FILED

U.S. COURT OF APPEALS

ELEVENTH CIRCUIT

JUNE 5 2000

THOMAS K. KAHN

CLERK

[PUBLISH]

IN THE UNITED STATES COURT OF APPEALS

FOR THE ELEVENTH CIRCUIT

________________________

No. 99-12646

________________________

T. C. Docket No. 27237-96

JAMES H. PUGH, JR. and ALEXIS PUGH,

Petitioners,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

________________________

Appeal from a Decision of the United States Tax Court

_________________________

(June 5, 2000)

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
 1

Mr. Pugh’s wife Alexis is party to the appeal solely because she filed joint returns with her

husband for the years at issue. 

2

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-ofdebt (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
 2

On Pugh’s personal return, he reported his distributive share of Epoch’s ordinary losses

($199,857) and an additional loss of $100,000. Taking only these loss adjustments into account,

Pugh’s basis was $394,802 at the end of 1990. 

 3The Tenth Circuit affirmed Nelson on the rationale of its opinion in Gitlitz v. Commissioner,

182 F.3d 1143 (10th Cir. 1999), cert. granted, __U.S.__, 68 U.S.L.W. 3497 (May 1, 2000) (No.

99-1295). See Nelson v. Commissioner, 182 F.3d 1152 (10th Cir. 1999).

3

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
 4

See 26 U.S.C. §§ 165(b), 1001(a), 1011. 

4

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
 5

The proper treatment of an S corporation’s COD income has been the subject of much

discussion by the courts and commentators. The Supreme Court has granted certiorari review in

one case, with two petitions for certiorari review pending as of the date of this opinion. See

Gitlitz v. Commissioner, 182 F.3d 1143 (10th Cir. 1999), cert. granted, __ U.S. __, 68 U.S.L.W.

3497 (May 1, 2000) (No. 99-1295); United States v. Farley, 202 F.3d 198 (3d Cir.), petition for

cert. filed, 68 U.S.L.W. 3670 (U.S. Apr. 17, 2000) (No. 99-1675); Witzel v. Commissioner, 200

F.3d 496 (7th Cir.), petition for cert. filed, (U.S. Apr. 17, 2000) (No. 99-1693); see also Nelson

v. Commissioner, 182 F.3d 1152 (10th Cir. 1999); Hogue v. United States, 85 A.F.T.R.2d 2000-

426 (D. Ore., 2000) (No. 99-302-K1, Jan. 3, 2000). For commentary, see, e.g., Richard Gore,

Quandary for S Corp. COD Income Pass-Throughs, 56 Tax’n for Acct. 157 (1996) (discussing

dilemma that accountants face in advising their clients on COD treatment); Richard M. Lipton,

Different Courts Adopt Different Approaches to the Impact of COD Income on S Corps., 92 J.

Tax’n 207 (2000); Richard M. Lipton, The Impact of Excluded COD Income on S

Shareholders–The 10th Cir. Gets Lost in Gitlitz, 91 J. Tax’n 197 (1999); Richard M. Lipton, Tax

Court Rejects S Corp. Basis Step-Up for COD Income in Nelson, 88 J. Tax’n 272 (1998); James

D. Lockhart & James E. Duffy, Tax Court Rules in Nelson that S Corp. Excluded COD Income

Does Not Increase Shareholder Basis, 25 Wm. Mitchell L. Rev. 287 (1999); Stephen R. Looney,

S Corp. Prop. Regs. – No Surprises, but Two Potentially Controversial Provisions, 90 J. Tax’n

69 (1999) (discussing controversy surrounding IRS’s position on treatment of COD income). 

5

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 (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.
6

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 passthrough 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. 
7

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 (1991); United States v. Kirby

Lumber Co., 284 U.S. 1 (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
 6

“‘Insolvent’ means the excess of liabilities over the fair market value of assets.” 26 U.S.C. §

108(d)(3). No one disputes that Epoch was insolvent. 

8

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). 
 7

S corporation shareholders also include in their income “nonseparately computed income or

loss.” 26 U.S.C. § 1366(a)(1)(B). This provision does not apply here because “nonseparately

computed income” means gross income (less the corporation’s deductions), see 26 U.S.C. §

1366(a)(2), and Epoch’s COD income was excluded from gross income. See 26 U.S.C. §

108(a)(1).

9

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
10

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

consequences.” S. Rep. No. 96-1035, at 2 (1980), reprinted in 1980 U.S.C.C.A.N.

7017. 

If the S corporation cannot use the COD income to reduce attributes, the

Commissioner argues, it never flows through to the S corporation’s shareholders. 

