Mel T. Nelson v. Commissioner ( 1998 )

110 T.C. No. 12UNITED STATES TAX COURT
MEL T. NELSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20811-95. Filed February 19, 1998.
Petitioner was the sole shareholder of M, an S
corporation. In the 1991 taxable year, M was
insolvent. In that year, M disposed of all of its
assets and realized discharge of indebtedness income
pursuant to sec. 61(a)(12), I.R.C. In accordance with
sec. 108(a), I.R.C., M excluded from gross income the
entire amount of the discharge of indebtedness income.
Sec. 108(a), I.R.C., excludes from gross income,
discharge of indebtedness income if, inter alia, the
taxpayer is insolvent.
In the same year, petitioner increased the basis
of his stock in M. Later, petitioner disposed of the
stock. In turn, petitioner reported a long-term
capital loss on his 1991 Federal income tax return. R
disallowed a portion of the claimed long-term capital
loss on the premise that sec. 108(d)(7)(A), I.R.C., did
not permit an increase in petitioner's basis in M
stock. Sec. 108(d)(7)(A), I.R.C., provides that the
discharge of indebtedness income exclusion from gross
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income operates, for purposes of subchapter S, at the
corporate level.
1. Held: In deciding whether petitioner may
increase his basis in the corporate stock, sec.
108(d)(7)(A), I.R.C., applies.
2. Held, further, sec. 108(d)(7)(A), I.R.C.,
precludes the application of the conduit rules of
subchapter S.
3. Held, further, petitioner may not increase his
basis in M stock to reflect discharge of indebtedness
income realized by M.
Neil M. Goff, for petitioner.
Virginia L. Hamilton, for respondent.
HAMBLEN, Judge: Respondent determined a deficiency of
$69,381 in petitioner's 1991 Federal income tax. After
concessions, the principal issue for decision is whether
discharge of indebtedness income realized and excluded from gross
income under section 108(a)1 passes through to shareholders of a
subchapter S corporation as an item of income in accordance with
section 1366(a)(1)(A) and, in turn, increases the basis of the
corporate stock under section 1367.2
1
All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
2
Petitioner conceded (1) respondent's reduction of a long-
term capital loss from a Metro Auto-Pico transaction by $10,000,
and (2) respondent's reduction of allowable passive losses from
Western United Service Corp., and Arapahoe Service Corp., by
(continued...)
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FINDINGS OF FACT
This case was submitted fully stipulated pursuant to Rule
122. The stipulation of facts is incorporated herein and found
accordingly. Petitioner, Mel T. Nelson, resided in Denver,
Colorado, at the time he filed the petition herein. Petitioner
was the sole shareholder in Metro Auto, Inc. (MAI), an S
corporation.
During the 1991 taxable year, MAI disposed of all of its
assets. In the same year, MAI realized discharge of indebtedness
income, pursuant to section 61(a)(12), in the amount of
$2,030,568 as a result of the disposition and a related agreement
between MAI and its creditors.3 In turn, the COD income of
$2,030,568 exceeded MAI's losses by $1,375,790 in 1991. Prior
and subsequent to the event giving rise to the COD income, MAI
was insolvent. MAI excluded from its gross income the entire
amount of the indebtedness discharged by its creditors.
Petitioner increased the basis of his stock in MAI by
$1,375,790 in 1991. Subsequently, petitioner disposed of his
stock in MAI and, in turn, claimed a long-term capital loss on
2
(...continued)
$54,275, thereby increasing petitioner's taxable income by
$54,275.
3
Discharge of indebtedness is also referred to as
cancellation of debt income (COD). For purposes of convenience
and clarity in this opinion, we refer to the income generated
from the discharge of indebtedness pursuant to sec. 61(a)(12) as
COD.
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his 1991 Federal income tax return in the amount of $2,403,996.
Respondent denied $1,375,790 of the loss on the premise that
petitioner lacked sufficient basis in his MAI stock.
Ultimate Conclusion
We hold that COD income that is excluded from gross income
under section 108(a) does not pass through to a shareholder of an
S corporation. Therefore, shareholder basis is not increased.
OPINION
In the instant case, the principal controversy is whether
petitioner is entitled to increase the basis in his S corporation
stock pursuant to section 1366(a)(1) by his pro rata share of COD
income. This issue is a question of law. Babin v. Commissioner,
23 F.3d 1032, 1034 (6th Cir. 1994), affg. T.C. Memo. 1992-673.
Section 61 requires that certain amounts be included in
income. Absent any exclusionary provision, items of income are
included in gross income. Sec. 61(a). Section 61(a)(12)
includes COD income in gross income. See also United States v.
Kirby Lumber Co., 284 U.S. 1 (1931). Sections 101 through 135
exclude specific items of income from gross income. In
particular, section 108(a)(1) provides, in pertinent part, that a
taxpayer is permitted to exclude COD income to the extent that a
taxpayer is insolvent when the discharge of indebtedness occurs.
Section 108(d)(3) defines "insolvency" for this purpose as the
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excess of liabilities over the fair market value of the assets,
immediately before the discharge.
There is, however, a condition for the exclusion of COD
income. Section 108(b)(1) requires the taxpayer to reduce
certain tax attributes by the amount of the debt discharged. In
particular, section 108(b)(2) enumerates the tax attributes to be
reduced and the order in which they are reduced: (1) Net
operating losses; (2) general business credits; (3) capital loss
carryovers; (4) basis reduction; and (5) foreign tax credit
carryovers. Section 108(b)(4)(A) governs the timing of those
reductions, requiring that the reductions be made "after the
determination of the tax imposed by [chapter 1 of the Code] for
the taxable year of the discharge." Thus, the tax attributes are
reduced as of the first day of the following tax year.
Section 108(d)(7) prescribes how section 108(a) and (b) are
applied to S corporations. Section 108(d)(7) provides in
pertinent part:
(A) * * *[Certain provisions] to be * * * applied at
corporate level.--In the case of an S corporation,
subsections (a) [and] (b) * * * shall be applied at the
corporate level.
(B) Reduction in carryover of disallowed losses
and deductions.--In the case of an S corporation, for
purposes of subparagraph (A) of subsection (b)(2), any
loss or deduction which is disallowed for the taxable
year of the discharge under section 1366(d)(1) shall be
treated as a net operating loss for such taxable year.
