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 PETITION FOR A 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 item of "income" which, under 26 U.S.C. 1366(a)(1)(A),flows through to petitioners as the shareholders of the Subchapter S corporation,thereby increasing their basis in the stock of the corporation under 26U.S.C. 1367(a)(1)(A), and thereby allowing them to deduct losses they previouslywere unable to deduct 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 PETITION FOR A 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(Pet. App. 21-24), which withdrew and replaced the initial opinion, 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. The jurisdictionof this Court is invoked under 28 U.S.C. 1254(1).

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. (PDW&A),a Colorado corporation that elected to be taxed for that year under theprovisions of Subchapter S of the Internal Revenue Code, 26 U.S.C. 1361-1379.Pet. App. 2-3. As this Court explained in Bufferd v. Commissioner, 506 U.S.523, 525 (1993), Subchapter S of the Code implements "a pass-throughsystem under which corporate income, losses, deductions, and credits areattributed to individual shareholders in a manner akin to the tax treatmentof 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 this income was $2,021,296, and this amount would have represented "[i]ncomefrom discharge of indebtedness" to the corporation (26 U.S.C. 61(a)(12))except that, at the time of the discharge, the corporation was insolvent.Because the corporation was insolvent, this amount was expressly excludedfrom income under Section 108 of the Code, which specifies that "[g]rossincome does not include any amount which * * * 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).

b. Although Section 108 of the Code thus specifies that discharge of indebtnessis 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 istreated as if it were earned (or lost) at the individual level; and (ii)that basis adjustments are made to avoid a double tax on those earningsor a double benefit 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 the corporate 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 continuing corporate losses onlyif their basis were somehow increased.1

Petitioners assert that the additional basis that they need in order totake further deductions from prior corporate losses can be found in thedischarge of indebtedness "income" of the corporation in 1991.They assert that this discharge of indebtedness is an "item[] of income"(26 U.S.C. 1366(a)(1)(A)) which increases their basis in the corporate stock(under 26 U.S.C. 1367(a)(1)(A)) even though, for the reasons described above,Section 108(a) of the Code expressly states that this item is "not"an item of income. They thus claimed additional deductions in an amountequivalent to their allocable share of the discharged debt of $2,021,296.Pet. App. 3.

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 Tax Court which 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).

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 judgmentin favor of the Commissioner. Pet. App. 21-24.

3. The Tenth Circuit affirmed. Pet. App. 1-20.2 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 an item that is "not"treated as an item of income under Section 108(a); at the same time, itwould allow the shareholders to reduce their gross income from other sourcesby treating this same item as if it were an item of "income,"thereby increasing their basis in the corporate stock and permitting deductionsotherwise barred by the prior exhaustion of their basis (Pet. App. 10).The court noted that this Court has emphasized that the Internal RevenueCode "should not be interpreted to allow [taxpayers] the practicalequivalent of [a] double deduction absent a clear declaration of intentby Congress." Ibid. (quoting United States v. Skelly Oil Co., 394 U.S.678, 684 (1969)). The court concluded that "only if taxpayers' theoryis unequivocally supported by the statutory text may we adopt it here"(Pet. App. 10) and that petitioners did not meet that burden.

The court noted that a discharge of indebtedness does "not" constitutean item of income under Section 108(a) if "the debt is * * * dischargedin a bankruptcy 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). The courtexplained that petitioners' effort nonetheless to treat it as an "item[] of income" under Section 1366 ignores "the 'price' Congressimposed upon entities whose discharge[ ] [of indebtedness] income is excludedunder § 108." Pet. App. 13. That "price" is set forthin the provisions of Section 108(b), which requires the insolvent corporationto reduce various "tax attributes" (such as carried over creditsor losses) "that could otherwise yield future tax benefits." Id.at 9. In deciding in Section 108 to "not" treat a discharge ofdebts owed by an insolvent as "income," Congress did not meanto provide additional tax benefits to the corporate shareholders in themanner proposed by petitioners; instead, Congress determined in Section108(b) to reduce the preexisting tax carryforwards available to the corporationthat might yield "future tax benefits." Pet. App. 9. The courtconcluded that petitioners' interpretation of these statutes "wouldnegate the effect of the tax attribution scheme and would give [petitioners]an unwarranted windfall." Id. at 16.

