the time the petition was filed in this case.      On

October 21, 1993, the Rosenthals filed an amended income tax

return for the taxable year 1988, claiming a carryback of a net

operating loss for 1991 to 1988.    The Rosenthals claimed

entitlement to a 1992 net operating loss which, in turn, was

carried back to 1989 and 1990.    Subsequently, on November 12,

1993, the Rosenthals filed a claim for refunds for the taxable

years 1989 and 1990, for $834,729 and $810,331, respectively.

     Respondent mailed notices of deficiency to petitioners.

The deficiencies relate to petitioners' stock investment in

Manchester Steel, Inc.   Subsequently, petitioners filed separate

petitions for a redetermination of their respective income tax

deficiencies for the taxable years at issue.

                            Background

     Manchester Consolidated Industries, Inc. (Old Manchester),

was founded in 1970 by petitioners.      It was a major independent

steel service center specializing in the resale and processing of

carbon flat rolled steel.   Old Manchester's success arose, in

part, to its niche in the coated products market, specializing in
                                 - 4 -


the hot-dipped galvanized and electro-galvanized steel market.

The company was extremely profitable over the years, and

petitioners, as its operators and investors, obtained significant

returns on their investment.

     Subsequently, petitioners engaged in negotiations with

Vernon Bremberg (Bremberg) and Irwin Kramer (Kramer) to explore

the possibility of acquiring specific assets from Old Manchester.

On August 28, 1989, the foregoing negotiations culminated in a

letter of intent on that date.    On April 17, 1990, Manchester

Steel, Inc. (New Manchester), a steel company which processed and

distributed flat rolled steel and other related products, was

incorporated.   At the time of incorporation, petitioners

purchased shares in New Manchester.      Petitioners each owned 97.5

shares of New Manchester which was the equivalent of 24.375

percent apiece.   The other shareholders in New Manchester were

Bremberg and Kramer, who each owned 102.5 shares.     Combined,

Bremberg and Kramer owned 51.250 percent of New Manchester.       At

all applicable times, New Manchester elected to be an S

corporation.

     Under the sale agreement, Old Manchester retained certain

assets and liabilities.   Specifically, New Manchester purchased

certain steel service center assets and assumed a related debt of

Old Manchester.   The assets acquired from Old Manchester

included: (1) Tangible assets of cash, accounts receivables,
                                - 5 -


machinery, equipment, inventory, land, building, improvements,

furniture, and fixtures; and (2) intangible assets such as

computer lists, software, goodwill, covenant not to compete,

trade name, and trademark.    New Manchester, in turn, assumed

$12.8 million of Old Manchester's liabilities including a secured

trade debt.    New Manchester was able to obtain financing for the

asset purchase secured by the assets purchased from its

predecessor.   The loan amounts also provided New Manchester with

working capital.   Also, at the time of the asset purchases, Old

Manchester amended its Articles of Incorporation and changed its

name to E&M Investments Co.

     New Manchester, however, suffered from a severe economic

downturn due to a variety of outside factors.     The steel company

suffered significant and continuing operating losses, and,

consequently, was unable to complete orders and attract business

in a timely and profitable manner.      Subsequently, the owners of

New Manchester were unable to find a purchaser for the assets of

the company.

     In that regard, New Manchester claimed a $10,102,289 loss

from its trade or business activities on its 1991 Federal income

tax return.    In the following year, the company claimed a loss of

$10,751,953 from its trade or business activities on its 1992

Federal income tax return.
                                 - 6 -


     One of New Manchester's creditors was the International

Nederlanden Bank N.V. (NMB).     The foregoing debt was secured by

and undertaken in connection with the acquisition of Old

Manchester's assets.     Since New Manchester had encountered

economic and financial difficulties, NMB sought to assist the

steel company to effectuate a sale of its assets.     In that

regard, the value of NMB's collateral had significantly

decreased.   Subsequently, New Manchester failed to make interest

payments due on or after September 20, 1991.

     On March 3, 1992, an involuntary petition for bankruptcy was

filed, on the behalf of New Manchester, under chapter 7 of the

U.S. Bankruptcy Code.4    The bankruptcy case was administered in

the U.S. Bankruptcy Court for the Northern District of Ohio.     NMB

was the senior secured lender in the aforementioned proceeding.

