US Supreme Court Briefs

No. 99-1295


In the Supreme Court of the United States


DAVID A. AND LOUISE A. GITLITZ, ET AL., PETITIONERS

v.

COMMISSIONER OF INTERNAL REVENUE


ON WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT


BRIEF FOR THE RESPONDENT


SETH P. WAXMAN
Solicitor General
Counsel of Record
PAULA M. JUNGHANS
Acting Assistant Attorney
General
LAWRENCE G. WALLACE
Deputy Solicitor General
KENT L. JONES
Assistant to the Solicitor General
TERESA E. MCLAUGHLIN
EDWARD T. PERELMUTER
Attorneys
Department of Justice
Washington, D.C. 20530-0001
(202) 514-2217

QUESTION PRESENTED

Petitioners are shareholders in an insolvent Subchapter S corporation. During1991, that corporation obtained a discharge of certain indebtedness. Thatdischarge would have been treated as an item of "[i]ncome from dischargeof indebtedness" (26 U.S.C. 61(a)(12)) except that, because the dischargeoccurred when the corporation was insolvent, the item is expressly "notinclude[d] * * * in gross income" under 26 U.S.C. 108(a)(1)(B). Thequestion presented in this case is whether the amount thus expressly excludedfrom "income" is nonetheless to be treated as if it were an itemof "income" which, under 26 U.S.C. 1366(a)(1)(A), flows throughto petitioners as the shareholders of the Subchapter S corporation, therebyincreasing their basis in the stock of the corporation under 26 U.S.C. 1367(a)(1)(A),and thereby allowing them to deduct losses they were previously unable todeduct because they had exhausted their basis by prior deductions.


In the Supreme Court of the United States


No. 99-1295

DAVID A. AND LOUISE A. GITLITZ, ET AL., PETITIONERS

v.

COMMISSIONER OF INTERNAL REVENUE


ON WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT


BRIEF FOR THE RESPONDENT


OPINIONS BELOW

The opinion of the court of appeals (Pet. App. 1-20) is reported at 182F.3d 1143. The initial opinion of the Tax Court (Pet. App. 25-31) is unofficiallyreported at 73 T.C.M. (CCH) 3167. The opinion of the Tax Court on reconsideration,which withdrew and replaced the initial opinion (Pet. App. 21-24), is unofficiallyreported at 75 T.C.M. (CCH) 1840.

JURISDICTION

The judgment of the court of appeals was entered on July 6, 1999. A petitionfor rehearing was denied on November 3, 1999 (Pet. App. 32-33). The petitionfor a writ of certiorari was filed on February 1, 2000, and was grantedon May 1, 2000. The jurisdiction of this Court rests upon 28 U.S.C. 1254(1).

STATUTORY PROVISIONS INVOLVED

Sections 108, 1366 and 1367 of the Internal Revenue Code, 26 U.S.C. 108,1366, 1367, are set forth at Pet. App. 34-58.

STATEMENT

1. a. During the 1991 taxable year, petitioners David A. Gitlitz and PhilipD. Winn each owned a 50% interest in P.D.W. & A., Inc., a Colorado corporationthat elected to be taxed for that year under the provisions of SubchapterS of the Internal Revenue Code, 26 U.S.C. 1361-1379. Pet. App. 2-3. As thisCourt explained in Bufferd v. Commissioner, 506 U.S. 523, 525 (1993), SubchapterS of the Code implements "a pass-through system under which corporateincome, losses, deductions, and credits are attributed to individual shareholdersin a manner akin to the tax treatment of partnerships."

The Subchapter S corporation was a partner in a partnership that was dischargedfrom $4,154,891 in debt during 1991. Pet. App. 3. The corporation's shareof the discharged debt was $2,021,296. This amount would have represented"[i]ncome from discharge of indebtedness" to the corporation (26U.S.C. 61(a)(12)) except that, at the time of the discharge, the corporationwas insolvent.1 Because the corporation was insolvent, this amount was expresslyexcluded from income under Section 108 of the Code, which specifies that"[g]ross income does not include any amount which * * * would be includiblein gross income by reason of the discharge * * * of indebtedness of thetaxpayer if * * * the discharge occurs when the taxpayer is insolvent."26 U.S.C. 108(a)(1)(B).2

b. Although Section 108 of the Code thus specifies that discharge of indebtednessis not an item of income for an insolvent corporation, petitioners claimthat it should nonetheless be treated as if it were an item of income forpurposes of Sections 1366 and 1367 of the Code. Those provisions determinevarious aspects of the tax treatment of shareholders of a Subchapter S corporation.In particular, they specify that "items of income (including tax-exemptincome), loss, deduction, or credit" pass through to the shareholders(26 U.S.C. 1366(a)(1)(A)), that the "items of income" that passthrough to the shareholders increase the shareholders' basis in the stockof the Subchapter S corporation (26 U.S.C. 1367(a)(1)(A)), that the lossesand deductions that pass through reduce the shareholders' stock basis (26U.S.C. 1367(a)(2)(B)), and that distributions of earnings or assets of thecorporation to the shareholders reduce their basis in the stock (26 U.S.C.1367(a)(2)(A)). The basic concepts reflected in these provisions are: (i)that the income earned (or loss incurred) at the corporate level is treatedas if it were earned (or lost) at the individual level; and (ii) that basisadjustments are made to avoid a double tax on those earnings or a doublebenefit from those losses.

A shareholder may deduct losses only to the extent that he has not previouslyrecovered (through prior deductions) his basis in the stock. 26 U.S.C. 1366(d)(2).In this case, petitioners had previously deducted losses representing theirentire basis in their stock. Pet. App. 3-4. At the time the indebtednessof the Subchapter S corporation was discharged in 1991, petitioners wouldthus be allowed further deductions from the corporate losses only if theirbasis in the corporate stock were somehow increased.3

Petitioners assert that the additional basis that they need in order totake further deductions from the losses of the Subchapter S corporationcan be found in the discharge of indebtedness "income" of thecorporation in 1991. They assert that this discharge of indebtedness isan "item[] of income" (26 U.S.C. 1366(a)(1)(A)) that increasestheir basis in the corporate stock (under 26 U.S.C. 1367(a)(1)(A)) eventhough, for the reasons described above, Section 108(a) of the Code expresslystates that this is "not" an item of income. On that theory, petitionersclaimed additional deductions in amounts equaling their allocable sharesof the discharged debt of $2,021,296. Pet. App. 3.4

Upon audit, the Commissioner determined that petitioners were not entitledto increase their stock basis by their reported pro rata shares of the dischargeof indebtedness that was "not" an item of income under Section108 of the Code. The Commissioner therefore disallowed the deductions claimedby petitioners and asserted a deficiency of $251,192 against petitionerGitlitz and of $242,555 against petitioner Winn. Pet. App. 64-66, 81-83.

2. Petitioners filed separate petitions in the Tax Court that were consolidatedfor disposition. On cross-motions for summary judgment, the Tax Court initiallyruled in favor of petitioners. Pet. App. 25-31. The court stated (id. at29-30) that, because income from the discharge of indebtedness is an itemof income in the general definition of gross income (26 U.S.C. 61(a)(12)),it qualifies as an "item[] of income" for which an upward basisadjustment is appropriate under 26 U.S.C. 1366(a)(1)(A) even though, dueto the insolvency of the debtor, it is excluded from income under Section108(a)(1)(B).

The Commissioner moved for reconsideration. While that motion was pending,the entire Tax Court held in a reviewed decision that a discharged debtthat is excluded from a Subchapter S corporation's gross income becauseof its insolvency does not constitute an item of "income" thatwould increase the shareholder's basis in the corporate stock (and therebyallow deductions of losses after that basis has been exhausted by priordeductions). Nelson v. Commissioner, 110 T.C. 114 (1998), aff'd, 182 F.3d1152 (10th Cir. 1999). Relying on its decision in Nelson, the Tax Courtthen granted the motion for reconsideration in this case and entered decisionsin favor of the Commissioner. Pet. App. 21-24.

