Supreme Court Allows S Basis Increase for Excluded DOI Income

In an 8-to-1 decision, the Supreme Court held that excluded discharge-of-indebt-edness (DOI) income under Sec. 108(a) is an item of income that passes through to S shareholders (thus increasing their stock bases), and further held that the increase occurs before the S corporation is required to reduce any of its tax attributes (Gitlitz,1/9/01). This issue had previously been addressed by the Tax Court, five circuit courts and various district courts. In addition, the IRS and Treasury, through final regulations under Sec. 1366 issued in December 1999, attempted to resolve the issue on a prospective basis. Because the Supreme Court has now ruled definitively on the issue, it appears likely that the regulations will be modified or withdrawn, and that the Service will concede in favor of taxpayers.

Background

For S corporations, Sec. 108 applies at the corporate level. In other words, DOI income is excluded only if it occurs in Title 11 cases involving the corporation or to the extent that the corporation is insolvent. The insolvency or bankruptcy status of any shareholder is irrelevant. Excluded income is applied to reduce the corporate attributes. For this purpose, corporate losses allocated to shareholders but suspended under Sec. 1366(d) are treated as net operating losses of the corporation. In addition, the bases of the corporation's assets are reduced to the extent required by Sec. 1017. In most cases, an S corporation will not have other Sec. 108(b) attributes to reduce. Finally, Sec. 108(b)(4)(A) provides that this attribute reduction is made only after a determination of the tax for the tax year in which the discharge occurs.

Many affected shareholders have taken the position that income excluded under Sec. 108(a) is tax-exempt income that results, under Sec. 1367(a)(1)(A), in an increase in their stock basis. As a general proposition, taxpayers and the IRS agree that, arguably, a basis increase produces an unintended windfall for shareholders, by permitting them to reduce their gain or increase their loss by an amount that does not represent an economic outlay by them. The Service has put forth several arguments in opposition to these positions, including the assertion that Sec. 108 is intended to produce a tax deferral rather than a tax exemption and that, because Sec. 108 is applied entirely at the corporate level, there is no item to pass through to shareholders under Sec. 1366. The latter conclusion formed the basis for the position set forth in final regulations adopted in December 1999; see Regs. Sec. 1.1366-1(a)(2)(viii). The regulations apply to tax years beginning after Aug. 18, 1998.

The position in the final regulations had been upheld by a series of cases, including Nelson, 182 F3d 1152 (10th Cir. 1999), aff'g 110 TC 114 (1998); Gaudiano, 216 F3d 524 (6th Cir. 2000); Winn, TC Memo 1998-71, aff'd sub nom. Gitlitz, 182 F3d 1143 (10th Cir. 1999); and Eberle, TC Memo 1999-287. The Third Circuit, in Farley, 202 F3d 198 (2000), and the Eleventh Circuit in Pugh, 213 F3d 1324 (2000), rejected the IRS's position. The Seventh Circuit had issued a mixed opinion in Witzel, 200 F3d 496 (2000).

Gitlitz

David Gitlitz and Philip Winn each owned 50% of PDW&A Inc., an S corporation. PDW&A was a partner in a real estate partnership that realized $4 million in DOI income in 1991; its share of that income was $2 million. PDW&A was insolvent to the extent of $2.1 million, and thus the DOI income was excluded from tax liability. Gitlitz and Winn both had suspended losses at the beginning of 1991 as the result of insufficient stock bases. On their respective tax returns, each claimed increases in their stock bases in the amount of their pro rata shares of the excluded DOI income. They then claimed their pro rata shares of PDW&A's 1991 operating loss, as well as losses incurred in prior years and suspended.

Tax Court and Circuit Court

The Service disallowed Gitlitz's and Winn's loss deductions, determining that PDW&A's excluded DOI income did not increase the shareholders' stock bases. The Tax Court initially ruled in favor of Gitlitz and Winn, but later granted the IRS's motion for reconsideration and ruled in favor of the Service based on Nelson, 110 TC 114 (1998).

