Couple Didn't Realize Cancellation of Debt Income

Kimberly L. Clark and Nhi T. Luu, for respondent.

During the years at issue, Dr. Mylander was licensed to practice dentistry in Oregon and was a member of the American Dental Association (ADA).³ In order to maintain his Oregon dentistry license as well as his membership in the ADA, Dr. Mylander was required to complete 40 hours of CDE each year. He generally met his CDE requirements by attending meetings of the Eastern Oregon Dental Society, by reading professional journals and taking exams based on the articles, and by attending various dentistry courses. Dr. Mylander fulfilled his CDE requirements for 2009.

Mrs. Mylander and Mrs. Lehman maintained a joint bank account (McCall account) that was used exclusively to pay the expenses relating to the McCall property. Every month petitioners and the Lehmans each deposited $250 into the McCall account. In 2009 Mrs. Lehman made payments from the McCall account totaling $5,288 for city services, utilities, insurance, and taxes, and she recorded these rental expenses in a ledger. In addition to the aforementioned expenses, petitioners paid $7,364 for various repairs and improvements to the McCall property during 2009 from their own accounts.

Around the same time, petitioners met Rodney and Katherine Ledbetter (Ledbetters). The Ledbetters had engaged in an unrelated business venture with a man named Hershell Murray. That venture failed sometime in the late 1980s. In 1989 the Ledbetters filed for bankruptcy in the U.S. Bankruptcy Court for the District of Nevada (bankruptcy court). Mr. Murray filed a claim against the Ledbetters in the bankruptcy action alleging that the Ledbetters had defrauded him of money. Mr. Murray and the Ledbetters reached an agreement whereby Mr. Murray agreed to settle his claim in the bankruptcy action in exchange for $500,000 in promissory notes from the Ledbetters. Under the terms of the [*6] promissory notes, the Ledbetters were jointly and severally liable to Mr. Murray for $500,000, plus interest, over five years. Mr. Murray conditioned the deal on petitioners' guaranteeing $300,000 of the $500,000 debt.

Mr. Ledbetter convinced petitioners to guarantee the $300,000 by promising to pay off the Koch debt. Mr. Ledbetter owned a convenience store in Nevada (Nevada store), which he led petitioners to believe was worth at least $400,000 and could be transferred to Mr. Koch to satisfy the Koch debt in full. Mr. Ledbetter also promised to indemnify petitioners for any payments they made to Mr. Murray under the guaranty. With petitioners on board, the Ledbetters entered into a stipulation agreement with Mr. Murray to pay the $500,000, plus interest, over five years.

The bankruptcy court issued an order which incorporated the terms of the stipulation and confirmed the Ledbetters' reorganization plan. Dr. Mylander signed an "Unconditional Continuing Guaranty" (guaranty),⁶ dated May 4, 1990, which stated that Dr. Mylander "unconditionally guarantees and becomes surety for the full and prompt payment to Murray at maturity, whether by acceleration or [*7] otherwise, and at all times thereafter, the principal amount of the note, namely $300,000". The guaranty was later amended to include Mrs. Mylander as a guarantor.

Pursuant to his agreement with petitioners, Mr. Ledbetter transferred his ownership interest in the Nevada store to Mr. Koch. Neither petitioners nor Mr. Koch knew that Mr. Ledbetter "had leveraged * * * [the Nevada store] to the hilt", leaving it with little to no equity. As the new owner, Mr. Koch became obligated to service the debt on the Nevada store, which required him to pay more than $50,000 each month. Mr. Koch soon realized the Nevada store was worthless and found a buyer who agreed to purchase it, and assume the liabilities, for an amount equal to what Mr. Koch had paid servicing the debt up until that point. In other words, Mr. Koch ended up breaking even on the transaction. Because no part of the Koch debt was satisfied by the transfer and sale of the Nevada store, petitioners remained obligated to pay the full $400,000 to Mr. Koch. Petitioners eventually paid off the full $400,000.

