U.S. v. Farley, 99-3209

• Decision Date: 27 January 2000
• Docket Number: No. 99-3209,99-3209
• Citation: 202 F.3d 198
• Parties: (3rd Cir. 2000) UNITED STATES OF AMERICA, v. HAROLD D. FARLEY; GAIL D. FARLEY, APPELLANTS
• Court: U.S. Court of Appeals — Third Circuit

Page 198

202 F.3d 198 (3rd Cir. 2000)

UNITED STATES OF AMERICA, v. HAROLD D. FARLEY; GAIL D. FARLEY, APPELLANTS

No. 99-3209

U.S. Court of Appeals, Third Circuit

Argued October 28, 1999

Filed January 27, 2000

Appeal from the United States District Court for the Western District of Pennsylvania District Judge: Honorable Maurice B. Cohill, Jr., (D.C. Civil Action No. 97-cv-00308E)

Harry Litman, Esquire United States Attorney Loretta C. Argrett, Esquire Assistant Attorney General Teresa E. McLaughlin, Esquire Edward T. Perelmuter, Esquire (Argued) Annette M. Wietecha, Esquire United States Department of Justice Tax Division P.O. Box 502 Washington, D.C. 20044, for Appellee.

Joseph J. Haspel, Esquire (Argued) Stein, Riso, Haspel & Jacobs 254 South Main Street New City, NY 10956, for Appellants.

Before: Mansmann, Roth, and Weis, Circuit Judges

Roth, Circuit Judge

This case presents a question of statutory interpretation; its facts are not disputed. The appellants, Harold and Gail Farley, are taxpayers and owners of two separate S corporations. The Farleys obtained income tax refunds from the Internal Revenue Service in late 1995 and early 1996 after filing amended tax returns for the years 1989, 1990, 1992 and 1993. They obtained these refunds after adjusting the basis of their S corporation stock upward to account for discharge of indebtedness income excluded from gross income due to the insolvency of their S corporations. By increasing the basis of their S corporation stock, the Farleys were able to take deductions for losses that had been previously suspended. The recognition of these suspended losses resulted in a reduction of the Farley's tax liability for 1989, 1990, 1992 and 1993. In addition, through the same increase in basis, the Farleys were able to take advantage of losses in 1995 resulting in an additional reduction of tax liability. The I.R.S. issued refunds, reflecting these adjustments, but later decided that the Farleys could not utilize discharge of indebtedness income to increase the basis of their S corporation stock. As a consequence, the I.R.S. concluded that the Farleys were not entitled to deductions for their suspended losses and thus were not entitled to the refunds issued in late 1995 and early 1996.

The Government subsequently brought suit in District Court to recover these refunds. Both parties moved for summary judgment. The District Court, relying primarily on Nelson v. Commissioner, 110 T.C. 114 (1998), granted the Government's motion for summary judgment. The Farleys appeal the District Court's grant of summary judgment.

Because we find that the District Court misinterpreted the relevant statutes in disallowing the refunds obtained by the Farleys, we will reverse the grant of summary judgment and remand this case to the District Court to enter judgment in favor of the Farleys.

I. FACTS

In 1986, the Farleys invested $200,000 and received fifty percent of the stock of two S corporations, SCI Acquisition, Inc. ("SCI") and CCI Camping Corporation ("CCI") (hereinafter referred to collectively as the "Farley S Corporations"). In 1986 and 1987, the Farley S Corporations incurred losses, which for tax purposes passed through to the Farleys. See 26 U.S.C. S 1366(a)(1) ("In determining the tax under this chapter of a shareholder for the shareholder's taxable year in which the taxable year of the S corporation ends... there shall be taken into account the shareholder's pro rata share of the 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....").¹ As a result of these losses, by the end of the 1987 tax year, the Farleys' S corporation stock had a zero basis.² From 1987 through 1992, the Farley S Corporations continued to incur losses. Because the Farleys' S corporation stock had a zero basis, the Farleys reported these losses as suspended losses on their tax returns (the "Suspended Losses"). See 26 U.S.C. S 1366(d)(1)(A) ("[The] aggregate amount of losses and deductions taken into account by a shareholder under [S 1366(a)] for any taxable year shall not exceed... the adjusted basis of the shareholder's stock in the S corporation."); 26 U.S.C. S 1366(d)(2) ("Any loss or deduction which is disallowed for any taxable year by reason of [S 1366(d)(1)] shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder.").

In 1992, the Farley S Corporations ceased operating due to their continued losses, and, as a result, the Farley S Corporations' secured creditors foreclosed on the assets of SCI and CCI. All debt not satisfied by the sale of these assets was forgiven by the secured creditors, resulting in discharge of indebtedness income (also known as cancellation of debt income) to the Farley S Corporations (the "COD Income"). From this point on, the Farley S Corporations were insolvent, and, as such, the COD Income was excluded from gross income. See 26 U.S.C. S 108(a)(1)(B).