This position was expressed by Judge Beghe in his concurrence in Nelson, 110

T.C. at 131-132 (Beghe, J. concurring) (opining that an insolvent S corporation’s

COD income could not pass through to a solvent shareholder and the “equivalence

rule of section 1366(b)” could not apply).

But as the Third Circuit pointed out, “This statement, made without

elaboration by Judge Beghe, is simply incorrect.” United States v. Farley, 202

F.3d 198, 208 (3d Cir. ), petition for cert. filed, 68 U.S.L.W. 3670 (U.S. Apr. 17,

2000) (No. 99-1675). The Commissioner’s argument ignores the clear language of

§ 1366, which provides that all items of corporate income that could affect

shareholders’ tax liability pass through to them as if “incurred in the same manner

as incurred by the corporation.” See 26 U.S.C. § 1366(a)(1)(A), (b). Accordingly,

the Commissioner’s argument has been rejected by every circuit that has
11

considered it. See Farley, 202 F.3d at 205 n.4 (“the language of section

108(b)(4)(A) is clear and unambiguous . . . COD income excluded from gross

income under section 108 passes through to the S corporation’s shareholders”);

Witzel v. Commissioner, 200 F.3d 496, 498 (7th Cir.) (noting that COD income

flows through to S corporation shareholder), petition for cert. filed (U.S. Apr. 17,

2000) (No. 99-1693); Gitlitz v. Commissioner, 182 F.3d 1143, 1148 (10th Cir.

1999) (“the items must pass through to shareholders unless they are absorbed by

tax attribute reductions”), cert. granted, ___ U.S. ___, 68 U.S.L.W. 3497 (May 1,

2000) (No. 99-1295). 

One important difference, however, separates Pugh from the taxpayers in the

above cases. Gitlitz, Witzel and Farley all personally carried suspended losses into

the years their corporations received COD income. See § 1366(d)(1) and (2)

(requiring that S corporation shareholders carry over losses that exceed their

adjusted basis in their S corporation stock). A suspended loss “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.” 26 U.S.C. § 108(d)(7)(B). Therefore,

Gitlitz, Witzel and Farley–either in the year of discharge or in years

thereafter–potentially faced direct changes in their tax liability relating to their
 8

See Gitlitz, 182 F.3d at 1150 n.6 (setting out illustrative examples, including Examples 3

and 4, where taxpayer’s suspended losses are characterized as part of the S corporation’s net

operating losses); Witzel, 200 F.3d at 498 (holding that shareholder’s suspended losses are

“offset at the corporate level by the amount of his corporation’s COD income”); Gore, supra

note 5 (“Because Section 108 may reduce a shareholder’s suspended losses, the COD income

must pass through to the shareholders.”). Contra Farley, 202 F.3d at 205 (COD income “shall

be applied to reduce the tax attributes of the corporation, rather than the individual

shareholder”). The Farley court further noted that even if § 108(d)(7)(B) required a

shareholder’s suspended losses to be considered as net operating losses, “nowhere does section

108(d)(7)(B) indicate that S corporation [COD] income should reduce such net operating losses

‘for the taxable year of discharge.’” Id. at 207 (quoting 26 U.S.C. § 108(d)(7)(B)). See also

Lockhart & Duffy, supra n. 5, at 299 (“Section 108(d)(7) does not operate to convert shareholder

suspended losses into S corporation NOLs. . . . Section 108(d)(7)(B) provides the mechanism by

which the shareholder attribute (suspended losses) will be subject to the existing corporate

attribute reduction regime under 108(b)(2)(A).”). Because Pugh possessed no suspended losses,

we need not today reach the issue of how to treat an S corporation shareholder’s suspended

losses.

 9See 26 U.S.C. § 1366(b) (pass-through income is characterized “as if such item were

realized directly from the source from which realized by the corporation”).

 10The Tenth Circuit appears to consider that COD income cannot pass through to

shareholders without suspended losses, as shown by its affirmance in Nelson, where the

shareholder had no suspended losses, and as shown in one of the examples the court used to

illustrate its reasoning in Gitlitz. See Gitlitz, 182 F.3d at 1150 n.6 (Example 1).

