able income in the amount by which his provable debts exceed the value of his surrendered assets. * * * [Id.]

The Court of Appeals distinguished United States v. Kirby Lumber Co., supra, as follows:

The instant case is substantially different from the [Kirby Lumber Co.] case * * *. In the last-mentioned case a corporation issued its bonds at par and in the same year repurchased some of them at less than par. The taxpayer's [Kirby Lumber Co.'s] assets having been increased by the cash received for the bonds, by the repurchase of some of those bonds at less than par the taxpayer, to the extent of the difference between what it received for those bonds and what it paid in repurchasing them, had an asset which had ceased to be offset by any liability, with a result that after that transaction the taxpayer had greater assets than it had before. The decision [Kirby Lumber Co.] *** that the increase in clear assets so brought about constituted taxable income is not applicable to the facts of the instant case, as the cancellation of the respondent's [Dallas Transfer & Terminal Warehouse Co.'s] past due debt to its lessor did not have the effect of making the respondent's assets greater than they were before that transaction occurred. *** [Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra at 96.]

In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the Board of Tax Appeals (Board) considered the insolvency exclusion established by Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra. In Lakeland Grocery Co., the taxpayer entered into a so-called composition settlement under which the taxpayer paid its creditors $15,473 in consideration of being relieved of its indebtedness to those creditors in the amount of $104,710. Prior to entering into the composition settlement, the taxpayer was insolvent. After that settlement, the taxpayer had net assets of $39,597, which, as noted by the Board, "were freed from the claims of creditors as a result of the *** [discharge of indebtedness].” Lakeland Grocery Co. v. Commissioner, supra at 291. The Board distinguished Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra, from the facts before it and concluded that the rationale of United States v. Kirby Lumber Co., 284 U.S. 1 (1931), was applicable to those facts. See Lakeland Grocery Co. v. Commissioner, supra at 291292. The Board held that the taxpayer realized gain to the extent of the value of the assets freed from the claims of its creditors, i.e., to the extent it had assets (i.e., $39,597) which ceased to be offset by any liability. See id. at 292.

We recently had occasion in Merkel v. Commissioner, 109 T.C. 463 (1997), to review the three cases (United States v. Kirby Lumber Co., supra, Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra, and Lakeland Grocery Co. v. Commissioner, supra) to which the committee reports accompanying H.R. 5043 refer and which we discuss above. In Merkel, as here, we had to determine whether a debtor qualified for the insolvency exception in section 108(a)(1)(B). However, in order to resolve that issue in Merkel, we had to determine the meaning of the word "liabilities" as used in the definition of the term "insolvent" in section 108(d)(3). See Merkel v. Commissioner, supra at 466-467. We observed in Merkel:

The Board's approach to a taxpayer in financial distress being discharged of an indebtedness, which approach was crystallized in Lakeland Grocery Co. v. Commissioner, supra, has been called, among other things, the "net assets" test. That test is based on the so-called freeing-of-assets theory derived from the Supreme Court's statement in Kirby Lumber that the transaction "made available $137,521.30 assets previously offset by the obligation of bonds now extinct”. * * * The net assets test is a corollary of the principle in Dallas Transfer that an insolvent debtor does not realize income when discharged of indebtedness. Under the net assets test, if the debtor remains insolvent (liabilities exceed assets) after being discharged of indebtedness, no assets have been freed as a result of the discharge since the debtor's assets are still more than offset by his postdischarge liabilities, and, thus, no gross income is realized; if the debtor is solvent (assets exceed liabilities) after being discharged, then the discharge has freed the debtor's assets from the offset of his liabilities to that extent, and, thus, gross income is realized from the discharge. In essence, the net assets test is simply an examination of the debtor's net worth after he is discharged of indebtedness-an increase in net worth gives rise to income, but a decrease in negative net worth does not. [Id. at 472-473; fn. ref. omitted.]

We explained in Merkel that Congress

codified the net assets test in section 108(a)(1)(B), (a)(3), and (d)(3) as a means of determining an exclusion from gross income of an item of income derived from the discharge of indebtedness. Aside from the parallel descriptions in the committee reports of the preexisting law and of the proposed insolvency exclusion, *** that codification is apparent from the statutory insolvency calculation coupled with the insolvency exclusion limitation provided in section 108(a)(3), which together share the same underlying analytical framework as the net assets test. That framework requires an examination of the debtor's assets and liabilities for the purpose of determining whether the debtor's net worth turns positive (assets

exceed liabilities), i.e., whether assets are freed, as a result of the debtor's being discharged of indebtedness.