3. The Tenth Circuit affirmed. Pet. App. 1-20.5 The court of appeals emphasizedthat petitioners' proposed interpretation of the Code would accomplish aninappropriate double tax benefit for taxpayers: it would permit the insolventSubchapter S corporation to avoid tax on the discharged debt (an item thatis "not" treated as an item of income for insolvent corporationsunder Section 108(a)) but, at the same time, allow the shareholders of thecorporation to reduce their gross income from other sources by treatingthe discharged debt as if it were an item of "income," therebyincreasing their basis in the corporate stock and permitting deductionsotherwise barred by the prior exhaustion of that basis. Pet. App. 10. Thecourt noted that this Court has emphasized that the Internal Revenue Code"should not be interpreted to allow taxpayers the practical equivalentof a double deduction absent a clear declaration of intent by Congress."Ibid. (quoting United States v. Skelly Oil Co., 394 U.S. 678, 684 (1969)).The court concluded that "only if taxpayers' theory is unequivocallysupported by the statutory text may we adopt it here" (Pet. App. 10)and held that petitioners did not meet that burden in this case.

The court noted that a discharge of indebtedness does not constitute anitem of income under Section 108(a) if "the debt is discharged in abankruptcy proceeding or at a time when the taxpayer is insolvent"(Pet. App. 9) and that this characterization of the item is necessarilymade and "applied at the corporate level" (id. at 11 (citing 26U.S.C. 108(d)(7)(A)). See note 2, supra. The court explained that petitioners'effort nonetheless to treat it as an "item[] of income" underSection 1366 ignores and "effectively eliminate[s] the 'price' Congressimposed upon entities whose discharged debt income is excluded under §108." Pet. App. 13. That "price" is set forth in Section108(b), which requires the insolvent corporation to reduce various "taxattributes" (such as carried over credits or losses) "that couldotherwise yield future tax benefits." Id. at 9. In deciding in Section108 to "not" treat a discharge of debts owed by an insolvent as"income," Congress did not mean to provide additional tax benefitsto the corporate shareholders in the manner proposed by petitioners; instead,Congress determined in Section 108(b) to reduce the preexisting tax carryforwardsavailable to the corporation that might yield "future tax benefits."Pet. App. 9. The court concluded that petitioners' interpretation of thesestatutes "would negate the effect of the tax attribution scheme andwould give [petitioners] an unwarranted windfall." Id. at 16.6

SUMMARY OF ARGUMENT

Long prior to the enactment of the provisions of the Internal Revenue Codeinvolved in this case, judicial decisions and Treasury rulings had bothmade clear that a discharge of indebtedness does not constitute an itemof "income" for an insolvent corporation. In enacting Section108 of the Code in 1980, Congress embraced and codified that establishedrule by expressly providing that the discharge of a debt does "not"constitute income to an insolvent taxpayer. 26 U.S.C. 108(a)(1)(B). Congressnonetheless determined, however, that it was appropriate to impose a pricefor this economic benefit for insolvent taxpayers by requiring them to usethe amount of such discharged debt to reduce or eliminate certain favorable"tax attributes" that they otherwise could employ to reduce theirtaxable income in future years. 26 U.S.C. 108(b)(1)-(2). For insolvent SubchapterS corporations, those tax attributes include the "suspended" corporatelosses that the shareholders were unable to deduct because they lacked sufficientbasis in the stock of the corporation. Under Section 108(d)(7)(B) of theCode, such losses are treated as "net operating losses" of thecorporation and any amount of discharged debt of insolvent Subchapter Scorporations is to be set off against those losses to reduce or eliminatethem. As the legislative history of Section 108 clearly states, "[a]nyfurther remaining debt discharge amount is [then to be] disregarded, i.e.,does not result in income or have other tax consequences." S. Rep.No. 1035, 96th Cong., 2d Sess. 2, 13 (1980).

In this case, petitioners' insolvent S corporation was discharged from adebt in 1991. Petitioners contend that the debt discharge to that insolventcorporation- an item that has never been regarded as an item of "income"in the lengthy history of the federal income tax and that Congress expresslyspecified is "not" income to the corporation in enacting Section108(a)(1)(B)-is nonetheless an "item[] of income" of the corporationwithin the meaning of Section 1366(a)(1)(A) that increases shareholder stockbasis under Section 1367(a)(1)(A) and thereby allows petitioners to takedeductions for losses "suspended" under Section 1366(d)(1) forlack of basis. The courts that have considered petitioners' contention haverecognized that petitioners are seeking to obtain the "windfall"of a double tax benefit from the debt discharge: they would avoid paymentof tax on the amount that is "not" treated as an item of incomeunder Section 108 and would also obtain an upward basis adjustment for theircorporate stock under Section 1367 that would enable them to deduct otherwisenondeductible losses.

Petitioners' argument conflicts with the plain language of the provisionsof Sections 1366 and 1367 that limit basis adjustments to "items ofincome" received by the corporation. Their contention would also nullifythe statutory mandate (in Sections 108(b)(2)(A) and 108(d)(7)(B)) that theamount of discharged debt that is "not" an item of income forthe insolvent corporation is to be applied to reduce (or eliminate) thevery suspended corporate losses (and other favorable tax attributes of thecorporation) that petitioners seek instead to deduct. Petitioners thus seekto obtain a double tax benefit in a context where Congress plainly soughtto reduce the benefit, not double it. The erroneous interpretation of theseprovisions for which petitioners contend would improperly transmute a statutethat was designed as a method of deferring the tax on debt forgiveness intoa mechanism for avoiding tax on the unrelated income of shareholders ofinsolvent S corporations.

ARGUMENT

THE AMOUNT OF DEBT DISCHARGED FOR AN INSOLVENT SUBCHAPTER S CORPORATIONIS NOT AN ITEM OF "INCOME" THAT FLOWS THROUGH TO THE SHAREHOLDERSOF THE CORPORATION UNDER SECTION 1366(a) OR INCREASES THEIR BASIS IN THESTOCK OF THE CORPORATION UNDER SECTION 1367(a)

A. The Discharge Of A Debt Is Not An Item Of "Income" To An InsolventCorporation

The intricate and interrelated tax statutes involved in this case are bestunderstood in the context of the unique history in which they were developedand enacted. Long prior to the enactment of the provisions of the InternalRevenue Code involved in this case, judicial decisions and Treasury rulingshad uniformly concluded that a discharge of indebtedness does not constitutean item of "income" for an insolvent corporation. In enactingSection 108 of the Code in 1980, Congress embraced and codified that establishedrule by specifying that the discharge of a debt does "not" constituteincome to an insolvent taxpayer. 26 U.S.C. 108(a)(1)(B). Since the debtdischarge of an insolvent corporation does not give rise to "income,"there is no "item of income" that passes through to the shareholdersto increase their basis under Sections 1366 and 1367.

1. The concept of "income" has a "sweeping scope" andis broad enough to include all "accessions to wealth." Commissionerv. Glenshaw Glass Co., 348 U.S. 426, 429, 431 (1955). In 1931, this Courtheld in United States v. Kirby Lumber Co., 284 U.S. 1, that a solvent taxpayerrealizes "income" from the discharge of indebtedness. The Courtreasoned that the taxpayer made a "clear gain" when it repurchasedfor a lesser amount bonds that it had issued at par, for it thereby "madeavailable * * * assets previously offset by the obligation of bonds nowextinct." Id. at 3. As the Court has further explained, a solvent taxpayerrealizes "income" when he is "released from his obligationto repay" a debt, for he "enjoys a net increase in assets equalto the forgiven portion of the debt * * * ." United States v. CentennialSavings Bank FSB, 499 U.S. 573, 582 (1991). In adding Section 61(a)(12)to the Code in 1954, Congress codified the result of these decisions byspecifying that gross income includes "[i]ncome from discharge of indebtedness."26 U.S.C. 61(a)(12).

