CCA 200844015: Settlement terms, not dismissal order, fixed debt discharge date

Plain-English summary

An S corporation sought to treat debt as discharged before October 11, 2001, so its shareholders could rely on the basis rule from Gitlitz v. Commissioner before Congress changed § 108(d)(7)(A). The parties had obtained a court order dismissing litigation with prejudice on an earlier date, but their settlement agreement said the creditor would release the debts and cancel the notes on a later defined effective date. Chief Counsel concluded that the dismissal order did not itself determine when the debt was discharged. The creditor retained enforceable rights under the settlement after the order and still had reason to await the required payment. The settlement agreement’s terms therefore controlled the actual discharge date.

Ruling snapshot

• Question: Did the court order dismissing the parties’ litigation with prejudice discharge the taxpayer’s debt on the order date?
• Outcome: Advice given. The order did not determine the discharge date; the settlement agreement controlled when the creditor released the debt.
• Key authorities: IRC § 108(d)(7)(A); Gitlitz v. Commissioner, 531 U.S. 206 (2001)

Full text (IRS public release)

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Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 200844015
Release Date: 10/31/2008
CC:PA:B06:MMAHANEY
POSTS-145086-07

UILC: 108.04-00

date: February 26, 2008

 to:     Natasha Chevalier
         Attorney (Dallas, Group 2)
         (Small Business/Self Employed)

from: Jason A. Spitzer, Senior Technician Reviewer, Branch 6
Office of Associate Chief Counsel (Procedure & Administration)

         Mark J. Weiss, Assistant Branch Chief, Branch 1
         Office of Associate Chief Counsel (Corporate)

subject: ----------------

       This Chief Counsel Advice responds to your request for assistance. This advice may not
       be used or cited as precedent.


       LEGEND

       Taxpayer            =         -----------------------------
       ---------------------------------------------------

       Creditor             =       -------------------------------------

       Date 1               =       ---------------------------

       Date 2               =       -----------------------

       Date 3               =       ---------------------

       Date 4               =       ----------------

POSTS-145086-07 2

Year 1 = -------

aa = ------

bb = --------

mm = ---------------

nn = -----------------

oo = ---------------

pp = ---------------

qq = ---------------

rr = ---------------

ss = ---------------

Issue

Whether a court order when an Agreed Motion to Dismiss with Prejudice was issued
and signed on Date 1, resulted in the discharge of Taxpayer’s debts with Creditor as of
Date 1.

Conclusion

The issued and signed court order does not determine the discharge date of Taxpayer’s
debt with Creditor. The terms of the Settlement Agreement determine the timing of the
actual discharge of taxpayer’s debt.

Facts

The taxpayer is attempting to claim additional basis in its shares of S corporation stock
by relying on Gitlitz v. Commissioner, 531 U.S. 206 (2001). The holding in Gitlitz
provides that cancellation of debt income excluded from an S corporation’s income may
be added to a shareholder’s stock basis. Gitlitz was subsequently appealed when
Congress amended IRC §108(d)(7)(A). This amendment became effective on October
11, 2001. Therefore, the holding in Gitlitz still applies to any discharge of indebtedness
that occurred prior to October 11, 2001. Thus, the date on which the debt at issue was
cancelled becomes critical in instant case.
POSTS-145086-07 3

On Date 2, taxpayer, an S corporation, entered into a Term Loan Agreement with an
unrelated third party lender (“Creditor”) and executed several Secured Promissory
Notes in favor of various Creditor entities by which taxpayer borrowed $mm from
Creditor at a stated interest rate of aa% per year. The Notes further provided that, in
addition to the aa% coupon rate of interest, the loan to taxpayer would also consist of
the conveyance of a “royalty adjustment” sufficient to yield Creditor a bb% internal rate
of return. Additionally, any overdue interest or principal amounts bore interest at bb%.

During Year 1, taxpayer’s partners began experiencing financial difficulties that resulted
in taxpayer defaulting on the required payments to Creditor. Taxpayer sued the
partners who failed to make payments on corporate obligations and received a $nn jury
verdict and judgment on Date 3. Since the judgment, which was later backed by a cash
bond in favor of the defendants, was a substantial asset of taxpayer, Creditor decided to
await the outcome of the defendants’ appeals before pursuing taxpayer’s collateral. On
Date 4, taxpayer executed in favor of Creditor additional security agreements under the
Notes.

In -------, the $nn judgment was reduced on appeal to $oo. Of that amount, Creditor
ultimately received $pp since the judgment was divided among several parties. The
appellate court suggested that the reduction in the judgment was due in part to
malpractice of taxpayer’s attorneys. Thereafter taxpayer filed a lawsuit against its
attorneys. Creditor filed a Plea in Intervention in that lawsuit, claiming that taxpayer
owed Creditor principal of $qq under the Notes, plus interest, royalties and other
amounts, and asserted a right to recover those amounts from any liability adjudged to
be due taxpayer from its former attorneys.

