Bump and Run Coverage for Troubled S Corporations
| Publication year | 1994 |
| Pages | 2349 |
| Citation | Vol. 23 No. 10 Pg. 2349 |
1994, October, Pg. 2349. Bump and Run Coverage for Troubled S Corporations
Throughout the tax-shelter years, and even today, experienced tax practitioners often have recommended a partnership tax structure for business entities. Partnership taxation offers formation, operation and liquidation rules superior to the other forms of conduit taxation.(fn1) Burdened with the one-class-of-stock rule, the strict pro rata allocation rule and the exclusion of corporate debt from basis, the S corporation is often viewed as the runt of the pass-through entity litter.(fn2)
However, the S corporation tax rules offer superior treatment for financially distressed business operations. An S corporation has a greater opportunity to exclude cancellation of indebtedness ("COD") income because, unlike a partnership or limited liability company, insolvency and bankruptcy status are determined at the S corporation level. Under current law, S corporations also offer favorable stock-for-debt exchange rules and debt-contribution rules.
This article addresses a unique tax issue involving insolvent or bankrupt S corporations---namely, whether an S corporation shareholder receives an increase, or "bump,"(fn3) in stock basis for his or her share of excluded COD income.(fn4) The authority for a basis bump flows from the statutory provisions of the Internal Revenue Code ("Code"), the legislative history of the Subchapter S Revision Act and the Treasury Regulations.
A basis bump is derived from the interaction of three different statutory provisions: Code §§ 108, 1366 and 1367. Section 108 is found within the part of the Code that sets forth items of income which are specifically excluded from gross income. Sections 1366 and 1367 are found within Subchapter S of the Code. These provisions provide the rules for the pass-through of income items to S corporation shareholders and for the adjustment of the basis in their shares.
Section 108(a) provides that gross income does not include any amount of indebtedness discharged or canceled (in whole or in part) when the taxpayer is insolvent or bankrupt. In the case of an insolvent taxpayer, the amount excluded from gross income is limited to the amount by which the taxpayer is insolvent.(fn5) Further, the amount excluded from gross income must be applied to reduce the tax attributes of the taxpayer.(fn6)
Section 108 also contains a special provision mandating that the exclusion from income, the tax attribute reduction and the insolvency and bankruptcy determinations be made at the S corporation level.(fn7) Section 108(d) also provides that for purposes of the tax attribute reduction rules, any losses of the S corporation suspended because the S corporation shareholder lacked tax basis must be treated as S corporation tax attributes and reduced by any excluded COD income.(fn8)
Sections 1366 and 1367 provide for the tax treatment of S corporation shareholders. Under § 1366(a)(1)(A), separately stated items of income, losses, deductions and credits of an S corporation pass through to its shareholders. Tax-exempt income is specifically included among the separately stated items of income passed through to shareholders. Under § 1367(a), a shareholder's basis in stock of an S corporation is increased by items of income passed through to him or her, including tax-exempt income. The placement of the phrase "including tax-exempt income" in § 1366(a)(1)(A) indicates Congress' belief that all types of S corporation tax-exempt income are income items that could...
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