Notwithstanding the facial breadth of this statute, the Treasury Departmentand the courts have uniformly concluded that a discharge of indebtednessdoes not constitute "income" for an insolvent corporation. Inadopting what became known as the judicial "insolvency exception"to the tax rules governing the treatment of the discharge of indebtedness,the courts explained that the rationale of Kirby Lumber does not apply toa taxpayer who is insolvent at the time the debt is discharged and remainsso afterward.7 See, e.g., Dallas Transfer & Terminal Warehouse Co. v.Commissioner, 70 F.2d 95, 96 (5th Cir. 1934); Astoria Marine ConstructionCo. v. Commissioner, 12 T.C. 798, 801 (1949) (collecting cases). These courtsheld that the forgiveness of a debt does not represent "income"for an insolvent taxpayer because, unlike the solvent taxpayer in KirbyLumber, an insolvent taxpayer does not experience an increase or "freeingup" of any assets by reason of the discharge. Dallas Transfer &Terminal Warehouse Co. v. Commissioner, 70 F.2d at 96; see 1 B. Bittker& L. Lokken, Federal Taxation of Income, Estates and Gifts ¶ 6.4.6,at 6-58 n.97 (2d ed. 1989). The court explained in Dallas Transfer &Terminal Warehouse Co. v. Commissioner, 70 F.2d at 96, that, when an insolventis discharged from debt, no "income" is realized because the insolventdoes not "acquir[e] something of exchangeable value in addition towhat [it] had before. * * * There is an absence of such a gain or profitas is required to come within the accepted definition of income." Asthe Tax Court stated in Astoria Marine Construction Co. v. Commissioner,12 T.C. at 801, when the "remaining obligations" of the insolventtaxpayer continue to exceed its remaining assets, no "income"is realized from the discharge of a debt because "no assets were freedfrom the claims of creditors by [the] discharge."

Even after Congress added Section 61(a)(12) to the Code in 1954 specificallyto enumerate "[i]ncome from discharge of indebtedness" as an itemof "income" (26 U.S.C. 61(a)(12)), the Treasury confirmed in implementingregulations that the longstanding judicial "insolvency exception"remained in force. 26 C.F.R. 1.61-12(b)(1). Since 1957, this regulationhas specified that "[i]ncome is not realized by a taxpayer" bythe discharge of his indebtedness "if immediately thereafter the taxpayer'sliabilities exceed the value of his assets." Ibid. See T.D. 6272, 1957-2C.B. 18, 31.8

2. In 1980, Congress embraced and codified this well-established "insolvencyexception" by specifying in Section 108(a) of the Code that the dischargeof a debt does "not" constitute an item of "income"to an insolvent taxpayer. 26 U.S.C. 108(a)(1)(A). This provision was enactedas part of the Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, § 2,94 Stat. 3389. In enacting that legislation, Congress noted that, while"[u]nder present law, income is realized when indebtedness is forgiven,* * * [t]here are several exceptions to the general rule." S. Rep.No. 1035, supra, at 8. In particular, "[u]nder a judicially developed'insolvency exception,' no income arises from discharge of indebtednessif the debtor is insolvent both before and after the transaction."Ibid. (emphasis added).

In codifying this longstanding "insolvency exception," Section108(a) of the Code specifies that "[g]ross income does not includeany amount which (but for this subsection) would be includible in grossincome by reason of the discharge * * * of indebtedness of the taxpayerif * * * the discharge occurs when the taxpayer is insolvent." 26 U.S.C.108(a)(1)(B).9 At the same time, however, Congress determined that it wasappropriate to impose a price for this preferential treatment of insolventtaxpayers-a price that had not been imposed under the judicial "insolvencyexception." See 1 B. Bittker & L. Lokken, Federal Taxation of Income,Estates and Gifts ¶ 7.6.3, at 7-58 (3d ed. 1999). The price that Congressimposed is the requirement added by Section 108(b) that the taxpayer mustuse the amount of the discharged debt to reduce or eliminate certain favorable"tax attributes" that the taxpayer could otherwise employ to reduceits taxable income in future years. 26 U.S.C. 108(b)(1), (2).10 The favorable"tax attributes" that Congress specified are to be reduced bythe amount of the discharged debt include the insolvent's net operatinglosses, its basis in property, its capital loss carryovers, and other specificitems set forth in the detailed provisions of Section 108(b). See note 10,supra. In enacting this provision in 1980, Congress clearly stated its understandingand intent that any portion of the debt discharge amount remaining afterapplication against these specified tax attributes was then to be "disregarded,i.e., does not result in income or have other tax consequences." S.Rep. No. 1035, supra, at 2, 13 (emphasis added).11 As Professors Bittkerand Lokken have explained, when the favorable tax attributes of the insolventcorporation are insufficient to absorb all of the debt discharge amount,"the unabsorbed amount is not gross income" and is therefore tobe "ignored." 1 B. Bittker & L. Lokken, supra, at 7-58.12

By thus using the amount of the discharge of indebtedness that does notrepresent an item of "income" for an insolvent taxpayer to reducecertain prospectively favorable tax attributes of the taxpayer, Congresssought to employ Section 108 as a tax-deferral, rather than a tax-forgiveness,mechanism: the taxpayer avoids immediate payment of tax from the debt dischargebut pays potentially greater taxes in future years as a result of the discharge."[T]he rules of the [statute] are intended to carry out the Congressionalintent of deferring, but eventually collecting within a reasonable period,tax on ordinary income realized from debt discharge." S. Rep. No. 1035,supra, at 10. As this Court stated in United States v. Centennial SavingsBank FSB, 499 U.S. 573 (1991), "the effect of § 108 is not genuinelyto exempt such income from taxation, but rather to defer the payment ofthe tax by reducing the taxpayer's" ability prospectively to employany favorable tax attributes existing at the time the discharge occurred.Id. at 580.13

B. The Discharge Of A Debt Of An Insolvent Subchapter S Corporation Is NotAn Item Of "Income" Or "Tax Exempt Income" That FlowsThrough To Shareholders And Increases Their Basis In The Corporate StockUnder Sections 1366 And 1367 Of The Code

Although Section 108 of the Code thus adopts the longstanding rule thata discharge of indebtedness is not an item of income for an insolvent corporation,petitioners claim that such a discharge should nonetheless be treated asif it were an item of income for purposes of Sections 1366 and 1367 of theCode. Those provisions determine various aspects of the tax treatment ofshareholders of Subchapter S corporations. In particular, they specify that"items of income (including tax-exempt income), loss, deduction, orcredit" pass through to the shareholders (26 U.S.C. 1366(a)(1)(A)),that the "items of income" that pass through to the shareholdersincrease the shareholders' basis in the stock of the Subchapter S corporation(26 U.S.C. 1367(a)(1)(A)), that the losses and deductions that pass throughreduce the shareholders' stock basis (26 U.S.C. 1367(a)(2)(B)), and thatdistributions of earnings or assets of the corporation to the shareholdersreduce their basis in the stock (26 U.S.C. 1367(a)(2)(A)).

At the time the indebtedness of the Subchapter S corporation involved inthis case was discharged in 1991, petitioners had previously deducted lossesrepresenting their entire basis in the stock. Pet. App. 3-4. They wouldthus be allowed further deductions from the corporate losses only if theirbasis in the corporate stock were somehow increased. 26 U.S.C. 1366(d)(2).Petitioners contend that the debt discharge of their insolvent SubchapterS corporation-a discharge that is "not" an item of income underSection 108-is nonetheless to be treated as if it were an "item ofincome" of the corporation within the meaning of Section 1366(a)(1)(A),which would increase their basis in the corporate stock under Section 1367(a)and allow them to take deductions for losses "suspended" whenthey had previously exhausted their basis by taking other loss deductions.The court of appeals correctly rejected that claim.

