Subchapter S and COD income: a taxpayer victory.

For the past several years, the IRS teas been engaged in a tug-of-war with tax practitioners over whether cancellation of debt (COD) income of an insolvent or bankrupt S corporation Bows through to shareholders, thereby increasing their basis in their S stock. Tax practitioners assert that under Sec. 108(a), COD income is tax exempt and, therefore, flows through to increase shareholder outside basis pursuant to Secs. 1366(a)(1)(A) and 1367(a)(1)(A). Not surprisingly, the Service disagrees. Recently, the Tax Court in wine, TC Memo 1997-286, has weighed in on the taxpayer side; unfortunately, the taxpayer victory, even if affirmed on appeal, does not completely resolve the matter.

Background

Sec. 61(a)(12) provides that COD income generally is includible in gross income. Sec. 108(a)(1), however, provides an exception when the discharge occurs in a bankruptcy case or when the taxpayer is insolvent, to the extent of the taxpayer's insolvency (other exceptions are beyond the scope of this discussion). The price for this "generosity" is that under Sec. 108(b), taxpayers generally must reduce certain tax attributes to the extent COD income is excluded: net operating losses (NOLs), general business credits, minimum tax credits, capital losses, asset basis, passive activity losses and credits, and foreign tax credits. Importantly, under Sec. 108(b)(4)(A), these attribute reductions are made after the tax is determined for the tax year of the discharge.

Thus, on its face, Sec. 1081a)(1) appears to be an exclusion provision. However, the reduction of favorable tax attributes arguably transforms the exclusion into a deferral. The legislative history of the Bankruptcy Tax Act of 1980 provides support for this theory; see,e.g.,S. Rep. No. 1035, 96th Cong., 2d Sess. 10 (1980); see also Centennial Savings Bank FSB, 499 US 573 (1991). Any debt discharge left over after attribute reduction is disregarded and represents excluded income.

COD Income and S Corporations

Special COD rules under Sec. 108(d)(7) apply to S corporations and their shareholders. First, the COD rules are applied at the entity level for S corporations. Second, any loss or deduction disallowance to an S shareholder under Sec. 1366(d)(1) is treated as a corporate NOL for attribute reduction purposes. (A third special rule is not relevant to this analysis.) In addition, the IRS has ruled in Letter Ruling (TAM) 9541001 that NOL carryovers (and presumably other carryovers) arising in a C year are not subject to attribute reduction if the debt discharge takes place in an S year.

As a consequence of these rules, the only attributes that an S corporation generally has available for reduction under Sec. 108(b)(2) are share holder suspended losses and basis in corporate assets. Under Sec. 1017(b)(2), asset basis reduction is not available if the aggregate adjusted basis of corporate property does not exceed corporate liabilities immediately after the discharge (unless the S corporation elects under Sec. 108(b)(5)).

IRS Concern

The following example shows why the Service is averse to treating S corporation COD income as tax exempt.

Example: In 1997, individual A invests $100 for all the stock of X an S corporation. X borrows $50 from a bank and incurs a $150 NOL during 1997. In recognition of X's insolvency, the bank forgives the debt on Dec. 31, 1997. If the $50 of COD income is treated as tax exempt, A's outside basis in X is increased to $150 ($100 investment + $50 of COD income), thereby permitting the entire $150 NOL to flow through to A in 1997 (and leaving no attributes to reduce "after the determination of tax. . . for the taxable year of the discharge"). Thus, $150 of loss passes through to A, who invested only $100.

To prevent this result, the IRS has advanced two theories. First, the Service has stated, in Letter Ruling (TAM) 9423003, that amounts excluded from income under Sec. 108(a)(1) are tax deferred, rather than tax-exempt, income. However, as previously mentioned, in the S corporation context the kind and amounts of available Sec. 108(b)(2) attributes are limited and any excess COD income is tax-exempt (which increases shareholder outside basis).

The IRS, therefore, has relied primarily on a second theory. Sec. 108(d)(7)(A) provides that the exclusions from income under Sec. 108 and the reduction in tax attributes are applied at the S corporation level. In Letter Ruling (TAM) 9541006, the Service held that this provision operates as an exception to the general passthrough scheme of subchapter S: "Therefore, to the extent that [an] S corporation . . . is insolvent [or in bankruptcy], there is no discharge of indebtedness income passed through to [shareholders] because the exclusion from income and the reduction in tax attributes apply at the corporate level."

The apparent flaw in this second theory is that while S corporation income from debt discharge should not flow through to shareholders as COD income, the IRS does not explain why such income should not flow through as a Sec. 1366(a)(1)(A) item of income (i.e., tax-exempt income), thereby increasing shareholder outside basis.

IRS Loses in Winn

The fallacy was not lost on the Tax Court. The taxpayers in Winn were shareholders of an S corporation which, in turn, owned an interest in a partnership. The partnership realized COD income of $4.1 million, the S corporation's share of which was $2 million. (Unlike S corporations and their shareholders, under Sec. 108(d)(6), the exclusion and tax attribute reduction rules of Sec. 108 are applied at the partner, not the partnership, level.) The S corporation was insolvent to the extent of $2.2 million at the time the partnership incurred the COD income.

The Service, relying on a variation of the second theory, argued that the S corporation's $2 million of COD income did not increase shareholder outside basis. In particular, it argued that, under Regs. Sec. 1.61-12(b), COD income incurred by an insolvent taxpayer is not realized in the first place and, thus, is not an item of income for purposes of Secs. 1366(a)(1)(A) and 1367(a)(1)(A)

The flaw in this argument was recognized immediately by the fax Court. Regs. Sec. 1.61-12(b) was promulgated in 1957, prior to the enactment of Sec. 108. The regulation merely restates the pre-Sec. 108 judicially created insolvency exception (see, e.g., Dallas Transfer S Terminal Warehouse Co., 70 F2d 95 (5th Cir. 1934)), which was superseded by Sec. 108 (see Sec. 108(e)(1)). The Tax Court therefore held, based on the arguments presented, that COD income "is en `item of income' for purposes of determining a shareholder's basis in S corporation stock by its inclusion in the definition of gross income under section 61(a)(12)."

Conclusion

The Tax Court in Winn rejected the IRS's position that COD income incurred by an S corporation is not a Sec. 1366 item of income and never flows through to shareholders Although this is an important taxpayer victory, it is tempered by the fact that the Service's reliance on Regs. Sec. 1.61-12(b) was misplaced. Further, the Service abandoned, and thus the Tax Court did not consider, the argument that COD income is "deferred" and not tax-exempt under Secs. 1366 and 1367. It is possible that the IRS will revive its argument that Sec. 108(d)(7)(A) operates as an exception to the general subchapter S passthrough scheme. It is also possible that the Service will concede the: issue.

FROM KENNETH N. ORBACH, CPA, PH.D., PROFESSOR, FLORIDA ATLANTIC UNIVERSITY, BOCA RATON, FLA.