Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990)
Zarin v. Commissioner is a staple in federal income tax courses because it tests the boundaries of cancellation-of-indebtedness (COD) income under Internal Revenue Code § 61(a)(12).
Does a taxpayer realize cancellation-of-indebtedness income under § 61(a)(12) when he settles a large gambling-marker obligation—largely unenforceable under state law and disputed in good faith—for a fraction of its face amount?
Gross income includes income from discharge of indebtedness. IRC § 61(a)(12). For COD purposes, "indebtedness of the taxpayer" means a debt for which the taxpayer is liable or subject to which the taxpayer holds property. IRC § 108(d)(1). Under the contested liability (or disputed debt) doctrine, if a taxpayer, in good faith, disputes the amount or enforceability of a debt and subsequently settles, the settlement fixes the amount of the liability; the excess of the original alleged debt over the settlement amount is not treated as COD income because the portion above the settlement was never a fixed obligation. Additionally, state law governs whether a liability exists or is enforceable, and federal tax consequences follow from that characterization.
No. The Third Circuit reversed the Tax Court and held that Zarin did not realize cancellation-of-indebtedness income from the settlement. The court reasoned that (1) the casino markers, issued in violation of New Jersey regulations and subject to regulatory orders barring judicial enforcement, did not constitute "indebtedness of the taxpayer" for which he was liable under § 108(d)(1); and (2) independently, under the contested liability doctrine, the good-faith settlement fixed Zarin's liability at $500,000, so no COD income arose from extinguishing any amount above that figure.
Zarin is a leading case on two fronts. First, it demonstrates how state law enforceability can determine whether a "debt" exists for federal COD purposes. Second, it revitalizes the contested liability doctrine: when a debt is disputed in good faith and settled, the settlement defines the debt's amount, often precluding COD income on the excess. For students, the case illustrates the interaction between statutory text (§§ 61 and 108), common-law doctrines, and policy (whether the taxpayer experienced a real accession to wealth). It has been criticized and limited by some authorities, and other circuits have read § 108(d)(1) more broadly, so its reasoning should be applied with attention to jurisdiction and facts.