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Section 1366(a) provides, generally, that income, losses,
deductions, and credits are passed through pro rata to
shareholders on their individual income tax returns. Secs.
1363(a), 1366(a). Section 1366(b) provides that the character of
each item of income is determined as if it were realized directly
from the source from which the corporation realized it, or
incurred in the same manner as the corporation. A shareholder's
gross income includes a pro rata share of the subchapter S
corporation's gross income. Sec. 1366(c). The shareholder’s
basis, once computed, limits the amount of losses and deductions
that may be taken into account by a shareholder for the taxable
year. Sec. 1366(d). Any losses and deduction that the
shareholder is not entitled to deduct currently are carried
forward indefinitely (suspended losses). Id.Section 1367(a)(1) limits the items by which the shareholder
may increase his basis in the stock of an S corporation to the
following items, inter alia:
(A) the items of income described in subparagraph (A)
of section 1366(a)(1), [and]
(B) any nonseparately computed income determined under
subparagraph (B) of section 1366(a)(1) * * *
Section 1367(b)(1) provides that an item "required to be included
in the gross income of a shareholder and shown on his return" is
taken into account under section 1367(a)(1)(A) only to the extent
included in gross income on the shareholder's return, increased
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or decreased by any adjustment of the item of income in a
redetermination of the shareholder's income tax liability.
During the 1991 taxable year, there were no regulations
addressing the application of either section 1366(a)(1)(A) or
section 1367(a)(1)(A). However, the legislative history provides
guidance with respect to section 1366:
The following examples illustrate the operation of
the bill's pass through rules.
* * * * * * *
d. Tax-exempt interest--Tax-exempt interest will pass
through to the shareholders as such and will increase the
shareholders' basis in their subchapter S stock. Subsequent
distributions by a corporation will not result in taxation
of the tax-exempt income. [S. Rept. 97-640, at 15-16
(1982), 1982-2 C.B. 718, 725.]
The Subchapter S Revision Act of 1982 (1982 Act), Pub. L. 97-354,
96 Stat. 1669, enacted section 1367(a) and defined "items of
income" by reference to section 1366(a)(1)(A), which refers to
"items of income (including tax-exempt income) * * * the separate
treatment of which could affect the liability for tax of any
shareholder". The Senate Finance Committee report accompanying
the 1982 Act, S. Rept. 97-640, supra at 18, 1982-2 C.B. at 726,
further explains:
3. Basis adjustment (sec. 1367)
Under the bill, both taxable and nontaxable income
will serve * * * to increase * * * a subchapter S
shareholder's basis in the stock of the corporation.
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Moreover, the legislative history states, generally, that the
basis adjustment rules are analogous to those provided for
partnerships under section 705 and require that the basis of a
shareholder in an S corporation will be adjusted for income and
losses for any corporate tax year before the distribution rules
apply for that year.
In the instant case, the parties agree that MAI realized COD
income in the amount of $2,030,568 in the taxable year 1991.
Moreover, the parties concur that MAI was insolvent at the time
the debt was discharged and that the attendant income derived
therefrom is excludable from gross income pursuant to section
108(a)(1)(B) and (d)(7). The parties separate, however, on
whether the Internal Revenue Code permits petitioner to increase
the basis of his MAI stock by the amount of the S corporation's
COD income.
In essence, petitioner argues that the excluded COD income
is described in section 1366(a)(1)(A) because it could affect his
income tax liability if it were treated as a pass-through item of
income. In particular, petitioner contends that COD income
excluded under section 108(a) is "tax-exempt" income under
sections 1366(a) and 1367(a). Thus, petitioner argues that after
the amounts are passed through, he is entitled to a basis
increase with respect to his MAI stock for the excluded COD
income. In sum, petitioner argues that the issue turns on
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whether COD income is an item of income (tax-exempt) that passes
through to the S corporation shareholders under section
1366(a)(1)(A) as a separately stated item of income. If it is,
petitioner contends that it results in a basis increase.
Conversely, respondent argues that the excluded COD income
does not pass through to petitioner as the sole shareholder of
MAI under section 1366(a)(1)(A). Specifically, respondent states
that the literal language of section 108(d)(7)(A) provides that
the exclusion will apply at the S corporation level. Thus,
respondent contends that petitioner must apply the reduction in
tax attributes under section 108(b) on the corporate level. In
other words, respondent argues that the COD income never flows
through to petitioner. This, in effect, precludes an increase in
basis for petitioner as the shareholder of the S corporation.
Therefore, we examine the juxtaposition of the subchapter S
provisions and section 108 to determine whether an S corporation
shareholder's basis in stock may be increased by the amount of
COD income derived by the insolvent corporation. We agree with
respondent.
Here, the express language of the subchapter S regime
provides that the determination of a shareholder's income tax
liability requires that the shareholder must take into account
his pro rata share of the corporation's "items of income
(including tax-exempt income), loss, deduction, or credit the
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separate treatment of which could affect the liability for tax of
any shareholder". Sec. 1366(a)(1)(A).4 Moreover, the subchapter
S regime incorporates all "nonseparately computed income or
losses". Sec. 1366(a)(1)(B). Under section 1367(a)(1)(A),
income that is enumerated in section 1366(a)(1)(A) increases a
shareholder's basis in a subchapter S corporation's stock.
Section 1366(f), however, specifies exceptions to the overall
statutory scheme, none of which is implicated here.
The parties' dispute herein centers on the language in
section 108(d)(7)(A). Specifically, the parties differ on the
precise meaning of the phrase, "In the case of an S corporation,
* * * [section 108] shall be applied at the corporate level."
Sec. 108(d)(7)(A). Respondent argues that section 108(d)(7)(A)
represents an adjustment and/or exception to the principles
underlying the subchapter S provisions that items of income
realized or recognized at the corporate level are passed through
to the shareholders. On the other hand, petitioner contends that
section 108(d)(7)(A) stands for the proposition that prior to the
determination of an individual shareholder's income tax
liability, the S corporation must be ascertained to be insolvent.
4
This Court addressed facts similar to those found in the
instant case when we ruled on cross-motions for summary judgment
in Winn v. Commissioner, T.C. Memo. 1997-286. The Winn case has
been withdrawn in accordance with T.C. Memo. 1998-71 released
this date.
