## Facts

- Lakeland Grocery Company operated a grocery business but faced severe financial distress beginning in 1930.
- In December 1930, creditors placed Lakeland into receivership.
- In March 1933, Lakeland filed a bankruptcy petition.
- Lakeland and its creditors entered a composition agreement allowing continued operations.
- Creditors cancelled $104,710.16 of Lakeland’s indebtedness in exchange for a $15,472.61 cash payment.
- After the compromise, Lakeland emerged with net assets of $39,596.93 free of creditor claims.
- The Commissioner determined a deficiency by treating the discharge as income; the initial computation treated $89,237.55 (forgiven debt minus cash paid) as taxable.
- During the proceeding, the Commissioner conceded the taxable amount should be limited to $39,596.93 (Lakeland’s post-compromise net assets).
- Lakeland argued the debt cancellation generated no taxable income because it occurred in insolvency and bankruptcy.

## Issues

1. Whether cancellation of indebtedness in bankruptcy produces taxable income when the debtor was insolvent before the compromise.
2. If taxable income arises, whether it is limited to the amount by which the cancellation left the debtor with net assets free of creditor claims (i.e., the extent the debtor became solvent).

## Decision

- The Board held that discharge of indebtedness in the compromise resulted in taxable income.
- The Board limited the taxable income to $39,596.93, the amount of net assets Lakeland possessed after the compromise.
- The Board rejected taxing the full “saving” amount ($104,710.16 minus $15,472.61) and sustained the deficiency only as revised to the net-asset figure.

## Legal Principles

- Cancellation of indebtedness can create taxable income because the debtor is released from an obligation to repay amounts previously received.
- When a debtor is insolvent immediately before the discharge, taxable cancellation-of-indebtedness income is recognized only to the extent the transaction creates positive net assets (assets exceeding liabilities) after the discharge.
- The “saving” from debt cancellation is not taxable beyond the point of solvency; amounts that merely reduce an insolvency deficit do not constitute taxable income.

## Conclusion

The Board treated debt cancellation as income in principle but applied an insolvency limitation, taxing only the portion of the discharge that left the debtor with net assets free of creditors—here, $39,596.93.


Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937)