On or around April 15, 1990, the Farleys filed their income tax return for the 1989 tax year. The 1989 Return disclosed a tax liability of $67,507, which the Farleys paid. On or around April 15, 1991, the Farleys filed their income tax return for the 1990 tax year. The 1990 Return disclosed a tax liability of $112,553, which the Farleys paid. On or around April 15, 1993, the Farleys filed their income tax return for the 1992 tax year. The 1992 Return disclosed a tax liability of $42,936, which the Farleys paid. On or around April 15, 1994, the Farleys filed their income tax return for the 1993 tax year. The 1993 Return disclosed a tax liability of $44,748, which the Farleys paid. Finally, on or around October 11, 1996, the Farleys filed their income tax return for the 1995 tax year. The 1995 Return disclosed a tax liability of $0.

On September 1, 1995, and January 12, 1996, the Farleys filed amended tax returns for tax years 1989, 1990, 1992 and 1993 (together, the "Relevant Tax Years"). As a part of the Amended Returns, the Farleys claimed refunds for the Relevant Tax Years as follows: 1989--$67,507; 1990 --$64,522; 1992--$42,936; and 1993--$44,748.

The Amended Returns were premised on an increase in the tax basis of the Farleys' S corporation stock as a consequence of COD income. Through this increase in tax basis, the Farleys were able to recognize the Suspended Losses and consequently reduced their tax liability for each of the Relevant Tax Years. In addition, through the same increase in basis, the Farleys were able to take deductions for losses in the 1995 tax year. The I.R.S. issued refunds in the amounts claimed by the Farleys (the "Relevant Refunds").

Shortly thereafter, in two undated letters (the"30 Day Letters") from Frank P. Nixon, District Director of the I.R.S., by I.R.S. Agent Robert V. Grosso, the I.R.S. proposed certain assessments. Along with the 30 Day Letters, the Farleys were provided with a series of reports authored by Grosso, which concluded that the Relevant Refunds were erroneously issued and therefore the Refund Claims were disallowed. According to the Grosso Reports, pursuant to the controlling statutes, the Farleys could not increase the tax basis of their S corporation stock even though the Farley S Corporations had discharge of indebtedness income; they could not, therefore, recognize the Suspended Losses; and ultimately they could not claim refunds for the Relevant Tax Years nor take a deduction for the losses in 1995.

The 30 Day Letters proposed tax liability as follows: 1989--$67,507; 1990--$64,522; 1992--$42,918; 1993--$44,748; and 1995--$92,980. By agreement between Grosso and the Farleys' accountant, the parties set July 31, 1997, as the last day to protest the issues raised by the 30 Day Letters. The Farleys promptly protested the assessments in the 30 Day Letters, and shortly thereafter the Government brought suit in U.S. District Court for the Western District of Pennsylvania seeking recovery of the Relevant Refunds.

In District Court, the Farleys moved for summary judgment, and the Government cross-moved for summary judgment. In their initial motion for summary judgment, the Farleys relied primarily upon Winn v. Commissioner, 73 T.C.M. (CCH) 3167 (1997) (Winn I). Winn I was squarely on point and supported the Farleys' position, but the Tax Court chose to re-visit the issue en banc in a different case, Nelson v. Commissioner, that presented the same question. After re-visiting the issue, the Tax Court's opinion in Winn I was withdrawn and superseded by a subsequent opinion issued the same day as the Tax Court's opinion in Nelson v. Commissioner. See Winn v. Commissioner, 73 T.C.M. (CCH) 3167 (1997) withdrawn and superseded by Winn v. Commissioner, 75 T.C.M. (CCH) 1840 (1998); Nelson v. Commissioner, 110 T.C. 114, 130 (1998). Relying on Nelson, which was affirmed by the Tenth Circuit Court of Appeals, the District Court in this case granted the Government's motion for summary judgment. See United States v. Farley, 99-1 U.S.T.C. P 50, 370 (1999); see also Nelson v. Commissioner, 182 F.3d 1152, 1152-53 (10th Cir. 1999) ("For the same reasons outlined in our published opinion filed today in Gitlitz v. Commissioner... we affirm the decision of the Tax Court."); Gitlitz v. Commissioner, 182 F.3d 1143, 1151 (10th Cir. 1999) (holding that discharge of indebtedness income excluded from gross income under 26 U.S.C. S 108(a) does not pass through to the shareholders of an S Corporation and thus does not increase the shareholder's basis in their S corporation stock). The Farleys appeal the District Court's ruling.

II. JURISDICTION

This action was filed by the Government pursuant to section 7405(b) of the Internal Revenue Code. Section 7405(b) of the Internal Revenue Code provides the Government with a civil cause of action to recover taxes "erroneously refunded." 26 U.S.C. S 7405(b); see, e.g., ...