Pugh v. Commissioner of Internal Revenue

• Decision Date: 05 June 2000
• Docket Number: No. 99-12646,99-12646
• Parties: (11th Cir. 2000) James H. PUGH, Jr. and Alexis Pugh, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1324

213 F.3d 1324 (11th Cir. 2000)

James H. PUGH, Jr. and Alexis Pugh, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 99-12646.

United States Court of Appeals, Eleventh Circuit.

June 5, 2000.

Appeal from a Decision of the United States Tax Court. (No. 96-27237).

Before CARNES, BARKETT and WILSON, Circuit Judges.

WILSON, Circuit Judge:

This case features a taxpayer who seeks to take personal tax advantage from his S corporation's insolvency. Put simply, the taxpayer owned shares in an S corporation. The corporation owed money, was forgiven the debt, and then liquidated. The taxpayer sought to have the cancellation-of-debt (COD) income flow through to him and increase his basis in his S corporation stock. Then the taxpayer claimed a tax deduction for a capital loss based on the increased basis. The Tax Court ruled that the COD income belonged only to the S corporation, did not flow through to the taxpayer, and did not increase his basis. We hold that although the tax treatment urged by the taxpayer seems contrary to the Code's spirit, it is dictated by the Code's plain language. We therefore reverse the decision of the Tax Court.

BACKGROUND

Appellant James Pugh ("Pugh")¹ owned shares in Epoch Capital Corporation ("Epoch"), an S corporation that fell on hard times in 1990. Being insolvent, Epoch was forgiven $661,357 in debt, realized the same amount in cancellation-of-debt (COD) income, liquidated, and filed articles of dissolution. At the time of liquidation, Pugh owned 97% of Epoch's then-worthless stock. He did not receive any distribution from Epoch when it liquidated.

On its 1990 tax return, Epoch excluded the COD income from its gross income. In preparing his personal tax returns, Pugh treated Epoch's COD income by applying the "pass-through" principles and basis adjustment provisions normally applicable to subchapter S corporate shareholders. Pugh adjusted his basis upward by $612,245, his share of Epoch's COD income. By increasing his basis, Pugh sought to take advantage of the losses resulting from the precipitous decline in the value of his stock. Pugh claimed a capital loss for the Epoch stock on his 1990 return and a carry-forward loss on his 1991 return.² Pugh had no other losses carrying forward from previous years.

The Commissioner determined that Pugh was not entitled to increase his basis by the amount of the COD income, and asserted deficiencies against Pugh. Pugh contested the deficiencies by filing a petition in the tax court. The tax court, relying on Nelson v. Commissioner, 110 T.C. 114 (1998),³ ruled that "COD income realized and excluded from gross income under section 108(a) does not pass through to shareholders of an S corporation as an item of income in accordance with section 1366(a)(1) so as to enable an S corporation shareholder to increase the basis of his stock under section 1367(a)(1)." This appeal followed.

DISCUSSION

We have jurisdiction to review the decisions of the Tax Court "in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury." 26 U.S.C. § 7482(a)(1). The Tax Court's statutory interpretation receives de novo review. See Estate of Wallace v. Commissioner, 965 F.2d 1038, 1044 (11th Cir.1992) (quoting Young v. Commissioner, 926 F.2d 1083, 1089 (11th Cir.1991)).

At issue in this appeal is the amount of loss Pugh can deduct as a capital loss on his tax return. Pugh's capital loss is determined with reference to his adjusted basis in his Epoch stock;⁴ Pugh and the Commissioner disagree on whether Pugh's basis could reflect his pro rata share of Epoch's cancellation-of-debt (COD) income.

This Circuit has not addressed the issue of whether COD income realized and excluded from gross income under 26 U.S.C. § 108(a) passes through to shareholders of an S corporation as an item of income under 26 U.S.C. § 1367(a)(1), and whether S corporation shareholders can increase their individual stock basis to reflect the corporation's COD income. The answer involves the interplay between the way the Code treats COD income and the way the Code treats the tax liability of S corporation shareholders.⁵

Our analysis begins with the language of the Code itself. See Griffith v. United States (In re Griffith ), 206 F.3d 1389 (11th Cir.2000) (en banc). "[I]f the language of the statute is plain, then our interpretative function ceases and we should 'enforce [the Code] according to its terms.' " Id. at 1393 (quoting Caminetti v. United States, 242 U.S. 470, 37 S.Ct. 192, 61 L.Ed. 442 (1917)). Because the Code clearly provides that all S corporation income passes through to the corporation's shareholders and increases their basis by the amount of the pass-through, we must reverse the tax court.