1. Petitioners improperly seek to characterize an item as "income"when Congress has instead specified that it is "not" income. 26U.S.C. 108(a). As all of the courts that have considered this issue haveobserved, petitioners' application of this statutory text would accomplisha double tax benefit from the discharged debt of the Subchapter S corporation:their interpretation would not only avoid payment of any tax on the dischargeddebt but it would also yield an upward basis adjustment for the corporatestock equal to that amount, which would enable petitioners to deduct "suspended"corporate losses against any unrelated income received by petitioners fromother sources.14 Petitioners thus seek to obtain a tax benefit from a statutethat was enacted by Congress to reduce or eliminate tax benefits. In short,petitioners would transmute a statute that was designed as a method of deferringthe tax on debt forgiveness into a mechanism for avoiding tax on unrelatedincome of shareholders of insolvent Subchapter S corporations. In addressingthe defects in petitioners' erroneous parsing of these statutory provisions,it is therefore appropriate to note the wisdom of the advice of eminenttax counselors that "the lawyer's passion for technical analysis ofthe statutory language should always be diluted by distrust of a resultthat is too good to be true." B. Bittker & J. Eustice, FederalIncome Taxation of Corporations and Shareholders ¶ 14.51, at 14-170(5th ed. 1987).

a. To begin with, it is incorrect to characterize the discharge of a debtas giving rise to "income" for an insolvent taxpayer. Neitherthe statute nor the applicable court decisions or administrative rulingscharacterize the discharge of debt for an insolvent corporation as an itemof "income." For decades prior to the enactment of the BankruptcyTax Act of 1980, including many years after Section 61(a)(12) of the Codewas enacted generally to include "[i]ncome from discharge of indebtedness"in gross income, the Treasury and the courts had consistently ruled thata discharge of indebtedness for an insolvent taxpayer does not "comewithin the accepted definition of income." Dallas Transfer & TerminalWarehouse Co. v. Commissioner, 70 F.2d at 96. See pages 10-13 & note7, supra. In enacting Section 108, Congress endorsed and codified this preexisting,established rule that "no income arises from discharge of indebtednessif the debtor is insolvent." S. Rep. No. 1035, supra, at 8 (emphasisadded). Moreover, in providing in Section 108 that an insolvent taxpayer'sdebt discharge is "not" income (26 U.S.C. 108(a)(1)(B)), Congressemphasized that any debt discharge amount remaining after application againstthe tax attributes set forth in the statute is to be "disregarded"because it "does not result in income or have other tax consequences."S. Rep. No. 1035, supra, at 2 (emphasis added). See also id. at 13 (same).

In requiring in Section 108(b) that the insolvent corporation apply theamount of such forgiven indebtedness to reduce its favorable tax attributes(see note 10, supra), Congress plainly did not intend to transform the dischargeamount into an "item of income" that would flow through to thetaxpayer and enhance its favorable tax attributes under Section 1366(a)(1)(A).Instead, any discharge amount remaining after application against favorabletax attributes is to be "disregarded" because "the unabsorbedamount is not gross income" and is therefore to be "ignored."1 B. Bittker & L. Lokken, supra, at 7-58. See note 12, supra.

In view of this clear legislative history, petitioners' disregard of theplain, limiting text of this statute is fatal to their claim. It is an established"rule that tax-exemption and -deferral provisions are to be construednarrowly" (United States v. Centennial Savings Bank FSB, 499 U.S. at583) and that "the Code should not be interpreted to allow [taxpayers]'the practical equivalent of double deduction * * * .'" United Statesv. Skelly Oil Co., 394 U.S. 678, 684 (1969) (quoting Charles Ilfeld Co.v. Hernandez, 292 U.S. 62, 68 (1934)).

b. Petitioners also err in contending (Pet. Br. 47-48), in the alternative,that the discharge of the debt of an insolvent taxpayer constitutes an itemof "tax exempt income" that would flow through to the shareholdersunder Section 1366(a) and increase their basis under Section 1367(a). Themost fundamental reason why the amount of a discharged debt of an insolventis not "tax exempt income" is that this amount does not represent"income" of any type.15 Unlike "tax exempt income" (suchas state and local bond interest) which represents an "undeniable accession[]to wealth" (Commissioner v. Glenshaw Glass Co., 348 U.S. at 431) andthus plainly constitutes "income," the amount of a dischargeddebt of an insolvent has not been regarded as yielding an accession to wealthand has instead consistently been held by the courts and the Treasury notto come within the definition of "income" at all. See pages 10-13& note 7, supra. In enacting Section 108, Congress adopted- it did notalter or discard-the established rule that the discharged debt of an insolventis simply "not" an item of "income" of any type. 26U.S.C. 108(a). See S. Rep. No. 1035, supra, at 2, 8.

Moreover, although "[t]here is no definition of 'tax- exempt' for purposesof section[ ] 1366," the term inherently signifies an item that is"exempt on a permanent basis." Nelson v. Commissioner, 110 T.C.at 125. The statutory provisions that concern "tax-exempt income"address items such as life insurance proceeds and state and local bond interest,which not only are excluded from income in the year received (26 U.S.C.101, 103) but also are not accompanied with the offsetting reductions intax attributes that make debt discharge income "subject to taxationin the future." 110 T.C. at 125. As this Court explained in CentennialSavings Bank, due to the offsetting adjustments of tax attributes requiredfor debt discharge items under Section 108, the result of the statute "isnot genuinely to exempt such income from taxation * * *." 499 U.S.at 580.16

When tax exempt items-such as life insurance proceeds and state or localbond interest-are received by a Subchapter S corporation and passed throughto its shareholders under Section 1366(a)(1)(A) as "items of income(including tax-exempt income)," the shareholders receive an upwardbasis adjustment (under Section 1367(a)(1)(A)) that is offset by a correspond-ing downward basis adjustment (under Section 1367(a)(2)(A)) when that incomeis distributed to the shareholder. 26 U.S.C. 1367(a)(2)(A). See pages 3-4,supra. As the Tenth Circuit explained in this case (Pet. App. 8-9), thetemporary basis increase under Section 1367 for these items of "tax-exemptincome" is logically required to preserve the tax-exempt characterof the income at the shareholder level. In the absence of that basis increase,the shareholder would be subject to tax upon the distribution of the incomeunder Section 1368(b)(2) of the Code, for any distribution of cash or propertythat exceeds a shareholder's adjusted basis in stock is treated as gainfrom the sale or exchange of property. 26 U.S.C. 1368(b)(2).

By contrast, as the Treasury Department and the courts have long recognized,when an insolvent is discharged from debt, the corporation acquires no assetfor distribution in cash or in kind to its shareholder. Because the corporationis insolvent, "there is a reduction or extinguishment of liabilitieswithout any increase of assets." Dallas Transfer & Terminal WarehouseCo. v. Commissioner, 70 F.2d at 96. If (as petitioners contend) an upwardbasis adjustment occurred under Section 1367 in this context, it would thusnot be followed by a corresponding downward basis adjustment, for thereis no "distribution" associated with the discharge of an insolventcorporation's indebtedness.17 An upward basis adjustment in this contextwould serve no purpose other than to defeat the plain mandate of Congressthat the discharge of indebtedness is "not" to be treated as "income"to an insolvent corporation (26 U.S.C. 108(a)(1)(B)) and that any amountof the discharged debt remaining after application against the taxpayer'sfavorable tax attributes under Section 108(b) has no "tax consequences"and is simply to be "disregarded" (S. Rep. No. 1035, supra, at2, 13).

c. Petitioners incorrectly assert (Pet. Br. 18-21, 46) that Treasury regulationshave characterized the debt discharge of an insolvent Subchapter S corporationas giving rise to "tax-exempt income." The brief portion of theregulations cited by petitioners simply paraphrases the statutory basisadjustment for "tax-exempt income" (26 U.S.C. 1366(a)(1)(A)) asan adjustment that applies to "nontaxable item[s]" of income (26C.F.R. 1.1367-1(d)(2)). Nothing in that abbreviated regulatory languagepurports to alter or enlarge the statutory text. The regulation merely employsa phrase that is similar, but not identical, to the statutory language indescribing its effect.

In particular, nothing in that regulation purports to conclude that thedischarge of indebtedness of an insolvent Subchapter S corporation providesa basis adjustment for the shareholders of the corporation under Sections1366 and 1367. That issue is not even remotely addressed in that regulation.There is, however, a different regulation-a regulation that petitionershave failed to cite-that actually is relevant to that issue. Since 1957,the Treasury has specified in its regulations that "[i]ncome is notrealized" from the discharge of the debt of an insolvent. 26 C.F.R.1.61-12(b)(1). This regulation conforms to the longstanding principle thatthe discharge of a debt of an insolvent does not represent an item of "income"of any type. See pages 10-13 & note 7, supra. By contrast, "tax-exemptincome" is an item of actual "income" that a taxpayer hasactually "realized," but that Congress has chosen, by statute,to exempt from tax. Section 108 does not make the discharge of indebtednessof an insolvent "exempt" from tax, for that item was never "income"subject to tax in the first place. See S. Rep. No. 1035, supra, at 8 ("noincome arises from discharge of indebtedness if the debtor is insolvent").