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Petitioner, in effect, argues that the result of the
interaction between section 108(d)(7)(B) and (b)(2), as governed
by section 108(b)(4), is to apply the attribute reduction rules
of section 108(b)(2) at the shareholder level. Section 108(b)(4)
states that the reduction in tax attributes will be made "after
the determination of the tax imposed * * * for the taxable year
of the discharge." (Emphasis added.) Next, petitioner points
out that "suspended losses" under section 1366(d)(1)-(3) are
deemed to be net operating losses. Sec. 108(d)(7)(B). Stated in
a different manner, the "suspended losses" of section 1366(d)(1)
constitute a tax attribute to be reduced pursuant to section
108(b)(2). Such "suspended losses" are determined at the
shareholder level. Sec. 1366(d)(1). Consequently, petitioner
extrapolates that the reduction in tax attributes occurs on the
shareholder level. Similarly, petitioner reasons that COD income
excluded under section 108(a)(1) passes through to the
shareholder, increases his or her stock basis, and thus affects
his or her "suspended losses" under section 1366(d). According
to petitioner, all of this occurs at the shareholder level, prior
to the reduction in tax attributes under section 108(b)(2).
Accordingly, in order for petitioner to prevail in this
matter, the COD income otherwise excluded from gross income must
pass through the corporate form and be apportioned on a pro rata
basis among the subchapter S shareholders. We disagree with
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petitioner's statutory approach with respect to the COD income
exclusion provision because it is simply not plausible. In this
instance, section 108(d)(7)(A) explicitly provides that the COD
income exclusion operates, for purposes of the subchapter S
regime, on the corporate level. Absent any legislative
indication to the contrary, we are required to apply the
provision as we find it in accordance with its plain meaning.
United States v. American Trucking Associations, 310 U.S. 534,
543-544 (1940).
In that regard, it is well established that a specific
statutory provision will override a general provision. Bulova
Watch Co. v. United States, 365 U.S. 753 (1961); D. Ginsberg &
Sons, Inc. v. Popkin, 285 U.S. 204, 208 (1932). Hence, we
believe that section 108(d)(7)(A) regulates the treatment of
excluded COD income in the context of the subchapter S regime
(i.e., sections 1363(a), 1366(a), and 1367(a)). In the same
vein, the exceptions delineated in section 1366(f) are not
material or applicable since they do not implement the COD income
exclusion in the context of the subchapter S regime.
The literal language at issue here provides that the
reduction in tax attributes applies at the corporate level. Sec.
108(d)(7)(A). We do not interpret section 108(d)(7)(A) in a
narrow manner. Here, we construe the provision to mandate that
insolvency is determined--and COD income is excluded from gross
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income of an S corporation under section 108(a)--at the corporate
level.
Having construed the literal language of the statute, we
find our construction of the statute confirmed by a proper view
of the statute in the overall statutory scheme. King v. St.
Vincent's Hosp., 502 U.S. 215, 221 (1991); Norfolk S. Corp. v.
Commissioner, 104 T.C. 13, 40, supplemented by 104 T.C. 417(1995). In that regard, petitioner's argument is undermined by
section 1366(b) which provides that the character of any item
included under section 1366(a)(1)(A) is determined "as if such
item were realized directly from the source from which realized
by the corporation, or incurred in the same manner as incurred by
the corporation." Consequently, we construe section
1366(a)(1)(A) in combination with section 108(d)(7)(A) to
preclude excluded COD income from recognition at the shareholder
level. Thus, since excludable COD income of an insolvent S
corporation does not pass through to the shareholders under
section 1366(a)(1)(A), it, therefore, cannot increase the basis
of their stock under section 1367(a)(1)(A).
Moreover, we note that section 108(d)(6) provides that, in
the case of a partnership, the COD income exclusion will be
applied at the partner level. Stated in a different manner, COD
income realized by the partnership may result in different
outcomes depending upon the financial position of each partner;
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i.e., insolvent or bankrupt. In contrast, the COD income
exclusion is determined at the corporate level for purposes of an
S corporation. Sec. 108(d)(7)(A).
Section 108(d)(6) permits the inference that Congress
intended to decouple the treatment of the COD income exclusion
with respect to partnerships and S corporations. Prior to
amendment in 1984, section 108(d) provided that, like
partnerships, section 108 applied to S corporations at the owner,
not the entity, level. The legislative history of the 1984
amendments to section 108(d)(7)(A) states:
In order to treat all shareholders in the same manner,
the bill provides that the exclusion of income arising
from the discharge of indebtedness and the
corresponding reductions in tax attributes (including
losses which are not allowed by reason of any
shareholder's basis limitation) are made at the
corporate level. [H. Rept. 98-432, at 1019 (1984.]
Consequently, we believe that Congress intended to preclude the
separate treatment and/or outcomes for S corporation shareholders
as opposed to the approach delineated in section 108(d)(6).5
That method is consistent with the application of the COD income
exclusion at the corporate level. In other words, if Congress
had intended a step-up in basis to accompany the recognition of
5
Arguably, the statutory design reflects that the
shareholders of an S corporation are generally not entitled to
include in their basis for the stock of the corporation their
share of the corporation's indebtedness to third parties. Estate
of Leavitt v. Commissioner, 90 T.C. 206 (1988), affd. 875 F.2d
420 (4th Cir. 1989).
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excluded COD income at the shareholder level, it would have
provided for statutory language reaching that result.
Furthermore, the ordering rules provide that the income tax
liability for the taxable year of the COD income is determined
prior to the reduction in tax attributes. Sec. 108(b)(4)(A).
The parties have not cited, and we do not find, authority
addressing the mechanism of section 108(b)(4)(A). Petitioner
asserts that the reductions in tax attributes in section
108(b)(2) are made after the determination of the tax imposed for
the taxable year of the discharge. In other words, the income
tax liability of an S corporation and its shareholders must be
determined first, and only after such liability is determined can
the attributes (including losses suspended under section 1366(d))
be reduced. On the other hand, respondent evidently contends
that the "suspended losses" of section 1366(d)(1) should be
reduced at the S corporation level before the income tax
liability of the shareholder is determined. Thus, respondent
argues that the losses of the S corporation must be eliminated
under section 108(b)(2).
