¹Harold D. Farley, 201 F3d 198 (3d Cir. 2000), rev’g and rem’g DC PA, 3/12/99; pet. for cert. filed, 4/17/00.

²James H. Pugh, Jr., 11th Cir. 6/5/00, rev’g and rem’g TC Memo 1999-227.

³David A. Gitlitz, 182 F3d 1143 (10th Cir. 1999), aff’g TC Memo 1998-71, cert. granted, 5/1/00.

⁴See Kirby Lumber, 284 US 1 (1931), codified at Sec. 61(a)(12).

⁵See Pugh, Jr., note 2 supra.

⁶For the effect of COD income on partnerships, see C. Stephen Babin, 23 F3d 1031 (6th Cir. 1994), discussed in Pollock, “Sec. 108(a)(1) Excluded COD Income,” 26 The Tax Adviser 259 (May 1995).

⁷See IRS Letter Ruling (TAM) 9739002 (5/19/97) (partnership) and Regs. Sec. 1.1366-1(a)(2)(viii) (S corporation).

⁸IRS Letter Rulings (TAMs) 9423003 (2/28/94) and 9541006 (7/5/95).

⁹Philip D. Winn, TC Memo 1997-286 (Winn I), withdrawn, TC Memo 1998-71 (Winn II).

¹⁰Philip D. Winn, TC Memo 1998-71 (Winn II).

¹¹Mel T. Nelson, 110 TC 114 (1998), aff’d, 182 F3d 1152 (10th Cir. 1999).

¹²See, e.g., Chesapeake Outdoor Enterprises, Inc., TC Memo 1998-175; Michael Friedman, TC Memo 1998-196, aff’d, 6th Cir., 6/8/00; Salvador A. Gaudiano, TC Memo 1998-408, aff’d, 6th Cir., 6/8/00; Pugh, Jr., note 2 supra; Robert H. Bettisworth, TC Memo 2000-30.

¹³Gitlitz, note 3 supra.

¹⁴Gitlitz, id., is contrary to the legislative history of Secs. 1367 and 108. Sec. 1367’s legislative history provides that both taxable and nontaxable income increase an S shareholder’s tax basis. Sec. 1367 was enacted by Section 2 of the Subchapter S Revision Act of 1982; see S. Rep’t No. 97-640, 97th Cong., 2nd Sess. (1982), p. 16. Sec. 108(b)’s legislative history states that tax attribute reduction is made after the computation of the current-year’s tax; see S. Rep’t No. 96-1035, 96th Cong., 2d Sess. (1980), 1980-2 CB 620.

¹⁵William C. Witzel, 200 F3d 496 (7th Cir. 2000), pet. for cert. filed, 4/17/00.

¹⁶The Tax Court (see Nelson, note 11 supra), the Tenth Circuit (see Gitlitz, note 3 supra) and the Seventh Circuit (see Witzel, note 15 supra), disagree with Farley, note 1 supra.

¹⁷Under Secs. 1366(a)(1)(A) and 1367(a)(1)(A), tax-exempt income increases the shareholder’s stock basis to allow the deduction of the suspended losses. The IRS unsuccessfully argued in Farley, note 1 supra, that COD income was tax-deferred, not tax-exempt, income.

¹⁸Friedman, note 12 supra.

¹⁹Gaudiano, note 12 supra.

²⁰In Gaudiano, id., the Sixth Circuit mistakenly states that the Tenth Circuit determined in Gitlitz, note 3 supra, that excluded COD income is not tax-exempt income. In fact, the Gitlitz opinion, at n. 7, explicitly states that “excluded discharge of indebtedness income is tax-exempt income.”

²¹The courts cited in note 16, supra, were concerned that if they allowed a stock basis increase, the result would be a “windfall” for S shareholders. In Farley, note 1 supra, the Third Circuit stated that, to the extent the application of a statute would result in a “perceived” unwarranted windfall to taxpayers, principles of judicial restraint required that it be applied as written, unless such application would create an absurd result. Further, there are numerous exceptions in the Code to the rule that a shareholder must have an economic outlay to receive a stock basis increase; the court gave as examples Secs. 101 and 103 tax-exempt income derived from life insurance contracts and state and local bonds that can be passed through to S shareholders. These passthroughs produce a stock basis increase without any direct economic outlay by shareholders. According to the Farley court, because Congress had seen fit to allow “unwarranted” tax benefits under Secs. 101 and 103, and the Sec. 108 statutory language (on excluded COD income) is identical to that in Secs. 101 and 103, Sec. 108 cannot be distinguished from those sections on the basis of “economic outlay” considerations.

²²The Eleventh Circuit in Pugh, Jr., note 2 supra, held that Sec. 108 clearly requires all items of income included in Sec. 1366 be used to increase basis under Sec. 1367.

²³James D. Hogue, DC OR, 1/3/00, appeal filed 3/9/00.

²⁴Chesapeake Outdoor Enterprises, Inc., note 12 supra.

²⁵Robert E. Eberle, TC Memo 1999-287.

²⁶S. Rep’t No. 96-1035, note 14 supra, p. 2.

²⁷TD 8852 (12/21/99).

²⁸Regs. Sec. 1.1366-1(a)(2)(viii) is an interpretive regulation, entitled to less judicial deference than a legislative regulation. (“Interpretive” regulations explain a Code section; “legislative” regulations are issued under specific a Code section’s authority.)

²⁹Pugh, Jr., note 2 supra, held that the Code clearly provides that all S corporation income passes through to shareholders and increases their basis by the amount of the passthrough.

³⁰For an excellent discussion of recent Supreme Court and Tax Court cases that have validated and invalidated regulations, see Salem, “IRS Unwise to Assume Regs Given ‘Incredible Deference’,” 79 Tax Notes 1631 (6/22/98).

³¹Arguably, if a shareholder discloses on Form 8275-R a position contrary to the regulation, based on Farley, Pugh, Jr. and the fact that Regs. Sec. 1.1366-1 is inconsistent with five circuits’ positions, this is a reasonable basis and good-faith challenge to the regulation, under Sec. 6662 and Regs. Sec. 1.6662-3(c)(a).