Ninth Circuit reverses Tax Court on timing of DOI income.

• Author: Madden, David
• Position: Discharge of debtedness income

In Milenbach, 318 F3d 924 (9th Cir. 2003), aff'g in part and rev'g and remd'g in part 106 TC 184 (1996), the Ninth Circuit reversed a Tax Court decision on when discharge of debtedness (DOI) income occurred. Although the decision addressed a number of issues, this item focuses exclusively on the DOI income aspects of the case.

Overview

Sec. 61(a)(12) includes in gross income "income from discharge of indebtedness" which is income that arises when a creditor releases a debtor from an obligation incurred at the outset of the debtor-creditor relationship. The Supreme Court articulated this principle in Centennial Savings Bank FSB, 499 US 573 (1991) and held that the imposition of early withdrawal penalties on certificates of deposits (CDs) was not the discharge of the bank's obligation to repay. When customers deposited money with the bank and the bank issued CDs, debtor-creditor relationships were created between the bank and the depositors. Like most CDs, the terms and conditions included an interest rate, maturity date and early withdrawal penalty.

Focusing on the meaning of the word "discharge" the Supreme Court found that "discharge of indebtedness" conveys the forgiveness of, or the release from, an obligation to repay. A depositor who cashes in a CD before the maturity date and pays the early withdrawal penalty does not forgive or release any bank obligation. By paying principal and interest, less the penalty, the bank pays exactly what it was obligated to pay under the CD's terms. Although the bank has income equal to the penalty amount, the income was not from the release of an obligation incurred by the bank at the outset of its debtor-creditor relationship with the depositor. The Supreme Court held that to determine whether the debtor has realized DOI income, "it is necessary to look at both the end result of the transaction and the repayment terms agreed to by the parties at the outset of the debtor-creditor relationship" (Emphasis in original.)

Facts

In Milenbach, the taxpayers owned the Los Angeles Raiders football team. In 1987, the Raiders announced an intention to leave Los Angeles and play their home games in Irwindale, California. In connection with this move, the Raiders executed a memorandum of agreement (MOA) with the city of Irwindale for a $115 million loan to construct a football stadium. Irwindale advanced the Raiders $10 million. Under the MOA, if Irwindale failed to perform its obligations, the Raiders' obligations...