We are not persuaded by petitioner's argument in this
regard. Here, there is nothing in the statutory language which
compels excluded COD income to be included in the calculations
for an S corporation shareholder's income tax liability. Also,
section 108(b)(4)(A) states that the reduction of the tax
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attributes occurs after the determination of the tax imposed for
"the taxable year of the discharge." Because section 108(b)
applies at the corporate level, we believe that the phrase
"taxable year of the discharge" refers to the taxable year of the
S corporation. Consequently, the S corporation reduces its tax
attributes by the amount excluded from gross income pursuant to
section 108(a) at the end of the corporation's taxable year.
Petitioner suggests that section 108(d)(7)(B) indirectly
applies the reduction in tax attributes delineated in section
108(b)(2) at the shareholder level. Thus, petitioner argues that
section 108(d)(7)(A) similarly permits the passthrough of the
excluded COD income. We do not agree. The language denominated
in section 108(d)(7)(B) is fairly explicit. It provides, in
pertinent part, that the "suspended losses" of section 1366(d)
are deemed to be net operating losses.
As noted, we construe section 108 as mandating the
determination of an S corporation shareholder's income tax
liability for the taxable year without reference to the excluded
COD income. In the process, the shareholder must ascertain the
amount and extent of any "suspended losses".6 Sec. 1366(d)(1).
6
The losses incurred by an S corp. are passed through to the
shareholders pursuant to sec. 1366(a)(1) and may be claimed by
the shareholders to the extent of their adjusted bases in the
corporate stock. In the event these losses exceed a
shareholder's adjusted basis, the losses are "suspended" and may
be carried over indefinitely pursuant to sec. 1366(d).
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After such determination, the "suspended losses" are carried to
the corporate level pursuant to section 108(d)(7)(A), and
converted to net operating losses pursuant to section
108(d)(7)(B). Thus, the remaining "suspended losses" under
section 1366(d) are deemed to be a tax attribute subject to
reduction pursuant to section 108(b). Sec. 108(b)(2)(A). In
short, the fact that the "suspended losses" are determined on the
shareholder level pursuant to section 1366(d), without more,
simply does not denote that the conversion and subsequent
reduction are performed on the same level.
Consequently, we do not interpret section 108(d)(7)(B) as an
explicit recognition by the Congress that excluded COD income is
included in the computation of a shareholder's income tax
liability and the subsequent calculation of the "suspended
losses" of section 1366(d)(1), nor that section 108(d)(7)(A),
through a parallel mechanism, requires that COD income derived by
an insolvent S corporation pass through to its shareholders.
In our view, petitioner has focused his analysis too
narrowly in construing the subchapter S provisions in the context
of the COD income exclusion. In particular, petitioner asserts
that COD income is "tax-exempt" income within the meaning of
sections 1366(a)(1)(A) and 1367(a)(1)(A). Consequently,
petitioner contends that he is required to take account of the
excluded COD income at the shareholder level. In that vein,
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petitioner attempts to correlate the exclusion from gross income
pursuant to section 108 with an item of income that is "tax-
exempt" pursuant to section 1366(a)(1)(A), e.g., sections 101(a)
(insurance proceeds in excess of premiums paid not subject to
taxation), 103(a) (State and local bond interest not subject to
taxation), 111(a) (no tax imposed on income arising from the
recovery of any amount deducted in prior years to the extent that
such income did not produce a tax benefit). In effect,
petitioner argues that the COD income otherwise excluded from
gross income is mandated by statute (sections 1366(a)(1)(A) and
1367(a)(1)(A)) to pass through to the S corporation shareholders.
On the other hand, respondent argues that the COD income
exclusion is tax-deferred, rather than permanently tax-exempt.
There is no definition of "tax-exempt" for purposes of
sections 1366 and 1367. The word "exclusion", however, has been
generally defined to mean the act of excluding or the state of
being excluded. Webster's II New Riverside University Dictionary
450 (1984). In turn, "exclude" is defined as to keep out, or to
omit from consideration, and disregard. Id. An exclusion that
is subject to an offset (the tax attribute reductions) and may be
subject to taxation in the future (that is, excluded from gross
income for the taxable year) does not signify or indicate an item
of income that is necessarily tax exempt on a permanent basis.
In contrast, the language in section 103(a) expressly delineates
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that gross income does not include income derived from interest
paid on any State or local bond. See also Cotton States
Fertilizer Co. v. Commissioner, 28 T.C. 1169, 1172-1173
(1957)(discussion of "wholly exempt" from tax versus postponement
of tax).
Moreover, the legislative history with respect to section
108 manifests an intention to "insure that the debt discharge
amount eventually will result in ordinary income". S. Rept. 96-
1035, at 11 (1980), 1980-2 C.B. 620, 625. Finally, the U.S.
Supreme Court observed in United States v. Centennial Sav. Bank,
499 U.S. 573, 580 (1991):
The effect of section 108 is not genuinely to exempt
such income from taxation, but rather to defer the
payment of the tax by reducing the taxpayer's annual
depreciation deductions or by increasing the size of
taxable gains upon ultimate disposition of the reduced-
basis property.
In short, section 108 is not designed or intended to be a
permanent exemption from tax. We, therefore, reject petitioner's
argument that excluded COD income is "tax-exempt" pursuant to
section 1366(a)(1)(A) and, thus, is statutorily required to pass
through to the S corporation shareholders.
Next, petitioner cites CSI Hydrostatic Testers, Inc. v.
Commissioner, 103 T.C. 398 (1994), affd. per curiam 62 F.3d 136(5th Cir. 1995), as being analogous and dispositive of this case.
However, we find the citation to be inapposite. The issue in CSI
Hydrostatic Testers, Inc. v. Commissioner, supra, entailed the
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effect of COD income excluded under section 108 upon the earnings
and profits of a subsidiary corporation for purposes of sec.
1.1502-32, Income Tax Regs. for the 1987 taxable year. We held
in that case that COD income had to be included in the corporate
taxpayer's subsidiary's earnings and profits for purposes of the
investment basis adjustment rules of section 1.1502-32, Income
Tax Regs. Accordingly, CSI Hydrostatic Testers, Inc. v.