DISCUSSION

In Section 108 of the Internal Revenue Code, Congress specified that thedischarge of a debt owed by an insolvent corporation does "not"constitute income to that corporation. The Tenth Circuit correctly heldin this case that shareholders of an insolvent Subchapter S corporationmay not treat the amount that is thus expressly "not" income asif it were an "item of income" which, under Section 1366, wouldincrease the shareholders' basis in the corporate stock and allow the deductionof otherwise nondeductible losses. The decision in this case is supportedby the recent decision of the Seventh Circuit in Witzel v. Commissioner,200 F.3d 496 (2000). But see note 7, infra. Both of these decisions, however,directly conflict with the decision of the Third Circuit in United Statesv. Farley, 202 F.3d 198 (2000) (Pet. App. 92-124), which expressly declinedto follow the decision in this case. See id. at 108-109 n.4.3

This direct and acknowledged conflict among the courts of appeals warrantsreview by this Court. The issue that has divided these courts has substantialadministrative importance and is frequently the subject of audits and litigation.In addition to the three circuits that have already issued conflicting decisions,the same question presented in this case is already pending in three other circuits. See Friedman v. Commissioner, 75 T.C.M. (CCH) 2383(1998), on appeal, No. 98-2378 (6th Cir.); Gaudiano v. Commissioner, 76T.C.M. (CCH) 858 (1998), on appeal, No. 99-1294 (6th Cir.); Pugh v. Commissioner,77 T.C.M. (CCH) 1367 (1999), on appeal, No. 99-12646 (11th Cir.); Hogue v. United States, 2000-1 U.S.Tax Cas. (CCH) ¶ 50,149 (D. Ore. Jan. 3, 2000), on appeal, No. 00-35208(9th Cir.); Eberle v. Commissioner, 78 T.C.M. (CCH) 366 (1999), on appeal,No. 00-70159 (9th Cir.). In addition, more than 30 other cases raising thissame issue are currently pending in Tax Court or in refund suits in federaldistrict courts. These cases are appealable to the various circuits locatedthroughout the Nation in which these taxpayers reside. See 26 U.S.C. 7482(b)(1)(A).

Unless this clear and acknowledged conflict among the circuits is resolvedby this Court, the taxation of shareholders of Subchapter S corporationswill vary due to geographical happenstance, depending solely upon the circuitin which the taxpayer happens to reside. Review of this recurring issueby this Court is needed to avoid continuing uncertainty and inconsistentapplication of the revenue laws, and we therefore do not oppose the grantingof the petition for a writ of certiorari in this case.

1. Under Section 108(a)(1)(B) of the Code, the discharge of a debt owedby an insolvent taxpayer is "not" included in gross income tothe extent of the insolvency. 26 U.S.C. 108(a)(1)(B), (d)(3).4 As the result,that item is not treated as an "item of income" for any purpose,including for the basis adjustment purposes of Section 1366. Instead oftreating and taxing this as an "item of income," the Code directsthe taxpayer to use this excluded item to reduce (or eliminate) certainfavorable "tax attributes" that the taxpayer could otherwise employto reduce its taxable income in future years.

26 U.S.C. 108(b)(1)-(2).5 Any debt discharge amount remaining after applicationagainst these favorable tax attributes 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 (1980) (emphasis added).

By thus using the amount of debt discharge excluded from treatment as "income"by the taxpayer's insolvency to reduce certain favorable tax attributesof the corporation, Congress sought to employ Section 108 as a tax-deferral,rather than tax-forgiveness, mechanism: the taxpayer avoids immediate paymentof tax from the debt discharge, but pays increased taxes in future yearsas a result of the discharge. See S. Rep. No. 1035, supra, at 10 ("therules of the bill are intended to carry out the Congressional intent ofdeferring, but eventually collecting within a reasonable period, tax onordinary income realized from debt discharge"). In United States v.Centennial Savings Bank, 499 U.S. 573, 580 (1991), this Court similarlynoted that the effect of the exclusion for the discharge of qualified businessindebtedness under former Section 108(a)(1)(C) "is not genuinely toexempt such income from taxation, but rather to defer the payment of thetax by reducing the taxpayer's annual depreciation deductions or by increasingthe size of taxable gains upon ultimate disposition of the reduced-basisproperty."6