Petitioners' reliance (Pet. Br. 21-22) on a similar abbreviated paraphrasingof the scope of the basis adjustment for "tax-exempt income" inthe legislative history of the Subchapter S Revision Act of 1982 provisionis inapposite for precisely these same reasons. Moreover, in describingthese same statutory provisions in 1993, Congress stated its clear understandingthat "[t]he shareholders' basis in their stock is not adjusted"by the amount of a discharged debt of an insolvent Subchapter S corporation.H.R. Rep. No. 111, 103d Cong., 1st Sess. 624-625 (1993) (emphasis added).That legislative statement is, of course, precisely at odds with the interpretationof these provisions advocated by petitioners.18

2. The assertion that the amount of a discharged debt of an insolvent SubchapterS corporation flows through to the shareholders and allows them to claimdeductions for otherwise nondeductible losses is also flatly inconsistentwith the requirements of Section 108(d)(7). That Section specifies thatthe amount of the discharged debt of an insolvent Subchapter S corporationis to be applied, "at the corporate level," to reduce the favorabletax attributes of the corporation. 26 U.S.C. 108(d)(7)(A). Those attributesare defined to include, inter alia, the "net operating losses"of the corporation for the taxable year of the discharge (26 U.S.C. 108(b)(2)(A))which, in turn, are defined to include any "suspended" lossesthat the shareholders were unable to deduct for that year because they hadpreviously exhausted their basis under Section 1366(d)(1). See 26 U.S.C.108(d)(7)(B); note 10, supra.

The obvious intent of these provisions-an intent that their language plainlysupports-is that the amount of the discharged debt is to be applied to reduceor eliminate the shareholders' suspended losses and does not pass throughto the shareholders to enable them instead to deduct those same losses.As Congress emphasized in 1993 in extending these provisions to "qualifiedreal property" loans (26 U.S.C. 108(a)(1)(D)), Section 108(d)(7) requiresthe amount of the discharged indebtedness to be applied to reduce favorabletax attributes "at the S corporation level" and "[t]he shareholders'basis in their stock is not adjusted" by that amount. H.R. Rep. No.111, supra, at 624-625 (emphasis added). See also Gaudiano v. Commissioner,No. 99-1294, 2000 WL 748179, at *18-*19 (6th Cir. June 8, 2000); Witzelv. Commissioner, 200 F.3d 496, 497-498 (7th Cir. 2000), petition for cert.pending, No. 99-1693.19 In short, a pass-through of the amount of the dischargeddebt to the shareholders is logically incompatible with the statutory requirementthat that same amount be utilized "at the corporate level" toreduce favorable corporate tax attributes. 26 U.S.C. 108(d)(7)(A).

In particular, petitioners' interpretation of the statute would nullifythe mandate of Sections 108(b)(2) (A) and 108(d)(7)(B) that the amount ofthe discharged debt of an insolvent S corporation be used to reduce theshareholders' "suspended" losses "for the taxable year ofthe discharge." 26 U.S.C. 108(d)(7)(B). See note 10, supra. As theSixth Circuit correctly recognized in Gaudiano v. Commissioner, 2000 WL748179 at *17, *18-*19, if the amount of the debt discharge were treatedas an "item of income" that flowed through to the shareholdersof an insolvent Subchapter S corporation under Section 1366 in the mannersuggested by petitioners, "the mandated reduction of the corporation'snet operating losses (which include suspended shareholder losses) wouldnever occur since there would be no [discharged debt amount] left at thecorporate level to apply against the losses." Under petitioners' interpretationof these provisions, the statutory requirement that the discharged debtamount be applied to reduce the "suspended" shareholder lossesfor the taxable year of the discharge could not be fulfilled. Id. at *28.

The facts of the present case illustrate this point. The discharge of indebtednessof the Subchapter S corporation occurred in 1991. Prior to that year, petitionerseach had several hundred thousand dollars in nondeductible "suspended"losses. During 1991, the Subchapter S corporation incurred additional losses;absent an increase in shareholder stock basis, these would be "suspended"losses that could not have been deducted in "the taxable year of thedischarge" (26 U.S.C. 108(d)(7)(B)). Those "suspended" lossesare specifically included on the list of favorable tax attributes that Congressspecified are to be reduced by the amount of the discharged debt. Ibid.;see note 10, supra. Under petitioners' reasoning, however, the dischargeddebt amount would not be used to reduce or eliminate these losses, as Congressdirected, but would instead be employed to generate additional stock basisthat would permit petitioners to deduct these very same losses. As the courtconcluded in this case, "[t]o embrace the taxpayers' position is toeffectively eliminate the 'price'" of tax attribute reduction thatCongress imposed when it endorsed the principle that debt forgiveness forinsolvent corporations does "not" constitute an item of "income"in enacting Section 108. Pet. App. 13. By depriving the tax attributionreduction requirements of Section 108(d)(7)(B) of plausible meaning, theposition advocated by petitioners violates the fundamental principle that"a statute must, if possible, be construed in such fashion that everyword has some operative effect." United States v. Nordic Village, Inc.,503 U.S. 30, 36 (1992).20

3. The notion that the amount excluded under Section 108(a) constitutesan "item of income" that passes through the insolvent corporationto its shareholders under Section 1366(a)(1)(A) and increases shareholderstock basis in the corporation under Section 1367(a)(1)(A) is further refutedby reading Section 108(d)(7)(A) in conjunction with Section 1366(b). Section108(d)(7)(A) provides that the debt discharge provisions for SubchapterS corporations are to be applied "at the corporate level." 26U.S.C. 108(d)(7)(A). Section 1366(b) in turn provides that the characterof an item to be passed through under Section 1366(a)(1)(A) is to be determinedas if the item "were realized directly from the source from which realizedby the corporation." 26 U.S.C. 1366(b). As the Tax Court explainedin Nelson v. Commissioner, 110 T.C. at 122, the amount of the dischargeddebt, which is captured and applied "at the corporate level,"cannot be treated as if it were obtained by the shareholders "directlyfrom the source" and thus can "not pass through to the shareholders"under Section 1366. The concurring opinion of Judge Beghe in Nelson madethe same point (110 T.C. at 131-132 (footnote omitted)):

Section 1366(b) refutes [Nelson's] passthrough interpretation of section108(d)(7)(A). There's no way, actually or fictively, in which the equivalencerule of section 1366(b) could apply to a solvent shareholder of an insolventS corporation.[]

As Judge Beghe explained, since Section 108(d)(7)(A) "dictates"that the debt discharge amount be determined and applied "at the corporatelevel" rather than at the shareholder level, the amount of that dischargecan not "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)."110 T.C. at 134. See also Blanchard, Debunking a Shibboleth, 58 Tax Notes1673 (1993).

4. Petitioners rely primarily on the decision of the Third Circuit in UnitedStates v. Farley, 202 F.3d 198 (2000) (Pet. App. 92-124), petition for cert.pending, No. 99-1675, which held that the amount of discharged debt of aninsolvent Subchapter S corporation passes through to the shareholders asan item of "income," thereby increasing their basis in the corporatestock and allowing them to deduct otherwise nondeductible suspended losses.21In reaching that conclusion, the Third Circuit did not dispute that thetaxpayer's position would result in "an apparent 'double tax benefit'"for the Subchapter S corporation's shareholders. 202 F.3d at 209. The courtalso acknowledged that there was strong evidence that the position arguedby the taxpayer "may not have been the result intended by Congress."Id. at 212 n.10. The court nonetheless concluded that "the clear andunambiguous language" of Section 1366(a) required it to rule in thetaxpayer's favor because, under that provision, "all income, tax-exemptor otherwise, passes through to the shareholders of an S corporation"and thereby "increases the shareholder's basis in their [S corporation]stock." Id. at 209, 210.

