By: Robert T. Leonard, J.D., C.P.A.
TAX LAW: The misfortunes of an insolvent S corporation can produce a considerable benefit to its Shareholders.
Call it a belated holiday present. The U.S. Supreme Court’s decision in Gitlitz v. Commissioner, 2001 Daily Journal D.A.R. 259 (Jan. 9, 2001), has preserved what the Internal Revenue Service, some lower courts and the opinion’s lone dissent, Justice Steven Breyer, have described as a “windfall” for certain taxpayers.
The “gift” presented in the Gitlitz decision was a shareholder-level basis increase for discharge-of-indebtedness income recognized by an insolvent S corporation. Thanks to this basis adjustment, solvent shareholders of an insolvent S corporation can now utilize suspended losses to offset taxable income on their personal returns or even receive refunds for taxes paid in previous years. This is despite the fact that the discharge-of-indebtedness income is not taxed at the corporate level. The misfortunes of the insolvent S corporation, thus, can produce a considerable tax benefit for its shareholders, with no economic outlay.
Sounds too good to be true? Here’s how it happened:
Gitlitz involved the unfortunate, although not infrequent, situation of a financially troubled S corporation, which had accumulated a series of operating losses before finally becoming insolvent. The two key issues presented to the court were simple enough: Is income from a discharge of corporate indebtedness an “item of income” that passes through to shareholders and increases their basis in the S corporation? And, if so, in what year must a corresponding reduction of tax attributes be made?
In other words, will taxpayers be able to utilize losses before tax-attribute-reduction rules are applied? Or, must tax attributes be reduced first, meaning that cancellation-of-debt income is offset against suspended losses at the corporate level, leaving nothing to pass through to shareholders?
The court’s answers, however, require an anything-but-simple analysis.
On its face, Internal Revenue Code Section 108 seems to offer a substantial comfort for the taxpayer. That section describes items of income that pass through to shareholders and provide that the reduction of tax attributes takes place after a determination of the S corporation’s taxes for the year in which a discharge of liabilities occurred.
In 1994 and again in 1995, however, the Internal Revenue Service issued Technical Advice Memorandums concluding that cancellation of debt wasn’t “tax-exempt” income of the sort allowed to pass through to increase shareholders’ basis. Tech. Adv. Mem. 9423003 ( Feb. 28, 1994), and Tech. Adv. Mem. 9541006 ( July 5, 1995). A spate of Tax Court decisions similarly denied taxpayers an increase in basis. See Nelson v. Commissioner, 110 T.C. 114 (1998), aff’d 182 F.3d 1152 (10 th Cir. 1999);Chesapeake Outdoor Enterprises Inc. v. Commissioner, T.C. Memo 1998-175, 75 T.C.M. (CCH) 2279 (1998).
In its decisions in Gitlitz and Nelson, the 10 th U.S. Circuit Court of Appeals used yet another variation on this analytical theme to reach the same result: that cancellation-of-debt income will pass through to the shareholders, but only after tax attributes, such as suspended losses, are reduced at the corporate level, thus effectively wiping out any basis-enhancing pass-through. See also Witzel v. Commissioner, 200 F.3d 496 (7 th Cir. 2000) (holding that suspended losses must be offset by excluded cancellation-of-debt income but that shareholder can nonetheless increase basis by amount of excluded cancellation-of-debt income).
Just a few days after the Witzel decision, however, the 3rd Circuit blazed its own path and, disagreeing with both the Tax Court and the 10 th Circuit, held in United States v. Farley, 202 F.3d 198 (3d Cir. 2000), that the plain language of Section 108 requires that tax attributes such as suspended losses, should be reduced at the corporate level only in the year following the discharge of indebtedness – after the taxpayers have already gotten a crack at the suspended losses. Other courts promptly followed Farley’slead. See Hogue v. Commissioner, 85 A.F.T.R.2d 2000-334 (D. Or. 2000); Pugh v. Commissioner, 213 F.3d 1324 (11 th Cir. 2000).