2. a. Section 1366(d)(1) limits the aggregate amount of an S corporation'slosses taken into account by a shareholder (under Section 1366(a)) to thesum of the shareholder's adjusted basis in the stock of the corporationplus his adjusted basis in any corporate debt owed to the shareholder. Lossesthat may not be deducted by the shareholder for this reason are describedas "suspended" losses; they may be carried forward indefinitelyand deducted in any subsequent year in which the shareholder increases hisbasis in the corporation's stock or debt. 26 U.S.C. 1366(d)(2).

A shareholder's basis in stock of the corporation is increased by his prorata share of the "items of income (including tax-exempt income)"of the corporation.

26 U.S.C. 1366(a)(1)(A); see 26 U.S.C. 1367(a)(1)(A). Petitioners claimthat the debt discharge, which is "not" income under Section 108(a),is nonetheless an "item of income" of the corporation which increaseshis basis and allows him to take deductions for losses "suspended"in a prior year because he had previously exhausted his basis by takingother loss deductions.

The court of appeals correctly rejected that claim, not only because itconflicts with the plain language of these provisions but also because itwould inappropriately provide petitioners with the "windfall"of a double tax benefit in a context where Congress plainly sought to limitthe benefit, not double it. Pet. App. 10.

Petitioners seek to characterize an item as "income" when Congresshas instead specified that it is "not" income. Moreover, petitionersdo so in an effort to double the benefit of the exclusion of this item fromincome, for they would use it to increase their ability to take additional,unrelated deductions. But Congress instead carefully specified in Section108(b) that the benefit of the characterization of this item as "not"income is to be diminished, rather than amplified, by requiring the corporationto make compensating reductions in its favorable tax attributes. See pages8-9, supra. Petitioners' contentions thus conflict with both the text andthe obvious spirit of these provisions.

b. In ruling in the taxpayer's favor on this issue in United States v. Farley,supra, the Third Circuit did not dispute that the taxpayer's position wouldresult in "an apparent 'double tax benefit' for S corporation shareholders."Pet. App. 117. That court also acknowledged that there was strong evidencethat the position argued by the taxpayer "may not have been the resultintended by Congress." Id. at 124 n.10. That court nonetheless concludedthat "the clear and unambiguous language" of Section 1366 requiredit to rule in the taxpayer's favor because, under that provision, "allincome, tax-exempt or otherwise, passes through to the shareholders of anS corporation" and thereby "increases the shareholders' basisin their S corporation stock" (Pet. App. 118, 124).

In so holding, however, the Third Circuit failed to take into account (i)that the plain language of Section 108(a) states that the discharge of indebtednessof an insolvent corporation is "not" income (26 U.S.C. 108(a)(1)(B));(ii) that Section 108(b) requires that item to be applied to reduce thefavorable tax attributes of the corporation (26 U.S.C. 108(b)); and (iii)that any remaining balance of that item is then to be "disregarded"and is not to be treated as "result[ing] in income or hav[ing] othertax consequences." S. Rep. No. 1035, supra, at 2.7

c. The Third Circuit also erred (Pet. App. 111 n.5, 117) in equating theamount excluded under Section 108 with "tax-exempt income," whichis encompassed within the items that may pass through to a shareholder andincrease the basis of his stock under 26 U.S.C. 1366(a)(1). Although "[t]hereis no definition of 'tax exempt' for purposes of section 1366," theterm inherently signifies an item that is "exempt on a permanent basis."Nelson v. Commissioner, 110 T.C. at 125. Thus, items of "tax exemptincome" include items such as state and local bond interest and lifeinsurance proceeds, which not only are "not" income in the yearreceived (26 U.S.C. 101, 103) but which are not accompanied with the offsettingreductions in tax attributes that make debt discharge income "subjectto taxation in the future." 110 T.C. at 125. As this Court explainedin Centennial Savings Bank, because of the offsetting adjustments of taxattributes required for debt discharge items under Section 108, the resultof the statute "is not genuinely to exempt such income from taxation* * * ." 499 U.S. at 580.8