In so holding, however, the Third Circuit failed to give effect to the plainlanguage of Section 108(a) which incorporates the longstanding rule thatthe discharge of indebtedness of an insolvent corporation does "not"represent "income" because it effects no gain or accretion ofwealth for the taxpayer. 26 U.S.C. 108(a)(1)(B). See pages 10-13, supra.The court also failed to acknowledge the role of Sections 108(b) and 108(d)(7)(A), which require the amount of the discharged debt to be applied, "atthe corporate level," to reduce the favorable tax attributes of theinsolvent corporation (see note 10, supra) and that any "remainingdebt discharge amount" is then to be "disregarded" for it"does not result in income or have other tax consequences." S.Rep. No. 1035, supra, at 2.

In particular, the decision of the Third Circuit in Farley would nullifythe statutory mandate that the amount of the discharged debt of an insolventcorporation be applied "at the corporate level" to reduce or eliminatethe shareholder suspended losses for "the taxable year of the discharge."26 U.S.C. 108(d)(7) (A),(B). The court acknowledged in Farley that Section108(d)(7)(B) specifies that the suspended losses that accrue in the yearof the discharge of indebtedness are to be treated as part of the "netoperating losses" of the Subchapter S corporation. The court erred,however, in stating that this statute does not "indicate" thatthe amount of discharged debt "should reduce such net operating losses'for the taxable year of discharge.'" 202 F.3d at 207. The statute,in fact, expressly imposes that requirement by specifying, in Section 108(b)(2)(A),that the amount of the discharge of indebtedness is to be applied to reduce"[a]ny net operating loss for the taxable year of the discharge."26 U.S.C. 108(b)(2)(A).22 As other courts have noted, by interpreting thestatute to pass the debt discharge amount through to the shareholders underSection 1366, the decision in Farley would allow the shareholders to deductthe very same "suspended" losses that the statute instead directsare to be reduced (or eliminated) "at the corporate level" underSection 108(b). Witzel v. Commissioner, 200 F.3d at 497; Gaudiano v. Commissioner,2000 WL 748179, at *18-*19; pages 27-29, supra.

Perhaps recognizing that its decision would allow suspended losses in theyear of the discharge to escape the attribute reduction required by Congressin Section 108(b), the Third Circuit suggested that "the tax attributereduction scheme set forth in Section 108(a)-(b)" can instead be "implementedby reducing" other tax attributes listed in Section 108(b), such as"the basis of an S corporation's assets." 202 F.3d at 207-208.The possibility that the court's holding in Farley would not nullify allparts of the tax attribution reduction scheme of the statute, however, plainlydoes not justify the court's nullification of Section 108(d)(7)(B).

Moreover, the Third Circuit's reasoning ignores the express ordering provisionsthat Congress adopted for application of the tax attribute reduction scheme.Congress specified in Section 108(b) that (absent a specific election bythe taxpayer) the amount of the dis- charged debt is to be applied firstto reduce the net operating losses of the insolvent corporation (Section108(b)(2)(A))-which expressly includes the "suspended" lossesof the shareholders (Section 108(d)(7)(B))-and only thereafter is to beapplied to reduce other tax attributes such as business credits or the basisof the assets held by the corporation. 26 U.S.C. 108(b)(2)(A)-(G).23 Seenote 10, supra. The reasoning of the court in Farley is flatly inconsistentwith this statutory directive that suspended losses in the year of the dischargebe the first tax attribute reduced by the discharged debt under Section108(b).

5. Petitioners further err in contending (Pet. Br. 35-41) that Section 108(b)(4)(A)of the Code supports their position in this case. Although the Tenth Circuitdiscussed that provision at some length in its opinion (Pet. App. 14-16),that statute has no bearing on the proper disposition of this case.

Section 108(b)(4)(A) provides a rule with respect to the timing of the attributereductions mandated by Section 108(b). The statute provides that those reductions"shall be made after the determination of the tax imposed by this chapterfor the taxable year of the discharge." 26 U.S.C. 108(b)(4)(A). Inpractice, this means that the amount of the discharged debt is not to betaken into account by an insolvent taxpayer, and results in no reductionof its tax attributes, until after the tax for the year of the dischargeis determined.24

This requirement that the reduction in the insolvent taxpayer's tax attributesunder Section 108(b)(4)(A) "shall be made after the determination ofthe tax imposed by this chapter for the taxable year of the discharge"(26 U.S.C. 108(b)(4)(A)) applies at the corporate level, not to petitionersas shareholders of the corporation. 26 U.S.C. 108(d)(7)(A). Nothing in Section108(b)(4)(A) addresses the question whether petitioners may take an amountthat is "not" income under Section 108(a) and treat it as an "item[]of income" for the entirely different purposes of Section 1366. Instead,by deferring the attribute reduction under Section 108(b)(4)(A) until "after"the end of the tax period, the statute ensures that the amount of the dischargeddebt of the insolvent corporation will be used to reduce or eliminate theshareholder "suspended" losses "for the taxable year of thedischarge" (Section 108(d)(7)(B)) and thereafter be applied to reduceother tax attributes of the corporation. See pages 27-29, supra.

Certainly, nothing in Section 108(b)(4)(A) can plausibly be said to be designedor intended to place any taxpayer in a better position than he would havebeen in had the discharge of indebtedness never occurred. As the Tenth Circuitobserved in this case, "[t]o embrace [petitioners'] position is toeffectively eliminate the 'price' Congress imposed upon entities whose dischargeddebt income is excluded under § 108." Pet. App. 13. The courtof appeals correctly concluded that petitioners' effort to convert a statutethat was enacted to reduce tax benefits into a provision that confers the"unwarranted windfall" of a double tax benefit is refuted by thetext, purpose and history of these provisions. Id. at 16.

CONCLUSION

The judgment of the court of appeals should be affirmed.

Respectfully submitted.

SETH P. WAXMAN
Solicitor General
PAULA M. JUNGHANS
Acting Assistant Attorney
General
LAWRENCE G. WALLACE
Deputy Solicitor General
KENT L. JONES
Assistant to the Solicitor General
TERESA E. MCLAUGHLIN
EDWARD T. PERELMUTER
Attorneys

AUGUST 2000

1 Prior to the discharge of indebtedness, the liabilities of the SubchapterS corporation exceeded the fair market value of its assets by $2,181,748.Pet. App. 3.

2 For partnerships, the Section 108 exclusion applies "at the partnerlevel" (26 U.S.C. 108(d)(6)) rather than at the partnership level.For Subchapter S corporations, however, the Section 108 exclusion applies"at the corporate level" (26 U.S.C. 108(d)(7)(A)) rather thanat the shareholder level. When, as in this case, an insolvent S corporationis a partner in a partnership that has been discharged from debt, theseprovisions make the insolvency of the corporation (rather than of the partnershipor of the shareholders of the Subchapter S corporation) controlling in determiningwhether the exclusion from income is available under Section 108.

3 The losses of the corporation incurred prior to 1991, which petitionershad been unable to deduct because they had exhausted their basis, are describedas "suspended" losses and are carried into future years. Theymay be deducted in future years only if the shareholder acquires a basisin the stock to apply against them. 26 U.S.C. 1366(d)(2).

4 Petitioner Gitlitz claimed the deduction on his 1991 tax return, whilepetitioner Winn claimed the deduction on his 1992 return. Pet. App. 4 n.3.

5 The taxpayer in Nelson v. Commissioner also appealed the Tax Court's decisionin that case to the Tenth Circuit. The court of appeals affirmed the TaxCourt's decision on the authority of its opinion in this case. Nelson v.Commissioner, 182 F.3d 1152 (10th Cir. 1999). The taxpayer in Nelson didnot file a petition for a writ of certiorari.

6 The court of appeals provided several examples that illustrate the interplayamong Sections 108, 1366 and 1367. Pet. App. 16-18 n.6. The court notedthat the amount excluded from an insolvent S corporation's gross incomeunder Section 108 can not pass through to its shareholders to increase theirbasis under Sections 1366 and 1367 because: (i) the debt discharge amountis first applied to reduce the corporation's favorable tax attributes (includingany suspended shareholder losses which, under Section 108(d)(7)(B), aretreated for this purpose as net operating losses of the Subchapter S corporation);and (ii) "[a]ny further remaining debt discharge amount is [to be]disregarded, i.e., does not result in income or have other tax consequences."Pet. App. 9 (quoting S. Rep. No. 1035, 96th Cong., 2d Sess. 2 (1980)).