     On March 11, 1992, the bankruptcy court granted a motion for

an order conditioning the use, sale, or lease of New Manchester's

property on NMB's interests being protected.     Next, on March 26,

1992, the bankruptcy court entered an order for relief.     It

stated that, since the statutory threshold had been satisfied:

"an order for relief is hereby entered thereon.     The Debtor is


     4
      A ch. 7 proceeding is, essentially, a liquidation.
Conversely, a ch. 11 case is a proceeding for the reorganization
of the debtor, and the idea is for the debtor to emerge from the
case as an operating entity with a different capital structure.
See Spiotto & Acker, A Bankruptcy and Insolvency Primer: Overview
of the Reorganization Process (1997).
                                - 7 -


hereby ordered to prepare and file the required schedules no

later than fifteen (15) days from the date of this entry."

     On March 30, 1992, an attorney was appointed as trustee in

bankruptcy.    Several days later, on April 3, 1992, the bankruptcy

trustee was authorized to operate New Manchester's steel

business.   Throughout the course of the aforementioned bankruptcy

proceeding, the trustee filed periodic reports with the

bankruptcy court on the state of the assets, receipts, and

disbursements.

     On May 4, 1992, a schedule of assets and liabilities for New

Manchester, with a statement of financial affairs attached, was

filed with the bankruptcy court.    The Chief Financial Officer for

New Manchester signed the schedule under penalties of perjury.

New Manchester's assets of real and personal property were worth

$9,241,153.    The steel company also held intangible assets,

valued at $3,991,457, such as the trade name, customer lists, and

a noncompetition agreement.    New Manchester's liabilities

comprised $19,681,047, $57,310, and $10,622,312, segregated

between creditors holding secured claims, creditors holding

unsecured priority claims, and creditors holding unsecured

nonpriority claims, respectively, for a total liability of

$30,360,669.

     On July 29, 1992, the bankruptcy court ordered certain

claims to be satisfied.    Pursuant to this order, NMB was paid
                               - 8 -


$3.3 million and $3.7 million, on July 30, 1992, and November 27,

1992, respectively.

     On December 1, 1992, petitioners reached an agreement with

Kramer and Bremberg which provided that Friedman would acquire

all interest in Kramer's holdings in New Manchester.    At the same

time, Rosenthal would acquire Bremberg's interest in New

Manchester.   Before December 31, 1992, in accordance with the

aforementioned agreement, petitioners became the sole

shareholders of New Manchester, each, respectively, owning 50

percent of New Manchester.

     On December 10, 1992, a proceeding was begun in bankruptcy

court to examine allegations by certain creditors that there were

"potential fraudulent conveyances and/or preferential transfers

with respect to [New Manchester]" prior to the filing of the

petition for bankruptcy.   The creditors further alleged that, in

connection with a prior leveraged buy-out of New Manchester,

petitioners rendered New Manchester insolvent or

undercapitalized.

     On January 4, 1993, the bankruptcy court amended its order,

dated July 29, 1992, and authorized the trustee to pay an

additional $177,000 to NMB to apply against its secured claim.

Subsequently, on March 22, 1994, the bankruptcy court authorized

the trustee to pay $684,635.75 to an assignee of NMB.
                               - 9 -


     Sometime in September 1993, the bankruptcy court granted the

trustee's request to retain an independent law firm as special

counsel to investigate and prosecute possible fraudulent

conveyance claims.   The trustee believed that the alleged

fraudulent transfers arose from the transactions that accompanied

the acquisition by New Manchester of Old Manchester's assets.

     On February 24, 1994, counsel for petitioners and E&M

Investments Co. served an answer to the bankruptcy court in

connection with the trustee's effort to recover approximately $11

million from, inter alia, petitioners.

     On February 28, 1994, petitioners submitted an offer in

compromise to the trustee in the amount of $300,000 to settle the

foregoing claim.   Sometime in April 1994, the trustee petitioned

the bankruptcy court for an order authorizing the acceptance of

the offer in compromise regarding disputed claims against

petitioners and E&M Investments Co., Kramer, Bremberg, and other

entities.   The trustee notified the bankruptcy court that

     Despite the disparity between the $11 million claim
     asserted by the Trustee against [petitioners], and the
     offer of $300,000 made by ***[petitioners] to settle
     the LBO litigation and any other claims of the estate
     against ***[petitioners], the Trustee believes the
     offer of settlement to be a good faith offer predicated
     upon ***[petitioners'] evaluation of their exposure and
     costs.


