Federal Taxation - Suellen M. Wolfe and Jennifer N. Moore

• Publication year: 2001

Federal Taxationby Suellen M. Wolfe^* and Jennifer N. Moore^**

I. Introduction

The Eleventh Circuit Court of Appeals examined prominent and controversial tax issues during 2000. The technically difficult concept of cancellation of indebtedness income as it relates to the basis of a Subchapter S shareholder's interest was examined just prior to the United States Supreme Court's interpretation of this tax concept. The Supreme Court agreed with the interpretation of Internal Revenue Code ("I.R.C.") section 1366 espoused by the Eleventh Circuit. The Eleventh Circuit also examined an issue that the Supreme Court may soon consider when the circuit court followed the lead of an early 2000 Tax Court case examining the tax consequences of a corporate stock redemption incident to a divorce. Though the Eleventh Circuit characterizes the transaction as a tax free sale to the nonredeeming spouse under the provisions of I.R.C. section 1041, disagreement among the circuits and split decisions of the lower courts insure further examination of the Eleventh Circuit's position. The Eleventh Circuit also determined that an amount received for damages to business reputation received before the amendment to I.R.C. section 104(a)(2) on August 20, 1996, is excluded from tax. In that case, the court was required to revisit the concepts articulated by the United States Supreme Court in Commissioner v. Schleier¹ and United States v.

Burke.² A case involving a procedural issue examined whether the action of a tax matters partner ("TMP") is binding on the partners and whether the partners were informed of administrative and judicial proceedings occurring on the partnership level. In addition, common tax transactions causing disagreement over the appropriate legal standard to be applied were also reviewed. The Eleventh Circuit denied a payor spouse an income tax deduction for a payment required by a divorce agreement. The payment was held to constitute child support because it was deemed to be fixed by a divorce instrument. Another case involving reimbursed traveling expenses reversed the grant of a summary judgment to the government.

II. Jurisdiction of Tax Court to Deny Leave to File Motion to Vacate Assessment of Tax Liability of Partnership Filed by TMP

In Davenport Recycling Associates v. Commissioner,³ the Eleventh Circuit affirmed the Tax Court's decision denying leave to file a motion to vacate its order upholding a tax assessment against a limited partnership.⁴ Respondent Davenport Recycling Associates ("Davenport") was a limited partnership. Davenport's general partner and its TMP⁵ was Sam Winer. Ernest and Marion Karras and DL Associates ("DL") were limited partners.⁶

Davenport and its partners were audited for the years 1982 through 1985. On February 18, 1986, Winer was enjoined from marketing certain partnership interests and from serving as TMP. Davenport's limited partners were notified of Winer's removal as Davenport's TMP. DL served as TMP until it was determined that, as a limited partner, it was ineligible to serve. The Internal Revenue Service ("IRS") and Winer obtained a court order permitting Winer to serve again as Davenport's TMP performing administrative services.⁷

Winer, as TMP, signed extensions to the statute of limitations for the audits for Davenport. An assessment of taxes was eventually issued by the IRS for the years 1982-1985. After notifying the Davenport partners, Winer appealed the assessment to the tax court. No partner of Davenport filed a motion at the Tax Court or moved to participate in the appeal. Winer, acting as TMP, eventually conceded to the adjustments, and the tax court entered the order on February 23, 1994. Winer failed to serve various documents about the case's disposition to the partners as required by tax court rules.⁸

The Karrases sought leave to file a motion to vacate on January 23, 1996, contending that Winer did not have authority to represent Davenport before the tax court because of the injunction prohibiting his service. They also contended that the IRS's failure to inform the tax court of the injunction constituted fraud. After an evidentiary hearing, the tax court denied the leave to file the motion.⁹

The Eleventh Circuit examined whether the tax court abused its discretion in denying the leave to file the motion.¹⁰ Typically, the tax court lacks jurisdiction to vacate a decision once it becomes final.¹¹ However, the court has some discretion to extend the stated thirty-day limitation that is imposed after its order is entered.¹² The extension can be granted only when (1) the decision is shown to be void or a legal nullity for lack of jurisdiction over either the subject matter or the party; (2) there has been fraud on the court; or (3) the decision was based on mutual mistake.¹³ The Karrases premised their argument before the Eleventh Circuit on the first two contentions.¹⁴

