Sup. Ct. to decide whether COD income increases basis.

• Author: Briskin, Robert A.
• Position: S corporation cancellation of debt income; U.S. Supreme Court

EXECUTIVE SUMMARY

* Currently, the circuits disagree on the treatment for Federal income tax purposes of S shareholders' stock bases when the corporation has excludible COD income.

* In the interests of uniformity, the Supreme Court has Decided to hear the Issue, in Gitlitz.

* Taxpayers should file protective refund claims now if they have already paid taxes based on the IRS's position.

Five circuits have decided whether S corporation cancellation of debt (COD) income excluded under Sec. 108(a) increases shareholder stock basis. The issue is important, because the increase in basis may allow the use of previously suspended S losses, or reduce gain (or produce a loss) on the corporation's liquidation or the stock's sale. The circuit decisions conflict, and the Supreme Court has agreed to hear the issue on Oct. 2, 2000. This article discusses the exclusion of COD income for an insolvent or bankrupt S corporation, the differing theories as to whether such income increases basis and what practitioners can do to protect clients until the Court speaks.

Currently, the courts disagree on the treatment for Federal income tax purposes of S corporation shareholders' stock bases when the corporation has excludible cancellation of debt (COD) income. The amount of basis can affect a shareholder's use of current-year and suspended corporate tax losses, as well as the recognition of capital gains and losses on the stock's disposition. The Third Circuit, in Farley,(1) the most favorable taxpayer result to date, recently held that S shareholders receive a basis step-up for COD income, thus allowing them to use previously suspended losses; the Eleventh Circuit, in Pugh, Jr.,(2) later agreed with Farley as to the basis step-up (however, Pugh, Jr., dealt with capital loss treatment, not suspended losses). As will be discussed, the Tax Court and three other circuits disagree with the Farley result, all for different reasons. Additionally, regulations state that excluded COD income does not pass through to S shareholders to increase stock basis. To resolve the conflict among the circuits, the Supreme Court recently agreed to hear the issue on Oct. 2, 2000.(3) Currently, CPAs should consider filing protective refund claims for clients who previously paid taxes based on the IRS's position, which denies an increase in stock basis for COD income.

Background

An S shareholder takes into account on his individual return his pro rata share of the corporation's income and loss items, including COD income, under Sec. 1366(a); According to Sec. 1366(d)(1), a shareholder can use S losses only to the extent of his basis in stock and debt. Tax losses that cannot be used are "suspended" under Sec. 1366(d)(2) and carried forward to the taxpayer's succeeding tax years, to be used if the shareholder later increases his stock or debt basis. Stock basis increases if the shareholder contributes additional capital, or if the corporation generates and passes through income (both taxable and tax-exempt) under Secs. 1366(a)(1)(A) and 1367 (a)(1)(A) . In Farley, the Third Circuit held that COD income was exempt income that increased an S shareholder's stock basis. This increased basis allowed the shareholder to use previously suspended losses. In Pugh, Jr., the Eleventh Circuit held that S-level COD income increased the shareholder's stock basis, entitling him to long-term capital loss treatment on the corporation's liquidation.

It is an established tax principle that income is generated when a debtor receives total or partial cancellation of his outstanding debt, without paying consideration in return.(4) S corporations experiencing financial difficulties may (1) have lenders or creditors forgive corporate debt, (2) file for bankruptcy protection under the Federal Bankruptcy Act or (3) have their assets foreclosed on, all of which can produce COD income. Under Farley, COD income is excluded by an insolvent S corporation via Sec. 108(a); however, such income still increases shareholder stock basis under Sec. 1367 (a)(1)(A), allowing the passthrough to shareholders of previously suspended losses. The result of Farley is that neither the S corporation nor the shareholders recognize the corporation's COD income (because the corporation is insolvent), yet the latter can deduct previously suspended S losses on their returns. If there are no suspended losses, the increased stock basis allows the (1) passthrough of current-year corporate losses to shareholders' individual returns or (2) recognition of capital losses on the corporation's liquidation or a stock sale.(5)

Excluding COD Income

Under Sec. 61(a)(12), S corporation COD income is passed through to shareholders. Under Sec. 108(a)(1), this COD income is excluded from an S corporation's gross income if the discharge of the corporation's debt occurs (1) in a Tide 11 case (i.e., bankruptcy) or (2) when the corporation is insolvent. The S corporation's bankruptcy or insolvency (not the shareholders') determines whether COD income is excluded under Sec. 108(d)(7)(A). Under Sec. 108(d)(3), an S corporation is "insolvent" if its liabilities exceed the fair market value of its assets. Insolvency is determined on the basis of the corporation's assets and liabilities immediately before the debt discharge.

The Sec. 108(a) insolvency and bankruptcy rules apply at the corporate level for corporations, but at the partner level for partnerships.(6) Partnerships recognize COD income at the partnership level, but the various Sec. 108(a) exclusions apply at the partner level. While the IRS agrees that a partner's basis in his partnership interest increases by his share of the partnership's COD income excluded from his share of income under Sec. 108(a), it has ruled that S shareholders do not get a similar basis increase.(7)

Reducing Tax Attributes

The Code imposes a cost for excluding COD income. Sec. 108(b) requires that specified tax attributes be reduced to the extent COD income is...