Supreme Court Hands Taxpayers a Victory in Gitlitz
April 2001
Ending years of controversy, the Supreme Court finally resolved the question whether the shareholders of an insolvent S corporation are entitled to increase their stock basis as a result of excluded cancellation of debt ("COD") income.1 In its 8-1 decision for the taxpayers, the Court emphatically rejected the IRS’ policy arguments and relied, instead, upon the plain language of the statute.
Although the technical issue decided in Gitlitz was a narrow one, the decision is likely to have major importance for taxpayers and tax practitioners. The statutory language at issue reached a result that could be viewed as producing a "windfall" for the taxpayer, i.e., COD income was excluded and the taxpayer was entitled to a basis increase. The Supreme Court concluded, however, that if the statutory language is clear, Congress’ mandate must be followed.
The Statutory Framework
The controversy in Gitlitz was the result of clear, albeit convoluted, rules contained in several sections of the Code.2 Section 108(a)(1)(B) provides an exclusion for COD income realized by an insolvent taxpayer.3 Section 108(b)(4)(A) provides that attribute reduction does not occur until after the determination of the tax imposed for the taxable year of the discharge, i.e., until after the close of the taxable year in which the COD income is excluded.
The statutory rules are much more complicated for S corporations. Section 1366(a)(1)(A) provides that the items of income of an S corporation (including tax-exempt income) are passed through to the shareholders and reported on the shareholders’ individual tax returns. Under Section 1367(a)(1)(A), the shareholder of an S corporation increases the basis of the stock in the corporation by the items described in Section 1366(a)(1)(A), i.e., by the items of taxable and tax-exempt income that flow through to the shareholder. To the extent that the losses incurred by an S corporation exceed the shareholder’s basis in her stock, the losses are suspended under Section 1366(d) unless and until the shareholder has sufficient basis to allow such losses to pass through to the shareholder.
In addition to these general rules concerning the exclusion of COD income and the taxation of S corporations, several other statutory provisions directly addressing the impact of COD income on S corporations must also be considered. Section 108(d)(7) provides two special rules that were potentially relevant in this situation. First, under Section 108(d)(7)(A), in the case of an S corporation, Sections 108(a), (b) (c) and (g) are applied at the corporate level.4 Second, under Section 108(d)(7)(B), for purposes of determining the amount of net operating losses ("NOLs") that are subject to attribute reduction under Section 108(b)(2)(A), any loss or deduction which is disallowed for the taxable year of the discharge under Section 1366(d) is treated as a NOL for that taxable year.5
The Facts in Gitlitz
David Gitlitz and Philip Winn were shareholders of P.D.W. & A., Inc, an S corporation (the "Corporation"). In 1991, the Corporation realized $2,021,296 of income from the cancellation of indebtedness. Because the Corporation was insolvent even after the debt was discharged, the Corporation excluded the COD income under Section 108(a)(1)(B). The taxpayers also increased their stock basis by their pro rata share of this COD income and used this increased stock basis to claim losses that had previously been suspended under Section 1366(d). The IRS disallowed the basis increase and resulting loss deductions.
The taxpayers’ tour through the courts was as tortured as the statutory language.6 The Tax Court initially granted summary judgment to the taxpayers, rejecting the IRS’ argument that the excluded COD income was not an "item of income." This victory was short lived, however, because the Tax Court withdrew and reversed Winn as a result of the Tax Court’s unanimous decision in Nelson that excluded COD income did not result in a basis increase for the shareholders of an S corporation.
The Tax Court’s decision in Nelson was based on the special rules set forth in Section 108(d) with respect to the treatment of COD income by S corporations. The Tax Court concluded that the COD income "disappeared" at the corporate level, which meant that there was no income to flow through to, and increase the basis of, the shareholders.
The Winn decision was appealed by the taxpayers to the Tenth Circuit, which heard the case under the Gitlitz name. The appellate court expressly rejected the Tax Court’s conclusion that excluded COD income does not pass through to the shareholders as a result of Section 108(d)(7)(A). However, the appellate court concluded that the taxpayers first had to reduce their tax attributes to offset the COD income under Section 108(b). Because the tax attributes were equal to the amount of discharged debt, there was nothing left to pass through to the shareholders. Thus, the taxpayers’ result was the same in the Tenth Circuit as in the Tax Court, although the grounds for the decisions were quite different.
The Nelson and Gitlitz decisions could have caused taxpayers to give up hope of receiving a favorable result, but hope was quickly revived as other appellate courts started to consider this issue.