Commissioner, supra, was decided within the context of the
consolidated return regulations as applicable to the subchapter C
corporations. We observed:
We find nothing in sections 1.1502-32 and 1.1502-19,
Income Tax Regs., which prevents the application of
section 312(l) when calculating a subsidiary's earnings
and profits for the purpose of either the investment
basis adjustment rules or the requirement that the
balance of an excess loss account be included in a
parent corporation's income when its subsidiary becomes
insolvent. Consequently, COD income is included in a
subsidiary's earnings and profits for purposes of
computing the parent corporation's balance in its
excess loss account in the stock of its subsidiary
under section 1.1502-19, Income Tax Regs. [Id. at 411.]
In other words, we concluded that a specific provision in the
Internal Revenue Code (section 312(l)) served to increase the
earnings and profits of the subsidiary and resulted in a
reduction or decrease in the parent corporation's income tax
liability. Here, there is no express support for the proposition
that the COD income must pass through to the shareholders of an S
corporation. In that regard, section 108(d)(7)(A) is the
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applicable provision here and, thus, we must apply it as written.
CSI Hydrostatic Testers, Inc. v. Commissioner, supra; Wyman-
Gordon Co. v. Commissioner, 89 T.C. 207 (1987).
Accordingly, there is nothing in the foregoing statutory
language that requires or even implies that the COD income passes
through to the S corporation shareholders. Hence, we do not
conclude from a literal application of the relevant statutory
provisions that a shareholder in an insolvent S corporation may
increase his or her basis in stock with respect to the excluded
COD income.
It is appropriate, however, to examine the legislative
history for further evidence of the legislative purposes. United
States v. American Trucking Associations, 310 U.S. at 543-544.
We look to the statute as written by the legislators, and we
consult the statute's legislative history to learn its intended
purpose and to resolve ambiguity in the words used therein.
Landgraf v. USI Film Prods., 511 U.S. 244 (1994); Garcia v.
United States, 469 U.S. 70, 76 n.3 (1984); Consumer Prod. Safety
Commn. v. GTE Sylvania, Inc., 447 U.S. 102, 108 (1980). Finally,
exemptions from taxation cannot rest on "mere implications".
United States v. Stewart, 311 U.S. 60, 71 (1940).
With these general principles in mind, we examine the
legislative history and purpose of section 108. Initially, the
insolvency exception was a judicially created doctrine. See,
- 22 -
e.g., Fifth Ave.-Fourteenth St. Corp. v. Commissioner, 147 F.2d
453, 457 (2d Cir. 1945); Dallas Transfer & Terminal Warehouse Co.
v. Commissioner, 70 F.2d 95, 96 (5th Cir. 1934); Mertens, Law of
Federal Income Taxation, sec. 11.42 (rev. 1990). Section 108
codified the judicially created insolvency exception as an
exclusion. Merkel v. Commissioner, 109 T.C. _____ (1997); Estate
of Delman v. Commissioner, 73 T.C. 15, 32 (1979). Section 108
was enacted by the Bankruptcy Tax Act of 1980, Pub. L. 96-589,
sec. 2, 94 Stat. 3389-3394; see also S. Rept. 96-1035, supra at
10, 1980-2 C.B. at 624. Section 108 was "intended to accommodate
both bankruptcy policy and tax policy." S. Rept. 96-1035, supra
at 10, 1980-2 C.B. at 624. The legislative history illustrates
that Congress did not want an insolvent or bankrupt debtor to be
"burdened with an immediate tax liability". Id. at 10, 1980-2
C.B. at 624. Also, Congress devised the statute to defer, and
eventually collect within a reasonable period, "tax on, ordinary
income realized from debt discharge." S. Rept. 96-1035, supra at
10, 1980-2 C.B. at 625. Thus, in effect, Congress established
the tax-deferral mechanism in section 108 so that the prospect of
immediate tax liability would not deter businesses from taking
advantage of opportunities to repurchase or liquidate their debts
at less than face value. H. Rept. 855, 76th Cong., 1st Sess. 5
(1939), 1939-2 C.B. 504, 507; S. Rept. 1631, 77th Cong. 2d Sess.
77-78 (1942), 1942-2 C.B. 504, 564. United States v. Centennial
- 23 -
Sav. Bank, 499 U.S. at 582-583. Accordingly, section 108 was
enacted to reduce the possibility of permanent deferral by
requiring the excluded income to be applied against the basis of
depreciable assets, net operating losses, capital loss
carryovers, and tax credits.
In light of the relatively sparse legislative history that
bears on the issue before us, we must construe what we can to
form a proper perspective and provide a definitive answer to this
anomalous situation. Here, petitioner has not borne an economic
cost. On the contrary, it would appear that the economic cost
was to others, the creditors of the corporation. Nor has
petitioner made an economic outlay. Section 108 allows an
insolvent S corporation to receive COD income sheltered from
immediate taxation to its shareholders. To permit petitioner to
increase basis in the stock of the corporation on account of such
tax-deferred income would produce a windfall to him.
The legislative history further illustrates that once a
taxpayer reduces its tax attributes pursuant to section
108(b)(2), "Any further remaining debt discharge * * * does not
result in income or have other tax consequences." S. Rept. 96-
1035, supra at 2, 1980-2 C.B. at 620-621. We conclude from the
foregoing language that Congress did not intend for the taxpayer
to have any further tax consequences, either favorable or
unfavorable, from the COD income subsequent to the reduction in
- 24 -
tax attributes. In particular, to the extent that COD income
exceeds the tax attributes that are reduced, or if there are no
attributes to reduce, such "excess" income does not go through
the corporate form to the subchapter S shareholders, pursuant to
section 1366(a)(1)(A). In this instance, we believe that the
relevant legislative history precludes an increase (or decrease)
in basis since this represents, in effect, a tax consequence. S.
Rept. 96-1035, supra at 2, 1980-2 C.B. 620-621.
Furthermore, we reject petitioner's contention that the
exclusion for income from the discharge of qualified real
property business indebtedness in section 108(a)(1)(D) is, in
effect, an ex post facto exception to the general design of
section 108 in which COD income with respect to an insolvent S
corporation passes through to the individual shareholders. The
legislative history with respect to section 108(a)(1)(D)
clarifies that the exclusion and basis reduction are both made at
the S corporation level. H. Rept. 103-111, at 624-625 (1993),
1993-3 C.B. 167, 200-201. Moreover, the committee report states
that "the provision simply defers income to the shareholders."
