Court's Reasoning
The court concluded that section 61(a)(12) and section 108 of the Internal Revenue Code set forth the general rule that gross income includes income from the discharge of indebtedness. However, the court held that neither of those sections applied to the case at hand. Section 108(d)(1), which repeats and further elaborates the rule set forth in section 61(a)(12), defines the term indebtedness as any indebtedness "(A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property." The court held that neither prong of section 108(d)(1) was satisfied in the case, and, as a result, Zarin could not have income from the discharge of his debt.
According to the court, the debt was unenforceable as a matter of New Jersey law because of the Emergency Order issued by the New Jersey Casino Control Commission. As a result, the credit line was clearly not debt "for which the taxpayer is liable." Furthermore, the Court held that the gambling chips were not property but "merely an accounting mechanism to evidence debt." Zarin could not do with the chips as he pleased, nor did the chips have any independent economic value beyond the casino. Additionally, since Zarin's debt at all times equaled or exceeded the number of chips he possessed, redemption would have left Zarin with no chips or cash. The court concluded that Zarin's indebtedness was not subject to property held by the taxpayer.
The court further held that the proper approach to the case was to view it as disputed debt or "contested liability." Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of debt, a subsequent settlement would be treated as the amount of debt cognizable for tax purposes. "The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes." Following this doctrine, the court concluded that the $500,000 settlement fixed the amount of loss and debt cognizable for tax purposes.
Read more about this topic: Zarin V. Commissioner, Holding
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