Subchapter S and COD income: a taxpayer victory.

• Author: Orbach, Kenneth N.

For the past several years, the IRS teas been engaged in a tug-of-war with tax practitioners over whether cancellation of debt (COD) income of an insolvent or bankrupt S corporation Bows through to shareholders, thereby increasing their basis in their S stock. Tax practitioners assert that under Sec. 108(a), COD income is tax exempt and, therefore, flows through to increase shareholder outside basis pursuant to Secs. 1366(a)(1)(A) and 1367(a)(1)(A). Not surprisingly, the Service disagrees. Recently, the Tax Court in wine, TC Memo 1997-286, has weighed in on the taxpayer side; unfortunately, the taxpayer victory, even if affirmed on appeal, does not completely resolve the matter.

Background

Sec. 61(a)(12) provides that COD income generally is includible in gross income. Sec. 108(a)(1), however, provides an exception when the discharge occurs in a bankruptcy case or when the taxpayer is insolvent, to the extent of the taxpayer's insolvency (other exceptions are beyond the scope of this discussion). The price for this "generosity" is that under Sec. 108(b), taxpayers generally must reduce certain tax attributes to the extent COD income is excluded: net operating losses (NOLs), general business credits, minimum tax credits, capital losses, asset basis, passive activity losses and credits, and foreign tax credits. Importantly, under Sec. 108(b)(4)(A), these attribute reductions are made after the tax is determined for the tax year of the discharge.

Thus, on its face, Sec. 1081a)(1) appears to be an exclusion provision. However, the reduction of favorable tax attributes arguably transforms the exclusion into a deferral. The legislative history of the Bankruptcy Tax Act of 1980 provides support for this theory; see,e.g.,S. Rep. No. 1035, 96th Cong., 2d Sess. 10 (1980); see also Centennial Savings Bank FSB, 499 US 573 (1991). Any debt discharge left over after attribute reduction is disregarded and represents excluded income.

COD Income and S Corporations

Special COD rules under Sec. 108(d)(7) apply to S corporations and their shareholders. First, the COD rules are applied at the entity level for S corporations. Second, any loss or deduction disallowance to an S shareholder under Sec. 1366(d)(1) is treated as a corporate NOL for attribute reduction purposes. (A third special rule is not relevant to this analysis.) In addition, the IRS has ruled in Letter Ruling (TAM) 9541001 that NOL carryovers (and presumably other carryovers) arising in a C year...