The trustee also noted that certain third parties or creditors

might object to the terms of petitioners' offer in compromise,
                             - 10 -


but believed that the inherent risks of litigation and other

factors involved supported the resolution on the terms offered.

However, on April 11, 1995, at a hearing, the bankruptcy court

empowered the trustee to settle and compromise his claims against

all of the defendants, including petitioners, for the sum of $2.2

million to be paid by E&M Investments Co.5   Subsequently, the

trustee was authorized to distribute the foregoing proceeds to

pay certain expenses and creditors.

     On November 30, 1995, the bankruptcy trustee filed a "Final

Report" (Final Report) with the bankruptcy court.   The report

states:

          All property of the estate, except that claimed as
     exempt by the debtor, without objection, or determined
     by the [bankruptcy] Court as exempt, has been
     inventoried, collected and liquidated, or abandoned.
     Any property not heretofore abandoned by the trustee is
     now abandoned.

          All claims have been examined and objections have been
     resolved. * * *


     Subsequently, on July 15, 1996, based on the trustee's Final

Report, the bankruptcy court issued an order which discharged the

trustee from his responsibilities, and the chapter 7 proceeding

involving New Manchester was adjudged closed.


     5
      Old Manchester's corporate successor and petitioners'
wholly owned company. See supra p. 5.
                              - 11 -


                              OPINION

     In the instant case, the principal issue for our

consideration is whether petitioners are entitled to an increase

in their basis in an S corporation's stock as a result of any

discharge of indebtedness income realized by that corporation.6

However, as a preliminary matter, we must ascertain whether New

Manchester, in actuality, realized COD income which, in turn,

determines whether petitioners are eligible to claim and carry

back, a $5,055,116 loss.

     First, petitioners raise a procedural issue.    They contend

that the Commissioner should bear the burden of going forward

with evidence establishing that the S corporation did not realize

COD income in the taxable year, 1992.   We find that if the burden

of proof were shifted to respondent that he would have fulfilled

that requirement by a substantial preponderance of the evidence

before us.   As will be shown below, the sum and substance of the

evidence in this case reflects that the S corporation, New

Manchester, did not realize COD income in the taxable year at

issue.

     We now turn to whether petitioners' S corporation realized

COD income in the taxable year, 1992.   Respondent argues that


     6
      Discharge of indebtedness income is also   referred to as
cancellation of debt income (COD income). For    purposes of this
opinion, we refer to the income generated from   the discharge of
indebtedness pursuant to sec. 61(a)(12) as COD   income.
                                - 12 -


petitioners have not identified the date or event by which New

Manchester realized COD income under section 61(a)(12) in that

year.   On the other hand, petitioners contend that New Manchester

received a discharge of debt in a title 11 proceeding in 1992.

Specifically, petitioners infer that the appointment of a trustee

to supervise and carry out the sale of the corporate assets, the

collection of outstanding claims, and distributions to creditors

were undertaken by the bankruptcy court itself, or pursuant to

that court's approval.   Consequently, petitioners suggest that

these actions taken as a whole constitute a "plan" within the

meaning of section 108(d)(2).    Finally, for purposes of section

108(a)(2) (the insolvency exception), petitioners, in effect,

argue that it was a virtual certainty that New Manchester could

not make any payments, subsequent to 1992, to satisfy the

indebtedness.

     Section 61 defines, in a general manner, gross income as

"all income from whatever source derived".   Section 61(a)(12)

further elaborates on this broad language by providing that gross

income specifically includes amounts received from cancellation

of indebtedness.   A taxpayer may realize COD income by paying an

obligation at less than its face value.    United States v. Kirby

Lumber Co., 

(1931).    The underlying rationale of this

principle is that a reduction in debt without a corresponding

reduction in assets causes an economic gain and income to the
                             - 13 -


debtor because the assets are no longer encumbered.    A

cancellation of indebtedness generally produces income to the

debtor in an amount equal to the difference between the amount

due on the obligation and the amount paid for the discharge.       If

no consideration is paid for the discharge, then the entire

amount of the debt is considered the amount of income which the

debtor must include in income.     Sec. 61(a)(12).