12

suspended losses.8 By contrast, when Pugh’s S corporation realized its COD

income, Pugh had no suspended losses. Even if Pugh treated Epoch’s COD

income as his own,9

 it would not have altered his tax liability directly because he

possessed no suspended losses to be affected. Therefore, Epoch’s COD income

does not at first blush fall within the category of items of income to be passed

through to Pugh. See 26 U.S.C. § 1366(a)(1)(A) (allowing for pass-through of

“items of income . . . which could affect the liability for tax of any shareholder”).10
 11In Farley and Witzel, the Commissioner argued that § 108 income was not tax-exempt but

only tax-deferred, because it would eventually be offset against tax attributes. See Farley, 202

F.3d at 209-10 (rejecting argument); Witzel, 200 F.3d at 498 (rejecting argument and similar

dicta of United States v. Centennial Sav. Bank, 499 U.S. 573, 580 (1991) (although the Supreme

Court described § 108 income as tax-deferred, it did so in passing while interpreting a nowdeleted provision of § 108). 

The IRS does not treat § 108 income as tax-exempt in its final regulations. See 26 C.F.R.

§ 1.1366-1(a)(2)(viii):

[T]ax-exempt income is income that is permanently excludible from gross income

13

Of course, the COD income ultimately affects Pugh’s tax liability by

flowing through under § 1366 and thus increasing Pugh’s basis pursuant to §

1367(a)(1)(A). In addition, § 1366(a)(1) does allow one type of income to pass

through that might not affect taxpayers’ liability initially, namely “tax-exempt

income.” 26 U.S.C. § 1366(a)(1)(A). Congress provided for pass-through of taxexempt income to preserve its nature: if tax-exempt income did not flow through

under § 1366 and increase shareholders’ bases, they would have to pay tax when

they sold their stock. See 11 Jacob Mertens, Law of Fed. Income Taxation §

41B:154 (“A shareholder’s increase in basis for tax-exempt income allows the

shareholder to avoid recognition of gain as a result of receiving such income

(reduced by any distributions) upon the sale of such stock.”). 

The Commissioner argues that COD income is not “truly” tax-exempt

because, unlike other sources of tax-exempt income, COD income is never

distributed to shareholders with a corresponding reduction in basis.11 This
in all circumstances . . . .For example, income that is excludible in gross income

under section 101 (certain death benefits) or section 103 (interest on state and

local bonds) is tax-exempt income, while income that is excludible from gross

income under section 108 . . . is not tax-exempt income.

Id. The regulations became effective August 18, 1998 (see 64 FR 245) and do not apply to this

case; accordingly, we do not address their validity. 

 12This point is made by Lockhart & Duffy, supra n.5, at 304 (“in light of the identical

statutory language of Sections 101 and 108, it is unclear why” COD income should be treated

differently than insurance proceeds).

14

distinction is not supported by the plain language of the Code, which simply

designates “tax-exempt” income without any limitation on whether or not the

income eventually becomes distributed to shareholders. See 26 U.S.C. §

1366(a)(1)(A).

The COD exemption is located in the part of the Code titled “Items

Specifically Excluded from Gross Income.” This section includes various types of

tax-exempt income, such as tax-exempt bond income and life insurance proceeds. 

See 26 U.S.C. §§ 101-136. The language in § 108 excluding COD income from

gross income is virtually identical to that in other sections. Compare 26 U.S.C. §

108(a)(1) (excluding COD income from gross income) with 26 U.S.C. § 101(a)(1)

(excluding life insurance proceeds from gross income).12 Nothing in the Code

distinguishes COD income from its cohort as being not “really” tax-exempt. 

This is particularly true here, where neither Epoch nor Pugh possessed tax

attributes to offset the tax-exempt status of Epoch’s COD income. As Judge
 13The circuits are split on whether the tax attribute reduction occurs at the corporate level

before the pass-through, e.g., Witzel, 200 F. 3d 496; Gitlitz, 182 F.3d 1143; or whether the

reduction occurs after the pass-through of COD income; see Farley, 202 F.3d 198. Because

neither Pugh nor Epoch possessed tax attributes to reduce, we need not reach the issue.

 14See 26 U.S.C. §§ 165(b), 1001, 1011.

15

Posner noted, absent suspended losses, COD income flows through to S

corporation shareholders “tax exempt in the fullest sense.” Witzel, 200 F.3d at 498.

See also Farley, 202 F.3d at 210 (acknowledging Commissioner’s concession that

“discharge of indebtedness income is sometimes tax-exempt”); Gitlitz, 182 F.3d at

1147 n.3 (“If a taxpayer’s attributes are insufficient to absorb all of his cancellation

of indebtedness income, § 108 effectively provides a permanent exception from

taxation on that income.”). We join these circuits in ruling that an S corporation’s

COD income passes through pro rata to its shareholders under § 1366(a)(1),13 and

add that this is so even when the shareholder possesses no suspended losses to

offset the COD income. 

2) Increase in Basis.