7 Although the conclusion that an insolvent taxpayer realizes no incomefrom the discharge of indebtedness has been referred to as the "judicialinsolvency exception," the exception originated in a 1923 Treasuryruling (I.T. 1564, II-1 C.B. 59 (1923)) that was confirmed by Treasury regulationsadopted as recently as 1957. See 1 B. Bittker & L. Lokken, Federal Taxationof Income, Estates and Gifts ¶ 7.6.1, at 7-56 n.1 (3d ed. 1999).

8 This regulation confirmed the ruling issued in 1923, in which the TreasuryDepartment first expressed the conclusion that the discharge of indebtednessdoes not constitute an item of "income" to an insolvent entity.See note 7, supra.

9 The amount of discharged debt that does not represent "income"under Section 108(a)(1)(B) may not exceed the amount by which the taxpayeris insolvent. 26 U.S.C. 108(a)(3). Section 108(d)(3) defines the term "insolvent"as "the excess of liabilities over the fair market value of assets,"and provides that insolvency is to "be determined on the basis of thetaxpayer's assets and liabilities immediately before the discharge." 26 U.S.C. 108(d)(3).Section 108 provides the same treatment for the discharge of a debt in abankruptcy case and for the discharge of "qualified farm indebtedness."26 U.S.C. 108(a)(1)(A), (C).

10 Under Section 108(b)(1), the amount excluded from gross income underSection 108(a)(1) "shall be applied to reduce the tax attributes ofthe taxpayer as provided in paragraph (2)." 26 U.S.C. 108(b)(1). Section108(d)(7)(A) prescribes that, in the case of discharge of indebtedness bya Subchapter S corporation, Sections 108(a) and 108(b) "shall be appliedat the corporate level." 26 U.S.C. 108(d)(7)(A).

Under Section 108(b)(2), the amount excluded under Section 108(a)(1) isgenerally applied to reduce the following tax attributes in the followingorder: (i) any net operating loss for the taxable year of the dischargeand any net operating loss carryover to the taxable year of the discharge,(ii) a general business credit, (iii) capital loss carryovers, (iv) thebasis of property of the taxpayer, and (v) foreign credit tax carryovers.26 U.S.C. 108(b)(2)(A)-(G). The reductions are dollar for dollar for netoperating losses, capital loss carryovers and basis reduction, and 33.33cents for each dollar excluded under Section 108(a) for the general businesscredit and foreign tax credit carryovers. 26 U.S.C. 108(b)(3)(A) & (B).Section 108(d)(7)(B) defines the "net operating loss" of a SubchapterS corporation, for the purposes of Section 108(b)(2)(A), to include "anyloss or deduction which is disallowed for the taxable year of the discharge under section 1366(d)(1)." 26 U.S.C. 108(d)(7)(B). The"suspended" losses of the shareholders, which can not be deducteddue the exhaustion of their basis in the corporate stock, are thereby definedas a "net operating loss" of the corporation for tax attributionreduction under Section 108(b).

Under Section 108(b)(5), the taxpayer may elect to apply any portion ofthe reduction referred to in Section 108(b)(1) to reduce "the basisof the depreciable property of the taxpayer." 26 U.S.C. 108(b)(5).Section 1017(a)(2) provides that "such portion shall be applied inreduction of the basis of any property held by the taxpayer at the beginningof the taxable year following the taxable year in which the discharge occurs."26 U.S.C. 1017(a)(2).

11 Congress provided in Section 108(e)(1) that "[e]xcept as otherwiseprovided in this section, there shall be no insolvency exception from thegeneral rule that gross income includes income from the discharge of indebtedness."26 U.S.C. 108(e)(1).

12 "In this situation, §§ 108(a) and 108(b) preserve an anomalyfrom the law predating their enactment in 1980, when a bankrupt or insolventtaxpayer was excused from recognizing debt discharge income and sufferedno collateral consequence." 1 B. Bittker & L. Lokken, supra, at7-58.

13 The 1980 amendments to Section 108 had no specific provisions for SubchapterS corporations. The statute, however, provided special rules for applyingthe provisions of Section 108(a) and (b) to partnerships. Section 108(d)(6)provided (and continues to provide) that the exclusion from gross income(in Section 108(a)) and the reduction in tax attributes (in Section 108(b))occur "at the partner level." 26 U.S.C. 108(d)(6). See note 2,supra.

In the Subchapter S Revision Act of 1982, Pub. L. No. 97-354, § 3(e),96 Stat. 1689, Congress amended Section 108(d)(6) to provide that, in thecase of S corporations, the exclusion from gross income and the reductionin tax attributes were to occur at the shareholder level, thereby treatingS corporations and partnerships similarly. In 1984, however, Congress alteredthat result by enacting Section 108(d)(7), which provides that, for SubchapterS corporations, (i) the exclusion and the attribute reduction are to takeplace at the corporate level and (ii) that any shareholder loss disallowedfor the year of the discharge under Section 1366(d)(1) is, for purposesof tax attribute reduction under Section 108(b), to be treated as a netoperating loss of the corporation for that year. Tax Reform Act of 1984,Pub. L. No. 98-369, § 721(b), 98 Stat. 966. The purpose of the 1984amendment is "to treat all shareholders in the same manner" (H.R.Rep. No. 432, 98th Cong., 1st Sess. 334 (1983)) by making "the exclusionof income arising from discharge of indebtedness and the corresponding reductionsin tax attributes (including losses which are not allowed by reason of anyshareholder's basis limitation) [operate] at the corporate level."Ibid. The 1984 amendment "t[ook] effect as if included in the SubchapterS Revision Act of 1982" (Pub. L. No. 98-369, § 721(y)(1), 98 Stat.972), and the 1982 provisions that would have made the exclusion and attributereduction operative at the shareholder level were thus never effective.Petitioners' citation (Pet. Br. 27) of the provisions of the former Section108(d)(6)- provisions that Congress rejected and that were never applicablefor Subchapter S corporations-is thus plainly incorrect.

14 As the court stated in Pugh v. Commissioner, 213 F.3d 1324, 1330 (11thCir. 2000), petitioners' reasoning "can lead to the result that shareholdersactually benefit from their S corporation's insolvency."

15 The decision of the Third Circuit in United States v. Farley, 202 F.3d198, 209 (2000), petition for cert. pending, No. 99-1675, and of the EleventhCircuit in Pugh v. Commissioner, 213 F.3d at 1331, erred in this regardby equating the discharged debt of an insolvent under Section 108 with thecategory of "tax-exempt income" that passes through to shareholdersto increase their stock basis under Sections 1366 and 1367. The court inPugh did so reluctantly, for it "acknowledge[d] the justice of theCommissioner's position, for unlike other sources of tax-exempt income,[debt discharge] income becomes tax-exempt merely from the infelicitouscombination of corporate insolvency and a lack of tax attributes to offsetthe [debt discharge] income [under Section 108(b)]." 213 F.3d at 1331.What these courts failed to recognize, however, is that the debt dischargeof an insolvent is not only not "tax-exempt income," it is notan item of "income" at all. See S. Rep. No. 1035, supra, at 8("no income arises from a discharge of indebtedness if the debtor isinsolvent"); 1 B. Bittker & L. Lokken, supra, at 7-58; pages 10-13& note 7, supra.

16 In 1999, the Treasury Department promulgated Treas. Reg. 1.1366-1(a)(2)(viii).That regulation formally specifies that the amount of any discharge of indebtednessof an insolvent Sub-chapter S corporation is not "tax-exempt income"within the meaning of the basis adjustment rules of Sections 1366 and 1367.64 Fed. Reg. 71,641 (Dec. 22, 1999). The regulation is effective only fortaxable years beginning on or after August 18, 1998, and thus does not,by its terms, apply to this case. 26 C.F.R. 1.1366-5.