The Karrases' subject matter jurisdiction argument was based on the assertion that Winer had no authority to consent to the extensions of the statute to assess Davenport and its partners.¹⁵ The Eleventh Circuit agreed with the tax court's holding that the statute of limitations is an affirmative defense that has to be raised by the partnership.¹⁶ It does not involve the subject matter jurisdiction of the tax court.¹⁷ The failure of the Karrases to file a timely petition to vacate the tax court's order precluded them from asserting that Winer, acting as TMP, had a conflict of interest thereby nullifying his action binding Davenport.¹⁸

The Karrases also argued that the tax court lacked jurisdiction over the parties because Winer had no authority to appear before the tax court on behalf of Davenport.¹⁹ The Eleventh Circuit held that the doctrine of implied ratification, recognized and as interpreted by New York, was properly applied by the tax court.²⁰ The Eleventh Circuit also concluded that the tax court did not abuse its discretion when it held that the Karrases accepted the benefit of Winer's authority, were properly notified, and impliedly ratified Winer's actions.²¹

The Karrases' final argument, that the order of the tax court was procured by fraud, had to be strictly construed. It is applied only when the ability of the court to render an impartial decision is compromised.²² The Eleventh Circuit held that no fraud had been committed on the tax court and affirmed the tax court's denial of leave to file a motion to vacate its order.²³

III. United States Supreme Court Affirms Strict Statutory Construction of I.R.C. Section 1366 Permitting the Basis of S Corporation Shareholder's Stock to be Increased by the Amount of Cancellation of Indebtedness

In Gitlitz v. Commissioner,²⁴ the United States Supreme Court sanctioned the taxing concepts articulated by the Eleventh Circuit in Pugh v. Commissioner.²⁵ In Pugh the Eleventh Circuit held that cancellation of debt ("COD") income, tax exempt because of the insolvency of the S corporation, is an item of income that passes through to the shareholders increasing their tax basis in the S corporation.²⁶ The tax benefit for the taxpayers in Gitlitz and Pugh differs because of their respective tax positions. However, the second principle articulated by the Supreme Court, that the pass through of amounts occurs before the reduction of the S corporation's tax attributes,²⁷ makes the taxpayer's position in Pugh stronger.

The income of an S corporation is not taxed at the corporate level because the shareholders of the corporation determine their tax liability by reporting their pro rata share of the S corporation's items of income.I.R.C. section 1366²⁸ specifically states that items of income include tax exempt income.²⁹ The character of items of income "shall be determined as if such item were realized directly from the source from which realized by the corporation, or occurred in the same manner as incurred by the corporation."³⁰

Appellant Pugh was a shareholder in Epoch Capital Corporation ("Epoch"), an S corporation. In 1990 Epoch, then insolvent, had $661,357 in debt forgiven. The corporation liquidated, and Pugh did not receive any liquidating distribution.³¹

Pugh's appeal was brought to determine the amount of loss in his investment in Epoch. Because there was no amount realized by Pugh on the liquidation of Epoch, his basis in the stock would determine the amount of loss he was entitled to recognize. Pugh sought to increase his basis in order to increase his reportable loss.³²

Cancellation of indebtedness generally constitutes income to the debtor.³³ Because Epoch was insolvent, the cancellation of debt income was excluded from the income of the S corporation at the corporate level.³⁴ An S corporation determines its income in the year of discharge, but to the extent that its COD income is excluded, it is required to reduce its favorable tax attributes.³⁵ In most cases the amount of COD income excluded offsets net operating losses or capital loss carryovers. However, Epoch had no tax attributes to offset.³⁶

The separate treatment of an item of income could affect the tax liability of a shareholder. Despite the fact that the COD income was excluded on the S corporation level and did not reduce any tax attributes of Epoch, Pugh treated the COD income as an item of income passing through to him that, though tax exempt, increased the basis of his stock in Epoch.³⁷

The Commissioner asserted deficiencies against Pugh contending that he was not entitled to increase the basis in his Epoch stock by the amount of the COD income. Pugh appealed to the tax court, which held for the government.³⁸ Pugh then appealed to the Eleventh Circuit, which held that I.R.C. section 1366(a)(1) clearly specifies COD income as an item of income that passes through to the shareholder.³⁹ Pugh was permitted to increase the basis of his stock under I.R.C. section 1367, thus increasing the loss he reported.⁴⁰

A. Character of Tax Exempt Income

In Pugh the IRS argued that the COD...