From our examination of the statutory language, the legislative history, and the relevant cases cited in the committee reports, we conclude that the analytical framework of the insolvency exclusion and its related provisions [in section 108] is based on the freeing-of-assets theory. * * *

A solvent debtor is capable of meeting his financial obligations because his assets equal or exceed his liabilities. That excess (if any) is not increased when an obligation that offsets assets is paid in full because the reduction in liabilities is equal to the reduction in assets. If the reduction in liabilities exceeds the reduction in assets, then, under the freeing-ofassets theory, the solvent debtor has realized a gain to the extent of that excess. * Pursuant to the freeing-of-assets theory, a debtor does not realize income when discharged of a particular indebtedness, however, if his postdischarge liabilities equal or exceed his postdischarge assets (if any); i.e., under the net assets test, the debtor's liabilities equal or exceed his assets after the discharge (or, the statutory insolvency calculation shows that the debtor is insolvent by an amount greater than or equal to the discharge of indebtedness income * * *

[Id. at 473-475; fn. ref. omitted.]

With the foregoing in mind, we shall now consider petitioners' argument that we follow Cole v. Commissioner, 42 B.T.A. 1110 (1940), in defining the word "assets" as used in the definition of the term "insolvent" in section 108(d)(3).7 In Cole, the Board began its analysis by acknowledging that under Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the taxpayer, a resident of New York, would realize income upon the discharge of his indebtedness "to the extent of the excess of total assets over total liabilities immediately after * * * [discharge]." Cole v. Commissioner, supra at 1112. In

7 Petitioners also urge us to follow Hunt v. Commissioner, T.C. Memo. 1989-335. Petitioners argue that we previously held in Hunt that, for purposes of sec. 108(a)(1)(B), the word "assets" in sec. 108(d)(3) does not include assets exempt from the claims of creditors under applicable State law. We reject that argument and petitioners' characterization of Hunt as a case decided under sec. 108(a)(1)(B). Hunt involved tax year 1980. The insolvency exception in sec. 108(a)(1)(B) that was enacted into the Code as part of the 1980 Bankruptcy Tax Act became effective for transactions occurring after Dec. 31, 1980. See 1980 Bankruptcy Tax Act, Pub. L. 96-589, sec. 7(a)(1), 94 Stat. 3411. Although in certain circumstances Congress made available to debtors in bankruptcy cases or similar judicial proceedings an election to substitute Sept. 30, 1979, as the effective date of the 1980 Bankruptcy Tax Act, see id. sec. 7(f)(1), there is no indication in Hunt that the taxpayers involved there made such an election, see Hunt v. Commissioner, supra. Our discussion in Hunt of sec. 108 as amended by the 1980 Bankruptcy Tax Act (amended sec. 108) is dictum and appears in Hunt after we resolved the issue presented to us with respect to DOI income under the tax law that was extant prior to the passage of the 1980 Bankruptcy Tax Act. See Hunt v. Commissioner, supra. In this connection, it is noteworthy that we began our discussion of amended sec. 108 in Hunt by stating: "Furthermore, the correctness of our result is reinforced by the language of [amended] section 108." Id.

determining whether there was such an excess, the Board stated:

In determining the amount in [sic] which petitioner's net assets were increased as a result of the cancellation of petitioner's indebtedness by his creditor, i.e., the amount of petitioner's assets which ceased to be offset by claims of creditors, there should be, and has been, omitted from the value of petitioner's assets the value of his equity in ten life insurance policies. *** [Id. at 1113.]

The Board explained in Cole that it excluded the value of the taxpayer's equity in certain life insurance policies from its determination of the value of the taxpayer's assets because "Under the applicable law of New York * * * such equity in insurance was free from claims of creditors." Id.