When permanently tax exempt items such as state and local bond interest(26 U.S.C. 103) and life insurance proceeds (26 U.S.C. 101) are receivedby a Subchapter S corporation and passed through to its shareholders underSection 1366(a)(1)(A) as "items of income (including tax-exempt income),"the shareholders receive an upward basis adjustment (under Section 1367(a)(1)(A))that is offset by a corresponding downward basis adjustment (under Section1367(a)(2)(A)) when such income is distributed to the shareholder. 26 U.S.C.1367(a)(2)(A). As the Tenth Circuit stated in this case (Pet. App. 8-9),the temporary basis increase of such "tax-exempt" items is necessaryto preserve the tax-exempt character of the income at the shareholder level.In the absence of that basis increase, the shareholder would be subjectto tax upon the distribution of the "tax-exempt" items under Section1368(b)(2) of the Code, which specifies that any distribution that exceedsa shareholder's adjusted basis in stock is treated as gain from the saleor exchange of property. 26 U.S.C. 1368(b)(2). By contrast, when debt isdischarged, there is no distribution in cash or in kind to the debtor SubchapterS corporation, let alone the shareholder. An upward basis adjustment inthis context would simply defeat the plain mandate of Congress that thedischarge of indebtedness by an insolvent corporation is "not"to be treated as "income" under the Code. 26 U.S.C. 108(a)(1)(B).

d. Petitioners err in claiming that the "plain language" of Section108(b)(4)(A) of the Code supports their position in this case (Pet. 13-24).Although the Tenth Circuit discussed that provision at some length in itsopinion (Pet. App. 14-16), that statute has no bearing on the proper dispositionof this case.

Section 108(b)(4)(A) provides a rule with respect to the timing of the attributereductions mandated by Section 108(b)(1)-(2). The statute provides thatthose reductions "shall be made after the determination of the taximposed * * * for the taxable year of the discharge." 26 U.S.C. 108(b)(4)(A).In practice, this means that the amount excluded under Section 108 is nottaken into account by the insolvent taxpayer, and results in no reductionof its attributes, until after the tax for the year of the discharge iscomputed.9

The requirement that the reduction in tax attributes under Section 108(b)"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)) appliesat the corporate level, not to petitioners as shareholders of the corporation.26 U.S.C. 108(d)(7)(A). By the express terms of the statute, nothing inSection 108(b) 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. Certainly,nothing in Section 108(b)(4)(A) can plausibly be said to be intended toplace any taxpayer in a better position than he would have been in had thedischarge of indebtedness never occurred. As the Tenth Circuit observedin this case, "[t]o embrace [petitioners'] position is to effectivelyeliminate the 'price' Congress imposed upon entities whose discharged debtincome is excluded under § 108" (Pet. App. 13).

3. Petitioners' contention that they "seek equal treatment with otherinsolvent taxpayers" (Pet. 24) is without merit. The court of appealsproperly noted that petitioners are in fact seeking a "windfall";they are seeking to transmute Section 108 into a double tax benefit thatwould not be available to any taxpayer except a shareholder of an insolventsubchapter S corporation (Pet. App. 10).

Petitioners also err in claiming (Pet. 25) that the "Tenth Circuithas unfairly denied any benefit flowing from the § 108(a) exclusion;it might as well have been taxable income." Petitioners have benefittedfrom Section 108 because they did not pay any tax, and recognized no "income,"on the occasion of discharge of indebtedness of the insolvent subchapterS corporation. The decision in this case merely denies petitioners the doubletax benefit that they erroneously seek.10

CONCLUSION

The petition for certiorari should be granted.