The Ledbetters, on the other hand, did not make any payments on their promissory notes to Mr. Murray. Pursuant to the guaranty, on April 26, 1994, Mr. Murray obtained a judgment (State court judgment) against petitioners in the District Court of the Fifth Judicial District of the State of Idaho, in and for the [*8] County of Blaine for $310,000. In December 2001 Mr. Murray entered into a covenant not to execute with petitioners in which Mr. Murray agreed not to execute on the State court judgment as long as petitioners made regular payments to him (first at $500 per month and later at $1,000 per month) until they had paid off the full $300,000 as set forth in the guaranty. Petitioners began making payments to Mr. Murray pursuant to the covenant not to execute and continued making payments through 2009.

The Ledbetters sent several checks to petitioners, ostensibly to meet their obligations under the indemnity; however, each of those checks was returned to petitioners for insufficient funds. Petitioners received nothing of value from the Ledbetters.

In 2010 petitioners made seven monthly payments of $1,006⁷ to Mr. Murray, leaving a $202,000 balance on the Murray debt. In or around that same year Dr. Mylander and his colleagues sold their dental practice in Baker City, Oregon. With extra cash on hand from the sale of the dental practice, petitioners offered to pay Mr. Murray a lump sum of $100,000 if he would agree to forgive [*9] the remaining $102,000 on the Murray debt (remaining debt). Mr. Murray accepted the offer and forgave the remaining debt by the end of 2010.

The following table shows relevant deductions petitioners claimed on their Forms 1040 for 2009 and 2010 and the amounts respondent allowed and disallowed in the notice of deficiency:

[*10]

 Item                     Amount on return        Adjustment per notice

When taxpayers establish that they have incurred deductible expenses but are unable to substantiate the exact amounts, we can estimate the deductible amount in some circumstances, but only if the taxpayers present sufficient evidence to establish a rational basis for making the estimate. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the amount allowable, we bear heavily against taxpayers whose inexactitude is of their own making. See Cohan v. Commissioner, 39 F.2d at 544. There must be sufficient evidence in the record, however, to permit us to conclude that a deductible expense was paid or incurred. Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957). Furthermore, we may not use the Cohan rule to estimate expenses subject to the strict substantiation requirements of section 274(d).⁸See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff'd, 412 F.2d 201 (2d Cir. 1969).

In order to substantiate their CDE expenses for 2009, petitioners offered into evidence a handwritten summary of figures (CDE summary) including [*13] expenses related to Dr. Mylander's dental practice. The CDE summary listed CDE expenses totaling $6,535. At trial, Dr. Mylander testified that he had prepared the CDE summary at the beginning of 2010 and based the figures contained therein on canceled checks and receipts. He also testified that he could not produce those underlying documents during the audit or at trial because he had placed them in a cardboard box which was subsequently misplaced by a moving company when petitioners moved to a new house in November 2009.

While we generally find Dr. Mylander to be a credible witness, we are troubled by the contradictions in his testimony regarding the preparation of the CDE summary. If the underlying documents were lost in November 2009, Dr. Mylander could not have used those documents to prepare the CDE summary in early 2010. Consequently, we find that the CDE summary is too unreliable to establish a rational basis for making an estimate.

The record establishes, though, that Dr. Mylander was required to earn 40 hours of CDE in order to maintain his professional license, that he fulfilled that requirement in 2009, and that he incurred deductible expenses in doing so. During the audit Dr. Mylander prepared a document, at the request of the revenue agent, explaining the loss of his CDE records and identifying, to the best of his recollection, the CDE courses he attended during 2009. In the document, Dr. [*14] Mylander also estimated that his "continuing ed studies result [sic] in about $100 per class hour." We find this estimate of costs incurred to be reasonable. Accordingly, because Dr. Mylander needed 40 CDE hours to maintain his dentistry license, we estimate that he had $4,000 of deductible CDE expenses for 2009.⁹ Respondent's disallowance of the remaining $2,535 is sustained.

Petitioners claim that, in addition to the $7,746 already allowed by respondent, they are entitled to deduct $2,644 (i.e., half of the $5,288 that Mrs. Lehman paid out of the McCall account in 2009). Petitioners concede the remaining $8 ($10,398 - $7,746 - $2,644).

