Exempt COD income creates S corp. basis adjustment.

The rules for determining the taxability of cancellation of debt (COD) income are primarily a creation of the Bankruptcy Tax Act of 1980, although the principles have roots in the common law. The rules for determining the tax treatment of S corporations and their shareholders can be traced back to 1958, but are now primarily defined by the Subchapter S Revision Act of 1982. As the following discussion illustrates, a peculiar interaction of these two major pieces of tax legislation may create an unexpected windfall for taxpayers.

The debt cancellation rules

Under Sec. 61(a)(12), gross income generally includes income from the discharge of indebtedness. However, Sec. 108(a)(1) provides that gross income does not include COD income if the debt discharge occurs in a Title 11 case, or to the extent the taxpayer is insolvent (i.e., the taxpayer's liabilities exceed the fair market value of assets). Sec. 108 is frequently only a deferral provision, since taxpayers with exempt income under Sec. 108(a) are required to reduce loss carryovers and certain other tax "attributes" on the first day of the tax year following the year in which a debt is discharged (Sec. 108(b)). However, in a number of situations, for example when a taxpayer has nontaxable COD income that exceeds his tax attributes or the basis adjustment limitation of Sec. 1017(b)(2) applies, Sec. 108 creates a permanent exemption from tax.

Sec. 108(d)(7) sets forth a number of special rules for applying the principles of Sec. 108 to S corporations. Unlike partners in partnerships, who are required to apply Sec. 108(a) and (b) at the partner level, the COD rules are applied at the corporate level. Thus, an S corporation can receive the benefits of Sec. 108(a) only if the corporation itself is in bankruptcy or insolvent, irrespective of the financial condition of its shareholders. Similarly, except for a special rule which subjects a shareholder's suspended S losses to reduction under Sec. 108(b), attribute reduction occurs at the corporate level.

The S corporation basis

adjustment rules

Under Sec. 1367(a)(1)(a), a shareholder's basis in his S stock is increased by the "items of income" described in Sec. 1366(a)(1)(a). One of the items of income included in Sec. 1366(a)(1)(a) is "tax-exempt income." Since COD income that is not taxable under Sec. 108 would appear to constitute "tax-exempt income" within the meaning of Sec. 1366(a)(1)(S), a shareholder should be entitled to an upward basis adjustment for his share of the corporation's nontaxable COD income. This basis increase occurs without regard to any economic investment or economic risk on the shareholder's part.

Example: X organizes ABC Co. as an S corporation on Jan. 1, 1992 with $100 of capital. ABC borrows $300 from the bank. During 1992, ABC incurs an ordinary loss of $400. On Dec. 31, 1992, ABC has no assets and $300 of unpaid bank debt, which the bank agrees to forgive. The following tax consequences result:

* The bank's debt forgiveness causes ABC to realize $300 of COD income.

* Since ABC is insolvent to the extent of $300 immediately prior to the forgiveness, the $300 of COD income is not taxable to ABC (or to X) under Sec. 108(a)(1)(B).

* Under Sec. 1367(a)(1)(A), X's basis is increased by $300 to reflect his share of ABC's tax-exempt COD income.

* Taking into account X's initial capital contribution of $100 and the $300 basis adjustment, X has $400 of basis in his ABC stock, and is entitled to deduct ABC's $400 ordinary loss for 1992 on Schedule E of his individual Form 1040. Absent the $300 basis adjustment, X would have been entitled to a current deduction of only $100, and would have a $300 suspended loss carryover. This carryover would be eliminated under Sec. 108(b)(1) and (d)(7)(B) on Jan. 1, 1993.

Although the interplay of these rules appears to produce a tax windfall for X, it is important to recognize that if ABC was operated as a sole proprietorship rather than as an S corporation, X would be in the same position (i.e., $300 of deductible tax losses, with no economic investment), provided he had no personal tax "attributes" subject to reduction. The "windfall," therefore, is really a product of the Sec. 108 exclusion itself; the basis adjustment under Sec. 1367(a)(1)(A) merely passes through the Sec. 108 benefit to the S shareholder.

The basis increase created by the interplay between Secs. 108 and 1367 provides several potential benefits to an S shareholder. The greatest benefit arises when, as in the example, the taxable losses allocated to a shareholder would otherwise have exceeded his basis in the corporation. A shareholder who does not have current or suspended losses from the S corporation may still obtain a benefit when he disposes of the S stock. The increased basis will either reduce the shareholder's gain from the sale or result in a capital loss that can be used to offset other capital gain income.

Risk of IRS challenge

Based on discussions with the IRS National Office, the Service is aware, and has been for some time, that an S corporation's nontaxable COD income apparently results in an upward basis adjustment. Some practitioners believed that the S corporation basis adjustment created by nontaxable COD income would be eliminated through a technical correction included in the Revenue Reconciliation Act of 1993 (RRA); however, the RRA did not include such a provision. Obviously, a technical correction could still be included in future legislation, perhaps even before the end of 1993. In the meantime, the IRS has indicated that a published ruling may be issued that will preclude the basis adjustment under current law, although the Service has informally acknowledged that the rationale for this conclusion is still being developed.

Perhaps the IRS will take the position that excluded COD income is not "tax-exempt income" within the meaning of Sec. 1366(a)(1)(a). However, the legislative history of Sec. 1366 is devoid of any language that would restrict or limit the meaning of "tax-exempt income." Treating amounts that are excluded from income under Sec. 108 as "tax-exempt income" is a fair application of the plain language of Sec. 1366(a)(1)(A), particularly since the COD rules are included in Subtitle A, Chapter B, Part III of the Code, which includes many of the statutory provisions creating other exclusions from gross income (e.g., Sec. 103 regarding tax-exempt interest). It may be argued, however, that nontaxable COD income constitutes "tax-exempt income" only to the extent a taxpayer has insufficient tax attributes to reduce the excluded amounts. If the COD income results in a reduction of attributes under Sec. 108(b), the statute provides only an income deferral rather than a permanent exclusion. In fact, it could be argued that permitting a Sec. 1367 basis adjustment only when a true exemption occurs would produce results more consistent with the impact of these provisions on a sole proprietor who has no tax attributes to reduce.

Another argument against the basis adjustment that has been suggested is that nontaxable COD income should be treated strictly as a corporate level item not flowing through to the shareholders. Under this argument, nontaxable COD income would not result in a basis adjustment at the shareholder level. This argument seems to be based on an extension of the special COD rules for S corporations found in Sec. 108(d)(7), which provide that the Sec. 108 rules are generally applied at the corporate level. However, this appears to be an unwarranted extension of Sec. 108(d)(7) to deny the passthrough effect that results from applying the rules at the corporate level.

It should be noted that the RRA Conference Report that accompanied the recent enactment of Sec. 108(c) (which provides an elective exclusion from income for the reduction of qualified real property business indebtedness) states that "[t]he shareholders' basis in their stock is not adjusted by the amount of debt discharge income that is excluded at the corporate level." This statement has no direct support in Sec. 108(c) or elsewhere in Sec. 108, thus creating some doubt whether the law actually achieves this effect. There may be some merit to the conclusion, however, since Sec. 108(c) effectively creates only a deferral of income rather than a permanent exclusion.

The result created by the interaction of Secs. 108 and 1367 may not have been anticipated by Congress when these provisions were enacted. Nevertheless, the result seems to be mandated by the pertinent provisions of the law, and should be changed legislatively, if at all.