Id. at 625, 1933-3 C.B. at 201. We believe that the committee
report does not indicate a congressional understanding that
section 108 generally provides that the S corporation
shareholders' bases in their stock are adjusted by the otherwise
excluded COD income.
- 25 -
Finally, the Supreme Court has repeatedly held that
exemptions as well as deductions are a matter of legislative
grace, and that a taxpayer seeking either must demonstrate that
he comes squarely within the terms of the law conferring the
benefit sought.7 Bingler v. Johnson, 394 U.S. 741, 751-752
(1969); Commissioner v. Jacobson, 336 U.S. 28, 48-49 (1949);
United States v. Stewart, 311 U.S. at 71; Helvering v. Northwest
Steel Rolling Mills, 311 U.S. 46, 49 (1940); New Colonial Ice Co.
v. Helvering, 292 U.S. 435, 440 (1934). In that vein, we have
sustained and applied this proposition. See, e.g., Nelson v.
Commissioner, 30 T.C. 1151, 1154 (1958).
In this instance, borrowed funds are excluded from income in
the first instance because the corporation's obligation to repay
the funds offsets any increase in the corporation's assets; if
7
The Supreme Court, over a century ago, observed:
These cases show the principle upon which is
founded the rule that a claim for exemption from
taxation must be clearly made out. Taxes being the
sole means by which sovereignties can maintain their
existence, any claim on the part of any one to be
exempt from the full payment of his share of taxes on
any portion of his property must on that account be
clearly defined and founded upon plain language. There
must be no doubt or ambiguity in the language used upon
which the claim to the exemption is founded. It has
been said that a well-founded doubt is fatal to the
claim; no implication will be indulged in for the
purpose of construing the language used as giving the
claim for exemption where such claim is not founded
upon the plain and clearly expressed intention of the
taxing power. [Bank of Commerce v. Tennessee, 161 U.S.
134, 146 (1896).]
- 26 -
the corporation is thereafter released from its obligation to
repay, it will enjoy a net increase in assets equal to the
forgiven portion of the debt, and the basis for the original
exclusion thus evaporates. See Commissioner v. Tufts, 461 U.S.
300, 307, 310-311 n.11 (1983); Commissioner v. Jacobson, supra at
38; United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931).
Here, we note that petitioner's construction of section 108
permits him to increase his basis in stock despite the absorption
and/or elimination of the enumerated tax attributes which is the
"cost" of excluding COD income from gross income. Petitioner's
statutory approach, in effect, vitiates the general Congressional
design of subjecting income in the indefinite future to taxation.
See S. Rept. 96-1035, supra at 11, 1980-2 C.B. 625.8 Similarly,
in the partnership context and prior to the enactment of the
provision at issue here, we have observed that an increase in
basis is allowable when COD income is actually recognized, and no
basis increase is warranted when application of the insolvency
exception prevents such recognition. Babin v. Commissioner, 23
8
We also note that in order for a shareholder to increase
the basis in his or her stock, or in the S corporation
shareholder's adjusted basis derived and apportioned from the
indebtedness owed by the corporation itself, to absorb deductions
or losses, the shareholder must make a genuine economic outlay.
See Uri v. Commissioner, 949 F.2d 371 (10th Cir. 1991), affg.
T.C. Memo. 1989-58; see also Hitchens v. Commissioner, 103 T.C.
711, 715 (1994). In this instance, petitioner has not made a
genuine economic outlay.
- 27 -
F.3d at 1034; Gershkowitz v. Commissioner, 88 T.C. 984, 1009
(1987).
Thus, we decline to adopt petitioner's construction which,
essentially, grants him an unwarranted benefit in addition to the
exclusion from gross income for an insolvent S corporation. We
believe that our construction is narrowly drawn and consistent
with the statutory design and intent. Nelson v. Commissioner,
supra at 1154.
Accordingly, we hold that an S corporation shareholder may
not increase basis in stock due to excluded COD income.
To reflect the foregoing,
Decision will be entered
under Rule 155.
Reviewed by the Court.
COHEN, CHABOT, SWIFT, JACOBS, GERBER, WELLS, RUWE, CHIECHI,
LARO, VASQUEZ, and GALE, JJ., agree with this majority opinion.
BEGHE, J., concurring: I concur in the ultimate conclusion
of the majority opinion and the part of it that Judge Foley
agrees with, that a straightforward inquiry under section 108
suffices to produce the conclusion. No extended exegesis to
determine the character of COD of an insolvent S corporation as
“tax-exempt income”, as “deferred income”, or as an unrealized
“tax nothing” is needed.
- 28 -
Applying the maxim that “superfluity does not vitiate”,1
I therefore concur in more than the “result only” of the majority
opinion, even though I don’t join it because I don’t adopt
everything it says. By a parity of reasoning, I don’t join Judge
Foley’s “concurring in result only” opinion--even though I fully
agree with his text--because of his restrictive description of
what he’s concurring in.
I.
Section 108(a) provides that gross income does not include
COD of an insolvent (or bankrupt) taxpayer. Section 108(d)(7)(A)
provides that, in the case of an S corporation, subsections (a)
and (b) of section 108 “shall be applied at the corporate level.”
Section 108 is properly interpreted in a way that prevents a
basis step-up in the stock of an S corporation on account of COD
excluded from gross income by section 108(a). To interpret
section 108 to the contrary would deprive the S corporation
corporate level attribute reduction scheme of any consequence.
Following the approach to statutory construction that favors
the reading of an ambiguous provision so as to avoid an illogical
result that is inconsistent with the larger statutory scheme of
which the provision is a part, I join the majority and Judge
Foley in reading section 108(d)(7)(A) as an exception to the
normal S corporation passthrough regime. Section 108(d)(7)(A)
1
See, e.g., Cal. Civ. Code, sec. 3537 (West 1997).
- 29 -
traps the excluded COD of an S corporation at the corporate level
in a mode similar to the corporate level rules of sections 1374
and 1375 regarding built-in gains and excess net passive income.
