Supreme Court allows S basis increase for excluded DOI income.

• Author: Sair, Edward A.
• Position: Discharge-of-indebtedness

In an 8-to-1 decision, the Supreme Court held that excluded discharge-of-indebtedness (DOI) income under Sec. 108(a) is an item of income that passes through to S shareholders (thus increasing their stock bases), and further held that the increase occurs before the S corporation is required to reduce any of its tax attributes (Gitlitz, 1/9/01). This issue had previously been addressed by the Tax Court, five circuit courts and various district courts. In addition, the IRS and Treasury, through final regulations under Sec. 1366 issued in December 1999, attempted to resolve the issue on a prospective basis. Because the Supreme Court has now ruled definitively on the issue, it appears likely that the regulations will be modified or withdrawn, and that the Service will concede in favor of taxpayers.

Background

For S corporations, Sec. 108 applies at the corporate level. In other words, DOI income is excluded only if it occurs in Title 11 cases involving the corporation or to the extent that the corporation is insolvent. The insolvency or bankruptcy status of any shareholder is irrelevant. Excluded income is applied to reduce the corporate attributes. For this purpose, corporate losses allocated to shareholders but suspended under Sec. 1366(d) are treated as net operating losses of the corporation. In addition, the bases of the corporation's assets are reduced to the extent required by Sec. 1017. In most cases, an S corporation will not have other Sec. 108(b) attributes to reduce. Finally, Sec. 108(b)(4)(A) provides that this attribute reduction is made only after a determination of the tax for the tax year in which the discharge occurs.

Many affected shareholders have taken the position that income excluded under Sec. 108(a) is tax-exempt income that results, under Sec. 1367(a)(1)(A), in an increase in their stock basis. As a general proposition, taxpayers and the IRS agree that, arguably, a basis increase produces an unintended windfall for shareholders, by permitting them to reduce their gain or increase their loss by an amount that does not represent an economic outlay by them. The Service has put forth several arguments in opposition to these positions, including the assertion that Sec. 108 is intended to produce a tax deferral rather than a tax exemption and that, because Sec. 108 is applied entirely at the corporate level, there is no item to pass through to shareholders under Sec. 1366. The latter conclusion formed the basis for the...