     Section 108(a)(1) provides an exclusion for COD income if

(A) the discharge occurs in a title 11 case, (B) the discharge

occurs when the taxpayer is insolvent, or (C) the indebtedness

discharged is qualified farm indebtedness.7    Section 108(d)(2)

defines the term "title 11 case" as "a case under title 11 of the

United States Code (relating to bankruptcy), but only if the

taxpayer is under the jurisdiction of the court in such case and

the discharge is granted by the court or is pursuant to a plan

approved by the court."




     7
      Sec. 108(a) reads in part:

     SEC. 108(a). Exclusion From Gross Income--
          (1) In general.--Gross income does not include any
     amount which (but for this subsection) would be includible
     in gross income by reason of the discharge (in whole or in
     part) of indebtedness of the taxpayer if--
               (A) the discharge occurs in a title 11 case, or
               (B) the discharge occurs when the taxpayer is
          insolvent, or
               (C) the indebtedness discharge is qualified
          farm indebtedness.
                                - 14 -


     An element necessary for the existence of COD income under

section 61(a)(12) is that the taxpayer was, in fact, discharged

from a liability.   Whether a debt has been discharged is

dependent upon the substance of the transaction.       Cozzi v.

Commissioner, 

, 445 (1987).     A debt is considered to

be discharged at the point when it becomes clear that the debt

will never have to be paid.     

for determining when

the required identifiable event occurred is a practical

assessment of all the facts and circumstances surrounding the

likelihood of repayment of the debt.      

event

that fixes with certainty the amount to be discharged may be

taken into consideration.     

States v. S.S.

White Dental Manufacturing Co., 

(1927)); 2925

Briarpark, Ltd. v. Commissioner, T.C. Memo. 1997-298.

     The existence of an almost imperceptible possibility that a

debt may be collected at some indefinite future point does not

preclude the recognition of COD income.      Exchange Sec. Bank v.

United States, 

, 1099 (5th Cir. 1974); 2925

Briarpark, Ltd. v. 

; cf. Fidelity-Philadelphia

Trust Co. v. Commissioner, 

, 531 (1954).      Simply

because a creditor has failed to remove a debt from its books

does not signify that the debt has not been canceled.       Exchange

Sec. Bank v. United States, supra.
                              - 15 -


     Moreover, the abandonment of collateral otherwise deemed

worthless and which represents a debt's sole payment source is an

"identifiable event" which establishes the moment when the

underlying debt is discharged.   Cozzi v. 

at

445-447; see also Brountas v. Commissioner, 

, 1074

(1980), supplementing 

(1979), vacated and remanded on

other grounds 

(1st Cir. 1982), affd. in part and

revd. in part on other grounds sub nom. CRC Corp. v.

Commissioner, 

(3d Cir. 1982).

      As a general matter, petitioners assert that respondent

narrowly interprets the word, "discharge" for purposes of section

108(a).   In particular, petitioners' arguments focus on the words

"title 11 case," in section 108(a)(1)(A) and (d)(2).   Petitioners

assert that the bankruptcy court's assumption of jurisdiction

over New Manchester, and the trustee's undertaking to manage New

Manchester's affairs in bankruptcy, occurred in a title 11 case

in 1992 and should, therefore, be deemed to constitute a

discharge of indebtedness for purposes of section 108(d)(2).

Conversely, respondent argues, that, during 1992, the bankruptcy

court did not effectuate a plan which discharged New Manchester's

outstanding debts, or, in fact, grant such a discharge.    In that

regard, respondent points out that New Manchester possessed

assets at the end of the taxable year, 1992, and that the
                                - 16 -


bankruptcy trustee was still actively pursuing claims beyond that

date.

     We reject petitioners' expansive reading of section

108(a)(1)(A) and (d)(2) which is contrary to the fundamental

principle of statutory construction that where a statute is clear

on its face, unequivocal evidence of legislative purpose is

required to override the plain meaning of the words used.

Huntsberry v. Commissioner, 

, 747-748 (1984).