The Supreme Court granted certiorari in Gitlitz to resolve this messy split of opinion among the lower courts. The facts that brought Gitlitz all the way to the nation’s highest court were fairly simple. David Gitlitz and Philip Winn were shareholders of PDW&A Inc., a troubled S corporation with $2,032,296 of imputed income from corporate indebtedness discharged in 1991. Because the corporation was insolvent at the time the discharge occurred, the corporation properly excluded this cancellation-of-debt income on its tax return under Section 108.
Gitlitz and Winn claimed an increase in the basis of their PDW&A stock from their pro rata shares of the cancellation-of-debt income and then used this increased basis to allow them to deduct suspended and current operating losses totaling $1,010,648 each. The Internal Revenue Service denied the taxpayers’ deductions.
The Tax Court initially sided with the taxpayers, then reversed itself after the Nelson decision, holding on reconsideration that cancellation-of-debt income did not increase the taxpayers’ basis in their stock. SeeWinn v. Commissioner, 182 F.3d 1143 (10 th Cir. 1999).
In an 8-to-1 opinion, the Supreme Court in Gitlitz brusquely rejected the tax commissioner’s argument that cancellation-of-debt income to an insolvent S corporation is not an item of income subject to pass-through, stating that “[u]nder a plain reading of the statute . . . excluded discharged debt is indeed an “item of income” which passes through to the shareholders and increases their basis in the stock of the S Corporation.”
The court then poked holes in the Internal Revenue Service’s argument that cancellation-of-debt income should not be considered “income” for purposes of the pass-through provisions of Section 1366(a)(1)(A). Just because discharge of indebtedness is not includable in income for tax purposes does not mean it ceases to be an item of income, noted the court. And the Internal Revenue Service’s claimed distinction between “tax-deferred” and “tax-exempt” also did not fly. The court concluded that “the section is worded broadly enough to include any item of income.”
Finally, addressing the crucial timing issue, the court again found its answer in the plain language of the statute. “Section 108(b)(4)(A) directs that the attribute reductions ‘shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge,'” the court said.
Neatly sidestepping the policy argument of a “windfall” for taxpayers, the court added only that “the Code’s plain text permits the taxpayers here to receive these benefits.” Gitlitz presents two important tax planning opportunities for solvent shareholders of certain insolvent S corporations.
The first opportunity is in the instance when cancellation of debt has already occurred. Where the S Corporation had suspended losses and cancellation of debt, but the shareholder had not previously claimed the suspended losses because he or his representative erroneously believed (pre-Gitlitz) that he had insufficient basis, the taxpayer may be able to amend his personal returns for earlier years and claim a refund for taxes paid.
This presumes, of course, that the taxpayer recognized taxable income on his previous individual tax returns. A taxpayer in this situation should immediately file amended personal returns reflecting the flow-through of suspended losses.
There is a caution, however. The April deadline to amend 1997 returns filed in April 1998 is fast approaching. If the S corporation had cancellation of debt in 1996 or previous years, it appears too late to file amended returns.
The second type of planning opportunity is when cancellation of debt has not yet occurred. Where the S corporation has not yet realized any cancellation of debt but has suspended losses, a taxpayer may wish to negotiate with the corporation’s lenders for forgiveness of debt, encourage foreclosure on certain assets, have the S corporation file for bankruptcy or otherwise take steps to generate cancellation-of-debt income in the current tax year. If suspended losses are already in place, cancellation-of-debt income recognition will free up those suspended losses – a very valuable asset for shareholders.
It would appear advisable to structure any transaction to utilize all the suspended losses in one year, if not, the attribute-reduction rules will operate to reduce or eliminate the remaining suspended losses on the first day of the next year.
If the Gitlitz decision is a gift to certain taxpayers, it is one that should probably be opened quickly. What the Supreme Court has given, Congress can surely take away. As dissenting Justice Breyer noted, this case offers taxpayers a significant tax loophole. Practitioners should, therefore, not count on it remaining open for long.