Final regs. provide guidance on S corp. treatment of COD income.

• Author: Szymkowiak, Dennis J.
• Position: IRS final regulations; cancellation of indebtedness

Several recent cases continue to explore the question of whether cancellation of debt (COD) income realized by an S corporation should be passed through to shareholders and increase the basis of their S stock.

Tax Court Memoranda

In January 2000, the Tax Court decided R.T. Mullen, TC Memo 2000-21, and R.H. Bettisworth, TC Memo 2000-30. In each case, an S corporation realized COD income that was excluded from taxable income under Sec. 108(a). The shareholders argued that the excluded COD income should pass through to them as an item of tax-exempt income. Further, the passthrough should increase the basis of their S stock, allowing suspended loss carryovers from the S corporation to be deducted on their individual tax returns. The Tax Court flatly rejected the taxpayers' arguments, citing Nelson, 110 TC 114 (1999). The court indicated that the current cases were not distinguishable from Nelson and reiterated that Nelson was decided correctly.

Nelson

In Nelson, the Tax Court held that excluded COD income did not pass through from a corporation to its shareholders. The holding was based, in part, on the court's interpretation of Sec. 108(d)(7)(A), which provides that the operative provisions of Sec. 108(a) and (b) are to be applied at the corporate level. The court believed this language was clear and prohibited excluded COD income of an S corporation to pass through to its shareholders. Further, the court ruled that excluded COD income did not fall within the meaning of tax-exempt income, reasoning that tax-exempt income, as referenced in S corporation basis rules,. meant income permanently excluded from taxation. In this case, excluded COD income was not permanently excluded from tax; instead, it was only deferred (through reduced loss carryovers or reduced future depreciation deductions).

Hogue

The Tenth Circuit had previously affirmed the Nelson holding; see Gitlitz, 182 F3d 1143 (1993), cert. granted. In J.D. Hogue, 1/3/00, a district court distinguished Gitlitz and held that COD income excluded from gross income under Sec. 108(a) passes through to S shareholders, allowing them to increase their stock basis under Sec. 1367. The court held that the Tenth Circuit's analysis was not supported by the plain text of the statute; rather, the district court indicated that the Tenth Circuit purposely interpreted the statute to avoid a windfall for the taxpayers.

The district court's analysis was similar to that of the taxpayers in Mullen and...