FTB REVISES POSITION ON S CORPORATIONS.

According to the FTB, the U.S. Supreme Court, reversing the 10th Circuit

Court, held in Gitlitz v. Commissioner, 2001-1 USTC 50,147, that the S corporation's excluded discharge of debt is an item of income that passes through to the shareholders pursuant to IRC Sec. 1366(a)(1)(A). The cancellation of debt income increases the shareholder's stock basis before the tax attributes reduction takes place pursuant to IRC Sec. 108(b)(4)(A).

Previously, the FTB took the position (consistent with the 10th Circuit Court) that the S corp's COD income does not pass through to the shareholder and does not increase the shareholder's basis. The FTB has revised its position to conform to the U.S. Supreme Court decision to allow the S corp to pass the COD income to the shareholder and increase the shareholder's basis.

The basis increase takes place at the time of the discharge (the year in which the COD income is incurred), and before the tax attributes reduction (the year following the discharge).

Treasury Regulation Sec. 1.1366(a)(2)(viii) recently was amended to specifically state that the COD income is not tax-exempt income. Nevertheless, the U.S. Supreme Court decision holds that S corp COD income is an item of income for pass through purposes per IRC Sec. 1366.

Treasury Regulation Sec. 1.1366(a)(2)(viii) no longer has a bearing on the COD income issue. The FTB will apply this position for all tax years retroactively.