The next decision, Farley, was the most important from the taxpayers’ perspective. In Farley the district court had granted summary judgment to the IRS on the basis of Nelson. The Third Circuit first rejected the Tax Court’s decision that there was no statutory basis for concluding that excluded COD income did not flow through to the shareholders. The Third Circuit then addressed and rejected the Tenth Circuit’s conclusion that attribute reduction prevented a benefit to the taxpayers. The Third Circuit emphasized that Section 108(b)(4)(A) is unambiguous—attribute reduction occurs on the first day of the tax year following the year of discharge.
Two more circuit courts subsequently weighed in on this issue, with the Sixth Circuit reaching the same conclusion as the Tenth in Gaudiano, while the Eleventh Circuit agreed with the Third in Pugh. Notably, all of the appellate courts rejected the Tax Court’s reasoning in Nelson. Thus, with five circuit courts having addressed the issue, two had held for the taxpayer, two had concluded that the taxpayers were neither able to increase their stock basis nor use the losses due to attribute reduction and one had denied loss utilization but had allowed the taxpayer a basis increase for the excluded COD income. The Supreme Court granted certiorari in order to resolve this obvious split among the lower courts.
The IRS’ Argument
In the Supreme Court, the IRS adopted as its primary position the argument that had been rejected by the Tax Court (on summary judgment) in Winn, i.e., that the COD income of an insolvent S corporation is not an "item of income" and, thus, never passes through to the shareholder.7 The Court had no difficulty concluding that this argument was inconsistent with a plain reading of the statute.8
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge… of indebtedness of the taxpayer if… the discharge occurs when the taxpayer is insolvent.
Moreover, Sections 101 through 136 employ the same construction to exclude various other items from gross income, such as insurance proceeds and interest on tax-exempt obligations. The consequence of reading this language in the manner suggested by the IRS would be to prevent all of these items from passing through to the shareholder, too. But the IRS recognized that it could not make such a sweeping assertion. Instead, the IRS argued (without specific statutory support) that COD income is unique among the types of income excluded from gross income because no economic outlay is required of the taxpayer receiving COD income.
The Court made short shrift of this argument. The Court emphasized that the exclusion of COD income under Section 108(a) does not alter its character as an item of income. According to the Court, this provision presumes that COD income is always "income" and that the only question for purposes of Section 108 is whether it is includible in gross income. If COD income was not "income," there would be no need to provide an exception to its inclusion in gross income.
Notwithstanding this plain language in the Code, the IRS further argued that excluded COD income is not "income" and, specifically, that it is not "tax-exempt income" under Section 1366(a)(1)(A).
Second, the IRS argued that excluded COD income is not "tax exempt" income but, rather, "tax deferred" income because the taxpayer is required to reduce tax attributes that could have provided future tax benefits. The Court concluded, however, that the IRS erroneously assumed that Section 1366(a)(1)(A) does not apply to tax-deferred income. According to the Court, Section 1366 applies to "items of income." The statute is worded broadly enough to include any item of income, including even tax-deferred income, which could affect the shareholder’s tax liability.
The Supreme Court’s dismissal of the IRS’ argument concerning tax-deferred income appears to be correct but for the wrong reasons. Tax-deferred income of an S corporation, such as gain that is not recognized in a like-kind exchange under Section 1031, does not flow through to shareholders or result in a basis increase under Section 1367. It would have been better if the Court had concluded that COD income of an insolvent S corporation is not tax-deferred income in any event. Because such COD income is not tax-deferred income, it could affect the
calculation of the shareholder’s tax liability under Section 1366(a). Any item that "could" affect this calculation must be treated as income (and taken into account) under Section 1366, even if such income is otherwise excluded or not recognized.
The Tenth Circuit’s Rationale
The Supreme Court then turned its attention to whether the rationale stated by the Tenth Circuit in Gitlitz should be affirmed. The appellate court had concluded that the S corporation’s tax attributes should be reduced under Section 108(b) before the COD income is passed through to the shareholders. The effect of the Tenth Circuit’s argument is that no suspended losses would remain that could be deducted by the shareholders. In contrast, if tax attribute reduction occurs after the COD income is passed through to the shareholders, then the shareholders would be able to deduct their losses under Section 1366(d).
Section 108(b)(4)(A) directs that attribute reduction shall be made after the determination of the tax for the taxable year of the discharge. In order to determine his tax liability, the shareholder must adjust his basis in the S corporation stock and pass through all items of income and loss. Thus, the individual shareholders of the S corporation were required to pass through the discharged debt, increase their stock basis and then deduct their losses—all before any attribute reduction could occur. Because in this case the shareholders’ basis increase was equal to their losses, the taxpayers had no suspended losses remaining to be reduced under Section 108(b).9
The Court believed it was necessary to address the Tenth Circuit’s rationale (which had also been adopted in Gaudiano) even though this argument was not pursued by the IRS in the Supreme Court.10 The circuit courts were concerned that if the COD income is passed through before tax attribute are reduced, instead of remaining at the corporate level as inferred from Section 108(d)(7)(A), then there can never be any attribute reduction. Under this rationale, the COD income must remain at the corporate level in order to result in attribute reduction.
