Friedman v. Commissioner of Internal Revenue

• Decision Date: 17 December 1999
• Docket Number: No. 98-2378,98-2378
• Parties: (6th Cir. 2000) Michael Friedman, et al., Petitioners-Appellants, v. Commissioner of Internal Revenue, Respondent-Appellee. Argued:
• Court: U.S. Court of Appeals — Sixth Circuit

Page 537

216 F.3d 537 (6th Cir. 2000)

Michael Friedman, et al., Petitioners-Appellants, v. Commissioner of Internal Revenue, Respondent-Appellee.

No. 98-2378

UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT

Argued: December 17, 1999

Decided and Filed: June 8, 2000

On Appeal from the United States Tax Court; Nos. 96-18735, 96-18736 J. Timothy Bender, Joseph P. Alexander, ROETZEL & ANDRESS, Cleveland, Ohio, for Appellants.

Teresa E. McLaughlin, Ann Belanger Durney, Paula K. Speck, U.S. DEPARTMENT OF JUSTICE, APPELLATE SECTION TAX DIVISION, Washington, D.C., for Appellee.

Before: BOGGS and NORRIS, Circuit Judges; NUGENT, District Judge.^*

OPINION

NUGENT, District Judge.

The Commissioner of Internal Revenue (hereinafter "Commissioner") issued notices of tax deficiencies to Michael and Madeline Friedman and Edward and Deborah Rosenthal¹ (hereinafter "Taxpayers") for the years 1989 and 1990. The notices stated that Taxpayers were not entitled to a loss in the amount of $5,055,116. As shareholders of an S corporation, Taxpayers made claims for net operating losses of their S corporation, New Manchester, by using the corporation's 1992 discharge of indebtedness income (a.k.a. "COD income") to increase their stock basis, and then in turn, using the increased basis to claim net operating losses from prior years. The Commissioner denied Taxpayers' claims for net operating loss deductions, determining that COD income of an insolvent S corporation cannot be used to increase the shareholders' basis.

Taxpayers petitioned the United States Tax Court for redetermination of the tax deficiencies. The Tax Court upheld the deficiencies, holding that there was no discharge of indebtedness income during the relevant tax year, and thus, New Manchester did not realize COD income for the 1992 taxable year. Further, the Tax Court held that even if the S corporation had realized COD income for 1992, such income does not increase the basis of the shareholders.

Taxpayers filed this timely appeal. For the reasons that follow, we AFFIRM the decision of the Tax Court.

Factual and Procedural Background

Appellants Michael Friedman and Edward Rosenthal were shareholders in an S corporation known as Manchester Steel, Inc². (a.k.a. New Manchester). Madeline Friedman and Deborah Rosenthal, spouses of Michael Friedman and Edward Rosenthal, respectively, were not shareholders of New Manchester; however, they are parties in this case solely by virtue of having filed joint tax returns with their husbands.³

New Manchester is a steel service company which processes and distributes flat rolled steel and other related products. It was incorporated on April 17, 1990, and it had elected to be taxed as an S corporation under Subchapter S of the Internal Revenue Code. Mr. Friedman and Mr. Rosenthal each owned 97.5 shares of New Manchester. Their individual percentage stock ownership was 24.375%. The remaining shareholders, Vernon Bremberg and Irwin Kramer, each owned 102.5 shares. Their percentage of stock ownership was collectively 51.250%.

On or about April 17, 1990, New Manchester acquired portions of the assets of Manchester Consolidated Industries, Inc. (a.k.a. Old Manchester), including cash, accounts receivable, equipment, inventory, land, buildings, improvements, fixtures, goodwill, trade name, and the trade mark from Old Manchester. New Manchester also assumed $12.8 million of Old Manchester's liabilities, including a secured trade debt. New Manchester financed such acquisition using the assets purchased from Old Manchester as security. When New Manchester purchased these assets, Old Manchester amended its Articles of Incorporation and changed its name to E&M Investments Co.

New Manchester was not a successful corporation. It suffered significant operating losses due to a variety of factors. In 1991 and in 1992, New Manchester claimed over $10 million in losses from its trade or business activities. In addition, New Manchester had a number of creditors to whom it owed in excess of $30 million. As a result of the continuing losses, on March 3, 1992, an involuntary petition for bankruptcy was filed on behalf of New Manchester pursuant to Chapter 7 of the United States Bankruptcy Code. A trustee in bankruptcy, who was authorized to operate New Manchester's business, was appointed on March 30, 1992. The trustee engaged in a number of activities on behalf of New Manchester, including the following: collecting accounts receivable, seeking buyers for saleable assets, paying claims, and filing reports with the bankruptcy court.