Petitioner argues that the only function of section
108(d)(7)(A) is to determine the character of COD as excludable
or not at the corporate level and that it’s then passed through
to the shareholders under the general passthrough regime of
subchapter S. As has been observed, see Blanchard, “Debunking a
Shibboleth”, 58 Tax Notes 1673 (Mar. 22, 1993) (letter to
editor), if petitioner’s passthrough interpretation were correct,
then section 1366(b) would come into play. Section 1366(b)
provides that the character of any item included under section
1366(a)(1) as a passthrough item is determined “as if such item
were realized directly from the source from which realized by the
corporation, or incurred in the same manner as incurred by the
corporation”. Section 1366(b) refutes petitioner’s passthrough
interpretation of section 108(d)(7)(A). There’s no way, actually
or fictively, in which the equivalence rule of section 1366(b)
could apply to a solvent shareholder of an insolvent S
corporation.2
2
It’s interesting but irrelevant that petitioner’s Form
1040 for 1991 includes a Form 982 (Reduction of Tax Attributes
Due to Discharge of Indebtedness (and Section 1082 Basis
Adjustment)) that indicates petitioner was also insolvent and had
substantial COD unrelated to MAI that was applied in reduction of
his own NOL for the year and carryovers from prior years. MAI
(continued...)
- 30 -
II.
I mush on in an attempt to make sense of the stipulated
record and arrive at an understanding of what happens to the
current year’s losses of an insolvent S corporation that
experiences COD. The case at hand is not the most satisfactory
vehicle for this purpose because the stipulation of facts is so
terse--the only documents in evidence are the statutory notice,
petitioner’s 1991 income tax return, and MAI’s 1991 Form 1120S--
as to raise and leave unanswered questions about what actually
happened and the significance of what was shown and claimed on
the MAI Form 1120S and petitioner’s return.3
Judge Foley’s reference to the “application of section
108(b) and the resulting reduction of tax attributes (i.e., MAI’s
net operating loss)” adverts to an issue that the parties didn’t
really address. This issue arises from the fact, which might be
inferred from the parties’ stipulation “that the COD income of
$2,030,568 exceeded losses of MAI by $1,375,790 in 1991", that,
as respondent asked the Court to find as a fact, “MAI had losses
of $654,778". The amount by which MAI’s COD of $2,030,568
exceeded those losses is $1,375,790, the portion of petitioner’s
claimed basis in the stock of MAI that respondent disallowed.
2
(...continued)
didn’t file a Form 982 of its own with its 1991 Form 1120S.
3
Perhaps the Rule 155 computation to be submitted by the
parties will clarify these matters.
- 31 -
Petitioner’s reply brief makes the point in footnote 2, but
doesn’t return to it in the text, that, under petitioner’s theory
of the case, petitioner in the first instance was entitled to
increase the basis of his MAI stock by the full amount of MAI’s
COD, $2,030,568, unreduced by its $654,778 of losses.4
Petitioner’s argument on the point runs as follows: “Section
108(b)(4)(A) states clearly that the ``reductions described in
paragraph (2) [the attribute reductions] shall be made after the
determination of the tax imposed by this chapter for the taxable
year of the discharge’. * * * However, under the timing rules
4
No net operating loss as such in the amount of $654,788
appears on the MAI Form 1120S. The capital loss claimed by
petitioner on his return on the disposition of MAI stock (for no
consideration) was $2,403,996, apparently not reduced on
petitioner’s return by any losses shown by MAI. The stipulated
record does not disclose the source of the basis of $1,028,206 of
petitioner’s stock of MAI that respondent allowed as a long-term
capital loss. One would have thought that, if MAI did have
losses of $654,788, and that petitioner did have $1,028,206 of
basis in his stock, then under the general ordering rule of sec.
108(b)(2)(A) and (D), such losses would have thus been applied to
reduce the basis. MAI’s Form 1120S shows on its face that MAI
had ordinary income of $522,091 (gross income less deductions)
which petitioner reported on his return and a section 1231 loss
of $651,626 and net loss from rental real estate of $3,152, which
add up to the losses of $654,788. Nevertheless, the sum of the
ordinary income shown above and the losses plus other items on
Schedule K of the Form 1120S show an overall loss of $155,287.
It also appears that petitioner, in addition to showing a basis
increase for his MAI stock, also reported positive income of
$2,630,730, which may be attributable in part to the COD of MAI.
The manner in which the MAI stock petitioner disposed of is
not described in the stipulated record. I would assume that the
stock was regarded as worthless. The MAI Schedule L for the 1991
Form 1120S provides an opening balance sheet but no closing
balance sheet.
- 32 -
of section 108(b)(4)(A), Petitioner should have calculated his
tax liability without reducing the COD income by his share of
MAI’s loss. * * * [This is because] § 108(b)(4)(A) states that
attribute reduction occurs only after the liability for the
taxable year of the discharge has been determined.” Thus, taking
petitioner’s argument to its next step, petitioner would have
sufficient basis in his S corporation stock at the end of 1991 to
allow a passthrough of the $654,778 loss and to start 1992 with a
net increase of that basis of $1,375,790.
That such is the result that seems to follow from
petitioner’s argument about the application of the ordering rules
of section 108(b)(4), reinforces the correctness of the Court’s
conclusion about section 108(d)(7), which specifically applies to
S corporations and their shareholders. Section 108(d)(7) trumps
section 108(b)(4), which is a provision of more general
applicability to insolvent taxable entities, such as C
corporations and individuals, who experience COD.
Nevertheless, the question remains: How would section
108(d)(7)(B) operate if MAI did actually suffer a 1991 NOL in the
amount of $654,778? Section 108(d)(7)(B), as in effect for the
year in issue, provides:
(B) Reduction in carryover of disallowed losses
and deductions.--In the case of an S corporation, for
purposes of subparagraph (A) of subsection (b)(2), any
loss or deduction which is disallowed for the taxable
year of the discharge under section 1366(d)(1) shall be
treated as a net operating loss for such taxable year.
- 33 -
Ordinarily, the current year’s NOL of an S corporation
passes through to its shareholder(s) under section 1366(a)(1)(A).
If such a shareholder should lack sufficient basis in his stock
in and debt from the corporation to use his share of the NOL
currently, it would be disallowed and suspended under section
1366(d)(1). Section 108(d)(7)(B) says that any loss or deduction
of an insolvent S corporation with COD that is so suspended shall
be treated as an NOL of the corporation and reduced at the
corporate level under section 108(b)(2)(A). The foregoing would
explain how petitioner arrived at the upward basis adjustment he
claimed in the amount of $1,375,790, reducing the total COD of
$2,030,568 by the amount of the corporate loss of $654,788, and
thereby accounting for the entire amount of MAI’s COD.5 Although
we have rejected petitioner’s arguments for the upward basis
adjustment he claimed, he and his return preparer deserve credit
for not taking a return position as aggressive as his counsel
argues he was entitled to.