During 2009 Mrs. Lehman maintained a ledger in which she recorded the rental expenses with respect to the McCall property that were paid out of the McCall account. Respondent now argues on brief that the ledger contained only [*16] rental expenses incurred during 2009 (i.e., $5,288),¹² but that respondent "generously-allowed petitioners $7,746.00 in rental expenses for 2009."

We find respondent's argument unpersuasive. During the audit, petitioners provided the revenue agent with sufficient documentation to substantiate the rental expenses they paid directly in 2009 but were unable to substantiate the expenses paid from the McCall account. At trial Mrs. Lehman credibly testified that in 2009 she paid expenses totaling $5,288 from the McCall account and that petitioners' share of those expenses was half, or $2,644.

[*17] We find that, out of the $10,398 deduction petitioners claimed, they have substantiated $2,644 of rental expenses paid out of the McCall account and $7,364 of repair expenses that they paid directly. As to the remaining $390 ($10,398 - $7,364 - $2,644), $382 was not substantiated by petitioners and was likely allowed by respondent in error, and petitioners have conceded the final $8. Respondent's disallowance of the remaining $390 is sustained.

Gross income includes all income from whatever source derived. Sec. 61(a). Discharge of indebtedness is specifically included as an item of gross income. Sec. 61(a)(12). The difference between the face value of a debt and the amount paid in satisfaction of that debt is in general includable in a taxpayer's gross income. Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994), aff'g T.C. Memo. 1992-673.

However, not all discharges of indebtedness are includable in gross income. For example, section 108 excludes certain discharges from gross income. See sec. 108(a), (e)(2), (f) (excluding discharge of indebtedness from gross income in certain cases involving, inter alia, insolvency, qualified farm indebtedness, lost deductions, and certain student loan discharges). The courts have also developed [*18] exceptions. For example, we have previously held that a guarantor does not realize COD income upon the release of a contingent liability. Landreth v. Commissioner, 50 T.C. 803 (1968); Hunt v. Commissioner, T.C. Memo. 1990-248, 59 T.C.M. (CCH) 635 (1990). In Landreth v. Commissioner, 50 T.C. at 813, we wrote:

Petitioners contend that respondent is misinterpreting the guaranty. According to petitioners, "[t]he obligation of a guarantor is not contingent because another party may or may not have to sign the guaranty; the obligation of a guarantor is contingent upon the primary obligor defaulting."

We agree with petitioners that the guaranty created a contingent liability because petitioners' obligation to make a payment under the guaranty was contingent upon the primary obligor's (i.e., the Ledbetters') failure to pay the debt.¹³See Perry v. Commissioner, 47 T.C. 159, 163 (1966), aff'd, 392 F.2d 458 (8th Cir. 1968); 38 Am. Jur. 2d, Guaranty, sec. 2 (2010) ("A guaranty creates a secondary obligation under which the guarantor promises to be responsible for the debt of another. The guarantor is only secondarily liable in the event the debtor does not perform the primary obligation."). The guaranty in this case creates the same type of contingent liability as those we discussed in Hunt and Landreth.

We agree with petitioners that they did not receive any valuable consideration in exchange for the guaranty. Petitioners entered into the guaranty with Mr. Murray in exchange for the Ledbetters' promise to satisfy the Koch debt and to indemnify petitioners for any loss petitioners might incur with respect to the guaranty. The Ledbetters, however, did not keep either promise. While they did transfer the Nevada store to Mr. Koch, it was "leveraged to the hilt" and had no [*21] value. As a result, petitioners' obligation to Mr. Koch was not reduced at all by the transfer of the store, and petitioners were required to, and did, pay the Koch debt in full. Then, when the Ledbetters defaulted and petitioners began making payments on the Murray debt, the Ledbetters sent checks to petitioners that were returned for insufficient funds. The Ledbetters made no good-faith attempts to make good on their indemnity. Therefore, we find that petitioners did not receive any valuable consideration in exchange for the guaranty.