17 Petitioners thus plainly err in arguing (Pet. Br. 47-49) that the treatmentthey seek for debt discharge of an insolvent taxpayer has no different consequencethan the treatment of "tax exempt income" such as state and localbonds. The treatment of "tax exempt income" such as state andlocal bonds simply preserves the statutory exemption for those items of"income"; the treatment sought by petitioners for debt dischargeof an insolvent taxpayer would create an addition to basis (and therebypermit additional deductions) for which no offsetting item of "income"exists. Indeed, it is through this very mechanism that petitioners seekto obtain a double tax benefit from the operation of these provisions. See,e.g., Pet. App. 10; note 14, supra.

18 Petitioners further err in claiming (Pet. Br. 46) that a Technical AdviceMemorandum (T.A.M. 97-39-002) issued by the Internal Revenue Service in1997 supports their position. This Technical Advice Memorandum serves asinternal advice within the agency, and Congress has specified that suchdocuments "may not be used or cited as precedent." 26 U.S.C. 6110(k)(3).In any event, the ruling contained in this Memorandum concerns partnershipprovisions that have no relevance to this case. The ruling addresses thefact that the insolvency rules for the discharged debt of a partnershipare applied at the individual partner level (26 U.S.C. 108(d)(6)), whereasthe insolvency rules for the discharged debt of a Subchapter S corporationare instead applied at the corporate level (26 U.S.C. 108(d)(7)). Incomefrom the discharge of a partnership debt is therefore first allocated toeach partner and tested at the partner level to determine whether the insolvencyof a partner would require elimination of that item in the determinationof the partner's individual tax obligations. An initial basis adjustmentis therefore made under Section 702(a) to reflect the allocation of thedebt discharge item to the individual partner; that adjustment is then offsetby a reduction of basis under Section 733 and 752(b) to reflect the reductionin the partner's liability for partnership debts. If the partner's insolvencyprecludes recognition of the discharged debt as an item of income, thatis to be treated separately on the partner's return and does not affectthe calculation of the partner's basis in the partnership. 1997 WL 592925(IRS TAM 97-39-002) at 2-3. These partnership adjustments made at the partnerlevel under 26 U.S.C. 705 (see 26 U.S.C. 108(d)(6)) obviously have no directrelevance for application of the statutory provisions involved in this case,which require that the treatment of discharged debt of insolvent SubchapterS corporations be determined "at the corporate level" (26 U.S.C.108(d)(7)) and that provide basis adjustments for any resulting item of"income" under 26 U.S.C. 1336 and 1367. Under the partnershiprules and the Subchapter S rules, however, the final result will be thesame: a debt discharge for an insolvent partner or for an insolvent SubchapterS corporation does not ultimately constitute an item of income for the partnersor for the shareholders and does not ultimately yield an increased basisfor the amount of the discharged debt.

19 In Gaudiano and Witzel, the Sixth and Seventh Circuits agreed with theTenth Circuit in this case that the amount of the discharged indebtednessof the insolvent Subchapter S corporation remains "at the corporatelevel" and eliminates suspended shareholder losses for the taxableyear of the discharge at that level. See Pet. App. 16-17 n.6, Examples 1and 3. In those cases, however, the Sixth and Seventh Circuits went on tostate that any amount of this discharged debt that remained after the eliminationof the shareholders' suspended losses passes through to the shareholdersand increases stock basis. Gaudiano, 2000 WL 748179, at *19-*20; Witzel,200 F.3d at 497-498. As we have explained (pages 10-13, supra), the conclusionthat a debt discharge amount that is not applied against the tax attributesof an insolvent Subchapter S corporation would then flow through to theshareholders as an "item of income" under Section 1366 (and therebyincrease the basis of their stock under Section 1367) is based on a misconceptionof what "income" represents. As the language of Section 108 indicates,and as the legislative history of the Bankruptcy Tax Act of 1980 expresslystates, any amount of the discharged debt of the insolvent corporation remainingafter application against the suspended losses "does not result inincome or have other tax consequences" and is therefore to be "disregarded."S. Rep. No. 1035, supra, at 2.

20 Petitioners do not dispute that, under their approach, the reductionor elimination of suspended shareholder losses required by Section 108(d)(7)(B)can not occur whenever the debt discharge amount exceeds the amount of thesuspended losses. They argue, however, that a reduction could occur in asituation where the debt discharge amount is less than the suspended losses(Pet. Br. 34-35). For example, if an insolvent S corporation is dischargedfrom $100 in debt, and its shareholder has $200 in suspended losses, petitionerssuggest that the debt discharge amount flows through to the shareholder,allows him to deduct $100 in losses, and then (magically) reappears at thecorporate level to eliminate the other $100 in suspended losses. As theSixth Circuit explained in Gaudiano v. Commissioner, supra, however, ifthe debt discharge amount passes through to and is used by the shareholder,there would be nothing left at the corporate level to apply against anyremaining losses. See 2000 WL 748179, at *18-*19.

Even viewed in isolation from the applicable statutory text, petitioners'argument is patently illogical, for it would create an inverse relationshipbetween the amount of indebtedness discharged and the amount of the taxattribute reduction that would occur. Under petitioners' approach, as thedebt discharge amount increases, the shareholder would be able to deductmore suspended losses at the shareholder level and, as a result, the netoperating loss reduction that occurs at the corporate level would be reduced.That absurd result would turn the tax-attribute reduction scheme enactedby Congress in Section 108 on its head.

21 Petitioners also cite (Br. 22-23 n.12, 24 n.13) various articles as supportfor their position. For the reasons we have described in detail, the articlesthat support petitioners have failed correctly to analyze the text and historyof these provisions. See pages 10-13, supra; 1 B. Bittker & L. Lokken,supra, at 7-58 (the debt discharge of an insolvent Subchapter S corporationis applied against the tax attributes of the corporation and "the unabsorbedamount is not gross income and is ignored"). The cited articles donot, in any event, provide an unqualified endorsement of petitioners' contentions.For example, one of the articles acknowledges that the Commissioner's positionis in "compliance with the literal language of Section 108(d)(7)(A)"and states that "[t]he problem with the taxpayer's position [is] thathe want[s] something for nothing." Lipton, Tax Court Rejects S Corp.Basis Step-Up for COD Income in Nelson, 88 J. Tax'n 272, 277 (1998). Anotherarticle observes that the government's position "is probably correctin its results from an equitable standpoint." Williford, Shareholderis Wrestled Down with a Full Nelson-Interplay of COD and S Corporation Rules,39 Tax Mgmt. Memo. 247, 257 (1998).

22 It is, of course, implausible that Congress would have taken the troubleto define Subchapter S corporation "net operating losses" forpurposes of Section 108(b)(2)(A) to include the "suspended" lossesincurred by shareholders in the year of the discharge (26 U.S.C. 108(d)(7)(B))if Congress believed that those losses were, as the court held in Farley,never to be reduced.

23 In describing these "ordering rules," Professors Bittker andLokken state (1 B. Bittker & L. Lokken, supra, at 7-59):

A bankrupt's or insolvent's debt discharge income is first subtracted fromits net operating loss * * * for the taxable year in which the dischargeoccurs * * * . The theory underlying this reduction is as follows: By reasonof the debt discharge, losses sustained by the taxpayer have been borneby the taxpayer's creditors. Normally, this would be reflected by requiringthat the taxpayer recognize gross income in the year of the discharge tooffset its earlier deductions of the shifted losses. However, because thelosses have not yet yielded tax benefit, this rule simply shaves down theloss deductions to eliminate portions not ultimately borne by the taxpayer.

24 If the taxpayer elects under Section 108(b)(5) first to reduce its basisin depreciable property in lieu of reducing the attributes in the orderprescribed by Section 108(b)(2) (see note 10, supra), the basis reductiontakes effect under Section 1017 not "after the determination of thetax imposed * * * for the taxable year of the discharge" (26 U.S.C.108(b)(4)), but, instead, "at the beginning of the taxable year followingthe taxable year in which the discharge occurs" (26 U.S.C. 1017(a)).The timing of the basis reduction in the event of this election was chosen"[in] order to avoid interaction between basis reduction and reductionof other attributes * * * ." H.R. Rep. No. 833, 96th Cong., 2d Sess.11 (1980); S. Rep. No. 1035, supra, at 14.

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