        The language in section 108(d)(2) is fairly explicit.   It

provides that a "title 11 case" means a case under title 11 (the

bankruptcy code), but only if the taxpayer is under the

jurisdiction of the bankruptcy court and the discharge of

indebtedness is "granted by the court or is pursuant to a plan

approved by the court".     Sec. 108(d)(2).   Consequently, we read

the statute to contemplate that, in general, in a title 11 case,

the bankruptcy court must grant the discharge either in a

specific order, or as part of a plan approved by the court

itself.

        We observe that the bankruptcy trustee was active in

conducting New Manchester's business as well as disbursing

amounts to creditors after the 1992 taxable year.     In that vein,

the trustee periodically filed reports with the bankruptcy court

on the status of the foregoing proceedings.     Certain creditors

filed a fraudulent conveyance claim against petitioners on
                               - 17 -


December 10, 1992.    This claim was settled, in 1994, when

petitioners' wholly owned company paid $2.2 million to the

bankruptcy trustee.    These funds were, in turn, utilized to

satisfy the outstanding claims of creditors.    Finally, in late

1995, the bankruptcy trustee delivered a Final Report which

concluded that all claims had been settled.    In the following

year, the bankruptcy court issued a final order which ruled New

Manchester's bankruptcy proceeding to be closed.    Thus, a

practical assessment of the relevant facts and circumstances does

not indicate or, even, suggest that the underlying indebtedness

was extinguished or discharged by the bankruptcy court in 1992.

Cozzi v. 

at 445-447.8

     Petitioners argue that New Manchester was insolvent, and as

a practical matter, there was a de facto discharge of

indebtedness, in 1992.    Sec. 108(a)(1)(B).   The parties have, in

effect, stipulated that New Manchester was insolvent.    In that

regard, petitioners assert that it was exceedingly improbable

that the outstanding liabilities would ever be paid.    However,



     8
      We note that, in addition, under the provisions of a ch. 7
bankruptcy proceeding, a "discharge" may not be granted to a
debtor who is not an individual. Stated in a different manner,
New Manchester, as a corporate debtor, was ineligible for a
"discharge" under the aforementioned ch. 7 proceedings. 11
U.S.C. sec. 727(a)(1) (1994)(effective for the years at issue).
In that regard, there are procedures which provide the debtor to
an absolute right to convert the case to a case under ch. 11. 11
U.S.C. sec. 706(a) (1994).
                                - 18 -


there must be an identifying event or other evidence to show that

a debt has, in fact, been discharged.    See, e.g., United States

v. S.S. White Dental Manufacturing Co., supra at 401 (any

"identifiable event" which fixes the loss with certainty may be

taken into consideration); Exchange Sec. Bank v. United States,

supra at 1099; Bickerstaff v. Commissioner, 

, 367

(5th Cir. 1942); Cozzi v. Commissioner, 

; Kent

Homes, Inc. v. Commissioner, 

, 828-831 (1971), revd.

on other grounds 

(10th Cir. 1972); Cotton v.

Commissioner, 

(1932), affd. 

(D.C.

Cir. 1933).9   In this instance, there was no identifying event or

forgiveness on the part of the creditors that gave rise to

discharge of indebtedness income during the 1992 taxable year.

Cozzi v. 

.    Accordingly, we hold that

petitioners' S corporation did not realize COD income for the

1992 taxable year.

     Finally, even if the S corporation had realized COD income

for that year, we have held that, where such income is shielded

from recognition by section 108(d)(7)(A), it does not operate to

increase the basis of the shareholders.    Nelson v. Commissioner,



     9
      See also Brountas v. Commissioner, 

, 1074
(1980), supplementing 

(1979), vacated and remanded on
other grounds 

(1st Cir. 1982), affd. in part and
revd. in part on other grounds sub nom. CRC Corp. v.
Commissioner, 

(3d Cir. 1982).
                              - 19 -

(1998).   Thus, petitioners, as S corporation

shareholders, would be precluded from increasing their basis in

the corporate stock on account of COD income excluded from the

corporation's gross income.   Cf. Winn v. Commissioner, T.C. Memo.

1998-71.

     To reflect the foregoing,

                                 Decisions will be entered

                          under Rule 155.