C. Primary Obligation

Respondent argues, in the alternative, that petitioners must recognize COD income because they became primary obligors on the Murray debt when the Ledbetters defaulted.

Under the guaranty petitioners were secondary obligors as to the Murray debt because they were obligated to pay the debt only if the Ledbetters -- the primary obligors -- defaulted. See Restatement 3d, Suretyship & Guaranty, sec. 1 (1996). When the Ledbetters defaulted, a cause of action against petitioners accrued to Mr. Murray which led to the State court judgment against petitioners and the subsequent covenant not to execute. Under the State court judgment, as well as the covenant not to execute, petitioners' secondary obligation became a primary obligation. See Chevron Chem. Co. v. Mecham, 536 F. Supp. 1036, 1043 [*22] (D. Utah 1982) ("Default on the primary contract by the debtor ripens an unconditional guaranty into an actionable liability of the guarantor separate and apart from that of the principal debtor. The guarantor's obligation becomes absolute and is no longer secondary[.]").

Petitioners argue that even if they had become primary obligors on the Murray debt, they did not realize any COD income when the remaining debt was forgiven because they "did not receive the benefit of the non-taxable proceeds from the loan obligation." We agree with petitioners.

Even though petitioners had become primary obligors under the guaranty, their situation remained similar to those of the taxpayers in Hunt and Landreth.

We observed in Landreth v. Commissioner, 50 T.C. at 813, that "where the guarantor is relieved of his contingent liability * * * because of a release given him by the creditor, no previously untaxed accretion in assets thereby results in an increase in net worth." See also Hunt v. Commissioner, T.C. Memo. 1990-248, 59 T.C.M. (CCH) at 649-650 (quoting Landreth v. Commissioner, 50 T.C. at 813). We do not see any material difference between the situation in Landreth and one in which a guarantor's contingent liability has ripened into a primary liability. Unlike a debtor who borrows funds, a guarantor who assumes a contingent liability does not receive an untaxed accretion of assets which is accompanied by [*23] an offsetting obligation to pay. This remains the case even after the guarantor becomes a primary obligor because of the debtor's default. Regardless of whether the guarantor is a secondary obligor or has become a primary obligor, when the debt is discharged the guarantor's net worth is not "increased over what it would have been if the original transaction had never occurred." Landreth v. Commissioner, 50 T.C. at 813.

Petitioners did not receive any untaxed accretion of assets when they gave the guaranty. Nor did they receive any untaxed accretion of assets with respect to the guaranty when they later became primarily liable on the Murray debt as a result of the State court judgment. Therefore, when the remaining debt was forgiven petitioners did not realize an untaxed increase in wealth any more than had they remained secondary obligors.¹⁴

D. Conclusion

Petitioners were initially secondary obligors on the Murray debt, under the terms of the guaranty. They did not receive any valuable consideration in exchange for the guaranty. Upon the Ledbetters' default, and the subsequent State [*24] court judgment and covenant not to execute, petitioners became primarily liable on the Murray debt. However, at no point did they receive an untaxed accretion of assets with respect to the guaranty. Accordingly, we find that, when the remaining debt was forgiven by Mr. Murray in 2010, petitioners did not have an accession to wealth and did not realize any COD income.

We have previously found that petitioners were able to substantiate only a portion of their rental expenses and CDE expenses for 2009. Petitioners failed to keep adequate books and records to substantiate the remainder of those expenses. See sec. 1.6662-3(b)(1), Income Tax Regs. Therefore, for 2009 respondent has met his burden of production with respect to the negligence penalty relating to the portion of the underpayment that is due to disallowance of deductions for those expenses.¹⁵

To the extent petitioners' underpayment is due to an understatement of income tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000 for 2009 or 2010, respondent has also met his burden of production as to the substantial understatement penalty.¹⁶

The accuracy-related penalty is not imposed with respect to any portion of an underpayment as to which the taxpayer shows that he or she acted with [*26] reasonable cause and in good faith. Sec. 6664(c)(1);Higbee v. Commissioner, 116 T.C. at 448. Petitioners claim that their records substantiating the CDE expenses were inadvertently lost by a moving company during their move in 2009 and argue that this loss was outside of petitioners' control. However, petitioners also claim that they gave their tax preparer a summary which he used to prepare their Form 1040 for 2009 and that they prepared this summary in early 2010 on the basis of the lost records. Petitioners' testimony as to this point is contradictory and not credible. Accordingly, petitioners have not shown that they acted with reasonable cause and in good faith as to the CDE expenses.

