For a number of years, taxpayers, the IRS and the courts have disagreed about the proper treatment of S corporations that have cancellation-of-debt (COD) income and are insolvent. Recently the U.S. Supreme Court ruled in a taxpayer’s favor.
David Gilitz and Philip Winn were equal shareholders in an S corporation. In 1991 the corporation realized approximately $2 million of COD income at a time when its liabilities exceeded its assets by $2.1 million. Therefore it was insolvent even after the debt cancellation. Based on IRC section 108, the corporation excluded the COD income from its gross income. Both Gilitz and Winn treated the COD income as passing through to them under IRC section 1366, resulting in an increase in the basis of their stock. Based on this increase, they deducted previously suspended losses. The IRS denied the deduction. After government victories in lower courts, Gilitz appealed to the U.S. Supreme Court.
Result. For the taxpayer. Justice Thomas delivered the Court’s opinion. He recognized there were two separate questions. First, does COD income pass through to S corporation shareholders? If the answer is yes, then the second question is, Does the attribute reduction mandated by section 108(b) occur before or after the stock basis adjustment?
Under IRC sections 61(a)(12) and 108(a), COD income is income; it simply is not included in gross income if a taxpayer is insolvent. Since section 1366(a)(1) requires all items of income to pass through to shareholders, including tax-exempt income that is excluded from gross income, COD income also passes through to shareholders. The government’s argument that COD income should be treated differently has no support in the code. Likewise, the government’s attempt to classify COD income as tax-deferred rather than tax-exempt is incorrect. Section 1366 says all income passes through to shareholders. Whether the income is exempt or deferred is irrelevant.
The second question, the order of basis increase and tax attribute reduction, is answered by section 108(b)(4) (A), which says attribute reduction takes place after the taxpayer computes his or her tax for the year. To calculate the tax, the taxpayer must calculate taxable income, which requires determining deductible losses first. Since the loss deduction depends on the stock basis, the basis adjustment must be made before the attribute reduction occurs.
In concluding his opinion, Justice Thomas said that policy issues involving double deductions and windfalls must be ignored because the “plain language” of the code dictates the outcome. The result is that COD income passes through to the shareholder, who increases his or her stock basis, claims any loss for the year or any suspended loss and then reduces any remaining loss carryover by the excluded COD income.
Gitlitz v. Commissioner, 87 AFTR2d 2001-345.
Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting
and director, MTA program,
Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.