The Court also noted the underlying fallacy in this argument, which is that attribute reduction may or may not occur depending upon the specific taxpayer’s circumstances. If the shareholder has no tax attributes at all, there will be no reduction at all. However, the exclusion under Section 108(a) does not depend upon tax attribute reduction occurring; the COD income of an insolvent S corporation is excluded whether or not the shareholder has tax attributes to reduce.
The final paragraph of the majority’s opinion may have been the most important. Some courts had argued that, from a tax policy perspective, if the shareholders were permitted to pass through the discharge of indebtedness before reducing any tax attributes, they would wrongly experience a "double windfall": they would be exempt from paying taxes on the full amount of the COD income and they would be able to increase basis and deduct their previously suspended losses. Justice Thomas answered this argument in one succinct sentence: "Because the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern."11
The Dissenting Opinion
In a muted dissent, Justice Breyer agreed with the majority’s reasoning other than with respect to the interpretation of Section 108(d)(7)(A). Justice Breyer argued that this provision could be read literally to require that both the exclusion of COD income and tax attribute reduction would occur only at the corporate level. As a result, the insolvent S corporation’s COD income would not increase the shareholder’s basis and would not help the shareholder take otherwise unavailable deductions for suspended losses.
The IRS had argued in its brief that Congress apparently believed this was the correct result, because similar language was included in the 1993 House Committee report when Congress added Section 108(a)(1)(D).12 The IRS also supported this argument by the fact that this reading would close a significant tax loophole, which grants a solvent shareholder of an insolvent S corporation a tax benefit in the form of an otherwise unavailable deduction, thereby sheltering other, unrelated income.
Furthermore, this deduction-related tax benefit would have very different tax consequences for identically situated taxpayers, depending only upon whether a single debt can be split into segments, each of which is cancelled in a different year.
The majority had acknowledged the policy concerns but contended that its reading is mandated by the plain language of the statute. Justice Breyer did not believe, however, that Section 108(d)(7)(A) should be interpreted as treating different solvent shareholders differently, given that the words "at the corporate level" were added "in order to treat all shareholders in the same manner."13
Justice Breyer believed that the arguments from plain text on both sides of this case produce ambiguity, not certainty. And other things being equal, Justice Breyer argued that ambiguous statutes should be interpreted to close, not maintain, tax loopholes. Here, other things are equal, and the IRS’ interpretation of Section 108(d)(7)(A) would neither cause any tax-related harm nor create any statutory anomaly. Justice Breyer was not persuaded that the adoption of the IRS’ argument in this regard would somehow affect the application of other provisions in the Code.14
Finally, Justice Breyer turned his attention to footnote 6 in the majority opinion, in which Justice Thomas had dismissed his argument on the grounds that Section 108(d)(7)(A) does not state or imply that the debt discharge provision shall apply only at the corporate level. Justice Breyer did not contend that Section 108(d)(7)(A) must be read in favor of the government. Instead, he believed that given the effect of the alternative adopted by the majority (a double benefit for the taxpayer), his interpretation of Section 108(d)(7)(A) provided the best reading of Section 108 as a whole.
Analysis
The Supreme Court’s resolution of the specific issue that was contested by the parties in Gitlitz is not likely to be of great historical significance; Congress will likely reverse the result by statute in the near future. Nonetheless, Gitlitz is likely to remain a significant decision for taxpayers for many years after the applicable law has changed.
What was more important in the long run, however, is that the Court also recognized that the Code’s rules must be respected even if the answer was not consistent with appropriate tax policy. The Court left the creation of tax policy to Congress as long as Congress had spoken clearly. Here, Congress had provided a complex statutory scheme that resulted in a double benefit to the shareholders of an insolvent S corporation. The Court recognized this benefit and seemed to say, "so be it." If Congress clearly created the loophole, the Court left it to Congress to fix it.
Needless to say, this is an important development from a tax-planning perspective. The Supreme Court’s decision in Gitlitz shows tax advisors that they do not need to shy away from taking a position that is clearly mandated by the Code, even if the result is unduly beneficial to the taxpayer. Put simply, Congress makes the law, and the Supreme Court said that when Congress has spoken clearly, taxpayers can rely on what Congress has said.