On May 7, 1992, New Manchester filed a schedule of assets and liabilities and a statement of financial affairs with the bankruptcy court. The schedule stated that New Manchester possessed tangible assets--real and personal property--valued at $9,241,153 and intangible assets--trade name, customer lists, and covenant not to compete--valued at $3,991,457. The schedule also reported liabilities totaling $30,360,669. On July 2, 1992, the trustee's report of sale of New Manchester's tangible assets was filed.

Several of New Manchester's creditors commenced a proceeding in Bankruptcy Court, on December 10, 1992, alleging potential fraudulent conveyances and/or preferential transfers with respect to New Manchester prior to the filing of the petition for bankruptcy. The creditors claimed that such fraudulent conveyances or preferential transfers rendered New Manchester insolvent or undercapitalized. The creditors sought $11 million from Taxpayers and E&M Investments. The bankruptcy court granted the trustee's request to obtain independent counsel to investigate and prosecute such claim in September, 1993. In February, 1994, Taxpayers offered to settle the creditors' claim for $300,000. The offer, however, upon a motion by the trustee, was refused by the court. Eventually, upon a second motion by the trustee, on April 11, 1995, the trustee was authorized to settle the claim for $2.2 million.

Throughout the bankruptcy proceeding, the trustee filed periodic reports with the court concerning assets, receipts, and disbursements. Such reports were filed in August of 1992, January of 1993, and January of 1995. On November 30, 1995, the trustee filed a final report with the bankruptcy court. The Final Report stated, in part, as follows:

All property of the estate, except that claimed as exempt by the debtor, without objection, or determined by the [bankruptcy] Court as exempt, has been inventoried, collected and liquidated, or abandoned. Any property not heretofore abandoned by the trustee is now abandoned...All claims have been examined and objections have been resolved....

Trustee's Final Report, November 30, 1995. A Supplemental Final Report was filed on January 31, 1996. Subsequently, the bankruptcy court issued its final decree on July 15, 1996, thus closing New Manchester's Chapter 7 proceeding and discharging the trustee.

During the pendency of the bankruptcy proceeding, Taxpayers filed joint federal income tax returns with the Internal Revenue Service for the calendar years of 1989, 1990, and 1992. On October 15, 1993, the Friedmans filed an application for a tentative refund, Form 1045, Application for Tentative Refund. The refunds were claimed for 1989 and 1990 in the amounts of $765,440 and $792,469, respectively. In such application, the Friedmans claimed net operating loss deductions from carrybacks relating to Mr. Friedman's stock interest in New Manchester.

On November 12, 1993, the Rosenthals filed a Form 1045, Application for Tentative Refund. The tentative refunds were claimed for 1989 and 1990 in the amounts of $834,729 and $810,331, respectively. The Rosenthals also claimed net operating loss deductions in its application from carrybacks relating to Mr. Rosenthal's stock interest in New Manchester. The Rosenthals filed an amended tax return for the 1988 tax year, claiming a carryback of a net operating loss for the years 1988 to 1991.

In its federal income tax return for 1991, Form 1120S, New Manchester claimed a loss of $10,102,289. In its tax return for 1992, New Manchester claimed a loss of $10,751,953.

The Commissioner issued notices of deficiencies to Taxpayers for the calendar years 1989 and 1990, on May 29, 1996. The Commissioner stated that Taxpayers owed additional amounts as follows: The Friedmans owed $686,400 for 1989 and $793,860 for 1990; and the Rosenthals owed $617,446 for 1989 and $811,723 for 1990. The notices of deficiencies stated that, for the taxable year ending 1992, Taxpayers were not entitled to a loss in excess of $5 million each from their interest in New Manchester. The Commissioner found that Taxpayers were not entitled to increase their basis in New Manchester by the cancellation of indebtedness income. Thus, Taxpayers' 1992 taxable income was increased accordingly.

Subsequently, Taxpayers filed separate petitions with the United States Tax Court, on August 27, 1996, for a redetermination of their respective income tax deficiencies for the taxable years at issue. In each case, Taxpayers claimed entitlement to the 1992 loss and carried the loss back to their respective tax years of 1989 and 1990. The two petitions were consolidated for the purpose of briefing and opinion in the Tax Court.

On May 27, 1998, the Tax Court issued its opinion, upholding Taxpayers' tax deficiencies. In its opinion, the Tax Court stated that the principal issue before it was whether Taxpayers were entitled to increase their basis in the S corporation's stock as a result of any COD income realized by the corporation. Initially, however, the Court found that pursuant to the plain language of section 108(d)(2) of the Internal Revenue Code, New Manchester had not realized a discharge of indebtedness, or COD income, in 1992. The Court observed that the trustee in New Manchester's bankruptcy case was actively conducting New Manchester's business and disbursing monies to creditors after 1992. The...