1) Pass-through income.

S corporations allow many small business owners to enjoy the limited liability of the corporate structure without, for the most part, being subject to taxation at the corporate level. See 26 U.S.C. § 1363(a); Beard v. United States, 992 F.2d 1516, 1518 (11th Cir.1993). Congress implemented this mechanism by providing that the tax repercussions of an S corporation's income and losses pass directly through to its shareholders. See 26 U.S.C. § 1366; Beard, 992 F.2d at 1518 (noting that S corporation "generally does not pay income taxes as an entity").

Accordingly, shareholders of S corporations determine their tax liability by taking into account their pro rata share of the S corporation's "items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and [ ] nonseparately computed income or loss." 26 U.S.C. § 1366(a)(1). The character of these pass-through items "shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation." 26 U.S.C. § 1366(b). Therefore, to determine whether Epoch's COD income passes through to Pugh, we must determine whether it is the type of income suitable for pass-through treatment.

Nature of Cancellation-of-Debt Income.

Forgiveness of debt is income because it frees up assets that the taxpayer previously had to dedicate toward repaying its obligations. See, e.g., United States v. Centennial Savings Bank FSB, 499 U.S. 573, 582, 111 S.Ct. 1512, 113 L.Ed.2d 608 (1991); United States v. Kirby Lumber Co., 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131 (1931). Normally, COD income is included in gross income and would thus pass through to an S corporation's shareholders. See 26 U.S.C. §§ 61(a)(12), 1366(a).

But there is an exception for insolvent debtors. For them forgiveness of debt means little, for even after forgiveness the debtors still owe more than they have. Because insolvents cannot enjoy the freed-up assets, courts have ruled that they need not include the COD amounts in gross income. See, e.g., Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5th Cir.1934) (noting that cancellation of insolvent's debt "did not have the effect of making the respondent's assets greater than they were before that transaction occurred.... A transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income."). Congress codified this exception in 26 U.S.C. § 108, which excludes COD income from gross income if the taxpayer is insolvent. See 26 U.S.C. § 108(a)(1)(B).⁶

In granting the exemption, Congress exacted a price. Taxpayers who exclude COD income must offset the exclusion against favorable tax attributes such as net operating losses and capital loss carryovers. See 26 U.S.C. § 108(b)(1), (b)(2)(A), (b)(2)(D). These reductions occur after determining tax liability "for the taxable year of the discharge." 26 U.S.C. § 108(b)(4)(A). Further, for S corporations the reductions apply "at the corporate level." 26 U.S.C. § 108(d)(7)(A). Because neither Pugh nor Epoch had unused net operating losses or carryover losses, the offset does not apply directly to this case. However, the Commissioner argues that these provisions show Congress's intent for COD income to stop at the corporate entity and not pass through to S corporation shareholders. To address this argument, we must consider how § 108 applies to S corporations in particular.

Effect on S Corporation Pass-Through.

In the case of S corporations, § 108's exclusion (and reduction of tax attributes) "shall be applied at the corporate level." 26 U.S.C. § 108(d)(7)(A). Further, "any loss or deduction which is disallowed for the taxable year of the discharge under section 1366(d)(1)"-that is, losses normally belonging to the shareholders themselves-"shall be treated as a net operating loss for such taxable year." 26 U.S.C. § 108(d)(7)(B).

This language, standing alone, does not explicitly trump the usual S corporation pass-through rules. All income that flows through an S corporation begins "at the corporate level." Nothing in § 108 expressly marks COD income for special bottlenecking-that is, that COD income "at the corporate level" means "at the corporate level and no further." To see whether COD income passes through to S corporation shareholders, we must inquire whether COD income is an "item of income ... the separate treatment of which could affect the liability for tax of any shareholder." 26 U.S.C. § 1366(a)(1).⁷

The Commissioner's position is that COD income does not pass through under § 1366(a)(1) because it is not an item of income that can pass to shareholders. The Commissioner argues that § 108 is merely a tax deferment provision, and that COD income not used to reduce corporate tax attributes becomes a nullity. The Commissioner relies on legislative history to show Congress's intent that once a taxpayer reduces its tax attributes, "Any further remaining debt discharge ... does not result in income or have other tax...