III.
Respondent’s and petitioner's briefs in this case and in
Winn v. Commissioner, T.C. Memo. 1998-71, and the voluminous
literature have devoted inordinate attention to the question of
5
Left unanswered is my question supra note 3, asking how
petitioner could have had a basis of $1,028,206 in his stock of
MAI that respondent did not disallow.
- 34 -
how excluded COD is to be characterized. As made clear by Judge
Foley and amplified in Part I. above, that question is of no
moment. The only relevant inquiry under section 1366 is not
whether COD excluded from gross income of an insolvent S
corporation is “tax-exempt income”, but whether it’s a
passthrough item at all. Because section 108(d)(7)(A) dictates
that it isn’t (as the majority and Judge Foley and I agree), it
doesn’t pass through to the shareholder under section
1366(a)(1)(A), and can’t increase the basis of his stock under
section 1367(a)(1)(A).
If the characterization question is to be addressed, as the
majority opinion undertakes to do, I believe there’s a
complementary relationship between respondent’s “deferred income”
argument and respondent’s other argument that COD excluded under
section 108 is an unrealized “tax nothing” for the purposes of
subchapter S: COD of an insolvent S corporation is “deferred
income” to the extent the S corporation has tax attributes to
adjust; as to any excess, it’s a “tax nothing”.
Both the majority opinion (pp. 22-23) and Judge Foley’s
concurring opinion paraphrase and quote as having application the
legislative history of the Bankruptcy Tax Act of 1980, S. Rept.
96-1035, 2 (1980), 1980-2 C.B. 620, 621: “Once a taxpayer
reduces its tax attributes pursuant to section 108(b)(2) ``Any
- 35 -
further remaining debt discharge amount is disregarded, i.e.,
does not result in income or have other tax consequences.’”
This language of the legislative history evidences an intent
to preserve the notion of section 1.61-12(b), Income Tax Regs.:
“Income is not realized by a taxpayer * * * as the result of an
adjudication in bankruptcy, or by virtue of an agreement among
his creditors not consummated under any provision of the
Bankruptcy Act, if immediately thereafter the taxpayer’s
liabilities exceed the value of his assets”, at least to the
extent that there are no more tax attributes to adjust under
section 108(b).
I therefore join the majority in rejecting petitioner’s
argument that COD is one of the “items of income (including tax-
exempt income)” mentioned in section 1366(a)(1)(A) that is passed
through to the shareholder(s). In so doing, I disagree with
petitioner’s corollary conclusion that all items excluded from
gross income under sections 101 through 135 of the Code must be
treated as the same kind of “tax-exempt income” under section
1366(a)(1)(A).6
6
I agree with respondent’s argument that the location of
sec. 108 with other Code provisions, such as secs. 101 and 103,
in subtitle A, ch. 1, subch. B, part III, entitled “Items
Specifically Excluded From Gross Income”, does not require that
all such sections be treated in identical fashion for the
purposes of applying sec. 1366(a)(1)(A). See sec. 7806(b) (No
inference, implication, etc., as to legal effects to be drawn
from arrangement, classification, location, grouping, descriptive
(continued...)
- 36 -
There’s a significant difference between COD under section
108, on the one hand, and items such as life insurance proceeds
under section 101 and tax-exempt bond interest under section 103,
on the other. The reference to “tax-exempt” income in section
1366(a)(1)(A) is clearly intended to include receipts excluded
from gross income under such sections as 101 and 103, which
represent returns on or arising from investment by or on behalf
of the recipient. The reference does not include excluded COD
that is attributable to loans to the S corporation by third-party
creditors; the entire structure of the subchapter S regime denies
basis to shareholders who lack any such investment. See, e.g.,
Spencer v. Commissioner, 110 T.C. ___, ___ (1998), and cases
cited at slip op. 25.
IV.
In Winn v. Commissioner, supra, the introduction of
Respondent’s Memorandum of Facts and Law in Support of
Respondent’s Objection to Petitioner’s Cross Motion for Partial
Summary Judgment in docket No. 5359-96 observes in passing that,
even if the taxpayer should be entitled to the upward basis
adjustment he claims, his right to take it into account for
current tax purposes would be subject to the at-risk limitations
under section 465.
6
(...continued)
matter, etc.).
- 37 -
I agree with respondent’s observation. Although “section
465 had its origins in Congress’ concern over the use of
nonrecourse financing or other devices in tax oriented
investments, the scope of section 465 is not limited to tax
shelters.” Lansburgh v. Commissioner, 92 T.C. 448, 451 (1989)
(citing Peters v. Commissioner, 77 T.C. 1158, 1165 (1981)). The
legislative intent of section 465--to forestall current
reductions in income tax liability arising from basis step-ups
that haven’t been and won’t be paid for--prescribes yet another
antidote for the unpaid basis step-ups claimed by petitioners in
the case at hand and other pending cases.
HALPERN, J., agrees with this concurring opinion.
- 38 -
FOLEY, J., concurring in result only: I agree with the
majority's holding. Section 108(d)(7)(A) explicitly provides
that subsections (a), (b), (c), and (g) of section 108 are to be
applied at the corporate level. I write separately to emphasize
that after the application of section 108(b) and the resulting
reduction of tax attributes (i.e., MAI's net operating loss)
there are no "items of income", tax-exempt or otherwise, to which
section 1366(a) may apply. The legislative history accompanying
the Bankruptcy Tax Act of 1980 states that after a taxpayer
reduces its tax attributes "Any further remaining debt discharge
amount is disregarded, i.e., does not result in income or have
other tax consequences." S. Rept. 96-1035, at 2 (1980), 1980-2
C.B. 620, 621. Thus, there are no "items of income", and, as a
result, no basis adjustment pursuant to section 1367.
Accordingly, there is no need to distinguish between "tax-exempt"
and "deferred" income.
SWIFT, PARR, WHALEN, and COLVIN, JJ., agree with this
concurring in result only opinion.