We reject petitioners' argument that we apply Cole in this case. When Congress enacted the insolvency exception into the Code as section 108(a)(1)(B), one of the related provisions it also enacted is section 108(e)(1).8 Section 108(e)(1) provides that, for purposes of title 26 of the United States Code (i.e., the Internal Revenue Code, including section 61(a)(12)), "there shall be no insolvency exception from the general rule that gross income includes income from the discharge of indebtedness" except as provided in section 108(a)(1)(B). As the Supreme Court very recently stated, "Section 108(e)[(1)] precludes us from relying on any understanding of the judicial insolvency exception that was not codified in §108." Gitlitz v. Commissioner, 531 U.S. at 69 U.S.L.W. at

4063. Even before Gitlitz was decided, we reached a similar conclusion in Merkel v. Commissioner, 109 T.C. 463 (1997). We stated in pertinent part:

As Congress enacted the insolvency exclusion [section 108(a)(1)(B)], it eliminated the net assets test as a judicially created exception to the gen

8 When Congress "codified the net assets test in section 108(a)(1)(B), (a)(3), and (d)(3),” Merkel v. Commissioner, 109 T.C. at 473, it codified the net assets test developed by Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933), and Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937). It did not codify the application of the net assets test by Cole v. Commissioner, 42 B.T.A. 1110 (1940). The committee reports accompanying H.R. 5043 make no reference to and do not describe the holding of Cole, whereas those reports do refer to and describe the holdings of Dallas Transfer & Terminal Warehouse Co. and Lakeland Grocery Co. Nor do those committee reports refer to the two cases that applied Cole v. Commissioner, supra, which had been decided as of the time Congress passed the 1980 Bankruptcy Tax Act, i.e., Davis v. Commissioner, 69 T.C. 814, 833-834 (1978), and Estate of Marcus v. Commissioner, T.C. Memo. 1975-9. See also Babin v. Commissioner, T.C. Memo. 1992-673, affd. on other grounds 23 F.3d 1032 (6th Cir. 1994); Hunt v. Commissioner, supra, decided after Congress passed that Act.

eral rule of income from the discharge of indebtedness. See sec. 108(e)(1). The fundamental difference between the insolvency exclusion [in section 108(a)(1)(B)] and the [judicially developed] net assets test is that the insolvency exclusion is applicable only if there exists income from the discharge of indebtedness, whereas the net assets test engages in the threshold inquiry. Therefore, unlike the net assets test, the insolvency exclusion does not necessarily invade the province of section 61(a)(12).

Essentially, the insolvency exclusion defers to section 61(a)(12) as to the definition of the term "gross income", but represents a policy judgment that certain of that income should not give rise to an immediate tax liability. The relevant committee reports intimate that the policy judgment underlying the insolvency exclusion serves a humanitarian purpose-to avoid burdening an insolvent debtor outside of bankruptcy with an immediate tax liability. * * *

[Merkel v. Commissioner, supra at 481-482; fn. ref. omitted.]

We conclude that section 108(e)(1) precludes in this case (or in any other case involving the insolvency exception in section 108(a)(1)(B)) the application of Cole v. Commissioner, supra, and any other judicially developed insolvency exception to the general rule of section 61(a)(12) that gross income includes income from the discharge of indebtedness. See Gitlitz v. Commissioner, supra at 69 U.S.L.W. at 4063;

Merkel v. Commissioner, supra at 481.

Our conclusion that Cole v. Commissioner, 42 B.T.A. 1110 (1940), has no application in the instant case not only carries out the directive of section 108(e)(1), it also carries out the intention of Congress in enacting section 108(d)(3) that assets exempt from the claims of creditors under applicable State law are not to be excluded in determining the fair market value of a taxpayer's assets for purposes of ascertaining whether the taxpayer is insolvent within the meaning of section 108(d)(3). Congress' intention is disclosed by an examination of section 108(d)(3) together with the 1978 Bankruptcy Reform Act and its legislative history and the 1980 Bankruptcy Tax Act and its legislative history. One of the stated policies of the 1978 Bankruptcy Reform Act was "to provide a fresh start", S. Rept. 95-989, at 6 (1978), for debtors coming out of bankruptcy. The principal mechanism adopted by Congress in the 1978 Bankruptcy Reform Act for providing such a “fresh start” in the Federal bankruptcy laws is through the discharge of debts.9 See id. at 98.

9 The discharge-of-debt provisions of the 1978 Bankruptcy Reform Act, Pub. L. 95-598, sec. 727, 92 Stat. 2609, are described in the accompanying Senate report as "the heart of the fresh Continued