FEDERAL TAXATION

July 2000

FINAL REGULATIONS ON TREATMENT OF COD INCOME BY S CORPORATIONS

By Dennis J. Szymkowiak

Several recent tax cases continue to explore the question of whether cancellation of debt (COD) income realized by an S corporation should be passed through to the shareholders and increase the basis of their S corporation stock.

Tax Court Memorandum Decisions

In January 2000, the Tax Court decided two cases with similar fact patterns--R.T. Mullen v. Comm'r (T.C. Memo 2000-21) and R.H. Bettisworth v. Comm'r (T.C. Memo 2000-30). In each case, the S corporation realized COD income, which was excluded from taxable income under IRC section 108(a). The taxpayers (shareholders) argued that the excluded COD income should pass through as an item of tax-exempt income to the shareholders. Furthermore, the pass-through should increase the basis of the shareholders' stock in the S corporation, thereby allowing suspended loss carryovers from the S corporation to be deducted on the taxpayers' individual tax returns. The Tax Court flatly rejected the taxpayers' arguments, citing its decision in Nelson v. Comm'r (110 T.C. 114). The court indicated that the current cases were not distinguishable from Nelson and reiterated that Nelson was decided correctly.

Tax Court in Nelson

In Nelson, the Tax Court addressed the COD income issue for S corporations by thoroughly analyzing the statute and its legislative history. It ruled that excluded COD income does not pass through from the corporation to its shareholders. The holding was based, in part, on the court's interpretation of IRC section 108(d)(7)(A), which provides that the operative provisions of IRC section 108 [subsections 108(a) and 108(b)] are to be applied at the corporate level. The court believed this language was clear: It prohibited excluded COD income of an S corporation to pass through to the shareholders because such excluded income was to be determined and subjected to attribute reduction at the corporate level. Furthermore, the court ruled that excluded COD income does not fall within the meaning of tax-exempt income, as the taxpayers next argued. The court reasoned that tax-exempt income, as referenced in the S corporation basis rules, meant income permanently excluded from taxation. In this case, excluded COD income is not designed to be permanently excluded from tax but is deferred through reduced loss carryovers or reduced future depreciation deductions.

District Court in Hogue

The Tenth Circuit had previously affirmed the Nelson holding [See Gitlitz v. Comm'r (182 F. 3d 1143)]. Now the U.S. District Court for the District of Oregon has distinguished Gitlitz and has held that COD income excluded from gross income under IRC section 108(a) passes through to the shareholders of an S corporation, allowing them to increase the basis of their stock under IRC section 1367 [J.D. Hogue v. Comm'r (DC Or, 2000-1 USTC, para. 50,149)]. The district court ruled that the Tenth Circuit's analysis was not supported by the plain text of the statute; instead, the circuit court had purposely interpreted the statute to avoid a windfall for the taxpayers.

The district court's analysis of the statute in the case was similar to that of the taxpayers in Mullen and Bettisworth. That is, the court held that excluded COD income passes through to the shareholders in the year of the discharge as an item of tax-exempt income. The basis of the S corporation stock was also increased in that year under IRC section 1367. Furthermore, the increased basis allows the taxpayers to claim suspended losses. Tax attribute reduction occurs the first day of the next year at the shareholder level, if at all.

The district court indicated that the IRC is too complicated for courts to strain against the language in an effort to achieve particular results. Moreover, the court addressed the windfall issue by citing the Supreme Court in Lewyt.

Where the benefit claimed by the taxpayer is fairly within the statutory language and the construction sought is in harmony with the statute as an organic whole, the benefits will not be withheld from the taxpayer though they represent an unexpected windfall [Lewyt Corp. v. Comm'r, 349 U.S. 237-240, 75 S.Ct. 736, 739, 99 L.Ed.1029 (1955)].

Finally, the district court provided that if Congress or the IRS wishes to prevent a windfall to taxpayers, it can do so by changing the law or regulations. The district court recognized that proposed regulations (not final regulations) were issued which would preclude the taxpayers' treatment, but indicated those regulations did not apply to the tax years at issue.

Circuit Court in Farley

Finally, and most recently, the Third Circuit has also distinguished the Gitlitz and Nelson decisions (See H.D. Farley, CA-3, 2000-1 USTC para. 50,179). In Farley, the circuit court followed an analysis similar to Hogue and ruled that the language of the statute is unambiguous and requires that excluded COD income pass through to the shareholders with the concomitant tax benefits. The court directly addressed the application of IRC section 108(d)(7)(A), the provision upon which the Tax Court had heavily relied in Nelson. The circuit court held that IRC section 108(d)(7)(A) has two primary effects, neither of which prohibits the pass through of excluded COD income, as the Tax Court suggested. First, the section requires that the determination of insolvency be made at the corporate level. Second, it requires that the tax attribute reduction rules be applied at the corporate level. The court did not believe that the section prevented the pass-through of excluded COD income to the shareholders.

Final Regulations

The Treasury has just issued final regulations under IRC sections 1366, 1367, and 1368. These final regulations indicate that tax-exempt income passed through to a shareholder does not include COD income excluded under IRC section 108(a). Accordingly, the shareholder's stock basis cannot be increased and the "windfall" obtained by the taxpayers in Hogue and Farley is not available. These regulations are effective for taxable years of an S corporation beginning on or after August 18, 1998.

For tax years beginning on or after August 18, 1998, the final regulations explicitly provide that COD income of an S corporation excluded under IRC section 108 is not tax-exempt income eligible for pass-through to shareholders. Accordingly, taxpayers wishing to claim the benefits outlined in Hogue and Farley must take an undesirable return filing position contrary to the Treasury regulations. For other taxpayers not subject to the final regulations, opportunity exists for claiming the benefits outlined in Hogue, particularly outside of the Tax Court's jurisdiction. *

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