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

MARCH 2000


1 Petitioners had exhausted their basis in the corporate stock by deductionstaken in prior years. See Pet. App. 3; 26 U.S.C. 1367(a)(2). The lossesof the corporation incurred prior to 1991, which petitioners had been unableto deduct because they had exhausted their basis, are described as "suspended"losses and are carried into future years; they may be deducted in futureyears only if the shareholder acquires a basis in the stock to apply againstthem. 26 U.S.C. 1366(d)(2).

2 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 (1999). The taxpayer in Nelson did not filea petition for a writ of certiorari.

3 We intend to file a petition for a writ of certiorari in United Statesv. Farley, supra, suggesting that that case be held pending the Court'sdisposition of this case.

4 Section 108 provides the same treatment for the discharge of a debt ina bankruptcy case and for the discharge of "qualified farm indebtedness."26 U.S.C. 108(a)(1)(A), (C).

5 Under Section 108(b)(1), "[t]he amount excluded from gross incomeunder * * * subsection (a)(1) shall be applied to reduce the tax attributesof the taxpayer as provided in paragraph (2)." 26 U.S.C. 108(b)(1). Section 108(d)(7)(A) prescribes that, in the case ofdischarge of indebtedness by an S corporation, Sections 108(a) and (b) "shallbe applied at 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). Section108(d)(7)(B) defines an S corporation "net operating loss" forpurposes of Section 108(b)(2)(A) as "any loss or deduction which isdisallowed for the taxable year of the discharge under section 1366(d)(1)* * *." 26 U.S.C. 108(d)(7)(B).

Under Section 108(b)(5), "[t]he taxpayer may elect to apply any portionof the reduction referred to in [Section 108(b)(1)] to the reduction undersection 1017 of the basis of the depreciable property of the taxpayer."Section 1017(a) provides that if a portion of the amount excluded underSection 108(a) is applied to reduce the taxpayer's basis in depreciableproperty, "such portion shall be applied in reduction of the basisof any property held by the taxpayer at the beginning of the taxable yearfollowing the taxable year in which the discharge occurs." 26 U.S.C.1017(a)(2).

6 In United States v. Kirby Lumber Co., 284 U.S. 1 (1931), this Court heldthat a taxpayer realizes taxable income from the discharge of indebtedness.Other courts concluded, however, that the holding in Kirby Lumber did notapply to a taxpayer that was insolvent at the time its debts were dischargedand remained insolvent after the discharge occurred. See, e.g., Dallas Transfer& Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5th Cir. 1934);Astoria Marine Construction Co. v. Commissioner, 12 T.C. 798, 801 (1949) (collecting cases). Under these decisions, the dischargeof indebtedness did not represent taxable income for the insolvent taxpayerand had no effect on any of the taxpayer's tax attributes. 1 B. Bittker& L. Lokken, Federal Taxation of Income, Estates and Gifts ¶ 6.4.6,at 6-58 n.97 (2d ed. 1989). A variety of statutory provisions have beenenacted, however, to require offsetting adjustments of favorable tax attributesto reflect an insolvent's discharge of indebtedness.

The current statutory scheme was first enacted as part of the BankruptcyTax Act of 1980, Pub. L. No. 96-589, § 2, 94 Stat. 3389. See 1 B. Bittker& L. Lokken, Federal Taxation of Income, Estates and Gifts ¶ 7.6.3,at 7-58 (3d ed. 1999). The original provisions of Section 108 enacted in1980, however, did not refer to S corporations. In the Subchapter S RevisionAct of 1982, Pub. L. No. 97-354, § 3(e), 96 Stat. 1689, however, Congressamended Section 108(d)(6) to provide that, in the case of S corporations,the exclusion from gross income and the reduction in tax attributes wereto occur at the shareholder, rather than corporate, level. Congress reverseditself on that issue, however, in 1984 by enacting Section 108(d)(7), whichprovides that, in the case of S corporations, the exclusion and the attributereduction are to take place at the corporate level, and that any (shareholder)loss disallowed for the year of the discharge under Section 1366(d)(1) isto be treated as a net operating loss 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 (1984)), and Congress envisionedthat "the exclusion of income arising from discharge of indebtednessand the corresponding reductions in attributes (including losses which arenot allowed by reason of any shareholder's basis limitation) are made atthe corporate level" (ibid.). Because the 1984 amendment "t[ook]effect as if included in the Subchapter S Revision Act of 1982" (§721(y)(1), 98 Stat. 972), the 1982 provisions that would have made the exclusionand attribute reduction operative at the shareholder level were never effective.

