Nelson v. Comm'r of Internal Revenue

• Decision Date: 19 February 1998
• Docket Number: No. 20811–95.,20811–95.
• Parties: Mel T. NELSON, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

110 T.C. 114

110 T.C. No. 12

Mel T. NELSON, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 20811–95.

United States Tax Court.

Feb. 19, 1998.

Neil M. Goff, for petitioner.

Virginia L. Hamilton, for respondent.

HAMBLEN, Judge:

Respondent determined a deficiency of $69,381 in petitioner's 1991 Federal income tax. After concessions, the principal issue for decision is whether discharge of indebtedness income realized and excluded from gross income under section 108(a) ¹ passes through to shareholders of a subchapter S corporation as an item of income in accordance with section 1366(a)(1)(A) and, in turn, increases the basis of the corporate stock under section 1367.²

FINDINGS OF FACT

This case was submitted fully stipulated pursuant to Rule 122. The stipulation of facts is incorporated herein and found accordingly. Petitioner, Mel T. Nelson, resided in Denver, Colorado, at the time he filed the petition herein. Petitioner was the sole shareholder in Metro Auto, Inc. (MAI), an S corporation.

During the 1991 taxable year, MAI disposed of all of its assets. In the same year, MAI realized discharge of indebtedness income, pursuant to section 61(a)(12), in the amount of $2,030,568 as a result of the disposition and a related agreement between MAI and its creditors.³ In turn, the COD income of $2,030,568 exceeded MAI's losses by $1,375,790 in 1991. Prior and subsequent to the event giving rise to the COD income, MAI was insolvent. MAI excluded from its gross income the entire amount of the indebtedness discharged by its creditors.

Petitioner increased the basis of his stock in MAI by $1,375,790 in 1991. Subsequently, petitioner disposed of his stock in MAI and, in turn, claimed a long-term capital loss on his 1991 Federal income tax return in the amount of $2,403,996. Respondent denied $1,375,790 of the loss on the premise that petitioner lacked sufficient basis in his MAI stock.

Ultimate Conclusion

We hold that COD income that is excluded from gross income under section 108(a) does not pass through to a shareholder of an S corporation. Therefore, shareholder basis is not increased.

OPINION

In the instant case, the principal controversy is whether petitioner is entitled to increase the basis in his S corporation stock pursuant to section 1366(a)(1) by his pro rata share of COD income. This issue is a question of law. Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir.1994), affg. T.C. Memo.1992–673.

Section 61 requires that certain amounts be included in income. Absent any exclusionary provision, items of income are included in gross income. Sec. 61(a). Section 61(a)(12) includes COD income in gross income. See also United States v. Kirby Lumber Co., 284 U.S. 1 (1931). Sections 101 through 135 exclude specific items of income from gross income. In particular, section 108(a)(1) provides, in pertinent part, that a taxpayer is permitted to exclude COD income to the extent that a taxpayer is insolvent when the discharge of indebtedness occurs. Section 108(d)(3) defines “insolvency” for this purpose as the excess of liabilities over the fair market value of the assets, immediately before the discharge.

There is, however, a condition for the exclusion of COD income. Section 108(b)(1) requires the taxpayer to reduce certain tax attributes by the amount of the debt discharged. In particular, section 108(b)(2) enumerates the tax attributes to be reduced and the order in which they are reduced: (1) Net operating losses; (2) general business credits; (3) capital loss carryovers; (4) basis reduction; and (5) foreign tax credit carryovers. Section 108(b)(4)(A) governs the timing of those reductions, requiring that the reductions be made “after the determination of the tax imposed by [chapter 1 of the Code] for the taxable year of the discharge.” Thus, the tax attributes are reduced as of the first day of the following tax year.

Section 108(d)(7) prescribes how section 108(a) and (b) are applied to S corporations. Section 108(d)(7) provides in pertinent part:

(A) * * *[Certain provisions] to be * * * applied at corporate level.—In the case of an S corporation, subsections (a) [and] (b) * * * shall be applied at the corporate level.

(B) Reduction in carryover of disallowed losses and deductions.—In the case of an S corporation, for purposes of subparagraph (A) of subsection (b)(2), any loss or deduction which is disallowed for the taxable year of the discharge under section 1366(d)(1) shall be treated as a net operating loss for such taxable year.

