S corporation stock basis.

When an insolvent S corporation negotiates a reduction in its liabilities, it recognizes cancellation of debt (COD) income. Because the corporation is insolvent, the income is nontaxable. Can shareholders in the S corporation increase the basis of their stock by the amount of their share of COD income?

In 1986, Harold Farley and his wife invested $200,000 and received 50% of the stock in two S corporations. The corporations had operating losses, which the Farleys deducted on their tax returns, reducing their basis in the stock to zero. The corporations continued to have operating losses, which the taxpayers carried forward because they did not have sufficient stock basis to permit a deduction.

In 1992 the corporations ceased operations at a time when they were insolvent. They negotiated a reduction in their liabilities, which gave rise to COD income. The Farleys excluded this income based on the insolvency exception in IRC section 108, increasing the basis of their stock by the amount of the excluded income. Because of the basis increase, the unused loss carryforwards became deductible. The Farleys filed tax refund claims, and the Treasury issued refund checks.

The IRS subsequently determined that the excluded COD income did not increase the stock basis. It claimed the Farleys, therefore, were not entitled to the refunds. The IRS sued, asking that the Farleys return the refunds. The case went to the district court, with both sides moving for summary judgment. The court granted summary judgment in favor of the IRS. The Farleys appealed.

Result. For the taxpayers. The question before the court was whether an S corporation shareholder could increase his or her stock basis by the amount of the excluded COD income. The Third Circuit Court of Appeals said the answer lay in the interplay among IRC sections 1366, 1367 and 108.

In the court's view, these sections provide unambiguous guidance. Under section 1366, all income, including COD income, passes through to shareholders. The income is then includible or excludible on a shareholder's tax return based on the solvency or insolvency of the S corporation. In this case, since the COD income passed through to the shareholders, they could, according to section 1367, increase their stock basis for the COD income. On the first day of the next tax year, the S corporation would reduce tax attributes such as net operating and capital loss carryovers, as listed in section 108(b). As a general rule this requires the corporation to reduce its basis in its assets. Given the unambiguous wording of these sections, the Third Circuit rejected all the IRS arguments for not increasing the stock's basis.

The Third Circuit issued this opinion 11 days after the Seventh Circuit Court of Appeals issued its opinion in Witzel (200 F.3d 486), another COD income/S corporation basis case. The Seventh Circuit concluded that excluded COD income reduces the shareholder's S corporation loss carryforward. After reducing any loss carryforward, the shareholder is entitled to increase the basis of his or her stock. While both courts agree on the basis increase, they appear to disagree on what attributes must be reduced.

Yet another opinion was expressed by the Tenth Circuit Court of Appeals in Gitlitz, (182 F.3d 1143). The court ruled that a shareholder may not increase his or her basis in S corporation stock by the amount of excluded COD income. In December 1999, the Treasury issued final regulations under section 1366. The regulations provide that COD income excludible under section 108 is not permanently tax exempt in all cases and therefore does not pass through to shareholders. If the income does not pass through, no basis adjustment is possible. The regulations--effective for S corporation tax years beginning on or after August 18, 1998--do not apply to the tax year at issue in Farley. These developments have set the stage for continuing litigation. CPAs who have not claimed the basis increase for their clients following Gitlitz may want to consider filing protective amended returns.

* United States v. Harold D. Farley, 85 AFTR.2d [paragraph] 2000-380.

--Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.