Zarin v. Commissioner: Is Canceled Debt Taxable Income?

The case of Zarin v. Commissioner involves a high-stakes gambler, a casino that flouted state regulations, and the Internal Revenue Service. The central question of the case was whether the forgiveness of a massive, and arguably unenforceable, gambling debt should be counted as taxable income. This dispute created a unique intersection of gaming laws and federal tax principles.

Factual Background of the Dispute

David Zarin was a compulsive, high-stakes gambler at Resorts International Hotel & Casino in Atlantic City. Beginning in 1978, the casino extended him a line of credit, allowing him to receive gaming chips in exchange for “markers,” which are IOUs promising future payment. The casino’s actions were in direct violation of New Jersey’s gaming regulations, which led to an Emergency Order making further credit extensions to Zarin illegal.

Despite this prohibition, Resorts continued to provide Zarin with credit. By 1980, Zarin had accumulated a debt of $3,435,000. The dispute between Zarin and the casino concluded with a settlement in 1981, in which Zarin agreed to pay $500,000 to resolve the claim.

The Initial IRS Position and Tax Court Ruling

The Internal Revenue Service views the cancellation of a debt as a form of income. This principle is rooted in Section 61 of the Internal Revenue Code, which defines gross income to include income from the discharge of indebtedness. The logic is that when a loan is forgiven, the borrower experiences an increase in net worth as assets are freed up.

Following this principle, the IRS determined that Zarin had realized $2,935,000 in taxable income from the settlement and issued a notice of deficiency. The case was first heard in the U.S. Tax Court, which sided with the IRS. The court reasoned that Zarin had received value in the form of gambling chips and the opportunity to gamble, and the settlement freed his assets from the obligation to repay the full amount. The Tax Court dismissed the argument that the unenforceability of the debt under state law changed its character for federal tax purposes.

The Third Circuit’s Reversal and Reasoning

The U.S. Court of Appeals for the Third Circuit reversed the Tax Court’s decision, finding that Zarin did not have to pay taxes on the forgiven debt. The court’s reasoning was based on the “contested liability” doctrine, an exception to the general rule of cancellation of debt income. Under this doctrine, if there is a legitimate dispute over the existence or amount of a debt, a settlement establishes the actual value of the debt for tax purposes.

Since Zarin and Resorts disputed the enforceability of the obligation, their $500,000 settlement established the claim’s true value, meaning no income was generated from a “discharge.” The court found the debt was genuinely contested because it was unenforceable under New Jersey law. The court agreed that because the debt was not legally enforceable, it did not constitute a loan in the traditional sense. A key element for a discharge of indebtedness to create income is that the taxpayer must be “indebted,” which implies a legally binding obligation to pay.

Furthermore, the court determined that the gambling chips were not property or a cash equivalent but a license to participate in the casino’s games. The chips had no value outside the casino, so the court concluded that Zarin did not receive a tangible asset that increased his wealth.