Section 1366(a) provides, generally, that income, losses, deductions, and credits are passed through pro rata to shareholders on their individual income tax returns. Secs. 1363(a), 1366(a). Section 1366(b) provides that the character of each item of income is determined as if it were realized directly from the source from which the corporation realized it, or incurred in the same manner as the corporation. A shareholder's gross income includes a pro rata share of the subchapter S corporation's gross income. Sec. 1366(c). The shareholder's basis, once computed, limits the amount of losses and deductions that may be taken into account by a shareholder for the taxable year. Sec. 1366(d). Any losses and deduction that the shareholder is not entitled to deduct currently are carried forward indefinitely (suspended losses). Id.

Section 1367(a)(1) limits the items by which the shareholder may increase his basis in the stock of an S corporation to the following items, inter alia:

(A) the items of income described in subparagraph (A) of section 1366(a)(1), [and]

(B) any nonseparately computed income determined under subparagraph (B) of section 1366(a)(1) * * * Section 1367(b)(1) provides that an item “required to be included in the gross income of a shareholder and shown on his return” is taken into account under section 1367(a)(1)(A) only to the extent included in gross income on the shareholder's return, increased or decreased by any adjustment of the item of income in a redetermination of the shareholder's income tax liability.

During the 1991 taxable year, there were no regulations addressing the application of either section 1366(a)(1)(A) or section 1367(a)(1)(A). However, the legislative history provides guidance with respect to section 1366:

The following examples illustrate the operation of the bill's pass through rules.

* * *

d. Tax-exempt interest—Tax-exempt interest will pass through to the shareholders as such and will increase the shareholders' basis in their subchapter stock. Subsequent distributions by a corporation will not result in taxation of the tax-exempt income. [S. Rept. 97–640, at 15–16 (1982), 1982–2 C.B. 718, 725.]

The Subchapter S Revision Act of 1982 (1982 Act), Pub.L. 97–354, 96 Star. 1669, enacted section 1367(a) and defined “items of income” by reference to section 1366(a)(1)(A), which refers to “items of income (including tax-exempt income) * * * the separate treatment of which could affect the liability for tax of any shareholder”. The Senate Finance Committee report accompanying the 1982 Act, S. Rept. 97–640, supra at 18, 1982–2 C.B. at 726, further explains:

3. Basis adjustment (sec.1367)

Under the bill, both taxable and nontaxable income will serve * * * to increase * * * a subchapter S shareholder's basis in the stock of the corporation.

Moreover, the legislative history states, generally, that the basis adjustment rules are analogous to those provided for partnerships under section 705 and require that the basis of a shareholder in an S corporation will be adjusted for income and losses for any corporate tax year before the distribution rules apply for that year.

In the instant case, the parties agree that MAI realized COD income in the amount of $2,030,568 in the taxable year 1991. Moreover, the parties concur that MAI was insolvent at the time the debt was discharged and that the attendant income derived therefrom is excludable from gross income pursuant to section 108(a)(1)(B) and (d)(7). The parties separate, however, on whether the Internal Revenue Code permits petitioner to increase the basis of his MAI stock by the amount of the S corporation's COD income.

In essence, petitioner argues that the excluded COD income is described in section 1366(a)(1)(A) because it could affect his income tax liability if it were treated as a pass-through item of income. In particular, petitioner contends that COD income excluded under section 108(a) is “tax-exempt” income under sections 1366(a) and 1367(a). Thus, petitioner argues that after the amounts are passed through, he is entitled to a basis increase with respect to his MAI stock for the excluded COD income. In sum, petitioner argues that the issue turns on whether COD income is an item of income (tax-exempt) that passes through to the S corporation shareholders under section 1366(a)(1)(A) as a separately stated item of income. If it is, petitioner contends that it results in a basis increase.

Conversely, respondent argues that the excluded COD income does not pass through to petitioner as the sole shareholder of MAI under section 1366(a)(1)(A). Specifically, respondent states that the literal language of section 108(d)(7)(A) provides that the exclusion will apply at the S corporation level. Thus, respondent contends that petitioner must apply the reduction in tax attributes under section 108(b) on the corporate level. In other words, respondent argues that the COD income never flows through to petitioner. This, in effect, precludes an increase in basis for petitioner as the shareholder of the S corporation.

Therefore, we examine the juxtaposition of the subchapter S provisions and section 108 to determine whether an S corporation shareholder's basis in stock may be increased by the amount of COD income derived by the insolvent corporation. We agree with respondent.

Here, the express language of the subchapter regime provides that the determination of a shareholder's income tax...