7 Section 108(d)(7)(A) provides that, in cases involving insolvent SubchapterS corporations, the amount excluded from the corporation's gross incomereduces the corporation's tax attributes at the corporate level. Those attributesinclude the corporation's net operating loss for the taxable year of thedischarge. 26 U.S.C. 108(b)(2)(A). Section 108(d)(7)(B) provides that an insolventS corporation's net operating loss for the taxable year of the dischargeincludes its shareholders' suspended losses for that year under Section1366(d)(1). Under these provisions, the amount excluded from the corporation'sgross income under Section 108 remains at the corporate level in order tobe available to reduce or eliminate the shareholders' suspended losses;it does not pass through to the shareholders to enable them to deduct thoselosses. Witzel, 200 F.3d at 497.

In Witzel, the Seventh Circuit agreed with the Tenth Circuit in this casethat the amount excluded under Section 108 remains at the corporate leveland eliminates suspended shareholder losses for the taxable year of thedischarge at that level. 200 F.3d at 497; see note 5, supra. The SeventhCircuit went on, however, in dicta, to state that the amount excluded fromthe corporation's gross income increased the shareholder's stock basis aftereliminating his extant suspended losses. 200 F.3d at 497-498. That conclusionis incorrect. As the language of these provisions indicates, and as thelegislative history expressly states, any amount remaining after applicationagainst the suspended losses "is disregarded, i.e., does not resultin income or have other tax consequences." S. Rep. No. 1035, supra,at 2.

8 On December 21, 1999, the Treasury Department promulgated Treas. Reg.§ 1.1366-1(a)(2)(viii), which specifies that income excluded underSection 108 is not tax-exempt income for purposes of Subchapter S, includingthe basis adjustment rules of Sections 1366 and 1367. 64 Fed. Reg. 71,643(1999). The regulation is effective for taxable years beginning on or afterAugust 18, 1998. Treas. Reg. § 1.1366-5.

This new regulation will not resolve the conflict that has developed amongthe courts of appeals. In ruling against the Commissioner's position inFarley, although the Third Circuit suggested (incorrectly) that its positionwas supported by the reference to "tax-exempt income" in Section1366(a)(1)(A), the court ultimately concluded that "the nature of dischargeof indebtedness income has little relevance" to this case for "[t]hestatute is clear--all income, tax-exempt or otherwise, passes through tothe shareholders of an S corporation pursuant to § 1366(a)(1)(A)."Pet. App. 118. The court concluded that discharge of indebtedness is an"item[] of income" for purposes of Section 1366(a)(1) regardlesswhether it is viewed as a tax-exempt or tax-deferred item. Pet. App. 118.

9 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 5, supra), the basis reductiontakes effect under Section 1017 on the first day of the taxable year followingthe year of the discharge. The timing of the basis reduction in the eventof this election was chosen "[i]n order to avoid interaction betweenbasis reduction and reduction of other attributes * * * ." H.R. Rep.No. 833, 96th Cong., 2d Sess. 11 (1980); S. Rep. No. 1035, supra, at 14.

10 Petitioners erroneously assert (Pet. 7) that the decision in this caseconflicts with the decision in CSI Hydrostatic Testers v. Commissioner,103 T.C. 398 (1994), aff'd per curiam, 62 F.3d 136 (5th Cir. 1995). As theTenth Circuit correctly explained (Pet. App. 19-20), the decision in CSIdid not involve Subchapter S corporations and has no relevance to this case.Instead, that case concerned whether the amount excluded under Section 108is includable in a Subchapter C corporation's subsidiary's earnings andprofits for purposes of the consolidated return regulations rules concerninginvestment basis adjustment under Section 1502. That case involves entirelydifferent statutory provisions and furnishes no support for the propositionadvocated by petitioners in this case.

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