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Subchapter S and COD income: a taxpayer defeat.

The Tax Clinic item "Subchapter S and COD Income: A Taxpayer Victory," TTA, Sept. 1997, p. 558, reported the following:

For the past several years, the IRS has been engaged in a tug-of-war with tax practitioners over whether cancellation of debt (COD) income of an insolvent or bankrupt S corporation flows 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 Winn, 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.

This prior Tax Clinic item concluded as follows:

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.

Subsequent Developments

On Feb. 19, 1998, the Tax Court withdrew its opinion in Winn and granted summary judgment for the IRS (Winn, TC Memo 1998-71). The Court's action was based on its decision in Nelson, 110 TC No. 12 (1998), which held that a shareholder of an insolvent S corporation may not increase his basis in the corporation's stock to reflect the corporation's COD income.

The court construed Sec. 108(d)(7)(A) to mandate that insolvency is determined--and COD income is excluded from an S corporation's gross income under Sec. 108(a)--at the corporate level. It further construed Sec. 1366(a)(1)(A), in combination with Sec. 108(d)(7)(A), to preclude excluded COD income from recognition at the shareholder level. Therefore, since an S corporation's excludable COD income does not pass through to the shareholders under Sec. 1366(a)(1)(A), it cannot increase their stock's basis under Sec. 1367(a)(1)(A).

The court also stated:

In light of the relatively sparse legislative history that bears on the issue before us, we must construe what we can to form a proper perspective and provide a definitive answer to this anomalous situation. Here, petitioner has not borne an economic cost. On the contrary, it would appear that the economic cost was to others, the creditors of the corporation. Nor has petitioner made an economic outlay. Section 108 allows an insolvent S corporation to receive COD income sheltered from immediate taxation to its shareholders. To Permit Petitioner to increase basis in the stock of the corporation on account of such tax-deferred income would produce a windfall to him.
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Title Annotation:IRC Subchapter S; cancellation of debt income; Tax Court 1998 opinions in Winn and Nelson
Author:Josephs, Stuart R.
Publication:The Tax Adviser
Article Type:Brief Article
Date:May 1, 1998
Previous Article:Automatic relief for certain late S elections.
Next Article:Compensation of S shareholders: is it reasonable?

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