Zarin v. Commissioner and the Taxation of Disputed Debts

The story of David Zarin, a professional engineer and real estate developer, details a high-stakes gambler’s financial dispute with an Atlantic City casino. His personal financial troubles stemming from his gambling activities escalated into a legal battle that set a notable precedent. This case explores how a disagreement over gambling markers evolved into a landmark decision on the nature of debt and income. The circumstances of Zarin’s conflict with the casino challenged conventional tax principles.

Factual Background of the Dispute

David Zarin’s relationship with Resorts International Hotel began in June 1978, when he was granted a $10,000 line of credit. The casino considered him a valued patron and regularly increased his credit limit, which reached $200,000 by November 1979. This credit was given as gambling chips in exchange for Zarin signing markers, a type of countercheck.

Over a period of gambling, Zarin accumulated a massive debt. The casino continued to provide him with credit even after the New Jersey Casino Control Commissioner had issued an order prohibiting them from doing so, a direct violation of state regulations. By 1980, Zarin had amassed a debt to Resorts International totaling $3,435,000, which he attempted to pay with personal checks that were returned for insufficient funds.

The casino sued Zarin to recover the money he owed. In his defense, Zarin argued that the debt was unenforceable because the casino had extended the credit illegally under New Jersey law. The dispute did not proceed to a final judgment; instead, the parties reached a settlement. In 1981, Zarin agreed to pay $500,000 to resolve the entire $3,435,000 claim.

The Commissioner’s Argument and Tax Court Decision

The settlement drew the attention of the Commissioner of Internal Revenue. The Commissioner asserted that the difference between the original debt and the $500,000 settlement payment constituted taxable income for Zarin. This position was based on the principle of “income from discharge of indebtedness,” codified in Internal Revenue Code Section 61. This rule requires taxpayers to recognize income when a debt they owe is canceled or discharged for less than the full amount.

The logic behind this rule is that the forgiveness of debt frees up a taxpayer’s assets that would otherwise have been needed to pay the liability. The Commissioner argued that by settling the debt, Zarin realized nearly $3 million in income. Following the Commissioner’s notice of deficiency, Zarin challenged the determination by filing a petition in the U.S. Tax Court.

The Tax Court, in a divided decision, sided with the Commissioner. The court reasoned that Zarin had received value in the form of the gambling chips, which it deemed the equivalent of cash. It held that the settlement released Zarin from his obligation to repay the full amount, and this release was a taxable event. The Tax Court’s ruling affirmed that the $2,935,000 difference was income from the discharge of indebtedness.

The Third Circuit’s Reversal

Zarin appealed the Tax Court’s decision to the U.S. Court of Appeals for the Third Circuit, which reversed the lower court’s ruling. The appellate court’s decision was based on two distinct legal arguments that dismantled the Commissioner’s position.

First, the court found the debt was legally unenforceable. The court gave weight to the fact that Resorts International had violated New Jersey state law by continuing to extend credit to Zarin. Because the underlying transaction was illegal, the resulting debt could not be enforced in court. The court concluded that if a debt is not a legally binding obligation, its settlement cannot give rise to income, as there was no valid “indebtedness” to discharge.

The second, and more influential, argument centered on the “contested liability” doctrine. The court viewed the situation as a legitimate dispute over the amount Zarin actually owed, not as a simple loan and forgiveness. Because Zarin contested the enforceability of the entire debt in good faith, the settlement of $500,000 established the definitive amount of the debt for tax purposes. Since Zarin paid this established amount in full, no portion of the debt was “forgiven.”

Clarification of the Contested Liability Doctrine

The Zarin case is a primary example of the contested liability doctrine. This doctrine provides that if a taxpayer, in good faith, disputes the amount or the validity of a debt, a subsequent settlement is treated as establishing the actual amount of the debt. Consequently, the difference between the original amount claimed by the creditor and the final settlement amount is not considered income from the cancellation of debt.

For the contested liability doctrine to apply, the dispute must be bona fide. A taxpayer cannot simply make an unsupported claim to avoid tax liability; there must be a legitimate disagreement. In Zarin’s case, the dispute was legitimate because the casino’s extension of credit was illegal under state law, creating a genuine question about the debt’s enforceability.

The doctrine distinguishes between a reduction of a recognized debt and the resolution of a disputed claim. When a debt is undisputed and a creditor agrees to accept less, the debtor has realized income. When the debt itself is contested and a settlement is reached, that settlement amount becomes the definitive liability. By paying the agreed-upon $500,000, Zarin was considered to have fully satisfied his obligation, leaving no amount discharged and no resulting income to be taxed.