The Tenth Circuit rejected the shareholders' position that PDW&A's income from the discharged debt was an income item under Sec. 1366 requiring an increase in their stock bases. While acknowledging that the income was an income item for this purpose, the court held that, for S corporations, the DOI exclusion provision and the tax attribute reduction principles of Sec. 108(d) "must be applied at the corporate level" before any remaining income is passed through to the shareholders—thus, the issue was one of timing. In the court's view, because attribute reduction must precede the passthrough from the S corporation to its shareholders, the corporation's excluded DOI income would be absorbed (in whole or in part) before it passed through to a shareholder, so there was little or no stock-basis adjustment and no windfalls.

Gitlitz and Winn argued that Sec. 108(b)(4)(A) requires the immediate passthrough of DOI income, because it provides that the attribute reduction is made after the determination of the tax imposed for the tax year of discharge (i.e., at the beginning of the first tax year after the tax year of the discharge). Again, the court disagreed, noting that Sec. 108(d)(7)(A) requires that tax attribute reduction be applied at the entity level for S corporations. The Tenth Circuit interpreted Sec. 108(b)(4)(A) as requiring the passthrough of all other items of income, deduction and credit to the shareholders first, followed by the computation of the shareholders' tax liability. After these steps are completed, tax attributes (including the suspended losses) are reduced; only the remaining DOI income (if any) is passed through to the shareholders as an item of tax-exempt income. The court did not read the law as mandating that attribute reductions be made in the tax year following the year of discharge.

Supreme Court Decision

The Supreme Court reversed the Tenth Circuit. Siding with the shareholders, the Court held that, under the plain reading of the statute, excluded income from discharged debt is an income item that passes through to shareholders and increases their S stock bases. The Court dismissed the IRS's theory that the exclusion from gross income under Sec. 108 alters the character of DOI so that it is no longer an income item. Instead, the Court held that Sec. 108 does not cause DOI income to cease to be an income item if the S corporation is insolvent; rather, it causes the DOI income to cease to be included in gross income. This aspect of the decision was based on an analysis of other exclusion provisions (Secs. 101–136) that exclude items from gross income, but stop short of providing that they are not income items. The Court also noted that nothing in Sec. 108 would cause the DOI income to be recharacterized as something other than an income item.

The Court next addressed whether the attribute reduction is performed before or after the DOI income is passed through to shareholders. Again agreeing with the shareholders, the Court stated that Sec. 108(b)(4)(A) expressly provides that attribute reduction is made after a determination of tax imposed, and noted that Sec. 1017(a) applies the same sequencing when Sec. 108 attribute reduction affects the basis of corporate property. Thus, the Court held the corporation must pass through the DOI income to its shareholders, at which point the shareholders increased their stock bases and deducted their losses before any attribute reduction occurs; because their bases increases equaled their losses, the shareholders had no suspended losses to reduce.

In subsequent actions, the Court acted on the petitions for certiorari that had been filed for four other appellate court decisions. On Jan. 16, 2001, the Court denied certiorari in Farley and Pugh (the two decisions that were consistent with the Court's opinion in Gitlitz) and vacated the judgments in Gaudiano and Witzel (the two decisions that were inconsistent with the Court's opinion), with further instructions to render judgments consistent with the Supreme Court's opinion.

1999 Regulations

Because the Gitlitz case involved the 1991 tax year, the Court did not have to rule on the validity of the 1999 regulations. Although the standards for determining the validity of a regulation are not the same as those for construing a statute in the absence of interpretive regulations, the Court's opinion did not appear to find much ambiguity in the statute. Accordingly, if the validity of the regulations had been in issue, it appears that the Court would most likely have held them invalid. Thus, the Service will likely modify those regulations to remove the requirement that DOI does not pass through to shareholders.

The decision does not preclude the IRS from raising other issues not raised by the Service or addressed by the Court in Gitlitz. For example, no DOI income is realized unless the indebtedness is properly classified as debt for Federal income tax purposes and unless there is a discharge of that debt. In addition, if a corporation purports to be an S corporation but does not qualify as such, steps prescribed by the Court for the passthrough of the DOI income to shareholders and the resulting stock basis increase do not apply. (However, in some cases, relief from the consequences of the inadvertent termination of an S election, a late election or ineffectiveness of the election may be available.)

From Kevin Anderson, J.D., CPA, and Don Herskovitz, J.D., Washington, DC