Entity selection revisited: will Gitlitz provide continuing vitality for S corporations?

• Author: Behrenfeld, Craig E.

In the alphabet soup of entity selection for Florida lawyers, S corporations have become second-class citizens to their more exotic cousins. LLCs, LLPs, and LLLPs offer the benefits of S corporation status (flow-through taxation with no owner subject to personal liability for the debts and obligations of the entity) without the restrictions imposed on S corporations (no corporate or nonresident alien shareholders, limited number of shareholders, one class of stock requirement, etc.). The recant decision of the U.S. Supreme Court in Gitlitz v. Commissioner, 121 S. Ct. 701 (2001), however, confirms that S corporations offer a significant advantage over other flow-through entities with respect to the tax consequences of cancellation of indebtedness (COD) income.

The Issue

The issue addressed by the Supreme Court in Gitlitz, and considered by numerous other courts as cited below, was whether S corporation shareholders can increase stock basis on account of COD income realized by the S corporation, and thereby deduct previously suspended S corporation losses. Specifically, the Supreme Court was asked to answer the following questions:

1) Is a shareholder of an insolvent S corporation entitled to increase his tax basis in the stock of such corporation on account of COD income realized by the corporation that is not currently taxable, and may never be taxable, to such shareholder?

2) If so, is the shareholder then entitled to deduct previously suspended S corporation losses to the extent of such increased basis?

As discussed below, the answers to those questions are of great consequence to S corporation shareholders.

The Law

An S corporation shareholder is not entitled to deduct S corporation losses that exceed the sum of his tax basis in the stock of the corporation plus his tax basis in monies loaned to the corporation directly by such shareholder.[1] Such losses are suspended and carried forward indefinitely until such time as the shareholder has sufficient tax basis to deduct the losses. Financially troubled S corporations typically have suspended losses.

Ordinarily, income realized by an S corporation flows through to the corporation's shareholders, and the shareholders' tax bases in the corporation are increased by the amount of such income.[2] Shareholders of an insolvent S corporation, however, are not taxed currently (and may never be taxed) on COD income realized by the corporation.[3] The S corporation, however, is required to reduce the amount of certain tax attributes, such as net operating losses (NOLs), by the amount of COD income that is not taxed to its shareholders.[4] For this purpose, if an S corporation has suspended losses at the end of a taxable year, those losses are treated as an NOL for such year.[5]

The Stakes

For purposes of illustration, the following example is used throughout this discussion:

Individuals A and B each contributed $100,000 to a subchapter S corporation (S Corp.) in exchange for 50 shares of S Corp. stock, representing 100 percent of the issued and outstanding stock of S Corp. S Corp. borrowed $2,000,000 to purchase an improved parcel of real property and operate a business on that property. The debt was secured solely by the property and improvements.

In year one, S Corp. spent $1,000,000 to purchase the parcel and incurred $1,200,000 of deductible expenses in connection with its unsuccessful business. In year two, S Corp. abandoned the project, the lender took title to the property (having a fair market value of $1,000,000) and the lender forgave the remaining $1,000,000 owed by S Corp.

For tax purposes, S Corp. recognized a loss of $1,200,000 in year one. $200,000 of such loss flowed through to A and B equally, and the remaining $1,000,000 of loss was suspended. In year two, S Corp. realized $1,000,000 of COD income.

Because S Corp. is insolvent in year two, the $1,000,000 of COD income realized by S Corp. will not be taxable currently to A or B, regardless of...