Petitioners also argue that they "relied in good faith upon their tax return preparer to make legal determinations as to what amounts constituted income and deductions for income tax purposes." For a taxpayer to rely reasonably upon advice so as possibly to negate a section 6662 accuracy-related penalty determined by the Commissioner, the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser's [*27] judgment.Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002).

Petitioners presented only limited testimony regarding their tax return preparer, Mr. Hammons, and how he prepared their 2009 and 2010 tax returns. The record shows that Mr. Hammons is an accountant and that petitioners provided him each year with bare summaries of their income and expenses. Petitioners did not call Mr. Hammons or any other member of Wilson, Harris & Co. to testify. Petitioners have not shown, by a preponderance of the evidence, that they have satisfied the three-prong test under Neonatology Assocs. Accordingly, they do not meet the reasonable cause and good faith exception.

In reaching our holdings herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.

² Respondent disallowed $2,531 and $8,447 in travel expense deductions that petitioners claimed on their Schedules A, Itemized Deductions, for 2009 and 2010, respectively. Respondent also disallowed deductions of $14,329 for supplies and $12,072 for other expenses claimed on petitioners' 2009 Schedule C, Profit or Loss From Business. Petitioners concede that they were not entitled to any of these deductions, but they do not concede the associated accuracy-related penalties.

³ Dr. Mylander was previously licensed to practice in Idaho, but his Idaho license was inactive during the years at issue.

⁴ Mrs. Lehman's husband's name does not appear in the record.

⁵ The record is unclear and we do not reach any findings of fact regarding the extent to which Mrs. Mylander and Mrs. Ledbetter were involved in the transactions described in this section.

⁶ Throughout the remainder of this opinion, we will refer to both the guaranty document and the obligation assumed by petitioners within that document (which was subsequently amended on February 1, 1993) as the guaranty.

⁷ The $1,006 consisted of a $1,000 payment on the principal and a $6 escrow fee.

⁸ None of the expenses at issue in this case are subject to strict substantiation under sec. 274(d).

⁹ Respondent states that, in the notice of deficiency, he allowed an itemized deduction of $2,801 for "licensing and training" expenses for 2009. However, this amount does not include any of petitioners' reported CDE expenses for that year.

¹⁰ Of the $10,398, $10,016 was reported on Line 14 as repair expenses and $382 on Line 17 as utilities expenses. The $382 was for electrical repairs on the McCall property, not for utilities, and should have been included on Line 14.

¹¹ The $7,746 consists of the $7,364 petitioners substantiated plus an additional $382. It appears from the record that respondent double-counted the $382 petitioners spent on electrical repairs.

¹² In making this argument, respondent relies on the following exchange between respondent's counsel and Mrs. Lehman during cross-examination:

¹³ Respondent's argument that the guaranty was not contingent because it was "absolute and unconditional, and * * * not conditional or contingent upon any other party signing [it]" lacks merit. See 38A C.J.S. Guaranty secs. 9, 60 (2008) (defining an absolute or unconditional guaranty and a continuing guaranty).

¹⁴ Respondent argues that, pursuant to our decision in Hahn v. Commissioner, T.C. Memo. 2007-75, petitioners received an accession to wealthupon the discharge of the remaining debt. We find that Hahn is distinguishable because in that case the taxpayer was a debtor, not a guarantor, and received untaxed loan proceeds. Id., slip op. at 2.

¹⁵ Respondent has not met his burden of production with respect to the negligence penalty for 2010.

¹⁶ We leave this to the parties to determine under Rule 155.