There will, however, likely be one immediate impact to the Court’s decision in Gitlitz. When the IRS finally recognized that the issue of the treatment of COD income by insolvent S corporations was not simply going to go away, the IRS issued regulations under Sections 1366 and 1367 providing that the shareholders of an insolvent S corporation do not receive a basis increase for any COD income excluded under Section 108(a)(1)(B) as a result of the corporation’s insolvency.15 It now appears unlikely that the regulation, which was issued under the general authority to prescribe interpretative regulations under Section 7805(b), would withstand a judicial challenge, particularly in light of the Supreme Court’s conclusion that the statutory language was clear. The IRS will likely have no choice but to withdraw the regulation or, in the alternative, re-promulgate it when Congress enacts legislation to eliminate the "loophole" sustained in Gitlitz.
As for taxpayers, every individual who was a shareholder of an insolvent S corporation should carefully review all tax returns filed for prior years. To the extent that the statute of limitations is still open, the shareholder may be able to claim losses that were not previously claimed. Alternatively, the shareholder may received a basis increase in a prior year, resulting in net operating losses or other beneficial tax results at the shareholder level. Every tax advisor whose clients include the shareholders of an insolvent S corporation should carefully review prior returns to determine what tax benefits, if any, are available to his/her clients as a result of the Supreme Court’s decision in Gitlitz.
1 This question has provided an "annuity" to commentators. See Lipton, "IRS Challenges S Corporation Basis Increase for COD Income," 81 JTAX 340 (December 1994); Lipton, "Tax Court Rejects S Corp. Basis Step-Up for COD Income in Nelson," 88 JTAX 272 (May 1998); Lipton, "The Impact of Excluded COD Income on S Shareholders–The Tenth Circuit Gets Lost in Gitlitz," 91 JTAX 197 (October 1999); Lipton, "Different Courts Adopt Different Approaches to the Impact of COD Income on S Corporations," 92 JTAX 207 (April 2000).
2 Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1986, as amended ("Code").
3 Sections 108(a)(1)(A), (C) and (D) provide exclusions for COD income in the event of bankruptcy, qualified farm indebtedness and qualified real property business indebtedness.
4 In contrast, Section 108(d)(6) provides that for purposes of a partnership, Sections 108(a), (b), (c) and (g) are applied at the partner level (and not at the partnership level). As a result, the partner in an insolvent partnership is entitled to exclude COD income under Section 108(a) only if the partner is insolvent. In the case of an insolvent S corporation, in contrast, a solvent shareholder of the S corporation is permitted to exclude COD income.
5 Section 108(d)(7)(C) provides that for purposes of Section 108(e)(6), which addresses the tax consequences of contributions to capital by a shareholder of a corporation, a shareholder's adjusted basis in indebtedness of an S corporation shall be determined without regard to any adjustments made under Section 1367(b)(2).
6 Before this issue even reached the courts, the IRS issued several technical advice memoranda rejecting the taxpayer’s contention that the exclusion of COD income by an S corporation results in a basis increase that allows the taxpayer to utilize suspended losses.
7 The Court noted that this argument had been made in Winn but had not been relied upon by the IRS in Nelson or any of the circuit court arguments.
8 As discussed below, even the dissenting opinion of Justice Breyer did not accept the IRS’ primary argument.
9 If the shareholders of an S corporation have suspended losses in excess of the amount of excluded COD income, such excess losses would be subject to tax attribute reduction pursuant to Section 108(d)(7)(B).
10 The IRS abandoned the sequencing argument before the Court, although the argument had predominated in the Tenth Circuit. In oral argument, the IRS went so far as to contend that the Tenth Circuit had developed its reading of the statute sua sponte, but the Supreme Court chided that the IRS had made this argument in its briefs filed with the Tenth Circuit.
11 Justice Thomas noted that the only solvent persons who can obtain a benefit from the exclusion of COD income under Section 108(a) are the shareholders of an S corporation. However, he also noted that Congress had provided a different result from 1982 through 1984, when Section 108 provided that the exclusion from gross income and attribute reduction occurred at the shareholder level for S corporations. In 1984, however, Congress amended Section 108 to provide that such provision shall be applied at the shareholder level. The solvent taxpayers were able to benefit from this provision as a direct result of this amendment.
12 H.R. Rep. No. 103-111, pp. 624-25 (1993) ("The exclusion and basis reduction are both made at the S corporation level.")
13 Citing to H.R. Rep. No. 98-432, pt. 2, p. 1640 (1984).
14 The taxpayers had noted that Section 183 also requires that the hobby loss rules be applied "at the corporate level," but Justice Breyer noted that the language was used in a different context and, hence, could be interpreted differently.
15 Reg. § 1.1366-1(a)(2)(viii).