The real sticking point, of course, is not whether Pugh can include Epoch’s

COD income as an item of income, but whether he can take a personal capital loss

deduction boosted by his share of that same COD income. Pugh’s loss deduction

is determined with reference to his basis;14 the question thus is whether Pugh can

increase his basis to reflect the passed-through COD income. 
16

In general, S corporation shareholders’ initial basis corresponds to their cost

of the stock plus capital contributions. See 26 U.S.C. §§ 1011-1016; 11 Jacob

Mertens, Law of Fed. Income Taxation § 41B:147. Shareholders’ basis in their S

corporation stock increases by “the items of income described in subparagraph (A)

of section 1366(a)(1)” and decreases by “the items of loss and deduction described

in subparagraph (A) of section 1366(a)(1).” 26 U.S.C. § 1367(a). These “items of

income” include not only gross income but also other types of income, including

tax-exempt income. See 26 U.S.C. § 1366(a)(1); Farley, 202 F.3d at 206; Witzel,

200 F.3d at 498; 15 Collier on Bankruptcy ¶ TX6.03[5][c] (“If discharge income is

excluded at the S corporation level under I.R.C. Section 108(a), the shareholders

should be entitled to increase the basis of their stock and debt under I.R.C. Section

1367 for their ratable share of excluded income. Under a plain reading of the

statutory language, a step-up in basis is allowed for all income, including taxexempt income.”) Therefore, § 1367 requires that Pugh’s basis be increased by the

amount of COD income that passed through to him from Epoch. 

We recognize that this statutory scheme can lead to the result that

shareholders actually benefit from their S corporations’ insolvency. Not only do

they avoid taxation on the corporation’s COD income, but also they may receive

capital loss deductions based on their share of the COD income. This jars with the
17

general rule that basis should increase only to the extent of a taxpayer’s actual

“economic outlay.” See, e.g., Sleiman v. Commissioner, 187 F.3d 1352, 1357

(11th Cir. 1999) (quoting Selfe v. United States, 778 F.2d 769, 772 (11th Cir.

1985)); see also Gitlitz, 182 F.3d at 1151. 

Normally, basis increases to the extent the taxpayer reports income from the

S corporation; otherwise, the taxpayer would pay double tax upon receiving a

distribution or selling the shares. See 26 U.S.C. § 1367(a)(1)(A). But if the S

corporation receives tax-exempt income that passes through to the shareholder, the

shareholder’s basis is increased to preserve the tax-exempt nature of the income. 

See id., 26 U.S.C. § 1366(a)(1)(A). This is so even without an “economic outlay”

by the shareholder. See, e.g., Farley, 202 F.3d at 207 n.5 (noting that “numerous

exceptions” to economic outlay rule exist, including treatment of COD income as

well as life insurance benefits and tax-exempt bond income: “section 108 cannot be

distinguished from sections 101 and 103 on the basis of economic outlay

considerations”); Lockhart & Duffy, supra n.5, at 304 (noting that in light of

identical statutory language, “it is unclear why the absence of an economic outlay

results in excluded COD income being treated differently”); cf. CSI Hyrdostatic

Testers, Inc. v. Commissioner, 62 F.3d 136 (5th Cir. 1995) (adopting Tax Court’s

rejection of argument that S corporation’s parent should not receive benefit of
 15See Farley, 202 F.3d at 212 n.10.

18

subsidiary’s COD income because parent had not “paid for” it (see 103 T.C. 398,

409 (U.S. Tax Court 1994))); but see Gitlitz, 182 F.3d at 1151 (distinguishing COD

income because taxpayer made no initial economic outlay).

The Commissioner argues that §§ 108, 1366 and 1367 should be read

together to prevent Pugh from enjoying twice the tax-exempt status of COD

income. We must acknowledge the justice of the Commissioner’s position, for

unlike other sources of tax-exempt income, COD income becomes tax-exempt

merely from the infelicitous combination of corporate insolvency and a lack of tax

attributes to offset the COD income. But we cannot ignore the language of the

statute, which clearly requires that all items of income included in § 1366 must be

used to increase the shareholder’s basis under § 1367. “The relevant question is

not whether, as an abstract matter, the rule advocated by petitioners accords with

good policy. . . . Courts are not authorized to rewrite a statute because they might

deem its effects susceptible of improvement.” Badaracco v. Commissioner, 464

U.S. 386, 398 (1984). While we agree with the Third Circuit that Congress may

not have intended the result dictated by the statute,15 we must leave rewriting the

Code to Congress.

CONCLUSION
19

Pugh is entitled to increase the basis in his Epoch stock by his pro rata share

in the corporation’s COD income for 1990. This case is REVERSED and

REMANDED for proceedings in light of this opinion.