In its Plea in Intervention Creditor claims that it should be permitted to intervene in the
malpractice action because it had “prior perfected first security interest in all property,
proceeds and other collateral owned by taxpayer. This security interest extends to any
judgment or settlement proceeds taxpayer may collect in this case.” Creditor argued
that it was entitled to intervene in the action because of its interest in the subject matter
of the litigation and the disposition of the action in Creditor’s absence may have
impeded its ability to protect its security interest. Creditor specifically stated in the Plea
that it was seeking to intervene in the action in order to protect its interest in any
property owned by taxpayer. The prayer for relief contained in the Plea stated that
Creditor sought to recover any an all amounts that taxpayer was entitled to recover from
defendants. Pleas in Intervention were also filed by two other parties. Taxpayer filed
Motions to Strike Interventions regarding all three parties that sought to intervene.

The court’s Order on Motions to Strike Interventions divided the action into the “Main
Phase,” which referred to the portion of the action that included claims asserted by the
taxpayer against the attorneys, and the “Intervention Phase,” which referred to the
portion of the action which included the claims, counterclaims and cross-claims
asserted by and among any of the intervenors and taxpayers, any third-party claims
which may have been asserted by any of such parties pertaining to the issues involved
POSTS-145086-07 4

in the Intervention Phase, and the defenses asserted to such claims, counterclaims,
cross-claims, third party claims, as such claims, counterclaims, cross-claims, third party
claims. The Order on Motions to Strike specifically provided that the Intervention Phase
was limited to claims, counterclaims, cross-claims and third party claims relating to
interests in the cause of action asserted by taxpayer against the attorneys in the Main
Phase and/or any proceeds thereof which are paid through judgment or settlement.
The attorneys were not parties to the Intervention Phase, which was to be handled in a
trial that was separate from the Main Phase.

All of the parties involved in the Main Phase and/or the Intervention Phase eventually
negotiated a settlement amongst themselves which was memorialized in a Confidential
Settlement and Release Agreement (the “Settlement Agreement”). The Settlement
Agreement states that effective as of the Creditor Effective Date as to the taxpayers
only and as to the Collateral Claims, and effective as of the Creditor Payment Date as to
all other taxpayer released parties other than with respect to the Collateral Claims,
Creditor unconditionally, fully and completely released and forever discharged the
taxpayers from any and all obligations, claims, demands, actions, causes of action,
suits, debts, liens, deficiencies, accounts, notes, convenants, contracts, agreements,
promises, liabilities, etc. whatsoever, known or unknown, accrued or unaccrued,
asserted or unasserted, contingent or otherwise, in law or equity arising prior to the
Creditor Effective Date or Creditor Payment Date, respectively. The “Creditor Effective
Date” was defined as the date which is five months after the Creditor Payment Date.
“Collateral Claims” is defined as any obligation, claim, demand, action, cause of action,
lien, security interest, contract or agreement which relate to or comprise any real or
personal property collateral or security pledged or encumbered by any taxpayer
released party to secure any debt or obligations to any of Creditor including without
limitation, the Notes.

The language in the Settlement Agreement specifically states that the release was
intended to be general and inclusive and therefore the claims to be released shall
include any claims in any way related to or in any manner arising out of the previous
Notes. In furtherance of the forgoing release, effective as of the Creditor Effective Date,
the Notes shall be deemed cancelled by Creditor.

In furtherance of the Settlement Agreement, on Date 1 (a date before October 11, 2001)
the parties filed an Agreed Motion to Dismiss with Prejudice wherein it stated that
plaintiffs, defendant and intervenors “no longer wish to prosecute claims among them”
and that they requested that the action be dismissed with prejudice “as to all claims,
cross-claims or counterclaims brought or that could have been brought herein.”

Accordingly, the Order Granting Agreed Motion to Dismiss with Prejudice (the “Order”)
states that the:

   cause of action in the present case is hereby DISMISSED WITH
   PREJUDICE towards refilling the same as to all claims, cross-claims or

POSTS-145086-07 5

  counterclaims brought or that could have been brought herein, including
  the claims in the intervention phase, with each party bearing its own
  attorneys’ fees, costs and expenses.

At the time of the Order, taxpayer’s total indebtedness to Creditor was approximately
$rr. As a result of the Settlement Agreement, Creditor received approximately $ss.

Analysis

The Order dismissed the cause of action and barred Creditor from pursuing any claims
that were brought in the malpractice action or those which could have been brought
within the action. The consideration for doing so was that each party entered into the
Settlement Agreement, which served as a binding contract between them. The
Settlement Agreement served as a general release, completely releasing taxpayer from
any and all debts that were outstanding with regard to its obligations to Creditor as of
the Creditor Effective Date, a date subsequent to the date of the Order. When all of the
parties signed the Settlement Agreement, it created contract rights that could be
judicially enforced amongst the parties. Thus, in the event a payment was not received
by Creditor pursuant to the Settlement Agreement, Creditor could seek subsequent
judicial assistance in enforcing the Settlement Agreement. If Creditor had no further
rights with respect to the debt as of the filing of the Order, then there would be no
incentive for a payment to be made to Creditor subsequent to the entry of the Order. As
Creditor clearly had further rights effective subsequent to the Order, there was no
discharge of Taxpayer’s debts to Creditor as of the date of the Order.

Please call Meghan Mahaney at 202-622-6869 or Mark Weiss at 202-622-7750 if you
have any further questions.

                                                         ____________________
                                                              Mark J. Weiss

                                                         ____________________
                                                              Jason A. Spitzer

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