S corporation shareholders are generally entitled to increase the basis of their holdings by their share of S corporation income, including tax-exempt income. A question that has been debated for several years is whether shareholders can increase their basis if the tax-exempt income in question is cancellation-of-indebtedness (COD) income.
Mel Nelson was the sole shareholder in an S corporation with significant COD income which was nontaxable because the corporation was insolvent. Nelson increased the basis of his stock by the amount of the COD income. The IRS denied the increase and Nelson appealed.
IRC section 1367 says a shareholder can increase his or her basis in S corporation stock for items of income that are described in section 1366(a) (1)(A) and section 1366(a)(1)(B). The code says a shareholder can take into account his or her ratable share of (a) items of income, including tax-exempt income that would affect any shareholder's tax liability and (b) non-separately computed income or loss. Thus, the question is whether COD income falls into either of these categories.
IRC section 108 says COD income is taxable unless the taxpayer is insolvent or qualifies for some other limited exclusion. Section 108(d)(7) says that, for S corporations, the determination of insolvency and the exclusion of COD income should be made at the corporate level.
Result: For the IRS. In ruling on whether Nelson could adjust his basis, the Tax Court reasoned that, since the COD income is excluded at the corporate level, it is not allocable to shareholders. As a result, it cannot affect any shareholder's tax liability. Therefore, it does not fit under section 1366 and thus does not increase the shareholder's basis.
Although the court's reasoning could easily be criticized, it is likely to be upheld. A decision in the taxpayer's favor would have generated a double benefit—exclusion of current income and a basis increase that would result in either future losses or reduced gains.
CPAs should be aware of this decision because the result is different from what it would be for a partnership where COD income does increase a partner's basis. In addition, the decision could have unexpected results if the corporation was owned by two or more people. Section 108(d)(7) says that the amount of any S corporation loss that is nondeductible because of insufficient basis should be treated as a net operating loss for attribute reduction purposes. If S corporation shareholders have different starting bases, they will have different disallowed losses that will be reduced or eliminated at the corporate level. The S corporation rules have no provision to offset this unequal elimination.
- Mel T. Nelson, 110 TC no. 12 (1998).