Taxpayers win in Supreme Court Ruling on Excluded Discharge of Indebtedness

By Peter C. Barton

In Gitlitz v. Comm’r (SCt, 2001-1 USTC para. 50147), the U.S. Supreme Court ruled 8–1 that excluded discharge of indebtedness (DOI) income of an insolvent S corporation passes through to its shareholders, thereby increasing their stock basis and allowing them to deduct suspended losses prior to reducing the S corporation’s tax attributes. This major decision overturns the Tax Court and three of the four courts of appeals that have ruled on this issue. Given the current economic climate, Gitlitz will benefit many shareholders of the nation’s 2.3 million S corporations.

Statutory Provisions

IRC section 61(a)(12) includes DOI in gross income; however, IRC section 108(a)(1)(B) provides an exclusion to the extent the taxpayer is insolvent when the discharge occurs. Under IRC Section 108(b), the amount excluded reduces the following tax attributes of the taxpayer: any net operating loss (NOL, including carryovers), followed by certain credits, capital losses (including carryovers), and the basis of the taxpayer’s property. IRC section 108(b)(4)(A) requires that this reduction of tax attributes be made after determining the income tax for the taxable year of the discharge. Under IRC Section 108(d)(7)(A), these provisions are applied at the corporate level for an S corporation. Finally, under IRC section 108(d)(7)(B), any NOLs (including carryovers) that have passed through to the shareholders and been suspended due to insufficient basis will be treated as the S corporation’s NOL for purposes of reducing tax attributes.

Under IRC section 1366(a)(1)(A), “items of income (including tax-exempt income), loss, deduction, or credit” of an S corporation are passed through to the shareholders, who account for these items on their individual returns. IRC Sec. 1367(a) requires an increase in shareholder stock basis for these “items of income,” and a decrease for losses and deductions. Under IRC section 1366(d)(1), a shareholder cannot deduct S corporation losses and deductions in excess of the stock basis, plus any shareholder loans to the S corporation. Under IRC section 1366(d)(2), the shareholder is allowed an indefinite carryforward of any disallowed (suspended) losses.

Gitlitz in the Lower Courts

In 1991, Gitlitz and Winn were shareholders in an insolvent S corporation that excluded DOI income of $2,021,296, an amount less than its insolvency. Each increased his stock basis by his $1,010,648 share of the DOI income and used this basis increase to deduct current and suspended S corporation losses. The IRS disallowed the loss deductions, arguing that the S corporation’s excluded DOI was not an “item of income” and therefore could not be used to increase shareholder stock basis. The Tax Court initially rejected this argument [Winn v. Comm’r 73 TCM 3167 (1997)], and the shareholders prevailed. In 75 TCM 1840 (1998), the Tax Court reconsidered and adopted the IRS’s position in light of its decision in Nelson v. Comm’r [110 TC 114 (1998), aff’d 182 F3d 1152 (1999)]. In Nelson, the Tax Court ruled that the requirement that the DOI exclusion and reduction of tax attributes apply at the S corporation level prevented any pass-through of the excluded DOI to the shareholders.

The Tenth Circuit affirmed the second Winn decision in Gitlitz [182 F3d 1143 (1999)], reasoning that, although the excluded DOI could be passed through to the shareholders and thereby increase their stock basis, it must first reduce tax attributes of the S corporation. Because the S corporation’s NOL, which was calculated under IRC section 108(d)(7)(B) as explained above, fully absorbed the discharged debt, no discharged debt remained and no basis increase existed to pass through to Winn and Gitlitz. Therefore, they could not deduct their current and suspended losses. The Tenth Circuit’s reason for this ruling was to prevent a windfall for the shareholders. The Sixth and Seventh Circuits followed the Tenth Circuit’s ruling, but the Third Circuit ruled in favor of the shareholders.

The Supreme Court’s Ruling

The Supreme Court first ruled that the excluded DOI of an insolvent S corporation is an “item of income” that passes through to the shareholders and therefore increases their stock basis under the plain meaning of IRC section 108(a), which states only that the DOI is not in gross income. IRC section 108(a) is silent about DOI being an “item of income.” In addition, IRC section 1366(a)(1) clearly provides that tax-exempt income passes through to shareholders.

Finding no statutory support for the IRS’s arguments against the pass-through of the excluded DOI to the shareholders, the Court made the following additional rulings:

• The absence of an economic outlay by the shareholders for the excluded DOI does not affect its pass-through status;
• IRC section 108(d)(7)(A) does not state that the DOI provisions apply only at the corporate level; and
• Whether the excluded DOI is tax-exempt or tax-deferred is irrelevant to the IRC section 1366(a)(1) pass-through provisions.

Next, based on the explicit language of IRC section 108(b)(4)(A), the Supreme Court ruled that the DOI passes through to the shareholders before the tax attribute reductions. IRC section 108(b)(4)(A) requires the attribute reductions to be made “after the determination of the tax imposed by this chapter for the taxable year of discharge.” To determine the tax imposed, all income and loss items, including the excluded DOI, must be passed through to the shareholders, which adjust their stock basis accordingly. The shareholders can then deduct any suspended losses, up to their increase in stock basis, from all of these income and loss items. Any remaining suspended shareholder losses are then treated as the S corporation’s NOL, which is reduced by the DOI. If the NOL is less than the DOI, the other tax attributes are reduced. The Court did not state when the tax attributes would be reduced, but the Third Circuit, the only circuit clearly in accord with the Court’s opinion, interpreted IRC section 108(b)(4)(A) to require the reduction on the day after the taxable year of discharge ends [US v. Farley 202 F3d 198(2000)].

Finally, the Supreme Court answered two questions posed by the courts of appeals:

The pass-through of the DOI to the shareholders does not prevent the subsequent reduction of the tax attributes at the corporate level.
Even if the shareholders, who are not insolvent, receive a windfall by deducting their suspended losses due to the excluded DOI pass-through, the plain meaning of the relevant IRC sections permits this result. The Court could have added that the reduction of tax attributes will adversely affect the shareholders in the future.

Gitlitz allows S corporation shareholders with suspended losses to increase their stock basis and deduct their losses to the extent of the S corporation’s DOI even though the DOI is excluded due to the S corporation’s insolvency. Gitlitz is also a reminder to not read limitations into statutes. Finally, Gitlitz’s navigation through a statutory maze illustrates that tax law simplicity remains elusive.

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Peter C. Barton, JD, CPA, is a professor of accounting at the University of Wisconsin, Whitewater.Editor: Thomas W. Morris The CPA Journal

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Editor:
Thomas W. Morris
The CPA Journal

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©2009 The New York State Society of CPAs. Legal Notices